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Why Are So Many Silicon Valley Companies Valued in the Billions?

• April 23, 2014 • 4:00 AM

(Photo: 360b/Shutterstock)

WhatsApp, Oculus, Instagram, Tumblr: These are just some of the technology companies recently valued at $1 billion or more. Whether we’re in a start-up bubble or not nobody can agree on, but one thing is certain: We have no idea what the future looks like, and an investment today could result in huge profits tomorrow.

In HBO’s new technology-business satire Silicon Valley, the bumbling protagonist Richard Hendricks stumbles upon an algorithm that compresses large digital files into smaller ones without sacrificing their quality. Hendricks is promptly offered $10 million for his tiny start-up by the founder of his employer, a Google-like entity called Hooli. Another investor jumps up to buy five percent of the company for $200,000. Those are both cheap price tags for what almost every character in the show refers to as a “billion-dollar” idea.

But what is the idea, precisely? As the investor Hendricks eventually chooses points out, the young entrepreneur doesn’t have any actual customers or a strategy to make money; he doesn’t have a business plan, let alone know what one looks like. When the first investment check comes, the founder doesn’t have a company bank account to deposit it in. Yet “this could be a billion-dollar company” becomes a refrain for the show’s characters, who jostle for equity and cling to the hope that all this could someday lead to the show’s other catchphrase: “making the world a better place.” Oh yeah, and bags of money.

Silicon Valley is spot-on: Start-ups being valued at billions of dollars seems to be the new normal. In fact, $1 billion isn’t even the highest a company might aim. In 2012, Facebook bought Instagram for $1 billion (just slightly less than what Yahoo paid for Tumblr last year), but more recently it was rumored to have offered the ephemeral messaging service Snapchat in excess of $3 billion. In February, Facebook dropped $19 billion on the international messaging platform WhatsApp.

Facebook is starting to look more like a digital holding company—a business that controls stock majorities or owns outright other, smaller companies and profits from them.

It’s hard to judge just what a start-up valuation means right now. The high prices and hype suggest that a bubble is building, and some are already suggesting that it’s on its way to popping (or at least losing air). High valuations are a self-reinforcing loop: Lots of venture capital flowing around the technology sector means more companies achieving high sale prices and positive results for their investors, which encourages even more investors to jump in and gamble small amounts of angel investment (often the first amounts of money a company receives in exchange for a small percentage of equity, as in Hendricks’ case) for big pay-outs later.

Examples abound. The DIY-hotel platform AirBnB just raised another $500 million, valuing the company as a whole at $10 billion (it reported revenue of $250 million in 2013). Yet the company faces legal pressure from state governments to regulate its users; unfavorable legislation could shut down its core business entirely.

Quora, a question-and-answer website with no source of revenue, recently netted $80 million in investment on a valuation said to be around $400 million. The $80 million would go not toward developing new products, the company’s founders said, but to the bank as an insurance policy to keep the company afloat long-term. “We raised money because we think it helps us ensure our independence and permanence,” Quora’s business and community leader Marc Bodnick told the New York Times. In other words, to ensure that they’ll still be around when the venture-capital flood dries up.

So if it’s not direct revenue and it’s not sustainability (as many as three out of every four start-ups fail, losing money for investors), what is it exactly that’s driving sky-high prices for start-ups?

The most basic answer is the companies’ expansion possibilities. AirBnB focuses on turning apartments into rentable hotels for now, but it plans to move into other areas of the hospitality industry, integrating an entire travel experience into one service. Uber, a company that runs a digital network of taxicabs and amateur drivers ready to pick up any fare, is valued at around $3.5 billion and faces regulatory measures similar to AirBnB. What opens investors’ wallets is Uber’s push into delivering not just people but transporting anything and everything and tracking it in real time—the company recently launched a courier service in New York.

These companies’ valuations are also about competition. As one-time start-ups like Facebook and Twitter continue to grow following their IPOs, they are morphing into large corporations, competing with places like Google over who is going to control the next generation of successful tech companies. Indeed, Facebook is starting to look more like a digital holding company—a business that controls stock majorities or owns outright other, smaller companies and profits from them—than a social network. In a bid to hit the jackpot on the next big thing, it recently bought Kickarter-funded Oculus—for $2 billion—which makes virtual reality devices, and had expressed interest in Titan Aerospace, a drone manufacturer, before Google (Facebook’s chief competitor in the escalating acquisition wars) snapped it up.

Tech companies are also invested in sustaining the hype surrounding their own industry. News of high-profile acquisitions, leaked to the biggest publications, build buzz for even more high-profile acquisitions, and in the industry’s ongoing consolidation, the next big buy might just be that of your own company. As the Titan Aerospace news shows, Facebook may even encourage rumors of its negotiations, whether they’re successful or not.

Yet the biggest reason for billion-dollar valuations, bubble or not, is the optimistic futurism of technology entrepreneurs. Value has become an abstraction because we don’t really know what kind of product is going to make the most money. We have no idea what kind of technology will dominate the commercial landscape over the next decade, let alone century, but making the right bet and getting in on the bottom floor could mean massive profits. Rather than building a better mouse trap, tech companies are chasing immaterial products with implications and business plans they won’t fully understand until the future.

That separation between old-school entrepreneurship and valley-style abstraction is illustrated in Silicon Valley when Hendricks’ compression company runs into a copyright problem. They want to call the company Pied Piper, but an irrigation-system business already exists under that name. Hendricks goes to bargain with the folksy farmer-type who owns it, looking out over a field of spraying sprinklers. “What does your business do, again?” the older man asks. “Something to do with algebra?”

Kyle Chayka

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