The self-involved nature of Bernie Madoff’s prison house interview with New York magazine (“I am a good person”) was annoying enough. More disturbing, however, was that his indictment of the entire financial system as a “ponzi scheme” might have had more than a whiff of truth to it.
The fact that news of his interview appeared on February 28 just about the same time that word of JPMorgan Chase’s potential investment in microblogging site Twitter came to the fore was particularly unsettling. The Financial Times, which orgiinallly broke the story, says JPMorgan’s new $1.22 billion social networking investmet fund plans to buy about 10 percent of Twitter for roughly $450 million, giving the site a valuation of about $4.5 billion.
Last week, private market Sharespost revealed that a private auction had pushed the value of Twitter’s series B preferred shares to $34.50, or an implied $7.7 billion for its estimated 223.7 million shares, according to Reuters. This, for a company that was valued at just half that level, or $3.7 billion, in December with venture capital firm Kleiner Perkins. Other backers have included Union Square Ventures and Bezos Expeditions, which is Amazon founder Jeff Bezos’ venture arm.
How can this soaring valuation be? There are a few reasons, none of which ultimately have much to do with Twitter’s business model or management. Twitter is expected to triple its revenue to $150 million in 2011 and to hit $250 million in 2012, according to eMarketer. The latest auction, therefore, values Twitter at about 75 times forward-looking revenue. That’s rich, but it’s in line with other up and coming Internet companies.
The catalyst for Twitter’s soaring valuation wasn’t the revenue model, but Goldman Sachs’s move in January to invest $500 million of its own money, along with $1 billion from wealthy European individuals, into Facebook. That deal valued Facebook at $50 billion, although the company now has a valuation of more than $65 billion in the private market. What about profits? Please don’t ask.
“I think the investment in Facebook got everyone else saying, we want to do this as well. There is a little bit of follow the leader going on,” says Jeffrey L. Dearth, partner with the New York-based media investment bank DeSilva+Phillips.
This is not to say that Twitter doesn’t have huge potential as a new media and communications platform. The service, which allows users to send 140-character messages, has 190 million users around the world. Twitter’s new CEO, Feedburner founder and Google veteran Dick Costolo, has a plan for expanding the use of advertising and promoted sites. It has a wide following, from celebrities to media types in the U.S. and revolutionaries in the Middle East.
But that still doesn’t justify the current valuation. “I’d say the winners in this situation are the sellers, and not the buyers,” Dearth says. “I’d say the VCs are driving this.”
The venture capitalists can take enough money off the table to declare the investment a total success for themselves and their limited partners, leave a bit of equity for future growth, and enjoy the upside.
The banks also benefit by locking in millions of dollars in fees and positioning themselves for Twitter’s future IPO.
The buying can be explained in several ways. Many people are susceptible to the argument that Twitter— or Facebook, or Groupon — might be the next Microsoft or Google. And, indeed, any one or or all three just might be. Who would want to miss that? But there’s a chance that at least one of these companies will be the next AOL or Yahoo, too.
As compelling as Twitter’s story is, there are reasons for caution. As Dearth notes, Twitter uses spend far less time with the platform than Facebook users spend. And Facebook’s environment is more suitable for certain kinds of advertising. Of course, Twitter can be monetized in many ways, including white-label services sold to corporate customers that put their own brand on the product.
Twitter’s valuation took off in recent months, because the business model finally started to become clearer, Dearth says. But its doubtful that investors in the private market know what much more about Twitter’s outlook today than they did just one month ago. Most of the recent buying is just a bet that Twitter will be worth more tomorrow than it is today, just because someone else will be willing to pay even more.
Investors who buy Twitter at its current level aren’t necessarily crazy or foolish, either. The point here is that Twitter’s valuation can’t be justified, not that the value won’t continue to rise. And in a large portfolio, there might be room for a few risky bets with the potential for a big payoff.
There’s nothing illegal or fraudulent about such investing. But the mindset of counting on an endless stream of new money to make the old money good still has an eerie ring of familiarity. And as Twitter’s valuation pulls ever skyward, the odds that someone loses will rise, too.
