Facebook, Twitter and the Bubble of 2011: Why It’s Different

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Social networking sites are worth megabillions without making billion dollar profits, but this isn’t another dot-com bust

The news that Facebook raised $450 million from Goldman Sachs and $50 million from a Russian firm raised a ruckus in the financial blogosphere on Monday that signaled a broad worry: are we in the midst of a new technology bubble?

The new investment puts Facebook’s valuation at $50 billion. The last time we saw companies with that kind of valuation growth was in the late 1990s, and we all know how that ended – in a burst technology economy.

This time, while Facebook, Twitter, Groupon and other digital companies are brandishing billion dollar price tags with limited revenue streams,  it isn’t the same as a decade ago.

Unlike the tech frenzy of the late Nineties, this time the risk is smaller, the revenue is real – and there are far fewer players.

“It’s truly naive and foolish to look at a handful of companies with surpisingly strong business models and say that there is a bubble,” Owen Thomas, executive editor of Venture Beat, told TheWrap.

Today’s social media giants may not have the capacious profit margins prized on Wall Street, but they are not mirror images of Xcelera.com or Boo.com, highly speculative internet companies that became hot stocks at the dawn of the new century before crashing and burning in spectacular fashion.

“Facebook and a handful of other companies might be overvalued, but look across the broader tech sector and you'll find dozens of big companies trading at perfectly reasonable valuations. (Microsoft, Google, Apple, EBay, Yahoo, for example),” wrote Henry Blodget, CEO and editor of Business Insider, in an email to TheWrap.

When it comes to bubbles, Blodget should know. The former equity research analyst was barred from the securities industry for fraudulently hyping tech stocks.

That’s not to say the market isn’t guilty of irrational exuberance. But even if some of today’s sexiest technology players are AOL-like burnouts rather than Apple-style legends, there are a number of reasons to think it’s a whole different ball game.

IPOs Are So 2001

Unlike the previous decade where much of the speculation surrounded initial public offerings of companies such as online travel agent Lastminute.com, the current flurry of trading is largely taking place on the secondary markets. Companies such as Facebook and Twitter aren’t raising capital by going public, rather they are selling shares to savvy investors without going through a costly IPO.

“The restrictions put in place against fraud after the dot.com bubble burst are pushing companies into the secondary market,” Caroline McCarthy, staff writer for CNET News, told TheWrap. “They are avoiding the scrutiny of public disclosure and pumping their valuations higher and higher by raising all this venture capital.”

The smart money is that Facebook will go public in 2012, but there’s no immediate need for the social network to go hat in hand to Wall Street.

“I think they'll wait as long as they can,” Blodget wrote. “If Facebook goes public, its IPO won't be driven by a need for cash (the company is profitable and can raise as much cash as it needs in the private markets). Facebook's IPO will be driven by the desire for its early investors to sell stock and regulatory reporting requirements.”

Facebook has raised over $1 billion from venture capital and in the process pushed its value as high as $56 billion. Other examples of this secondary market frenzy include Twitter, which parlayed its $200 million round of funding into a $3.7 billion valuation and Zynga, the gaming company that is trading shares based on a $5.16 billion price tag.

“It’s absolutely disproportionate to anything we’ve seen in the tech sector before. Google raised $25 million in venture capital before it went public, Amazon raised $8 million, Facebook is following a new strategy as an alternative to an IPO and raising over $1 billion,” McCarthy said.

That also prevents the companies from being answerable to a broad base of stockholders and a slave to the markets’ twitchy reactions to a softer than expected quarterly report or a flurry of negative publicity.

“There is such a fear of the public market because of its extreme reaction. The real problem is that its so darn scary to go public that it's easier to raise $1 billion on the secondary markets,” Thomas said.

Keeping the investment out of the wider marketplace means that if these companies go belly-up, the fallout won’t be as great as after the bubble burst from 2000 to 2002. In other words, Grandma won’t lose her shirt should users abandon Facebook en masse for the next hot online venture.

There’s a downside, however. Average investors won’t get burned by a flameout, but they won’t be able to get their taste of the profits either.

“Widows and orphans are not getting screwed over by tech stock, they are getting screwed because they can’t invest in Facebook. Instead of getting outraged that Facebook is worth $50 billion, there should be outrage that only already wealthy and accredited investors worth more than $1 million can buy stock,” Thomas said.

Instead of Sexy Domain Names, Real Companies

Twitter may have only racked up $50 million in ad revenue last year, but that’s a lot more money than companies such as freeinternet.com made when they drove the last internet boom more than a decade ago. Moreover, Twitter's 175 million users show that while investors are primarily putting up money based on future rather than historical earnings potential, their speculations are at least based on some hard numbers.

“During the internet tech stock bubble, there were dozens of companies going public that had no business going public like pets.com. These were just awful companies with terrible financials that thrived on the general hype surrounding the internet. This time Zynga is a real business, Groupon is selling lots of daily offers and making a profit, and Facebook sells lots of ads,” Thomas said.

Whereas the last bubble was based largely on hypothetical future earnings, the current crop of billion dollar boomers can point to real money. Facebook commands 20 percent of all internet page views, a figure that could someday be worth as much as $200 billion in ad revenue.

Likewise, analysts speculate that Zynga’s revenues have jumped 70 percent this year to some $525 million. It may not be the money generated by an old media titan like Time-Warner or Disney, but there is a legitimate potential for growth.

“The company's current revenues certainly don't justify the valuation, but the future revenues might,” Blodget said. “If you think Facebook can grow from $2 billion of revenue last year to $5 billion this year and $10 billion next year, then the valuation makes sense. If you don't, it doesn't.”

It's Demand, Not Supply

The ranks of blue chip technology companies has thinned considerably since the go-go Nineties. Facebook has triumphed over would-be competitors such as Friendster and MySpace, leaving investors clamoring to be part of the victor's camp.

Likewise, the number of profitable and profitable social media and gaming players such as Twitter and Zynga are few and far between.

“Facebook is exceptional. The problem is you can’t take lessons from Facebook or even Twitter because they are one-of-a-kinds. In the nineties there were five or six search engines all seeking money from public investments, most of which never survived,” Thomas said.

The problem is that while all glory may be fleeting, online companies’ rapidly changing fortunes may accelerate both the boom and bust times.

“The long term question is whether anyone remains on top over the long run. In 1997 or ‘98 it seemed like no one would ever come along and dominate like Microsoft, but that changed," Wired Magazine's Clive Thompson told TheWrap.  "It’s tricky to figure out what we’re doing with the internet. There’s not any one sure thing." 

One thing is for certain, even if this current crop of  internet all-stars stumble, this time they won't be taking Wall Street down with them … though Mark Zuckerberg might be a bit peeved.