I've been thinking about this for a long time, and I just can't see how Twitter is going to make enough money to justify their venture capital investment (which is reported but not publicly verified to be around $20M) or $80M valuation. Five years from now we're going to look back at the Twitter phenomenon the same way we scratch our heads today when we try to explain Pets.com. If you can't look at the $80M valuation of Twitter and figure out that the Web 2.0 bubble is going to pop, then there's just no helping you.

A lot of people have been musing about how Twitter can make money. As users that's important, because we don't want to see the service disappear. But frankly, if you have to think long and hard about how a business idea is going to make money, it's probably not going to work. I'm really wondering what the elevator pitch was for Twitter, because after reading a dozen blog posts on this subject I still haven't seen a complete idea. Maybe I'm wrong and they've got something absolutely brilliant up their sleeve, but more likely the pitch went along the lines of "We'll have millions of users, that's got to be worth something!"

It Takes a Lot of Money to Be a Successful VC Investment

You have to keep this in the context of a VC investment. VC's don't invest to get a 7% return on their money. They're not in that game. They invest in high risk levels, and fully expect only 1 out of 20 companies to pop big time if they're doing a good job. Which means to break even, they define success as 20x return on investment. That doesn't mean they'll get it, but in order to justify the investment they have to be able to see a way that they'll get a 20x return. That means that Twitter has to sell for at least $400M in the exit. In that case, the founders probably get a pittance because the VCs are going to get the first grab at the money until they've met their goals. It doesn't matter that you've only sold them 20% of the company, you won't get your money until they get theirs.

What kind of revenue does a company with a valuation of $400M have to generate? It depends upon the multiplier, but in this environment a valuation of 10x revenue would be pretty strong. Or maybe 100x earnings. So Twitter has to be a $40M revenue company just to break even in the eyes of the investors. The general rule of thumb for silicon valley VC investments is that you want the company to get to $100M in five years to be a success. If you want to see an explanation of how VC investments work, go back to our oldie but goody post on Venture Capital Term Sheets.

Riding the Wave

There's no way they can hit those kinds of numbers. Not a chance. Let's keep in mind some of the major factors in their successful adoption so far:

• It's Cool - Twitter was riding a wave of coolness at the height of the Web 2.0 madness. Anybody who was anybody was Twittering. To quote Eldon Tyrell, "The light that burns twice as bright, burns half as long. And you have burned so very very brightly, Roy."
• It's Free - The barrier to adoption was miniscule. Just go to their page and sign up. They don't even collect much demographic data; you just need a nickname and an email address. Unfortunately, as Twitter is finding out, there's a huge difference between free and a nickel.
• Third Party Tools - They were smart and built an ecosystem for third party tools. They provided a fairly open API, which allowed a wide array of blogging plugins, readers, bots, etc to be built. There's only one problem with that: They killed their advertising potential. You can't serve banner ads to someone that doesn't visit your pages. Judging from the people I'm following, more than 75% of the Twitter power users are using something other than the web interface to tweet.

Basic Assumptions about Twitter's Business Model

Let's take a look at the basic business model limitations for Twitter. To do this, we need an idea of the number of transactions, users, customers, etc that they can support. Since none of this is publicly available, we'll have to make some guesses.

• How Many Twitter Users are There? - I've seen estimates of 3.8M users, but frankly there's no way the number of active users is that high. The 3.8M number may be the total number of people that have actually signed up for an account, but there just aren't that many active users of Twitter. Take a look at Twitterholic. The number one Twitter user in terms of followers is BarakObama, with 60,601 followers this morning. What percentage of active Twitter users are following Obama? 10%? I'll bet it's a lot higher than that because it's something cool to do. But if it's 10%, then there are 600K active Twitter users. If you look at the entire top 100 users and assume there is no overlap in followers between any of the 100 (in other words, just add up all the followers in the top 100), you get an upper limit of 1.3M users. Now that 600K is starting to look a bit high, isn't it? But I'm going to be generous and assume that there really are 600K active Twitter users, although it's completely apparent that there aren't. The actual number, which only Twitter knows, is probably a lot closer to 100K active users.
• How Many Pages Views a Day do they Get? - This is pretty hard to even guess. A SWAG on it would be that the average number of refreshes for their 600K users is 5/day? So 3M pages views a day? Evan Weaver did some playing around with Compete and came up with 71M views/month, which is a mere 2.3M pages views/day. Twitter's Alexa rank is hovering around 1,000, so 3M page views seems extremely optimistic.
• What Rates Can Twitter Charge for Advertising? - Pubmatic says the CPM for large sites is down to $0.67. I doubt very much that Twitter can command high CPM rates because people aren't on their site to look for advertising, they're focused on something else. The average CPM of large sites is $0.92 for the last three months, so let's be generous and say Twitter can get a CPM of $1.00 because they're so cool.
• How Many Tweets Could an Advertiser Send? - I'd be really surprised if users would put up with more than 1 tweet a day from a sponsor, and even more surprised if they'd take up to 3. But let's assume that Twitter can deliver 3 tweets/day as a sponsored advertisement.
• How Much Would Someone Pay to be a Twitter User? - This is tough because different users get different value from Twitter. For most users, anything over free would cause them to stop using the service. But as Andy Beal pointed out, he's got 3,000 followers so he'd be willing to pay $5/month. LinkedIn gets $19.95/month for their premium service, but there's a lot more utility and payback. When you're on a job search, $19.95 doesn't seem like much. Let's be generous again and say that Twitter could charge $20/month and get the top 10,000 power users to pay. That's pretty aggressive. It's more than Andy said he would pay, and he's a real Twitter nut.
• How Many API Users Do They Have? - It's a lot. The rumor is they have peaks of 12K/sec on their API services. My guess, based purely on sampling from my own feed, is that about 50% of the users out their are getting their Twitter fix without hitting Twitter's web page. That sorta fits with the 2.3M page views/day estimate and their 600K active users. That would be 300K users doing 7.6/page views/day, and the other 300K leaving their readers open and hitting the API every minute or so.

What Options Do They Have?

Andy Beal over at Marketing Pilgrim brought my attention to this in his article "Twitter Needs Your Help to Make Money". He summarized Ben Kunz's viewpoint article at Business Week that suggested 4 routes Twitter could take to monetize:

• Twitter Could ask Users to Pay - Alas, this one just won't generate enough revenue. If they can charge $20/month ($240 year! Wait until the wife sees that credit card charge!) and 10,000 of their power users that would see the value sign up, it's just $200K/month in revenue, or $2.4M/year. In other words, an underpaid CEO's salary would be 10% of their revenue. And the value to someone like Andy goes way down when his 3,300 followers start to bail from the service because it's not worth that much money to them. $5/month is much more reasonable, and that's only a $600K/year company. The bulldog will be mighty hungry.
• Twitter Could Get Paid for Messages - The idea here is to insert tweets into the twitter stream. Kevin Makice had a great comment on Andy's blog that suggested that Twitter could "make it a requirement to follow 2-3 (minimum) official sponsors in the same way and context you would any other friend or organization." Again, the problem here is numbers. 600K users getting 3 tweets/day at $1 CPM is $648K/year. But what is a 140 character, easily filtered message worth? Realistically, it's $0.50 CPM for $324K/year. That won't even cover the sushi bill. Worse yet, to get to just $10M in revenue at a CPM of $1 they'd have to send their 600K users 46 commercial tweets/day. Think about that. I doubt there would be many users left.
• Twitter Could Extract Money from User Data - Which would cause a backlash among users who seem to forget that the intimate thoughts they're tweeting every day are available for all to see. Besides that, the cat is already out of the bag. Google crawls Twitter heavily. Just do a site:twitter.com google search. I just can't see more than a few million in value here, and the risk of completely alienating the customer base. But let's give them $2M because they need it. This one is important to remember because it's bait for someone like Google to buy them.
• Twitter Could Sell Ads - Again, the numbers are even worse. They're getting at best 3M page views/day, so at a CPM of $1 they can get $1.09M/year in revenue. Ben Kunz came at the number in a very different fashion and came out with an upper value of $12.26/user/year. Using his numbers and the estimate of 600K active users you get $7.3M in revenue at a max. But his numbers require a CPM of $7, which I just don't see advertisers being willing to pay in this climate. And people getting their tweets through a Reader don't see the ads, so divide everything by 2.

What My Tweet Peeps Had to Say

I also asked this question of my Twitter Followers and additional ideas were:

• Charge for API Access - Twitter would charge API providers to have access to the API, perhaps on a sliding scale with a certain amount of activity for free. The basic problem with this is that whenever your business plan includes the concept of building a platform for someone else you're likely to fail. Missionary work takes a very long time -- much longer than Twitter has if you make a few guesses about their burn rate. But the bigger problem is that it's now a revenue split. Using our assumption of 300K API users, could the API vendors really extract more than $10/user/month in fees? Most API users would just stop if it required cash to use the tool. Trust me, it's hard to get people to shell out cash, even when you've got an awesome tool. And yet still, Twitter can only take a percentage of the revenue that the API using applications generate or they kill the ecosystem. A license fee of more than 10% is probably not sustainable. So 10% of 300K users at $10/month = $3.6M/year. And that's if all of their API users switch over instead of dropping out. If they only convert half, it's $1.8M/year. No way.
• Make Money From SMS - Communications companies make money when you receive text messages. A lot of money, because they get to use unused bandwidth to deliver your messages. It's not like voice where it has to have a guaranteed delivery time. So there's probably a model in there where they can get some money as a kickback for generating all that traffic. So you'd think Twitter could pull off a deal where they get paid to send SMS traffic. Unfortunately, the money goes the other direction, which is why Twitter had to abandon SMS Services in many countries. "Twitter estimates its costs to be as high as $1,000 per user outside the US, Canada and India." $1,000 for a user worth $12.26? But even if they could work out a deal with a carrier in the US, the revenue potential is less than that of banner advertising. Nobody is going to sign up for a paid SMS model to get Tweets about what someone is having for dinner at 10 cents a pop.

Andrew's Thoughts

Andrew Finkle posted a response to the Business Week article titled "Monetizing Twitter." He covered a lot of the same ground we already have, but here are a few of his unique ideas:

• The Roboform Model - He rightfully points out that RoboForm was very successful with the freeware model. The problem for Twitter is that there is a wide variance in the value proposition among users. While everyone gets the same utility out of the freeware model, only a small percentage of Twitter users get enough return on investment to justify any kind of cost. And the fewer users that convert, the less the value proposition becomes to the users willing to convert. Would Andy still pay even $5/month for Twitter if he only had 100 followers?
• Contextual Ads - This is a really interesting idea.

  Someone will "Tweet" about a great book they just read, and that Tweet will be tied to an Amazon affiliate link where others can purchase the book. Or perhaps the Tweet will be location aware - "Craving Pizza in NYC", and as GPS allows Twitter will attach ads from local pizza parlors in NYC.

  But again, the numbers don't add up for enough money to make it worth Twitter's while. First, only a small percentage of Tweets have any content that could be monetized. I did a somewhat random sample and came up with about 2% of the tweets in my feed that one could attack an ad to. But you'd have to analyze every single tweet to determine if you can overlay an advertisement, so we're dramatically increasing the processing power requirements on a system that's already struggling. And what will be click through rates be? I commented on Andy's blog that they might be lucky to get a 2% CTR on 3.8M users for 10/day. That works out to $3.4M in revenue for the context ads. And that's back when I was willing to give them 3.8M active users. Use the more likely number of 600K and it's $536K/year. I'll bet that there computing cloud charges at Amazon would go up more than that for this scheme.

The Real Problem for Twitter

The real problem is that "All of the Above" is not an option for them. They could do a combination of things, but some of these are competitive. For instance, nobody is going to pay $20/month for a service that bombards them with ads. Nobody is going to pay a user fee and also pay an API fee. What they probably can do is charge for API access, thus driving people to the organic site, and then place advertisements. So what's their revenue potential? Usually the best way to approach these things is to look at the high and low ranges of the very pieces of your business model and then do a best and worst case analysis.

The best case scenario for Twitter doesn't cut it. They took $20M in venture capital. If things go perfectly they're still at less than half the $40M in revenue they need for the VCs to think they broke even. Remember, the standard benchmark for a company that does well but isn't a home run is $100M in revenue after five years.

Here Comes the Fire Sale

So why should you care about whether the VCs are happy? Because to paraphrase, if the investors aren't happy, ain't nobody gonna be happy. They've got to get their cash out. They don't make these investments because they're nice guys. When the VCs start to realize they've made an investment that's not going to work out, they start doing these things:

• Bring in Outside Advisors - Who will wager that the analysis they did on the foreign SMS costs was driven by a VC board member who was aghast at their burn rate? Their last round was for $15M, which usually is supposed to cover the burn for 2 years. 4 months later they were looking to cut costs, which means that the VCs started getting worried about the burn. They realize they've got to make that $15M last for quite some time given the current investment climate. I wonder if that last round of $15M came in traunches?
• Bring in Adult Supervision - You can always spot a VC funded startup in trouble. The founder/CEO gets a new business card that says "Architect" or "Visionary" and a CEO with gray hair is brought in to fix things. Why VCs don't just require that startups have adults in charge is beyond me.
• Cut Costs While Looking for a Suitor - If the company can't make the big hit it needs to, the VCs will administer a "haircut" and get costs in line so that the company can be bought. The problem for the founders is that their exit is pretty much gone at that point. The problem for the customers is that the original vision is not going to happen.
• Sell It Off - It's always funny to note that the amount an underperforming venture funded company is sold for is closely related to the buyout value for the preferred investors. The company doesn't have to be failing -- it just has to not be in range of a major home run any more. It costs VCs money to give their attention to companies, so it's better for them to sell it off and make it someone else's problem rather than continue the care and feeding, even if the company was making a small profit.

So to all the well wishers who say "Twitter is going to be able to make revenue somehow": I hate to rain on your parade, but some revenue isn't enough. They are a heavily venture funded company. Less than a home run means the sharks will be circling. If they turn into a $20M a year in revenue company they're a failure. They'll be sold off in a fire sale.

And their problems go much deeper than that. Evangelical work is always extremely difficult in any market. They've already accomplished something hugely impossible -- they started with nothing and created a ubiquitous service. That's a home run. But now they need lightning to strike in the same place 4 times, because they have to build a new business model, switch everyone over from free, and somehow grow their user base, without a competitor knocking them out. And everything they do to monetize will make their user base numbers trend downwards. Their only way out is a fire sale.

Why won't Google or someone just buy them as a "hood ornament" as Kunz suggests? They may very well do so, but the price will be a fraction of what Twitter needs. What if Google decided to provide a competing Twitter product? It could integrate with Gmail, Reader, their social networking, even search. It's a slam dunk for them. And it would probably be less expensive for them to develop it themselves to work within their existing architecture than to even pay a fire sale price for Twitter. The perfect time for Google to launch this service would be the day that Twitter announces their new monetization scheme. Google could offer to migrate all of your data from Twitter into their system. They're already crawling Twitter heavily anyway. Does anyone think they couldn't do it? And why would users take a chance on Twitter if the venerable and reliable Google offered a competing service for free? The same goes for Microsoft and Yahoo. And given the way the market is right now, are any of the big guys going to make a hood ornament acquisition unless it's a steal?

So enjoy Twitter while you can, but don't get too attached to and certainly don't make your business reliant upon it. It's fun, but so was Igrocer, pets.com, and a thousand other sites that we couldn't figure out how they were going to make money.

I'll say it again. If you have to think long and hard about how a business idea is going to make money, it's probably not going to work.

The otherwise very very smart Don Dodge posted this gem that gets some bits right:

I talked to a Facebook App developer at the ReMix conference. He told me his app is generating 300 million page views per month. Wow! Then I asked what kind of CPM (Cost Per Thousand) ad rates he was getting. He shrugged and said somewhere between $0.02 and $0.05 per thousand. That pencils out to between $6K and $15K of advertising revenue per month for those 300 million page views. Pretty good for a couple of young hacker/coders with very low overhead, but not the kind of business that commands million/billion dollar valuations.

Basic Assumptions

What I don't know about Facebook could fill Wembly Stadium with just enough room for a Flock reunion, so let's assume:

• This is app is at the median of the top 50 Facebook apps
• The actual income is at the top range of $15K/month
• The top app earns 10X what the bottom app earns and it's a smooth distribution

So, the total revenue for all 50 companies is around $12M a year.

No Money In the Ecosystem

Take these three data points:

• I have a friend who runs a three person shop that supports Cisco routers for a fairly large school system. He billed $3M last year. That is $600K/person.
• We work with a small Oracle outsourcing shop (5 guys in the US and 25 in India) that billed $7M last year. That is $230K/person, but if you cost average that by salary dollar the number is $700K/person.
• There was a local business paper article about a 12 person company that does custom Microsoft VP/Apps/whatever programming and just broke $7M in total revenue or $580K/person.

What's the point?

There is a LOT of money in the Cisco, Oracle, and Microsoft ecosytems. I'm sure all three of these remora companies are too small to even barely come to the notice of Microsoft/Oracle/Cisco.

If any of them were doing Facebook work they'd be #1 with a bullet.

But I bet the 25th largest Facebook Widget Maker can get some 1:1 time with whomever they choose.

Let's review: $12M/year in the Facebook ecosystem and, what, a couple billion for each of the big three? Hmm, well, there may be a network effect from the users of Facebook, but the outside world is starving to death.

Wiser Words

Let's parse one particular part:

Pretty good [$15K/month] for a couple of young hacker/coders with very low overhead, but...

It may sound good to make $15K/month, but that is only a buck eighty a year. Take 50% out to pay for taxes and basic health insurance and you're making $90K. Hope you don't have any hosting or other costs....

So, really, it's krep income, even when you come near the top.

Valuations

The next bit is even more interesting:

... not the kind of business that commands million/billion dollar valuations.

Good lord, Facebook is "worth" $15B to Microsoft and a host of other people and it's certainly going through money like this bubble will never pop.

Let's look at the valuations of our ecosystem companies for a second:

• Oracle - Market Cap=$112B, Rev=$20B, Operating Margin=34%
• Microsoft - Market Cap=$280B, Rev=$58B, Operating Margin=40%
  
• Cisco - Market Cap=146B, Rev=37B, Operating Margin=25%

(By the way, if you aren't impressed with a HARDWARE company like Cisco having a 25% operating margin, you should be.)

So, Facebook is worth 10% of Cisco or Oracle and 5% of Cisco? I think we know that is crazy talk. But if that is the talk, then why is Dan dissing the 300M page views of a Facebook widget maker? Isn't Facebook just a bigger aggregator of page views?

Do Some More Facebook Math

What did Zuckerberg have to say about Facebook revenue on a con call in January of this year:

Revenue for Facebook for 2007 will be $150 million, as has been widely reported. But for 2008, Zuckerberg projected revenue to be increased to $300 million to $350 million.

Currently they have 450 employees, so this year their revenue was $333K/employee, which is not bad.

Next year they plan to have 1,000 employees ... yes that keeps their revenue/employee pretty much flat.

Remember the 25th most popular widget maker pulling in $180K gross/year? He's not looking too stupid, relatively.

How does this math work again?

Summary

There aren't very many people making money adding value to Facebook, it monetizes it's users poorly, and management plans to ramp staff and keep revenue/employee flat this year.

I was reading a very sad, frank, and wise notice from Russell Beattie about the death of Mowser, his mobile browser project. I know, and you know, that most startups die young, the ones that don't mostly become zombies living on consulting, and the small remaining percentage are bought for peanuts by larger companies lusting after their IP and management team.

But it is still sad.

And before anyone misconstrues anything I am about to say, I've been there, so I am very sympathetic.

The Aftermath

I think Russell can say it better than I can:

Seriously... A salary will be a good thing to have again. I'm *thousands* of dollars in debt to my family and friends, maxed out on every credit card (all of which are in collections), on my last chance for my apartment (if I bounce one more check...), had my car repossessed *twice*, electricity turned off, cellphones switched off, landline canceled outright, and on more than one occasion (this weekend in particular) eaten little more than buttered macaroni as I waited for an overdue PayPal deposit to arrive (3-4 days? Come on!). Having a steady income will be a welcome mental break, believe me.

So, here's the thing, did he make a mistake or, even in hindsight, was this the right way to fund his company?

VC or Credit Card Debt

Well, that's the question, unless you're Guy and have been rich and famous for so long you forget why.

There is no answer. I know that's all very Yoda, but there it is.

The Third Way

Jeff Bezos is supposed to have sat down and gone through all the different items that could plausibly be purchased via the internet (pet food: no) and settled on books.

My last startup we went though a host of things we could startup that had serious FY money potential and that could be started while we were still consulting and earning our basic dough.

You see, we'd both done it the VC way and the credit card way and, since we didn't like the outcome of either, we went for the third way.

India

If I wanted to start a company without going into debt and without selling my soul to a VC, I'd go live in India and insource my project. 

A good mid-level manager who was willing to move to India could easily make $50K USD, which is the equivalent of $400K in SFO.

Take your partner with you, share an inexpensive room. You now have $70K to play with to hire technical people.

Which, in the good old US of A might get you a semi-palatable Flash programmer, but in India one can get a very good technical programmer for $15K.

Bootstrap four or five good programmers and be there to supervise them.

Plus, should things go badly, as they likely will, you now have an impressive resume to take home to the US.

You can rinse and repeat this process in China or Vietnam if you like, but I prefer curry to eel.

Keep A Stiff Upper Lip

Personal advice to Russell and everyone else swimming in the dead pool - it's all very survivable, and likely you'll take another run at the brass ring. I did, and I believe you can catch it if you work hard enough.

Look, this is not something you can write on 1-Apr and have anyone believe it:

Li Ka-shing, Hong Kong billionaire and CEO of telecommunications conglomerate Hutchison Whampoa, has increased his investment in Facebook in excess of $100 million.

Man, that is some walking-around money to throw around. Or away. I know this cat is several billion dollars smarter than I am, but look at the numbers:

• Facebook: 60M subscribers
• QQ: 300M subscribers

What is QQ? Well, I'd say it was the facebook of China, but there is a major difference - it is profitable.

Profitable?

Yep , they had around a 40% operating margin - $224M bottom line off $523 million.

Facebook? Uh, not so much. I've heard estimates that Facebook lost $200M last year on revenue of, well, diddly.

What is kind of interesting to me about QQ is that <15% of their revenue comes from advertising and the rest is ringtones and krep like that.

So there is some real upside left there.

Why Invest In Facebook

I have no idea. Perhaps it gives him some leverage to be a dealmaker, maybe the later investors are getting crazy mad warrants.  Or maybe there is so much money and so few good deals that people are spreading their bets around the margins.

Why is QQ Profitable?

I suspect that the QQ guys went into this thing from day one with plans to make money.

I know the Facebook guys were just "gaining marketshare" (of what?) and "getting momentum" (towards what?) and "achieving critical mass" (I know of what!).

Beware The Bubble

Remember the Time Warner / AOL merger?   Remember what happened six months later?

Well, if you see QQ and Facebook merge to get "synergies" or "global market" then you should probably go long on cash equivalencies. 

I was over on Mixed Martial Arts and saw the best google ad in a long time:

It'd take a long time to make a million bucks at $20K/month! 

But, for some reason, it seemed very apropos given that the topic was Entrecard taking $112K on a pre-money valuation of $998K. It wasn't the odd numbers that caught my attention because that sort of thing is always negotiated and you get some strange round-offs.

It was the odd deal.

First, What is Entrecard?

It takes a bit of time to tease out what is going on since there are no fees, etc. It turns out that their business plan is to get footprint (they are on 6,500+ blogs) through cooperative advertising.

Imagine if instead of getting paid when someone clicked an adsense link on your blog you got a google credit to buy a keyword. Also then you'd have to imagine that you could click on the ads on your site and get paid for that too, but put that aside for a moment.

Short Term Revenue

To bring in short term cash:

Once per day we will allow a larger company to drop their card into the inbox across the entire network. This will not appear on your website anywhere, but rather only in your inbox when you log into entrecard. You will also receive 5 bonus credits for visiting these sponsors. We will also allow for sponsorship opportunities for our system emails and all of our RSS feeds.

Longer Term Revenue

Once the network is very very large:

When the [Entrecard] economy is in great shape, we will roll out a credit exchange for bloggers to sell their credits to advertisers, and we will take a commission.

So you can sell advertising slots (and thus traffic) like, well, like you do today for lots of other people.

A Revenue Model

Since Entrecard has 6,500 blogs in their network and can place an ad a day on each of them, that means they can serve up 2.3M ad/days/year. If every ad/day gets 10 views and they get a CPM of a quarter that is $6K/year in revenue across your revenue.

Which is not bad to start off with, because if you can scale up your blog network to fifteen or twenty million you have some serious dough rolling in.

I'm not dissing 6,500 blogs, but there are probably a million or more created every single day and these guys are getting naught point diddly percent of them. I looked through their "featured" page and didn't see any biggies.

I reckon that this model is pretty much stuck to the bottom end of the market. This is not stupid because that is the biggest part of the market, and if you can serve it right and with low costs, then you can get very very big - see WalMart.

And this "traffic for an ad-a-day" model really works in the bottom end of the market where people live on their sitemeter stats and are excited when they break a 100 for a week in a row.

Why do I say low volume blogs only? Because a big traffic blog doesn't want marginal traffic from other blogs, it wants placed ads (at best) or expensive adsense ads (at least).

Also, as a side note, this is why google bought blogger and why it has always amazed me that adsense isn't a default on all blogs. (Yes, I understand why, but they barely push it.)

You can also see that they aren't exactly ramping crazy revenue or traffic - look at the valuation.

Clearly these guys are not getting valuation based on hype. Facebook is losing money hand over fist and is "worth" billions pre-money to Microsoft (who are not stupid).

So they are getting their valuation based on revenue.

As a side note: this is why I would NEVER have released the details of this deal. Your competitors and the general public can find out a lot from a little.

Valuation Information

Ignore the $112K number because it's really three numbers: $34K in three tranches. So the revenue valuation ends up with the end-of-period revenue of the company - or in a year. Differently put, Andrew Te paid $112K for 15% of a company based on it's valuation at the end of a year.

Nice trick, and that tells us that the Entrecard guys really needed that money.

I know $34K can sound like a lot of money, and if you've hooked yourself up into Amazon's Web Services (like I said you shouldn't), then you've got to write that check every month. I know they're there because their model spreadsheet showed hundreds of thousands of bloggers signing on every month and they (thought they) needed the capacity - and I might have done the same.

For example, if your last 12 months revenue was $50K, then the investor will say: "Five times trailing is a pre-money of $250K."

But if the last month was $8K and this month was $10K, then you'd say "At a growth rate of $2K/month over the next 12 months our revenue will be $252K so our five times leading valuation is $1.26M!"

And if you're hot hot hot then you say, "Our growth rate is 25%/month so our yearly revenue will be $670K and our five times leading valuation is $3.3M."

So, yeah, if you're trying to figure out how strong someone is you can kind of look at their valuation and see what they managed to pull off.

The Devil Is In The Details

One of the things you often see with tranche based investment is some really tough conditions for the seller. Looking at the valuation options you can see that the Entrecard guys fell towards the bottom.

How can I say that? Well, remember that they're really only getting $34K, which is what percent of $250K? Right.

If they use the money to keep paying Amazon and to, say, quadruple their blog base, then, hey-ho, they get the next $34K. And so on.

And if they miss their numbers, I am betting that there is some ugly change of control stuff in there.

Conclusion

Look, I'm not saying they shouldn't have taken the money, and I'm not dissing their business plan. I hope to never be in the position of having to take VC money again, and if I do, I hope it's a big big pile for a teeny tiny piece of the pie.

Earlier this week I had a perfect storm of things go wrong at work, any one of which would have been likely to infuriate me on a normal day. Combine them all together in a row, thrown in a quick round trip flight on United Airline (motto: You Think K-Mart Has Lousy Service?) and then add in several off-diet expensive-but-yucky airport food meals that made me gain three pounds. Result: One Ready To Explode Guy.

Bad Temper = Bad Decisions

I'm about as old as a dinosaur and one of the things I've learned is that I make bad decisions when I'm mad. Really really bad decisions. It's not that I haven't made good decisions when I was tee'd off, I have. It's that the ration of good:bad decreases. (Or increases, if that is what I meant, I have never properly understood how to say ratios.)

Worse Ever Bad Decision Made When Mad

At an earlier startup we negotiated a $12M round with a fund-of-funds that wanted to get some exposure to the boom in tech. As this was right before the bust, you may assume that they got more exposure than they really wanted. But at the time everyone and their grandmother's bond fund was buying into tech startup.

So we negotiated a deal with these cats, and while they were not VC's per se, they were very very smart and tough people, who checked us out from top to bottom, inside and out. Like seeing the doctor after 40, but with a spreadsheet instead of a glove. At the end of several months of work, and tens of thousands of dollars of legal bills (on my side alone, who knows what they spent) we had a rough draft of a contract and were just fiddling with valuation and board seats ($20M or $18.5M, 3 seats or 4.) I must admit that I was negotiating pro-forma and really was already getting a better valuation than I'd hoped and losing fewer board seats.

Then, after it was all settled, I got the final copy of the contract and they'd slipped in warrants for 15% of the company.

What you can't see is what signs he's making with his paws.

I even slept on my answer, thinking that would help me be more reasonable and let me re-enter negotiations.

Not As Smart As I Thought I Was

Because, you see, I'd confused letting some time lapse to letting my temper subside. So the next day, feeling deceived, I called them up and read them the riot act and, basically, told them where they could stick 12 million one dollar bills folded up into tiny little points. Not that you could have fit them all in there, but the piledriver I suggested they rent might have packed a few more in.

Now, this is a very human response to being systematically deceived, but it was foolish on many levels.

Wait, Deceived?

Yes, well, someone doesn't come up with a perfectly worded 4 page section in a contract overnight, with full references to other sections special provisions. So they'd always been planning on putting this section into the document right before signing. And, thus, I was deceived and duped into spending the things that are most scarce in a startup:

• Money
• Time
• Attention
• Energy

Why It Was Foolish

Well, turning down the money because they would be bad business partners would have been fine, assuming one had other options (we suddenly didn't) but turning it down mad was foolish because:

• I burned bridges. I have those guys in my contacts list so I can avoid them because I can only imagine how stupid they thought I was.
• We needed the money. Knowing what I know today, I would have taken the money. Could I have come to that conclusion if I was calm and focused? Maybe.
• Their plan was to manipulate me. They weren't making a mistake in slipping that stuff in. The only reaction where I could have still been in control was if I'd remained calm. So they won as soon as I got mad and started reacting without calm, deep, and mature thought.

Getting Smarter

Now I know that time does not equal calm, and I have learned to recognize when I'm stomping around mad, or even just sitting working on strategy stuff in a rapid simmer. So today I have restricted myself to working on the administrative items that I hate but have to be done: review of next year's health care plan, lease renewal review, reading all the inbound customer comments for the week (yes, I still do that), etc, etc. All things where I might take a to-do, or have to get something done, but all transactional and places where even a bad decision is not disastrous.

And if I'm not better by Monday, I'll know to keep myself out of the game until my head is ready to go there and do a good job.

Here's where you are: balancing on a razor's edge. You are juggling competing needs:

• Capitol for product development
• Cash flow to pay for sale effort
• Attention required to staff two different models:
• Traditional consultants for your cash flow business
• Developers and support staff
• Sudden need to build an infrastructure to support a growing business
• Finance guys, admin staff, human resources/recruiting

You're enormously attracted to the rush of 90% profit margins on each product sale but you are starting to miss the simpler days, when you had half a dozen guys out doing consulting and a one-room office that you and your partner shared. And if you were both out consulting, you answered client calls at the Homewood Suites at night.

Why is Your Profit Margin Dropping?

You may note that in our earlier piece on the transition from Product To Consulting we'd started with a 30% (gross) margin on consulting and a 100% margin on 'the product.' Well, that was true when the product was client financed and improved by salaried bench consultants. But now that you have a few developers, a server room, bigger offices, etc, etc it starts to eat into your profit margin. So it's down to 90%.

Oh, wait, your new finance guy just completed an ABC (Activity Based Cost) on your organization and found that your consulting margin has dropped to 20% due to turnover and higher bench rates and that the cost of sales you calculated did not include sales shows and the taxes you now need to pay in California on your sales office in the valley. Ok, product margin is now down to 70%.

But it is still a lot higher than consulting, and the requirement for capital for expansion is even more necessary.

Persevere

You don't get to a $3M/year company employing 30 people without having some drive, so you make a plan. A business plan. A real one. With expected, best, and worst case scenarios. And a spreadsheet showing how you'd use $1M to take your business to $15M in 18 month.

Reality check: $1M a year with six guys to $3M a year with 30 guys in a year. Can we go to $15M with 60 guys? Yeah, we can do that again. Make the powerpoint and hit 'send' on the email.

Enter the Venture Capitalist

You are lucky and your product enables web 2.0 enabled mobile social enterprise marketing. (Please feel free to add or subtract buzzwords here.) So you're hot enough to get into four or five VC's and one of them thinks you 'fit into our portfolio' and wants to do a deal.

Fitting Into A Portfolio

Just a quick note - this means that quite aside from anything else the VC thinks of you, he is expecting you to provide (at best) at cost services to other companies with cash crunch issues. At worst they will expect you to take over struggling product/development/sales issues for dying startups.

Your salesguy is already calling on their core customer base, it'll be a synergistic sell. Yes, I know that your product is a back office enterprise solution and theirs is a front office spam mail filter, but he's already on site!

Right. Let me give you a hint: this is bad.

Before you go to bed every night, practice looking yourself in the mirror and saying: No. You may need to add juicer words to the front of "no" to make it work. At the end of the day the VC can fire you and take your company, but it's the last thing they want to do, especially before you are in trouble. So you can start early on and get them used to going to find someone else to push around.

The Deal

We've already talked about what to look out for in a VC contract, and we've already talked about how the VC will probably wipe out your Mom's investment. And you know to watch out for those salesguy's Amex cards with your personal guarantee, the phone system with your personal guarantee, the copier with your personal, well, you get the drift.

We have not mentioned the absolute necessity of using a real payroll provider like ADP (small is fine, may not save you any money though) and ensuring that they are escrowing all your payroll taxes and unemployment insurance, etc. Because no matter how nicely you're incorporated, the feds will come after YOU for that money, and if they don't get it you are very likely to end up in Federal Pound You Prison.

So go read those back posts and come on back, because this is where the VC kills your business.

Consulting is Dead, Long Live Product Specialists

To the VC investing $1M to ramp your company up to $50M (Remember that excel sheet? The numbers got bigger.) the $1M you're making in consulting is not worth it in:

• Cash flow: they want you to spend their money to get to the second round to own more
• Your Attention: product has the multiples, leverage, and profit margin
• Market Confusion: Are you a product or services company?

To give them their due, aside from the ulterior motives of the first point, they are right. You have a thin management team and you are fighting to get recognized in the market, so you have to focus on the future.

So the core of your business goes away - you dump 8 of your 12 consultants and keep four around to test, install, and write custom reports. There are always custom reports.

Because your typical bag carrying billable consultant is terrible at this, you eventually have more turnover, which feels good at first because the new guys cost less, are more compliant to doing this kind of horrible scut work, and the probably don't have any expectation of equity.

The Money Is Gone

You burned through your VC money, probably on schedule, and while sales have been good they aren't making up the burn rate. Two things can happen:

Thing the First: - A Down Round B

Your previous pre-money was $3M and you gave up 1/3 of the company for $1M. Now your pre-money is $750K and you give up 75% of the remaining company for $500K. I could do the math, but it would depress you. Suffice it to say they will take your net profit margin on trailing 12 month sales and use that as the market cap value.

And your boss sits in San Jose. Almost all non-essential staff is laid off, but your're paying $10K/week for two hours a week of CFO time from another portfolio company. Plus your development guys are "taking a look at" some "other interesting technology products."

You ever heard of LinkedIn or Monster? Get familiar. I have been doing startups for a long time and have seen this zombie phase a lot. And I've yet to see a company come out of it.

Thing the Last: Retrenching With Consulting

If you decide to stop taking the Devil's Money and you've been very successful in saying "No" a lot and very loudly, you can probably bull your way into trying to resurrect your consulting business. But you find that the consulting market has moved on, you don't have any more consultants on staff except you, and, frankly, it's hard to get too excited to going back to six guys and a cube. In my mind this is just another type of zombie.

The Moral Of The Story

There isn't one. There is nothing wrong with transitioning from consulting to product, but it is darn hard, for reasons we've discussed. And there is nothing wrong with VC money if you're in a hurry and you are willing to take the risks. Me, personally, I can't imagine taking VC money in today's highly leveraged global human resources market, with cheap high quality hosting, powerful tools, and ready access to millions of particular customers. But your product may have different requirements, so good luck to you!

Today's 400 point drop in the DJIA in the first three minutes of trading may be a temporary bump or a glimpse of things to come. So far it has recovered most of the loss, but if we're headed into a bear market we could be seeing the end of the Web 2.0 venture capital driven bubble.

Most Venture Capital funded companies think of themselves as cool, new startups that aren't affected by the goings on of Wall Street and huge companies. They live in their own world. How could something as far away as the NYSE affect their small business?

Most people don't realize how connected venture capital is to the health of the stock market.

• A bear market provides an inhospitable environment for an IPO, elminating a key potential exit for the VCs. Admittedly, there hasn't been a good IPO environment in a while, but a bear market won't help.

• A bear market hurts valuations for acquisitions. Big companies, if they have cash available, will pay less when buying the small companies because values are down all over. If your busisness plan is to get a lot of trafic and then sell yourself to Google or Yahoo, you're going to have difficulty when they stop buying or are offering less than the VC put into your company.

• A bear market hurts the ability of other businesses to buy your services. When the market goes down because of a recession, the big companies stop buying. Even if you don't sell to the Global 2000, the chances are your customers do. Or they're the ones getting laid off. Either way, a bear market hurts your ability to grow the business organically. And if you don't have a clear revenue model, you're really in trouble.

• VC Cash Calls threaten failure in a bear market. This is the big one that few people understand. When a venture fund raises money, they're really only gathering committments for funds. When they announce they've raised $200M, they don't have $200M in the bank. They've got $200M worth of committments from individuals and institutions that they can call and get money when they're ready to fund. The problem is that when the market turns south, a lot of these committments become less solid. Since it would be a very bad thing if a VC firm were to make a cash call and have it fail, they tend to call their investors and ask them if they have the funds to invest. If the answer is no, they don't tell anyone. They just stop funding companies. When a VC says "We're keeping our powder dry in this market" what they really mean is "We have no funds available to invest." Deals that would have flown through 3 months ago stop, and perfect deals get denied. Unfortunately, the VCs are all too willing to let you waste time delivering pitches when they know they can't respond. You can also see beauty contests that hit small snags blow up into dead deals.

The big one is the cash call failure. Few people understand it, it's the most insidious, and has the biggest effect on drying up venture capital.

So how does this affect your business? I'd say you're in a world of trouble if:

• You have no revenue mode for your business other than the idea that you're going to bring in a lot of traffic and figure out how to monetize it later or sell to a big company.

• Your revenue model is based upon advertising rates staying the same or growing. When the bubble breaks, a lot of VC money that was propping up the currently high rates for Adwords is going to go away. On the other hand, if your business model involves paying for Adwords, you could see your costs go down.

• You've taken a VC investment that allows them to take control of your company if you don't reach a certain milestones. "The company has stalled in its growth" is a favorite phrase VCs use when replacing the founder CEO with their analyst that needs a job because they don't have more deals to look at and need to trim payroll.

• You've taken a VC investment with the idea that you'll meet certain milestones and get the next round, or even worse, the next traunch. Yes, they can come up with a reason for withholding the next traunch that they've committed to even if you meet the milestones. They know you'll be fighting with decreasing resources and an increasing position of weakness.

• You've got a clear revenue model, but it's based on selling to startups funded with VC money. Take a look at your client list. If it's full of cool, new VC funded startups, it's time to look for new clients. You can calculate their life with their burn rate and the cash on hand, because they probably won't be getting any more. Don't let those invoices drag.

• You have become dependent upon a product or service from a VC funded company. If you've built a business where one of the core functions depends upon a VC funded startup, it's time to reevaluate your vendors. In fact, it's not a smart move to become dependent upon anyone that doesn't have a clear revenue model.

On the other hand, if you're lean and mean and haven't taken VC money and have a clear revenue model, you can do well in a recession. Recessions tend to trim out the slow and bloated, which can be your competition. Look at the companies that survived the first dot-com bubble -- they'll probably survive this one too. And a lot of the 100s of websites that make up the critical mass of Web 2.0 that do absolutely nothing will go away.

It's going to be an interesting ride.