How Controversial Startup Klout Sold For Hundreds Of Millions Of Dollars

Instagram/KloutKlout's officeLate at night on Sunday, Feb. 9, Joe Fernandez sat alone in Klout's 67-person office on 77 Stillman Street in San Franciso. A pile of paperwork lay on his desk.

It was a term sheet from Lithium Technologies. If Fernandez signed it, his startup would be acquired for hundreds of millions of dollars. If he didn't, Klout would continue to run independently. "The overwhelming pro of staying the course was you remain in control and you chart your own path. That for any entrepreneur means a lot," he says.

Fernandez, 36, weighed the decision, which needed to be made before midnight, just minutes away. To his left, a 5-foot stuffed bison loomed near reception. It was a not-so-subtle reminder of the quirky, Western-theme culture Klout had adopted. An employee, or "Kloutlaw," had purchased it from a thrift store. If Fernandez sold, would his aligned team and product vision persevere?

On the far wall, red lettering as tall as the bison screamed: "Be Bold."

Fernandez picked up his pen. It was 11:58 when he finally signed his name. He went home to tell his wife.

48 hours later, while sitting at a Goldman Sachs conference, Fernandez received a troubling email. Kara Swisher, the founder of technology site Re/Code, had caught wind of the proposed sale and was about to make Klout's acquisition news public. The deal was so fresh, Fernandez hadn't told his parents yet. His sister who worked for Klout didn't know about the acquisition either.

Two minutes later, Swisher's article was live. It said Klout would be acquired by privately-held Lithium Technologies for at least $100 million.

Fernandez dashed back to the Klout offices and found the article up on nearly every screen. He quickly called an all-hands meeting.

"It was definitely a panicked moment," Fernandez recalls. "Term sheets can take 45 to 90 days to close; we didn't know what to say. But we knew we had to be transparent to employees. We said, 'The news is rumor and speculation, but we also know this is your job and passion. We've come to this agreement [with Lithium]. We're going to explore it; we're going to see if we can get it done. But it's super early and we don't know what's going to happen.'"

External notes began to pour in.

"I received an email from just about everyone I've ever met," Fernandez says. The messages broke down into two categories: congratulations and deepest sympathies.

"Everyone I grew up with read the article and said, 'Oh my God, $100 million, that's amazing,'" Fernandez says.

After all, it sounds like lot of money - unless you're from San Francisco where billion-dollar exits are the new normal. Klout's last fundraise valued the company at just under $200 million, a far cry from the $100 million reported by Swisher.

Which is why, as Fernandez puts it, "Everyone in Silicon Valley said, 'Wow, I'm so sorry.'"

From its founding to its exit, Klout has been a controversial startup. What began as a way to get Twitter's attention morphed into a red-hot company that drew investment from Kleiner Perkins, Microsoft, and other big-name backers. Klout is a social influence tool that ranks people's influence on various topics and tells them how to become more powerful on those topics. Brands use it to target the most influential people on the web.

The company itself has seen its clout fluctuate over time.

Last fall, Klout's COO resigned. Press ebbed and flowed. Over the past year, Klout has awkwardly tried to grow from a buzzy startup into a sustainable business.

Wired Shut

Joe Fernandez KloutJoe Fernandez, CEO of KloutPrior to starting Klout, Joe Fernandez had never managed more than four people. The son of a casino worker, he grew up in Las Vegas and attended the same public school as Digg founder Kevin Rose. Fernandez was never a gambler despite living in Caesar's Palace for a few months during grade school. He didn't even know how to play poker until he learned as an undergrad at the University of Miami, Florida.

Fernandez, a Computer Science and Finance major, moved to New York after graduation. There he met his wife, a children's book author. He spent six years co-founding Evalulogix, a startup that crunched data for 10,000 school districts. The startup stumbled, but Fernandez was able to secure a decent outcome: Arkansas-based company Computer Automation System agreed to pay Fernandez and his co-founders an ongoing royalty for their licensed product.

"Managed to pull out a big victory when it looked like we had fallen on our face," Fernandez says of Evalulogix on his LinkedIn profile.

Klout was founded during a difficult time in Fernandez's life. At age 17, Fernandez had been told he'd need to have a serious jaw surgery to correct some stomach issues and headaches he had developed. Fernandez put off the surgery until he was 30, in December 2007. He assumed it would be a quick recovery, but the surgery resulted in a series of complications that required his mouth to be wired shut until March 2008. One inch of his jawbone had been removed, which changed the shape of his face. Even soup had to be blended and consumed through a straw.

"I looked different before the surgery than now," says Fernandez. "My face was longer. My mouth actually moved. When you pick a fork up - I had to re-train myself to eat - my mouth was no longer in the same spot."

Instagram/KloutThe idea for Klout came to Fernandez after a serious jaw surgery impaired his ability to communicate.Unable to talk for three months, Fernandez became obsessed with Twitter. As he began using it as one of his chief means of communicating, he realized what a powerful tool it was. He began plotting a way to get hired by the company.

Fernandez figured if he built a tool that utilized the social network, Twitter might eventually acquire it. At the very least, the experience might land him a job there. "That was really the motivation behind Klout," Fernandez now says candidly.

"I don't know if it was the pain relievers, but I got really obsessed with the idea that, for the first time, word of mouth was scalable and the data was there to measure it," Fernandez said in an early interview.

Initially, Fernandez worked on the social influence project by himself, having tried and failed to convince friends and former colleagues to quit their jobs and join him.

Determined, Fernandez shipped himself off to Singapore for three months and lived on a friend's couch while hacking together the beta version of his software. It launched on Christmas Eve, 2008. Fernandez soon found a co-founder, Binh Trahn, and the pair moved to Silicon Valley to be neighbors with Twitter.

"The main reason we moved to San Francisco was because all of our data came from Twitter and Facebook," Fernandez says. "We figured it was a good idea to become best friends with those guys."

In fact, he did one better. He moved Klout into the same building as Twitter, on 4th and Folsom Street. Before long, he developed a friendship with Dick Costolo, who became a mentor. That wasn't the only way the company's physical proximity to Twitter proved useful.

"I would keep a Twitter search running in the office," Fernandez says. "Anytime a brand would say, 'I'm stopping by Twitter HQ,' we'd respond to them and say, 'Oh, you should swing by Klout! We're in the same building on the first floor.'" Klout was able to nab a number of meetings with big-time advertisers using that piggyback method. The best outcome was Turner Media. The impromptu meeting spawned a lucrative, ongoing advertising deal with Turner-owned TNT.

The advertising deals have since multiplied into a multi-million-dollar business for Klout. Last year, Klout generated $10 million in revenue with profitability in sight. It works with more than half of the 100 biggest advertisers and this quarter will be Klout's largest in terms of sales revenue yet.

Initially, its algorithm just measured activity - such as retweets and follower counts - on select social networks.

Although advertisers like Klout's product, its reception among consumers has been controversial since the beginning. That's just how Fernandez likes it. He says he could turn all of the hate-tweets he's favorited about his company into a book.

"I've done a ton of stuff that no one cared about," he says. "I'll take being relevant and I'll take people hating and discussing and talking, because all that means is people care."

The negativity surrounding Klout springs from the way it encourages competition and induces social anxiety; a high Klout score seems like bragging, whereas a low score can feel like a sign of personal failure.

And then there was Bieber-gate.

In 2011, when bloggers learned Justin Bieber had a perfect Klout score of 100, the controversy surrounding Fernandez's company exploded. President Barack Obama had a lowly score of 58. How could Klout's algorithms be reliable, users wondered (especially those whose own scores were lower than they'd have expected).

"There was a point where I was like, 'The next person who asks me about Justin Bieber I'm punching in the face,'" Fernandez joked to Business Insider last year.

Klout tweaked its scoring algorithms to measure 400 signals, like Wikipedia pages and Bing searches, in addition to social media activity. It wrote a detailed explanation about how scores are created, and it got a big vote of confidence from investors to the tune of $30 million.

Finally, even its most vocal skeptics eased up.

Justin Bieber once had a perfect Klout score, which was higher than Barack Obama's."Klout has been one of my go-to punchlines for some time now," TechCrunch founder and CrunchFund investor Michael Arrington wrote in August 2012. "I've changed my mind. So much so that CrunchFund has now invested in Klout, and we're big believers in what they're doing … They've relaunched the product and a lot of the tricks that people used to game the system are gone. And better, Justin Bieber is no longer considered the most influential person in the world on Klout."

Once the controversy around Klout died down, so did much of its press.

"The controversy surrounding Klout is why it was in the conversation a year or two ago," Emil Michael, Klout's board member and former COO, told told Business Insider in September. However, he added, "Controversy does not equal momentum."

And in September, Klout had a momentum problem.

Last fall, Klout battled rumors that it was failing. Michael left his role as COO for an executive title at Uber. Investors wondered if Klout would ever deliver a compelling product for brands. Consumers didn't seem to care about their scores any more.

Part of Klout's problem was that there were too many aspects to its business and it couldn't figure out which ones to focus on.

"Everyone thinks they have the idea for the perfect business model for us," Fernandez said in September.

Klout has a consumer business, the Klout scores that you're probably familiar with. It also has a lesser known enterprise business. With enterprise clients, CMOs can utilize Klout as a Customer Relationship Management (CRM) tool. They also use it to offer advertising promotions to influential people through what are known as "Perks." Klout delivered over 1 million perks last year.

Some of Klout's investors felt the company should focus on enterprise and charge CMOs for more CRM tools or social media analytics. Their logic was simple. More than 200,000 companies use Klout for Business, a suite of enterprise tools that rolled out last March. There are 10,000 businesses using Klout's API, which is pinged 60 billion times per month. There have been 500 Klout Perk campaigns. In addition, Klout has powerful partnerships with Salesforce and Microsoft.

Others investors felt Klout should buff up the consumer product, Klout scores, since it needs users in order to offer real value to brands.

"Klout is very much like LinkedIn in that it will always need a consumer base," Michael said in September. While Klout can score people who haven't linked their social media accounts to the website, it unlocks infinitely more data once they've granted access to Instagram, Facebook, Foursquare and other profiles.

The struggle to create a lucrative advertising product is part of the reason Klout decided to sell. Lithium Technologies is used by many of of the top advertisers and it already offers a suite of business solutions. Its business is similar to the content-recommendation tool Klout launched for consumers in January. Between Klout's influence scores and Lithium's suite of content creation tools, the two companies can create a robust suite of tools for brands instantly.

Instagram/KloutKlout delivered 1 million perks for advertisers last year."I think Joe's vision for Klout is compelling," says David Pakman, the lead Klout investor at Venrock. "Brands should know the influence of their customers and realize the power they have over them. We as consumers in a social world have a lot more power over brands." With the acquisition, he adds, "Finally there's a chance for Klout's vision to be realized."

As he sat in his office on that fateful day in February, Fernandez didn't doubt that Klout could find its business footing on its own. But doing so, he knew, would require a new round of financing, a lot of hiring, and more years of grueling trial and error. Lithium offered an immediate solution, bringing Klout the infrastructure it needed in order to thrive.

"It's all about being ruthlessly opportunistic around finding ways to deliver your vision at bigger and bigger scales," Fernandez says of his decision to sell Klout. "When you find someone you can join forces with, and you believe you are aligned on vision and values, and that opportunity to deliver your product to a bigger audience presents itself, you have to seriously consider it."

A Dose of Lithium

Twitter/@rtarkoffRob Tarkoff Lithium CEOIn early January, Fernandez received a phone call.

A senior executive at Lithium Technologies wanted a reference check on a mutual acquaintance. During the call, the executive mentioned that Lithium was one of the 10,000 companies that used Klout's data. That phone call spawned a meeting between the two companies to see if there were more ways they could work together. Soon, a sit-down was scheduled between Fernandez and Lithium's CEO, Rob Tarkoff.

"As soon as Rob and I spent time together we realized how aligned we were on vision and value," says Fernandez.

Before long, Fernandez found himself hunched over that term sheet. While neither company will reveal the exact sale price, a source says it's "way more" than the reported $100 million but less than $500 million. All investors, Fernandez says, will make money on the deal, although some are happier with the outcome than others. The company has even worked out an unexpected gift for some long-term employees.

The acquisition doesn't require Fernandez to join Lithium, although he says he intends to stick around for awhile. After that, he's sure he'll start some new company - though perhaps not one in the consumer area. He feels he may be "too old" for that, given how most hot new apps seem to be startedby young college drop-outs.

Throughout its entire journey, a startup's future is uncertain. In January, Fernandez admitted he felt "as close to $0 as to $100 million on any given day."

How does it feel to finally know the fate of his startup?

Mostly exciting, Fernandez says.

"I think the narrative around consumer entrepreneurs is so much around this stubborn product vision that you're not going to give up," Fernandez notes. "But when you have the chance to take your dream and vision to a bigger scale you jump at it. When signing the term sheet, I felt excitement for the team. But it is impossible - when I think about being in my apartment with my mouth wired shut and the team we've built and all the people who use Klout and rely on it - not to feel emotional too."

Whether you consider Klout an epic success or a modest failure, Fernandez has the support of those who matter most: his employees (none of whom have left since the news broke) and his family.

On March 25, Fernandez received a phone call from his grandmother. She was crying.

"She had finally heard the acquisition rumors," Fernandez says with a smile. "She was afraid I didn't have a job anymore and said she had money to lend me if I needed it."

Fernandez assured her he'd be ok.

As for his Klout score, it dipped by around 10 percent on the news. It now stands at 70 - less than Bettheny Frankel but tied with Vladimir Putin.

Fernandez isn't worried. "It fluctuates all the time," he says.