Why Snapchat's rumored funding raises the high stakes for LA's startup ecosystem

By Michael Carney , written on June 10, 2013

From The News Desk

When the news leaked late last week that Snapchat was on its way toward raising $100 million at a valuation between $500 million to $1 billion, there were no shortage of opinions. Depending on whom you listened to, Snapchat was a high-flier like Instagram or Facebook or further evidence of a Silicon Valley bubble. But what does the deal mean for the Los Angeles startup ecosystem?

That’s right, Snapchat isn’t based in Silicon Valley. It’s in LA’s Venice Beach. If the deal closes at the high end of the reported range, it would be the first billion-dollar consumer Internet company to come out of the burgeoning Southern California market and one of only a few to cross that metaphoric threshold in any category. Doing so instantly makes it the highest profile company in town. As Sarah Lacy pointed out previously, however, it is often better to be the heads down company on a market’s fringes than its most vocal and celebrated posterchild.

While LA hasn’t had many companies raise rounds at such stratospheric valuations, it has had its fair share of massively-hyped companies deflate shortly after raising heaps of funding. As my colleague Erin Griffith said when first hearing of the deal rumors: “Overpriced money-losing social media apps are back with a vengeance apparently. That cycle didn't take long.” The last thing the market needs is another flameout.

So all of this begs the question, should Angelinos and supporters of the region’s startup ecosystem be celebrating this rumored funding?

Snapchat’s founders have been notoriously private since launching the platform a little more than a year ago. As a result, many local investors have been cautious not to publicly comment on the deal, seemingly hesitant to ruffle feathers at the hot company. However, a few were willing to share their thoughts anonymously.

One prominent local investor with numerous successful startups to his credit says, “It’s huge for LA in that it shows that the next big thing might not be in the Valley. The growth is meteoric. For a late stage investor, yes, it makes sense to invest.” Another added, “It's a more attractive company than Instagram was, with higher engagement, faster growth, and a more natural path toward monetization.”

Yet another LA investor with a wealth of consumer internet and media experience echoed this sentiment saying,

There's a definite case to be made for $500 million because later stage funds can look at this as a call option on the next Google. They get 6 to 8 percent on their money and a liquidation preference so they are first money out, with a percentage ownership of what could be a multi-billion dollar company. That was probably the theory behind the Viddy valuation. Sometimes it blows up in your face.
Even at a half a billion dollar valuation, not everyone views the deal as so attractive. One local investor said he would pass at $500 million:
We target at least 5X return and don't see a lot of folks buying this for more than Instagram even under great success. It’s hard to see today how it could drive revenues, though the usage is impressive. It’s a great product. I'm sure the deal gets done somewhere near there given the heat. Those investors can live with a 2-3X if they can deploy a big check.
While many in LA will happily take credit for Snapchat’s success if it holds the course, there’s reason to question whether this would be justified. In other words, is SnapChat indeed a product of the LA startup ecosystem?

The company was founded by two Stanford grads who -- appropriately, given its target demo -- built the initial product in their dorm rooms before they graduated. Despite relocating to sunny SoCal shortly thereafter, the company is backed by three Silicon Valley firms: Benchmark, SV Angel, and Lightspeed Venture Partners. While there is no concrete information as to who will be leading the current rumored round, the two names I heard most while reporting this story were General Catalyst and Institutional Venture Partners (IVP), neither of which have ties to LA.

Unlike Tumblr, FourSquare, and even Groupon, all posterchildren of their respective markets, it doesn’t look like Snapchat will benefit any hometown VC firms. As the company grows, it is likely to hire locally, and an eventual liquidity event will mint plenty of millionaires, many of which will presumably remain local and reinvest into the ecosystem. And local firms will welcome a success story to point to when raising future funds. How their LPs will feel, if it turns out that these firms missed out what could be this cycle’s biggest success story located in their backyard, is another matter entirely.

There’s little arguing that Snapchat’s ephemeral photo messaging service has caught on in a spectacular way. The number of Snaps sent daily doubled between February and April of this year, reaching 150 million messages per day according to data that the company provided Kleiner Perkins partner Mary Meeker (a number that is likely much higher today, given its recent growth trend). The app has also captured the attention of the highly coveted 13-to-25-year-old demographic, one whose attention on Facebook has been waning and over which Instagram and Tumblr have been battling for mindshare.

Despite this massive engagement, however, the company has yet to monetize, and is valued purely on its future money-making potential and/or its ability to attract an acquisition.

It’s not the first company to follow this playbook. Facebook famously eschewed monetization for years due to a fear of turning off early users before reaching scale. Instagram reached more than 40 million users without generating a dime of revenue before selling to Facebook for $1 billion (a deal whose value has since declined in conjunction with the acquirer’s stock price).

The other issue is that young people are notoriously fickle and today’s hot social platform is tomorrow’s old news. A bet on Snapchat today is a bet that this can be the once-in-a-generation company to beat the odds and demonstrate staying power.

It’s still too early to determine whether Snapchat is sustainable as a standalone platform, or whether it’s a fad or merely a feature that belongs within a broader platform. The answer to these questions will go a long way toward determining the wisdom in this reported financing. At the same time, the degree to which the company chooses to recruit from and engage with the local tech community – through mentorship, acquisitions, angel investing, etc. – will determine the impact that it has on the success and the perception of the LA ecosystem.

The next company to pick up the LA baton and run with it had better carry it over the finish line, otherwise doubts about the market’s validity look more legitimate. In other words, tread lightly, LA.