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Why big money is chasing Silicon Valley tech startups

It's either eager investors are overvaluing them or enthusiasm is once again getting ahead of reality in tech industry

Huge investment: Three-year-old Pinterest doesn't have any revenue yet. Still, the investors behind a US$225 million round of financing estimate the company's value at US$3.8 billion. - PHOTO: BLOOMBERG

PINTEREST is a kind of Internet message board where people post their favourite images of clothing or furniture. It's a three-year-old company, and though it has an estimated 50 million unique monthly users, it doesn't have any revenue yet. Still, the investors behind a US$225 million round of financing that was announced last week estimated the company's value at US$3.8 billion.

To put that in perspective, the estimated value of Pinterest, based in San Francisco, is about a third of Twitter's. The micro-messaging service could have US$600 million in revenue this year (though it isn't profitable) and is set to go public in a few weeks.

Even in Silicon Valley, where financiers don't often let pesky business metrics such as revenue and profit damp their enthusiasm for a startup, Pinterest's new financing round seemed like a reach.

So why the eye-popping numbers? A pessimist would say more big money finding its way to tech startups is a sure sign of an investment bubble, because Pinterest is hardly the only young company landing huge investments.

Earlier this year, Fab, a designer e-commerce site that hasn't made a profit, increased its valuation to US$1 billion by taking a US$150 million investment from the Chinese Internet conglomerate Tencent Holdings. This month, Alibaba Group Holding, a Chinese e-commerce company, led a US$206 million investment in ShopRunner, which offers unlimited two-day shipping from retailers, that valued the company at US$600 million.

On Friday, AllThingsD reported that Snapchat, the messaging app based in Los Angeles, which also lacks revenue, is weighing a "huge" investment round that would value the company at US$3.5 billion.

At the very least, that's a frothy list that argues that enthusiasm is once again getting ahead of reality in the tech industry.

The Pinterest investment is also an opportunity to see how big, outside money is added to the mix in Silicon Valley. While the latest Pinterest round included Valley heavyweights such as venture capital firm Andreessen Horowitz, the bulk of the money came from Fidelity Investments, the mutual fund giant in Boston. And Fidelity plays by different rules than the typical tech investor.

Cash-rich financial outfits such as Fidelity, which has more than US$1.7 trillion in managed assets, are not as worried about hitting the home run ball as typical tech investors. Double your money when you invest US$200 million? That's fine for Fidelity. And if the investment doesn't work out, it's still chump change for a company that large.

That would never do for venture capitalist firms. First, they can't throw around that kind of money. Second, those firms typically promise their own backers a return of 10 times or more on the money they have put into a company.

They have to. Many of the companies they put money into never pan out, and they're always looking for the next Facebook or Google to make up for the numerous bad bets.

Venture capital is a high-risk business. As risky as throwing US$200 million at a company with no revenue? It'll be a while before we know the answer on that one.

Likewise, when foreign financiers put money into startups, they also don't look for huge returns. Following the lead of Yuri Milner's investment company, which put money into companies such as Facebook and Twitter, they also have more modest goals: turn a profit, improve their cachet among the startup community and - as is often the case - learn from the companies in which they are investing.

"It depends on the glasses you're wearing whether these investments are too high," said Mark Leslie, a managing partner at his own venture firm, Leslie Ventures, and a lecturer at the Stanford Graduate School of Business.

Fidelity declined to comment on its investment. Pinterest said it was using the money to invest in the core of the company and international expansion but would not discuss the valuation. Now, the idea of Silicon Valley's investment community - which brought you and other website wonders - wagging fingers and noting that others are driving irrational valuations might strike some people as, well, funny. Or sour grapes.

But startups court risk when they court investments at such generous valuations. As I've written before, once a startup reaches a US$1 billion valuation, the number of big companies capable of acquiring it is more limited.

It can be difficult to say for certain how much a young company should or should not be worth. Private investors may gamble that a fast-growing startup with no obvious revenue may figure out, as Google did, how to pair a smart business model with millions of users.

That said, it can be hard to figure out how these valuations add up. Take Square, the mobile payments startup best known for its slick credit card reader. Last year, it raised a reported US$200 million from investors that valued the company at US$3.25 billion.

Square is expected to process US$15 billion in transactions in 2013. Compare that to MasterCard, which processes more than US$3.6 trillion in credit card transactions annually. MasterCard is valued at US$90 billion on the public market. If the market were applying valuations based on transaction volume alone, MasterCard would be valued at almost US$800 billion.

Not surprisingly, "unlike Square's previous financing rounds, which prominently featured big venture capital names such as Sequoia Capital and Kleiner Perkins Caufield & Byers", its most recent round was not led by a traditional Silicon Valley backer, The New York Times reported at the time. Instead, the majority of the financing came from Suhail Rizvi, head of Rizvi Traverse Management, a private equity group. Rizvi Traverse and Square both declined to comment about the company's financing.

Does Mr Rizvi, who is also among Twitter's biggest investors, have a greater appetite for risk than tech's usual financiers? Perhaps. Or maybe, as Mr Leslie put it, he's looking at his investment with a different set of glasses. - NYT