Instagram, Obama, and Why We Should Be Wary of Social Media Start-Ups Part 2 by Isaac Matson

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Before we start carving the images of Mark Zuckerberg and Kevin Systrom into a mountainside, there should be a word of caution. Instagram is a unique case: it only has 13 employees and makes zero revenue. 

That’s right—Instagram doesn’t make any money. This brings up the question of valuation. How do you assign value to a company that has 35 million users but only 13 employees and zero revenue?

Valuation in the age of social media is tricky. According to the Wall Street Journal, “the traditional ways of valuing a company—by its cash flow, or sum of its parts—are ineffective when that company makes only one product and gives it away free.” Derek Thompson writes, “The new Web economy, which draws its value not from employees making hardware but from users employing software, operates with a totally different valuation calculus than AT&T or Microsoft…Instagram and Facebook are free. They’re valuable because they’re selling (or have the potential to sell) so much of you.”

Some say social media companies are overvalued and fear a bubble may be forming. While reporting on LinkedIn’s volatile stock prices after that company went public, James B. Stewart wrote in the New York Times, “There is widespread agreement that bubbles occur when a speculative mania causes the price of an asset to soar far above its intrinsic worth. After the mania runs its course, and investors finally recognize their divergence, the bubble typically bursts, causing prices to plunge.”

After the Instagram deal, Rebecca Greenfield of The Atlantic Wire posted, “Facebook’s $1 billion acquisition of Instagram, a photo sharing app that costs zero dollars to use and has no source of revenue, sure feels like a social networking tech bubble.” Even more compelling: days before Zuckerberg and Systrom shook hands, a group of Silicon Valley investors valued Instagram at $500 million, exactly half of what the Facebook CEO paid.

Talk of a social networking bubble may be premature, but the U.S. remembers past bubbles well. The dot com bubble of 1990’s—and more recently, the devastating housing bubble that left many new homeowners underwater in value—beg us to exercise caution.

Is entrepreneurship vital to our recovering economy? Absolutely. Start-ups have the potential to create new jobs and hopefully the JOBS Act will help do that. But we should be wary of billion dollar social media start-ups that have no definite source of income. After what happened to the housing market, we cannot afford another bubble, regardless of who wins in November.

Isaac J.Matson