This question originally appeared on Quora: Are tech startups really as valuable as investors perceive?
It might be helpful to think through what a "valuation" really is, in the tech startup context.
When Facebook offers to buy SnapChat for $3B, they are not making that offer because they believe SnapChat will eventually turn out to be worth three billion dollars when it's all said and done. What this price tag actually means is: "We acknowledge that there's a wide breadth of possible outcomes for this company, but we believe that the expected outcome of this investment is greater than three billion dollars."
What I mean by "breadth of outcomes" is this: A company could have a very high chance of failure and yet still be super valuable if the upside scenario is high enough. Let's say SnapChat's eventual outcomes are bimodal:
- There's an 80% chance that the company fails before delivering any profits... so the company ends up being worth $0.
- There's a 20% chance that the company delivers significant profits (let's say $30B in present day value terms).
... then the expected value of SnapChat is $6B today ($30B * 20%). If you truly believed in this, then you could honestly say "I'd happily buy SnapChat for $3B today, and I think there's a 80% chance the company will fail", and it would be a true & consistent statement.
I haven't answered your question yet, but I wanted to first establish that valuations are related to expected value. Obviously they also have to do with things like supply and demand, and hype, and scarcity, but people who buy speculative technology stocks are doing so with full knowledge that these assets are risky. The fact that SnapChat is pre-revenue--and thus does not have a predictable revenue stream, and is far from generating profits--is additional risk that is taken into consideration by the investors who price the asset.
Which means that saying "$3 billion is more than I would like to risk on an immature product" is kind of silly. What if the "20% success scenario" I sketched out above actually delivered $300B in profits instead of $30B? Is $3B still too much for you to pay for that company? I hope not!
Back to the initial question... "Are tech startups really as valuable as investors perceive?" Well... I guess that time will tell. Every asset is mis-priced to some degree, and "tech startups" are not one monolithic entity. At the end of 1999, the valuation of WebVan was enormously overvalued, whereas the valuation of Google was immensely undervalued. I suspect that the same will be true for the 2015 cohort of technology companies. Maybe Uber and SnapChat both IPO and become super profitable companies. Or maybe Lyft beats Uber and Meerkat crushes SnapChat.
"Difficult to see. Always in motion is the future."--Yoda
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