The Twitter investment and the decline of venture capital

There has been a lot of talk the past few days about Twitter raising $100M at a $1B valuation. To understand what is going on from the investor side, you need to know about David Swensen, the man who (inadvertently) destroyed venture capital.

Mr. Swensen manages Yale University’s endowment and is the inventor of the so-called “Yale Model.” Basically this is a model for people who manage the largest pools of capital in the world – universities, pension funds, wealthy family funds, etc. The major idea behind the Yale Model is to put significant portions of one’s fund into “alternative asset classes” like venture capital. Yale had phenomenal returns for many years (until this year, which was a disaster) and thus was copied by fund managers around the world. This created demand to invest hundreds of billions of dollars into VC funds. This in turn radically increased competition amongst VCs, thereby driving down their returns (public pension funds like California’s release the returns of their VC investments and they aren’t pretty).

What this means is that there are lots of VCs out there with huge funds and very little chance of getting “carry” (performance fees), since most will have negative returns (and they know it). So instead they are collecting management fees (typically, 2% of the fund for 10 years, so 20% of the total fund). They need to justify collecting these fees, which is why if you hang out with VCs you’ll often hear them talk about needing to “put more money to work.” I would bet that the new investors were the ones arguing for Twitter to raise more and more money, even if it meant a higher valuation. I’ve seen it happen many times.

http://www.aweissman.com aweissman

Or, an investor looked at Twitter and said, quite rationally, that this has the potential to be one of the iconic companies of our time, and therefore there is a 5% chance that it could be worth 10x what it is today, and thus it's entirely rational to make a $50mm or $100mm bet on those odds.

http://www.cdixon.org chris dixon

If it was Betaworks I'd believe it. But I don't believe T Rowe Price or Insight (a dialing for dollars momentum shop) are web visionaries.

http://www.aweissman.com aweissman

I am suggesting one does not need to be a web visionary to still conclude this is a rational investment

http://www.cdixon.org chris dixon

I actually don't think the valuation is totally irrational – more the amount of money raised.
http://www.cdixon.org chris dixon

Tell me you haven't seen vc's arguing to “put more money to work.”
http://twitter.com/howardlindzon howardlindzon

weisssssman…you are a visionary and have an easy fast

http://shanacarp.com/essays ShanaC

And the same (as my mom would say, I hope you kicked the coffee habit now.)

http://fiveyearstoolate.com ewiesen

I've yet to hear anyone provide a rational narrative for what Twitter will do with $155 million in venture capital. While I have no evidence for this belief, I suspect there was massive founder liquidity here, in which case it's more a partial sale of twitter than a traditional VC funding.

http://www.cdixon.org chris dixon

The only rational things I can imagine are either founder liquidity or (arguably rational) an acquisition spree.

http://fiveyearstoolate.com ewiesen

Acquisitions are a strange, but notionally rational possibility. If
Twitter can't generate revenue but can raise capital at this
valuation, they can buy revenue fairly cheaply (although it would surprise me if that is what they do). Curious to see how this plays out.

davidshore

very curious to see what they buy, yes. having a $1B valuation when using your stock as the currency certainly helps.

http://fiveyearstoolate.com ewiesen

Acquisitions are a strange, but notionally rational possibility. If
Twitter can't generate revenue but can raise capital at this
valuation, they can buy revenue fairly cheaply. Curious to see how
this plays out.

dasht

Narrative of what they will do: They will become real-time market makers – somewhere between craigslist, ebay, and NYSE.

-t
Seventy_Seven

Fund their increasingly lavish lifestyle.

http://twitter.com/davidsmuts David Smuts

What recourse do the LPs have if the VCs aren't giving them the returns? As far as I'm aware, they have ZERO recourse except for not throwing any more money in, in future VC funds.

http://www.cdixon.org chris dixon

I'm not an expert on this but I believe they can default on their commitment and thereby lose their invested capital but not more. (VCs “call” capital as they invest it).
http://fiveyearstoolate.com ewiesen

Chris is correct – LPs can simply stop making capital calls. This causes them to get washed out of existing investments from that particular VC, so it's a pretty extreme measure.

http://flint.sparcq.com/ umairmufti

chris,
any thoughts on whether somebody like t. rowe price may be in the investment for the coupon rather than the exit?

if they can invest, say, $50m at 8%, they might do it just to diversify. relatively low risk, and a huge upside if the company is acquired someday (although, a $10b acquisition is hard to believe). this is a late-stage investment, so the motivations of the investors are different than the early investors.

http://www.cdixon.org chris dixon

That would be pretty unusual. But I have no knowledge of the deal terms so you never know.

http://flint.sparcq.com/ umairmufti

probably not that unusual. if that really is the rationale of t. rowe price, it just serves as another example of how misalignment of interests can cause snowball effects.

i see now how bubbles are formed.
http://www.pedatacenter.com/ PEDC

You can see all of the filings and Deal Terms, includgin the latest from 9/22/09 for the Series E Preferred at http://www.pedatacenter.com.

http://www.cdixon.org chris dixon

You are claiming to know detail deal terms of the latest Twitter round? How would you get that. It's confidential.

http://www.pedatacenter.com/ PEDC

The information is public. You can see all of the rounds at http://www.pedatacenter.com. There is also coverage of approximately 2400 other private, US, VC backed companies, including Facebook, Ning, LinkedIn, Slide, to name a few.

http://www.oyster.com/about/leadership/ Elie Seidman

“you never know when you will need it”. That being said, sometimes raising a lot of money can be the right thing to do. The example that jumps to mind is Qwest (telecom). It had an incredibly cheap currency before the telecom crash of 2000/2001 and used that currency to buy US West which generated massive cash flows as a local telecom monopoly. Amazon was similar – it used its incredibly lofty valuation to invest massive amounts of capital into all the brick and mortar it needed to become the dominant company it is today.

Since servers and ISP costs won't cost Twiter $100M, what can they use the money to insure that they do create value?

BTW – I don't know if Twitter is or is not worth $1B -my observation from using it for the past 90 days is that the signal to noise ratio inside of Twitter is often bad and that a large component of what Twitter is today are marketers who think – or have been told – that they are “supposed to be there” talking to each other. That, in and of itself, is not a bad thing bc marketers are voluble and if you can get through to them with your message, they can be very effective at getting it out there for you. All that being said, no idea whether it's worth $1B or not.

Brad

“I don't know if Twitter is or is not worth $1B”

- don't worry, it's not; i took corpfin 101 in college, so i know that. but i do hope the best for webvan…err, i mean twitter.

in all seriousness though, i wish there was a real market for these twitter shares. hedge funds would be having a field day right now.

http://www.cdixon.org chris dixon

In fairness, there was a time when everyone mocked Google for turning down $1B acquisition offers when they had very little or no revenue. Same with Facebook.

http://www.oyster.com/about/leadership/ Elie Seidman

Totally – having guessed wrong many times about the future of other companies, I've learned that it's hard enough to be right about your own company without having to be right about the future of someone elses. The folks who are running Twitter are not dumb – there is likely, but not certainly, method to the madness. It will be interesting to see what happens. In the interim, they will become close friends with T-bills.
Dasher

Both twitter and facebook are overvalued. You can not compare them with google. Google was making a lot of money by the time they were same age of these companies.

vadim

Does anyone think that a valuation as high as this might cause a down valuation on the next round? (But I guess with $100mm who needs more financing).

http://www.cdixon.org chris dixon

That's always a risk. But as you say, with that much cash they should be good for a few decades.

Dasher

But it does take the acquisition out of the exit equation for the foreseeable future. So that is the cost of this valuation.

Name

Hi: this might be a stupid question but can you please explain why “demand to invest hundreds of billions of dollars into VC funds, which radically increased competition amongst VCs, drove down their returns?

Is it because having a lot of money to “put to work” has driven up valuation which in turns drove down returns?

http://www.cdixon.org chris dixon

Exactly, more VC dollars chasing roughly the same amount of companies/exits meant 1) valuations went up and 2) too many companies were funded, lowering exit values (in some sectors you see acquirors having *downward* bidding wars).

Adrian Ionel

I think it's a perfectly rational investment. On the upside Twitter has a realistic chance to be worth $2B-$5B within 3-5 years based on real revenues. On the downside the new money likely has strong liquidation preferences. And the probability than Twitter will exit at less than $200M is low. Summary: Good chance of a 2-5x return. Low chance of losing your money. Regarding the size of the round from Twitter's perspective: if you can get $100M at $1B valuation for a company with no revenues you do it. You can still operate lean & mean but now have more options and room for mistakes & bad surprises. If they start spending like crazy – it'd be foolish but I don't think they will.

http://www.cdixon.org chris dixon

I think you could argue this particular investment was rational, although given who the investors were this was clearly a bidding war with the highest valuation winning. Maybe in this case they get a return (who knows) but industry-wide you have a lot of winner's curses going on, which is a big reason why VC returns are lousy.

Adrian Ionel

Agreed. It's also bad for entrepreneurs who have to fight extra hard when too many similar companies chase the same market.

http://bit.ly/19kduZ Greg4

It probably does become much harder to operate lean and mean after getting $100M. It's just human nature. I wonder if we'll look back at this point and say that this was the point when Twitter relaxed too much and let someone start to overtake them.

Adrian Ionel

Good point. There is nothing like 'we don't have the money for this' to keep everyone focused on what's really important.

http://twitter.com/sdanielleon S. Daniel Leon

Interesting post & discussion in the comments. RT @cdixon: The Twitter investment & the decline of venture capital http://bit.ly/1b2UTD
http://www.freddestin.com/ Fred Destin

Time to get into VC then. The sentiment cannot possibly get worse

http://www.cdixon.org chris dixon

probably true… but in 5 years after the excess money has worked its way out of the system.

http://twitter.com/howardlindzon howardlindzon

we got to fix that avatar of yours…

I argued a week ago on my blog that its great for twitter but really bad for the space. to much pressure now on everyone. a small float IPO would have rally done the trick for the whole industry. shame.

http://www.cdixon.org chris dixon

Although maybe they'll start acquiring some of the small guys?
Seventy_Seven

Agreed with you in the past on this Howard and continue to. A twitter IPO would have been well-liked by the consumer market (even if the big institutions balked). Could it be the VCs don't really want an IPO?

Name

Its rare in today's world to find someone who will put the information out in the market place with no hidden agenda. I am new to your forum and I want to say, thanks.

CJB
http://www.thenetworkgarden.com hypermark

For Twitter (and Twitter's investors), this makes a lot of sense if one assumes that they roll up the choicest portions of the third-party twitter ecosystem into their core (through M&A), refine their API approach to this newly aggregated/federated platform and then cultivate a deeper, richer ecosystem around same.

Then, when the tree needs a good “pruning” again, start the M&A process anew.

Mark
–
Read: iPhones, App Stores and Ecosystems
bit.ly/xcP8T

http://www.cdixon.org chris dixon

That's the only sensible thing I could imagine them doing with that much money.

http://www.thenetworkgarden.com hypermark

Just wrote a short post on this topic:

Twitter Financing: Pruning the Garden with $100M Shears http://bit.ly/1902st

Check it out, if interested.

http://www.pedatacenter.com/ PEDC

You can see all of the filings and deal terms, including this latest Series E Preferred filing from 9/22/09 at http://www.pedatacenter.com. The terms were fairly close to the previous rounds, but check it out for yourself.
http://twitter.com/lgilchrist Lauren Gilchrist

I'd be curious to hear who you think is actually earning their management fee these days, Chris.
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http://pegobry.tumblr.com/ Pascal-Emmanuel Gobry

Heeey, you guys went with Disqus for comments! Good!
Crack Kills

@Dixon, bingo!

300M fund @ 2% offers $6M in management fees to 3 general partners, one analyst, a receptionist and a virtual pbx system that costs $29.99 per month.
VC = the great American heist

http://www.cdixon.org chris dixon

i think wall street=great american heist
but VC in 2009 has definitely gotten corrupted.
http://fiveyearstoolate.com ewiesen

I'd be curious to know which $300M venture funds have that level of staffing. Names, please.

http://shanacarp.com/essays ShanaC

Alright. Caveat, I'm a nice art student whose been holding this off, because technically I'm trying to work on an art piece about the nature of Twitter for my BA. Twitter is a difficult substance to work with. That's life. My current thought:

No one person is homogeneous, and hence the quality of information they have to provide is rich. I don't know if they deserve that valuation, (I am not trained to start valuing companies at that level of competence), but I expect them to be ok.

A) they need to burn some capital doing either a major buyout of all the little twitter apps or a rehauling of the api. Reason: They need to clarify their design mission. Twitter works well in an addict sort of way; it isn't clear for what. It is equally as much about what one thinks as what one does. Most people have yet to come to terms with this idea. Doing a major design rehaul will get people to behave more in this direction. The reason I am not a heavy tweeter of just randomness is it is immensely hard to sum up one's thoughts in 140 characters in English. It's more valuable to me when I pass other forms of information in it, in the form of links. Then I've actually (sort of) said something. I'm pretty sure that the more we slowly force people to say more/do more- the more they'll act on that impulse.

b) some of that money is going to into building infrastructure to support long term expansion and storage of tweets. Guess what, there is a lot of data in there, and even if it “belongs to us”, I would not underestimate the power of datamining in those tweets. They're in the sharable category, and by reworking the api and storing all those tweets, we now have a great way to analyze both link relationships and people relationship. I agree with Fred Wilson when he says that Link Passage is the most important thing about Twitter. In fact, mastering that data would mean being able to search in a more fine grain way.

I think the plan to have verified accounts actually might help them, depending on how it is done. They really need to develop a system so that at first glance (without something like tweetdeck) you get that it's about questions and answers, about finding stuff, about linkpassage. Forcing people to verify themselves, or a variety of levels of verification (not everyone needs to be a super user) hopefully should make it easier to see quality links, and thereby also make it easier to track them back and forth in an effort to find quality information between different types of people as they share.

Though that doesn't really answer how I am going to hack my screenshot of twitter. Still working on that one.
http://mealercompanies.com jlmealer

Venture Capital is not dead. It's just sleeping until the investors find the next BIG thing.
We are unabashedly the next BIG thing. Just look and see… Then pull out your check book and let's get to work.

JL Mealer
Mealer Companies LLC
http://mealercompanies.com
America's Next Major Automaker
& 100% Self-Regenerative-Fueled
High Cap Elec Producing Device MFG

Seventy_Seven

Yeah, VC is a pro-cyclical play.

http://leftovertakeout.com gbattle

{{Sniff, sniff, sniff}}

I smell a bit.ly purchase.

{{sniff sniff}}

I smell a *lot* or purchases.
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geogebell

Chris — good lens on this, but there is another layer here. VCs are not always best served by maximizing the amount of money they can get from David Swensen and his ilk. Human nature says that bigger is better. But VCs need to learn from consumers who took on impossible home mortgages while the money hose was still flowing, only to then complain that banks should have known better. VCs need to decide on their investment and portfolio strategy first. Fund size should be an outcome of this process, not an industrial testosterone contest to see who has the biggest fund.
http://www.pedatacenter.com/ PEDC

The information is public. You can see all of the rounds at http://www.pedatacenter.com. There is also coverage of approximately 2400 other private, US, VC backed companies, including Facebook, Ning, LinkedIn, Slide, to name a few.
geogebell

Chris — good lens on this, but there is another layer here. VCs are not always best served by maximizing the amount of money they can get from David Swensen and his ilk. Human nature says that bigger is better. But VCs need to learn from consumers who took on impossible home mortgages while the money hose was still flowing, only to then complain that banks should have known better. VCs need to decide on their investment and portfolio strategy first. Fund size should be an outcome of this process, not an industrial testosterone contest to see who has the biggest fund.
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Chris Dixon

The Twitter investment and the decline of venture capital