Debt woes weigh on Foursquare

Debt financing can be great for established companies with proven business models and strong cash flow, but for a tech startup with a monthly burn rate that is at least equal to annual revenue, taking on loans is less than ideal.

For this reason, the recent round of fundraising by Foursquare Labs Inc. raised some eyebrows in the venture capital community. Instead of raising money by selling a share in itself, the social media company announced in an April 11 blog by founder Dennis Crowley that it had raised $41 million through a combination of debt from new investor Silver Lake Waterman and convertible debt from its existing investors.

Generally, going into debt is not a good sign for a late-stage startup, and at least one private company analyst said it does not bode well for the future.

"Essentially, the money was a stay of execution, but they're still on death row," said Sam Hamadeh, founder and CEO of research company PrivCo.

In January, PrivCo predicted that Foursquare would fail by the end of the year and that its investors would end up pulling out after losing money. While this funding will provide enough liquidity for Foursquare to make it through the end of the year, the overall thesis remains intact, according to Hamadeh. A lack of revenue and the failure of Foursquare to create enough traffic to attract the necessary interest and corresponding advertising dollars from companies spells trouble.

Foursquare chose not to release specific details on the debt funding, but the numbers circulating among the VC community put Silver Lake's loan in the $20 million range with the rest of the capital infusion coming from existing investors.

Hamadeh said this was not necessarily a typical investment for Silver Lake but that the private equity firm's venture debt fund is relatively new. PrivCo said that based on statistics compiled from similar venture debt financing, the typical structure for this type of loan has a five-year term and a 14% to 17% interest rate as well as additional warrants on the borrower's equity, with a strike price equal to the lender's assessment of the borrower's fair equity value at the time of the loan with a 10-year warrant expiration date.

A Foursquare spokesman said the company was declining to release additional details on the debt financing other than what Crowley stated in his blog post. However, it would appear that the reason the company took the debt financing came down to valuation. The company was last valued north of $700 million when Spark Capital bought stock in early 2012, according to The Wall Street Journal.

However, times have changed. Even in the shadow of Facebook Inc. buying social media company Instagram Inc. for $1 billion, it is unlikely the valuation would be close to that now. The Foursquare app was originally released as something of a game, allowing users to check in at places and alerting friends while earning badges and sometimes discounts from companies for check-ins. However, there wasn't much money in that. Foursquare has worked on signing up advertisers and seems to be focusing on that business model now, but the money hasn't exactly been pouring in.

People in the VC community generally agree that the company saw only $2 million in revenue last year while seeing a burn rate of $2 million per month. These kinds of numbers make it difficult to justify a valuation in the high hundreds of millions of dollars.

"Essentially what they're saying is that any valuation that would have made sense now would have been massively dilutive," Hamadeh explained. "They kind of dodged it by finally just taking debt funding."

That assessment rings true based on a blog by Fred Wilson, a principle at Union Square Ventures, one of the existing Foursquare investors that led the convertible debt. He wrote that convertible debt was the "optimal structure" at this point as any kind of equity stake would have ended up being immediately dilutive. It didn't appear Union Square wanted to be responsible for putting any kind of value on the late-stage startup right now.

"We get the comfort of knowing that eventually our investment will become equity and we will not have to price it," Wilson wrote. "Someone else will."

Hamadeh said this kind of deal is slightly out of the ordinary for a company in Foursquare's stage of development.

"This isn't a totally unusual structure, but it's usually used for early stage companies," Hamadeh said.

Despite a lack of love from the investing community, the company has developed some loyal fans in the tech community such as Om Malik, founder of business and technology news site Gigaom and a venture partner at True Ventures. Following the fundraising announcement, he wrote on Twitter that he loves Foursquare "more than Yelp or any other service" and that he wants it to be around forever.

For this to happen, the company will need to start turning that love into advertising dollars. Sadly, great products don't always lead to great revenue generation.

As further evidence of Foursquare's popularity, the company reports users have checked in more than 3.5 billion times since its inception. The problem has been converting this activity into revenue.

Revenue numbers from other social media sites tower over those from Foursquare. For instance, Facebook clocked in with approximately $470 million of mobile app advertising revenue alone in 2012, according to its 10-K, which said mobile advertising accounted for 11% of its $4.3 billion advertising revenue. However, mobile advertising for Facebook looks to be climbing. In Q4 2012, it accounted for 23% of the company's $1.3 billion in advertising revenue to total almost $306 million.

According to research organization Canalys, mobile app revenue grew 9% in the first quarter of 2013 versus the fourth quarter of 2012, reaching $2.2 billion before revenue sharing. This increase was accomplished through app download growth of 11% quarter-over-quarter for a total of 13.4 billion downloads.

Clark Fredricksen, a vice president at research firm eMarketer, said Foursquare needs to prove that they can make money and that they can grow their user base.

"At the moment, they haven't made a compelling argument for a broad swath of consumers to use their services," Fredricksen said.

Foursquare is working on changing that perception. This month the company launched a major update to its iPhone app, which made it more like the Android version. The company hopes this improvement will help make the app more than a game to its users and become indispensible to people looking to discover local businesses. That, in turn, would give companies a reason to pay for advertising and start generating the long-awaited revenue.

Still, Fredricksen said company officials need to prove that they can make money and expand the user base -- and it needs to happen sooner rather than later.

"Whatever the silver bullet is, I think they need to find it fast," Fredricksen said.

Hamadeh added that Foursquare was hiring 30 salespeople in an effort to jumpstart the company. If it can't start selling the services, then he said the investors will be forced either to put the company up for sale quietly or to sell it to a portfolio company for stock to keep the valuation from getting out -- meaning his overall view on the company hadn't changed from the start of the year.

"My prediction stands that the VCs will seek an honorable exit," Hamadeh said.