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What Gives with the Monster Funding Rounds?

Posted October 23rd, 2010 by Andrew Goodman

Talk of Twitter potentially giving some thought to raising as much as $200 million (that’s one hundred times what many Series A rounds raise) made me wonder about the monster-raise trend and tech startups that have raised way more than you’d expect as they progress towards maturity (Zillow, Facebook, and a few others).

To the layperson, when a successful company says they have “most of the money from their financings” still in the bank, it means they don’t need to go out and raise more money, especially amounts that far outstrip the amounts raised to date. Surely, in most cases, too much dilution is bad for the founders and early stage investors. Why not stand pat and enforce financial discipline for a bigger payoff down the road?

There are approximately four (seven, if you count related items) potential explanations that stand out. With Twitter, we’re left to wonder, “which is it?”.

1. If someone wants to overpay to play in your sandbox, let them! Facebook was able to sell several small chunks of their company early on for very generous valuations nearly in line with the type of valuations they might reach at IPO three to four years hence.

2. Before an IPO, a “mezzanine” round may be raised to insulate the company against any potential instability that might arise in the lengthy process leading up to that IPO, and to introduce a bunch of players who may be needed as part of that process of raising much larger sums of capital.

3. Deserving, successful company insiders and employees need a breather from financial uncertainty, to take some risk off the table. They get to sell some of their shares in the transaction, gain partial liquidity, so they can relax and focus on business. Early investors are diluted, but commit no additional cash while gaining a massive insurance policy against changes in investor sentiment that might make it difficult to raise a similar amount later to keep on fighting.

4. They’ve reached scale, and the cost is huge, and they wildly miscalculated the huge gap in managing the time lag between reaching scale and reaching profitability.

4a. Related to that, scaling up has, in particular, led to massive overhiring and recruitment of A+ level talent — signing bonuses, unsustainable salaries. The company is practically begging for massive rounds of cuts, severances, and “writedowns” of big quarterly losses three years down the road, even if it does turn the corner and become successful. IPO investors beware!

4b. A lack of scale and diversification are somehow hurdles to the company growing into the business model it’s shooting for. No home run means no company. Big bet, or go home. There is no middle ground.

4c. There’s a huge chance their chosen business model isn’t going to monetize as expected, because it hasn’t so far.

Going “this big” is VC investing in its purest form, in a way. The Big Bet. Rather than being a comfortable scenario, it’s either a huge idea that pays off, or just a huge, costly, unprofitable failure. (Companies can be both at different times, obviously. MySpace was a hit, then a flop.)

All of Explanation 4 is a strong possibility for Twitter. There remains considerable risk mainly because not all that many tech companies have made it all that big with an advertising model. Google did. Yahoo did. Facebook will. Yelp seems healthy. And a handful of others. For everyone else, that doesn’t make it a high-probability model.



2 Responses to “What Gives with the Monster Funding Rounds?”

  1. Andrew, when Charles Ponzi tried to get out of his scheme in 1920, he produced a plan to the banks, one of which he was the majority shareholder in, which involved a near 17 fold increase in his debt from $15 million to $240 million to purchase the entire US merchant fleet – which was being retired.

    If there is no legitimate business model, of course you need monster funding to keep the music going.

    Some user generated content do produce valuable small world networks, linkedin, flickr, and possibly facebook come to mind. But, I think, that each user generated platform has to have some freemuim business model for it to work. I don’t have the vision to see what twitter’s freemium model might be.

  2. To date, Twitter is rolling with ad units that appear to appeal to large brands and large advertisers — promoted tweets, and some other things. That is quite different from how Facebook and Google have evolved. Although both are getting plenty of interest from big advertisers today, there is also a base of “self serve” highly targeted advertising. Also, ecosystem-wise, AdWords & Facebook have some complexity to them, so agencies and geeks get interested in playing around with them, and that spreads the opportunity farther. So far, we don’t know about Twitter, but it looks like a straight sales relationship without an interesting targeting platform, which seems to run counter to some of what we’ve seen working best online as far as advertisers are concerned.


 


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