Why VCs Should Be Worried About Groupon

Much the same as everyone else I have been watching Groupon, the company that apparently invented the idea of the coupon, explode out of nothingness, turn down an extremely large acquisition offer by Google and prepare to make a tremendous public offering.

And this last bit worries me greatly.

There are already “last round” calls being made to get to the funding bar before it closes. More bloggers than I care to count are driving home the message that valuations are nearing their apex. If you’re new to this game you’ll think that’s good – just wait a little bit longer and hungry investors will give you an even higher valuation.

I’m not so new to this game. I know that while high valuations beget even higher valuations, the inflection point (when valuations start to go down) is not so much a smooth curve as it is a stomach-churning drop off a cliff. And just as the rising tide floats all boats, so too do all boats sink when the tide goes out.

I’m not a pessimist, I’m actually a horribly misguided optimist – I wouldn’t be an entrepreneur if this wasn’t so. But I’m also fairly good at seeing situations for what they really are.

Go on, take the money and run
Groupon should have taken the Google Money and run. It is clear with even minimal understanding of the situation that Groupon’s business model is unsustainable in the long run, both for Groupon and for the participating retailers.

Some businesses use loss-leaders to bring in new customers, but many of the Groupons sold are one-time affairs, with the companies incurring the loss, but rarely getting the longer-term benefit of the leads.

Groupon has to keep on taking money from new clients in order to pay existing clients (this is starting to sound oddly like some public-sector pension funds), which some have called a Ponzi Scheme. Others are less biting in their analysis but making more or less the same point.

As in previous funding rounds, the current shareholders may want to take a lot of money off the table.

Dream On
As I said above, I’ve been in this game for a while. There are founders who build companies because it’s their dream; if they get rich along the way then so much the better. And then there are entrepreneurs who view the market as a purely speculative opportunity, a way to make money for some at the expense of others. You can guess to which group I think Groupon belongs.

Fortunately the SEC is eyeing the S-1 application with caution, sending Groupon back to do its homework and make clarifications about its financial statements.

Clearly I won’t be putting my money down on this company. When the whole thing eventually goes bust, as I think it will, it won’t be my money evaporating. VCs who put their money into Groupon may not be able to get it out as the company’s valuation sinks like a stone (remember, this is pure speculation on my part).

So, you say, all the VCs who don’t have Groupon in their portfolio have nothing to lose. This is the part that’s most troublesome. Given all the noise and high expectations surrounding Groupon, if its IPO fails or the company’s market value – once public – implodes, it will kill the IPO market for everyone. That, combined with the weak and threatened US economy will not just cause the tide to go out, it will be more like someone pulled the plug in the bathtub and all the startup rubber-duckies are getting sucked down.

My fear is that this will be another Microsoft Moment. It was the DOJ filing against Microsoft that sparked the burst of the “Dotcom Bubble”. It may not have been the actual metaphorical pin that popped the balloon, but it certainly was the catalyst.

I think this may be a lose-lose situation for venture capital. If the SEC denies Groupon’s IPO, obviously the current shareholders lose. $6B Google acquisition? Forget about it.

The larger picture has to do with the expectations being built into the market regarding a Groupon IPO. If Groupon can not file, or must seriously amend its offering, it will have a deleterious effect on other venture-backed firms now standing in the IPO queue.

If Groupon does go public only to fall through the floor (as I think it will), it will set the IPO market back significantly, not to mention the carry-over effect it will have on other (newish) high-tech stocks.

So what can VCs do to minimize the damage (I dunno, I’m not a VC. But I’ll give it a go)? In their place the first thing I would do is have the conversation at the weekly partners’ meeting. Do they agree with the thesis or not?

If yes – how is their portfolio affected? Who is currently in the pipeline? Can we push them forward or should we hold them back? How would a Groupon crash affect our portfolio? Will it make it harder to for them to raise new rounds in the year or so to come? Do they have enough cash now?

How do we handle the PR aspect vis-à-vis the rest of the world? What message can we send to relay our preparedness for this event to our Limited Partners, without the blasé business-as-usual, everything’s fine, you-can-relax-now whitewash (which they won’t buy anyways)?

And you entrepreneurs out there – how would this affect you?

For one thing, if you’re in the social-commerce-daily deal space, lock down your business model and differentiation now, put money in the bank (don’t try to optimize for valuation – but don’t give the farm away either), and if you can’t do that and have some money left, consider a pivot that makes sense.

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