Digg: No Money, No Problems

In an article entitled “A Wrench in Silicon Valley’s Wealth Machine”, BusinessWeek reports that financial statements it reviewed for Digg indicate that the circle jerk social news aggregator lost $2.8 million on $4.8 million in revenue in 2007 and lost $4 million on $6.4 million in the first three quarters of 2008.

Not very impressive.

Quite telling: the numbers even caught Web 2.0 smoke-blower Michael Arrington off guard. The man who once wrote “The reason Digg is, and will continue to be, successful is because of the community it has created” and who just months ago commented that Digg’s rumored ~$175 million valuation in its last financing round “seems about right for the company” called Digg’s revenue “sorry” and stated “Digg shouldn’t be losing money.”

Based on the opinions of unnamed experts. he argues that Digg could get away with “no more than 15 engineers”; apparently “most” of Digg’s 70 employees are in product development and engineering and Digg’s headcount will bloat to 150 employees next year. Arrington thus comes to the brilliant conclusion that “they [chose] to lose $5 million or more this year” and “if I were Digg I’d be thinking a lot about revenue.”

Isn’t that brilliant?

Fortunately, Digg’s investors and management seem to share Arrington’s brilliance. According to Digg’s CEO Jay Adelson, “All I care about is making sure the business foundation is solid.”

That’s when he’s not drinking wine with beautiful women, as depicted in the photo above, of course.

Back to reality. Adelson and Digg founder Kevin Rose have basically partied the past several years away and all the while, Digg has been losing money. Not surprisingly, the company continues to do so – losses are growing almost as fast as revenue, indicating that scaling is proceeding perfectly along the path detailed in the book “How to Drive a Business into the Ground for Dummies.”

Adelson’s renewed focus on “making sure the business foundation is solid” couldn’t have come at a worse time: the foundations of the global economy have faltered and now companies like Digg find themselves in perhaps the worst economic environment since the Great Depression. And advertising-based consumer Internet startups that still don’t accept this should just wait until 2009, when advertiser budget cuts will be felt by many for the first time.

Of course, Digg has an advertising relationship with Microsoft that guarantees it certain payments, which serves as a buffer between economic reality and Silicon Valley delusions. As Valleywag notes, “Without that arrangement, struck last year — driven, most believe, by Microsoft executives’ desperation to get in on the Web 2.0 craze — Digg’s losses would likely be far worse.”

While Microsoft’s stupidity might give Digg a reprieve for the time being, good things don’t last forever and Digg’s situation highlights what I’ve been arguing for more than two years now under the pseudonym Drama 2.0: a business has to make dollars to make sense.

Clearly the management at Digg is starting to realize this; BusinessWeek reports that “Digg is dialing back some expansion plans and trying to reach profitability as soon as possible.”

As soon as possible, huh? Digg has been around for more than four years. What’s four years in Internet time? About 50 launch parties, 30 conferences and 7 TechCrunch get-togethers. In other words, four years in Silicon Valley time is an eternity in hell for a regular person.

Frankly, I think the question has to be asked: is it all too little, too late for companies like Digg? Are Adelson’s words as meaningful as the words of GM CEO Rick Wagoner? After all, both Adelson and Wagoner talk about turning their businesses around but they’re the very individuals who presided over a strategy that mortgaged the futures of those companies when times were better.

Venture capitalist David Sze of Greylock Partners, who invested in Digg and who sits on the company’s board of directors, is in the “everything is honky dory” camp. Despite acknowledging that Digg’s valuation today (to any potential buyer) would probably be lower than the one he gave the company earlier in the year, Sze isn’t worried. He states, “If you have the cash and are building a good business and can get to breakeven in a reasonable time, this is where you make hay.”

Unfortunately, most of us aren’t interested in hay. We’re interested in making cash.

Frankly, I believe Sze is as clueless as Adelson, who told BusinessWeek, “We know [that] if we are a profitable business, then the valuation will ultimately follow.”

Note to Sze and Adelson: reaching profitability doesn’t instantly give you the ability to “flip” your company for more than it’s worth. While you might treat profitability as some sort of rare state of existence on par with nirvana, profitability is a state of existence known by many businesses.

Is a company instantly worth hundreds of millions of dollars because it’s profitable? Of course not. Profitability doesn’t justify insane valuations. Valuations, by definition, are designed to place dollar values on businesses that accurately reflect their potential to generate profit. Therefore, profitability simply permits more accurate valuations. Valuations that are based less on speculation of profit potential and more on realized profit potential.

So where does Digg stand valuation-wise?

BusinessWeek reports that Digg’s last round of funding gave it a valuation of $167 million. Obviously Digg’s financiers need a multiple of that to walk away with a happy ending, meaning that Digg has to sell for several hundred million dollars. Major companies, including News Corp. and Google, have already reportedly passed on Digg at such exorbitant valuations and I think there’s a decent chance that when the global economy recovers (which could very well be on the order of years), many big companies will be a little less eager to be as open with their bank accounts as Julia Allison is with her legs.

The reason? This economic meltdown has reminded major companies of an important fact: cash is always king. While some publicly-traded companies with strong cash positions were pressured during boom times to invest that cash aggressively, the downturn has demonstrated that acting prudently with cash positions is wise. Investing it too aggressively or blowing it on speculative acquisitions that don’t add much to market share (and more importantly the bottom line) is foolish.

The question thus becomes: even if Digg managed to double its revenue next year and turn a small profit, would you buy it for $300 million?

Unless you’re stupid, the answer is: of course not. You’d have to be dumb, deaf and blind to trade hundreds of millions of dollars for a four year-old business that turns a marginal profit after 8 figures worth of investment.

Fortunately, for Digg and its management, no money means no problems. Kevin Rose and Jay Adelson can continue partying like it’s 1999 because they don’t have to deal with all the shit that making money entails.

After all, when your company isn’t turning a profit, you don’t have to worry that much about tax strategy. And when your stock is illiquid (hence: worthless) you don’t have to worry about your paper (read: illusory) wealth attracting all sorts of drama. If Kevin Rose thought dealing with Julia Allison was bad, he’d be horrified if he actually had $60 million in the bank.

Perhaps this is why so many of the consumer Internet startups created in Silicon Valley over the past several years seem to be perpetual money-losers: nobody involved with them wants to deal with all the hassles of profitability.

So I’ll close this post with some advice from a man whose companies are turning a profit to those whose companies are losing money: keep doing what you’re doing. Mo’ money means mo’ problems and you’re far too busy “innovating” for that. Leave the problems to us professionals. Being profitable is a tough job but somebody’s gotta do it.