Faith Merino's The Deal


Tech bubble? Or a new Web 3.0 boom?

Are sky-high valuations pointing to a bubble or a new era for Web companies?

Innovation series by Faith Merino
June 20, 2011
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So, in case you haven’t heard, Web IPOs are a-boomin’! (I bet that’s the subject line in the company emails VC firms send out.)  So far, we’ve seen rockstar first day trading performances by Demand Media, LinkedIn, Yandex, and Pandora. And there are more to come: Groupon is gearing up for an IPO that promises to be huge, and Facebook’s long-awaited IPO is just over the 2012 horizon. But there’s something all of these IPOs have in common: they’ve all inspired the dreaded tech bubble talk.

I admit: I’m guilty. I’ve questioned whether the newly public companies truly merit the high valuations they’re commanding, or if it all boils down to over-eager investors pumping up the market with a lot of hot air. Actually, as an embarrassing aside, at a recent Vator Splash event, I was covering a speaker who asked for a show of hands: Who thinks we’re in a bubble? Without looking up from my computer, I raised my hand, and when I looked around, I realized my hand was the only one up.

But I think my skepticism is justified. Demand Media closed its first day of trading at $22 a share for a market cap of $1.5 billion, after opening the day at $17 a share. While the company’s revenues were impressive ($252 million in 2010), it still isn’t profitable. When the company filed for its IPO in August, it claimed to be profitable, but closer inspection revealed that it was not calculating the expense of paying writers as an upfront cost, but was spreading it out over the course of five years.  The company used the rationale that a single piece of content is capable of generating revenue for five years, so the cost of paying the writer should be considered within that same time frame. But all of this hinged on the assumption that Google’s algorithm, which Demand relied upon for distribution, would continue to operate as usual—which ended up not being the case.

And then there was LinkedIn—which is a different case as it’s a totally different industry, but with a market cap 445 times its net income for 2010, there would appear to be some cause for alarm. On its first day of trading, LinkedIn shares soared 109% to close out at $94, more than double the company’s IPO price of $45.

And finally, there’s Groupon, which is not only not profitable yet, but is spending much, MUCH more money than it actually takes in. And even that is unclear as Groupon’s accounting practices are a little wonky. In its prospectus, Groupon explains how it calculates its revenue and gross profit thusly: “Our revenue is the purchase price paid by the customer for the Groupon. Our gross profit is the amount of revenue we retain after paying an agreed upon percentage of the purchase price to the featured merchant.”

In other words, when Groupon totals up its revenue for all Groupons sold for the year, it’s including the merchant cut as well. Take out the merchant cut, and you have Groupon’s gross profit. Add in the usual cost of operations, and you have net income. So…essentially…Groupon’s gross profit is actually its revenue, and its net income is what’s left over after operating expenses (it looks like Groupon came to its original calculation by lumping in the merchant cut as an operating cost).

So what is Groupon really taking home after it divvies out the merchant’s cut of each deal? In 2010, Groupon took home approximately $280 million, not $713 million. And in Q1 2011, Groupon’s cut of the Groupons sold totaled $270 million. So the company is still doing fairly well for itself—its revenue is still higher than Demand Media’s ($253 million) or LinkedIn’s ($243 million). It’s just not as hot as Facebook (a rumored $700+ million). The thing is, Groupon is rumored to be shooting for as much as $30 billion, roughly six times LinkedIn’s market cap despite not having a real social graph of its own.

Tech bubble, anyone?

Doug Chu, an SVP for NYSE in Palo Alto, says no. “These are new sectors. A lot of these companies that are seeing very high demand are in the new sectors where there aren’t a lot of existing companies. What you’re seeing is investor enthusiasm, which is natural.”

Chu is referring to what he calls the Web 3.0 wave. But he also pointed out that when Google, Amazon, and eBay went public, there were a lot of concerns about those companies as well.

“There are plenty of detractors for every company,” Chu added. “There is a trend: if you look at NYSE deals, we’ve seen a lot of Internet-related and social media-related companies that have done really well. A lot of people saying it’s a bubble, but this is the next wave of Web 3.0. These are businesses that have reached scale in this newer area. Their initial success is well deserved.”

Indeed, you can’t dispute the fact that we’ve entered a new era when it comes to Web companies, and companies like Facebook and LinkedIn are charting new territory. Is it safe to assume that we’re not staring down the barrel of another bust? Looks like we’re going to find out. 

Image source: americanelephant

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