The purpose of Silicon Valley couldn’t be more straightforward…
Breed amazing and irresistible technologies that captivate the masses – and ultimately garner absurd public valuations.
The latest example is text messaging service, WhatsApp, which Facebook (FB) is purchasing for a whopping $19 billion.
What’s different this time, however, is that even Silicon Valley insiders are shocked at this massive price tag.
Like Aaron Levie, Co-Founder of Box Inc. – an online storage company that’s about to go public in a multi-billion-dollar deal. He didn’t believe it when news of “the bomb that shook Silicon Valley” hit, in the words of The Wall Street Journal.
He received a text that simply read: “WhatsApp, $19 Billion, Facebook.”
His response? “I thought, ‘I don’t know what those three things mean to each other, but there’s no way that this means that Facebook bought WhatsApp for $19 billion.’”
Oh, there’s a way, Mr. Levie. And the implications for everyday investors like us aren’t good.
Here’s why…
New “Zombie Companies” Forming
Facebook’s willingness to pay (way) up for WhatsApp immediately makes other Silicon Valley executives think that their startups are worth just as much, too.
To them, the deal serves as a validation signal – that mobile apps do, indeed, warrant premium valuations.
Heck, I bet you that almost every mobile app company in Silicon Valley updated their pitch books over the weekend. There’s nothing like using WhatsApp’s purchase price as a proxy to inflate the perceived value of your own company… and convince investors to part with their hard-earned capital, right?
Therein lies the danger to us…
By simply taking the amount Facebook paid per WhatsApp user ($42) and multiplying it by the number of users for any other mobile application, we can justify multiple billion-dollar valuations all day long. But that’s the wrong way to go about valuing an investment.
For one thing, not every company promises to be acquired. And very few get bought out at such lofty valuations as WhatsApp.
If we’re only investing in a company because of its takeover potential, we’re going to end up losing money more often than not.
More importantly, though, we need to avoid letting the hype over the deal influence how we evaluate startup investments.
Remember, stock prices don’t follow users. They don’t follow page views, either, like so many dot-com era startups tried to convince us. They follow earnings. Period.
So unless we can justify the same lofty valuations based on a hot startup’s ability to generate actual profits, we should pass. Otherwise, we’ll see a rash of “zombie companies” that are supported entirely by (clueless) investors.
In case you’re wondering, WhatsApp fails miserably in that regard. Forget turning a profit, the company struggled to generate sales.
At the time of the deal, the company had reportedly only booked $20 million in revenue. That works out to a staggering price-to-sales (P/S) ratio of 950, based on the $19-billion acquisition price.
Meanwhile, the average company in the S&P 500 Index trades at a P/S ratio of only 1.6.
Making Matters Worse
The problems with the WhatsApp deal don’t stop with entitlement, though.
In addition to existing startups falsely believing they’re worth just as much, we can expect the premium valuation to convince a new crop of entrepreneurs to get into the game.
In other words, the deal is going to usher in a new wave of startups, intent on striking it rich, too.
It happened in the aftermath of The Social Network, which glorified Facebook’s origins. In fact, one of the best-known technology incubators in the country noted a 30% uptick in startup applications following the film’s release, according to The Wall Street Journal.
Bottom line: The fallout from “the bomb that shook Silicon Valley” threatens to harm everyday investors the most, as more and more startups look to convince us to part with our hard-earned capital to own a piece of their billion-dollar dream.
Thanks to equity crowdfunding, raising capital from everyday investors has never been easier for startups.
My advice to you? Don’t be a fool and easily part with your money. Instead, be more vigilant than ever before investing in any startups.