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The best properties always look too expensive
The best properties always look too expensive. Market leaders command the highest prices. It is only a year or two later that they look like great deals. The experts thought Microsoft was crazy when they invested $240M in Facebook at a $15B valuation. Crazy like a fox.
Digital Sky Technologies invested $200M in Facebook in May of 2010 at a $10B valuation. The "experts" thought the Russians had gone crazy. What do they think now? Just 7 months later Goldman Sachs is investing $500M at a $50B valuation. No one ever called Goldman Sachs crazy.
I learned this lesson from my father-in-law who built a 40 store chain of tire and auto part stores. In the process he bought a lot of real estate for store locations. He told me "great properties always look too expensive." "It is only five years later that you look like a genius and the purchase price looks cheap." Technology moves much faster than real estate.
Kleiner Perkins is reported to be placing a market cap of $4B on Twitter for a new round of funding. Techcrunch reported that Facebook has been valued at $50B based on sales on Second Market. Techmeme has stories every day of startups with rich valuations, or later round financings with multi-billion dollar valuations.
Paying premium prices for the best property usually pays off. However, extrapolating the valuation of the market leader down to a much smaller player or clone company almost never works. Market valuations are asymmetric. Many investors forget this simple truth. Market leaders demand much higher valuations than smaller players or clones. The reasoning goes if Groupon is worth $6B, then my Copypon.com is worth at least 1% or $60M. Sorry, but that is not the way it works. The market leader has huge market share, higher margins, and much higher vaulation than the 2nd, 3rd, or 4th place player. Typically the top four companies in any market own 95% of the market. Everyone else fights for the remaining 5% of the market and loses boat loads of money.
Critics point to Twitter raising $200M at a $3.7B valuation, and Facebook being valued at $35 Billion, or Groupon at $6B valuation just 6 months after raising a $135M round at a $1.35B valuation as evidence of a bubble. Bubbles don't typically start with the market leaders. Bubbles happen when investors extrapolate market leader valuations onto 3rd tier players. Sound the bubble alarm when you see this happening.
Here are some things to consider when valuing private companies;
- Market leaders always get premium valuations.
- Most markets have a gorilla #1, a chimp #2, and a monkey #3. No one else matters.
- There must be a growth plan to move the business far beyond its current state to support the valuation.
- Valuing a business on how much it would cost to build it (replicate) is foolish. The value is about the customers, revenues, and growth prospects, not how much it cost to build it.
- Never underestimate what competitors will do in response to astronomical growth.
- Pay up for the leaders during the rocket fuel growth stage. Momentum matters.
(Image source: backreaction.blogspot.com)
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