Daily Tech Snippet: Wednesday, September 23

• The Risk of a Billion-Dollar Valuation in Silicon Valley: Deep inside a Silicon Valley unicorn lurks a time bomb. It is a peculiarity of venture capital financing that the engine that pumps money into a promising start-up can later cause the same start-up to self-destruct. With all the hoopla and debate over sky-high valuations of technology start-ups, it is worth keeping in mind that the switch that helps to drive those surging valuations can also be turned off. The “bomb,” so to speak, is known as a liquidation preference. In every financing round, the money that a venture capital firm invests is not given freely. The firm and the start-up will negotiate terms of protection. Negotiable terms include voting rights, seats on the start-up’s board and assurances that a future fund-raising won’t unduly dilute the venture capital firms’ stake. The liquidation preference is among the most important of these protections. This feature provides that the venture capital firm’s investment will be repaid before the founders and employees are rewarded. If the firm has particular leverage, it can negotiate an even more protective form, known as the senior liquidation preference, which provides that the firm will be paid not only before the common stockholders but also before anyone else who bought preferred stock in earlier rounds. These provisions apply in a sale but not in an initial public offering of stock. The idea is to ensure that even if the investment does not perform well, the venture investor will still get back its initial money. According to a recent survey by the law firm Fenwick & West of 37 unicorns — private companies with valuations of $1 billion or more — every investment had a liquidation preference. Higher valuations create higher expectations, and failure to meet them can set off a downward spiral and a forced sale. In that event, the venture capitalists are paid first, leaving “unicorpses” in their wake and the founders with nothing. And don’t expect I.P.O.s to save these companies. Some unicorns, like Honest Company, have terms that require minimum I.P.O. prices for the V.C. investors that they just won’t be able to meet anytime soon. As these valuations go up and down, remember that reaching a $1 billion valuation is not all good news for a start-up. Instead, it can simply mean that the newly foaled unicorn has made a Faustian bargain.

• Instagram Hits 400 Million Monthly Users, Mostly Outside U.S.  Instagram has passed 400 million monthly active users, mostly by adding people in countries outside the U.S. That compares with Twitter Inc.’s 316 million and Pinterest Inc.’s 100 million. Instagram’s number increased from the 300 million mark reached nine months ago, according to the company. Facebook has 1.49 billion monthly active users. More than 75 percent of Instagram’s users live outside the U.S., with most of the new participants coming from Brazil, Japan and Indonesia, the company said.  As it expands, the photo-sharing application has started to ramp up its advertising business, taking advantage of Facebook’s network of tools and marketers to increase its offerings and global reach. At the beginning of this month, Instagram advertised in eight countries. By the end, they’ll be making money in more than 200, the company has said.

• The tech behind how Volkswagen tricked emissions tests: Volkswagen isn’t hiding from its emissions cheating scandal, which the company now says affects some 11 million diesel cars worldwide. “Let’s be clear about this: Our company was dishonest with the EPA and the California Air Resources Board and with all of you,” Volkswagen U.S. chief Michael Horn said Monday night. “In my German words, we have totally screwed up.” Thanks for finally coming clean, VW. But how exactly did the technology behind Volkswagen’s so-called defeat device actually work? Regulators allege that Volkswagen installed software into its cars that allowed the autos to circumvent EPA tests. But that still doesn’t explain how VW vehicles were able to determine when they were being subjected to an emissions test in the first place. To understand more about how Volkswagen cheated, we have to know a bit about the EPA’s testing process. When carmakers test their vehicles against EPA standards, they place a car on rollers and then perform a series of specific maneuvers prescribed by federal regulations. Among the most common tests for passenger cars is the Urban Dynamometer Driving Schedule (UDDS), which simulates 7.5 miles of urban driving. In the first 505 seconds of the test, the driver pushes the car to highway-level speeds. The second phase of the test looks more like what you’d see in stop-and-go city traffic. In all these tests, the driver has to stay within two miles per hour of the required speed at any given moment. Along the way, the testers collect emissions data. There's a dizzying array of other tests that cars sometimes face. There’s a test to simulate aggressive driving, which tops out at some 80 miles an hour, and a test that simulates urban driving on a hot summer day, with the air conditioning on full blast. There’s a cold-start test, where you begin the test with everything in the car turned off. There’s a hot-start test. There’s something called a New York City cycle, which simulates driving in a busy downtown area where you never get above 30 mph. And then there’s the Federal Test Procedure, a 30-minute test that mixes various elements of the other tests. In the end, the detailed requirements for each test gave Volkswagen the advance knowledge it needed to teach its cars when to behave more cleanly. By measuring how long the engine was running, the vehicle’s speeds, and even seemingly esoteric factors, such as the position of the steering wheel and barometric pressure, Volkswagen vehicles could understand they were being tested and so adjusted their engine performance to pass the tests, according to the EPA. Using a special engine setting for vehicle tests isn’t all that unusual, according to Consumer Reports. Most new vehicles do something similar because otherwise vehicles might interpret some of the testing procedures, like traction issues from being on rollers, as dangerous. But the problem here is that the EPA says the carmaker used its testing mode in an inappropriate attempt to beat the system.

• Quirky, an Invention Start-Up, Files for Bankruptcy:  Quirky, an ambitious crowdsourced invention start-up, which raised $185 million from investors that included General Electric and leading venture capital firms, filed for bankruptcy on Tuesday. The failure of the company, based in New York, will surely raise questions about how far the crowd-based model of innovation and product development, made possible by the Internet, can go. Other companies are using crowdsourcing to make physical goods, from Threadless for T-shirt designs to Local Motors for automobiles. None, though, were doing it as broadly and across as wide a range of products as Quirky. The company said on Tuesday that it was seeking protection from its creditors while it arranged a sale of “substantially all its assets.” Quirky said that it already had an initial bid of $15 million for its Wink subsidiary, which was created last year. Wink makes software so that an array of Internet-connected home devices, as varied as thermostats and door locks, can be controlled from a smartphone app. Quirky had some success, with revenue rising sharply last year to about $100 million. But the scale of its ambitions — managing a sprawling community of inventors, transforming raw ideas into product designs, and orchestrating manufacturing and distribution — proved daunting and too costly.

• The Plot Twist: E-Book Sales Slip and Print Is Far From Dead: Five years ago, the book world was seized by collective panic over the uncertain future of print. As readers migrated to new digital devices, e-book sales soared, up 1,260 percent between 2008 and 2010, alarming booksellers that watched consumers use their stores to find titles they would later buy online. Print sales dwindled, bookstores struggled to stay open, and publishers and authors feared that cheaper e-books would cannibalize their business. Then in 2011, the industry’s fears were realized when Borders declared bankruptcy. Now, there are signs that some e-book adopters are returning to print, or becoming hybrid readers, who juggle devices and paper. E-book sales fell by 10 percent in the first five months of this year, according to the Association of American Publishers, which collects data from nearly 1,200 publishers. Digital books accounted last year for around 20 percent of the market, roughly the same as they did a few years ago. E-books’ declining popularity may signal that publishing, while not immune to technological upheaval, will weather the tidal wave of digital technology better than other forms of media, like music and television. E-book subscription services, modeled on companies like Netflix and Pandora, have struggled to convert book lovers into digital binge readers, and some have shut down. Sales of dedicated e-reading devices have plunged as consumers migrated to tablets and smartphones. And according to some surveys, young readers who are digital natives still prefer reading on paper. The surprising resilience of print has provided a lift to many booksellers. Independent bookstores, which were battered by the recession and competition from Amazon, are showing strong signs of resurgence. The American Booksellers Association counted 1,712 member stores in 2,227 locations in 2015, up from 1,410 in 1,660 locations five years ago.

• Payments Businesses Are Damn Hard: The Cover App Edition: Cover, a young payments app, is accepted in 350 restaurants in four cities. It has processed more than $10 million in transactions since the beginning of the year. But it will record, at most, just $150,000 in revenue in 2015 after passing on a big cut of its fees to other financial institutions, its founder says. So go the economics of a young payments business. And so ends Cover’s life as a stand-alone company. Founder Mark Egerman said today that his startup has sold to European competitor Velocity in a small deal, after passing on taking on more venture capital under less-than-great terms. “Payments is really a hard business,” Egerman said flatly. Cover allows diners to pay for a meal by pressing a few buttons in a smartphone app at partnering restaurants instead of handing over a credit card or cash. The company generates revenue by charging restaurants 3 percent of the price of each meal. But, like many payment processing businesses, Cover passes along about two-thirds of that fee to banks and other financial institutions behind the scenes. So on a $100 meal, Cover’s cut is $3, but it only keeps $1 for itself. Then it has to pay for all of its expenses. If that doesn’t sound sustainable for a small, venture-backed company, that’s because it’s not. (Cover has raised about $7 million.) Cover’s fate underscores how hard it is to build sustainable payment-processing businesses without enormous transaction volume, and why even much bigger payments startups such as Square and Stripe are diversifying their product offerings to beef up profit margins and create new e-commerce markets. Square processes more than $30 billion in brick-and-mortar transactions each year, charging merchants a 2.75 percent fee for each transaction. Like Cover, it passes on about two-thirds of that fee to other financial players in the payments ecosystem, including banks and credit card companies. To supplement this business as it readies for an IPO and to live up to its $6 billion valuation, the company has unveiled a host of products to create new revenue streams with better profit margins. Its cash-advance business, Square Capital, was doling out $1 million a day as of August. It is also selling software products to merchants through monthly subscriptions — another avenue to move past the minor margins of the payments business. Stripe, the online payments company, has said it processes billions of dollars in payments, but it already has a $5 billion valuation. Its one and only revenue source is still the 2.9 percent cut it takes of most transactions, plus a flat 30-cent fee. It, too, is looking for new areas of growth from new types of commerce.

• Groupon to Cut About 1,100 Jobs Worldwide:  Groupon, operator of a daily deals website, said it would cut about 1,100 jobs globally as it restructures outside North America. Groupon is shutting operations in Morocco, Panama, the Philippines, Puerto Rico, Taiwan, Thailand and Uruguay after exiting Greece and Turkey, the company said in a separate blog post on Tuesday. Groupon, which had about 11,800 employees globally at the end of December, said that it expected to complete the job cuts, mainly in sales and customer service, by September 2016. A strong dollar has hurt companies with a large presence in markets outside the United States. Markets outside North America accounted for about 43 percent of Groupon’s revenue in 2014. The company said in April it would sell a 46 percent stake in its South Korean business as part of its turnaround efforts. “I think it’s actually a good thing for investors to hear that they’re taking some more cuts out of their international operations,” Topeka Capital Markets analyst Blake Harper said. Groupon, once the leader in the online coupons market, has also been struggling to boost sales as competitive deals on online marketplaces operated by Amazon and eBay make its coupons less attractive to shoppers. The company has started selling products on its website. Groupon said it expected to incur pretax charges of up to $35 million, including $22 million-$24 million in the third quarter, related to the job cuts.