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Is Social Media's Investment Bubble Ready To Pop?

Overinflated value of social media and Internet companies makes it likely we'll see a repeat of the late 1990s dot-com crash, say investment bankers.

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A survey of investment bankers shows 75% of them believe the valuation of pre-initial public offering (IPO) Internet and social media companies are inflated, and 62% say a repeat of the late 1990s stock bubble is at least somewhat likely.

The results come from a survey conducted by accounting and consulting firm BDO USA, looking at the effect of private markets such as SecondMarket and SharesPost, where U.S. law allows only a limited amount of trading in shares that are not available to the public. Sellers may be early investors or employees seeking to liquidate some fraction of the shares they have been granted.

"These firms facilitate transactions among private buyers, but because there are not enough sellers in the market, it creates a bit of a frenzy when the company finally does go public," said Lee Duran, a partner in the capital markets and technology practices at BDO. The effect is particularly exaggerated with respect to consumer social media companies because that's where the greatest interest lies, Duran said.

Recent social media firm IPOs, such as LinkedIn, have ignited fears of a new Internet stock bubble, but the hunger for equity in these companies is reflected as much if not more in private markets. Social gaming company Zynga is planning an IPO and an IPO for Facebook is likely to follow within the year.

Most--79%--of the investment bankers surveyed thought the existence of these markets was having a positive impact on the U.S. market for IPOs, despite their misgivings. More than two-thirds (71%) feel the small volume of trades in the private, pre-IPO marketplace has served to inflate the value of these businesses and a majority (64%) are in favor of the Securities and Exchange Commission easing constraints on the number of shares that can be issued and the amount of capital raised before a business is forced to go public.

The SEC rules are a factor in pushing Facebook toward a public offering, as is currently required for an organization that exceeds 500 shareholders and $10 million in assets.

Although the investment bankers saw the scarcity of shares as one factor driving high valuations, they did not all see it as the primary reason. When asked about the major driver:

-- 34% cited the scarcity of shares in pre-IPO markets hyping demand;

-- 25% attributed the valuations to the growth of the Internet itself;

-- 22% identified the profitability of the businesses; and

-- 19% alluded to the positive performance of recent Internet offerings.

Duran said many of the companies receiving high valuations today look more like real businesses than those Internet firms that imploded at the end of the 1990s. "Unlike the early dot-com era, these guys actually have good business plans and ideas about creating net income," he said. On the other hand, only a few like Facebook are so deeply entrenched that potential competitors face a high barrier to entry, he said, contrasting that with a more easily replicated business model such as that of Groupon.

The national telephone survey of capital markets executives was conducted by Market Measurement on behalf of BDO.

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