Why investors are all atwitter about social

21 March 2016

Social tech firms are the hot stock for investors these days, yet a look at their balance sheet would put most people off. Sarah Henson talks to Sotirios Paroutis to find out why Twitter and the like are so popular even when they don’t make any money

Traditionally, investors would pore over financial statements looking at revenue and forecasted profits before they would consider backing a start-up.

Investing in a company that was yet to make any money and without any indication of how it planned to monetize itself in the future, would be seen as a huge risk.

The dot-com bubble between 1997 and 2000 taught investors harsh lessons about overlooking traditional financial metrics and putting their trust in the potential of the internet. But over the last few years we have seen sky high valuations of social tech giants such as Twitter, Instagram and Snapchat, companies who in many cases are yet to turn a profit. Investors have been queuing up to get a piece of the social media pie. So what exactly is it that gives this new phase of tech companies the power to woo investors without being able to show them an expected return?

Sotirios Paroutis, Associate Professor of Strategic Management and Assistant Dean at Warwick Business School, says in a digital age investors are willing to part with their cash based on their confidence in tech firms’ future potential. “It’s the Facebook effect,” he says. “The expectation is that some of these endeavours will make money, as Facebook did - eventually.”

It was of course Facebook, the big daddy of the social tech world, which started the trend for huge valuations and provided investors with a taste of how these firms could expect to grow. Facebook was already valued at up to $5 billion in 2008 according to Businessweek before it announced it was ‘cash flow positive’ reaching 300 million users in 2009. It is now used by a sixth of the world’s population and reached a peak market capitalization of $104 billion after it held its initial public offering (IPO) in February 2012.

The majority of its revenue now comes from advertising, particularly from mobile, which is the fastest growing area for the company. 

“Investors have seen Facebook grow its user base exponentially to reach a point where it can use its commanding position to flex its advertising and pricing muscles, and so to start generating revenues. It has changed the way investors think about the success of a firm,” says Paroutis.

“In the case of Twitter and other tech start-ups, investors are more open-minded to allow a bit more time for revenues to materialise. They are not looking only at revenues when making a decision in this industry space - it is more about the growth opportunities and the innovation behind the endeavour that is at the spotlight.”

And this was proven when Twitter launched its IPO in 2013 with a value of over $14 billion, despite having never made a profit. Investors had learned from the Facebook IPO, says Paroutis and were willing to invest in the power of Twitter’s user base rather than the figures on the balance sheet.

Staying useful for users

But a flexible business model is also key in this industry space. To succeed in the social media sphere you need to attract users, engage them and keep them or you will be drowned out of the market like Myspace, one of the original social networking sites, that lost 10 million users between January and February 2011, and saw its unique user number fall from 95 million to 63 million during the previous 12 months.

Paroutis explains: “We tend to see social tech start-ups go through three phases. First, they offer the service for free to grow their user base. If users see value in it, you see a rapid growth.

“The second phase is a slight tweaking of their business model to generate more revenue, often by allowing advertisers to interact with the user base - this is when Twitter brought in promoted tweets. The third phase is a further refinement of the business model, leading users to actively seek engagement with companies without the need for advertising. The service becomes so smooth that users utilise it to get products and connect with firms – for example, when seeking discount coupons. Throughout the process the key idea is not to lose your user base and to keep users active.

“In the case of Twitter there are three key revenue streams: advertising, utilising their database for interested parties, and providing advertisers insight into new international markets by expanding their service in those countries.

“At some point, like Facebook, Twitter will reach a stage where they will have a commanding position in terms of their user base. That will allow them to re-negotiate contracts with advertisers and keep investing in refreshing their service to be one step ahead of competing platforms, to place them in an even more dominant position.

“But the key factor is having a growing user base. As long as there is confidence that the business model is still innovative enough to keep users interested, investors will give social tech firms the time to find those revenue streams.”

The growth of Snapchat

Another way these companies will start to make money is to sell consumer behaviour data. If these sites know where we live, where we shop, who our friends are, how we are feeling and what we are doing elsewhere on the web, not only can they command high fees for advertising and promotions on their sites but they can also sell the data to marketers.

Photo messaging service Snapchat which was developed by Stanford University students was valued at $10 billion in August 2014 after becoming the hottest new app among teenagers. The success of the firm is largely due to the power of its audience.

“Snapchat, the most popular app with teenagers, has the future customers of corporates at their fingertips,” says Paroutis.  “The insights and data that this provides can give early indications of consumer and market trends, and allow corporates to find the right products to sell at the right time, to these teenagers, especially as they get older and have more disposable income.”

So can these tech firms satisfy investors and will they be around 15, even 10 years from now? Paroutis believes they can’t be complacent; they must keep refreshing themselves if they want to find more users and keep them engaged.

“Advertisers need to see you are still a relevant platform,” he says. “If a firm can’t sustain their follower growth and keep up with competing innovations, marketers will simply move their budget to other emerging platforms that can target their audience in a more effective way.”

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