VCs’ Wallets Say Social Media Is Dead

Venture capitalists apparently are quickly losing interest in social deals.

According to a recent report from CB Insights, “Social companies saw only 2% of funding to the Internet sector in Q2’13.” And that’s no fluke — social funding has been at 2% or lower in three of the past four quarters. That’s a stark contrast from just a couple of years ago, when that figure was well into double digits at 21%!

This certainly is bad news for entrepreneurs desperately seeking money for their social startups, and could lead to a spate of shutdowns.

But hey … if no one’s backing startup social projects, that’s fewer threats — and less well-funded ones — knocking at Mark Zuckerberg’s door, right? So, big win for Facebook (FB).

OK, maybe not.

See, in an efficient market, capital flows to those opportunities that have the most potential for profits. In other words, VCs are talking with their wallets — and they’re saying that growth in social media has ended.

With more than 1 billion users, Facebook already has a huge chunk of the market — one shared by other key players like Twitter, Pinterest and Google’s (GOOG) YouTube, the last of which has more than a billion users itself. And of course, when it comes to business, LinkedIn (LNKD) is the dominant player.

It’s almost shocking how quickly the market has reached such high saturation levels; the first social networks hit the market back in 2012, with Friendster.

But the quick ramp should be no surprise, as it’s fairly common with network-effect businesses. In short, these businesses involve platforms that get more valuable as the number of users increase. Take the telephone — it’s not worth much if only a few people have one, but as more people adopt telephones, the value of the network they operate on increases exponentially.

With Internet businesses, the power of network effects is supercharged even more, if only because it’s so easy to sign up for an online service (as opposed to, say, buying and installing a new phone, and setting up service). An early example of this was eBay (EBAY), which pioneered the online auction business back in 1995. As it gained more sellers, the listings increased. This, in turn, attracted more buyers, which attracted more sellers, and so the virtuous cycle went.

So by 2000 or so, eBay really hit the saturation point.

Facebook could be facing the same thing. For the past couple years, growth has decelerated — even has it has invested heavily in mobile and has the most widely used apps in the world. The result has been a fairly dismal IPO and aftermarket stock performance.

None of this is to imply that Facebook is without hope. Transformative acquisitions have worked for eBay and other companies like Google (GOOG) that leveraged their huge cash flows into other growth businesses, with shareholders reaping strong returns.

FB has the cash — but so far, it has engaged primarily in small-time deals. That’s a good way to pick up knowledgeable engineers, but it won’t do much to push the needle.

So in the short-term, perhaps Facebook’s best hope is to do what VCs aren’t right now in social, and open its wallet wide.

Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO StrategiesAll About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.

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