Update: Commentary added on 7th September after news emerged that the Groupon IPO may be delayed.

The traditional path from startup to success used to be as follows: a company gets founded, it gets funded by VCs and then it either IPOs or gets sold to another company, allowing the founders, VCs and employees who have been granted share options, to cash out their shareholdings and reap their just rewards.

Over the past few years, however, things have begun to change. Companies like Facebook and Twitter are now eschewing IPOs in favour of staying private, in order to avoid the public disclosure requirements and regulations that a public company must comply with. The downside of this is that the time horizon for founders and employees to receive their pay-off stretches out into the dim and distant future. To solve this problem, it has become common practise for shareholders to cash out small portions of their shareholdings as part of investment rounds, thereby liquidating some of their wealth and enabling them to buy a house, a Ferrari or whatever else they fancy. However, when this occurs, it normally only accounts for a small fraction of the investment round, with the majority of the money raised going into the company, to fund its growth and expansion towards an eventual exit (or, if they opt to remain private, profitability).

Groupon have been doing things slightly differently.

Between its founding in 2007 and the Series E round in November 2009, Groupon raised $35.8m.

Then it stepped up a gear. Since the beginning of 2010, the company has raised over a billion dollars – $1,098.2m to be exact.

Here’s the interesting thing: of that $1,098.2m, $946.8m (more than 86%) has been distributed to the founders or earlier investors in the form of share buybacks.

In April 2010, Groupon raised $135m from Digital Sky Technologies and Battery Ventures. The company retained $15m of that money and used the remaining $120m to buy shares back from existing stockholders.

In December 2010 and January 2011, Groupon raised $946m. It retained $136.2m and the remaining $809.8m went to existing stockholders.

In February 2011, Groupon raised $17.2m from a group of investors including Howard Schultz (chairman and CEO of Starbucks). The company retained just $200k and used the remaining $17m to buy shares from existing stockholders.

During these rounds, Andrew Mason, the CEO, received a total of $27,931,440, while companies owned or controlled by Eric Lefkofsky and his family received $381,904,359.

Between 2008 and 2010, Groupon also paid $28.6m in dividends to its shareholders, although the company now says that they “do not anticipate paying cash dividends” for the foreseeable future, planning instead “to retain all of our earnings … to finance the operation and expansion of our business.”

It’s not just the founders who’ve taken money out. In January 2011, New Enterprise Associates (who had invested $4.8m in 2008 and another $10m in 2009) sold 738,694 of their 8,026,450 shares back to the company for $70m, making a very nice profit while retaining more than 90% of their shares. Accel Partners (who had invested $20m alongside New Enterprise Associates in November 2009) sold 211,037 of their 2,932,552 shares back to Groupon for $20m, thereby recouping their original investment. However, like New Enterprise Associates, Accel retain most of their shares.

In short, pretty much everyone who invested in Groupon up to, and including, the $30m ‘E’ round in November 2009, have gotten back at least what they invested in the company (and, in the case of the founders and early investors, a great deal more), while retaining significant shareholdings. (The only exception I can find is the Board of Trustees of Leland Stanford Junior University (yes, that’s the Stanford University), who invested $50,000 in November 2009; there’s nothing in Groupon’s S-1 filing (the source of all these numbers) to suggest that any of Stanford’s shares were bought back.)

However, the ‘F’ and ‘G’ round investors (listed below, with the amount they invested) are now left holding the can.

Between them, these companies, funds and individuals have paid over $967m for less than 25% of a company that’s running out of cash and whose business model may not be as profitable in the long-term as it has been up until now. It beggars belief that they didn’t know that the money they were investing in the company was going to be paid out to existing shareholders.

The Internet industry is, of course, no stranger to startups that fail to live up to their hype but end up making their founder a lot of money at the expense of late investors. For me, the original dot-com bubble’s peak was the IPO of Lastminute.com. Its founders, Martha Lane-Fox and Brent Hoberman, had met while working at a media strategy consultancy. They put that media experience to good effect – Lastminute became a darling of the British media and floated on the London Stock Exchange in March 2000, at a share price of 380p, valuing the company at £571m. The share price slumped to 270p within two weeks and below 190p within a month. The company was acquired just over five years later for 165p per share – less than half the floatation price.

I don’t know whether Lane-Fox and Hoberman truly believed that the company was worth that much and was destined for great things or whether they opted to exploit the hype they had helped create to raise as much money as possible. All I know is that, a few days before the company floated, when it was announced that the floatation price range was being raised from 190-230p to 320-380p, my instinctive reaction was to say “It’s not worth that much.”

I was proven right and, ever since, I’ve been skeptical of companies that I feel are being over-hyped. A decade working in the City gave me first-hand exposure to the way in which share prices are determined by investors’ expectations and, at business school, we read case studies on how the actions of a company’s management team can artificially inflate those expectations. There are shades of grey, all the way from brutal honesty on the part of company management at one end, all the way through to Enron-esque fraud at the other.

Of course, hype doesn’t always stem from dishonesty. There are two factors one must take into account when deciding whether or not to trust someone – honesty and competence. I would say that most situations where a company’s prospects are over-hyped are due a lack of competence, whether on the part of the journalists, who believe that reporting on a company or industry sector somehow makes them an expert; the management team, who are 100% convinced that their business model is sound, that the competition will never catch up and that the company will grow to become the next Apple, Amazon or Google; or the investors, who really ought to know better.

The frustrating thing about all this, of course, is that hype can only be positively identified with hindsight. At the beginning of this year, I was so convinced that Facebook wasn’t worth $50bn that I was prepared to put my money where my mouth was. Had someone taken me up on that bet, they could have cashed out last month with a tidy profit of 31% – at my expense, clearly – after Interpublic sold part of their stake in Facebook at a price that valued the company at over $65.5bn. A salutary reminder, perhaps, that the market can remain irrational longer than you can remain solvent, but also a lesson that the possibility always exists that the perceived hype is not, in fact, hype, and that the company really will indeed become the next Apple, Amazon or Google (after all, that’s how those companies got there!).

I do believe that Groupon is over-hyped and I can’t shake the feeling that there’s more to it than simple over-optimism on the founders’ part.

In August, Andrew Mason sent an email to Groupon employees, rebutting Groupon’s critics. The email was, inevitably, leaked. It arguably skirted the SEC’s “quiet period” rules, which are intended to prevent “pump and dump” scams, and it came very shortly after Groupon’s head of PR (Bradford Williams, a PR heavyweight with experience at eBay, VeriSign and Yahoo) abruptly departed the company after just a few months in the role.

It doesn’t take a huge leap of imagination to guess that the reason Williams quit was because he counselled Mason against sending the email and Mason decided to ignore that advice. If that’s the case, then Mason arguably knew that he risked breaking the SEC’s “quiet period” rules when he sent the email.

So, why did he send it?

I realised something while I was reading Henry Blodget’s piece on Groupon’s cash position – right now, at this point in time, before it IPOs, the biggest risk that Groupon faces is a loss of confidence on the part of merchants.

Groupon’s growth, in terms of customers and revenues, has been phenomenal and everybody has been focusing on whether that growth can continue or whether it will decline in the face of increasing competition. However, what nobody seems to be focusing on is the fact that continued growth is also contingent upon Groupon having something to sell its customers. It needs merchants to supply it with deals. If anything were to interrupt that deal-flow, Groupon would face a serious problem. Competition is unlikely to restrict the supply of deals available to Groupon, at least in the short term (if a merchant is willing to offer a Groupon-style deal in the first place, there’s no reason they wouldn’t be prepared to offer it through multiple deal sites).

However, bear in mind that Groupon operates a negative working capital model – i.e. it pays a merchant at least 60 days after it sells the deal to a customer. The fact that it’s current liabilities exceed it’s current assets implies that it’s paying merchants for vouchers it sold two months ago, with the cash it made from selling vouchers last month. As long as Groupon keeps selling more and more vouchers, it can keep paying its merchants and, assuming the IPO goes ahead, it will receive an infusion of cash that, presumably, the management team expects will keep it going until it reaches cash-flow positivity.

But if something were to interrupt that growth, or if the IPO didn’t go ahead, Groupon would, sooner or later, need a significant infusion of cash in order to be able meet its obligations.

So the question that merchants should be asking themselves is this: Will Groupon be able to pay me what they owe me in 60 days time?

If a merchant ever thinks that the answer to that question might be “No.”, they’ll opt not to offer deals through Groupon. Why would you sell (at a heavy discount, mind you) your products or services through a company that may not be able to pay you? Better to take the guaranteed revenue from normal customers who pay up front, than risk selling through Groupon and never recouping a penny.

Without deals to offer to the people on its mailing list, Groupon can’t make sales. If it can’t make sales, it can’t generate revenue. And, if it can’t generate revenue, its negative working capital model will very rapidly lead it to run out of cash.

The most dangerous thing about this situation is that it doesn’t matter whether or not Groupon actually can pay the merchants. If enough merchants believe that Groupon is not creditworthy, a tipping-point will be reached and it will become a self-fulfilling prophecy.

So, Groupon’s negative working capital model exposes it to the risk that a loss of confidence could cause it to become insolvent. Which begs the question, why did Groupon’s board of directors opt to pay the last round of investment out to existing shareholders instead of retaining it in the company as a cash cushion? If they didn’t recognise the risk, then they’re incompetent. If they did, then they arguably failed to discharge their fiduciary duty.

Like all S-1 filings, Groupon’s contains a section titled “Risk Factors“. Although it doesn’t explicitly address the loss-of-confidence issue, it does state that future revenue growth depends on, among other factors, the company’s ability to “attract new merchants who wish to offer deals through the sale of Groupons” and “retain our existing merchants and have them offer additional deals through our marketplace”. That’s probably vague and generic enough to present a defence if it ever came to court but, if I were a potential investor, I wouldn’t be satisfied.

I suspect that Mason, at least, is aware of the loss-of-confidence risk. It wouldn’t surprise me if he feared that the negative coverage of the company in the press (like Blodget’s piece) risked bringing about the loss of confidence, and that’s why he felt the need to answer the company’s critics.

Ironically, in doing so, he risked delaying the IPO, although informed opinion has it that he violated the spirit, but not the letter, of the law and is, therefore, likely to get away with it. However, for me, it raises a question mark over both his judgment and honesty.

I fear that we have become far too tolerant and accepting of people who use less-than-honest tactics to achieve success, as if success is all that matters and the means to that end are irrelevant. I never found it surprising that someone who was prepared to betray people he had entered into a business agreement with, would be prepared to play fast and loose with users’ privacy, if it suited his ends. In a similar vein, I wouldn’t be surprised if more controversy lies in store for Groupon.

7th September – Update: Groupon reevaluating IPO plans

News emerged this morning in the Wall Street Journal that Groupon has cancelled its investor roadshow, signalling a likely delay for its IPO.

It’s worth noting that, at this point, the IPO process is largely controlled by the lead underwriters – Morgan Stanley, Goldman Sachs and Credit Suisse, in the case of Groupon’s offering. The reason that the investment banks leading an IPO are called “underwriters” is because, in theory at least, they guarantee that all the shares will be sold by actually buying them from the company and then distributing them to the investors taking part in the IPO (i.e. they “underwrite” the IPO). If there isn’t enough investor demand, the underwriters end up owning the unsold stock. It’s a bit like an insurance policy, and the company that’s floating agrees to pay an underwriting fee from the proceeds of the IPO, to compensate the underwriters for the risk they’re taking.

In practise, however, IPOs are priced to go, to minimise the risk that the underwriters will be left holding a pile of stock that’s not worth as much as they’re paying for it. This is why you so often see IPO stocks shooting up on the first day of trading – the floatation price is effectively determined by what the underwriters say it should be and they minimise their risk by under-pricing the stock to guarantee investor demand.

The WSJ’s source said that “given the recent fluctuations in the stock market, Groupon executives decided to take a wait-and-see approach”. A volatile stock market would certainly give underwriters cause for concern – you don’t want to price the IPO and commit to buying a pile of stock if there’s a risk the stock market with drop five percentage points before you get a chance to off-load it to investors. At 37, the VIX is still relatively high. You would ideally want to see a clear and steady downward trend before going ahead with an offering like this.

However, with Groupon, it seems likely that there are other concerns.

The recent negative media coverage will have affected investor appetite for the stock. The exploratory conversations the salespeople at Morgan Stanley, Goldman Sachs and Credit Suisse will be having with potential investors are likely revealing a higher degree of apathy and more questions than the underwriters are comfortable with. Ideally, Groupon would update their S-1 with more recent (and positive) numbers.

There are also likely to be specific concerns like, for example, whether there are guarantees in place to ensure that the proceeds of the IPO are used to grow and expand the company, instead of being redistributed to the founders, and whether, given the recent “leaked” email debacle (which apparently prompted the SEC to contact the firm), there is an appropriate level of corporate governance and oversight in place.

Another concern that’s likely to be weighing on investors’ minds is that, while under normal circumstances, there’s not a huge amount of potential downside to an IPO, at least when compared with the stock market as a whole. Sure, the company might end up dropping a bit but you’re unlikely to lose all your investment.

That’s not the case with Groupon. It is not beyond the realms of possibility that Groupon could end up taking $750m from an IPO and still go bust within a year if it fell victim to the worst-case loss-of-confidence scenario I outlined above. With the company operating a significant working capital deficit and question-marks hanging over both Andrew Mason’s competence and suitability as a CEO, and the sustainability of the company’s business model, the perceived risk may simply be too much for potential investors.