Is There a Valuation Bubble for Social Media Companies (and if so, is it Bursting)?

bubble poppingWelcome to the latest passionate debate over the ‘valuation bubble or not?’ question in venture capital.  This time, the debate centers on the “favored few” Social Media venture backed companies that have brought tremendous windfalls to a select group of venture funds and management teams, both pre- and post-IPO.  Does the primary and secondary capital raising prowess of companies such as Facebook, Linked In, Pandora, Twitter, Groupon, Zynga, and others, mean that we have finally crossed the threshold and reached a sustainable new valuation paradigm (it’s different this time, really), or is this another accident now happening in real time?

Capital Markets Advisory Partners cleaves the demand for pre-public VC-backed equities into two worlds: “Demand Pull (Buzz) and Supply Push (No Buzz) companies. The former includes the Twitters, Facebooks, Linkedins, Tesla Motors of the World and the latter is the 95% of companies (B2B SaaS, Semiconductors, Cap Equipment, Biotech, MedTech, etc) that need to be marketed (Supply Push) by legions of brokers. … We have a stock market that works for one kind of buzzy (Demand Pull) stock but is a disaster for the rest of the economy. The problem is, that it is the capital intensive stocks in manufacturing that create most of the jobs and these companies are overwhelmingly “Supply Push.” While this post is about the Demand Pull companies, we should all be focused on the Supply Push companies if we want to move the needle on job creation, risk taking, and new venture formation in America.

In April 2011, just prior to the Linked In, Pandora, and RenRen IPO’s, Fred Wilson reaffirmed his belief on his blog that we were not in a bubble in this sector: “In all the posts over the past year or so outlining my thoughts on the financing and valuation environment in the internet sector, I’ve avoided using the word Bubble. It is intentional. For me Bubble will always be inexorably linked to what went down in 1999 and 2000 in the internet sector. And I agree with Mike Arrington that what is going on now is different. I do not think we are in a Bubble per se.”

On August 11, 2011 Dan Primack wrote on this topic in Term Sheet and concluded differently: “I believe that the current Internet bubble is economic. Specifically, too much money has gone into VC-backed Internet companies at too high a valuation. It has been a private market phenomenon much more than a public market one”.

I agree with Dan Primack’s conclusion, largely because the overvaluation omelette has been scrambled in illiquid, non-public grey markets for both primary and secondary capital.  These markets are not yet well developed and remain asymmetric.  Consequently, values for “hot” companies have a greater likelihood of being inflated because the basic nature of the process brings out more buyers than sellers, and it only offers access to a small subset of high profile companies.

Subsequently, the IPO underwriters for these companies that won the business did so by successfully setting IPO premiums to these private valuations and telling a story that the public IPO buyers bought.  Because over 70% of daily trading activity is driven by rapid turnover funds, public market valuations at any given point in time are even less indicative of fundamental enterprise value than they ever have been. David Weild of Capital Markets Advisory Partners and former Vice Chairman of NASDAQ concludes that, beginning in 1999 The self-directed market, gratis of the Internet itself, took the IPO market from one intermediated exclusively by professionals to one frequently dominated by unpredictable gunslingers.”

The combination of hype and the fact that, at least initially, there were more buyers than sellers for these “hot” IPO’s, is how these deals got done.  Short-term trading patterns even allowed some people to make money from the IPO’s themselves—most likely the public market winners circle is largely comprised of those short-term high velocity traders that pay most of the commissions to the underwriting firms…

An important point that Fred Wilson did make in his April post is that investors should recognize that the current valuation environment will not exist at some point in the future. The companies we invest in will need to grow into these valuations or we will face writedowns and writeoffs. We should not let the greed emotions cloud our judgement. Yes, that hot deal sure looks damn good right now. But deals are actually companies and most venture investments are held for five to seven years.”  I would add, however, that, in my view, the valuations at which VCs invested in these “hot” social media companies are precisely the product of “greed emotions”.  It is also now evident that these inflated valuations have not proven to be sustainable in the public markets.  I will post separately on valuation metrics and the implications of the dichotomy between recent public company valuations and merger & acquisition statistics.

One collateral effect of inflated valuations in hot sectors has been an increase in pre-money values across the board, which is not a good thing for whoever is the “last one in” when the music stops.  This is similar in effect to the epic 1996-2000 Internet Bubble cycle but for the expansion of the players in the pre-IPO inner bubble circle.

As Primack points out in his post: “Law firm Fenwick & West reports that valuations for Silicon Valley venture financings rose 61% in Q4 2010. This was the sixth straight quarter in which their barometer showed an average valuation increase, including a 28% bump the prior quarter. Thomson Reuters data indicates that pre-money valuations for VC deals in the U.S. tech sector have more than doubled since 2007. MoneyTree reports that “Internet-specific” companies raised more first-round VC dollars in Q2 2011 than in any other quarter since Q4 2000.”

Company valuations cannot defy gravity indefinitely, and I roundly reject the notion that a new valuation paradigm has been defined for Social Media companies or anything else (including Gold). The music has now paused, though it may not have stopped, for the favored few.  For the other companies that comprise 95% of the venture-backed universe, the music never started.

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