How A Startup With No Revenue Can Be Worth A Billion Dollars

kevin systrom mike krieger instagram foundersThe Instagram cofounders

When Facebook

snapped up Instagram for $1 billion last year, lots of people in the tech industry were baffled.Instagram had no revenue, but for some reason Facebook decided the company was worth spending a billion dollars on. 

Earlier this year, Pinterest sold $200 million in stock to new and current investors for less than 10% of the company, effectively valuing it at $2.5 billion. Pinterest still has yet to generate any revenue, but investors are betting that the social pinboard startup could be the next Facebook. 

Paul Buchheit, the creator and former lead developer of Gmail, says this is the most counterintuitive aspect of the venture capital business.

“The general public doesn’t understand start-ups at all,” Buchheit recently told Nathaniel Rich of The New York Times. “They’re mystified how a company with no revenue can be worth a billion dollars. It’s because of this power law: If a company has a 1 per cent chance of being a hundred-billion-dollar company, then it’s worth about a billion dollars. That kind of thing doesn’t happen in your normal life experience. If I get a cup of tea, it’s a cup of tea — there isn’t a chance that it’s actually made out of solid gold. But that’s how this works.”

NOW WATCH: Tech Insider videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.