Category Archives: Funding

April 2, 2012 · 4:37 pm

The JOBS Act Part I – Crowdfunding.

The JOBS Act has passed both House and Senate, and all signs point to it being signed into law sometime this week. The JOBS Act does a few things, but the two big ones that will be widely publicized are 1). it allows companies to “crowdfund” by selling securities to nonaccredited investors for total funding amounts below $2 million, and 2). it raises the number of shareholders that trigger a company to file SEC disclosures from 500 to 2000.

First off, let’s get one thing out of the way: This isn’t going to create many JOBS. Despite the title, this is not a “jobs” bill. No money is being spent on anything (you can imagine the pitch and see why it passed: will you vote for this bill that has JOBS in the title but doesn’t increase the deficit or raise taxes?). The crowdfunding portion of the act will likely increase the misallocation of money in the economy, and the increase in the shareholder limit doesn’t have any clear connection to increasing jobs at all. So ignoring the blatant pandering by the Act’s title, is it a good law?

I’m going to focus on the crowdfunding portion of the bill for now, and save the shareholder number increase for another time. I’m also only going to talk about equity – crowdfunding small business loans will likely catch on as well, but people seem to be more interested in the equity side of the equation. Anyway, two obvious questions spring to mind:

What sort of company will raise money this way?

Not the Facebooks of the world. The startup/technology world probably won’t go the crowdfunding route very often. There is already plenty of angel and VC money available to promising startups in major cities, and startups tend to burn through cash pretty quickly before they become profitable, so few will have a business plan where $2 million is sufficient to get them to profitability. Furthermore, raising 100k from 100 people is going to be less attractive than raising it all from 1 angel who can add some value through expertise and connections. It’s also not going to be pretty to raise a Series A after taking investments from a few hundred random people, and VCs will probably be less than excited to get onboard with that cap table. I wouldn’t be surprised if mainstream VCs never back crowdfunded businesses. So forgetting startups, that leaves your regular ye olde small business, and they are probably the sort most likely to avail themselves to crowdfunding. But….

Who wants to invest in crowdfunded companies?

In an era of Shark Tank and The Social Network, it is no surprise that everyday people want to invest in young companies. But keep in mind, these aren’t going to be the sexy startups that regular Joe American has heard about. The companies that pursue a crowdfunding route will either be less-known startups that are struggling to raise money through traditional channels (which you’d think would lower the potential IRR for a portfolio of such companies, but more on that in a second), and small businesses. I’m no expert on the state of small businesses in the majority of the country, and I can’t say I really have a clue whether this crowdfunding option will be appealing to them as an alternative to other fundraising options. But I just have this gut feeling that if you want to start a small restaurant in a suburban neighborhood, it’s gonna be really really hard to convince a random person on the internet to care, let alone invest. The business plan on the investor side just doesn’t make a lot of sense: investors in startups (Angels and VCs) have one basic premise – if you invest broadly in enough startups, you’ll get a solid return by losing money on 80% of them, breaking even on 10-15% of them, and hitting homeruns (10x+++ returns) on 5-10%. The ability to get the homerun return is absolutely essential to a portfolio where 80% of the investments go bankrupt, but what small business can reasonably project a world where they offer their investors those kind of returns? The local restaurant/crafts store/yoga studio sure can’t.

This is the main problem I have with the crowdfunding plan: In a few years, we will probably say that no rational investor should invest in companies this way. The Act offers low net-worth investors the chance to make small investments in a number of small companies. This is essentially what high net worth investors do at the angel stage for startups, but the companies in the crowdfunding portfolio are 1) less likely to be wildly profitable, as most small businesses can’t even project 10-15x returns with a straight face, and are 2) more likely to be fraud [and this isn’t being alarmist – states first passed securities regulations specifically to combat fraud]. Oh, and the portfolio is even less liquid than an angel portfolio, because angel portfolio companies will be acquired or go public with some frequency, something no small business will do. Plus small businesses fail at an extremely high rate. What rational investor would take this portfolio of high-to-extremely-high risk, low upside, illiquid investments over a 5-year treasury? When the stock market is doing well, I just can’t imagine this being an attractive way to invest money.

In conclusion, I think the sale of equity through crowdfunding platforms just won’t catch on. I don’t think investors will want to put money into the sorts of businesses that will use the platforms, and over the long run those investors that do will realize they aren’t making a reasonable return. Maybe debt financing through crowdfunding will take off, but I just can’t see the equity side ever becoming popular.

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March 14, 2012 · 1:47 pm

SharesPost gets a slap on the wrist from the SEC

I’ve been surprised with the level of activity on SharesPost and SecondMarket over the last year – more specifically, I’ve been surprised that the activity hasn’t drawn more scrutiny from regulatory bodies. While I think that giving liquidity to large private companies is theoretically a justifiable goal on market efficiency grounds, many people had questions about how the SEC would view these transactions, which by their nature encourage speculation in companies that have not gone through the exhaustive IPO process.

Today the SEC finally took some action against SharesPost, though by all accounts the action was relatively innocuous and will do little to stem investor enthusiasm in these new pre-IPO markets. The SEC announced fines for SharesPost and the CEO, but the total cost is only $100,000. For some context, J.R. Smith, a professional basketball player, was recently fined $25,000 for tweeting a picture of his girlfriend’s scantily clad behind. Insert comment about America’s priorities here. The complaint is particularly interesting if you want to get a peak into how SharesPost grew into what it is today, and it also reveals that SharesPost has been a registered broker-dealer since December of 2011, making the fines today something of a retroactive punishment.

In a sense, this is a huge victory for both SharesPost and SecondMarket – after a long investigation into the markets for shares of stock in private companies, the SEC did no more than slap SharesPost on the wrist, charging them what the NBA would charge one of their players for four tweetpics of a girlfriend in a thong. Maybe this is just the first step in formally eliminating the 500 shareholder rule, something many pundits have been speculating about since the Facebook IPO was just a glimmer on the horizon.

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October 27, 2011 · 1:51 pm

Groupon’s IPO will challenge the SecondMarket business plan, just as the company releases positive growth data

SecondMarket, the secondary market (it’s a well-named site, at least) for shares of private companies, is going to be tested by one of the major companies it provides liquidity to when that company goes public.

Two big events are going on right now for SecondMarket: First, they released their Q3 numbers, and they are growing significantly. The number of participants is up to over 75,000, a 333% growth from last year. The company has conducted $435 million worth of transactions this year, a 75% increase from last year. As they noted on their blog (first link above), the company is conducting “liquidity programs” for many companies at sizes that, in the past, would have likely necessitated an IPO. They also released some descriptive statistics on the people behind the transactions themselves – the sellers of the securities are overwhelmingly ex-employees (64.5%) or current employees (16.9%), and the buyers are overwhelmingly private individuals (63% of the cash spent). The top companies purchased were Facebook, Twitter, and Groupon, in that order.

Second, Groupon is looking like they will actually go ahead with their eternally-delayed IPO, and it’s being guesstimated at a price of $16-18 per share. Comparing it to the big IPOs of this summer (Pandora and LinkedIn) seem to sugest that’s a reasonable range, if you are a fan of young companies with unproven economics (no judgment intended there – many investors apparently are). Problem is, shares on SecondMarket (and SharesPost, a similar site) have traded at an implied valuation of $20-30 billion, whereas the IPO looks to value the company at far less. For reference, I’ve heard of Groupon stock selling on SecondMarket for as much as $60 a share. That’s a pretty big gap for holders of the stock on these secondary markets, who look like they stand to lose more than 70% of the value they paid for just weeks ago.

There are a ton of interesting issues raised by the existence of SecondMarket in the first place (isn’t it clear that SecondMarket supports a speculative bubble if the valuation of a major company traded on the market is inflated by as much as 70% per share? isn’t selling shares at a massively inflated rate to a majority consisting of private individuals the definition of subprime?), but this should challenge the business model as a whole. If we see the other 3 major companies on the exchange (Facebook, Twitter, and Zynga) go public to similarly deflated valuations (compared to the valuations on SecondMarket and SharesPost), then we may see individual investors losing and subsequently pulling back from the private company market entirely. I’d guess Zynga is the next to go, and maybe if investors on SecondMarket believe that Groupon’s IPO is a representative of how Zynga’s IPO might go, we may see shares fall in price as a result.

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October 25, 2011 · 3:08 pm

Breaking my hiatus with a flurry of random thoughts

After a long hiatus for some personal reasons, I’m back! But, this means I have a store of ideas that I didn’t write about. Some of those ideas are now no longer worth covering because they’ve been beaten to death by other sites, but the ones that are still interesting I’m just gonna run through right now to get it out of my system, no rhyme or reason, and little theme besides being among the topics I frequently write about. Let’s get going:

Arkham City is great, but the initial user experience is flawed, and the game outlines a problem with comics-as-broad release media

Loved Arkham City. Played a LOT of it last weekend, probably only possible because my girlfriend is out of the country at the moment. Arkham City launched with a pretty bold, but increasingly common plan to increase sales and profits. Sales, by offering a ton of extra content for new game purchasers (as opposed to used game purchasers), and profits, by having a ton of extra downloadable content to squeeze a few extra bucks out of hardcore fans. It’s hard to fault Rocksteady, the studio behind the game (or any of the other members of the supply chain), for this approach – the used game market is a constant concern for studios, especially during a recession, and providing lots of bonus content both incentivizes new game purchases (by including the content for free with new games), and giving the studio a way to make money on the used games (through the customers then paying for downloadable content). I’ve ranted about terrible DRM as a system that only punishes good customers on my blog before, so I should be in favor of this setup, right?

The problem is, the customer is still the loser here. I bought the game (in fact, I pre-ordered it!), and my reward was that the first time I sat to play the game, I had to enter 3 separate 16 digit codes into the Playstation Network, wait for each of those 3 packages of content to download, and then wait for each of those packages to install. So I spent 15-20 minutes downloading and installing the content I paid for before I even got to fire up the game. Loading screens are obviously a problem for any game with downloadable content, and installation is unavoidable in some situations (PC games in particular) – but having your big blockbuster piece of work open with 20 minutes of downloading and installing is not exactly a killer introduction to the product. Is it better than a lot of DRM? Definitely, because at least it rewards the honest customer with more content rather than punishing them with potentially invasive bloatware. But it’s still a pain, and there must be a better way.

In another unrelated complaint, of the many reviews for Arkham City I saw this week, only one (Kotaku) mentioned a major gripe I had with the game – it doesn’t really push the Batman plot anywhere. This is a problem with any comic-based mainstream story at this point, in that the non-comic media is often limited to stories drawn from the official “canon” of the lore as told in the comics. Put another way, Batman can’t die unless he dies in the comic. Obviously nobody is going to kill Batman anyway, but this mostly holds true for every plot element – none of the villains can die unless they die in the comics. So they are stuck rehashing events that comic fans would already know, and they can’t deviate far from the story as outlined in the comics. This has basically been an issue for every single superhero movie in the recent wave of superhero movies, and while it hasn’t hurt box office numbers much, it might in the future as the limitation plays out over sequels. I’d love to see more companies take the JJ Abrams/Star Trek approach with their IP, giving full reign to a new retelling of an old story keeping just the characters and breaking canon.

Seed stage funding bubble, part II of my post on regulating securities of private companies rumored to come soon

Basically everybody reported on a WSJ article that claimed there was a dearth of funding out there for seed stage companies. It was vigorously responded to, mostly by people refuting the sentiment. My opinion is that while the data the WSJ looked at seems to match historical, quarterly variations in funding statistics, it still seems obvious that new technology has been making it easier to invest, while not making it quite as easy to gain liquidity and get out. Assuming there is a class of people who only want to invest in the seed stage (the angels), then those people have had an easy time of late finding companies to invest in, without finding an easy way to get liquidity from even successful early investments. Angel.co has made finding companies to invest in quite easy, but the time it takes to get money out of those investments hasn’t been quickened in any respect (in fact, given the many delayed IPOs and general malaise of the economy, it’s probably harder than it has been in the past). SecondMarket is definitely doing something to help liquidity for pre-IPO company stock, but it is probably being utilized by employees more than investors, and it’s still a relatively small group of companies compared to the number of companies on Angel.co. So, to me, it seems quite natural that there would be a slowdown in seed funding, and that companies who found plenty of seed investors would have trouble finding Series A and B money. Tech is also prone to bubbles, but that’s for my future, upcoming post on private company regulation.

Tale of two major branding efforts of social games, with very different results

Probably the two most anticipated social game releases on Facebook this year were by traditional console/PC powerhouses new to the Facebook platform. I’m talking about EA’s Sims Social, and Firaxis’s CivWorld. Both were closely watched, as they both were backed by major studios, utilizing the full force of their IP, hoping to break into the Facebook social game scene. Obviously there is a major difference between the studios in that Electronic Arts has 45 titles on Facebook right now, and they’ve spent hundreds of millions of dollars on acquisition like Popcap and Playfish to become a force in the social game market, whereas Firaxis has just the one title, CivWorld, and no experience on Facebook (parent company Take-Two also has no titles on the platform). Both games have been out for a while now (CivWorld in July, Sims Social in August), so it’s safe to make some conclusions about how the efforts went.

Who won? Sims Social by a landslide. Sims Social reached an all-time high of 65 million monthly users (though they took a 20 million hit when Facebook updated their user calculation algorithm), and they are currently cruising along with about 8 million daily users. CivWorld, on the other hand, completely crashed. The all-time high for CivWorld was only half a million monthly users, and they’ve since slid quickly to less than 100,000 monthly users and only 10,000 daily users. I haven’t played either game enough to know if there was some sort of specific disaster with CivWorld, but I played both and they were both solid efforts. Reviews were mixed for both (nobody knows how to review a social game yet, though), but obviously the results were dramatically different.

There are probably numerous takeaways here, but the big one is that having a strong IP, with lots of buzz, and even a strong game itself, isn’t enough on Facebook. The Firaxis team just simply doesn’t have the experience that the EA team has, and obviously those Playfish and Popcap acquisitions are paying off in some fashion. EA knows how to make social games now, and Firaxis doesn’t. Lots of factors go into that – the ability to effectively cross-promote with other games in the network is obviously a huge advantage for EA, but one would have thought that the amount of exposure CivWorld was getting could have made up for that. Now we know that no amount of exposure can make up for a huge installed user base and multiple games to draw experience from. Zynga has probably known that for years, but if there was any question, CivWorld’s flop may have settled it. People may look at EA’s success as a sign of weakness for Zynga, but that’s overlooking the fact that EA spent over a billion dollars to acquire two huge social game studios to reach a point where it could leverage it’s IP into fans on the platform. A billion dollar barrier to entry is pretty solid protection for Zynga’s business model.

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September 15, 2011 · 1:03 pm

SEC considers loosening regulations, how big would a “crowd-funding” market for startups actually be?

The SEC has formed a committee to analyze regulation around fast-growing companies, and today the House held a hearing on “crowd-funding” for small companies.

On the SEC side, looking to reform regulation around private companies and their ability to raise money is probably a good thing – the market is already doing it, perhaps most publicly exemplified by Facebook using Goldman Sachs and a special purpose vehicle to effectively beat the 500 shareholders of record limit – so, it’s about time that the SEC at least looked at the regulations and decided if they make sense in the context of successful, private companies. But considering those market shifts, I’m not sure regulation is needed to further open the floodgates to private, unsophisticated investors – The Groupons, Zyngas, and Facebooks of the world have no problem raising money until the time comes to file for an IPO, and smaller companies don’t feel pressure from the 500 shareholder limit, which is really the only regulatroy constraint on a company’s growth in that stage. If Facebook’s Goldman Sachs strategy becomes popular, I’m not sure there’s a good reason to loosen regulations on a segment of the capital market that seems to be working quite efficiently. That said, the makeup of the committee is largely representatives from the big private companies I just mentioned, and likely they will push for an abandonment of that 500 shareholder cap.

As for the notion of “crowd-funding”, that doesn’t make much sense to me either. Small companies as a whole have a tremendously low success rate, and I’m not sure it’s in the public’s best interest to have a private market with lower disclosure requirements for funding small companies with 90% failure rates. Even if you focus on the technology/energy/etc startups that tend to come out of startup-heavy regions like Silicon Valley, those startups still have a huge failure rate (at least 40%, my quick survey of blogs seems to suggest), and the startups already have pretty excellent access to capital through VCs, superangels, and angels on Angel.co. Maybe the costs of raising capital for some of those startups would go down, but probably not by much, and it might be better for the public if the risk of those companies failing was taken on by large institutional investors who can better calculate the odds. While I’ll admit that I’ve only considered the benefits of “crowd-funding” for about 15 minutes, it doesn’t strike me as something the startup world is dying to have – picking winners in the early stages of startups is hard enough for institutional investors, and I imagine after one or two rounds of losing money on short-term, low-value investments, most small-time investors would realize it isn’t as fun to invest in startups as it is to read about them. VCs aren’t even that great at picking winners: ten-year returns for VCs as a whole are reported at anywhere from 8.4 percent to a loss of .09 percent, depending on where you get your information, which isn’t necessarily a better return than investors get in the existing public market. If VCs can’t pick winners with all of their knowledge and all of the advantages they convey to the companies they invest in, why would anybody think the public could?

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August 22, 2011 · 2:18 pm

Would regulation of the VC/private company market help anybody? Part I

Some background for this post: Facebook has recently been rumored to have raised money at a valuation of $100 billion; SecondMarket, a brokerage for private company stock, has grown as a place for robust trading of consumer web company stock, transacting over $150 million in the first quarter of 2011; interest in private or pre-IPO consumer web companies like Groupon/Facebook/Zynga are possibly at an all-time high; everybody is sure that we are either in a bubble, or not in a bubble. Also, I’m writing a paper for a class. 🙂

Now, looking at the information above, it’s not clear by any stretch that the market for private company stock needs to be regulated more than it is. In fact, the presumption is probably that government should stay the hell away from one of the few sectors of our economy that is experiencing some growth. Considering the general health of the industry, regulation seems to make little sense – But I would argue that the industry could benefit from regulation if and only if that regulation helped cure the one systemic ill that seems to serve as a detriment to the startup/tech world, the bubble cycle. As people in the tech world are acutely aware, tech seems to ebb and flow, with a bubble/crash/bubble/crash cycle. The system, unregulated trading and all, seems to work great in the boom years, and then in the bust years nobody is looking to put more restrictions on already rare funding rounds, so regulation seems unlikely to ever be advocated for by insiders. But if some regulation would soften the bubble by lowering the volatility of the market, that would be one scenario where regulation might be favorable.

Currently, private company funding is essentially unregulated. Public companies are forced to disclose a whole ton of information through various (expensive) public disclosures. On top of restrictions regarding insider trading, liability for false statements, and other shareholder protections, this is how public companies are regulated. Private companies are largely exempt from reporting most of these things, as they raise money from institutional investors or “accredited investors” through non-public offerings.

Why we don’t regulate private companies now – 

The justification for the exemption of private companies usually falls into some combination of: “accredited investors” don’t need as much protection as the public and transaction costs associated with disclosure are too high for small companies to afford. The first justification, however, is slowly becoming less applicable, as the standard for who qualifies as an “accredited investor” has failed to keep pace with inflation, and sweeps in a much larger percentage of the population than Congress must have intended when they wrote the regulations in 1933. The second justification becomes less convincing when the companies seeing large markets for their stock are highly profitable and valued in the billions, as is the case with currently-private Facebook and Zynga. So maybe it is time to start considering whether some regulation for at least the upper-class of private companies could temper the boom and bust cycle without disrupting the markets for fundraising at the lower end of the private company spectrum.

Could regulation temper the bubble cycle? – 

The most common form of securities regulation is probably mandatory disclosure. Public companies are asked to do this very consistently, as a way of providing their shareholders or potential shareholders with a broad view of the state of the company. Private companies don’t provide public disclosures – they get information to their smaller group of investors through other means, such as by granting those investors board seats or simply meeting with the investors frequently. Being a seed or angel investor in a private company surely grants that angel a more favorable position in terms of access to information than I have buying stock in Microsoft, thus the lack of formal disclosure has little practical significance for the institutional investor in the market for private companies.

But the issue I am most interested in, and the angle from which I believe regulation looks most desirable, arises when the successful private company files for an IPO. Focusing here makes sense – many use the IPO market as a proxy for whether there is a tech bubble, and bubbles seem to burst at the IPO level rather than at the level of, say, Series B or C investments. When a company files for an IPO, they are forced to make their first public disclosure, and likely the only disclosure they’ll make before shares of their company are put up for sale (unless they make Groupon-level mistakes and are forced to amend multiple times). This, and the newspaper articles describing the unbelievable valuations of the company, are all the public investor has to go on to make his or her judgment about the value of the company – and in reality, the public investor probably didn’t actually read the public filing anyway, but maybe skimmed a blog post on it. I’ve also noted elsewhere on this blog that usually VCs backing the IPO company are looking for a hasty exit, so the very group setting the earlier valuation now benefits from a public perception that the company is worth more than it actually is.

So the real question is, would forcing companies like Facebook or Zynga or Groupon to file more than one public disclosure before filing for an IPO make the market any more efficient? Would it effectively stem the tide of irrational investments into non-performing or underperforming companies, the canary in a mineshaft for a bursting bubble? Are there any other mechanisms or other forms of regulation available to fight the bubble problem? I’ll save looking into those answers for Part II.

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August 1, 2011 · 4:17 pm

We are approaching a nuclear war era with patents, but at least people are noticing

My last post on Intellectual Ventures and the NPR article that gained national attention was the most read post I’ve ever written, in no small part because people are more interested in the state of patent law in America than possibly ever before. And that’s because patents in America are reaching something of a boiling point. We are seeing really unprecedented wars over patents in completely ridiculous technologies and software, and as more and more people become familiar with Apple and Google and Microsoft as technology spreads, more and more people are becoming interested in the fights behind the companies.

Things have really been building lately in terms of patents in the news: Nortel sold a portfolio of their patents for $4.5 Billion to a consortium of buyers lead by Apple and RIM just last month. Google, missing out on the Nortel bunch, jumped at the chance to buy a bunch of IBM patents for an undisclosed price, but likely somewhere north of half a billion. Apple is currently engaged in a boat load of patent suits against Android phone makers like HTC, who, by the way, just bought a small company for $300 million solely based on the fact that the company won two patent cases against Apple. Rovi is suing Hulu. A company that hasn’t released a product in a decade is suing Spotify over a patent that they claim covers streaming music. Patent troll Lodsys is suing a bunch of mobile app makers, including Angry Birds developer Rovio, indicating that no app maker is safe right now. And of course there was the Intellectual Ventures/NPR piece, highlighting the fact that most software patents don’t inform anybody of new technology, and don’t actually help innovate. Oh, and by the way, the DOJ thinks patents are becoming important.

It’s really an unprecedented era for patents – all the major tech companies are arming themselves with hundreds if not thousands of patents to use against one another, and small rogue nations (Intellectual Ventures and the rest of the non-practicing entities) are taking pot shots at every company they can construe their patents to read on. We might be on the cusp of a patent war unlike anything we’ve ever seen, if we aren’t in that era already. The mainstream media is starting to notice that patents are getting out of control more than usual – the NPR article, this economist article, a post on the Guardian, and a great article by Mark Lemley that is getting some attention. Will this help? Probably not – don’t expect substantial patent reform from Congress. Perhaps the Supreme Court will continue their trend of cutting back on the rights associated with patents, but that process is likely to be slow, and with billions of dollars being spent on the transactions, the court might actually hesitate to cut back on the property rights further to avoid angering those who have already invested.

I think patents are interesting because they cover technologies I love, and they have innate notions of property implicit in their use, but I also think anybody in any software/tech industry (which is increasingly where a lot of business is going) has to be aware of the activity in this space. A company really can’t launch in those spaces without factoring in the cost of licensing patents from patent trolls at this point, as Lodsys is teaching many app developers in the mobile space right now. And while I agree that the notion of a defensive patent goes against the aims of patent law, new companies need new patents so they retain some leverage against the biggest companies in the space they seek to enter. Take Hulu or Spotify, for example, who are both being sued over obvious patents on streaming video and streaming music, respectively. While Hulu is being sued by a real company, Spotify is being sued by a company that hasn’t released a product in a decade. Spotify is an extremely well-funded startup and can mount a strong legal defense if need be, but if it wasn’t, this sort of suit could potentially ruin the business. If Spotify was smaller (watch out Turntable.fm), this patent could be used to strong arm them into an acquisition, or could force them to take a funding round on unfavorable terms to mount a defense, or in any number of ways disrupt their progress. One could wax poetic about how ridiculous this outcome is, and how our patent system is completely stifling the innovation is was meant to inspire, but I’ll leave that to Techdirt. The real lesson is that new companies need patents to protect themselves in this cold war/nuclear era of software patents, at least until something major changes. If Hulu held just one patent that could read on Rovi, they might have avoided this suit – or at least they might have bought some leverage in a settlement negotiation.

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July 11, 2011 · 10:47 am

Internet imperialism – Every company makes a play for every other company’s territory

Over the last few months, there has been a rather unprecedented amount of competition for consumer attention in a couple spaces among the major players in the tech/consumer web industry. Companies respond to success in an industry by trying to compete immediately, and the same goes for space where they think consumer attention might shift to next, all in a giant game of follow the leader. To spice up this post, I’ll predict winners. Let’s start with music:

Entrants into the internet music space:

Pandora (old)

Grooveshark (old)

Spotify (old/new)

Amazon with Cloud Player (last 6 months)

Google with Music Beta (last 6 months)

Apple with iCloud (last 6 months)

turntable.fm (last 6 months)

Somebody forgot to tell all the tech companies that the music industry is dead. (note: Music isn’t dead, it’s probably more vibrant than ever. It’s just not gonna make people the kind of money it did in 2001.) It’s not a distribution problem just waiting to be solved either – it’s a price problem. People are now accustomed to paying $0 for music, and that will not change no matter how many social tweaks and ease of access manipulations tech companies throw in. Look at Pandora – unless the law actually changes (the DMCA specifically), Pandora utilizes every currently legal feature that a company can use streaming online music. Pandora is the pioneer of adaptive, social, internet music access, which is where all of the current tech companies getting into the space would like to head, and Pandora hasn’t yet turned a profit, and their IPO was less than a success, currently trading $2 dollars below what they opened at.

Despite this, news came that Facebook is looking to enter the internet music space, possibly as part of a collaboration with Spotify. This plan would make Facebook a competitor, presumably, to prior entrants Apple (iCloud), Amazon (Cloud player), Google (Music Beta), and, of course, the entrants with many months head start, Pandora and Grooveshark. Nobody has yet found a way to make this space profitable – It’s almost impossible, because record labels still demand extremely large licensing fees despite the year-to-year declines in revenue they’ve faced in the internet era. Eventually the labels may jump on board and try to replicate something like a how social games monetize, letting users access music for free and charging for content associated with the music rather than the music itself, but because the industry was so comfortable for a while there selling CDs for $15, it may take a while for the industry to adjust.

Who will come out on top? My winner: a tie between iCloud and TURNTABLE.FM. iCloud is what Mom will use to put music on her newest device, and what most consumers will use to get music. Apple just has too much of a lead in music to lose here – Apple has an established presence in the music industry with the ipod and itunes, and they already have partial licenses. Turntable.fm, though, could be wildly successful as the greatest music based social game ever (sorry, Night Club City). Imagine if Pandora got every user to pay $5 a month for sweet clothes for their avatar DJ, which the DJ knows everybody on their channel can see? They can sell ad space in the form of special chat rooms (clubs), and by giving out special promoted avatar gear. Zynga proved the virtual currency model works, and it’s Turntable.fm’s race to lose at this point.

Entrants into the app market space:

Apple with app store (old)

Google with Android (old)

Facebook with their Facebook applications, but no official “market” (old)

Blackberry with whatever they call their app store (old)

Amazon with app store (last 6 months)

Google with Chrome app store (last 6 months)

Microsoft with Kinect SDK (to come)

Facebook with “Spartan” (to come)

The app store entrants haven’t all been so fast, with Facebook and Microsoft still to come, but the competition is clearly there. Google’s running two app stores, sort of, with Android obviously being a huge hit and challenging Apple’s dominance. Apple is far in the lead at this point, with Amazon and Facebook looking to play catchup in the mobile space. Facebook has complete dominance on laptops and non-mobile computers, at least when it comes to games, which, as it turns out, is where a whole lot of the money is (see Zynga).

Who will come out on top? My pick: Apple and Facebook. Apple for mobile, where they already have a huge lead, and Facebook for non-mobile, where they also already have a huge lead. There is some chance Google+ will start to pressure Facebook for social games, and might even be able to work a bit of the Android apps into Google+, but that’s a ways off and Google might want to think twice before letting the unfiltered nightmare of Android loose on their tightly controlled social network.

Local Deals:

Groupon (old)

Living Social (oldish)

Google with Google Offers (new)

Amazon with Amazon Deals (new)

Facebook with Facebook Deals (new)

Movement into this market has been a bit slower for the tech giants, with Google and Facebook still basically in Beta versions of their deals platforms (Google only offering deals in Portland), despite the fact that the deals industry clearly makes money as compared to the music space. Groupon has a big lead, but it’s less important in this space, because businesses just have to say yes to one of or all of the other deals offerers for Groupon to start losing their market share. Groupon did a great job getting millions of people to sign up to receive their daily emails, but Groupon now isn’t getting much love in any mobile application I use, at least, and Amazon, Facebook, and Google won’t let their users see Groupon ads over their own Deal service ads if they can help it.

My pick: Amazon Deals. Sounds weird, but hear me out – a year ago, 90% of consumers only had their credit cards on file with 1 of the companies listed above, and it was Amazon. Amazon has a great history of reducing friction between the seller and the buyer (1-click checkout), they have established relationships with thousands of businesses who already use their infrastructure to sell full price items, and setting up deals can be easily integrated into that system. Of Google, Facebook, and Amazon, Amazon may have a smaller number of total users, but ALL of Amazon’s users are looking to buy something when they log in, compared to a small fraction of Google and Facebook users who are looking to do the same.

I’ll cut it off there. There’s probably a bunch more I could detail; I’ve already covered Google+ v Facebook in another post, everybody is making a move into photo sharing it seems, and mobile games is a topic I love and might touch on similarly in a future post. But mark my words on Amazon Deals, it’s gonna be HUGE.

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July 1, 2011 · 12:06 am

“when does zynga shares hit th market” – The link between the IPO market and the tech bubble

I laughed and rolled my eyes when I looked at the sentence above, a search term from Google that brought a reader to a post of mine referencing Zynga’s IPO. No offense to the innocent internet wanderer who stumbled upon my site through that horribly constructed sentence, but he/she highlights a problem with the IPO exits of many of these buzzworthy tech companies. I’ll discuss them in the popular lazy blogger format of “some bolded words as a means of generating structure”:

Everybody involved in the startup wants the company to exit, eventually.

Most people involved in young companies like being involved in young companies. Typically the talent at young companies got there in one of two ways – they always worked at young companies, or they left big companies to work with young companies. Both of those sorts of people end up wanting to work at young companies, which means that if the young company works out and becomes a tremendous hit, the company is no longer the sort that the person wants to work for. It’s ironic (I think, though after being peeved by other people when they incorrectly label something ironic for so long, I’m actually beginning to wonder if the word has any meaning whatsoever). Look at the co-founders of a startup you pay attention to, and it’s almost guaranteed that they jumped over to startups from a larger company in the space, or they’ve always been a startup person. Startups draw a sort of entrepreneurial spirit, which typically isn’t sated by the bureaucracy of an IPO-ready company.

Despite my personal turmoil over the uses of the word ‘ironic’, it is decidedly not ironic that venture capitalists want the companies they invest in to exit. VCs have two goals: invest money and make money on that investment. It’s hard to make money if the company never sells to anybody and never IPOs – the company must make an exit in 90% of circumstances, or the VCs delay reporting a success to their limited partners. Only with rare, super successful mega companies can a VC potentially get out of an investment with a gain, but that’s not ideal, as it forces the VCs to rely on inaccurate, non-free market pricing and the wiles of the secondary market for private stock, a market that probably shouldn’t exist and requires approval from the company for the institutional investor to access.

And we are now seeing a third group that clamors for an exit, though only through an IPO – the everyday investor. Mr. “when does zynga shares hit teh market” wants in on the big private companies he reads about, and wall street wants to get in on the action as well. Private companies can legally only be held by 500 people before the company must report to the SEC as if it were public, essentially forcing the company to go public when it reaches a certain capacity. If you aren’t in that lucky 500, Zynga, Facebook, and Groupon stock has been off-limits (largely, and in the US) despite the fact that half of the tech articles you read are about the three companies. So everything is lined up from the beginning to push startups towards an IPO exit, or a sale to another company.

Everybody involved in the success of the company is probably leaving when the company exits (aka when Ivonna Zyngastock buys her shares).

People get terrified at the slightest hint of news that Steve Jobs is ill. When Jobs coughs, Apple stock drops. Not that every founder is as valuable to their company as Jobs is to Apple, but there is a general consensus that the founders are pretty darn important, even when the company has years of institutional knowledge and thousands of employees. You could argue that the founder is even more important to a small company with less institutional knowledge and likely a smaller number of employees. Obviously not every founder leaves the company when the company exits, and often in acquisitions the key founders are contractually obligated or heavily incentivized to stay, but many upper level executives feel compelled to leave. For one, the desire to work with startups outlined above makes founders want to move on to their next venture. Upper level execs are also likely to be holding on to years worth of stock, and looking for a chance to finally make some money for those shares they’ve had for so long, and often divesting from the company financially means divesting personally. Employees at all levels can now also jump ship more easily, as the pressure to stay to make something off the stock is no longer there.

Success is also, in part, driven by the investors (at least, if you believe the investors). VCs have tangible connections and expertise in areas, often with insider knowledge of the going-ons at other companies they invest in. But once the company exits, the VCs are less likely to play an intimate role in the company’s direction and business decisions. VCs at least see their % ownership of the company decrease, especially as they begin pulling their own stock out to make money on their investment (which has, like the founders stock, been practically illiquid for years). Another odd part about this is, the VCs are the ones who set the price of the company closest to the IPO – take Pandora for example, which just had an IPO despite the fact that the company doesn’t make any profit. Or Groupon, who raised nearly a billion dollars from VCs, then paid most of it out to other investors, then reported a loss for the quarter before their IPO. How do you value a company with no profits? VCs set valuations in the most recent series round, and often the IPO price is, at least in part, based on that valuation. So VCs sort of cooperate to create the illusion that a company has an enormous amount of value, then they dump the company on the public and sell those shares to investors who’ve only heard about the company because of the reporting generated by the investments the VCs made in the first place. I’m not saying it’s crooked or anything – probably just basic marketing – but when the public hears about how valuable a company with no profits is, and then the guy who last invested is very excited to sell, some alarms should go off.

Public disappointment in the quality of companies in the IPO market is what drives the tech bubble cycles.

So all of the above is driving cycles where the public hears about awesome companies, but then gets to invest at a point in time where the company is probably undergoing its biggest transition in terms of culture, turnover, and makeup at the top. Sometimes it works out or the founders truly retain control (google), but often it doesn’t, and if the hype gets too big around a few success stories, its in the best interest of the founders, the VCs, and everybody “in” the bubble to keep pushing young companies to IPO, then jumping out to show a strong short-term gain on the financials or cash out the founders cheaply-bought stock. Eventually the public catches on, gets frustrated buying shares of hot young companies that aren’t businesses yet but are still valued in the millions, and the public stops buying. The fact that people who can’t even construct sentences are googling to find out when they can buy into Zynga is great in some ways – if the overall value of the companies coming out of sillicon valley is high, then the companies deserve the buzz and the valuations – but in other ways it’s bad – once the public starts getting carried away with IPOs, the next phase is discontent with the performance of the companies, followed by a quick burst of the bubble. So get your Groupon stock while you can, but remember that all the people who’ve believed in the company up til now will probably be doing the opposite. (Note: Zynga is great though, I’ll probably be a Zynga stockholder one day. Anybody who can make millions selling 50 x 50 pixel art is on to something.)

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June 14, 2011 · 12:39 am

Groupon and Pandora getting killed in the media as their IPOs approach, Will Zynga reach $1,000 a share?

LinkedIn’s IPO earlier in the Summer seems to have sparked a major IPO push for a lot of the big web companies that have found success as of late. Groupon filed their initial docs last week, Pandora’s shares hit the market on Wednesday, and Zynga is by all accounts filing their initial documents sometime very soon.

While LinkedIn’s IPO was largely a success (so far), it still raises eyebrows: the initial IPO price of $45 represented a Price-to-Earnings ratio of about 250, and the current trade price has a P/E of 500, much higher than the average for the market, and certainly not the hallmark range of a strong company. With that said, Groupon and Pandora are likely to have even worse states, but unlike LinkedIn, the companies are getting lambasted in the media before their IPOs. Rocky Agrawal has been doing his best to ruin Groupon’s IPO through a series of guest posts on Techcrunch, which are sticking on the top page as featured posts with rather uncouth titles like “Why Groupon is Poised for Collapse“, “Groupon was ‘the single worst decision I ever made’“, and “Why I want Google Offers and the entire daily deals business to die“. You can probably guess the gist of those articles from the titles, and they are good reads despite being titled as if they were trollish posts on a business forum frequented only by 16 year olds.

In slightly more journalistic corners of the world, Fortune ran an article today on Pandora’s business model as a loser in the long run, detailing how they have yet to find a way to generate a profit from any aspect of their service, yet they are raising the price of their IPO anyway.

So really, it’s not looking good for the tech IPOs right now. Groupon’s core business looks completely copy-able, a bad sign, Pandora is going to start getting quashed by iCloud and other cloud music providers, and neither is making money. And this follows LinkedIn’s astronomical valuations, which seem hardly justifiable if you actually think about LinkedIn’s business model. Yet people ate up the LinkedIn IPO, and even with all this bad press, nothing seems likely to stop Groupon and Pandora from becoming overvalued by months end as well.

Zynga, though, has solid financials. They actually MAKE money, but that little detail could backfire in the face of investors’ rabid hunger for tech stocks: If they deputed at a P/E of 250 like LinkedIn and opened with as many shares as LinkedIn (roughly 100M), assuming a net income figure of $400 million (who really knows with a private company, but I’ve seen that number frequently), then Zynga would be the highest priced stock in the history of the stock market at around $1,000 per share. Remember, that’s at the P/E multiple that LinkedIn opened at, BEFORE their stock DOUBLED in price.  That would put our irrational exuberance in a company at a new, embarrassing high, and even staunch anti-bubble supporters would have to admit that something was wrong. Something tells me we will find out before the end of summer.

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