Nuances of Twitter Financing

by nikiscevak on September 24, 2009

99% of the people who prognosticate on Twitter raising $100m at a $1bn valuation will focus on one thing: $1bn for a company that has no revenue! And that’s fine. But what are some of the subtleties for those involved?

1) Are the investors leading the round, T Rowe Price and Insight Venture Partners crazy? Maybe they are but there is likely very little downside for them. That is, it may be extremely hard for them to make money but they probably won’t lose it. Shares bought are of the preferred variety and so if Twitter sold for $100m they get their money back and no one else gets anything.

Additionally, liquidation preferences of > 1 are most common for East Coast firms with later stage investment – exactly the kind of deal this is. So in theory, just say the investors got a 2x liquidation preference, then the first $200m would go to them. A 2x is probably a stretch but something like a locked in 10% a year is not.

What I am saying is that the investment expectation is not so much ‘venture capital’ but a ‘loan with some upside potential’.

Private equity firms are sitting on gigantuan piles of cash (or rather gigantuan piles of commitments from stretched pension funds who, although they are legally obligated to, would very much not like to fulfill in the next 1-2 years). Counting all the probability scenarios, the two firms will likely make the 10% a year (or whatever number) in a huge percentage of cases. The one case they need to worry about is whether Twitter could ever be worth less than $100m, which is likely small (but still real).

2) That’s great for T. Rowe Price and Insight Venture Partners but what about the rest of the investors? The earlier investors, particularly Union Square Ventures, have a real choice to make. They have a small fund relative to the size of this investment. To keep their pro-rata share they would have to put a decent chunk of their fund into an investment with the risk profile of point 1 – something their limited partners have not asked them to do.

Also, in some ways the funding is a negative for USV and Spark as now there is the overhang of this $100m (plus the $35m from Benchmark and IVP). Just like the founder and senior management, taking larger and larger amounts of preferred equity financing puts the early venture investors on an ever distant express train where there is very little scope to get out profitably at lower amounts. A $100m IPO on a $1bn valuation is much more attractive as that is for common stock, every preferred stock holder converts to common stock and the strings go away.

3) On the upside, Union Square Ventures, Spark Capital just got a huge valuation validation that would put the respective funds in the money on this investment alone. They can now go out and raise another fund easily.

4) Twitter is now legitimately not for sale. The management team can tell reporters that they are not for sale until they are blue in the face but now those claims actually have credibility. No one has any incentive to sell for less than 10 figures. It will now be easier to tell the magpies of the corp dev teams at Google, Facebook, Microsoft, News etc. that they really aren’t looking to sell.

5) Raising this much money at this point in time is a huge risk for the company. As anyone who has ever heard of the name Steve Blank will tell you: The number one cause of startup failures is pre-mature scaling. Twitter may have found product-market fit with one of its constituencies (users) but they are so early on with paying users (businesses, power users) and have not even started with some (advertisers) that there is a huge risk they will scale up with the wrong product and then put themselves in a death spiral following that.

6) Do they actually need this money? No. There is a paradox in that only companies that don’t need to raise money can but with this amount it’s actually quite perplexing. The standard answer will be more servers and look at what Facebook has spent etc. but there is one huge difference with Twitter: They don’t host photos.

Facebook is the largest photo site on the Internet and has to store a shitload of images and deliver them to users around the world. Twitter has no such problems. It would be analogous to saying AT&T needed to upgrade their network due to the boom in text messaging vs needing to upgrade because of rabid iPhone users in the bay area. The latter is valid but the former is not.

7) With such a large amount of money it would not be surprising if some early employees and angel investors, particularly those from Summize, cashed out at this round. There is limited upside for them with a long line of preferred investors ahead of them in the que. And a $1bn valuation would be a fantastic outcome and nothing to scoff at. No one got poor selling at a $1bn valuation.

8 ) Good luck to employees joining Twitter now. Although the common stock valuation is not $1bn because of all the preferred stock obligations and given the stage of the company, if you are interested in Twitter go out and build a Twitter app instead of joining the company.

  • Kyle F Flaherty

    Fantastic commentary, thanks for diving in and pushing away a lot of the noise around the investment. Point 8 is the most interesting to me because I think it will curtail talented and innovative folks from joining Twitter, which is what they need the most at this point in time...well that and better server load balancing capabilities ;)

  • Great analysis of the deal and explained very clearly. Excellent.

  • The most under-reported part of this whole story is #8, and actually ANY employee of Twitter.

    Because the fact is that almost no company that raises over $100 mil in venture capital ever generates positive return for the investors - and the investors get paid out before the common (employees).

    The only way any common shareholder from twitter ever makes a dime is if twitter creates the next AdWords. If they can pull that off, then everything will be fabulous and we'll all forget this conversation.

    Here's how the math works against EVERY employee at an overfunded startup - take the mint deal for example: $170M exit (maybe $70 or so is future perf related so that leaves $100M), even without liquidation prefs, the employees get basically nothing. $40mil VC = maybe 60% of the company, 20% for the founder CEO, 3% each for the next 5 guys. That leaves everyone else sharing $5mil to vest over the next 4 years. And even that's skewed for a few people. So with the biggest VC exit of the year, the employees are basically vesting a $20k annual bonus. gee thanks.

    Huge VC rounds are only good for people who own big, early, preferred chunks already.

  • gellert14

    Great points - was thinking many of these things myself. The $1BN is not meaningless as it tells you how much your $100MM investment gets, but it is a senior security and there is no way Twitter doesn't sell for $100MM. While this money is good for all investors, the Series A guys (USV) put their investment at risk (even only a tiny bit) with this round.

    The other thing that I would add - while everybody is talking about how USV didn't participate because of their fund size - that is certainly the primary reason - another just as valid reason could be that they think the valuation is too rich and they don't believe that putting in $11MM for 1% of the company is worth it.

    Don't agree with #2 (in part - there is no way there is a 2x liq pref on these shares) and #6 (Twitter is probably burning north of $2MM a month with the SMS fees which definitely add up - not as expensive as photos / videos, but it adds up). Overall great post

  • Many thanks for your comment and completely agree over the USV decision logic (since I wrote this it was confirmed they didn't participate).

    On point 6) from what I hear SMS spending in the US is actually capped. That is, once you reach a certain threshold (I am told $1m/mo) then it's just a flat fee and not a variable one. Also, internationally carriers will actually pay Twitter per message carried. That is, SMS is a revenue not cost since the carriers rightly see that Twitter is encouraging completely incremental SMS use.

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