While the sub-prime mortage mess has gotten a lot of press about the excess of sheer idiocy and greed in certain financial institutions, the second great VC funded dotcom bubble has been every bit as crazy and yet receives little coverage. Sure, the amount of money wasted doesn't even remotely approach what's going on in the broader markets, but somehow this business got away from counting revenue and started counting eyeballs. And that's after everyone swore it would never happen again after the crash of 2000. I guess the problem is that most of the 20-something CEOs weren't around for that crash, and most of the VCs just don't know any better.

So this week, the news has been hot and heavy that twitter has raised yet another round of venture capital. Which is really impressive considering the current venture capital climate. The new valuation is widely reported as $250M. The Twitter team is to be congratulated, because while they haven't done much on the revenue side, they sure can raise money! I made the statement several times that Twitter wouldn't be able to raise more capital. If these rumors are true, then obviously I was wrong. Luckily, that's just the first time (you can ask my wife about that).

So Why is This Bad News for Twitter?

It's probably not, but the link bait value of the title was just too good to pass up.

But this really can be viewed as bad news for Twitter. People are heralding the $250M valuation as confirmation of Twitter's value. You can spot the people without any experience in VC funded startups because it's nothing of the sort. The pre-money valuation of a company in a round of venture funding is merely the number that sets the minimum payouts for the exit. Let's say you have a company that is absolutely worthless. A VC comes along and says "I'll give you a $1M valuation. I want 10% of the company for $100K." You take the deal and think "I'm a millionaire! My company is worth $1M!" No, your company has the same value it did, plus the $100K in cash you now have in the bank. But if you wrap up the company, you owe the VC their $100K back (last money in, first money out) plus whatever guarantees you had to make. The usual term is a multiplier of three. So had you sold the company for $300K, you would owe the VC $300K and you'd be left with nothing. A lot of term sheets require that the VCs get their money back, plus the guaranteed multiplier, plus guaranteed back dividends, and then you split the proceeds along the percentages. So let's say you sold the company for $1M five years later. It would be very easy to owe the VC $300K, plus $200K in dividends, and then you'd split the remaining $500K according to your percentages. And by the way, there are a hundred other things in the deal that will take care of the VCs before you. The founders only do well when the startup hits a grand slam. Hitting a single or surviving means the founders get nada. And that's as it should be, because without the VC's money they wouldn't have had anything anyway.

Remember that criteria if you're ever thinking about taking venture capital. It only makes sense for the founders if without the VC money they wouldn't have had anything anyway. Other than that, you're just signing up for an 80/hour week job with little pay and tons of aggravation. If you're not swinging for the fences and starting with nothing, you shouldn't go near a venture capitalist.

So what does this mean for Twitter? Go back and read the fire sale article we did last August if you didn't click the link the first time. By doubling the VC money in, they've doubled their yearly revenue break even point, and added another 20x factor to the exit number. When they had $20M total in VC money, they had to sell for $400M in order to be a win. With $40M in, they have to sell for $800M. They've just doubled down at the roulette wheel. Keep in mind that the only other thing the $250M valuation means is that they may have reset the percentages of earlier investors too.

Other than seeing an increase in users, what have they accomplished in the last year? Since their last venture round they had the Summer of the Fail Whale, shut down SMS in several countries, throttled their API, and still don't have a revenue model. Oh, and they turned down a bunch of Facebook stock that probably wasn't worth as much as they already had capital in. But they were able to raise another round of VC money, so you really have to hand it to them.

Revenue Prospects

Despite a ton of chatter on the intarweb about possible revenue models for Twitter, I still haven't seen a single model where the numbers break down into any hope of Twitter hitting the break even point from a VC funded standpoint. Most people think of revenue break even as being able to cover your expenses (revenue in > cash out). When it's postive the owner can usually sell the company for some multiplier of either revenue or earnings. That's true of a normal business, but the numbers are different in a VC funded business. To be a success, the company has to sell for 20 times the investment in. Less than that and it's a miss and the VCs will lose interest and wrap up the company. Twitter has the advantage of being so hyped right now that they'll keep interest, but that won't last forever. When the revenue numbers eventually start to come in and the business model doesn't work the fire sale signs will go up.

Once again, Marketing Pilgrim took a stab and getting Twitter some revenue. There were some very novel ideas there. Let's take a look at those and some other ideas floating around the net for how Twitter is going to hit it big and become a cash cow:

• Search and Analytics - They've got a ton of data, and it should be straightforward to put together a search engine that's compelling. The ability to get to real time news in the twitterverse has to be worth something, right? There are a ton of problems with this. First, how much would anyone pay for this? Either through memberships or advertising, access to the search data just isn't that compelling. And the search data is already available for free now -- anybody can just spider the site. Google already has. You can find anything you want with the appropriate site:twitter.com query. If Twitter can become the next Google by monetizing search of their data, then why haven't all the other social networks been able to monetize any of their data?
• Twitter as a Protocol - Alistair Croll suggests that Twitter isn't a site but a protocol. I agree with what he says in the article, but the jump that others make that somehow Twitter can monetize this fact just doesn't add up. The reason protocols work is that enough people agree on them, which means they're very difficult to monetize. A monetized protocol has another name -- a closed standard. The same thing that made Twitter so popular to begin with -- a plethora of third party apps to make up for their interface -- is also the reason they can't monetize. They don't control the user experience.
• Sell API Access - The idea here is to sell unlimited API access to certain companies. The problem is the market isn't very big. Take the total amount of revenue all those companies could generate, and then multiply that by a small percentage that they could afford as a "tax" on their business and you have the amount of revenue Twitter can generate from this. That's why Twitter throttles their API rather than trying to pursue it as a revenue opportunity -- there just isn't enough money there to make it worthwhile. Could this possibly be a business model with more than a few million a year in revenue? Doubtful.
• Sell an Enterprise Version - Much like the Global 2000 already blocks AIM, MSN, and other chats out of security concerns, it's only a matter of time before they figure out that Twitter is a giant security hole that's leaking their confidential information and start blocking it. Imagine a lawsuit where the plaintiff is showing the jury the CEO's tweets! So the solution is to just have Twitter transform itself into an enterprise software startup and sell a private version of Twitter to run on the corporate intranet. Those of you with experience in the enterprise software market can now take abreak and wipe the spewed coffee off your monitor. To those of you who don't let me explain a few things. 1) Twitter is Small Fry in this Market. Competing with IBM, Oracle, Microsoft, and SAP will not be a pleasant or lasting experience. The most they could accomplish is to establish that the market exists. All of those companies could roll out a secure enterprise version of Twitter that works in their own architecture in a few months. In fact, they may already be doing it. Twitter small group of business development people are not going to compete with 10,000 IBM salespeople. Oracle could drop more money into a marketing campaign for a new twitter product than Twitter's current valuation and it wouldn't even approach a round off error. Microsoft could put it into Office for free. At the same time, they'd all be telling their customers about the security risks of allowing their employees to use the free version of Twitter, cutting into their market. 2) Startups Can't Sell to the Enterprise. It used to be the case that two guys and a coffee pot could write some great software, sell it to a big company, and get rich. That ended during the crash of 2000. Enterprises became completely gunshy after getting burned by the Dotcom 1.0 failures. Add in the post-Enron compliance standards and selling into the enterprise became a game only for the very large. That's why the startup software model moved away from enterprise sales -- either to open source, advertising supported, or membership/SaaS. The first question to every Twitter salesman would be "What about the fail whale?"
• Insert Affiliate Ids into the Twitter Stream - This one is cute. They could analyze the twitter stream and every time someone posts a link to Amazon or something similar they could modify the URL and put in their affiliate code. Or they could do their own version of TinyURL and move people into something that's framed with advertising. I don't think most people would be happy with having their links hijacked. By drawing attention to the affiliate opportunities they'd just encourage people to put their own ids into any links. And frankly, it's just not that much money. Go look through your last 1,000 tweets. How many of them were monetizable links? Perhaps they could do a Kontera deal and turn words in the twitter stream into hot links. Take Twitter's 40M visits/month times 10/pages/visit and you get 400M page views. Let's say 10% of those have something that can be monetized (highly unlikely it's that high since your last 1,000 tweets didn't). If you get a click through on affiliate ads of a half percent, and 1% of those convert, you're getting 2K conversions/month. If they got a $10 commission on that, it's a $240K/year business. And I think those numbers are WAY overestimated. Of course, how long would it be before the third party tool vendors just replaced that? Or someone wrote a FireFox plugin to get that junk out of your way?

There are lots of other ideas out there and I'd be glad to hear them. But before you claim that you've got the idea that will save Twitter, be prepared to show how the amount of revenue you'll generate will turn them into a billion dollar company. Because with this last round of VC money, that's where the bar has been moved to.

So What is Their Plan?

Remember the criteria for when to take venture capital. When you don't have anything without the money. Twitter meets that criteria. There's corollary to this as well: If you can't get a big exit, keep raising money and have a good time. Perhaps the Twitter guys are swilling the koolaid and still think they're going to build a billion dollar company. Or maybe they're just chuckling at how foolish the VCs still are. They're young, they're famous, and they've got a ton of cash to play with. They're the 16 year olds that have been handed the keys to Dad's car and a bottle of whiskey for their birthday. People complain about how tough the dotcom crash of 2000 was, but frankly there were a lot of CEOs making a ton of cash and throwing great parties. The Twitter guys are living the vida loca. They just may know something the Twitter fanboys don't know and are living it up while the living is easy. Given the numbers, that explains raising this last round of capital better than any other explanation I've seen.

BTW, the news of this last $20M are just rumours. Nothing has been announced. There's many a slip between the cup and the lip. The VCs still have to make their capital call, and we're likely in for a rough couple of months in the market. They may find that negotiations break down at the last moment. A term sheet is not a check.

I'd just like an invite to the party when they close the deal.