Arjun Sethi recently published a compelling analysis on vcexperts.com that examines how to estimate the value of Web 2.0 companies, and the challenges of doing so with traditional valuation models.
Since many of these companies are pre-revenue, or collecting only meager revenues, a great deal of the company valuation is a reflection of the capital invested, rather than a multiple of earnings. For this reason, private equity firms are not a suitable investment partner for social network sites.
In other words, many of these social networking sites would not be a good investment for private equity because a large part of their value would actually come from the money invested by the private equity firm. Even more, the fact that many of these sites have shown decreases in member over the past year means that advertising revenues will likely decrease.
Because of this, the authors advise that venture capital frims would be better investment partners for these kinds of opportunities, since they have the agility to focus resources surgically, and to harvest returns through other means than selling the company on a secondary market.
Venture capital firms have more freedom to focus on the short-term to move in and provide a company with necessary capital and then seek repayment of the investment in one way or another. In addition, venture capital firms, by their very nature, are in a position to give smaller amount of money to companies in order to provide a source of capital for future growth. Rather than being determined about book values, equity, and changes in revenue, they can be more concerned about helping a company get off the ground or grow through a period of transition.
The paper is chock full of tables and charts illustrating its analysis. Anyone interested in understanding valuations of social media companies will find it a worthwhile read.
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