Introduction
How do we estimate the valuation of a startup that has a large user base and high user engagement, but does not fit into traditional revenue models based on sales of products or services? What is a reasonable investment to get such a firm up and running based on what return investors can expect in an exit strategy?
In the IST domain, user population and usage are highly prized metrics, and the number of unique users contributing to regular usage even more so. Once a startup is able to amass a following, the question quickly becomes: how do we monetize that user population and their subsequent usage of the digital product? But outside of e-commerce based businesses, many social media startups do not have a business model that sells a product or provides some other billable service.
With several high profile startups, like Facebook, in recent years, investors and the startups themselves have had to find novel ways of assigning value to their products in the absence of traditional revenue generating business models. In this report, we will look at some ways disciplines outside of information systems and technology (IST) have influenced valuation discussions, and how the resulting impact may affect future social media startups.
A Primer on Social Media
So what is social media? Charlene Li describes social media as part of a
phenomenon called the groundswell that is “a social trend in which people use technologies to get the things they need from each other, rather than from traditional institutions like corporations” (Li et. al., 2011). Social media emerged from the Internet Web 2.0 movement at the turn of the 21st century — a movement that sought to leverage technology applications to facilitate user-generated content creation and sharing. The implementation of Web 2.0 practices has increased participation in user based activities like crowdsourcing (Kaplan et. al., 2012), and thus has enhanced pathways by which people communicate with brands, institutions and each other.
Also included in the Web 2.0 movement was the increased usage of service oriented architecture (SOA) that made it easier, and more cost effective, for information and processes to be shared between disparate systems. A social media application that has implemented SOA principles makes it feasible for developers to leverage popular features, like commenting in the case of Facebook, without the developer having to know how the code works, and without the owner of that code risking exposure that degrades the code’s integrity and functional quality. Developers simply “plug in” to an application programming interface (API), often referred to as a plugin. These plugins make it feasible for developers to integrate existing, well-tested and highly functional code snippets into external applications that are likely built on disparate technology platforms.
Digital Trends
To understand the complexities involved in valuation of social media startups, it is important to highlight several trends in the IST domain that are fueling the rapid changes in technology, and thus social media valuation. First, the growth in mobile device usage, and noticeably the rise of smartphones such as the iPhone, is helping to fuel the growth of mobile Internet access overall, and to facilitate access to social media on the go. By 2015, Google and other IST industry leaders like Mary Meeker predict that mobile computing will overtake desktops in terms of total page views (Meeker et. al., 2012).
In a recent study by Pew Internet, more than 50 percent of cell phone users
access the Internet via their mobile phone (Smith, 2012). Within the 25-34 age group, a group that already has high rates of smartphone device ownership, 80% use their mobile phone to access the Internet (Smith, 2012). Users who are heavy text and voice users on mobile devices tend to also be regular users of social media in general, and are more likely to access social media on their mobile phone or tablet. Mobile access establishes opportunities for brands and businesses to engage consumers in real-time and in the context of activities they are engaged in. For example, geolocation apps like Foursquare and Yelp provide information about restaurants in the nearby area along with reviews, menus and even special deals.
Not only does mobile access translate into more traffic for those businesses, it also increases the lucrative nature of mobile ad revenue presented when users engage with these apps. In fact, business spending on mobile advertising is expecting to continue increasing while budget allocation towards traditional media, like billboards is expected to decrease. The increased favorable response rates for well-targeted mobile ads, versus online banner ads, is also fueling this increased interest in mobile advertising overall.
Second, aspects of social media like crowdsourcing generate large amounts of data and information that are valuable to organizations in the form of general chatter about a product or industry, as well as more direct interaction with products in the form of ratings and comments (Yelp), blogging (WordPress, Tumblr, Twitter), image sharing (Instagram, Pinterest), fan page visits (Google+, Facebook) and even parodies or memes that make light of ad campaigns or products themselves (YouTube). Even bad PR in the form of memes can be good PR if it drives traffic to brand destinations without permanent damage to brand goodwill or sales.
Metrics derived from social media data directly impact brand and product
decisions by highlighting areas where better PR is needed to address negative perceptions, or even influencing how an organization increases its workforce capability through talent recruiting and retention. Capturing, aggregating and sharing this information in a meaningful way presents a challenge and an opportunity for organizations. This creates strong opportunities not only for those who build social media platforms, but also for other innovators who can develop ways of effectively aggregating and reporting on trending social media data.
Third, the continued growth of mobile computing will alter the way organizations interact with their customers and clients, as well as their employees. As mobile usage grows, employees will want access to more organizational resources via mobile devices including smartphones and tablet computers. Security, however, is a major concern when exposing corporate assets outside the firewall onto devices with varying degrees of security implementation. Apple iOS currently does not support Adobe Flash, which has been a mainstay for developing rich, interactive applications. HTML5 is still an experimental development platform, and while it can replace some Flash functionality, it is far from being a complete replacement for Flash.
This lack of reliable and standard platforms makes it difficult to create mobile websites and apps that deliver either visually rich or information rich applications reliably across a variety of devices. In addition, bandwidth and data plan constraints continue to challenge developers and content creators to provide rich experiences that can scale — a particular challenge when dealing with robust corporate applications employees may need to access in the field. Organizations are continually exploring and implementing new methods to better connect with the outside world via mobile, not only for their customers, but for their employees as well.
Lastly, social media and mobile computing work in tandem to satisfy the
growing need for immediacy. People will demand richer access to knowledge and services, and will demand it on any device, any time. Organizations like Google have taken a “mobile first” approach that is in contradiction to how mobile is prioritized today in most organizations (Hardy, 2010).
However, not incorporating mobile and social media as part of the larger information strategy could hinder efforts to improve knowledge management from within an organization (e.g., employees in the field or in meetings on their smartphone), as well as with external agents (e.g., clients, customers, students, etc.). The need to prioritize mobile over desktop is imminent and will have an impact on how organizations build the solutions, foundations, infrastructure, technologies and mechanisms needed to successfully deliver knowledge and services where and when they are needed.
Averting the Social Media Bubble
In summary, these digital trends indicate the rising desire for information,
immediacy and two-way communication indicative of social media. As computing becomes more powerful and ubiquitous, it reduces barriers to entry allowing users to engage in these activities seamlessly, and to increase the reach of their communication activities.
This leads us to our discussion of the network effect, which explains why large communities of active users are a highly prized metric in the IST discipline, and how the network effect in combination with observed digital trends have influenced valuation discussion. The network effect, also commonly known as Metcalfe’s Law, states that the value of a network grows proportionally based on the number of users, or stated mathematically, n(n-1) = O(n2) (Hendler, 2008). This is a phenomenon observed in other disciplines like telecommunications where the advent of the telephone became increasingly valuable as there were more nodes (i.e., more people with telephones), and those with a telephone had more people they could engage with. Robert Metcalfe applied this same concept to explain to company executives why investing in Ethernet expansion, while costly from a linear perspective, had increasing value as more nodes were added (Hendler, 2008).
Therefore, it is easy to conclude that the more nodes there are on a network, in this case people when speaking about social-based networks, the more valuable that network becomes. When a social network like Facebook reports that they currently have over a billion user accounts with 584 million daily active users and 600 million daily active users via mobile devices (Facebook, 2012), Metcalfe’s law presumes that such a network should be of high worth, and indeed Facebook’s recent phenomenal IPO valuation of over $100 billion underscores this (Raice et. al., 2012). Since Facebook is free for anyone to use, how do we explain where revenue is generated, how operating expenses such as servers are paid for, and how we can predict future revenue potential? How does this indirect perception of value translate to direct revenue for a social media startup?
And therein lies the problem: there is often no tangible and sustainable business model for generating revenue for many digital startups, and social media is no exception. Facebook had to face this pressure throughout its eight-year history and over time has implemented revenue generating concepts that now set it apart as one of the few profitable social media firms in the IST domain (Raice et. al., 2012). Pressure from marketing and finance disciplines led Facebook to explore and adopt methodologies that were already well known paradigms in those disciplines.
The success of social media startups like Facebook provide a framework for analyzing how IST can more realistically interpret Metcalfe’s Law by incorporating concepts from other disciplines into their social media strategies and subsequent social media valuations. These large, often disproportionate, valuations of social media startups coupled with the absence of core revenue generating activities, excluding investor capital influx, create high risk within the IST discipline. The field is in the midst of a social media bubble for this very reason. If this over inflation is not moderated by way of substantive changes in valuation behaviors, substantial losses could occur that will mirror, if not exceed, the tech bubble of the early 2000s.
Finance, Marketing and Television
To analyze further how transdisciplinary thought has permeated IST and social media business modeling, we will look specifically at influential concepts that span marketing, advertising, finance and television ad sales.
Social media resonates well with the main tenet of marketing, which is to build and manage profitable relationships where groups and individuals can obtain what they need through the exchange of products and value (Kotler, 2004). A marketing team would identify the target market for a product or brand, and then create a messaging campaign that appeals to that market’s needs and wants.
In television advertising, and later in digital web advertising, the number of times that message is displayed is referred to as impressions. A broadcast or cable network prices impressions according to how many viewers would be tuned in during a specific time period. More viewers drive up the cost per mille or impression, often abbreviated as CPM or CPI. Likewise, in the digital space, several factors determine the CPM for online display ads including, where on the page an ad will be located, how far up or down in the site hierarchy is the page and how large or small will the ad be.
But delivering an impression is only the beginning of the engagement process. If the marketing team has targeted their ad well towards the market with the highest intent for their product, then we would expect some percent of impression viewers to take the next action. Marketing would then measure the effectiveness of that ad message based on response over time, and these responses could include calling a phone number, visiting a website, signing up with an email address or clicking on the
ad displayed.
As we move further down the sales funnel, the level of response to
increasingly valuable actions decreases so that if one million impressions were served, it would not be uncommon for 25 percent of impression viewers to take the next action (e.g., signing up with an email address), and for only one percent, or 10,000 of the one million impression viewers, to result in an actual sale of product.
In the entertainment industry, television is often spoken of as an advertising platform first and foremost, where we slot in show content that viewer might like to see. The ads are the key concern for broadcasters while the content ensures there will be impressions ascribed to those ads. Borrowing this model, how can social media create a platform that marketers can leverage as an effective customer relationship management channel? Twitter and Facebook responded to this market need by borrowing concepts from marketing and the television advertising model, which subsequently led to the reinvention of their social networks as advertising platforms — all without causing massive disruption to the general user experience.
Once a startup takes on the model of social media as advertising platform, they can exploit product marketing expansion opportunities reminiscent of other well established business models in marketing, finance and sales. For example, Twitter now offers a suite of products for advertisers including promoted tweets, promoted trends and promoted accounts. An organization can invest in promoting certain tweets they have broadcasted. These promoted tweets are then prioritized on users timelines or in search results on related keywords. Twitter also leverages the mobile trend we discussed earlier by offering market segmentation and customized ad delivery on mobile devices, especially those devices built on smartphone operating systems like Android and Apple iOS.
Hashtag trending is a popular Twitter metric that identifies what hashtags are being utilized the most in tweets, and this is typically synonymous with which topics and conversations are going viral at the moment. Advertisers can compete for the opportunity to promote a trend for some period of time, thus increasing name recognition and alignment with topics that already have high user engagement (Twitter, 2012). To increase the lucrative nature of promoted trends, Twitter implemented the rule of scarcity by forcing advertisers to who want a hashtag to wait in line, thus driving up the perceived value. The usability heuristics around how these various ad products are displayed are based on algorithms that analyze what users are tweeting about and then present the relevant ad product most closely targeted to their content interests. In this way, Twitter has satisfied advertisers concerns about effective consumer targeting while also alleviating investor concerns around the company’s ability to grow revenue by offering monetizable and valuable services.
Similarly, Facebook has also evolved into an advertising platform that now offers various products for marketers including Facebook Exchange that delivers ad retargeting based on user cookies (Vaughn, 2012); Sponsored Results for search advertising (Constine, 2012); and Promoted Posts that marketers as well as Facebook users can leverage to draw attention to specific timeline/wall postings (Facebook Inc., 2012). Facebook and Twitter both found a way to turn the intrinsic value of a large user base into a revenue stream that has satisfied requirements from marketers and investors without negatively impacting user engagement. While both Facebook and Twitter have responded to the call for more responsible and sustainable revenue generation in the social media domain, their success also raises two critical concerns: fragmentation and interoperability.
While end users may see Facebook and Twitter as complementary in their goal to communicate and discover information, from a business perspective, the two firms are in direct competition for a share of already tight marketing budgets. Additionally, the diversity of their IST platforms creates concerns around how marketers can coordinate brand messaging efforts across multiple platforms that have the power, if they choose, to turn off API plugin functionality for one digital media competitor but not another.
To address this concern of interoperability, we discuss a case study reminiscent of mergers, acquisitions and intercompany alliances in the disciplines of corporate finance and organizational strategy. In 2011 at Facebook’s F8 conference, CEO Mark Zuckerberg announced that the social network would be launching a new type of app integration destined to create a more frictionless experience for end users. Instead of posting happenings to friends’ walls, apps would post user activities in real-time to a less intrusive ticker (Olivarez-Giles, 2011). Facebook already has a developer-targeted platform that includes features like Open Graph2 and Facebook Canvas3 where developers can create apps that enable users to stay within the Facebook experience while interacting with external brands, products and services.
Partnering directly with firms, including other social sharing utilities, like Spotify, represented a strategic move to increase Facebook’s value as a service provider, and to break down barriers of interoperability by expanding its API plugin integration framework. In addition, Spotify itself is a social media advertising platform that has implemented a freemium business model. Ad impressions are compulsory for users who prefer to engage with the social utility for free, but for varying service levels at costs, users can utilize the application sans ads and unlock other value added features not available in the free version. The freemium model does not work for all social media startups, but serves as a compelling option that digital media startups in the IST domain should consider when developing their revenue models.
For other social media startups, the intercompany alliance approach
implemented by Facebook could serve in the future as a basis for their revenue generating prospects early on. Returning to our discussion of Metcalfe’s Law and the network effect of large social media networks, we can reinterpret this presumption of value by asking what user information does the social media startup store about its user base? As we noted previously, marketing relies on its ability to properly target advertising messages to the market segment most amenable to its brand, product or service. To the extent that a social media startup can provide detailed demographics around age, geolocation, content consumption and income, their real value as an advertising platform increases, thus raising the startup’s ability to drive higher CPMs and to present investors with a stronger revenue generating business model.
Social media startups can also leverage another business model, which is to
consciously pursue tangential opportunities in an established space. In spring 2012, Facebook announced that it would purchase the social photo-sharing utility Instagram for $1 billion in cash and stock — nearly twice its estimated valuation. Instagram, prior to its acquisition by Facebook, boasted a user base of 30 million users, and this was while it was only available to Apple iPhone users before launching on the competing Android platform.
Instagram popularity as a photo-sharing application was complementary to the photo sharing capabilities users were already leveraging on Facebook. Such acquisitions typically happen when a new entrant to the market or a smaller market player presents a threat by offering a product with a compelling user experience, or a product that offers functionality not available from the established player in the market. Analysts opine that the acquisition of Instagram by Facebook was a prime example of such an event because Instagram had presented a compelling option for social sharing of visual experiences via mobile devices (Malik, 2012).
In fact, until fall of 2012, Instagram did not have a website for users to share their Instagram photos, and the only way to interact with the social utility was via mobile devices, mostly notably, the Apple iOS and, later, Android smartphone platforms (Instagram, 2012). Devotion to delivering high quality user experiences, and especially doing so in a responsive way across multiple mobile display attributes, is a valuable offering startups should not underestimate as they design and develop their product for market.
Finally, would-be startup innovators and their investors should also investigate pathways to exploiting existing social media platforms to deliver valuable B2B or consumer products and services. In the B2B space, one of the challenges business leaders face is calculating the real value of their social media efforts, and thus identifying which actions would help them maximize return on social media advertising spend.
As Charlene Li points out, “creating and implementing a social strategy is hard, primarily because there are few [precedents] and role models to follow” (Li et. al., 2011). Businesses have struggled to measure the reach and engagement social media provides, and also to feel that the organization’s investment in social media was both well targeted and well received. Firms like Adobe, have mined this opportunity with the recent launch of their Adobe Marketing Cloud. Adobe Marketing Cloud is a suite of products that facilitate execution of the end-to-end engagement lifecycle by enabling ease of content publishing across multiple channels; real-time insights as consumers interact with brand messaging; and visibility into what content is resonating most with consumers along with tools to take action and stay on top of those conversations (Adobe Systems Inc., 2012).
In the consumer space, startups have an opportunity to deliver additional
functionality made possible by existing platforms like Facebook Open Graph, and to leverage the vast size and high level of engagement such a social network presents. Mobile game developer Rovio, the creator of Angry Birds, has expanded the reach of their popular game by creating Angry Birds with Friends. This Friends version runs within the Facebook experience and allows users to compete against friends who have
also opted into the Angry Birds game.
These competitions can be level by level, as well as through weekly Tournaments. Rovio has exploited the high daily user engagement observed on Facebook by offering daily rewards for users who return to the game regularly (Rovio Entertainment Ltd., 2012). The independently popular Angry Birds franchise is now able to expand its reach and loyalty by aligning new product offerings with successful social media utilities, like Facebook.
Conclusion
Financial analysts, economists and investors can no longer look at just the
traditional models of goods sold and billable services when attempting to ascertain the future earning potential of a social media startup. At the same time, IST experts building a social media startup cannot only consider Metcalfe’s Law and value a social media startup based solely on its network effect. Even though social media startups do not typically follow traditional valuation, we have discussed several options for assessing
the financial future of a social media startup:
- Does it serve a need in the market or develop a new feature that would be an attractive purchase for an established firm?
- Can the social media application be converted into a platform that subsists on B2B revenue while still providing a free service to consumers?
- Can the social media startup monetize some of its consumer services by leveraging the freemium concept?
- Can the social media startup generate enough revenue from display ads that can be accurately targeted towards the different demographics that make up its user base?
Business decision makers must understand the social and psychological impact created through crowdsourcing and viral propagation of content, and consider how they can create a platform from a single app idea — a platform that can overcome price sensitivity of its user based to generate sustainable revenues through one or multiple streams.
Sales and marketing models have long since assigned value to these effects in terms of how the quality of a message, the reputation of its source (the organization, brand or product), and the number of impressions feeds into a sales funnel model that informs what percentage of those leads (impressions) convert to real sales of goods or services for various industries. Social media, and its ability to magnify the effect of peer
recommendations, has value when it comes to creating and sharing messages and knowledge through crowdsourcing, PR generation, pop culture contribution, and general awareness in a population. These activities have a real cost inside organizations, and the influence of marketing and finance has prompted IST to analyze and understand such models and devise ways of applying lessons learned to new technology development.
When digital firms like Facebook and Twitter have been pressured by industry to demonstrate real revenue streams, they eventually transform their ‘forever free to all’ models and pursued revenue based activities. Investors have taken note. The idea that a startup can succeed infinitely without a plan for revenue generation that goes beyond angel investor and venture capital influx has reached a point where it may become increasingly less palatable within the IST community.
The novelty of ‘build it and they will come’ technology innovation, and startups that appear overnight, seemingly with the singular purpose of demonstrating prowess in leveraging Metcalfe’s Law, will have stronger competition from those startups who have taken feedback from their peers in finance, marketing and other disciplines, and created real business models that not only have high social value, but pursue sustainable, revenue generating pathways from inception.
Further, the IST domain can benefit from engaging other disciplines to ascertain what implementation models have worked in the past. Certainly, business modeling and valuation should not become so constrictive that they stifle innovation effectively reducing rewards for ideation. However, increasing the IST domain’s focus on transdisciplinary thought leadership could aid in extracting more value from investments and innovations earlier, and with greater success if we are able to find strong implementation and business models that can provide new technology with a strong operating foundation for the future.
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