Big Doesn't Always Mean Beautiful

Fareed Zakaria writes,

The Obama campaign’s attack ad about Bain Capital presented a simplistic picture of a complicated reality. Private-equity firms can play a crucial role in keeping companies competitive. And although some firms have engaged in some bad practices, on the whole the industry has grown so large because it performs a useful function.

I am not going to argue that private equity serves no purpose, to deny the possibility of a collateral benefit to the public or even to the businesses in which they're involved as they seek to extract their profits, because that would be untrue. But at the same time the fact that an industry exists and is large does not mean either that it supports a useful function for society. I don't want to read too much into Zakaria's shorthand - in stating that private equity "has grown so large because it performs a useful function" he is not saying that every industry that grows large and rich performs a useful function. In a perverse sort of way, there might be truth to the generalized statement - trade in illicit and diverted drugs provides a service wanted by drug addicts and is a bona fide multi-billion dollar industry - but I expect that Zakaria means "to society as a whole". And if his statement is so qualified, again with the illicit drug industry as an example, size and wealth is no guarantee of usefulness.

When discussing private equity, the important thing to remember is that a private equity company's principal "useful function" is to maximize return for its proprietors and investors, and that they tend to think and act in the short-term. There can thus be many contexts in which a private equity company's approach to an investment may be at significant odds with what is in the long-term interest of society, or even of the company they acquire. When private equity companies mess things up for the rest of us, they can still turn a huge profit - or get the benefit of a government bailout. It's all part of a game in which any benefit to society is incidental.

Don't Bet on Vaporware

Unless, of course, you have money to lose.

I keep seeing articles suggesting that ordinary investors should not try to purchase Facebook stock at the time of its IPO. You know, as if an ordinary investor will have the opportunity. Facebook is selling a small amount of stock, not because it needs the money but because it has too many shareholders to remain private. It is clearly hoping that by keeping the offering small the shares will be picked up by investors who see the company as worth a roll of the dice - in three years will they be Google or will they be MySpace?

The thing about Facebook is that for years now we've been told that their data will allow them to sell advertisers high-value advertisements, targeted based upon exceptionally granular demographic information, resulting in high conversions. CJR offers a reminder of what that presently means, in practice. Ads do not appear to be well-targeted, ad revenues are dropping, and any suggestion that it can grow its income to justify its present, ostensible valuation (as opposed to identifying and implementing new income streams - the type of revenue streams we've been promised will inevitably appear because of the amount of traffic and data that Facebook enjoys) is simply not credible. It's more credible, I suppose, than the similar valuation of Internet companies during the first Internet bubble, due to improved online advertising technologies, but not by a large margin.

The recent action that should have investors scratching their heads about Facebook is the acquisition of Instagram. Not in the sense of "CEO's Gone Wild". To some degree you have to credit Facebook for seeing a potential competitor on the horizon and buying it before it became much more costly - recognizing that such acquisitions are a gamble. It was Facebook's promise to own and manage Instagram without folding it into Facebook that was telling. If Facebook can only maintain its dominant position by acquiring upstart social networks, it's going to be buying a lot of small companies for a lot of money.

If Facebook can only keep the users of acquired social networks happy by maintaining them separately from Facebook, even if it offers a level of integration by allowing people to log in to all of its services through their Facebook account, it's headed toward an expensive form of fragmentation, having to support and maintain a lot of marginal or obsolete properties - or at times cut their losses and make users angry. Facebook's strength is in being Facebook, singular, not in being an agglomeration of sites. And let's not forget we're actually talking about a platform war - you don't want to reduce your operations to an app on somebody else's platform, and you certainly don't want to reduce it to a panoply of apps. You want to be the platform.

A year ago Facebook released numbers that, although not justifying its pie-in-the-sky valuation, were impressive. More recently they have reported that they have more users than ever - and that their profits have declined. Neither that nor the potential fragmentation of their platform is the type of thing that I would be looking for in an investment. But heck - if I were getting an annual fee and a percentage of the profits to invest your money (or your pension's money) I can see why I might roll the dice.

Romney's Dishonest Pitch to Michigan Voters

Mitt Romney has a problem in Michigan. Four years ago, part of his case for his candidacy was that he could deliver Michigan for the Republican Party. He won the primary, but with less than 40% of the vote. Now he's the presumed nominee, and he may lose Michigan to, of all people, Rick Santorum. Then, as now, Romney claimed a form of inherited connection with the state and auto industry that, like pretty much everything else he claims, just doesn't ring true for a lot of the voters he expects to support him.

Four years ago, Romney argued that we should "let Detroit go bankrupt."

If General Motors, Ford and Chrysler get the bailout that their chief executives asked for yesterday, you can kiss the American automotive industry goodbye. It won’t go overnight, but its demise will be virtually guaranteed.

Can you feel his brilliant business insight at work? He follows that up with a number of observations that range from the trite (the need to renegotiate labor contracts for lower wages and benefits, the need to replace bad management, the need to focus on a long-term strategy and not simply he next quarter's financials), and suggests that the auto industry is the wrong place to spend government money,

I believe Washington should raise energy research spending to $20 billion a year, from the $4 billion that is spent today. The research could be done at universities, at research labs and even through public-private collaboration.

Yes, that's right, Romney was for massive public investment in companies like Solyndra before, with the benefit of hindsight, he was against them. It's astonishing that a guy who claims to be a genius venture capitalist believes that you can invest $20 billion in research without taking any losses. Most good venture capitalists have a success rate of what, one in three?

Let's start with my 1/3, 1/3, 1/3 assumption that regular readers will be familiar with. This says that 1/3 of an early stage venture portfolio will be losers, 1/3 will get your money back or make a little money, and only 1/3 will deliver the kind of performance you expect when you make an investment (5-10x).

Romney complains when people criticize his record at Bain, and point to the companies that ended up failing, but he predictably applies a very different standard when going after the President. Solyndra obtained almost a billion dollars in private equity - money from companies like Bain - prior to its collapse. Romney can argue that the scale is different, an argument undermined by his own assertion that the federal government should push $20 billion into alternative energy research, but as others have pointed out the entire effort resembles a push Romney made as governor of Massachusetts, with some of his administration's selections for the receipt of millions in grants ultimately failing. By the time he was criticizing Solyndra, Romney had either forgotten or flip-flopped on his proposed $20 billion budget for energy research, with a campaign spokesperson arguing, "Gov. Romney worked to limit the role of the state as venture capitalist". As a former head of the Massachusetts fund argues,

"[Romney's] administration was certainly at that point willing to support the establishment of a fund that was going to be in the business of giving money to individual companies and in effect picking winners," Leon said. "This is true. In some ways, it's a question of on what basis one wants to be critical of his position now."

Romney's other arguments about Solyndra seems remarkably detached from reality,

"When they put $500 million into Solyndra, they thought they were encouraging solar energy in this country," Mr. Romney told a friendly audience packed with business executives. "They did the opposite. Because when they put $500 million into Solyndra, the other 100 entrepreneurs in America working on solar energy just lost any potential to get capital."

He added: "When the government chooses to put in $500 million, who wants to put $2 million in some idea from this person in Montana? No one."

Seriously, not one venture capitalist in the country will invest in alternative energy if the U.S. government is providing loan guarantees to large ventures that have been vetted and funded by large venture capital firms? And his evidence for this is... that it makes for a great, if mendacious, sound bite in his speech?

You could argue that the U.S. government was following Romney's advice, creating a program that offered a total of about $20 billion in loan guarantees, and that it has a pretty remarkable record, having only one company (Solyndra) default. Perhaps Romney would like to bring out a panel of working venture capitalists, and have them explain how a 2.5% default rate on their investments would bring their companies to their knees. And while Romney likes to bandy about phrases like "crony capitalism" for why the Obama administration (like the V.C. firms that invested the $billion) thought Solyndra was an appropriate recipient for government support, he omits mention of the fact that Solyndra started to receive loan guarantees during the Bush Presidency.

What critics fail to mention is that the Solyndra deal is more than three years old, started under the Bush Administration, which tried to conditionally approve the loan right before Obama took office. Rather than “pushing funds out the door too quickly,” the Obama Administration restructured the original loan when it came into office to further protect the taxpayers’ investment.

If Romney is a brilliant businessman and investor, he knows all of this.

Moving back to Detroit, Romney whines that when the government restructured G.M. it gave a block of shares to the union,

Instead of doing the right thing and standing up to union bosses, Obama rewarded them.

A labor union that had contributed millions to Democrats and his election campaign was granted an ownership share of Chrysler and a major stake in GM, two flagships of the industry.

The first statement is an outright lie. Unions had to make significant concessions as part of the restructuring deal. The "ownership share" was part of the negotiation between the unions and the failing auto companies, and was designed to ensure at least partial continuation of medical benefits to retirees.

In virtually every respect, the concessions that the UAW agreed to are more aggressive than what the Bush Administration originally demanded in its loan agreement with GM. Among other things, the UAW’s existing VEBA – to which GM has a $20bn obligation – will be replaced by a new VEBA as described below....

This new GM will establish an independent trust (VEBA) that will provide health care benefits for GM’s retirees. The VEBA will be funded by a note of $2.5 billion payable in three installments ending in 2017 and $6.5 billion in 9% perpetual preferred stock. The VEBA will also receive 17.5% of the equity of New GM and warrants to purchase an additional 2.5% of the company. The VEBA will have the right to select one independent director and will have no right to vote its shares or ther governance rights.

Let's contrast the type of private investment that Romney implicitly argues is superior, and which he practiced back in his days with Bain,

The [investors] who ran Harry and David into the ground have a defense: economic conditions changed in unforeseeable ways. But that’s precisely why loading firms with debt in order to reap short-term benefits is bad. It leaves companies unable to weather tough times, and allows private-equity firms to make money even if things go wrong.

As if this weren’t galling enough, taxpayers are left on the hook. Interest payments on all that debt are tax-deductible; when pensions are dumped, a federal agency called the Pension Benefit Guaranty Corporation picks up the tab; and the money that the dealmakers earn is taxed at a much lower rate than normal income would be, thanks to the so-called “carried interest” loophole. The money that Mitt Romney made when he was at Bain Capital was compensation for his (apparently excellent) work, but, instead of being taxed as income, it was taxed as a capital gain. It’s a very cozy arrangement.

Recall also that before the government stepped in, Chrysler was not a publicly traded company. It was privately held by Cerberus Capital Management, a company that appeared adept only at running the company into the ground. In Romney's book, it appears to be a very good thing for a corporate raider to be able to pick the meat off a company's bones, leaving it to the taxpayer to cover defaults on pensions and retiree medical benefits. Surely he understands that the calculus is different when you're a government actor and you care less about profit than the survival of the company and the avoidance of an additional burden on the taxpayer. If Romney doesn't understand the difference between being President and running Bain, he has no business running for President.

Romney is now purporting that everything good about the government bailout of G.M. and Chrysler was his idea, and that everything else about the bailout was bad. Well before this speech was made, Paul Krugman gave an apt assessment:

So what the story of Romney and the auto bailout actually shows is something we already knew from health care: he’s a smart guy who is also a moral coward. His original proposal for the auto industry, like his health reform, bore considerable resemblance to what Obama actually did. But when the deed took place, Romney — rather than having the courage to say that the president was actually doing something reasonable — joined the rest of his party in whining and denouncing the plan.

And now he wants to claim credit for the very policy he trashed when it hung in the balance.

Romney he wants us to imagine that in private hands a company like Chrysler could have survived and thrived, ignoring the fact that Chrysler had spent years in the tends of people like Romney who were either indifferent to its survival or beyond incompetent in their effort to engineer a turnaround. He wants us to believe that G.M. and Chrysler could have survived a private bankruptcy, despite the far that credit markets were frozen and nobody was going to finance the companies' operations over the course of a traditional bankruptcy, even if expedited. He wants us to imagine that GM's bondholders, and Chrysler's private owners, were somehow duped or tricked into believing that they would do as well or better through the Obama Administration's plan that they approved, as opposed to rejecting the deal and pursuing a traditional bankruptcy. And, as a brilliant investor, Romney now encourages the Obama Administration to inflict a massive financial loss on the taxpayer, apparently because this will somehow punish the UAW.

American taxpayers have been left on the hook for billions to benefit unions and the union bosses who contributed millions to Barack Obama's election campaign. Such a state of affairs is intolerable, and as president I would not tolerate it. The Obama administration needs to act now to divest itself of its ownership position in GM.

The shares need to be sold in a responsible fashion and the proceeds turned over to the nation's taxpayers.

I recognize that anti-union demagoguery is par for the course for the Romney campaign, but you would think that in using the word he would have some sense of what it means to be responsible. The numbers are pretty basic: To recoup its 'investment' the government needs to sell its stake in G.M. at $53 per share. The present value of G.M. is $25.33 per share. Were the Obama Administration to follow Romney's advice, they would be "turning over" to the taxpayer a loss of about $20 billion. How can you view Romney's pressure for divestment as anything but dishonesty, demagoguery - a single (albeit very large) company's failure that results in a $500 million default on loan guarantees is government at its worst, but inflicting a $20 billion loss on taxpayers would be "responsible".

The Biggest Threat to Facebook: Data Liberation

Facebook's strengths and weaknesses are summarized reasonably well on CNET, with the leading strengths being reach (the huge number of Facebook users), dwell (the huge number of hours a typical U.S. user spends on Facebook) and lock-in (you can't get the same social experience elsewhere). When I speak to people who use Facebook they emphasize that last point: they use Facebook not because they particularly like it, but because that's where their friends, kids, grandchildren, grandparents, and distant relatives... pretty much everybody in their lives, can be located. And when they comment on why they don't have Google Plus accounts, or why they don't use their Google Plus accounts, it boils down to "I don't want to check multiple sites and a lot of my friends and relatives are only on Facebook."

Google understood that and, in launching Google Plus, made obvious the benefit of porting their Facebook information over to your Google Plus account. Facebook panicked and slammed the door shut, twice. Work-arounds appear to remain, but they involve more work than the typical user is going to do. History suggests that if Facebook sees a significant uptick in the number of users exploiting a work-around, it will shut off that avenue as well.

Meanwhile, Google has taken to talking about how its users own their own data, and has coined the term "data liberation". They have a dedicated engineering team focused on mak[ing] it easier for users to move their data in and out of Google products.

Users should be able to control the data they store in any of Google's products. Our team's goal is to make it easier to move data in and out.

At present, at least from a U.S. standpoint, pretty words, right? What are the odds that Congress is going to get in the way of Facebook's claiming to own your data. But then there's the E.U.

Key changes in the reform include:...

• People will have easier access to their own data and be able to transfer personal data from one service provider to another more easily (right to data portability). This will improve competition among services.

• A ‘right to be forgotten’ will help people better manage data protection risks online: people will be able to delete their data if there are no legitimate grounds for retaining it.

Google is, in a very real sense, using its present position of strength to its advantage. People are tied into Google for a range of functions that Facebook does not offer, and are unlikely to switch over even to one of Google's more direct rivals. But if they create an environment in which the users of other services (who, for the most part, already have Google accounts) can more easily break Facebook's lock and replicate their experience on Google Plus, over time Facebook's advantage will erode.

Facebook's cautious IPO suggests that they know their present weakness, and that investors understand it as well. There is no indication that Facebook needs the money it's going to raise through the IPO, unless "need" includes the desire of certain early investors to cash in. Facebook has managed to grow, support itself, acquire other companies, and sign up pretty much every easily attainable Internet user in the world without going public. Their $5 billion offer is "real money", but the odds seem pretty good that those shares will be snapped up by investors hoping that Facebook will become the next Apple or Google, investors who can afford to take the risk that they'll be more like MySpace or even pets.com. A larger offering would run the risk of quickly saturating that market, then establishing a void of demand for Facebook at its exceptionally high claimed valuation. There's a point at which investors start to weigh performance against potential, and the more weight you put on performance the less shiny Facebook looks.

I think it was pretty brilliant of Facebook to try to shift from being a social network to a platform, as evidenced by the fact that Zynga accounts for a huge percentage of its revenues - and an even larger portion, when you consider Facebook's profits from ads on Zynga pages. But for the platform aspect of Facebook, its present revenues would look pretty weak. But as people increasingly use portable devices, a platform in their own right, are they going to want to go through Facebook to access Zynga, or are they going to want to access Zynga games the way they access Angry Birds - through a standalone app? Zynga can as easily pay Apple a 30% commission on sales of virtual tractors (I'm sure Apple appreciates Facebook's setting that commission point), and can do even better through the Android platform - and Zynga's shareholders, no doubt, want to see it grow well beyond the walls of Facebook. Facebook's apps have been criticized as under-featured, but how do you create an app for use on a rival platform? If the app is good enough that people don't use your web interface, you're "just an app". And if you try to become a platform on a platform - "Load the Facebook app, then load additional apps through Facebook" - you're going to have difficulty replicating the experience of using a native app on the device in your user's hands.

Facebook has also done surprisingly well with advertising revenue, selling billions of dollars worth of ads to be viewed by people who aren't in consumer mode. But unless they can translate that into something along the lines of AdSense, such that their ads are placed on third party sites where people are in consumer mode, they seem to have a growth problem. Outside of China, pretty much everybody who is likely to be an active Facebook user is on Facebook, and Facebook is reluctant to try to enter China. Adding more nominal users doesn't generate revenue (or sell virtual tractors). How do you increase revenue per user without making your ads a huge money loser for advertisers?

What's the future of Facebook? Beyond noting that it's going to be around for many years to come - that if it fades it will face in the manner of MySpace or Yahoo, not in the manner of Pets.com - nobody knows. That's both a strength (as seen by its ability to hype up its valuation based on potential and the theory (echoing the first Internet bubble) that they'll find a way to generate huge revenues from their user base. If you have the money to gamble, and are in the investor class that is only looking for one in three of your investments to show significant returns, why not buy in? But if Facebook cannot hang onto the elements that lock people into its services, its being the only social service with your great aunt Marge and Farmville, the lock-in effect starts to fade. And with changes to its interface and privacy policy seemingly driven by a desire for profit, whatever its impact on the user experience, Facebook's drive to prove its exaggerated value could turn out to be what triggers its decline.

Investing in the Misunderstood

Fred Wilson has some words of advice for people looking for places to invest their money:

When people ask me, "how do you know which companies and services are going to be the biggest successes?", I usually tell them to look for the companies and services that are mocked and misunderstood. For some reason, that correlates highly with the biggest breakout successes.

That seems reasonable, to a point. If you see momentum toward a product or technology that "doesn't make sense to me", odds are you're missing something. And the more investors who say, "That doesn't make sense, so I'm not going to invest in it," the more opportunity there is for those who see its virtues, or don't see its virtues but trust in the wisdom of the crowd, to become early investors in a technology that may turn out to be the next big thing.

As a VC, Wilson has experience investing money in ventures that fail. So I don't want to read too much into his defense of Twitter, a phenomenal social success that has had great difficulty translating traffic into revenue.

For years, every post, column, or article written about Twitter would have comment after comment making fun of a service where people "told the world what they had for lunch." Of course, people were doing that on Twitter and people still do that on Twitter. But what those mocking Twitter were missing is that in between the tweets about pizza and pita were posts about politics and poetry. There was substance in the midst of nonsense.

I've commented on what I believe to be the primary attraction of Twitter, the illusion of close contact or relationships with other Twitter members, including celebrities. But whatever you make of Twitter, and even if you filter the wheat from the chaff so as to read about "politics and poetry" rather than "pizza and pita", it's difficult to see how that distinguishes Twitter from other technologies or starts it down the path toward profitability. Before the public's attention shifted to Twitter feeds and walls, the blogosphere was ridiculed for its superficiality - despite being full of good political commentary, poetry, and information of substance that in a Twitter feed would appear only as a link. Twitter is not a unique, stand-alone phenomenon, but is part of a progression of technologies that facilitate the public exchange of information. But is that enough to make it viable in the longer-term? It's an open question. The dot-com graveyard is full of good ideas that attracted traffic but made no money, as well as companies who did not find a way to monetize their ideas before they were copied and commoditized by others, and even of companies that briefly made money before being supplaced by something "newer and shinier" or swallowed by and incorporated into a larger company.

If I were investing millions in startups, and expected that only one in three of my investments would succeed, a company like Twitter might look like a good bet. Get in early enough and there's a possibility of making serious money when the company finds a way to turn its traffic into cash. Even if the company never figures out how to turn a profit, it may still be possible for it to go public and provide a huge return on my investment at that time. But as an individual, investing on a very different scale and with very different expectations, my first real chance to get in on a company like Twitter is after the IPO - and if you look at recent IPO's for similar companies, if you join the early rush to buy their stock on the promise or expectation that they'll eventually figure out a path to profitability you're apt to lose some money.

The Lifespan of Dot Coms

A while back I read an editorial that argued,

It appears to take about 10 to 15 years for technology to improve enough to make a new idea powerful enough to dislodge the incumbent money maker on the Web. To date, no one has been successful at turning around an Internet company that is past its peak.

I agree with that in part - it has proved to be very difficult to turn around a failing Internet company. But I disagree with the author's concept of the 10-15 year lifespan, or her reasoning behind asserting such a lifespan.

Consumer-oriented Internet companies are brought to life through the application of a new technology and then unseated about 10 years later by a newer technology. Yahoo had an incumbent advertising platform (display ads) that couldn't do advertising as well as Google search. Google today has an incumbent platform that can't do better than Facebook because Facebook began with a clean sheet of paper and an extra 10 years of technology.

But take a look at MySpace, "unable to turn itself around despite its first-mover advantage", and ask yourself whether that had more to do with outdated technology, or its acquisition by a company that didn't know what to do with it. For an example from much earlier in the life of the Internet, Yahoo! and Excite ran neck-in-neck until Excite was acquired by @Home Networks, and its subsequent tanking seemed to have a lot more to do with post-acquisition management decisions than with technology. I similarly find no merit in the notion that Facebook has an a technological advantage over Google - I suspect the opposite, particularly in relation to its core service of social networking - or that it's nascent advertising platform is going to be Google's undoing.

But as I see another dot com bubble emerge, with our being urged to believe that perennial money-losers like Angie's List, companies with no clear path to significant earnings like LinkedIn, or companies like Groupon and Facebook that respectively claim that their brand is so powerful that we can ignore their unprofitability or that their valuation is justified by their potential to develop new revenue streams from a large user base, I can't help but be reminded of the first dot com bubble.

First, the thing that makes Internet companies so attractive to investors or buyers (and here I'm speaking of VC's, angels and corporate acquisitions, not ordinary investors) seems to be the same thing that makes them vulnerable to collapse. You can start a dot com with a good idea, a tiny core staff, and a seven figure investment. You can create a company ostensibly worth billions that has (or rents) a server farm, and has a few hundred to a couple of thousand employees. But if what the company does is not special, or does not remain special, a competitor will have the opportunity to take most of its market share. When a genuine competitor is available, minor missteps by management can have serious consequences for the company's long-term viability.

Although it's an imperfect test, one interesting thing about companies like LinkedIn, Groupon, Facebook, Twitter and the like is how little disruption there would be if they dropped off the face of the planet. If you woke up tomorrow morning and you weren't an employee of Zynga, how much would your life change if you found that Facebook was gone? Minutes? Hours? If it would take you days, odds are you're either a major online marketer or you simply aren't invested enough in Facebook to take the time to set up, say, a Google Plus account.

Second, no company can survive in the long-term unless it has a path to profitability. If you want to roll the dice on the IPO of an unprofitable or barely profitable Internet company and you're not an insider, recent IPO's confirm that you should wait for the dust to settle as the share price is likely to drop significantly within days to weeks. Even then, you're evoking the expectations of the first dot com bubble - that "eyeballs" will translate to massive profits before the company burns through its cash and investor confidence wanes.

If an Internet company brings nothing special to the table, and barriers to entry remain low, and they lack either the vision or the capital to preempt a "new kid in town," it's reasonable to expect that they will eventually be replaced by a "cool new" alternative. And once your popularity tanks, no matter how cool you were the first time around, if you want to pull off a comeback you will probably need to rebrand.

Groupon Deal: Buy Early Shares for $10 and Get $50 Worth of Investor Money

That's not intended to be a literal expression of Groupon's business model or IPO, but as Frank Reed notes, early investors have been doing very well on their Groupon shares:

And remember when Groupon raised $950 million not so long ago? Guess what that did? It simply paid out the early investors in handsome sums. It did little to build the business. You can get the details in the All Things Digital post.

If history should teach us anything, it's that the financial industry loves bubbles. It loved the profits it made during the first Internet bubble. It was ecstatic over its profits during the housing bubble. And now, having been bailed out, pampered, and guaranteed immense profits and compensation at taxpayer expense on the ground that they're "too big to fail", why not do it again? Besides, a few IPO's that result in pumped up valuation, enormous, easy profits for early investors, insiders and investment banks, and... well, quite possibly not much for ordinary investors in the longer term, if that counts for anything... don't make for a bubble, do they? It's just a few hundred billion, maybe a trillion. Chump change.

I am of the impression that Groupon's founders want to build a sound, dominant business. But that doesn't mean they don't want to cash in. Is that the new economy? Build a $billion business, a $5 billion business, a $10 billion business, a remarkable accomplishment in itself, take it public at a ridiculously inflated valuation, the bankers, and investors and founders get rich beyond fabulously rich. As for the ordinary people left holding the stock? Sure, they may have paid $50 for $10 worth of company, but they got the exact number of shares that they paid for. Whose fault is that?

"Conventional Valuation Models Don't Apply to Us"

I recall, back in the days of the first Internet bubble, how the popular wisdom was that there was incredible value in "eyeballs" - the volume of traffic to your site, and information you might glean from your users, was far more important than turning a profit... or even generating revenue. As it turns out, although there have been innovations in how traffic and information can be monetized, it is important to generate that revenue.

I commented recently (and cynically) on the LinkedIn IPO, taking the position that the argument that the bankers put one over on LinkedIn's owners was a stretch. It seemed, and still seems, more symbiotic. LinkedIn, its owners and the investment bankers who handled the IPO made tons of money. Whether or not LinkedIn ever generates enough revenue to justify a tenth of its present valuation, its owners and early investors will walk away with truck loads of money. Meanwhile, the businesses of the nation's proverbial "Main Streets" have difficulty obtaining financing. Wow. There's less risk in floating a multi-billion dollar IPO for a business that has no clear plan or path to justify its valuation, than in investing in traditional brick and mortar businesses. There must be, because you can see for yourself what banks are doing.

Groupon plans to be the next business to clean up through an IPO:

The IPO, which could value Groupon at $15 billion to $20 billion, prompted Richard Brenner, president and CEO of financial-advisory firm The Brenner Group, to say that he would tell would-be investors to “sit out” the IPO because Groupon “doesn’t appear to have a sustainable business model yet.”

“Why would the public support a company that can’t figure out how to be profitable?” Brenner said.

But Mark Lehmann, a Wilmette native who heads up JMP Securities in San Francisco, said investors are clamoring for a long-awaited IPO by a company that shows such terrific growth.

“Groupon has the brand and the first-mover advantage, and it is extremely well-regarded,” Lehmann said.

Groupon came into business with a simple but clever idea, and its latest efforts suggest that it is capable of innovation. But this type of thing makes me nervous:

We don’t measure ourselves in conventional ways.

There are three main financial metrics that we track closely. First, we track gross profit, which we believe is the best proxy for the value we’re creating. Second, we measure free cash flow—there is no better metric for long-term financial stability. Finally, we use a third metric to measure our financial performance—Adjusted Consolidated Segment Operating Income, or Adjusted CSOI. This metric is our consolidated segment operating income before our new subscriber acquisition costs and certain non-cash charges; we think of it as our operating profitability before marketing costs incurred for long-term growth.

A more sophisticated explanation, certainly, but why does the phrase, "We make it up on volume" come to mind?

The Joke Will Be on Facebook Investors

Reid Hoffoman, one of the most sophisticated Internet investors in the nation, a major investor in Facebook and a principal in LinkedIn, took LinkedIn public. The outcome resembled some of the rip-offs of the first Internet boom, with the initial offering price of LinkedIn being far below its "market value" at the end of the day, and Joe Nocera is concered that LinkedIn may have been scammed.

The company had hired Morgan Stanley and Bank of America’s Merrill Lynch division to manage the I.P.O. process. After gauging market demand — which is what they’re paid to do — the investment bankers priced the shares at $45. The 7.84 million shares it sold raised $352 million for the company. For this, the bankers were paid 7 percent of the deal as their fee.... When LinkedIn’s shares started trading on the New York Stock Exchange, they opened not at $45, or anywhere near it. The opening price was $83 a share, some 84 percent higher than the I.P.O. price. By the time the clock had struck noon, the stock had vaulted to more than $120 a share, before settling down to $94.25 at the market’s close. The first-day gain was close to 110 percent....

The fact that the stock more than doubled on its first day of trading — something the investment bankers, with their fingers on the pulse of the market, absolutely must have known would happen — means that hundreds of millions of additional dollars that should have gone to LinkedIn wound up in the hands of investors that Morgan Stanley and Merrill Lynch wanted to do favors for. Most of those investors, I guarantee, sold the stock during the morning run-up. It’s the easiest money you can make on Wall Street.

Yes, it's a sweet way for insiders to make a quick buck. But the fact that LinkedIn could have raised more money doesn't mean that its insiders sold at $45 per share. And the low price will help major shareholders of Facebook reap huge profits if investors anticipate a similar run-up in price.

There's also a legitimate question of whether it's the job of the investment bank to value the company (even with a premium for investor hubris) at a value that has nothing to do with it's actual or potential fair market value, under the assumption that an appreciable number of investors are ready to repeat their experience investing in sites like pets.com. A company that made $16 million in profits last year producing, as best as I can see, a torrent of email notices that most members delete unread, now has a market capitalization of $8.8 billion dollars - and that valuation is significantly lower than its peak. Let's say it experiences 100% growth in profits, each and every year, for the next... century? Seriously, how is that valuation even slightly realistic? Facebook is reported to have earned between $400 and $500 million in profits last year with what, by all appearances, is a considerably more viable model for growth - should we expect it to have a market capitalization of $220 to $250 billion?

Really, I think this was less about LinkedIn being cheated and more about setting up the next round of suckers in the "social network IPO" scheme. I recognize that some people say that the LinkedIn IPO won't affect the timing of a Facebook IPO, and (yes) among them are many who care far more than I about the markets and investment, but I suspect otherwise. When you see this much investor hubris, this much disregard of profitability, this much willingness to gamble, you would be pretty foolish to sit on your hands. Realistically speaking, LinkedIn is going to continue to decline in value, and you'll be wanting to get your own shares sold before investors start to association that deflation with the value of social networks in general.

Ordinary People Retreat From the Casino

The Times informs us,

Renewed economic uncertainty is testing Americans’ generation-long love affair with the stock market.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.

But wait a minute. Aren't these the same people who were sold mutual funds because they're "professionally managed," and that by having their money pooled and used to buy a diverse portfolio of securities they could reduce their risk? That they could select from different funds that offered different levels of risk (and ostensibly return) so as to plan for the future with a reasonable level of financial security?

How many of them have seen their financial advisers and mutual fund managers profit even as their investments have tanked? Or have seen their investments decline while the executives of the companies in the (declining) portfolios of their mutual funds pay themselves like the hereditary heirs of a banana republic?

Maybe people aren't so much "pulling back from risk" as they are recoiling at being ripped off.

Investors pulled $19.1 billion from domestic equity funds in May, the largest outflow since the height of the financial crisis in October 2008.

Over all, investors pulled $151.4 billion out of stock market mutual funds in 2008. But at that time the market was tanking in shocking fashion. The surprise this time around is that Americans are withdrawing money even when share prices are rallying.

Surprising? Perhaps they're cashing out their retirement accounts, despite financial penalties, in order to pay bills.

Compensation Limits on a Government Giveaway?

In keeping with its long pattern of unnecessarily granting anonymity, often in violation of its own policies, the New York Times recites,

But some executives at private equity firms and hedge funds, who were briefed on the plan Sunday afternoon, are anxious about the recent uproar over millions of dollars in bonus payments made to executives of the American International Group.

Some of them have told administration officials that they would participate only if the government guaranteed that it would not set compensation limits on the firms, according to people briefed on the conversations. The executives also expressed worries about whether disclosure and governance rules could be added retroactively to the program by Congress, these people said.

The easy reply to that is, "Okay then, don't participate." But let's think for a moment - why would this even be a concern? They're entering the program as investors not employees, right?

Well, sort of.

They're barely investing. The plan is overwhelmingly generous, and we may be looking at an "investment" of only $3 for ever $97 in taxpayer money put on the line. Picture the moral hazard:

• The "investor", with its comparatively minimal contribution and vast quantities of federal money in the form of non-recourse loans, snaps up a bunch of securities.

• Based upon its profitable investments, the investor draws out the maximum return allowed under the plan, keeping its stake in the plan to an absolute minimum.

• Within a year or two, it becomes apparent that they overpaid for most of the securities, and their investment is a long-term disaster.

• Once they've recouped their investment, perhaps also taking a reasonable return on their actual stake, they walk away and leave taxpayers with the mess.

Taxpayers at that point might cry, "Foul!" The investor would have increased our exposure by overbidding for securities, so why should he be allowed to draw out billions of dollars while costing taxpayers many times that amount?

Is "Because otherwise he wouldn't have 'invested'" an adequate response?
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Update: Krugman's done the math. I'll defer to his numbers not only because he's, you know, a Nobel Prize-winning economist, but because he's actually done the math. ;-)