Many companies today, especially the companies that provide a service based on network effect (ie social networks that become more valuable as more people are on them), focus on the quantity of users as a metric for their success. Whether it be daily active users, user retention, or user acquisitions rates, it all has to do with the quantity of their user base.
And based on that number, the company derives their value.
Historically, this method of valuing a network makes a lot of intuitive sense. In a world where many of these networks are powered by free accounts (Facebook, Twitter, Pinterest, etc), calculating the number of active users allows a company to estimate it’s earning potential based on advertisements or other media reach.
And thus we have gone to see many of the simplest apps reach exorbitant valuations based merely on the growth of it’s user base. Yik Yak, Snapchat, Slack, WhatsApp, etc have been able to reach extremely high valuations relatively recently based on these principles.
And despite the fact that they all have had impressive user growth to justify their valuations, I believe most of these to be overvalued.
I’m no expert in corporate valuation and I don’t claim to be, but as someone who has followed the happenings of the Silicon Valley closely in the past couple of years, these are my thoughts.
How a company should be valued
The value of a company, regardless of industry or product, should be based fundamentally on the value that they create. So in order to properly determine how valuable a company is, we must be able to determine how much value they create.
Of course, investors are making bets on the value that a company is going to create in order to maximize their returns, so the investing mindset is more complicated than the scope of this post.
Value is hard to measure. It generally tends to be more of a qualitative analysis rather than a quantitive. It’s clear that Facebook creates a different value than Twitter which creates a different value than Instagram which creates a different value than all the other social media platforms. And based on that value that they create, they build a community of users that use their products.
This is where knowing your user comes into play. The kind of users that use your products plays a big role in the potential future monetization of your platform. Using the pay certainty technique outlined by Ramit Sethi, determining the profitability of an idea is as simple as asking if the user has the ability and willingness to pay.
But once again, in the world of free accounts and value being based on potential advertising or other vehicles of revenue, the pay certainty technique has a little twist. If your product is being supported by advertisements instead of what users pay, you no longer become the recipient in the pay certainty equation, you become the mediator.
So what does this mean practically?
Understanding your users is important. And I say this not only in understanding their needs and desires, but also understanding how they provide value back to your company to help you grow and become profitable. If your average user is a young college student that uses your product to complain about their professor, they aren’t worth much monetarily to your company if you’re selling advertisement space to maternity products.
Thus, the value of your user base should be dependent on their ability and willingness to pay multiplied by the number of users that fall into that category. And unfortunately, many of the recent social networks that have been appearing with the intent of solving our first world problems attract a group of users that generally don’t care to pay money for the services.
As an entrepreneur, you should be working to build a network with high quality users to maximize profitability. It’s better to have 1000 people that absolutely love and evangelize your product than 100,000 people that merely think your product is cool.