Silicon Valley's social tech formula doesn't add up

Open...And Shut In technology, as in other industries, only a few companies make it to the top. The rest get bought by the successful few, or go out of business. Unfortunately, the formula for tech seems to be a bit askew at the moment, with heavyweights Zynga and Groupon both on the ropes.

If these supposedly successful companies can't buy the up-and-comers, and the IPO market doesn't seriously heat up, what will happen to Silicon Valley's social start-up population?

For those who missed the news, Groupon has been furiously backpedaling ever since it filed to go public. Most recently, the company was forced to restate its earnings, cutting its 2010 sales number in half to $312.9 million. 2011 revenue was also cut in half.

With the publication of its IPO filing we also had a peek into how Groupon's financials could be off. In the filing we discovered something called "adjusted consolidated segment operating income" that Groupon said it's using because "we don't measure ourselves in conventional ways". The company then revised this, slightly.

Since then, head of operations Margo Georgiadis has hit the Eject button and coasted back to greener pastures at her previous employer Google.

If only Groupon were alone in this. Zynga, while not guilty of the same creative math and while it can actually boast profitability, its numbers have been getting worse as it nears its IPO, not better. Much worse, as Business Insider points out. Zynga's profits have cratered 90 per cent over the past year, giving pause to euphoria about its ability to sell virtual goods for real cash.

More worrying, however, is the fact that Zynga's total active users have been flat for the past year. This, despite acquiring game developers in an attempt to raise the number of users playing Zynga games. Only 10 per cent of Zynga gamers are new, suggesting that Zynga is really struggling to get new users into the fold. Once it has them there, however, Zynga's user engagement numbers look quite good.

In response, Zynga is actively trying to broaden its reach beyond Facebook, most recently closing a deal with Google to put its popular CityVille game on the Google+ platform. Whether it works is anyone's guess at this point.

What seems more certain is that Zynga and Groupon are less likely to be able to splash cash on start-ups. The same may also be true of LinkedIn, whose shares are well off their high-flying opening IPO price. These social startups-turned-giants were supposed to usher in the next wave of Silicon Valley riches, but they're increasingly looking vulnerable. So is the IPO market, with 2011 challenging 2008 as the worst year for IPOs, ever.

So what is an aspiring social software entrepreneur supposed to do?

Well, you could of course consider selling to Facebook or Google. Many do. But not everyone can.

For those that are either more ambitious or simply not as lucky, the only road forward may be to build a robust business. This is, of course, what any entrepreneur should be aspiring to do, anyway, but if you've taken a look at the recent crop of social start-ups, it's hard to believe they look themselves in the mirror and say with a straight face that they think they're building a billion-dollar business. And it's not clear that social business models work at modest scale, anyway. Facebook is a fantastic business, but it has the benefit of 800 million users.

At best, then, many social start-ups may be relegated to building features that a Facebook or Groupon might want. Or not. And if the answer is "not," they either need to build a big business or find a good attorney to wind down the company.

Indeed, this may be the likely fallout from the stumblings of Groupon and Zynga: there is no middle ground success. This is particularly true in social, when network effects ensure that you either dominate or exit. Google is up against this phenomenon now, challenging Facebook with Google+ but struggling to keep users engaged when they're largely alone among their friends to be using the service.

With fewer successful social companies, there are fewer potential buyers to give shareholders a healthy but not overwhelming $100m to $200m exit. Unfortunately, there is even less chance to IPO in the current market. Most unfortunately still, with few proven business models in social, except at massive scale, it's unclear that social start-ups are going to be able to go it alone. But at least they won't be alone. ®

Matt Asay is senior vice president of business development at Strobe, a startup that offers an open source framework for building mobile apps. He was formerly chief operating officer of Ubuntu commercial operation Canonical. With more than a decade spent in open source, Asay served as Alfresco's general manager for the Americas and vice president of business development, and he helped put Novell on its open source track. Asay is an emeritus board member of the Open Source Initiative (OSI). His column, Open...and Shut, appears twice a week on The Register.