News and thoughts from the people at EllisLab.

Valuation Lunacy

Posted by Rick Ellis on March 21, 2008

It never ceases to amaze me how astoundingly overvalued online companies with no revenue model are worth, simply because they have a large captive audience.  In Silicone Valley economics (silly-conomics?), the number of visitors seems to be the single most important determinant of worth.  The VC motto should be “You got traffic?  We got money!”.

Paul pointed out today that a Facebook widget called RockYou is rumored to be valued at $400 million.  Derek Jones said it best in our group email:

$400 mill for a widget...that is used on a social networking site that has made billions without ever proving it has a sustainable business model.  It’s not even the site itself, it’s an app for a specific site.  I could probably repeat that sentence with different wording for another hour and not be any less amazed.

This lunacy hits home for me because we’ve recently undergone our own company valuation.  We’re in the process of building a stock plan for our employees.  In order to do that we hired a valuation firm to determine our worth. 

There are several ways to valuate a company.  The firm we hired used the “income approach” to create a valuation model that forecasted our projected cash flow against our historic results and future assumptions.  They then compared EllisLab as an investment against a range of traditional investment instruments, did a bunch of number crunching, came up with a capitalization rate, and ultimately our worth, as a multiple of our earnings.

The easiest way to express the worth of a company is as a multiple of revenue.  As a point of reference, most companies fall somewhere between a multiple of 2 and 10.  In other words, if your company makes one million a year, and you’re valued at “2 times revenue” you’re worth 2 million.  Anything over 5 is considered quite good.  10 or more is usually a home run.

With high-tech companies or startups, however, much higher ratios are common, even though the odds are quite small that the buyer will ever recoup their investment.  At that level, companies are being bought for strategic purposes, not economic. 

MySQL, for example, was valuated at 20 times earnings, selling for $1 billion despite revenue of only $50 Million.  Even more astounding, Facebook was valuated at 100 times revenue, or $15 billion, by Microsoft.  That has to rank among the highest valuations ever.  Clearly a purely strategic move for MS.

Personally, I’m very happy with our multiple ratio, even though it’s in the single digit range, since our goal was a true, realistic worth for internal stock purposes.  I’d like to think that if we ever did sell the company we could command a much higher value (not that we have even the remotest interest in that at this point), although given that site popularity seems to trump all other concerns, we will likely never have the traffic and user numbers to put us into the land of luny valuations, despite having built a profitable and fast growing company without ever taking a penny in funding.

The high-stakes world of funding and acquisitions seems a lot like a real-life version of Monopoly.  Roll the dice, maybe you’ll get lucky and hit Park Place.  A few more rolls, maybe you’ll control the whole board.  And just like the board game, most people who play lose.