Froth or Famine?

Let’s be serious – EVERYBODY is wondering if there is another shoe to drop in the Great Internet Gold Rush of 2011. $6 billion for Groupon? Nah, too low. Something between $8-$10 billion for Twitter? Sure, why not? Eight-figure pre-money valuations for numerous West Coast consumer web start-ups? Hey, it’s just supply and demand, and besides which, they DID go through YCombinator. $50 billion+ for Facebook? How about $70 billion in a handful of trades on SecondMarket. Even $315 million for HuffPo. Is AOL nuts? What’s up?

There is a strong desire to characterize the market in a homogenous way, e.g., “We’re in a bubble” (Fred Wilson) or “Valuations are reasonable” (Chris Dixon). Bottom line, this doesn’t begin to explain the variations observed in nature. There is a world of difference between Quora and Facebook, YCombinator start-ups and Groupon, every “social shopping” start-up and Twitter. One needs to look beyond the headlines and ask “What is REALLY going on here?”

Great franchises cannot always be valued purely on the basis of revenue or current cash flow. This isn’t sophistry, it’s simply reality. When Google paid $1.65 billion for YouTube, many thought this was merely a symbol of having way too much cash to spend on something irrational which it coveted. Fast forward, Google has had to pump hundreds of millions into integrating and scaling the YouTube platform, but will this acquisition pay off on an ROI basis? Google has created a unique property in one of the fastest growing segments of the online market, and they have the resources to take the long view. I bet it will turn out to have been a prescient deal for the company.

Facebook has effectively created a parallel Internet, fostering a level of engagement and stickiness Google would drool to have. Social, messaging, location, recommendations, commerce and more. Facebook also hosts the websites of millions of businesses globally. Are the levels at which Facebook is trading irrational? I have no idea what its fundamental value is, only what others are willing to pay. But there is no question that it represents a massive and rapidly growing franchise, a business that has immense competitive barriers and powerful network effects. It may well be worth what people are paying for it – and more. Its mid-11 digit valuation is certainly not indicative of a bubble.

Groupon? Please. The company is generating cash like a casino, except in a much more predictable manner. Was turning down $6 billion crazy? Not if you consider the valuation that it may well be able to claim via IPO. Given that its principals were able to take hundreds of millions off the table in the most recent financing, there is no reason for them to sell the company. They are in it to win it, and have the momentum to support its growth through an IPO and beyond.

Twitter is an enigma. A household name with an large and engaged user base. A powerful platform that has supported the growth of countless businesses on top of its pipes. A force for freedom, commerce and distribution. The revenue story is only just beginning at Twitter while rumors swirl about its eventual acquisition by either Facebook or Google for a reported $8-$10 billion. It has also had some legendary outages, and continues to crash on a fairly regular basis. Few revenues, iffy infrastructure, $10 billion. Really? Crazy? Well… Twitter, like Facebook is a unique property. It is the global connective tissue linking together millions of people across the globe, enabling the sharing of news, ideas, hopes, dreams, product reviews and offers. For some it has replaced newspapers, magazines and RSS as a vehicle for aggregating relevant information from trusted sources. For others it serves as a platform for sending messages to a targeted audience. Widespread adoption and brand are its competitive barriers, much as Bloomberg chat locked in hundreds of thousands of terminal subscribers for decades. In the hands of Facebook or Google, might a $10 billion price tag be rational from both economic and strategic perspectives? It may, indeed.

I can’t pretend to understand the valuations of many West Coast consumer web start-ups, and I won’t attempt to rationalize them here. There has been an explosion in the availability of seed stage capital in and around Silicon Valley, and I believe it has had a marked effect upon valuations of consumer-driven businesses in the region. As I’ve discussed previously, I do not believe there has been a parallel phenomenon in New York or Boston, and I don’t find the froth around Foursquare to be indicative of bubble-like behavior on the East Coast. Supply and demand appear to be out of whack among a segment of the West Coast seed stage universe, driving up valuations to what seem to be unsound levels, but the jury’s out.

All in all, I do not see pervasive bubble behavior among US-based technology companies. In fact, in several segments of the market and across myriad geographies, there appears to be a dearth of Series A capital available for investment. So depending upon where you’re standing, the tone of the market looks very different. Froth or famine? Both can be observed in nature. But deal discipline coupled with common sense can yield attractive values across much of today’s venture investing landscape.

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