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Investors see e-commerce startups as overvalued

– As e-commerce companies prepare for the remainder of the holiday season, their investors are in the market for some discounts.

Fab Inc., a marketplace for luxury wares founded last year, raised money at a lower valuation than it had sought after watching Facebook’s stock plummet. Flash-sale site Gilt Groupe and subscription retailers BeachMint and ShoeDazzle.com are bracing for an increasingly competitive climate after funding rounds in the past 18 months.

After pouring more money into retail startups in the third quarter than in any period since the dot-com bust in 2000, venture capitalists concerned over the formation of an e-commerce bubble are balking at deals they consider overpriced.

The valuations in recent funding rounds and executive exits suggest investors are no longer willing to sink cash into online stores that don’t have proven growth prospects.

“There were definitely some inflated valuations chasing e-commerce,” said former eBay executive Dana Stalder, a partner at Matrix Partners, which has backed fashion startups Gilt Groupe and Just Fabulous.

“They’re complex businesses to run. They generally are capital-intensive, have low margins, and therefore the exit multiples are typically one to two times revenue.”

Inventory and shipping costs make new businesses hard to build, and those that do attract shoppers can quickly fall prey to clones. That makes it tough for new companies to vie with stalwarts such as eBay and Amazon.com in the $226 billion online retail market.

The froth means later-stage backers may be poised for losses, like those who made costly bets on Facebook, Zynga and Groupon. And it can hurt returns for venture investors and jeopardize future fundraising.

Promising growth

Until last year, e-commerce businesses had spent a decade struggling to attract capital, because venture backers were having more success with Internet advertising, business software and Web analytics.

Those markets have more potential acquirers and command higher multiples than e-commerce. Web companies Google, Yahoo, Priceline.com and Facebook all trade for at least four times revenue.

Amazon paid no more than about two to three times sales when it bought online shoe peddler Zappos.com in 2009, and again when the retailer last year purchased Quidsi, the company behind Soap.com and Diapers.com.

But e-commerce is changing. More recent startups are chasing shoppers with flash sales, customized apparel and subscription services – all pushed to consumers on smartphones and via social-media sites.

They use Facebook, Twitter and Pinterest to gain fans, communicate with customers and promote products. Tablets and smartphones make shopping more convenient, while advanced analytics tools enable more targeted promotions.

E-commerce made up 4.9 percent of U.S. retail sales in the third quarter, according to the Department of Commerce. Online sales will surge 45 percent to $327 billion in the U.S. in 2016 from $226 billion last year, estimates Forrester Research.

So, expecting dollars to keep flowing to the Web, investors turned bullish last year and stayed that way through September. Venture investing in online retail doubled in the third quarter from a year earlier to $242.1 million, according to the National Venture Capital Association. That’s more than venture backers committed in all of 2010.

“We’ve seen more disruptive ideas in e-commerce in the last two to three years, and more innovation than in the 10 years before that,” said Josh Kopelman, a partner at First Round Capital in Philadelphia, which previously founded Internet retailer Half.com. “Mobile and tablets are changing the methodology of how people shop online.”

Reality check

But the recent Fab deal suggests investors may be pulling back.

Fab has surged in popularity by integrating with Facebook and allowing users to see what their friends are buying. It now boasts 9 million members in 26 countries.

In July, the New York retailer raised $105 million, led by London-based Atomico. Chief Executive Officer Jason Goldberg said he had planned to close the deal at a $700 million valuation. Fab is on track to post $150 million in sales this year, Goldberg said.

However, in late June, a month after Facebook’s IPO, he sent an email to existing investors, including Andreessen Horowitz and Menlo Ventures, saying he was lowering the valuation to $600 million.

“I did not take the highest valuation offer, and I also made sure that our investors all thought they were investing at a fair and appropriate valuation,” Goldberg said in an email to Bloomberg.

Some investors, who asked not to be named, said they passed on the round because they thought it was too expensive.

Nevertheless, Andreessen Horowitz, which invested in Fab’s last two rounds, is still betting on the industry. The Menlo Park, Calif., firm led an $85 million investment last week in Zulily Inc., a daily-deal site for moms. Jeff Jordan, a partner at the firm and former eBay executive, called it “one of the fastest-growing businesses we’ve ever encountered.”

And eyeware maker Warby Parker, also based in New York, raised $36.8 million in September. That valued the company, which sells eyeglasses online and at some retail locations, at about 10 times revenue, according to a person familiar with the fundraising. Investors were attracted by the company’s gross margin of 50 percent, the person said, or twice Amazon’s profitability.

But high margins and valuations often aren’t sustainable, said Alfred Lin, a partner at Sequoia Capital, who previously ran operations and finance at Zappos. Since joining Sequoia in 2010, he’s mostly steered clear of e-commerce.

“We certainly have discussed e-commerce in partner meetings,” Lin said. “We’ve gotten to the point where we were doing due diligence and were interested in investing, but valuations have taken over at levels that we think are not sustainable.”

Battery Ventures has the same idea. General Partner Brian O’Malley has led investments in men’s clothing maker J.Hilburn, subscription flower-delivery service H.Bloom and home furnishings seller Serena & Lily. But he’s declining to invest in most new deals because prices are too high.

“Some of these businesses are going after really large markets,” he said. “I’m not bullish on all the companies, and I’m not bullish on all the prices people are paying to get into these companies.”

While the economy is ripe for some emerging companies to succeed, bad bets at irrational valuations will hurt the whole market, said Kirsten Green, a former retail equity analyst who raised a $40 million fund at Forerunner Ventures in July to make early bets in digital commerce.

“I would much prefer that people keep their heads on straight,” Green said.

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