GroupOn – Ponzi schemes, insolvency, the next Amazon and proxy valuations

It is rare for an IPO filing to be greeting with such a wave of negative sentiment but GroupOn is an exceptional business in many respects. GroupOn filed to raise $750 million in IPO. Headline revenue growth is massive: 2008: $94,000; 2009: $30.5 million; 2010 $713 million. The S-1 filings though have revealed some very interesting things about the business and a wave of negative sentiment (and as far as I can see very little positive coverage).

UPDATE: I have added some additional, positive, coverage at the end of this post.

Some examples:

GroupOn is effectively insolvent.

“Investors beware — the company owes $230 million more than it has, appears to be burning through $100 million or more a quarter, and is using money raised from later investors to pay back early investors.” Conor Sen, in Minyanville

Conor looks at the balance sheet, the income statement, the basic fundamentals of the business and ask some obvious questions:

“How can they possibly sustain this kind of revenue growth? Can they get costs under control? What about merchant and customer fatigue? How about deep-pocketed and savvy competition, either doing exactly what they’re doing (LivingSocial) or coming to the table with a ton of customer data, i.e., Facebook andGoogle (GOOG)? How can you possible build a sustainable business by going from 0 to 8,000 employees in two years? Why did the COO and CTO both leave the company in late March, barely two months ago? How do you value a business that could do $3 billion in revenue this year but might not be able to keep the lights on in 12 months?” Conor Sen, in Minyanville

He also touches on something else that has been picked up elsewhere – fundraisings that pay out to investors in earlier rounds. Most notably, Jose Ferreira, CEO of Knewton, says,

Groupon Is a Straight-Up Ponzi Scheme

“Let us briefly examine the tulip mania that is Groupon.

“Why is Groupon not merely a tech-bubble datum but a Ponzi scheme? Simple: Groupon has found that you can get local merchants to try anything once if it brings them new customers. A few local merchants in Chicago get them started, and Groupon shows good revenues. In fact, Groupon immediately remits half of those “revenues” back to the local merchant — they were never Groupon revenues in any meaningful sense of the word. But, optically, Groupon revenues look high — which they use to raise a financing round at a high valuation. Then they use the proceeds to hire vast armies of salespeople to dig deeper into Chicago’s local merchant community and repeat the trick in other cities.”

He goes on:

“Groupon’s management publically avers that “local merchants come back” — well, sure, some of them do. For a while. But what do the audited numbers look like? Just what percentage of local merchants come back? How many times? Do local merchants show a strong tendency to decline in participation over time?

“Groupon management won’t release these numbers, and certainly won’t release thoroughly audited and vetted versions of these numbers. Instead, what Groupon management is doing is withdrawing an astonishing amount of cash out of the company. It’s also creating a new class of B shares so that it can keep control of the company in the hands of management — all the better to keep the Ponzi scheme going for as long as possible.“

Now Jose is not your average commentator. He is the founder and CEO of Knewton. He received his MBA from Harvard Business School. Before founding Knewton, Jose worked as a Kaplan executive, derivatives trader, venture capitalist, and strategist for John Kerry’s presidential campaign.

Knewton and GroupOn also share a common investor, Accel Partners, so these comments are frankly astonishing. That should make for a very entertaining CEO retreat.

But, but, but what if they’re the next Amazon?

Elsewhere, Shortlogic explains why there is a huge difference between GroupOn and earlier Internet businesses like Amazon, describing the ‘moat’ that Amazon built around its business to protect it from competitors.

“First, Amazon spent the billions that bled their balance sheet digging an incredible moat. They built warehouses and distribution centers, and had to keep every fucking item in the world in inventory. That turns out to be very expensive too, but repaid at scale.

“Where’s Groupon’s moat? Sure, they have a list of 56,000 merchants who might do business with them again and 83 million email addresses of people who might buy another coupon. Do you really think that’s comparable to the infrastructure moat Amazon built?

“And if that actually is their moat, why aren’t they bragging about how low their churn rate is? Their investment in cold-calling merchants will only pay off if most merchants stick around to do many more deals. The same goes for coupon shoppers. They need to be loyal enough to keep buying from Groupon without needing to be wooed over and over again with expensive ads.

“Update: Analysis from one of Groupon’s oldest markets, Boston, show that there is no moat. Acquisition costs are skyrocketing and revenue per customer is plummeting.” Shortlogic.

Groupon float looks like another offer at a price that’s too good to accept

Stephen Foley, writing in The Independent, points out:

“Groupon has also paid dividends to the same early investors, to the tune of 18.3 per cent of revenues in 2009. This is highly unusual for a loss-making start-up. Groupon has hundreds of millions of dollars pouring through its doors, and its early investors have shown a determination to grab large portions of those, irrespective of whether these revenues can certainly and sustainably be turned into profits.”

He also highlights the other big issue with the GroupOn IPO Filing.

“The other notable and unnerving thing about Groupon’s flotation prospectus, filed with regulators in the US late on Thursday, is that the company insists on highlighting a ridiculous accounting line it calls adjusted consolidated segment operating income, which strips out practically all the costs of acquiring new subscribers, including acquisition costs and the expense of buying online ads. Investors must not ignore these vital and ongoing expenses, particularly since they will only go up as competition increases and Groupon has to fight for customers against the likes of Facebook, Google, local newspapers, specialist e-commerce sites like Travelzoo and Gilt, plus a burgeoning number of copycats.”

Internet investors, beware of the proxy valuation.

Final word for me on that one goes to Bill Gurley at Benchmark Capital in a great post about how to value, and when to be wary of valuations, of Internet businesses.

“We are witnessing an increase in companies that file for IPO’s with losses that are as large as (if not larger than) revenues. Recognize that this means that expenses are over twice that of revenues—economics that are actually worse than my company that sells dollars at a discount. Additionally, it is rumored that certain Internet CFOs are pushing investor’s to look at EBITDAM. The M represents marketing, and is an attempt to get Wall Street to ignore what has become the single biggest expenditure for Internet startups. This only makes sense if you truly believe that marketing costs will one day go away, which should be considered unlikely. Perhaps we should make it easier and skip straight to EBE (Earnings Before Expenses)… but that looks suspiciously similar to price-to-revenues, doesn’t it?” Internet investors, beware of the proxy valuation.

This is well worth a read though don’t be put off by some of the examples that Bill uses in this post – “Is an E-Trade customer worth the same as a CDNow customer? Does a page view on Yahoo equal a page view on GeoCities? It’s hard to say.” For God’s sake those examples are so 1999.

Actually, Bill’s post was written in August 1998. Seems not much has changed in the intervening period.

On the positive side…

The Reports Of Groupon’s Death Are Greatly Exaggerated

Vinicius Vacanti, co-Founder of Yipit, a Daily Deal aggregator who works with GroupOn and other Deal sites, considers some of the concerns raised above.

Unfounded Concerns – Here are the some of the most widely circulated concerns that are largely unfounded:

1. Local Merchants Don’t Like Daily Deals

2. Local Merchants Can’t Effectively Discount More Than 10%

3. Groupon Insiders Are Cashing Out

4. Groupon is Not Building a Moat

5. Groupon’s Trying To Trick Us By Emphasizing a New Accounting Metric

6. Groupon is Effectively Insolvent

Vinicius addresses all of these issues, with varying degrees of success. The full post is here.

He also outlines what he considers his, ‘Real Concerns’

• Groupon Stores, their attempt at self-serve, did not work
• Groupon Now is unproven and a very different business. I’ve used Groupon Now in New York and it may need at least 10 times more deals to really be effective
• As we reported yesterday, it appears that increasing competitive pressures are causing Groupon’s business model to weaken in its older markets
• Groupon’s shareholder structure makes it so that public market investors will have very little say in the company
• Groupon faces serious competition from LivingSocial and bigger media companies

“Like any other company Groupon faces several challenges; but, like Mark Twain once said after reading his obituary, the reports of Groupon’s death are greatly exaggerated.”

Some of these ‘real concerns’ seem to be relatively minor – in any evolving business, there will be trials of new models that don;t work out immediately, and as new products and services come online, it will take time for them to get up to speed, even with an army of active sales people. I am not even sure that the shareholder structure is a killer – in reality, small investors have virtually no say over how a business is run, GroupOn is no different. The increase in competitive pressure is a concern of course.

The major issue that  he seems to have missed however is that there seems to be a big difference between passive subscribers to emails and the engaged users that Facebook has. As ‘Nate’ writes in the comments:

“The real issue with Groupon & all Daily deal sites is engagement. An email subscriber is passive and can jump to multiple deal sites — these ppl are horrible long term customers for local merchants. To pay $10+ for per emails is unsustainable. This is a marketing cost and should not be capitalized bc these users WILL jump to other deal sites…

“On the other hand, you have FB with an extremely engaged 700MM user base, pays $0 for real engaged users (plus the get their emails). They can easily get merchants onboard bc of the value add they would provide to them (i.e. FB can create your FB fan page, checkin, increase your social presence, etc.)…!” Nate.

Read more: http://www.businessinsider.com/6-widespread-groupon-concerns-that-are-unfounded-2011-6#ixzz1OTTWjT9M

Why Groupon is Worth $25 Billion Dollars

Steve Cheney Engineer with an MBA. Current entrepreneur. Former programmer, marketer, investment banker, and vc.

Steve makes a great point that some have missed…

“But these naysayers who are fixated on the current “daily deal” economics as long-term unsustainable are completely missing the point. The real innovation Groupon brought to the table wasn’t in advertising deals per se, it was their ability to profit off of closing the attribution loop in online-to-offline commerce. And this is a huge land grab that others had completely missed.”

He continues.

“This is precisely why Google wanted Groupon – they were able to solve a REALLY difficult problem in a simple way, creating an offline link between customer and merchant and profiting off of it. Hopefully for them a link that is valuable over the long term…

“So the real end-goal for daily deal sites is in assembling a marketplace and exchange that has enough inventory and users to support these types of new online to offline behaviors at massive scale. And if Groupon doesn’t figure it out, someone else will. There is way more money to be made in offline commerce than there is in online commerce. Everyone knows that by now.” Why GroupOn is worth $25 billion.

I agree with almost everything Steve says, this is a rapidly evolving space and there are lots of business models that could win out. For me however, that in itself does not mean that GroupOn is the guaranteed winner in the space. It still doesn’t mean the potential pricing of the offering reflects the risks involved.

All that just gives me an excuse to share my favourite video – if you want to know how the investment bankers in Silicon Valley are feeling right now, look no further…

For more information, and an Early Bird discount until 8th June: http://growthforum2011.thebln.com/