The big story right now is that group-buying site Groupon just raised a huge new round at a $1.2 billion valuation. Predictably, a lot of people think that’s too high.They’re wrong!
Here’s why we think Groupon is cheap at $1.2 billion:
Groupon is already big and profitable. They’ve said before they expect $100 million in revenue for 2010, but the number will probably be higher. They are quite profitable.
Market leadership is absolutely worth a premium. Groupon has spurred a wild array of competitors, both abroad and in the US. Here’s the deal though: the leading company in a market is often a much, much better investment than #2. Market leadership comes with brand equity, with economies of scale, etc. that make them worth a big premium. Coca-Cola is a better investment than Pepsi (and we love Pepsi!), Wal-Mart better than Target and so on.
Investing in market leaders is one of the big reasons why Warren Buffet can buy Sweden and you can’t. When it comes to Groupon, the guys have already built a great brand on top of their business, which is a huge asset in a fast-growing market where new users will go to the “top of mind” service. They have more resources and more experience than the competitors. We don’t have a doubt that there will be other winners in the group-buying space but it seems increasingly inevitable that Groupon will be the Coca-Cola of group buying.
They probably have negative working capital. Working capital is an accounting concept that is defined by current assets minus current liabilities. What it really means is that working capital is the money you need to keep “in” the business to run your operations (as opposed to e.g. the money you need for investments). If you make and sell widgets, working capital is the money you need to pay your suppliers and build the widget before you can recoup that from sales. Some businesses have negative working capital: they get money from sales before they pay suppliers. How does that work? The classic example is retailing: when you go to Wal-Mart (or Amazon) you pay upfront, but these companies pay their suppliers after 30, 60 or even 90 days. A business with negative working capital is brilliant because your business is actually financed by your customers. This is one of the reasons why Amazon and Wal-Mart are such great businesses. Groupon probably has (or will have at scale) negative working capital: they charge buyers upfront, take a (large) cut, and pay their partner businesses later. Negative working capital is a tremendous thing to have in a business, especially a high-growth business, and this is worth a premium as well.
This is seems to be a “DST-type” deal so the actual valuation is probably lower. What is referred to as “DST-type” deals, after Digital Sky Technologies’ investments in Facebook and Zynga, is a deal where the investor puts money in a business at a large valuation, but then buys stock from founders and employees at a lower valuation, allowing these guys to have early liquidity. Because the investor keeps buying stock at a lower valuation after his main investment, the overall valuation it gets for its holding is lower than the “sticker price.”
The growth potential is basically infinite. Groupon deals are for things like sushi, spas and other mum and pop local businesses. How many such businesses are out there? Millions. Millions of small businesses who would gladly give a discount to reach new customers, millions of businesses that people beyond the current Groupon audience will be interested in. Probably large segments of such businesses will be “captured” by other Groupon-style sites, particularly in verticals (Groupon for restaurants! For sports!), but that still leaves basically infinite room to grow.
This is just a magic business. Related to the previous concept is the idea of a “magic business” that Netscape founder and über-VC Marc Andreessen talks about. There are a handful of businesses each year that get started that are worth more than one billion. But even among those, there is a smaller number that are “magic” businesses, that tap into a broad societal trend and basically cannot help from becoming positively huge. Intel and Microsoft were magic businesses built on top of personal computing. EBay, Amazon, Google, probably Facebook, are magic businesses. Groupon is also probably in that category. Andreessen seems to agree — he was an investor in MobShop, a previously failed group-buying site, and yet is bullish on Groupon.
Here’s the deal. When a deal happens at a high valuation, people tear their hair out talking about how out of line this is with “the fundamentals.” But the fundamentals of a company’s valuation is that it’s the net present value of all its future earnings. But even with a high discount rate to account for risk and illiquidity, given the business, the business model and the growth prospects, there’s little doubt that that number is above $1.2 billion.
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