Friday, March 25, 2011

A start up named Color has raised $41 million of capital.

This news has obsessed the tech world and beyond for the past 48 hours, with the majority of the peanut gallery huffing and snorting about how it's obviously ridiculous and a clear sign of a bubble.

Here's what most of these instapundits fail to understand:

* There are two basic strategies in raising capital -- "lean startup" and "fat startup"-- and Color is intelligently pursuing the latter. Most digital startups in recent years have pursued the "lean startup" strategy: They raise a small seed round, then a bigger Series A round, then a bigger Series B round, and so on. With lean startups, investors only put up new money if the business is going well, and entrepreneurs generally give up less equity in each round. With "fat startups," in contrast, companies raise a big first round and really stomp on the gas, without having to worry about raising more money for years (if ever). Importantly, neither of these strategies is "right." They both work (or fail, as the case may be). Which strategy one chooses is usually dependent on the specific opportunity, the entrepreneur, and the investors. For a company with an opportunity as big as Color's in a highly competitive sector with several well-funded companies, with an experienced entrepreneur, and with deep-pocketed investors willing to roll the dice, the "fat startup" strategy makes a lot of sense.

* The $41 million is almost certainly preferred stock, not common stock. This is a hugely important point that almost everyone misses. With preferred stock, Color's investors will get the first $41 million from any sale of the company, and probably a lot more (if there's any "participation" feature baked in). The investors will get this money before Color's team gets a dime. And, unless Color spends every penny of this cash, Color's business does NOT need to be worth more than $41 million for its investors to get their money back (see the next point).

* Color now has $41 million in the bank, which means it's already worth at least $41 million to any buyer -- TODAY. This is another huge point that everyone seems to miss. Color now has a huge, liquid asset on its books: $41 million in cash. If the company fired everyone today, never developed anything, and closed its office, it would be worth $41 million to an acquirer. Now, of course, Color is eventually going to spend a lot of that money developing a product, which may or may not turn out to be worth anything. But the cash it has left will still be cash. So say, in a year or two, Color has developed a moderately successful product and team that might be worth $20 million to someone. If Color still has $21 million of the cash left, its investors will break even (because a buyer will buy the team and product for $20 and the cash for $21 million. The only way Color's investors will lose money is if the product and team end up being worth LESS than the cash spent to develop them. This could easily happen--it often does--but that can be said about any startup investment.

$41 million in cash provides Color with enormous flexibility and a major competitive advantage. Let us say hypothetically that Color's first idea and product sucks. The company will probably figure this out relatively quickly (six months?). It will have learned a lot by then, however, and it will still have, say, $38 million in the bank. $38 million is a lot of money to "pivot" with. And Color is run by smart people, so they'll presumably pivot into something related. And they'll keep on pivoting until they find something that works.

This big a financing will scare the bejeezus out of everyone else in the sector, and it will deter future competitors and investors in other companies from entering the business. Color just raised a LOT of money. That is a fact that is going to make entrepreneurs and investors who are thinking of betting on similar ideas take a deep breath before they place their bets. Color's first version of its product may blow, but that doesn't mean the second one will. And with this amount of cash on its books, Color will probably have the second version out before a would-be competitor even gets its deal-documents signed. (Check out how much more money Color has than its rivals).

This is a potentially huge opportunity that will likely be worth many billions if it works out. Color's founders are not thinking small here. They're laying out a vision for a massive global enterprise. If they can successfully execute on that vision, $41 million is going to seem like chump change. Could they fail? Of course they could fail. Every startup could fail. That goes with the territory. Color's investors understand the risks, and they build their portfolios to account for it. If Color fails, its investors will shrug and move on. If it works out, they'll look like they got it for a song.

In the grand scheme, $41 million is chump change. Digital industry folks have a very skewed vision of the the world of financings, in part because they generally build, invest in, or work for companies that require extraordinarily little capital to succeed. Most other infrastructure or hard-technology businesses, in contrast, require hundreds of millions or billions of capital to build. Think of wireless companies, satellite companies, biotech companies, energy companies, cable companies, telephone companies, transportation companies--these companies raise hundreds of millions of dollars before breakfast, with no one even batting an eye. And when they don't work out, their investors often lose everything (or close). So digital instapundits raving about the ludicrousness of a $41 million startup investment should keep in mind that, in the grand scheme, $41 million is still chicken feed.

BOTTOM LINE: Color's financing is a big bet on an idea that could turn out to be, well, big. If the idea works, $41 million will seem like nothing (imagine investing $41 million in Facebook or Twitter or Zynga 7 years ago--chump change). It will also be a big asset in the company's ability to achieve its vision. And, contrary to public perception, Color's investors actually have a lot of downside protection, including diversified portfolios. So, as is often the case, most of the huffing and snorting instapundits have no idea what they're talking about.


Post a Comment