Analysis of Yelp S-1: An illustration of how investors look for weaknesses in investment pitches

By November 22, 2011 One Comment

Yelp filed it’s S-1 last week in preparation for an IPO next year, and yesterday Rocky Agrawal, wrote on Venturebeat about the company’s strengths and weaknesses as an investment prospect.  Rocky describes himself as a fan of Yelp as a consumer (he was one of the early adopters in 2006 and used to email the CEO with product suggestions) but his analysis is nicely balanced.

Rocky cites a number of strengths in the business (deep review content, the most up to date business listings, highly engaged local communities, clever community management, high percentage of revenues from independent businesses), and I also think that Yelp is a strong company – growing revenues from $12.1m in 2008 to $47.7m in 2010 and $58.4m in the first nine months of this year is no mean feat.

That said, for the rest of this post I’m going to focus on the weaknesses in Yelp’s investment pitch that Rocky highlights.  Investors have to look for the weaknesses in a company’s pitch, we start with the strengths, but the weaknesses come next – one significant flaw is enough to sink an otherwise excellent company. 

I think Rocky’s points are a good illustration of the way that investors look for the ways that companies might go wrong and that anyone who is about to embark on the fundraising trail would do well to make a similar analysis of their own business, both to improve their pitch and prepare for investors questions.  This is not intended to be an exhaustive analysis of Yelp, and there are many things that aren’t considered – not least valuation.

(Investors look first for the strengths in a company, but after that we have to look for the weaknesses.  One significant flaw is enough to sink an otherwise excellent company.)

First off, Rocky lists two areas in which Yelp’s presentation of data is either incomplete or misleading:

  • The S-1 contains a pie chart (inset right) which shows the breakdown of reviewed businesses by category, of which 23% are restaurants.  That’s interesting, but the split of reviews by category would give a much more accurate picture of the business.  That would show a much higher percentage in the restaurant category where the number of reviews per business is much greater.  This question is important because the extent to which Yelp is ‘just a restaurant site’ is critical to estimates of its market size and medium term revenue prospects.
  • No data on the cost of acquiring merchants to the platform or what the churn rate is.  From the perspective of a venture investment (which is different from an IPO) a clear understanding of the unit economics is key to understanding whether the business is ready to scale and are worth getting in the first investor deck.  I would even argue that if the unit economics aren’t clear or in good enough shape then the best thing might be to put off raising money until they are, or at least keep the size of the fundraise to a minimum.

Second, he draws a perhaps unexpected unfavourable conclusion from some of the data that is presented (note that if you want a positive and trusting relationship with your investor the right thing to do here is to answer the question raised, not take the data out and hope that nobody asks for it):

Low-hanging fruit
One of my biggest concerns about Yelp’s model is that the company seems to have already picked the low-hanging fruit. As you would expect, Yelp started with larger metro areas and has filled in smaller markets over the years. It’s S-1 is honest on this point:

Although our revenues have grown rapidly, increasing from $12.1 million in 2008, to $47.7 million in 2010, we expect that our revenue growth rate will decline in the future.

Cohort data showing how various groups of markets have performed starkly illustrate this. The earliest cities, including San Francisco, New York and Chicago, generated $4 million per market year to date. For the 2007-2008 cohort, which includes Portland, Dallas and Miami, revenue drops to $761,000 per market.

And finally he raises a question about the business model:

Yelp’s S-1 shows what we’ve known all along about the small business market: it’s a really, really tough business. Getting and keeping small business advertisers is difficult and expensive.

Groupon touts a “no risk” model. In reality, it’s a “no money down” model. There is plenty of risk, it’s just hidden. Yelp sells its product as a media buy. It turns out that when you’re upfront about what you’re selling and how much it costs, it’s harder to get people to buy.

I like what Rocky has done here because it is balanced and thoughtful.  Like most VCs who get serious about investing in a company he starts from a positive position and then looks for the holes in the investment case, the only difference is the motivation, which in Rocky’s case the motivation is to write a piece of analysis, but for VCs is to make sure their investment thesis is sound.