Understanding Twitter’s valuation

By Felix Salmon
February 10, 2011
Paul Kedrosky: there's something extremely irritating about Shira Ovide's Deal Journal blog post this morning kvetching about how high the mooted valuation of Twitter is.

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Count me in with Paul Kedrosky: there’s something extremely irritating about Shira Ovide’s Deal Journal blog post this morning kvetching about how high the mooted valuation of Twitter is.

The valuation — somewhere between $8 billion and $10 billion — is explicitly not based on Twitter’s current revenues. Yet Ovide insists on calculating silly ratios designed to make the valuation look as outlandish as possible:

Twitter’s revenue last year was $45 million, our Journal colleagues reported. So a $10 billion valuation would be more than 200 times the company’s revenue, or nearly 100 times its estimated 2011 revenue of $100 million to $110 million. Help me out here, folks: has any real business ever been slapped with such a high multiple?

Or, let’s pick another valuation metric. At $10 billion, Twitter is valued at $105 for each of the 95 million tweets its users write every day. (I’ll wait for my share of the check for those Twitter messages.)

I’m sorry, Shira, but “capitalization per tweet per day” is not a “valuation metric.” And in any case, your share of the check is likely to be pretty small: you’re averaging 0.4 tweets per day yourself, so far this month.

And valuing Twitter based on its revenues is exactly what Twitter’s suitors aren’t doing:

“Are these prices justifiable based on financial multiples? No,” said Ethan Kurzweil of venture capital firm Bessemer Venture Partners. But these start-ups are building social services and have lots of data about their users and “the market is valuing that mightily right now.”

In fact, the value of Twitter’s user data is just a part of what’s making it attractive right now. The interesting question about Twitter’s valuation is not how high it is, but rather the way in which it can be justified. People are putting real cash money into Twitter at massive valuations — the company just raised $200 million at a $3.7 billion valuation, and Andreessen Horowitz just bought $80 million of stock in the secondary market at levels which might well be higher than that. These investors aren’t stupid, so what’s their reasoning?

Ovide actually provides a hint, early on in her post, although she doesn’t realize it:

Twitter has swaths of devoted users, but it still requires repeated explanation to my mom –- and to many regular Joe Web users. Of the people who use the Internet, just 12% use Twitter, according to a recent survey by Pew Research Center. Compare that to Facebook (used by 62% of Internet users), and text messaging (used by 74% of cell phone owners), Pew found.

If you take Ovide’s own comparisons, Twitter’s valuation makes pretty good sense. If Twitter is 20% the size of Facebook, and Facebook is worth $50 billion, then Twitter can be worth $10 billion, no? And the proportion of the market capitalization of all the telcos around the world which can be attributed to text messaging is so mind-bogglingly enormous as to make $10 billion seem like a rounding error.

The point here is that Twitter is becoming central to how people communicate with each other — a key part of the new social architecture. Maybe not for Ovide’s mom, to be sure. But Twitter serves a very important purpose in the lives of the people who have adopted it, and it’s likely to serve the same purpose for ever more people as its user base grows and people start feeling left out if they’re not on it. Take a look at Owen Thomas’s wonderful essay on how he used social networking to lose weight, making important distinctions between various different networks:

When I went to the gym, I also checked in on Foursquare, announcing my location to friends and eventually winning the rank of “mayor” of my local gym. When I completed my food and exercise diary, the computer informed my Facebook friends; when I lost weight, it broadcast the news to the world on Twitter…

I post my exercise calories and announce the completion of my daily food diary on Facebook, while limiting Twitter posts to weight-loss milestones. I share the details only with other MyFitnessPal users.

Or, more powerfully still, listen to Louisa Lim’s story on how microblogging is reuniting families of abducted children in China.

Twitter has already, to a very large degree, supplanted blogging for millions of people; even people like me who cling loyally to the old-school blog format tend to find ourselves doing ever more of our job on Twitter. Twitter is the ultimate democratization of the commons: never has it been easier to publish material online, for all the world to see and respond to. And at the same time it’s also intensely social: it’s fantastic at strengthening bonds between individuals. I’ve befriended people I never knew before thanks to Twitter, and at the opposite end of the spectrum I’ve learned a substantial amount about my wife just from the material she posts on her Twitter account. (Go follow her! She’s great!)

How exactly will crucial social infrastructure get monetized in the future? Nobody knows for sure — but everybody knows that it’s not simply going to happen by scaling up current-day revenues from promoted tweets and the like. Twitter’s on track to make $100 million this year without even breaking a sweat, but the one thing all of its investors understand is that priority number one for the company is to become an indispensable service for millions of people around the world.

Twitter has a couple of hundred million dollars of cash in the bank: it’s not like it’s running out of money. And the chances are that as Twitter succeeds in cementing itself into the way that people live their lives each day, it will be bombarded with opportunities to monetize its position. In the history of humanity, everybody who owns the means by which people communicate and socialize with each other has been very rich and powerful. That might be less true going forwards than it was in the past, but it’s unlikely to disappear entirely.

On top of that, the putative $8 billion to $10 billion valuation is for the company as a whole: it surely includes a substantial control premium. If Google and Facebook are fighting over Twitter, a large part of its value to each company is that the other one won’t own it.

Twitter is a highly speculative investment, of course, and in fact only a very select group of carefully-qualified and extremely rich investors can invest in the company at all. Everybody putting money into the company right now is well aware that they’re taking a calculated risk: in order to capture the potential upside, they’re willing to accept a lot of downside as well.

The news yesterday from Andreessen Horowitz that it has bought an $80 million stake in the company is particularly interesting, because the shareholding was acquired on the secondary market. The idea behind VC firms like Andreessen Horowitz is that they provide expertise and guidance along with their money, and that they generate alpha by acting as real owners, rather than simply as passive shareholders. But in this case, their stake is much more speculative.

Why would Andreessen Horowitz invest this way? Kara Swisher I think hints at the answer:

Sources said that the firm made the move because it is already deeply invested in other key companies in the social space, including gaming giant Zynga, location-focused Foursquare, local discounting phenom Groupon and general social networking behemoth Facebook.

The idea here, I think, is that it’s hard to pick individual winners in this space, even if you’re convinced that the space itself is going to be extremely valuable. The last thing that Andreessen Horowitz wants, after making an enormous bet on social media, is to find that it isn’t invested in one of the handful of companies which will generate massive returns. And so it’s spreading its money around all the possible winners, trying to buy every ticket in the lottery.

Looked at this way, the valuation of Twitter makes sense even if it will probably go down. That’s the way of lottery tickets: their value is nearly always higher than their payout. And people looking to buy into Twitter at a $5 billion or $10 billion valuation aren’t doing so because they’ve discounted a bunch of predictable cashflows and decided that the present value is that ginormous. Instead, the investment is more in the form of a hedge. Twitter just might turn out to be one of the most important and valuable companies in the world. And if it does, then everybody will have wanted to get in around now. If you have that opportunity, it’s a hard one to turn down.

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