Both Groupon and Zynga are slowly stumbling toward their initial public offerings. But don't feel sorry for either company - it's largely their own fault.
The Groupon and Zynga offerings were to have been the event of the fall I.P.O. market. Both companies were expected to make their debuts to fat valuations and large stock price run-ups reminiscent of the Internet boom.
Instead, both have been delayed, and in a much more volatile market, their expected values are starting to drop.
Groupon has struggled more than Zynga. Groupon filed for an I.P.O. in early June. The filing revealed some extraordinary numbers. In two and a half years, Groupon had grown from nothing to $645 million in revenue in the first quarter of 2011. This was amazing growth, but Groupon's costs were also astronomical. In 2010, Groupon spent $263 million on marketing and lost $456 million. In the first quarter of 2011, Groupon disclosed that it spent roughly $208 million on marketing and lost $146.5 million. Apparently, it takes a lot of money to make a deal.
In the filing, Groupon's chief executive, Andrew Mason, asked prospective shareholders to put these numbers into perspective by using a novel accounting metric: adjusted consolidated segment operating income. This measure subtracted hundreds of millions from online marketing and acquisition costs from operating performance. If used, Groupon's results were strongly positive. With this metric, Groupon had income of $81.6 million in the first quarter of 2011.
While the accounting metric seemed to turn lead into gold, the response was negative. A number of commentators called the metric "income before expenses." Groupon was polishing its numbers by simply taking out things that cost a lot. How could that be a valuable measure of the company's worth?
Groupon's revenue numbers also raised questions. In its initial filing, Groupon included payments to third-party merchants for the goods purchased. The result was to double Groupon's revenue. But this appeared to count as revenue something that Groupon never earned.
Groupon has subsequently backed down from both the accounting metric and the revenue measure. The result: In Groupon's latest filing, revenue for 2010 declined to about $313 million from $713 million. Groupon's revenue for the first half of 2011 declined even more, to $688 million from $1.5 billion. Groupon also erased all references to the accounting metric in its revised filing, leaving only Groupon's enormous marketing expenses of $432 million in the first half of 2011.
Groupon has refused to give up. It now asks shareholders to focus on Groupon's free cash flow, which was about $36.8 million in the first half of 2011 as well as a new measurement, the consolidated operating income for the company. This number excludes Groupon's acquisition-related costs and stock-based compensation expenses. Using this number, Groupon's loss in the first half of 2011 declined to $160.6 million, from $254 million.
While Groupon's accounting maneuvers would most likely have delayed its I.P.O anyway, Mr. Mason ensured a longer delay. On Aug. 25, he sent an e-mail to Groupon's employees, defending the company and the accounting metric. He heatedly defended Groupon's performance, noting its positive cash flow and that it was experiencing "unprecedented growth."
This type of communication arguably violates the mandatory quiet period for an I.P.O., when companies are not permitted to promote their stock. The Securities and Exchange Commission appears to have responded, forcing a delay of the Groupon I.P.O.
Like Groupon, Zynga has also been caught up in using accounting metrics to show that high growth trumps low (or no) profits. In Zynga's case, the company wants investors to focus on a Zynga-created metric that follows average daily users and average daily bookings (or revenue) per daily user. Not surprisingly, at the time of Zynga's filingthis figure was heading way up. Zynga had 62 million average daily users in the first quarter of 2011, compared with 24 million in the same quarter in 2009. These users spent roughly $287 million in the first quarter of 2011.
The S.E.C. is no doubt carefully reviewing these new Zyngametrics.
Zynga's second-quarter numbers subsequently showed that its performance was weakening, though this may be in part a result of the release of only one major game, Empires and Allies, in the first half of the year. Zynga's bookings declined to $275 million, from $287 million, while average daily users were down by almost 5 percent. Upon announcing these numbers, Zynga also announced an accounting change: the estimated life of its virtual goods (yes, they have a life) was cut to 11 months from 14 months. The consequence was to add $27 million in revenue to Zynga and turn what would have been a second-quarter loss of a few million dollars into a $1.4 million profit. The change also put Zynga on a course to have $1 billion in revenue this year.
Zynga has also proposed a very aggressive ownership structure. Zynga's founder and chief executive, Mark Pincus, will receive shares that have 70 votes apiece, Zynga'sventure capital shareholders and Zynga employees will have shares with seven votes apiece, and ordinary shareholders will be able only to purchase shares with one vote each. This maneuver effectively disenfranchises shareholders and puts control of the company with Mr. Pincus for as long as he wishes.
Groupon will also issue high vote shares to its insiders, keeping its founders in control.
After pushing the envelope when it comes to accounting and corporate governance, it's no wonder that neither Groupon nor Zynga has been able to get an I.P.O. off the ground.
Would either company try to play with its numbers so much with its own private investors? Would these investors have accepted a governance structure that put control in the founders' hands when the company was private? In either case, the answer is likely no.
By turning accounting principles into Grouponomics and Zyngametrics, the companies have shown the value of the S.E.C.'s review of I.P.O documents. While that review can be at times burdensome, pushing companies to conform to accounting principles is a cornerstone of good capital markets. Similar accounting standards allows us to compare apples to apples. And given how malleable accounting can be, the S.E.C. is needed to enforce the rules.
The experiences of Groupon and Zynga also illustrate how hype can obscure fundamentals. In the midst of an investing frenzy, principles of good governance and accounting are often ignored.
Unfortunately for both Groupon and Zynga, the delay occurred at a time of market turmoil. While both are likely to still have successful I.P.O.'s, they may not be extraordinary. But Groupon and Zynga don't have any reason to complain. It is partly their fault.