Some Thoughts on the Instagram Valuation

Andy Baio provided an excellent perspective on Facebook’s acquisition of Instagram by analyzing the price per active user.  This analysis shows that at about $30 per user this deal is far below many previous acquisitions.  It also indicates that Yahoo’s acquisition of Broadcast.com continues to stand as the most outlandish deal at more than $10,000 per active user.  At USV we have tracked a meaningful number of investment rounds across our portfolio and the data from this suggests that $30 per user falls well within the observed range of valuations (even when looking at registered instead of active users, assuming that a meaningful percentage of registered users are active).

But there are two important questions that this analysis does not consider.  First, how should the dollars per active user change as a company’s user base grows larger.  Many of the comps had smaller users bases and hence arguably more growth ahead of them (that was of course also the argument for the crazy Broadcast.com valuation but that growth never materialized).  On the other hand for companies with network effects there is an argument to be made that the per user value should go up as the company grows larger:  end users are getting more value from a larger network, making the service stickier, thus increasing lifetime value. Since Instagram is a network this argues in support of the valuation.  That argument is particularly strong for a service such as Skype which has very strong network effects and is well reflected in the per user value.

Second, what is the steady state realistic value of each enduser?  This is where things get a lot more difficult.  It is unclear what the right business model for a service such as Instagram is.  Charge for special filters?  Charge for storage?  Run advertising?  To get to to $30 per active user if you assume a 10 year average user retention you have to get of around $4 per year per user (assuming an 8% discount rate).  That has proven easy for social games companies such as Zynga (which can achieve as much as $2 per active use per month) but the precedents in photo sharing seem less compelling.  For instance if you look at typical conversion rates to a paid account in the low single digit percentages, then those who do pay would have to pay annually around $80 - $100 which suddenly seems like a lot.

As with any of these discounted cash flow valuation exercises there are a lot of dials to turn here, such as the discount rate or how long users are retained (obviously 20 years would make a big difference over 10 years) and I am sure one can come up with theoretical constellations that justify the $30 per user.  But it would appear that as a practical matter photo sharing services to date have not monetized that well.  It would be great to get some data here from people who operate other services but I don’t believe that Yahoo ever broke out the economics of Flickr, but Fotolog was acquired for only $90 million at pretty large scale.

So did Facebook overpay for Instagram?  Probably not.  Photo sharing is an important core activity on Facebook and there was a meaningful threat of Instagram “unbundling” that activity from the rest of Facebook.  If acquired by someone else such as Google that could provide the engine for a broader effort and potentially hollow out Facebook.  As a defensive move spending 1% of its presumed market cap makes eminent sense in the near term.  But that does not imply that similar services that don’t achieve critical mass should count on valuations even remotely close.  It also raises an interesting question whether Facebook will have to make similar acquisitions repeatedly in the future to protect its core network.

Conversely, did Instagram sell too early?  The above analysis suggests not.  The deal removes all operational and monetization risk.  It is all the sweeter considering how much equity the founders were holding and how small the team was.  If they had wanted to double down from there they would have had to commit to building something much larger (not in terms of number of users where growth was strong, but in terms of potential for per user revenues).

Facebook’s Valuation

I was going to write a post about Facebook’s valuation, but Bill Gurley has done such an excellent job, that the better idea is to point at his post explaining “Why Facebook Clearly Belongs in the 10x Revenue Club.”  There is one other important point to consider in thinking about Internet company valuations in the current economic environment: low interest rates.  Companies that are still growing and have a lot of room for future growth have a fair bit of their value sitting in the future — that’s certainly true for a company such as Facebook.  As we are currently in a global deflationary environment (*) the discount rate being applied to these future cash flows is lower than it has been in a very long time and possibly ever.  When I started learning about DCF models in the late 80s, a common rule of thumb was to use 7% for the risk free rate of return!

The (*) above is to indicate that we have been expanding the money supply like never before but the lending multiplier has contracted even faster and supply is far outstripping demand in combination resulting in a deflationary environment.

PS If anyone has seen a good analysis of revenue composition for Facebook (advertising versus credits, assuming that’s even disclosed in the S1) please let me know

Options and Startup Common Equity Value (Bubble Talk)

There is something frequently missed in thinking about the value of common shares in startups.  These shares are actually options!

The Theory

A common share in a startup has the same payout structure as a call option.   There is a range of outcomes in terms of total enterprise value at exit for which common shares are worth exactly zero.   This range is from no enterprise value (shutdown) to the aggregate value of preference (including, if applicable, participation multiples and dividends) plus any debt that may be outstanding.   For enterprise values above that, the value of common shares rises more or less linearly (exactly linearly if you have only straight preferred).

This option nature of common shares explains why startups have a pre-money value at all even if they haven’t built anything.  That pre-money is *not* the value that has already been built.  If that were the case, then a prototype stage startup should have a pre-money of near zero (just try selling the prototype).  Instead, the pre-money valuation represents a view towards future possible values of the common shares.  A theoretically fair pre-money value would be one that looks at all possible future paths and discounts the price of common for various outcomes back to today.  Actual pre-money values are of course determined by the current market conditions.

Application: Is There A Bubble in Early Stage Valuations?

Now some folks have argued that the current significant rise in startup valuations is attributable to the fact that companies can achieve much higher exit valuations than before.  First, there are vastly more people on the web now than before.  Second, we have examples of hugely profitable Internet companies. Third, the time it might take for a company to grow to huge size has compressed.  With higher valuations possible faster that would indeed increase the option value of common today and thus explain higher pre-money valuations.

There is, however, an important offsetting argument.  Because the cost of getting started is now so low, there are many more companies being started to do more or less the same thing.  That significantly reduces the likelihood of any one company being the one that achieves these high value exits.   If your top-end valuation is 10x what it might have been in the past but there are 10x more startups being created to go after the same opportunity, then these two more or less offset each other (more or less is important here as this is non-linear and I am applying linear math).

I am pretty sure that what is going on right now is a largely unwarranted inflation in pre-money valuations because of survivor bias in the observable data.  It is easy to see the Youtubes and Zyngas.  No doubt the top end has moved out and speed to value has increased.  But nobody is really counting the huge explosion of startups that is launching, many of which will fail or pivot without really registering.