Startups are extremely popular today, since the Internet and the post-PC era have allowed small companies to reach an audience of billions. Everybody carries a smartphone with them, which gives the potential access to your new idea to users. Assuming your startup idea is good, you can really hit it big. We have seen this happen to Facebook, Twitter, and Snapchat, who grew (and continue to grow) users at levels retail businesses would kill for. By the way, these services are free.

After reaching such a large audience, these social media companies require money to pay for the cost of doing business, which they first get from investors in angel rounds. The investors, in return, expect to be paid back more than their initial investment. Thus, a social media company (and all companies that require investment, really) must somehow start producing revenues and hopefully profits to pay their investors back. Since their service is free, online advertising has been the only way to generate these revenues. The way online advertising works is the more users see or click the ad, the higher revenues a social media company will get. Key performance indicators (KPI’s) such as monthly active users (MAU’s) are used to calculate a valuation on many such advertising companies.

As I’ve written in the past, these new valuation techniques are extremely young, and their results are to be taken with a grain of salt. My favorite view on this issue is from Aswath Damodaran, a finance professor at NYU Stern. His take says there are currently two major ways to valuate social media companies. The first is from the traditional investor, who looks at revenues, profits, and investments. The newer valuation technique looks at user growth and other user-focused metrics like MAU’s. He argues that as a company matures, it must transition from telling stories to showing meaningful results. These results are mainly focused on the fundamentals of business, like revenues and profits.

As a social media company grows, the way it is valuated shifts from the younger model, to the older, traditional model. Most of the successful social media companies are still too young to fully appreciate this valuation shift. In fact, most investors will probably shift their techniques unknowingly. They will notice how social media companies are maturing, and begin applying the traditional models. Stories will no longer be enough to take investor’s money, and results will have to be shown.

I must admit, in the past I was highly skeptical of staggering acquisitions like WhatsApp, which sold for $19 billion. I did not believe that a company such as WhatsApp, with almost no revenues and an unclear business model, would be able to monetize and provide that amount of value in a million years. To be perfectly honest, I still am a bit skeptical, but I am now more willing to accept these insanely pricey acquisitions. My thinking on this topic has changed fairly recently, as I've been trying to think outside of my traditional business education, and understand this new wave of valuations.

I'm not the only one who is trying to understand valuations in high growth industries. Here is what Jeff Liu and Jim Reinhart write in a report for EY:

Clearly, traditional valuation metrics based on multiples of current earnings or revenues don’t accurately reflect the future expectations that the valuations imply in recent large transformative transactions. Consider the $19 billion price tag placed on WhatsApp, which reportedly generated only about $20 million in 2013 revenue — a multiple of 950x revenue! In fact, applying traditional valuation approaches may cause companies to overlook acquisitions that can transform their business by propelling growth in new markets or industries.

This whole time, I was looking at these acquisitions through my traditional accounting and finance education, which preaches metrics like book value, net income, and simple year over year growth. While these are still solid metrics to gauge most businesses by, they begin to break down for unprofitable companies that are experiencing rapid growth, which defines most social media startups. The truth is, there is no fundamental metric that can precisely predict the future growth, profitability, and success of companies in this industry. Social media, startups, the other companies that we associate with Silicon Valley all fall into an extremely young industry that has not been studied in enough detail yet. Everything in this business is an estimate, at best. And while new metrics to value these companies have emerged, they are not battle-tested enough to spend billions of dollars based on their results. I bet a large part of the WhatsApp purchase was Zuckerberg's gut.