Silicon Valley Cringes Over Facebook Fallout


The fallout and blame game from Facebook's (NAS: FB) IPO has spread from Morgan Stanley to retail brokers all the way up to founder Mark Zuckerberg. Fingers are pointing back and forth, pundits are weighing in on who's at fault, and as usual, retail investors feel like they're left out in the cold. But the even bigger fallout from Facebook's IPO and subsequent performance on the market may just be making its way through Silicon Valley, the home of the tech boom.

It's not only retail investors, investment bankers, and institutional investors who will look at the next round of companies differently after Facebook. Venture capitalists are also paying attention. These are the investment firms who fund start-up companies like Facebook, Twitter, Zynga (NAS: ZNGA) , Pandora (NYS: P) , and so many others that you may use every day, and they drive the innovation we know and love.

A gamble of epic proportions
A venture firm invests money in a company that may be so early in its development that it has little or no revenue and nothing more than a prototype to go on. Look at Instagram, which had no revenue when it was sold to Facebook, as an example of one of these early-stage companies. These investments are risky, very risky, but the payoff can be huge.

For their risk, venture capitalists look for an extremely high return on investment. One venture capitalist I talked to years ago said if he could generate a 10x return on 15% to 20% of his investments, it would be a smashing success. The other 80% to 85% of companies would fail and leave the fund with zero return on investment, so the few winners had to be big.

To make this kind of money, not only does a venture firm have to choose good companies, it has to have an exit plan to cash out. This may be a sale to a larger company, or in the case of many tech companies recently, an IPO. If the market is willing to pay for tech stocks, the money flow continues -- if not, the flow through Silicon Valley may dry up.

Questioning the market's appetite for tech
Just take a look at the string of IPOs that have happened in the last year or so to see how weak the appetite for tech companies is right now. Pandora, Zynga, Yelp (NYS: YELP) , Groupon (NAS: GRPN) , and Facebook have all flopped as early investments, primarily because they were valued too highly by those offering shares and funding earlier rounds. The only real success was LinkedIn, which had the best revenue stream at the time it went public.

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I don't blame investors on the public markets for what has happened. Many of these companies had weak competitive advantages at best, and valuations didn't stack up against more established players like Google. But what this will do is make venture capitalists question their ability to exit investments in the future. When a company hits the public market, it often isn't a complete exit for venture capital investors, so they're also left holding the bag when the stock drops.

Losing money before they even make it public
The trickle-down effect will make it from public stocks all the way down to startups. Investors will realize they've paid too much for recent IPOs and adjust what they're willing to pay for future tech IPOs. Investment banks will have to cut back on how much they ask for an offering, venture firms will lower valuations of new startups, and even popular new tech companies will see their valuations suffer.

Last September, Twitter raised $800 million in a funding round that valued the company at around $8 billion. This is for a company that estimates say generated less than $150 million in revenue last year. Don't think that any future investment rounds or an IPO won't re-evaluate the multiples we can put on companies like Twitter with little in the way of natural revenue streams.

There are plenty of other big names that may also have to reconsider how much they're worth. Rovio Entertainment, maker of Angry Birds, had its sights as high as a $9 billion valuation after around $100 million in sales in 2011. I would take the under on that valuation any day.

Workday, Evernote, Trulia, and many others were hoping to hit the public markets soon with valuations over $1 billion as well. That's less likely after Facebook.

Silicon Valley shakes its fist at Facebook
The biggest fallout may be with companies we will never see. The next innovative website or app may not get the funding it needs to grow and expand, putting a damper on an innovation boom in tech. As venture firms evaluate just what Facebook, Zynga, Groupon, Pandora, and others mean to the future of startups, we will see the real fallout from Facebook's IPO.

It's too bad, but what the market wants now is revenue, profits, and a good valuation. Startups will have to consider that before asking for a massive valuation from venture firms in the next go around.

Don't give up on all new companies after Facebook's drop. Our analysts have found one IPO that's worth buying, and it is revealed in a free report called "Forget Facebook - Here's the Tech IPO You Should Be Buying."

At the time thisarticle was published Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.The Fool owns shares of Facebook and Google. Motley Fool newsletter services have recommended buying shares of LinkedIn and Google. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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