How Are Startups Worth Billions?

Over the past few years, it has become apparent that technology startups are the future of big business. How are these companies, which are neither profiting nor generating revenue, worth this much money?

Recently Marissa Mayer, the CEO of Yahoo! bought Tumblr for $1.1 billion. While this is a fast growing startup company, it has not generated revenue remotely close to the figure it was bought for. In similar fashion, last year Facebook acquired Instagram for $1 billion, despite the fact that Instagram generates no revenue.

“Value isn't related to capital deployed, it is a function of what was done with the money.”

Generally service companies are valued at 2-3x their revenue, while younger product firms can attract 5-10x their revenue because of the hyper-growth possibilities. Investors these days are savvier and have an amazing understanding of business models. It is not just about products and services anymore. Decades ago we were concerned with business models, now we can engineer them and understand each individual component.

Pinterest, a virtual social media scrapbooking site generates absolutely no revenue, but somehow has become worth $2.5 billion in less than three years. According to Business Insider, Pinterest sold $200 million in stock to new and current investors for less than 10% of the company, effectively valuing it at $2.5 billion. Investors are convinced the future of Pinterest is similar to that of Facebook and are putting their money where their mouth is.

Paul Buchheit, the creator of Gmail has said, “This is the most counterintuitive aspect of the venture capital business.”

"The general public doesn’t understand startups at all. They’re mystified how a company with no revenue can be worth a billion dollars. It's because of this power law: If a company has a 1% chance of being a hundred-billion-dollar company, then it’s worth about a billion dollars."- Paul Buchheit

Amazon’s profits do not nearly coincide with the amount of money the company is worth. When it went public in 1997, it was valued at $438 million, while only generating $116 million worth of revenue for that fiscal year.

As each private investor invests more money behind their startup, it intensifies the bidding for outside investors. The ever-present problem remains: how can a company with no revenue, that is valued at over $1 billion, sustain a profitable future while still maintaining its original image?

“Nothing works better than just improving your product.”

These companies all have one single thing in common: they are rapid growing platforms with an extensive user base, whose core service fits with the ideas of the technology super companies that have acquired them.

In the sense of Yahoo! And Tumblr, Mayer basically looked at the audience and the speed at which this service is growing and basically guessed the amount of advertising profits Tumblr could generate in the future if this aspect were to be expanded upon.

VIA Business Insider & NY Times