Several prominent web-based companies have gone public in the last few weeks, but are their eye popping values the result of their potential to make big money, or are they due to something else entirely?
Over the past few weeks there have been a series of very high profile, very high value tech IPOs (Initial Public Offerings) that have hit Wall Street, fueling speculation that we are either entering into, or are already in, yet another tech bubble. As many of you are probably aware, much has been said and written about the wild overvaluation of these web goliaths, yet despite this pervading belief, investors have firmly bought into the hype surrounding them.
Now, before we delve too deeply into this issue, let me say that I am not a ‘finance guy’. I don’t understand the ins and outs of taking a company public, nor do I have a deep comprehension of what factors directly influence the monetary valuations of companies when they do go public. If I’m being honest, I typically do what my accountant and my financial planner suggest that I do, and sometimes I have to make them repeat it to me twice before I know what they’re talking about.
That said, finance and business, while intrinsically related, are not two sides of the same coin. The goal of this article is to examine the business practices, and by extension the branding practices, that have recently proven so effective in influencing the financial markets, and to do that we are going to focus on three big tech companies; Pandora, Groupon, and LinkedIn.
Pandora, for example, has been around since 2000, and in that time it has lost over $92M. Last year, their most “profitable” ever, the company was still $1.8M in the red, due mostly to paying nearly $140M in artist’s royalty fees. For those that aren’t familiar with it, Pandora is an internet radio service that allows users to customize the styles of music they want to listen to, without specifically requesting the tracks they want to hear. For anyone listening up to 40 hours per week (the vast majority) the service is free, while anyone over 40 hours is asked to pay $.99 to continue listening for the remainder of that month. Over the past couple of years, the company has also begun inserting short 30-second advertisements every 6 to 8 songs in an effort to increase revenue, as well as offering a yearly $36 unlimited, ad-free account, yet nothing they have done has been able to turn the company into a solvent entity.
As a Pandora user, I love the service, but there doesn’t seem to be much a business model in place. They can only insert so many advertisements before people stop listening, and as a program or service that typically runs in the background, visual ads on the site would have little to no value. Any corporate partnerships with music labels or individual artists would compromise their ability to tailor music specifically to the users preferences, and with so many smaller, free competitors, they cannot hope to move to become a paid only service without losing the majority of their user base. So what is it about a company that can’t turn a profit and doesn’t seem as though they will be able to in the foreseeable future that is worth a valuation of $2.6B? Fans of the website are borderline rabid in their devotion to its simplicity, its ease of use, and its comprehensive music library, but their usage does not directly translate to money in the company’s pocket, and the stock price has been fairly volatile since its offering as investors try to make sense of the situation.
One of the biggest trends on the web at the moment is collective buying, and Groupon is currently the leader of the pack. Collective buying works on the same principle as bulk warehouse clubs like BJs or Costco, except that they typically feature only a few deals each day, in each regional market that they serve, and it is most often for a service, event, or credit at a specific restaurant, rather than a physical item or set of items. A typical deal is initiated by the service provider and placed through Groupon with a 50% reduction in cost. Groupon then splits the revenue on each sale, meaning each party gets 25% of the total actual value. Launched in November of 2008, the company hosts more than 35M users in more than 250 separate markets, and recently turned down a $6B offer from Google, preferring instead to go public.
Groupon claims that their revenues topped $713M in 2010, yet several analysts contend that upwards of $615M of that came from various acquisitions and substantial marketing spending. In fact after accounting for all of the various movements that the company made last year, less than $100M of that revenue came from the natural growth of the business, and since Groupon does not release their actual financials, we don’t know whether any of this has made them profitable. Yet the company, which has filed for its IPO, but has not yet completed it, claims that they will seek to raise over $750M at a price that will value the company at around $20B – $25B.
To the vast majority of users, the beauty of Groupon is in its simplicity; a couple of carefully selected deals per day, no usage fees, and full accountability in case anything goes wrong. The deals represent a pleasant little opportunistic surprise for those with some expendable income, but who probably would not deliberately seek out the services that are being offered to them. In many ways, the community of Groupon users all share the common desire to indulge in something out of the ordinary, but they do so only because they can rationalize it as ‘a deal that was too good to pass up’. The majority of businesses who participate in these deals praise the company for the one-on-one attention they receive, and despite only 66% of them profiting from their offers, almost all say that due to the exposure they receive, they would host another deal in the future. But many argue that in order to meet the expectations of its future stockholders, the company is going to have to drastically shift its business model to allow many many more deals each day, in larger geographic markets, with lower discount rates, from a wider variety, and thus, less curated selection of merchants, and the deals themselves will automatically be set up over the web, without the personal attention of a regional representative.
Essentially, this means that the business formula that has made Groupon so successful today is being thrown out for one that is far less special in an effort to increase their profitability. Troublingly, this is not raising any red flags for investors seeking short-term gains, and the IPO is expected to achieve the valuation the company has placed on itself.
The first decade of the 21st century is bound to be remembered as the one where social networking was the answer to every single problem in the world. Want to reconnect with your high school girlfriend? Social Networking! Want to meet someone new instead? Social Networking! Want to find a new job? Social Networking! Want to solve global warming? Social Networking! Have a toothache? Social Networking! And it is in this regard that LinkedIn has become the modern day equivalent of the power lunch, allowing professionals to endlessly connect with each other through mutual acquaintances.
Founded in 2002, the site has more than 100M members from around the world, and claims to grow by 1M each week. Although the company offers paid memberships that allow for more advanced methods of connection, the vast majority of members hold free accounts (Aura is on there, check us out!). And while the company sells advertising to the more than 2M companies on the network their primary source of income is actually the sale of ‘hiring solutions’, which essentially amounts to digital headhunting. Last year the company posted a net income of $243M and a first time profit of $15M, 42% of which came from being hired to match employers and employees.
LinkedIn’s IPO, which took place on May 18th, valued the company at just over $9B and shares, which opened at $45, have traded as high as $103 over the past few weeks. This, coincidentally, accompanied news that the company expects NOT to turn a profit this year, despite their extremely modest gains last year, alluding to the fact that they simply do not do enough paid business to meet the needs of their sustained growth. Having discovered that advertising and paid accounts simply don’t pay the bills, the company is going to have to massively expand their job matching efforts, which may prove to significantly impede their ability to be seen as an impartial, unobtrusive networking tool in the future.
In case the subtext of the three recaps wasn’t clear enough, these companies simply do not make, nor are they expected to make, enough money to justify their valuations. The fact that each of them is planning a tremendous shift in business model following their IPO should be a warning flare to investors, but very little seems to temper their enthusiasm for the possibility of big gains. Long-term, what really are the chances that all three services become better than they are right now after their core strategies have been altered in order to increase their profitability? I’d wager the odds are not in any of their favor, and in a way it’s not entirely their fault.
The problem is a gross misunderstanding of scale in the digital age. LinkedIn boasts over 100M users, and the first mistake is thinking that a user is the same thing as a customer. Many investors are seeing such eye-popping numbers, and they can’t help but start to salivate, but they do so without realizing that in this day and age, the size of a business is no longer a good indicator of its financial potential.
Once upon a time, any company with over 100M customers was a world changer. Unless they were inept and on their way to bankruptcy, it was almost automatic that they would be making serious money and wielding a serious level of influence. The logistical tasks associated with physically making and moving more than 100M of anything goes a long way toward establishing a price for that item, and the majority of consumers can subconsciously justify the cost of an object based upon its size, origin, and perceived complexity.
But the internet has greatly changed this dynamic. Some online retailers have, of course, been very profitable, but they still trade primarily in physical goods. Rather, we’re talking about a trio of web-based companies that are highly visible, well known, and yet whose primary offering has little or no monetary value to their users. And these three are just the tip of the iceberg; there are literally thousands of successful web networks and services that are immensely popular, and nearly every one of them has achieved their level of success by giving access and the majority of their content away for free. As each has demonstrated, when it comes to the web you can be the industry leader in your segment, and you can have tens or even hundreds of millions of loyal fans, but none of that equates with making money when your users don’t feel they should have to pay for the service you’re providing.
Now in the interest of fairness, each of these three companies has found ways to make money without damaging or changing the relationships they have with their users. In fact the wealth of the founders and executives of these types of companies is often a high-profile topic, but the issue again is one of relative scale. Traditional finance thinking says that a business with 100M customers and $15M in profit must be doing something wrong, and that with the right cost-cutting measures and business adaptations, they could be making significantly more money. I would argue, however, that a social networking company with 100M users and $15M in profit may well be the new norm, and that by the very nature of the service they provide, it is quite unlikely, for all of the previously listed reasons, that they can substantially increase that profitability without losing the trust of their community of users.
It would be easy to call Groupon the black sheep of this trio. While their service is based in social behavior, they are not really a social network, and their users conduct monetary transactions which the company is ultimately benefiting from, as opposed to providing free usage for the vast majority of their community like Pandora and LinkedIn do. They are also arguably the most financially successful of the three companies as well, and are probably the best positioned for significant profitability in the future. But the point I’m trying to make not that they will never make money, it’s that they will never be worth what traditional economics says they will. Any company that nets $700M in the same year they refuse to reveal their profit statements simply is not worth $20B – $25B, but Groupon is essentially getting a free pass because investors cannot seem to reconcile the notion that in the digital age, a company can be both big and small at the same time.
Ultimately, the world of finance is falling in love, not with the companies themselves, but with their brands and the abstract immensity they represent. These brands are modern and exciting. They are popular and very ‘now’. Their users are loyal, and each service has succeeded in striking an emotional chord within its respective community. But these are generally not businesses that have been built as money-makers from their inception. Digital technology has given rise to the ability to build a website or network from your living room that satisfies a perceived need, and global interconnectivity means that it can grow at a rapid pace. But without the need for pre-launch financial backing and extensive management, these sites can grow to extremely large sizes before anyone realizes that they aren’t properly positioned for profitability.
Clearly this is a concept that traditional finance cannot seem to grapple with, and with so much positive attention at such a grand scale, investors are sticking by the notion that each has to be able to make money somehow, despite most evidence to the contrary. So, rather than investing with businesses that continually demonstrate the ability to turn a profit or utilize a business model that allows them to eventually turn a profit, they are throwing money at these ultra visible, well-known, yet ultimately unprofitable brands, in the hopes that they can magically transform reputation into revenue. As a fan and user of all three services, I sincerely hope that each company has an ingenious plan for increasing their net income without fundamentally changing who they are and what they do, but it is fairly unlikely that this is the case.
Keep in mind that cautioning against fundamental change is not a castigation of the type of organic growth that a company must sustain to keep itself ahead of its competition. Successful brands typically have a culture of innovation, adaptation, and reinvention, and they do so without losing sight of the goals and characteristics that make them uniquely desirable. Instead, we are talking about the type of growth and expansion that abandons, or worse, deliberately opposes the brand values that made the company successful in the first place.
Dude, you're gettin' a Dell, and I am SO sorry...
In the late 90’s through the early 2000’s, Dell was one of the most popular and fastest growing computer companies in the world. As they grew more and more ubiquitous, the Dell brand began to take on a life of its own, becoming known for inexpensive, reliable, somewhat cool machines, and the company cultivated an exciting, startup feel that lent it a great deal of credibility with consumers. However over the course of several years, as their product lines grew and their global market cap expanded, the quality of their machines and customer service plummeted to make room for increased profit margins. They expanded into TVs, radios, MP3 players, and printers, and in short order, the Dell name came to embody opportunism, empty promises, cheap products that they refused to stand behind, and a lack of dedication to their customers. The brand has yet to recover its luster, even if the company has survived on selling to schools and offices, and new players have taken their place as the PC maker of choice for consumers.
Brands, we can draw from this, are not names which lend credibility to the products and services under them, rather it is quality products and services that lend credibility to the brand. The management teams at Pandora, Groupon, and LinkedIn have succeeded thus far in building products that people like, and will undoubtedly do everything in their power to maintain the integrity of their companies. But facing so much pressure from shareholders, it will become increasingly easier to rationalize one unsupported, or off-brand service extension after another in an effort to meet financial benchmarks, until there is very little left of the brand that everyone was so excited about in the first place.
Now for me to conclude that it was simply a mistake for these three companies to go public is to take the easy way out. IPOs have become the bar mitzvahs of the business world. They are a rite of passage that signifies that the company has achieved a level of size, maturity, and stability that is coveted and respected in the corporate community, and often, an IPO is a way of financially rewarding the creators and executives of these companies for all of their insight, ingenuity, and hard work. To suggest that web-based businesses, especially social networks, avoid this process is unrealistic, and frankly, would ultimately deprive us of many of the great innovations that we see as a result of companies continually having to prove their value to both consumers and investors.
Rather, the point of this article is two-fold; I am suggesting that we think long and hard about the future relationship between social value and monetary value, but I also want to highlight these three companies as branding success stories. In fact, these three brands have been cultivated so well that it actually may have hurt them in the long run.
Last month, we published an article that warned against trying to quantify your brand. You can read it here, but in summary, it is more or less impossible to place a dollar value on what your brand alone is worth, and ultimately it is a fruitless endeavor since the moment you try to capitalize on it, rather than continually build and improve it, you begin to erode what makes it so special in the first place. But these three IPOs have showcased a different side of brand monetization. The extraordinary valuations that each has achieved relative to its actual size, revenue, and profitability, can be attributed almost exclusively to the effectiveness of its brand.
Each service represents something wonderfully unique to consumers. And while dissecting and reporting back on the detailed tactics that each of the three businesses have utilized to become as successful and well known as they are would be another article altogether, the underlying message is that their popularity, and thus their perceived value, is a direct result of the brands they have created. A company that makes car parts, is $92M in the hole, and doesn’t turn a profit would never dream of valuing itself at $2.6B, but Pandora is getting away with it because their brand has positioned the company as exciting, authoritative, trendy, and cutting edge. These attributes have succeeded in attracting a large user-base to the service, and that user-base in turn, has convinced investors that the company has far more potential than it probably does. And the same holds true for the other two, as well as the dozens, if not hundreds, of social networks, web-based communication channels, and content sharing sites that have succeeded in satisfying an emotional need, but do not necessarily satisfy the company’s financial needs.
One would hope that with the ever quickening bubble and burst cycle of the recent past serving as a backdrop, investors will be paying close attention to the performance of these three companies over the next year or two, with the intention of gathering some perspective on how accurately their success was predicted. But if the past is any indication, opportunism often wins out when pitted against rationalization. The practice of overvaluing a company based upon the perceived potential of its brand, rather than its demonstrated performance, is not a new phenomenon, but rarely is it this obvious that things aren’t adding up. If nothing else, these circumstances demonstrate the true power of a brand. For the sake of the health of our economy, I hope that we learn our lessons quickly, and start looking at companies like LinkedIn, Pandora, and Groupon for what they really are, but as a case-study in effective branding, there is no better proof of concept than a trio of companies that uses what they represent, rather than what they do, to define themselves. If there is anything to be taken away from this scenario, other than maybe ‘do not invest in web-based tech companies long-term’, I would hope it would be that a strong, emotionally rooted brand can go a long way toward real-world change in the performance and perception of a business, and with social media powerhouses like Facebook and Twitter expected to go public this year or the next, some serious evidence supporting this may be just around the corner.
Business Week, Money Morning, The Guardian, Market Watch, Signpost, Reuters, Bloomberg, Media Post, and The LA Times.
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