Why Technology Company Valuations Might Be More Rational Than You Think

Sarah Friel's "No Filter" is a well researched, thoroughly enjoyable re-telling of the creation of Instagram, its acquisition by Facebook, and of the David and Goliath struggles in conflicting culture that ensued after the acquisition.   

I enjoyed the book tremendously - but it also brought home for me how to try and explain the phenomenon of high technology company valuations in the absence of established cash flows to CEOs and leaders in more established companies.  Many of our clients are tempted to use small investments in technology companies as a mechanism for diversification into more attractive areas of the market, but are often put off by what they view as sky high acquisition prices in the absence of a business model (i.e. "why would I pay so much for a company that doesn't make any money today").  

What No Filter made very clear in simple terms is that you can value a technology company on the back of growth in its user base, even if it makes no money today - indeed that is what Facebook did ahead of buying Instagram. Why - simply because of the assumption that if your user base enjoys the experience linked to the company sufficiently to get truly locked in to your product, overlaying a business model at a later date should be possible. Whether that business model is ad-based, subscription-based, or influencer-marketing based doesn't really matter.  Indeed when the Instagram revenue model was overlayed on a large and established user base, the company started making a lot of money.

That doesn't mean that all technology company valuations are fully rational, nor are they all immune from exuberance.  When leaders in more established companies consider the benefits of small investments into start-ups as a mechanism for diversification - they need to investigate not simply the existence of current cash flows, but the possibility of future cash flows once a business model gets overlayed on a user base, and of course the nature of that business model and how the revenues and costs will work. If you can see your way to that under rational assumptions, you might be able to reverse engineer a price that reflects intrinsic value. That is how Facebook valued Instagram  - and it seems quite rational in hindsight even though it was viewed by many as exuberant at the time.