Tumblr Acquisition – Cautionary Tale for Later-Stage Investors

The Tumblr acquisition announced this morning was great news for the company, founder David Karp, and the New York technology scene.  Likewise, early-stage investors Spark and Union Square Ventures should be congratulated for what was undoubtedly a fantastic return.  Funds that invested in Tumblr’s Series D round in September 2011, however, are likely not feeling as pleased today.

Reports indicate that Tumblr was valued at $800MM at their Series D round.  Companies typically refer to pre-money valuation (how much the stock is worth before the fresh capital went in) – so almost two years ago new investors were sitting at a $885MM post-money valuation following the $85MM investment round.  Given the competitive nature of that round, I would speculate that the terms were relatively “clean”, meaning that the shares didn’t carry a participating preferred structure or any other features which would otherwise boost returns.

The return on the Series D, however, isn’t as simple as computing the difference between $885MM and the $1.1BN purchase price that Yahoo! agreed to pay.  Because Yahoo! wants to retain Karp and other key talent, a significant portion of the purchase price is almost certainly being allocated specifically to management rather than shareholders.  Such arrangements have become commonplace in deals over the last several years.  Assuming 15% (or $165MM) of the $1.1BN goes to management in the deal, shareholders are left with $935MM of consideration for their shares. The Series D shareholders’ roughly 9.6% stake in the business will be worth just shy of $90MM – not much of a return on their initial $85MM investment.  And this assumes no incremental dilution over the past two years for employee grants and the like.  Assuming a mid-August close of the deal, under the above scenario the IRR would be around 2.9% – that’s better than treasuries, but not by much, and certainly not on a risk-adjusted basis.

Obviously the math above is based on press reports and makes a number of assumptions (the most important being the lack of structure on the Series D), but regardless it does show the challenge of making “later-stage” investments in companies with great user growth and usage dynamics but limited revenue.  For the investors in Tumblr’s Series D – largely smart firms with strong track records – Tumblr represented a grasp at creating another Twitter or Facebook that fell short.  Getting capital back plus some small return is better than the proverbial stick in the eye, and certainly better than I’ve done in some of my investments, but  in this case a $1.1BN sale was not the hoped-for outcome.  

Later-stage investors – venture funds, hedge funds, and the like – as well as their limited partners should view this acquisition as a cautionary tale.  Entrepreneurs should also take heed – if you’re going to take money at a lofty price, your investors aren’t always going to see eye-to-eye even on a large exit – what is a great outcome for some will be a disappointment for others.  If you’re unwilling to provide the investors who came in later with some mechanism for earning a reasonably good return, at least be sure that you don’t give them the ability to block a sale!