A recent issue of Fortune’s daily Term Sheet included a link to a copy of documents relating to YouTube’s 2005 seed round fundraising. The documents, attached to a 2010 court filing, include the presentation made by YouTube’s founders to potential investors and an internal investment memorandum from Roelof Botha, partner at Sequoia Capital, outlining the rationale for an investment in the Company.
The documents provide a fascinating peek behind the curtain, demonstrating what actual market participants care about (and don’t care about) when evaluating early-stage companies. For valuation specialists preparing fair value measurements of early-stage companies, the documents are great reminders of the key elements of start-up valuation. In this post, we highlight a few of the primary themes.
- Comparison to Observed Trends. While YouTube’s file sharing technology was clearly a critical factor in the Company’s success (and valuation), the lead VC supporting the investment focused on the broader trends in user-generated content when evaluating YouTube’s potential. Although a novel technology, YouTube’s video-sharing service was a natural evolution of the broader user-generated content sharing trend which was manifest in the success and popularity of blogs (sharing user-generated written communication) and sites like Flickr (sharing user-generated still photos).
- Importance of Enabling Technologies. According to the investment memorandum, two enabling technologies were paving the way for YouTube’s growth at that particular time: the proliferation of relatively inexpensive digital video recording devices and the spread of broadband internet access. YouTube’s file-sharing technology was not an isolated engineering feat, but represented a timely “fit” with other technological changes in the broader market.
- A Clearly Identified Problem. Why did the world need YouTube? Video files were bulky and in a variety of file formats (and therefore difficult to share). In addition, by serving as a reputable central “clearinghouse” for user-generated content, YouTube would help meet the need for community among individuals with common interests.
- Focus on Human Capital. The experience and track record of YouTube’s three co-founders was prominent in the investment memorandum. It is clear that Sequoia was investing in people as much as in technology. Even so, the investment memorandum acknowledged the need for additional management resources and leadership to support the Company’s growth and development.
- A Clear-Eyed View of the Competition. Given the observed trends, growth and availability of enabling technologies and the defined problem, YouTube was not the only potential solution hitting the market. The investment memorandum carefully evaluated, classified, and compared competing product offerings.
- Revenue Thesis. Despite being at the pre-revenue stage, alternatives for generating revenue (primarily through advertising) were identified. Revenue (and profitability) was the ultimate objective, and even though precise forecasts were not feasible, identification of the means by which YouTube would earn revenue was not deferred to a later date.
- Personal Experience. Mr. Botha reported being drawn to the investment opportunity, in part, because he had used the site himself. Obviously, not all innovative products lend themselves to sampling, but the threshold question of “Why YouTube?” was, at least initially, answered through personal experience of the company’s service offering.
Somewhat disconcerting for valuation specialists is what the investment memorandum did not include: financial forecasts, discount rates, probability factors, or option-pricing model equity allocation analyses. The absence of these valuation tools does not mean they should be dropped from the specialist’s toolbox – they are indispensable for providing an audit trail – but does suggest that the tools need to be used with consistent reference to the “qualitative” factors discussed in the YouTube investment memorandum. The credibility of the valuation analysis will depend upon it.
Mercer Capital provides valuation services for early-stage companies, including fair value measurement for equity-based compensation. Give us a call to discuss your needs in confidence.