If This Report Is True, LivingSocial Is In Far Worse Shape Than We Thought

tim o'shaughnessy livingsocial founder

Photo: Fortune Live Media via Flickr

PrivCo, a research firm tracking private companies, says that daily-deals site LivingSocial took $110 million from its existing investors in the form of debt, not equity.If that’s true, LivingSocial is in a world of hurt.

(Update: LivingSocial has strongly denied the report. Read the latest.)

For one thing, the debt deal described by PrivCo CEO Sam Hamadeh is on loan-shark terms. He says LivingSocial took convertible debt. That’s debt which the lenders have the right to convert into equity under certain conditions—but it’s still debt.

Hamadeh says the debt has a 4x liquidation preference. That means that if LivingSocial ends up being worth anything in a sale, the new investors—sorry, creditors—will get the first $440 million, not just the $110 million they put in.

According to the PrivCo report, the new infusion of cash essentially wipes out founders, employees, and executives who hold common shares or options. It also reprices earlier investment rounds, making the $823 million Amazon and others had previously put in essentially worthless.

Then again, if they forced LivingSocial to accept a debt deal on the terms PrivCo’s Hamadeh describes, existing investors essentially own the company now.

Amazon took a big writeoff on its LivingSocial investment last year. At the time, LivingSocial CEO Tim O’Shaughnessy wrote an email to employees telling them the writeoff was related to impairment charges on acquisitions and the company had become cash-flow positive.

Shortly afterwards, LivingSocial started laying off 400 employees.

Here’s what’s really scary about LivingSocial accepting a debt deal, though.

It could start a death spiral for the company.

Convertible-debt investors are “senior” to other creditors in a bankruptcy or other scenario where the company has to wind itself down.

LivingSocial’s creditors include the merchants who run daily deals on the site.

Here’s how daily deals work: LivingSocial and other deal providers collect money upfront from consumers. The merchants get paid over time. (LivingSocial pays merchants faster than Groupon.) But the merchants have to deliver the goods or services for the deal over a longer time period.

In some sense, the merchants are giving LivingSocial a short-term loan in exchange for promising to give LivingSocial customers goods or services in the future. LivingSocial then pays that “loan” back.

But merchants will now fall behind LivingSocial’s investors in line.

In a worst-case scenario, savvy merchants will steer clear of LivingSocial, which means only merchants who are really desperate to drum up business will offer deals through the company.

Deal quality and volume will fall off, which in turn will hammer revenues and consumer satisfaction at a time when LivingSocial desperately needs those to go up.

That’s the strangest thing about a convertible-debt deal. It may be the only way LivingSocial could raise money. And investors understandably want to protect themselves from a business that’s burning cash. But they both may have shot themselves in the foot.

LivingSocial investor Jeremy Liew of Lightspeed Venture Partners congratulated LivingSocial on the deal yesterday:

We asked Liew and the company for comment on the PrivCo report, and haven’t heard back.

Update: LivingSocial has strongly denied the PrivCo report in an email to employees.

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