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Why High Start-Up Valuations Don’t Bother Me One Bit

I’ve been fascinated by some of the large web 2.0 financings that have either gotten done (Slide) or are rumored to be on the table (RockYou, Meebo, etc). I am a bit perplexed about some of the grumblings about how start-up valuations are out of line with reality. I tend to disagree, but for different reasons than I’ve heard articulated by others. My thoughts below:

Valuations based on actual market transactions are never “wrong” – they reflect prices at which buyers and sellers were able to get together and get a deal done. Saying that private market valuations for web 2.0 companies are “wrong” is like saying that $4 gasoline is “wrong” – while both prices may be hard to understand or justify, high web 2.0 valuations and high gas prices are both reflect the price at which a seller and a buyer were able to agree and complete a sale.

The gasoline analogy is imperfect, though. A portion of the people who buy gasoline at $4 are doing so not because they expect the price to appreciate but because they actually need it. That is to say that some portion of people buying gas aren’t investing or speculating – they need to heat their homes and put gas in their cars and will pay a market price. In the case of web 2.0 valuations, the people are explicitly investing, so the price paid must reflect what it takes to get a deal done while leaving some reasonable upside for the new money into the deal. There is an inherent upside expectation in any equity investment and web 2.0 investments are no different in that regard.

Unlike public equity markets, private markets don’t get “marked to market” every day. This is a simple point (I think). Whereas public market valuations get tested and re-evaluated on a minute-by-minute basis, private company valuations only really get validated when a company looks to raise money. This isn’t to say that investors don’t mark private investments up or down on their own books in between financings. It is to say, however, that private company valuations can best be thought of as snapshots – they give you some sense as to what the market will bear at any given point in time. Companies that raised money on a given set of terms 6 months ago might get better or worse terms tomorrow. In private companies, timing really is important as you get relatively few opportunities to re-validate your worth.

Like public market valuations, valuations for web 2.0 companies will correct if there is a pricing issue going on. It’s important to note that while many companies are raising or seeking to raise rounds of financing at pretty high valuations (north of $100 million) relative to the revenue they’re generating, relatively few of them are actually getting bought at these prices. This imbalance will correct itself of its own accord. Either the companies raising money at these high valuations will continue to grow and justify their valuations to the point that an acquisition or IPO is possible and a liquidity event pegs the valuation or they won’t. In the event that they don’t succeed in growing, we’ve seen what happens – companies have down rounds or are bought out at lower prices than previously imagined. Many times, the pain is borne most heavily by founders and employees. I see no reason to suspect things will roll out differently in this case.

I wonder if the people who are investing in these deals at $100 million+ valuations (many of them are not traditional VCs – they’re corporate, strategic, or financial investors) know something we don’t know. With Google’s stock price being a bit muted and the Yahoo / Microsoft saga unfolding, there don’t appear to be a ton of ready buyers looking to use cash or stock to pick up these companies at the prices required to close deals. With the notable (and I mean notable) AOL / Bebo deal, we haven’t seen a lot of big-ticket M&A happening from traditional web players outside of the ad network space.

There are two scenarios I can envision that would create a very ready market for these deals on the M&A side. One would be Facebook getting aggressive and starting to buy up some of these companies and integrating them into their core services. The other would be some strong investment activity from the media folks (Viacom, Sony, Walt Disney, etc) in snapping up web 2.0 talent.

As is always the case with markets, if we wait and see, we will wait and see.

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