The JP Morgan “Twitter Fund”

The announcement last week that JP Morgan is launching an investment fund for certain digital companies has proponents of the “greater fool” theory crawling out of the woodwork and pointing to the wreckage of the tech bubble from ten years ago.  This announcement closely follows the news that Goldman Sachs is offering clients an opportunity to buy into Facebook at a valuation of $50 billion.  While many have pointed to the copycat nature of the JP Morgan fund, I believe that the bigger theme is a nearing peak in valuations for social media companies.

First, the facts.  The fund is going to have no more than six companies in it, and Twitter alone will represent over half of the fund.  Not surprisingly, this opportunity has quickly been named “the Twitter fund.”  JP Morgan intends to raise $500-750 million from wealthy investors from its Private Banking division, each of whom must pony up a $1 million minimum.  The other companies have not been identified publicly and may not be known yet even within JP Morgan.  Fund manager Larry Unrein has confirmed that the terms of the investment give Twitter a notional value of $4.3 billion, up slightly from $3.7 billion in December, based on an earlier round of funding.

A quick dive into the numbers show some frothy sentiments from investors.  Twitter had actual revenues of $45 million in 2010, and the most aggressive predictions put the upper limit for 2011 at $150 million.  Using this assumption, JP Morgan investors value Twitter at nearly 29x revenues.  By way of comparison, Goldman Sachs investors value Facebook at 12x 2011 revenues of $4.1 billion.  Keep in mind that we are talking about revenue multiples, not earnings multiples.

Now, this lofty valuation could be justified if Twitter opens up its ad platform to the general public and starts bringing in billions of dollars of ad revenue over the next three years.  And it could be justified if one assumes that either Google or Facebook will buy Twitter very soon and integrate its functionality.  But neither scenario is likely to happen.  Twitter doesn’t have the eyeballs necessary for advertisers to pay top dollar, and most Tweets don’t occur on twitter.com anyway, so potential users won’t see the ads.  All user metrics point to far lower levels of engagement on Twitter than on other leading social media sites.  As for a buyout, Google and Facebook have both had on-and-off talks with Twitter for over two years now, but there has been no offer.  Why?  Both companies are wary of overpaying for a company that isn’t likely to ever hit a billion dollars of revenue.

So ten years after the collapse of the tech bubble, why are investors lining up to take more pain?  Isn’t it obvious that when retail investors buy companies at insane valuations, most experts call the top?  Is it different this time?

No, it isn’t different this time.  Twitter management insists that its consumer database alone is worth billions, but in the end, valuations always come down to multiples on earnings.  JP Morgan itself isn’t putting any money at all into the Twitter fund – that should represent a clear warning sign.  Unless there is someone else out there willing to value Twitter at $6-8 billion, the JP Morgan fund could take a beating if consumer sentiment changes directions quickly.

Rock You acquires Playdemic

Last week, Rock You acquired Playdemic, a social gaming company based in England with 16 employees. What makes this acquisition interesting is that Playdemic has only created one game with about 500,000 active users. Gourmet Ranch is a hybrid game that combines cooking and farming, much like FarmVille. The strategy behind the acquisition appears to be to add active gamers to the stable of applications that Rock You launches.
Most Rock You apps are not games, however, which brings the overall strategy into question. Social gaming has proven to be very profitable at firms like Zynga and Playfish. Apps such as Super Wall and MyGifts for Facebook have hundreds of thousands of users, but little to no revenue. Rock You might be better served by developing its own games from scratch. While the purchase price was not disclosed, it makes little sense to step into the overbuilt farming genre at this point, unless the company was able to get a very favorable price (terms of the acquisition were not disclosed), or unless there are multiple games with huge potential that Playdemic is prepared to launch. Barring these scenarios, it doesn’t make much sense to acquire a tiny company with one minor hit.

The Goldman Sachs – Facebook deal

Goldman Sachs upped the ante for Facebook earlier this month with its investment of $450 million for 0.9% of the company, giving Facebook a notional value of $50 billion.  A Russian investment, Sky Digital, chipped in another $50 million for 0.1% of Facebook, giving the rapidly growing social networking company a total of $500 million to use for growth.  The consensus revenue estimate for Facebook for 2011 is $4.05 billion, giving it a revenue multiple of 12.3x.  (For comparison, the most valuable tech company in the world is Apple, trading at about 3x revenue.)  12.3x is mighty steep, and brings back memories of the tech bubble in 1999 and 2000, but it may be justified, given that nearly all of Facebook’s revenue comes from advertising, and the company has not even begun to tap into other, more lucrative sources.

Google closes on Zetawire

It was announced on Monday that Google bought Zetawire for an undisclosed amount. The founders of Zetawire had received a patent for a mobile payment technology for mobile banking, advertising, identity management, credit card, and mobile coupon transaction processing. In other words, they were in the process of figuring out a way to replace the entire personal wallet with software when Google bought them.
This is a smart purchase for Google, because they plan to outfit the later versions of the Android with this technology once it is perfected. In a world in which the iPhone has a significant lead on the Android, this technology could prove to be the great equalizer. If men don’t have to carry their wallets around anymore, and if women require far fewer items in their purses, then carrying around the Android could be the next cool thing. Google may become the leader in cashless and cardless financial transactions with this technology in its stable.

Facebook acquires event tagging specialist Divvyshot

Facebook recently completed its acquisition of Divvyshot, a relatively new group photo-sharing operation with 40,000 users. While terms were not disclosed, it is clear that Facebook is buying technology and talent, not revenue or subscriber base. Divvyshot specializes in event tagging in photos, and has made a name for itself in maintaining photo quality, an area in which Facebook has struggled. With just three employees, Divvyshot gives Facebook a way to stay ahead of its would-be competitors in photo technology. This purchase makes a great deal of sense – buying Divvyshot before it gets big is the least expensive way to improve photo sharing technology. Facebook users upload 3-4 billion photos a month to the website. The ability to perform group tagging at events will keep users happy and ward off other competitors.

A closer look at the Facebook/FriendFeed deal

Facebook announced today that it acquired FriendFeed for about $47.5 million ($15 million cash / $32.5 million stock) in a deal that values Facebook at $6.5 billion.  While this is down from the $10 billion or $15 billion valuations that have been talked about in recent months, it still represents a rough valuation of 13x revenue, which the company expects will be around $500 million for 2009.  FriendFeed had no revenue, but it had lots of good ideas:  Facebook has been implementing several FriendFeed innovations  on its own site this year, and the founders of FriendFeed were the guys responsible for G-mail and Google Maps.

This was a preventative acquisition.  Facebook perceived a hole in its offering and moved to patch it up before someone else exploited the problem.  FriendFeed has no real revenue, but it offered something that Facebook didn’t, and Facebook didn’t want anyone else to buy it first.  The FriendFeed team didn’t waste any time transitioning, because apparently they had vacated their old office and were set up in Facebook’s space before the end of the day.  If the technology is good, and you don’t have it, you better get it quickly.

Deals like this are going to happen more and more frequently over the next 24-36 months in the social media space.  There is a land grab opportunity, plain and simple.  He who gets there first and establishes a position early on tends to have an excellent chance of being snapped up by a bigger player in a neighboring area.  Eventually the universe is fully populated and developed further, but the rewards typically go to those who had a clear vision of where technology was going very early on, and were able to move quickly to establish a position with a viable offering that people need.  Facebook is a mighty powerful force right now, but it certainly hasn’t cornered the market on good ideas, and buying the good ideas is a lot easier than trying to create them.

So how can we predict these deals over the next 2-3 years?  Start with where the people are now and where they will likely be in the not so distant future.  Then look at all the cool things that niche players are doing that aren’t happening yet at the bigger sites.  The only way to remain relevant is to keep improving content, improving user interaction, and improving stickiness.  The companies that provide these things are buyout candidates.

Next, look at big businesses, which have largely remained on the sidelines as they grapple with understanding how fully they will have to retool their marketing efforts.  Their early efforts in the space have largely been weak and ineffective, but they know where they have to go to meet the consumers on the new turf.  Companies that are able to bridge the gap between big brands and social media are also excellent targets.  These are the players who are going to put big businesses on Facebook, MySpace, and 20 other social networks.  They will develop apps to engage the consumers and have them interact with the brands. And the deals that happen will be a lot bigger than $47.5 million.

Should be interesting!  There will be plenty more deals like this before the end of 2009.

The Amazon – Zappos Deal

In case you hadn’t heard, online retail leader Amazon agreed to purchase Zappos last week for 10 million AMZN shares that gave the deal a total value of about $850 million.  Zappos has been one of the early leaders in using social media (especially Twitter) to bring attention to its brand and boost the top line to about $1 billion as of last year.  Amazon has less experience with social media and saw the Zappos deal as a way to leverage social media across all $20 billion of its revenue.

Zappos has been around for 10 years and has grown steadily, from $8 million in 2001 to $70 million in 2003 all the way to $1 billion.  The company has received $49 million of venture funding since inception, $35 million of it from Sequoia Capital, and turned profitable in 2006.  Zappo’s earnings over the last 12 months have been about $50 million, making this deal .85x revenue and about 17x earnings.  While these numbers both seem extreme at first (revenue multiple too low and earnings multiple too high), shoe retailers have net margins of only 4-5%, and value is created primarily by running the company extremely efficiently, which Zappos has done for years.

It is clear that Zappos got a good deal – 17x earnings is very high even for a rapidly growing tech company, never mind a shoe retailer that has been around for more than a decade – and its social media prowess was an important aspect in Jeff Bezos’ decision to buy out its competitor.  Sequioa invested its two rounds in 2004 and 2005, so in five years they made a gain nearly ten times their initial investments.

The lesson here is very clear:  Companies that embrace social media marketing techniques and execute them well, will grow more quickly and be worth more at sale than those that do not.

Breaking Down The Social Media Universe

There is an increasing amount of attention being paid to the revenue side social media.  The sites that have attracted the most eyeballs over the last 15 years have (not coincidentally) also been the sites that gave the user the most valuable experience for free.  Yahoo’s access to the world, Google’s search prowess, Napster’s rich repository of music, YouTube’s millions of videos, Facebook’s endless gamut of games and activities, and many other popular sites, have all come without a price tag for the user.  But “eyeball companies” have found it difficult to turn billions of hours of engagement into billions of dollars of revenue.  Google is the obvious exception – it has mastered paid search and turned the company into a cash machine.  But all of them have had to rely on advertising on the sites to pay the bills and to make money.  As the web has turned into a far more social experience for users, it has become imperative for every company to have some sort of strategy to take advantage of this new dynamic.

I see the social media world containing three very broad categories of companies.  Each has enormous revenue potential with proper execution.

Social Platforms  (Facebook, MySpace, LinkedIn, Classmates, YouTube, etc)

These companies are where the consumer eyeballs actually reside.  These are the sites that rank very highly in number of page views and minutes.  Some of them have millions of concurrent users, and hundreds of millions of accounts.  The business model for these sites has always been to get the eyeballs first, then sign up advertisers quickly.  Since the ads can be tailored to the information supplied by users in their profiles, there are good chances of getting high numbers of clickthroughs.   There are limitations, however; advertisers will only pay so much, and there is not a great deal of room on many of these sites for quality advertisements.  So until the eyeball companies can shift the majority of their revenue away from ads, they will be limited in their ability to grow.

Social Satellites (Zynga, MegaPlayer, etc)

These companies are a very loose amalgamation of companies doing all sorts of things related to social media, but they have several things in common.  They charge their customers for a value-added service they provide, they create, enhance, or improve content on existing social media sites, and they are very focused on experiences and user engagement.  These firms want to sell their services (in some cases these are virtual goods) to paying clients who see the value in social media for either personal or business reasons.  Satellite companies are the ones who add the meat to the loose framework provided by the social media sites.  Their revenue will depend on their ability to bring a great deal of added value to their customers.  This revenue is only limited by the number of paying customers and clients (marketing budgets or discretionary income)

Big Brands (GE, Coca-Cola, Procter and Gamble, etc)

These companies are the ones with existing products and marketing dollars.  They need new ways to market to their customers, and they need to keep pace with rapidly changing consumer behavior.   They have the most to gain in the long run, assuming they adjust their marketing to where their customers are.  It is incredibly inexpensive to build a powerful marketing campaign around social media, and there are ample opportunities to convert fans of the brand into a virtual sales force.  Small investments in social media can and will result in very large returns via an increased customer base.  Several studies have shown that well-executed social media campaigns have produced ROI far higher than any other form of marketing.  These companies have the best opportunity to make the most money in the long run.

I will explore each of these three types of companies in greater detail in future blog posts.