The Best Or Worst Of Times For VC's Who Fund Social Media Start-Ups?

Submitted by Kip on Wed, 04/13/2011

I’ve been working with Thomvest Ventures (a VC fund based in Silicon Valley) for about a year as a Venture Partner and it’s been a very enlightening experience. After working in the corporate world as a marketer for almost 30 years, it was “back to school” time for me to fully understand and appreciate the role the critical role VC’s play in funding social media and other start-ups.

The biggest benefit of VC’s in the U.S. is they help keep the start-up pipeline full. We all have a lot riding on them getting it right for our collective future economic well being. While the U.S. economy has grown 50% since 2000 (despite all of our recent challenges), during the same time period, China’s economy grew over 300%.

Despite the importance of this, venture capital funding in this country is now less than 1% of total GDP. For perspective, $15 billion was invested by VC’s last year compared to $787B for the American Recovery Act….which investment do you think is going to generate more jobs in the long-term for our country? I'd put my money on the start-ups ever time....small businesses generated 100% of the incremental job growth in the U.S. last year (and for the past decade).

So, given what's at stake, how have VC's done in the past and how will they do in the future in helping create successful new start-ups as well as generating decent financial returns for their investors? After a truly lousy decade of VC performance, venture funds are poised to generate much better returns in the future (i.e. the next 10 years). The primary reason for this prediction is based on basic supply and demand.

Consider this:

  • A decade ago (right before the dot-com crash), there were about 1300 venture capital firms in the U.S. with about $83 billion available to invest.
  • Fast forward to today and you’re down to about 300 VC firms with much smaller funds at their disposal. That means fewer VC firms with less money to go after new start-up opportunities. And with less money to invest, VC's are going to be a pickier on where to place their bets.

Other big changes compared to a decade ago is the amount of information available online and the speed in which it travels. Today there’s an army of bloggers who follow what’s happening in the tech space and it’s a lot harder for anything to go unnoticed. Thus, the marketplace is even more finely tuned to what’s happening than ever before (and stocks are priced accordingly).  So if a sector or company start to heat up in terms of online "buzz" and metrics, the VC money will pile on faster than ever before (which is what's helping to drive "hot" start-up valuations). 

A decade ago, the investing public enjoyed the majority of the financial upside (i.e. 90% of the gains) from investing in companies such as Microsoft, Cisco, Electronic Arts, Juniper Networks, etc. once they'd gone public (those were the good old days when there were plenty of IPO's...another big difference vs. today). While it’s true several of these stocks went up and down more than a yoyo following their IPO, odds were still pretty good Joe Public could buy these stocks and make a nice financial return.

Let’s look at what Joe Public can look forward in the future from the following companies in terms of upside potential after their eventual IPO’s based on the following estimated market valuations for these social media based companies (based on analysts reports from SharePost as of March, 2011):

  • Facebook: $75 billion
  • Zynga: $9 billion
  • GroupOn: $5 billion
  • Link-In: $3billion

Is there much room left for future gains in these valuations for the general public? Keep in mind publicly traded stocks such as Walt Disney have a current market cap of $77 billion and my previous employer, eBay, has a market cap around $40 billion. And the biggest publicly traded stocks of all (such as Apple at $300 billion and Microsoft at $200 billion) generate tens of billions in revenue and profits which help justify their market valuations.

And if you look at another social media company (such as the largest social network in the world which is based in China - TenCent - it's even bigger than Facebook in terms of members with 50% profit margins), it’s currently valued at a $50 billion market cap. To be fair, Facebook is estimated to be on track to generate about $4 billion in revenue this year (with about 60% of that coming from gaming sites such as Zynga).

There have been seriously undervalued companies in the past – Blockbuster had the chance to buy Netflix for under $50 million and Excite turned down the chance to buy Google for less than one million dollars. So while it’s always possible Facebook will continue to grow exponentially in the future, odds are the upside market cap growth for this company and ones with similar market caps (compared to their revenues) are going to be pretty limited.

It’s also a pretty good bet as far as social media and other high tech stocks go in the foreseeable future, you’d rather be a (lucky) VC or an early stage employee to make serious money on these investments instead of taking your chances on the same company once their stock has goes public.

What do you think? Are today's tech start-ups overvalued or a bargain? What's the appropriate role of VC's in all of this? I'd welcome your comments and opinions on this topic.