Are venture capitalists paying too much for Web 2.0 start-ups?

5 July 2007

At the end of May, Last.fm, the social music discovery tool that established itself as the go-to destination for many music lovers, was sold to US broadcaster CBS for a reported $280m (£141m), the latest in a growing list of burgeoning European success stories in digital media.

Over the past two years, Europe's VC community has been pouring money into digital media start-ups. Disruptive business models and disruptive growth trajectories have enabled the emergence of a new wave of high-profile start-ups. And this time they can turn into significant cash generators, fast.

Let's look at UK social networking newbie Bebo. Let's assume that Bebo generates E1 (74p) net per impression or per thousand (CPM) on half of its inventory of over 3bn monthly page views, and that the cost of serving these pages is around 20¢ (15p) CPM. The ten-person company could therefore be generating around E900,000 (£662,880) a month for running the site.

Spurred on by the success of Skype and the acquisition of MySpace, Euro VCs have aggressively set out to find the best digital media entrepreneurs.

These entrepreneurs tend to be divided into two camps. On the one hand are 'copycat' plays designed to appeal to the regional media players. A key issue for most large European media groups is that they don't have good access to the flow of promising start-ups being established in the US. AOL, Google, Yahoo! et al are actively snapping up promising companies early on. MyBlogLog, Flickr and Upcoming.org have allowed Yahoo! to build a social networking hub at low cost. Some savvy Euro entrepreneurs are therefore quickly engineering local champions that they push into the welcoming embrace of media groups.

Germany offers a number of recent examples. UGC video site MyVideo.de shunned the advances of institutional investors to strike a deal with ProSieben, and StudiVZ, a Facebook lookalike, achieved an early exit with Holtzbrinck for an impressive E100m (£73.7m). A friend of mine remembers looking at StudiVZ for its seed round and turning it down. "It didn't even change the Facebook layout," he said. Famous last words, as it turned out.

On the other hand, European innovation is also starting to produce some world-class companies. Netvibes would be in this category, a lightweight in pure technology terms but a fantastic service that has grown to millions of users and is moving to the next stage - the de-portalisation of the web through widgets. Recently funded Plazes is also worth watching, with a very unique take on geolocalisation.

In VC land the debate rages as to whether the industry, with its notoriously short memory, is setting itself up for Bubble 2.0. Equally worrisome are the valuation pressures that competition is creating - it seems that $20m (£10.8m) is the standard asking price for a first round of financing, with plenty of takers, and there have been a number of examples of Series A financings in the $50m (£27.1m) range.

My view is that a correction is due but that talk of a bubble is premature. Last time round, people made wild assumptions about the number of users who would move online. This time, the target population is already online and the debate is about conversion rates and cost of customer acquisition. I can see some diminished returns from overpaying for deals and some depressed EBIT lines because virality fails to materialise and has to be complemented with good old marketing, but I can't quite see that bubble yet.



Fred Destin is a partner at international venture capital company Atlas Venture