High Valuations: An Ephemeral Example

This message will self-destruct in 10 seconds.

No — not Mission Impossible. Self-deleting messages were brought to life (albeit in a less incendiary fashion) three years ago by Snapchat, the mobile web app that specializes in creating and sharing ephemeral picture and text messages.

Last week, the company became famous for receiving, and rebuffing, a $3 billion acquisition offer from Facebook. Both the size of the offer and its rejection surprised nearly everyone familiar with the deal.

Since then, dozens of articles have been written trying to justify the vaulted valuation — either through referencing advertising potential, digital good sales, or user base. While many of these quantitative analyses have merits, many miss the fundamental truth of valuations: a company is worth what someone is willing (and able) to pay for it.

As Lydia DiPillis explained, the “price tag actually has nothing to do with value — not advertising revenue, user base nor any other typical metric of determining what a company is worth. Rather, that number is determined by the market, which right now is starting to look like the housing bubble of the mid-2000s.”

We have seen the inflationary impact of market-driven strategic interest several times in the past few years. We saw it when both Instagram and Tumblr played off the competitive environment to earn billion dollar valuations; and we saw it when Square leveraged its pre-existing relationships with Starbucks and other distribution partners to secure a $3.25 billion valuation.

The ability and desire of strategics to pay higher valuations for a company can be appealing — and should be an integral factor of building a buyer list. However, business owners should not place too much emphasis on the strategy. Member Tim Butler of GrowthFire explained, “When selling a company, it is logical to play to the strategics in the space. But, at the end of the day, if you bank everything on getting the attention of the strategic, it is a thin and risky model.”

Semil Shah echoed DiPillis’ idea in his TechCrunch column when he wrote, “It is more precise to say that Snapchat is worth $3-$4Bn to Facebook, or to Google, or to Tencent [than its intrinsic value]. Each potential acquiring company is playing a slightly different game, but their strategies all converge at the same place — in the palm of our hands.”

He continued, “Tencent, which owns WeChat, may view Snapchat as a key piece on its chessboard; Facebook may see Snapchat as a potential runaway freight train that needs to be bought and killed; and Google may either want to bolster its mobile portfolio, or simply just get under the skin of its social network rival.” It’s also possible that Facebook wants Snapchat to address its waning popularity among teenagers.

The combined strategic interest and high growth potential of these technology companies predispose them to unique valuations. “Companies like Snapchat and Instagram tend to be subject to hyper-inflated valuations,” explained Butler. “My perspective is that buyers tend to overpay for the potential of the company — but they are still willing to pay it.” He continued, “the best way to determine the valuation of the company — and if a strategic is interested — is sometimes just to begin exploring the market and testing the waters.”

While your client or portfolio company might not be Snapchat, the importance of understanding the competitive environment, the market dynamics, and which strategic acquirers could benefit from the add-on could help drive the best value for the company.