Who Cares If Corporate Valuations Are Crazy?

The credit crunch may not have fazed tech startups much, but the recent turmoil in the global financial markets is worrying. Whether it’s eBay paying $4.1 billion for Skype in 2005 or, more recently, Microsoft deciding Facebook is worth $15 billion, the tail wagging the dog on outlandish valuations of Web 2.0 companies are corporate buyers and investors.

Unlike the venture-fueled overvaluations that led to the dot-com crash, misplaced corporate optimism shouldn’t lead to a nuclear winter for tech, but if M&A dries up, VCs will likely be quick to cut funding for me-too sites that can’t find buyers.

Venture investment hasn’t been too crazy of late, but investors set valuations by looking at what people have paid for similar companies or how IPOs have fared. When VMWare gets a $31 billion market cap or Citrix pays 500 times revenue for XenSource, for example, virtualization valuations go through the roof. But if startups need VCs need to put in more cash, that valuation needs to keep rising. If not, it’s called a down round — and nobody likes those. That’s why one of the worst things to do as a startup is to raise VC money at too high of a valuation.

But in today’s world, corporate buyers and investors are resetting the crazy meter on valuations. First off, corporate buyers and investors generally don’t shell out for a business unless it makes some sort of strategic sense to its executives. That strategic element automatically takes it out of the realm of pure financial consideration.

In the case of Microsoft assigning a $15 billion valuation to Facebook based on its $240 million investment, part of the allure was to get a stake in the social network for the value it may eventually bring to the company. Ballmer and Co. don’t care about recouping their Facebook investment in the public market, all they care about is getting a relationship with one of the fastest-growing Internet startups and a say in how (and with whom) it grows its advertising business.

Not only can strategic importance drive valuation through the roof, if those lofty expectations don’t hold true, corporate buyers aren’t punished by their inattention to reason. For an example of what happens when a corporate buyer overvalues something and later admits it, look no further than eBay.

When eBay said it would pay up to $4.1 billion for Skype, folks looked at the supposed benefits of eBay offering a “click-to-call” service to seal auctions and scoffed, but judging from eBay’s stock price, investors were ambivalent about the deal. Although eBay’s stock opened down 1.5 percent on Sept. 12, 2005, the morning it announced its deal with Skype, it ended that day with a nearly 1 percent rise.

On Oct. 1 of last year, eBay wrote down $1.43 billion of the value associated with the Skype deal, essentially admitting that it overpaid — yet its shares closed up 1.6 percent. Corporate buyers can encourage bubbles by paying too much, but can generally weather the pop.

But for video startups who raised money based upon the valuations set by Google when it bought YouTube for $1.6 billion, or the open-source startups out there checking out MySQL’s eye popping $1 billion price tag on what’s reported to be about $50 million in 2006 sales, the party may be dragging to an end. Slide’s recent $550 million valuation set by private equity funds notwithstanding, free-spending strategic buyers are showing signs of coming to their senses, so valuations may be coming down.

It might not be as bad as a bursting bubble, but everyone hates to see a party come to an end.