Last week, news broke that a 2.5-year-old company called Snapchat had rejected an all-cash $3 billion takeover offer from Facebook.
Predictably, the cat-calls and howls of indignation began. Snapchat and its investors were obviously delusional idiots, Twitter pundits agreed. And arrogant! How else could they pass on a crazy offer from a "desperate" Facebook? Snapchat doesn't even have revenue. Even a one billion dollar offer for a company like that was "insane," let alone a three billion-dollar offer. If anyone needed confirmation that we're right back in a "tech bubble," this was it.
Well, as we pointed out last week, this insta-consensus around startling valuations is nothing new in the tech world. People said exactly the same thing when the revenue-less Facebook was first valued at tens of millions of dollars. Then they said it again when the still revenue-less Facebook was valued at hundreds of millions. And then billions. And then tens of billions. And they said the same thing when Twitter was first valued at tens of millions. And Pinterest. And Google. And Amazon. And, basically, every other successful Internet company that has burst on to the scene and grown rapidly over the past 20 years.
Because, despite the phenomenal success of these companies—and their demonstrated ability to attract users first and build a business later—some observers can't seem to fathom that this is a proven way for amazingly successful and valuable companies to be built.
But it is. So instead of reflexively howling about the "obvious stupidity" of any executive or investor who passes up a big offer for a revenue-less company, it makes sense to ask what the insiders might be seeing that outside observers aren't.
We were curious about that with respect to Snapchat, especially because $3 billion is indeed a very large amount of money. So we asked a couple of insiders. And now we know. Before we explain, though, let's put that $3 billion in context.
Back in the mid-1990s, when I was a Wall Street analyst, I once read a research report by one of the best Wall Street tech analysts of the era, a former basketball star named Bill Gurley, who at that point worked for legendary tech banker Frank Quattrone at DMG Technology Group. Gurley has since gone on to become a legendary venture capitalist at Benchmark. And as fate would have it, he's actually a big investor in Snapchat.
In his research report, Gurley was attempting to make sense of the valuation of a small but fast-growing tech company that was trading at a stratospheric multiple of earnings (150X, or something). And in the context of the report, Gurley laid out what I have ever since referred to privately as "Gurley's Law." Gurley's Law is this: At some point, every successful tech company will trade at a normal earnings multiple—say, 20X-25X earnings. (Gurley used 30X in the 1990s, but the 1990s were unusual).
Importantly, Gurley's Law does not mean that any young tech company that is trading at a multiple higher than 20X-25X is "overvalued." Tech companies can grow earnings super-fast, so, as an analyst, you have to be careful not to be too conservative in your earnings projections. (See the mistake everyone made with LinkedIn as an example of this.) But if you find yourself thinking that your favorite little tech company will always trade at, say, 100x earnings or 200x earnings, you're probably hallucinating. (With companies that aren't making money, and don't plan to make money for a good long while—Amazon, for example—you can also use Gurley's Law with revenue multiples.)
The point is that, some day, when the company's growth has slowed to the more normal mature rate experienced by, say, Google and Apple, the multiples on the company's stock will also be normal. So when you're trying to think about what valuation is "fair" for your favorite little company, you would do well to remember that.
The other technique that Mr. Gurley taught me was to use a company's valuation to "back into" the implied financial performance that the market was expecting from the company at a given price. And that's what we're going to do with Snapchat.
What Snapchat needs to do to be worth $3 billion
Like Twitter, Facebook, and other social networks, Snapchat has no content costs. So let's assume that, eventually, it will have at least a 50 percent operating profit margin, and a 35 percent margin after tax. That means that, for every $3 of revenue, Snapchat will likely earn $1.
So how many dollars of profit would Snapchat have to generate to justify a $3 billion valuation Using Gurley's Law, and a reasonable mature earnings multiple of 25X (way lower than Facebook's current multiple, similar to Google's current multiple), we can estimate that Snapchat would have to earn about $120 million of profit to justify a $3 billion valuation.
At a 35 percent profit margin, Snapchat would have to generate about $350 million of revenue to produce that profit. So, for Snapchat's $3 billion valuation to be reasonable, you have to assume that Snapchat will some day generate, say, $500 million of revenue and $200 million of profit (there's a time-value of money and a discount rate that need to be factored into the valuation. For simplicity's sake, we'll just use numbers than are bigger than the actual revenue and profit numbers we need.)
Could Snapchat ever generate $500 million of revenue? Already, more photos are shared on Snapchat than on Facebook. Well, Facebook is currently generating $8 billion of revenue (annualized), LinkedIn is generating $1.2 billion, and Twitter is already generating $600 million. So if Snapchat becomes a major global social platform in the future, it is perfectly reasonable to think that the company can someday generate $500 million of revenue, if not a lot more. But how? What will Snapchat sell to generate that revenue?
How Snapchat plans to make money
According to one insider we spoke with, here are Snapchat's basic plans. The company will experiment with these products and then, when it has found the best ones, hit the gas.
Advertising. The average active Snapchat user, of which there are likely already 10s of millions, receives about 150 "snaps" a day, our insider says (Wow!) Snapchat has already experimented with mixing in one video or photo advertisement in every 20-30 snaps. Advertisers are jazzed about this, because Snapchat allows them to reach a coveted demographic (teenagers) that they have trouble reaching anywhere else, including via Facebook. What's more, Snapchat's users don't care about seeing the occasional ad, especially if it's from a brand they like or think is cool. So the Snapchat advertising opportunity seems real.
Virtual goods. New app-based messaging companies like Japan-based Line are already coining money by allowing users to pay modest amounts for the right to send things like emoticons or copyrighted characters to each other, as well as to send each other "virtual gifts." Users might pay 50 cents or $1 for these, or buy a pack of them for $5. Given the size of Snapchat's current user base, not to mention its future growth opportunity, successful virtual sales like these could get big in a hurry.
The big potential for Snapchat, our insider went on, is to become the "start app" for a whole new generation of Internet users. Teenagers don't really use the web these days, the insider explained. They don't use email. And they also don't use Facebook (which is web-based and un-cool because their parents are there). They use their mobile phones. And they communicate over the phones with texts and app-based messaging services like Snapchat, WhatsApp, and Instagram.
Because of this teen behavior, the insider explained, Snapchat believes it can become one of the key "platforms" from which the next generation of Internet users will use the Internet. To this end, Snapchat plans to release an application programming interface (API) like the one Facebook and Twitter offer, so that third parties can build applications that run on top of Snapchat. And Snapchat plans to continue to expand the capabilities of its service to make it more useful to its users.
The bottom line, another Snapchat insider tells us, is that Snapchat insiders believe Snapchat has an opportunity to reach "web scale" (vast) and become a dominant global messaging platform. And, based on the valuations of other "web scale" social platforms—Twitter ($22 billion), Facebook ($115 billion), and LinkedIn ($26 billion)—$3 billion just doesn't seem that outrageous.
What would be silly, the insiders think, would be to reflexively cash out now and forgo the opportunity to build another Twitter-sized platform—especially because they think their Twitter could eventually be a more successful platform than the real Twitter.
Before you scoff at that idea, remember this: As recently as a few years ago, most people thought the idea that Twitter would ever become a real business was preposterous. And they howled with indignation at anyone who suggested it might. And, before that, people had exactly the same reaction to Facebook. And Google.
Will Snapchat actually become the massive global profitable business that its insiders think it can? We'll have to wait and see. There will be a lot of questions, challenges, and hurdles between now and then. But one thing is certain: Snapchat has a reasonable shot at achieving this vision. And "reasonable shots" are what aggressive venture capitalists and digital entrepreneurs are all about.