Wednesday, December 15, 2010

Betting too much on Twitter

Silicon Valley and the VC world are-a-twitter about the $200m venture investment in Twitter that leaked today. The number is mind-boggling on several levels.

First, this is a Series F round when most companies would have IPO'd by now. We can’t really call it a mezzanine round if no IPO is in sight.

Second is the huge bet by Kleiner Perkins, which seems to be moving away from its recent dalliance with cleantech and a certain VP-turned-VC. I was being interviewed by a reporter on this topic and my planned response ended up on the cutting room floor:

In funding Twitter, Kleiner Perkins is going back to its roots -- the sort of information technology companies that Gene Kleiner and Tom Perkins knew best, and the ones that created its reputation.

One might read this as a repudiation of the Al Gore-led foray into cleantech. Certainly the venture industry -- as well as those of us who study it -- have figured out that the scale and timeframes of building energy companies or car companies aren't going to work for venture investors.
Finally, there’s that $3.7 billion valuation. I’m a regular Twitter user, and recognize it success in building network effects and an installed base. Even so, I haven’t seen evidence that its planned revenue model is going to work (which must be why it needs expand via dilution rather than retained earnings).

Apparently I’m not the only skeptic. Business Insider quotes Series B/C investor Union Square Ventures as not being interested in this round due to the valuation. As Fred Wilson of USV wrote:
One thing I've seen many VCs do wiith their initial investment in a company is invest more when the valuation gets expensive. They are ownership driven, not valuation driven. So if they originally wanted to invest $4mm at a $20mm post money valuation and buy 20% of the company, they talk themselves into investing $8mm at a $40mm post money valuation so they can still buy 20% of the company.

I have never liked this approach. When the price of an initial investment goes up, I prefer to invest less, or nothing at all.

Investing more when the price is too high makes no sense to me. If you are overpaying by 2x, doubling down feels like overpaying by 4x.

I think the root of this "doubling down on the overpay" issue is that many VCs manage large funds of other people's money and they really don't care so much about how much they invest in each deal. They are looking to buy large stakes in companies and hope that one or more turns into a big winner.

So instead of being ownership focused, I prefer to be valuation focused. And the key figure I look at is average valuation of our entire investment. We take the total amount of capital we have invested in a company and divide it by our total ownership. We like that number to be as low as possible relative to the current value of the business. I believe that is the recipe for the best returns and that is what we seek to deliver to our investors.
This is yet another example of herd mentality among VCs, and the disconnect between VC risk and limited partner risk as VCs make these huge bets.

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