The social media investment conundrum
Social media has been the investment sector which has created many of the biggest companies within the tech industry over the last decade. By social media, I’m using a broad definition of businesses which either rely heavily on user generated content as the underpinning of the service and / or user to user (viral) communication as the principal means of propagating and marketing the service. Successful exits in this space include Youtube, Skype, Last.fm, Bebo and MySpace and big private companies include Facebook, Linkedin, Yelp, Zynga and Playfish.
The appeal of this sector to venture investors are clear
- Rapidity of value creation. The ability to create multi-hundred and billion $ value companies in the space of a 1-3 years is almost exclusive to social media. Try doing that in software, semiconductors, ecommerce or cleantech. All typically require 5-10yrs to grow to this scale
- Reasonable cost / capex requirements. Limited capital is required to launch and test a product. Often the successful social media companies breakeven or at least have the ability to breakeven quickly. Hence capital at risk is lower and multiples on successful exits can be higher than in many other sectors
- Defensibility. Once at scale, network effects give these businesses a competitive advantage and robustness which acquirors value. Over the next 12-18 months, we will probably get to see how public markets value some of the key players in this space also.
So lots of good reasons to invest and a few exciting businesses which already validate the investment thesis. So far so good, now for the challenges…
The chart above shows the various stages which a social media business may go through and what the usage, revenue and valuation metrics might typically be at each stage. Also my perception of the probability of the business ultimately generating a great return which not only justifies VC investment but can contribute a substantial return.
This evidences some of the real challenges with investing in this sector
- Volume of investment opportunities in social media sector can be overwhelming. Particularly at early stages we see twenty business plans / investment opportunities for social media businesses for every one we see across the whole spectrum of other investment sectors (software, life science, hardware, semi, cleantech, etc). This means the chance of ultimate success for investments at pre-launch and early stages (1-2) is vanishingly small and even the low valuations don’t typically reflect the risk inherent at these stages
- Late stage valuations (5-6) are very high and often leave limited upside for investors.
- Pinpoint timing is required. In my experience the best time to invest for a venture capital firm is post launch when the business has 100,000’s or low millions in Monthly uniques (stages 3-4). Here the metrics and to an extent the business model may be proven and the valuation still gives room for venture returns. However businesses can often pass through this stage in a matter of a few months, so unless you are already very close to an investment opportunity as it moves from stage 2 into stages 3 and 4 you will likely miss the opportunity
- Early metrics are useful, but often don’t differentiate between future leaders and losers. The red and blue lines show the trajectories of 2 social networks (can you guess which?). These are essentially the same until a specific breakout point for one of them.
So while social media can offer the big and quick rewards for venture investors, it can also be a minefield and is particularly challenging and unpredictable for those tasked with making early stage investments.
