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Who is right on internet valuations? Public markets or VCs?

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What do Facebook (s FB), Zynga (s ZYNG) and Groupon (s GRPN) have in common? Yes, they went public recently. Yes, they are all part of the grand web evolution. Yes, they have been growing really, really fast. Yes, they all are desktop-first companies struggling to find traction in an increasingly mobile world. Yes, they are buying up companies willy-nilly in order to figure out this mobile thing. However, there is one thing that really unites them: they were overvalued as private companies and after going public they have been presented with a reality check.

The latest to get that reality check in Zynga, which today saw its stock tank almost 40 percent to about 3 bucks a share in after-hours trading. The reason? It missed its second quarter 2012 revenue targets and painted a dismal picture for the near future. The sentiment on the company is quite negative on Wall Street.

ZNGA Chart

ZNGA data by YCharts

Same goes for Groupon, which was at one time offered $6 billion by Google and now has a market valuation of about $4.68 billion. Private investors are rumored to have valued Zynga between $7-to-$9 billion, but in public markets it is being valued at around $3 billion. Facebook was valued at $80 billion when it was private. These days, it is valued at around $62 billion.

It is hard to imagine a web without Facebook and its authentication system and it is only a matter of time before Facebook launches their version of an off-Facebook ad network, much like Google’s AdSense. So is it worth a $100 billion or $60 billion?

In reality, the big question that really comes to mind: are private investors (that is, VCs and late-stage investment groups) overvaluing the new-breed of Internet companies? Or is the public market not valuing them properly? The answer – private investors. Why? Because these fast-growing companies are getting nosebleed valuations from private investors without much regard for the business logic.

Is Pinterest is worth $1.5 billion? Who knows, but it will eventually grow into that valuation? Twitter is valued at $10 billion – which is great for them but in order to become a business to justify that (or higher) valuation, they need to do some crazy things, including going against their own core values. Private investors can convince themselves that they know better.

Now compare this with software companies that have gone public this year. In a recent report for his clients, Ted Tobiason of Deutsche Bank noted:

Twelve software deals priced year-to-date, continuing last year’s strong run. Nine of the twelve priced above their filed ranges and each of these is above issue. The sector’s median return is an impressive 41%. The median software deal priced at 3.6x forward sales versus 3.3x last year. The range at pricing extends from 1.6x for Exa to 7.8x for Splunk, with SaaS names in particular garnering significant focus from investors. Splunk is currently trading at 13.8x forward sales. After appreciating 65% from its IPO price of $17.

Software companies have other advantages that are important in volatile markets. Subscription-based models have much greater forward visibility in their businesses. While consumer-based Internet companies can have tremendous top-line growth opportunities, their businesses can be very difficult to forecast. And the point has been emphatically made recently that one of the challenges of creating a new market such as social media is that it is tough to predict consumer behavior and how things like the shift to mobile will impact revenues and margins.

It is hard to fault Ted’s logic. So, if there is any inefficiency in the market, I think it is how private investors value fast growing Internet companies. And the overvaluation starts early.

15 Responses to “Who is right on internet valuations? Public markets or VCs?”

  1. Mary Jesse

    A. Does right mean good investment and wrong mean poor investment? B. Or does right equal a “fair” value which implies a stable, sustainable business model? If A, unless the returns for the VCs and the public investors are compared over time, there is no way to truly know. If B, again only time will tell if the risks can be mitigated and these companies can continue their growth. Still I agree that even then, both sets of valuations are too high because they are driven in part by emotion and hype – there is no ROI for emotion and hype, unless you sell quickly to the next guy.

  2. Om,

    First, let me congratulate you on an excellent site and a very strong stable of writers.

    As to private vs. public market valuations, I think one point hasn’t been mentioned yet – the manipulation of what I’ll call “apparent market cap” by VCs.

    In my mind, reported “market cap” really translates into “market crap”.

    Even in the public markets, market cap can be extremely misleading because it suggests that a given company is worth, in toto, the total number of shares outstanding times the last share price paid – *regardless* of the *size* of that share purchase.

    But it is one thing to find a buyer(s) for 100 shares – it quite another to find buyer(s) for 100 million.

    But the dominant media image (carefully cultivated by market insiders, be they Sand Hill VC or Wall Street) is that “market cap” is somehow real/inviolate and utterly indicative of real economy significance (ignoring revenue, net income, etc.).

    This makes the system *much* easier to game by the insiders, since they can create news events/price spikes through the choreographed purchase of a small number of shares.

    At least in the public markets, there is *some* push-back against insider hype due to short sellers (although they are constrained in ways that the “upside artists” are not).

    But in the *private markets* that VCs inhabit/manipulate, there is a very, very, very carefully choreographed stair-step pattern of upward value manipulation through successive rounds – all in anticipation of the big IPO blow-off to retail bag-holders – the retail investors.

    Of course, the attempted price manipulation by VCs doesn’t always work – it often doesn’t, that is why down-rounds can be a death-knell.

    But in *hot* startups, successive rounds are very carefully choreographed, even, especially, as to the point of absurdly spiking market cap (which draws the media attention needed for the blow-off to retail) through comparatively small purchases of shares (percentage-wise).

    Again, it is one thing to say Facebook is worth $100 billion because .01% sold for $10 million (higher than the normal VC kabuki actually) and quite another to try and round up enough dumb money (retail investors and brain-dead institutions) to sell 25% (still nowhere near an actual 100%) for $25 *billion*.

    The former is stage-managed manipulation (and 99% of VC kabuki takes place at much lower numbers than Facebook) while the latter is nation-straddling market hyping. Their relative probability of success differs tremendously.

    The private exchanges were initially embraced by VCs because they *aided* the VC hype process by publicizing essentially illusory market cap numbers (lets call them “market crap numbers”).

    Go back and look at the puny volumes traded on those private exchanges – then compare those numbers to what Facebook tried to sell at IPO – then gird your loins to look at the shares coming (post multiple lockups and full dilution).

    So Facebook was worth $100 bazillion because some largely hidden buyer on paid $X for .0000000000000000001% of the company?


    Yes, the private secondary markets have painted VCs into a corner *but* it is a monster of their own manipulative creation.

    Look for a return to old school intra-VC stair-stepping rounds – where the market manipulation can be tidier and infinitely more hidden.

  3. Roham Gharegozlou

    People who say the public markets are efficient make me laugh. The sheer volatility (billions, sometimes trillions, of dollars gained and lost in a matter of hours) should prove that public markets are affected just as much (if not more) on imperfect signal, herd mentality, hype (both positive and negative), and excess liquidity. I see your point, Om, and it’s a great one backed up by research, but the situation is gray not black nor white.

  4. This is one more time we are debating valuations of internet companies. It’s hard not to get dejavu feeling. Valuation here is a function of imagination. Imagination of potential. In long run we can’t buy companies on these imaginary no.s and profitability has to be delivered to sustain the valuations.

  5. Come on. Fair value = what was actually paid; not what we think.
    Stocks go up and down. Tech companies are more volatile because of the intangible nature of the business. Plus young companies need tons of growth capital. Growth is expensive.
    Let’s allow these companies to breathe and see what happens.
    Linked In tanked shortly after its IPO (if I remember correctly). Now it’s booming.

  6. Semil Shah

    This analysis omits one possible motivation that likely impacts the whole — the ability to dump shares on secondary markets before IPO. Yes, many VCs do hold positions to and after IPO, but some do hedge positions with these alternative markets, and if so, that provides them an incentive to see the price go above FMV. [email protected]

  7. Healy Jones

    Most of the pumping up of these companies’ private valuations was not done by VCs; it was done in the private secondary markets. In fact, some VCs and early investors used these private secondary markets to exit some of their positions prior to the IPO. So I’m pretty sure I’d put a lot of the blame on the new secondary markets more than anything else

    The companies may also have gone public at pretty aggressive valuations. Perhaps they were forecasting better growth than they actually achieved? We’ll see about Facebook today, but the other two have unfortunately not hit their revenue and earnings expectations. That will ding any company’s public valuation.

    • Healy

      I agree to some extent but most of it is also over-the-top valuations offered by the clueless is now coming back to roost. Basically the private markets never really want to deal with the reality: a company eventually has to grow into its valuation and has to become a business. It is what is happening right now.

  8. You don’t need to rely on “rumored” valuations. Zynga did a private round at $14/sh so those VCs (including KP’s growth fund as buyers even as buyers even as the early stage fund sold) are 75% underwater. All described in the s-1.

  9. “Who is right on internet valuations? Public markets or VCs?”

    This question is rhetoric right? By definition, the public markets are right. Even when the public markets are “wrong”, overvaluing or undervaluing something in the short run they are — by definition — right. VCs operate in a market that is automatically inefficient and automatically, therefore, less right. Period.

    By the way, no company is worth 13.8x forward sales, even if the “correct” public market temporarily believes it is. But then, just ask Microsoft shareholders what happens when you hold a software trading at 9x revenues in 2002…

    • Mostly true except I don’t agree with your version of short term truth. When you have momentum traders providing positive feedback both to tr upside when there is hype and to the downside when the shorts take over you can have prices that radically diverge from ny would be theoretically true in an infinitely liquid market. Since VCs have to consider that they don’t know when they can get out there wil be less of this “I think it’s a terrible company at this price but my technical charts say it will go higher for a few days so I’ll buy” style of trading. Markets are probably “right” in time frames of more than a year but can be dry wrong quarter to quarter. VCs also often have more information and due diligence than the typical public trader.