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Groupon filed their S-1 to go public, prompting a flurry of commentary:
- David Heinemeier Hansson says to pass on this deal.
- A Minyanville commenter argues that Groupon is effectively insolvent.
- Business Insider is worried about insider selling.
- Not to be outdone, the founder of Knewton argues that it’s a ponzi scheme.
There’s plenty of less specific chatter, too: Groupon has high marketing expenses, they’re losing strength in older markets, their second derivative looks worse than the first derivative, and the third derivative looks worse than the second. But most of these criticisms are seriously short-sighted.
Groupon’s critics are missing four key points:
- Groupon’s numbers are not a realistic depiction of the business. Customer acquisition is only an “expense” if your churn rate is 100%. It’s more like an investment.
- Groupon’s capital structure is circumstantial: the company has some very savvy early investors, and it has never been easier to raise arbitrarily large amounts of pre-IPO capital for a startup. It would be a red flag if Groupon’s capitalisation history looked normal.
- Scale isn’t as easy as it looks.
- Of course they’re selling into a hot market. If you want cheap, read their emails, not their prospectus.
Why Groupon Should Be “Losing” Money Right Now
If Groupon had reported a profit, it would be an outrage. They would be wasting billions of dollars in economic value in order to make cosmetic changes to their prospectus.
The problem is not that they’re spending money hand-over-fist. The problem is that contemporary accounting doesn’t reflect the fact that they’re buying an asset, not paying an expense. When Walmart buys a tube of toothpaste they’re going to sell in a week, that’s an expense; when they buy a new location, that’s an asset. Marketing spend looks like an expense, especially to your average accountant. But in a case where Groupon can likely predict their long-term monthly churn rate down to the tenth of a percentage point, they really ought to amortize customer acquisition costs over the life of the customer.
In fact, it would be more realistic to amortize customer acquisition costs over the expected liftime gross profit from each customer. That would still front-load costs—their revenue per subscriber is smoothly declining over time:
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If Groupon’s marketing expenses are amortized over four years, they’d book marketing expenses of $80mm last quarter instead of $208mm; their operating loss of $117mm would be an operating profit of $11mm.
That’s not a spectacular profit just yet. (Well, it’s amazing for a three-year-old company, but not amazing for a company with a projected market value of $20bn to $30bn.) However, it illustrates the massive difference between a company that’s hemorraging money and a company that’s rapidly transforming cash into an asset that it’s unusually well-equipped to earn a profit on.
Groupon’s Insider Selling: It Would be Weird if They Didn’t
Have Groupon’s insiders ganged together to cynically fleece investors—before they’re even public? Hardly. This is once again a case in which it would be pretty weird if investors hadn’t sold some shares early on.
Groupon is one of the first big companies to reach the IPO stage in the post-IPO era. Even five years ago, going public was an event. Now, “Public” is a continuum. Companies aren’t just raising money from late-stage VCs who act like mutual funds: they’re raising money from mutual funds. Meanwhile, the secondary market is more active (in dollar terms) than the market in many OTC-traded stocks. And DST has singlehandedly changed the way fundraising works by writing massive checks for passive investments.
In short, there’s never been so much capital chasing pre-IPO stocks. And that means those stocks aren’t going to behave like pre-IPO stocks. For many but not all intents and purposes, Groupon has been public for a year or more already, and its executives are quite within their rights to sell—especially into such a frothy market.
One factor most Groupon-watchers ignored until recently was Eric Lefkofsky. Groupon’s CEO, Andrew Mason, is affable and more than weird. Lefkofsky, who cofounded the company and wrote the first check to fund it, is a very savvy financier whose record indicates a willingness to sell when it’s time to sell. (He launched a startup in the late 90′s, merged it with an old-line industrial company, and saw the whole thing collapse in a flurry of lawsuits just a few months later.)
Meanwhile, Lefkofsky is involved in multiple public companies. He’s a major shareholder in InnerWorkings (INWK 8.56 ↑0.12%), a print broker roll-up play, and also a player in Echo Logistics, another public company. Oddly enough, InnerWorkings was an early investor in Echo Global, and a few executives have worked at both companies. Echo sells some services to InnerWorkings, and leases office space from them. Lefkofsky also owns a stake in MediaBank, which leased space for InnerWorkings. Groupon leased some space ,too, though they’ve since moved out. (All this is detailed in InnerWorkings’ SEC filings). Echo Logistics’ own prospectus mentions that InnerWorkings handles their printing needs, and has a referral agreement with them.
Oh, and Lefkofsky’s brother’s law firm does legal work for Groupon.
So it’s clear that Lefkofsky is a deft juggler of public and private interests. He’s managed to put together deals between different companies in which he has varying ownership stakes. Meanwhile, the guy knows how to pick stocks: while InnerWorkings is down from its IPO, Echo Logistics appears to be trading at a bit more than 100X the price InnerWorkings paid for its shares ($.125/share on a split-adjusted basis, versus a current $14.80 per share). I’m impressed that Lefkofsky can keep track of all these investments, much less turn a profit on so many of them.
But it’s worth keeping in mind: many of these companies have relationships with one another. Lefkofsky has the somewhat interesting habit of hiring people at companies he’s cofounded, in order to cofound new companies with them. Put another way, Lefkofsky leased a portion of InnerWorkings’ office (he owns a little over 7% of the firm), to Groupon (of which he currently owns over 20%, and of which he probably once owned a lot more—given that he was the first investor, and that Andrew Mason owns about a third as much, it’s entirely possible that Lefkofsky owned 75% of Groupon at the time of this arrangement). If you own 7.5% of one party to a transaction, and 75% of another party to that transaction, negotiating with yourself can be a difficult.
There’s nothing strictly wrong with that. In fact, it makes things a whole lot more efficient: it’s great that Groupon got some good office space so they could focus on being Groupon. And it’s obviously easy to get a lot more done when you can provide a nice roster of talented executives to whichever of your firms takes off. But it’s tricky to do this in a way that doesn’t draw attention: I’m sure plenty of investors are now scrutinizing Lefkofsky’s other business dealings to see if anything appears too one-sided.
Is This a Scale Business?
Groupon looks like an easy business to clone. Plenty of people have tried. All it takes is a few sales calls and a decent mailing list.
And therein lies the problem: generating that mailing list is more expensive than it used to be, now that all of the group-buying sites are bidding up ad inventory. Cold-calling that business is tough—small businesses get plenty of pitches from group-buying companies.
There’s nothing stopping a competitor from cloning this business, but there’s a lot slowing them down. And on the margin, who is the smart bidder for new subscribers? Groupon, with their data on types of subscribers and their behaviour, plus a well planned-out schedule of exactly what kinds of deals to highlight? Or their new competitor, making a best guess as to which subscribers will stick and which deals they’ll want?
Groupon has also won an interesting PR coup: they took an existing business, and somehow convinced the press that other competitors were “clones.” This concept is so old that people made jokes about it during the hangover after the last bubble. And yet “Groupon Clone” as a search query is in the middle of the pack in terms of search query popularity. That’s pretty bizarre; it would be as if social networking, as a category, got renamed “Twitter clones.”
But it also puts Groupon in a tough position: they can’t afford to be second-best anywhere. Their name recognition is an asset, but it’s an asset they need to pay up to maintain. Any journalist who uses the phrase “Groupon clone” is alert to the possibility that Groupon will be the industry’s MySpace. That’s certainly what their top competitor LivingSocial has in mind.
Groupon’s IPO Timing: Of Course They’re Selling
There’s no denying it: Groupon’s executives are selling now because now is a good time to sell. Investors should know that if all goes well, it may still be a merely mediocre deal: a company going public priced for perfection, executing perfectly, and getting commensurate returns.
There’s nothing wrong with that, though. Investors clearly have an appetite for social media companies, and Groupon fits the bill. Moreover, the company has exposure to the small business market, which is something investors sometimes clamor for.
What Does the Groupon IPO Illustrate?
Groupon’s critics are missing lots of obvious points. But there’s also one non-obvious factor: Groupon’s bad numbers, high fundraising, and early IPO may be a deliberate strategy.
What if Groupon is raising so much money to suck out all the fundraising oxygen from their competitors? Usually, that kind of conspiracy theory doesn’t work, because everyone’s interests are too disparate. But it’s possible. If Groupon is willing to sell you all the “Group Buying” exposure you want at a sane price, and then turns around and invests that money in growing even faster, then it has a decent shot at a monopoly. It’s the kind of monopoly that creates a lardy cap structure and cost structure, so nobody should expect insane returns here. But it’s also a good way to create an enduring competitive advantage.
The silly “Insolvency” claim fits in well here. They’re funding the growth of their business through their accounts payable: every deal they do puts money in their pockets with a corresponding liability they only deal with later. Negative working capital is a cheap source of funds. And another advantage of scale: the money they’re holding on to can fund relentless expansion—people who don’t have that cash on hand need to get it elsewhere.
The two key ingredients to massive scale in this industry are fresh capital and new users. Groupon might be soaking up all that capital and using it to bid up the cost of acquiring new users, too. (It’s no secret that the group-buying industry has been a big part of the display advertising renaissance, since they can monetise even better than the usual high bidders for bad inventory.)
The Groupon IPO isn’t as exciting as the rest of the Groupon story, but it isn’t sinister, either. Groupon is the fastest-growing company in history, and every investor knows it. At this point, valuing the company becomes a question of how quickly and how effectively they’ll exploit the opportunities ahead. The standard critiques misunderstand accounting and the changing fundraising environment. They’re a distraction from pricing the IPO of a generally great business.