Covering the Middle Market in Chicago and the Midwest
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Paying for Narcissism...
The Valuation of Social Networking Sites
By Anthony L. Alfonso, ASA, and Sladjana Djordjevic
“I just had the best cup of coffee at the corner café”
“Little Johnny just skinned his knee at the playground”
“Wonderful… words can’t describe”
Sound familiar? If so, you are probably a member of one of multiple social networking sites available to anyone with web access. Does anyone really care about a great cup of coffee or the often cryptic messages or status updates broadcasted in the public domain? Apparently people do care. While investors may not care about the great weekend you had or little Johnny’s incident in the playground, what they do care about is your user profile and the user base as a whole. In an investors mind, this user base can translate into value.
Value, it is an interesting word. Value can be relative. Value can be a matter of perspective. Value has a formal definition from the Internal Revenue Service. Value has a different formal definition from the Financial Accounting Standards Board. Formal definitions aside, from an investor’s perspective, value is ultimately the price someone (informed or uninformed) will pay for (or sell) a company or asset. It sounds easy enough, but how does an investor value a company based on a relatively new medium, with unproven staying power such as social networking websites? What makes it even more difficult is that the majority of these websites or companies are privately-held, with financial data hidden from an outside investor’s view.
Ambiguity exists in the revenue generation models and cost structures of social networking sites. Furthermore, there is very little data publicly available that can translate into traditional valuation models. Challenges aside, a significant amount of capital has been poured into the shining stars of the group such as MySpace, Facebook and Twitter. Depending on the data source, the implied valuation of Facebook was in the range of $5 billion to $15 billion in the 2007 to 2008 timeframe. According to the Wall Street Journal’s tech blog Digits, the latest valuation for Facebook is between $35 billion and $40 billion.
The increase in the value of Facebook can leave intelligent people wondering how the value can more than double in the midst of one of the most severe global economic downturns in history. Empirical evidence does exist; Facebook currently has almost half a billion active users, up from approximately 140 million active users in December 2008. A logical person can imply that more users translates to more revenues. What isn’t clear is how much revenue can be derived from the users. Going a step further, can the amount of revenues currently generated cover the expenses incurred, leading to profitable cash flows? People may be speculating now, but at the end of the day a company needs to return a positive investment in the long run to keep investor’s happy.
The majority of the revenues are derived from advertising. Advertisers are smart; they use keywords, demographics, gender information, etc. in your public profile and messages. Advertisers then run algorithms to produce targeted marketing based on these results. As efficient as advertisers are, there is probably no amount of advertising revenues that can be generated to make these social networking websites profitable. Additionally, advertisers want to be efficient in their marketing spend, so the advertisers are going to focus on the largest and currently most successful social websites available.
Arguably, Facebook is currently the most successful social website available. You know you have arrived, when you become a verb. Remember when Google was a website? Now Google is a verb... “Google it.” Facebook is not only a website; it has become a verb… “Facebook me.” Despite Facebook’s new verbiage, risks do still exist. Websites such as Facebook need to develop additional functionality to make its user base sticky. Only several years ago MySpace was the leader of the pack, only to be overtaken by Facebook and there is an entire generation who has never even heard of Friendster. The challenge that social networks face is how to charge for the additional functionality. Facebook already has the user base; they now need to further monetize the eyeballs on the screen. In the early 2000’s Amazon was simply an online bookseller, the naysayer’s did not believe that such a business model would be sustainable. Amazon capitalized on its user base and expanded to be a portal for independent stores and developed a proprietary ebook reader. Now, in addition to buying books, you can download them and subscribe to periodicals, all while shopping for power drills and lawn furniture. Social networking sites such as Facebook may need to be just as innovative to provide value to investors.
Questions still remain on how to value these social networking websites. The valuations that were quoted earlier are implied valuations based on a bottom up approach. The overall valuation is given based on the most recent round of financing, essentially the arithmetic of the dollars invested for a certain percent of the company. It sounds as simple as taking the implied value, and dividing the value by the number of shares outstanding to calculate the value of a common share that an ordinary investor can purchase, but it isn’t. The implied valuations being quoted are based on rounds of financing for preferred shares on the company.
These preferred shares have rights and preference over and above the previous rounds of financing and even more so over the common shareholders. These rights and preferences typically include liquidation preferences (the rights to claim certain dollar amounts before the subordinate classes of equity should the company liquidate), accrued dividends, conversions features, etc. These rights and preferences make the preferred shares more valuable than the common shares available to employees and ordinary investors. Typically, at the time of an initial public offering, these preferred shares convert into common shares and the value of the shares become equal, but before an initial public offering, preferred shares are more valuable than common shares.
Undoubtedly, social networking websites are here to stay. These sites have changed the way we communicate and share information, which is a valuable commodity to investors. Quantifying the dollar value of this new commodity is a challenging process, especially given the lack of financial information currently available to investors, and reliability and nuances of recently published valuations. With respect to Facebook, an IPO may be in the near future and investors will need to make informed decisions regarding its true value. To avoid the same mistakes made during the dot-com bubble, core fundamentals should be considered to develop a reasonable assessment of value. But as we have learned, value can be relative, and in the case of Facebook, everyone has an opinion and is willing to broadcast it.
“Have to take an aspirin… I have a headache”
About the Authors:
Anthony L. Alfonso is the President of BDO Valuation Advisors, LLC and is based in their Los Angeles office.
Sladjana Djordjevic is a Director at BDO Valuation Advisors, LLC and is based in their Chicago office.
BDO Valuation Advisors, LLC is a separate legal entity and is an affiliated company of BDO Seidman, LLP, a New York limited liability partnership and national professional services firm.