Twitter and Facebook Investment Terms and Game Plans

Written by Bernard Lunn / September 28, 2009 6:00 PM / 12 Comments

This post is part of our ReadWriteStart channel, which is a resource and guide for first-time entrepreneurs and startups. The channel is sponsored by Microsoft BizSpark. To sign up for BizSpark, click here.

There is a lot of chatter in the blogosphere about the recent $100 million investment in Twitter at a $1 billion valuation, but most of it based on speculation. Twitter and Facebook are private companies. You cannot get the facts simply by typing a stock symbol into Yahoo Finance. Our mission at ReadWriteWeb is to add to the facts, not just the speculation. Rather than posting confidential information that someone has leaked to us, we prefer to start with publicly available data. That takes a lot of leg work and crawling through regulatory filings. Luckily, a firm in this industry does that professionally: the VC Experts Valuation and Terms database. It has given us access to and permission to publish the investment facts, as publicly recorded, for both Twitter and Facebook. We could not refrain from a bit of game theory speculation on how this could play out, and we invited a specialist in startup deals to add his speculation as well. But let's start with the facts.

The Twitter Rounds of Investment

The Facebook Rounds of Investment

Data courtesy of VC Experts Valuation and Terms database.

Our Theory on This Investment and Twitter's Game Plan

These high-profile deals have "optics" (i.e. the PR or headline story for public consumption) and fundamentals (i.e. how the investors actually make money). They are very different.

The key to the fundamentals is the Liquidation Preference. We touched on this in one of our "Startup 101" chapters: How to Scale Without Losing Your Shirt. Basically, upon exit, the investors get their money out before the entrepreneurs do. That's reasonable. For example, the Twitter team has not actually built a business worth $1 billion; it is only saying it can do so (with some credibility).

So, the investors putting in $100 million have their risk (or downside) covered. The only way they can lose money is if Twitter sells for less than $100 million, which is pretty unlikely... not impossible, but unlikely. But if it sells for $100 million, then all of the other investors lose everything. The exit valuation has to be higher than $157.97 million (total money invested) for the founders and management team to see a dime.

So, with their downside covered, investors can focus on the upside. This is where optics matter. With this deal, the entrepreneurs can say the following to any potential acquirers:

"Negotiations have to start at $1 billion. It clearly cannot be lower than that," and
"We have a long runway. If you don't do this deal now, the price will only be higher later."

In this case, the optics are critical. Although the investors in this latest round have protected their downside, they won't see any upside unless the exit valuation is greater than $1 billion. By putting in a large amount (which they cannot really lose), the investors help to ensure that the exit valuation is high.

Ideally, Twitter will exit before revenue, when revenue potential is unlimited. As soon as actual revenue comes in, three bad things happen:

Acquirers say, "Let's wait and see how this pans out."
Costs go up: you have paying customers who demand real service.
Revenue targets may go south. Exponential hockey-stick growth is hard enough for a free service (kudos to Twitter for doing that brilliantly) but way, way harder when money changes hands. Real money (not investment money) paid by someone to Twitter becomes friction. Twitter ceases to be a friction-less flywheel.

Twitter does have enough cash now to execute on a revenue plan and outlast acquirers who like to sit on the fence. So any way you look at it, this is a smart deal. It is not "evil": this is all business between consenting adults. Evil would be selling stock to "widows and orphans" in the public market who (A) don't have Preference and (B) don't have the means to evaluate the risk on a deal like this. That was Bubble 1.0, and it won't happen again. This is not Bubble 2.0. This is fundamentally different, even if the optics may look similar.

So What Do the Investment Facts Say?

Enough about theory, what do the facts tell us?

Yes, the Series E investors (the ones that just put in $100 million) get Liquidation Preference. Look at the line for the current round that says Liquidation Preference. If it says "Senior," then they get their money out first. If it says Pari Passu, then all investors get their money out equally (i.e. all investors get their money out before the founders and managers).
But they get only 1x Preference. They don't get money back plus interest. Nor do they get 2x or 3x. Hint to entrepreneurs: any time you see 2x or 3x, run a mile!

What Is the Difference With Facebook?

All of the Facebook rounds are Pari Passu. What that really means is that earlier investors in Facebook have more clout. They have bigger funds and can essentially say, "If you don't do this, we will." The small funds that invested in Twitter early on, such as Union Square Ventures (USV), cannot meaningfully invest in a $100 million round without Twitter becoming too big a percentage of their portfolio. But based on the valuation it invested in early on, USV will make out big time on any exit over $200 million.

The Great Facebook vs. Twitter Exit Game

This is high-stakes poker. Facebook has the potential to do an IPO. It has enough revenue and has at least neutral cash flow. With its actual finances not being in the public domain, we don't really know how good Facebook's finances are and therefore cannot know how ready it is to do an IPO. But that's not a problem; it has enough cash in the bank to wait until it's ready.

So, any company that really wants to buy Facebook and keep it from doing an IPO will have to pay big time. Only two acquirers are motivated enough and big enough to do this: Google and Microsoft.

Where does that leave Twitter? The $100 million round helps a lot. It is for show, not for spending. It has enough cash for negotiating clout. Facebook would cost Google or Microsoft way more than Twitter. If one of them bought Facebook, Twitter would be even more valuable to the other.

If Facebook does an IPO, Twitter's valuation would go up based on that public market comparable.

We cannot bet on this in the public markets, so we can only have fun watching the game.

How Does Perception of the Founders' Motivations Influence the Game?

In poker, perception matters. What you think the other person will do affects how you play your hand.

The exit valuation depends in part on how credible is the founder's drive to remain independent. Do acquirers really believe the founders are sincere in their stated desire to remain independent by going all the way to IPO? If the acquirer believes that the founder's desire to remain independent is very strong, then it will raise its bid. So, who does the market see as being more driven to remain independent: Mark Zuckerberg of Facebook or Ev Williams and Biz Stone of Twitter?

We asked Greg Boutin of Growthroute Ventures to comment on this part of the game. This is what he had to say:

"My perception of Ev Williams/Biz Stone is that they are not in it for the journey, but for the destination. Any way I look at it, those guys are not geek visionaries with a mission; they are money-driven. They'll flip Twitter to the highest bidder, if there is one. They know everyone is questioning Twitter's potential for revenue creation, and the hype effect will die out in a matter of months. Twitter has mostly unfolded during the crisis; being in SF has sure influenced their thinking. And unlike Facebook with its platform status, it really has only so many options to create revenue, none of which is likely to support the valuation."

Greg thinks that Mark Zuckerberg is a different story:

"Zuckerberg strikes me as someone who is driven less by the money - especially now that Facebook is turning a profit - than by the visceral "geek need" to prove he's smarter. He's demonstrated a strong desire to grow Facebook into the next big thing and I'd say even challenge Google for domination of the Internet."

Greg is willing to stick his neck out and make a prediction: "Twitter will sell next year for $2.5 billion to Google (or some other company that can come up with that kind of money). And Facebook will IPO."

He also thinks the high price will be based on non-rational factors: "They want to acquire it for the trophy factor, like top lawyers fighting to get the most expensive downtown offices. It's an ego and brand thing."

What Insights Do You Get from This Data?

We hope that people who are better qualified than us can describe what is significant in these deal terms, apart from the obviously high valuation.

What jumps out at you from this data? How do you think this will play out?

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Comments

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if the twitter could reach a IPO in the end, how much will it worth?

Posted by: 汇率网 | September 28, 2009 6:21 PM

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Posted by: Jorge Clan | September 28, 2009 6:31 PM

Bernard,

Just so we're all clear, you haven't confirmed what (if any) liquidation provisions were included in Twitter's latest round correct? Also, I don't know Greg Boutin, but I'm wondering what particular insight he has in to Ev/Biz/Mark? Does he know then personally? I for one don't agree with Greg at all vis a vis Evan & Biz.

This seems to be pure speculation based on hunches and partial data. Having said that, I do enjoy the circus as much as anyone :)

My view on the Twitter round here: http://www.uniquevisitor.net

Posted by: Jeff Pester | September 28, 2009 6:58 PM

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Posted by: onewetbed | September 28, 2009 7:20 PM

Having made the decision to sell the "Promise not the Performance" (or put another way, sell the "Sizzle not the Steak") as a path to valuation, I think Twitter has a relatively short window of opportunity to either turn on their revenue engine(s) or to be acquired.

What I mean by stating that they sold the "Promise not the Performance" is that instead of turning on revenue streams and be judged/valued at a forward multiple to these actual figures, Twitter is selling the fantasy of possibilities and allowing the potential investors to formulate a fantastic view of what could be - not what is.

Hence the sizzle/steak analogy. They have allowed the potential investors (hungry diners) to "hear" the sizzle of the steak in the pan and "smell" the wonderful aromas, building up an "atmosphere" of anticipation, hunger and fantasy without actually delivering the steak. Brilliant strategy and bravo for pulling it off.

Let me be very clear. I am not saying that Twitter cannot achieve significant, multi-channel, sustainable streams of revenue. I am confident that they have the potential to do so. What I am saying is this is a strategic choice Twitter made in terms of positioning. They have to now move fast to the next stage - revenues or flip to exit.

On the technological and platform fronts, at the moment Twitter has the lead in the real-time activity streams space. This can and, in my layman's educated opinion, will change with the advent of new paradigms coming on line such as Google's Wave.

Twitter's model is, at its core, a "top-down" Hub-n-Spoke model. They control the data, features such as SUL etc.

Google's Wave is a federated, more open, Hub-n-Spoke-Hub-n-Spoke-Hub-n-Spoke distributed model. Get the picture?

This model will (this is not a maybe - it is a certainty, by design) propagate both top-down - i.e. radiating from Google's implementations - and, more importantly, bottom-up via individuals, corporations and causes building their own Waves, Wavelets and Blips. Key differentiator is that each of these will have the capability to be laterally meshed, by design and choice. Powerful, game changing concepts.

This is why I believe that the considerable beachhead Twitter has afforded themselves so far faces the probability (note: not possibility, but probability) of being eroded much faster than most of the Twandits (that's Twitter Pundits) anticipate. Twitter Tic Toc Tic Toc.

Now envision these Waves and Wavelets enabled with Google Apps, Ads, Voice, Checkout and ... Google virtual currency and micro-payments powered by Google's Open Social currency platform. Interesting picture? Indeed, we are living in interesting times and my gut tells me that we are on the cusp of a paradigm evolution of our communication and interaction transport mesh.

While Google's demo of Wave earlier this year was presented low-key as a 20% project by two Googlers in Australia who had worked on Google Maps, this is the furthest from the truth. Google set up an internal, quasi-autonomous, start-up with 60 (yes, that's SIXTY) engineers who were presented to on the wave concept and then given the choice to join the project. This was in 2007. This initiative came directly from the top.

Imagine the productivity and innovation that 60 Google engineers can and are infusing into the Wave paradigm. Conceptually, Google is betting the farm on this Wave and its Tsunami potential. For more background on the wave story see this:

FROM AUSTRALIA TO THE WORLD: THE STORY OF GOOGLE MAPS & GOOGLE WAVE
Dr. Lars Rasmussen at the The Warren Centre for Advanced Engineering Limited, June 2009 *Note: Scroll down to page 5: http://bit.ly/Wave_Story

Fact. Twitter will have a really hard time hiring the bodies to ramp up their play - no matter how much cash is in the bank. Google & Facebook are way ahead in quality body count.

If you would like a plain language explanation on Google Wave, please see:

- Google Wave: You need to pay attention to this. By Jason Kolb http://bit.ly/zufDb

As for Facebook, I think that IPO or MSFT are good possibilities. However, there may be a dark horse in this game. Zynga.

Zynga is, at present, a huge contributing factor in Facebook's positive revenue profile. Additionally, Zygna is seriously intending to beat FB to an IPO. A Zygna IPO, in my way of thinking, has the effect of a Facebook IPO, via proxy.

You and your readers may find value in reading this post "The @Zynga Influence" on allfacebook.com http://bit.ly/2q0owq and my comments where is ask the question:

Does @Zynga have a #PacMan_Strategy?

1-Beat Facebook to an IPO on the back of a $150-200 million revenue run rate
2-Ramp up the value of Zynga paper
3-Reverse merge Facebook into Zynga using Zygna patents as leverage

Importantly, Zygna is holding a key social networking patent which they could use to great effect if it decided to "go hostile". Reid Hoffman, together with Mark seem to be keen strategists and big thinkers.

Result: $MSFT and the rest get pawnd.

If I were Mark. I would go extra large and swing for the fences. After all, Life's a game, isn't it?!

Tuesday morning quarterback commentary & 2cts courtesy of @AAinslie - follow me if you dare!

Posted by: Alexander Ainslie | September 29, 2009 4:08 AM

Hi Bernard Lunn,
I read this blog. This is nice information. I want to ask that if the twitter could reach a IPO in the end, how much will it worth? Thank for sharing information...

Posted by: r4 software | September 29, 2009 4:50 AM

Hey Bernard you really post here a very nice information for the Twitter and Facebook Investment Terms and Game Plans.. I really loved this stuff because here i get all the solutions of my que for invt terms...

Posted by: jeu en ligne gratuit | September 29, 2009 5:42 AM

In response to Jeff, who commented above, I want to clarify that my comments are not based on any personal relationship with the Twitter founders but on my own thinking, which is itself based on what I know about them and about such deals.

The important thing to note is that, in such "high-stake poker", as Bernard put it nicely, perception IS reality. So while knowing what the founders really think surely would help, potential acquirers rely largely on public tidbits like I did to gauge the willingness to sell.

Actions speak louder than words. Even knowing about their thinking might help less than looking at their past: Stone has flipped businesses before. Zuckerberg hasn't. Larry and Sergey hadn't either.

So, yes, it certainly is speculation, and Bernard has been careful to clearly label the article as such. But it's not groundless, and it is also a starting point for discussion. I'd welcome any data point from people who do know the founders personally.

The bottom line: the perception of a founder's personality does influence valuation. Knowing what you know about them, I'd like to know what you (and other readers) would say they'll do?

Posted by: Greg Boutin | September 29, 2009 6:26 AM

Sorry, I meant to write: Williams has flipped businesses before.

Posted by: Greg Boutin | September 29, 2009 6:28 AM

"for show" or not, it's real money and $1 Billion is too high of a valuation for no proft/no revenue stage company. While I don't think twitter is a "Fad" the concern is certainly there that like a ponzi scheme, the new members coming in to tweet will eventually not replace the tweeters who are dropping out and burning out fast enough and the whole thing might tank out of either exhaustion (been there done that) or simply a new better mousetrap that becomes the next must do social media app.

I have nothing but good things to say about Twitter (and Facebook) and Evan, Biz and Mark all have wonderful tigers by the tail... but tulips were once over-valued too and Internet companies have show the propensity for irrational exuberance before. Let's not forget the lessons of the past - there still needs to be a way to make money.

As for the investors going back for multiple rounds... that's a poker analogy too. You have to stay in the hand to the end to win. But a good poker play knows when they have the hand and doesn't chase. Until some money is made and the company is in the black with a model one can scale, this feels a lot like chasing to me.

Posted by: R.J. Lewis | September 29, 2009 9:22 AM

Amazingly, its quite unknown to a lot of people how much money goes into sites like facebook and twitter in the start of their business, and how much VC money is used without signs on recovering their money!

Posted by: KA | October 4, 2009 7:00 PM

I just cant understand why Twitter is so popular! i dont particularly think its the intresting to find out what people are doing every other second of thier lives! lol so i find the 1 Billion dollar price tag a little over priced!

Posted by: Tony | October 11, 2009 6:06 PM