VCs Court Controversy by Backing Penny Auction Sites

The lure of quick money from penny auctions sites appears to be too strong for even venture capitalists to resist.

Among the venture firms that have invested in the sites are Atomico Ventures, August Capital, First Round Capital, Foundation Capital, Mayfield Fund and Wellington Partners.

In a penny auction, bidders generally have to buy bids. Each time they place a bid, the price of the item goes up and the time of the auction is extended. Bidders who lose the auction also lose what they’ve spent on bids.

While such sites are perfectly legal, they have come under increased scrutiny from consumer advocates and even the Washington State Attorney General.

“There are new penny auction sites going up almost daily—some are attracting venture capitalists,” says Jake Bernstein, assistant attorney general for the state of Washington. “[But] without an adequate user base, penny auctions quickly become a financial disaster, and many cheat to survive during the initial growing up period.”

There are new penny auction sites going up almost daily—some are attracting venture capitalists. [But] without an adequate user base, penny auctions quickly become a financial disaster, and many cheat to survive during the initial growing up period.”

Jake Bernstein

Some sites have used software to place fake bids to extend auctions and inflate the price of items, which is illegal, says Bernstein. Case in point: Pennybiddr.com. The site agreed to shut down and refund $7,700 to 85 consumers as part of a settlement with the Washington State Attorney General in late September. “[I]f you don’t know how these auctions work or you find it difficult to stick to a spending limit, you can easily be suckered out of lots of money,” says Bernstein, who was lead attorney on the case.

Jaded penny auction participants are increasingly voicing their concerns to the Better Business Bureau. On Oct. 1, the bureau issued a warning against penny auction sites, reporting hundreds of complaints from people who said they’d lost thousands of dollars bidding on what were supposed to be deeply discounted items.

The complaints haven’t stopped venture capitalists from investing in the sector. In September, Penny Auction Solutions (PAS), announced a $10 million equity line of credit from Kodiak Capital Group and said it was preparing to file an S-1 the SEC in hopes of going public in the fall.

PAS has been acquiring Web domains, including .mobis, in several countries and plans to roll out sites around the world, starting with the United States and Canada early next year. PAS has been telling investors that penny auction sites can make $2,000 to $3,000 an hour in a matter of months and can collect as much as 800% of retail on their merchandise.

“Usually when these sites do have problems they’re undercapitalized,” says PAS Chief Executive Corey Park. “We’re of the opinion that someone needs several million dollars to do it right.”

Usually when these sites do have problems they’re undercapitalized. We’re of the opinion that someone needs several million dollars to do it right.”

Corey Park

The penny auction craze started with Swoopo, which launched five years ago in Germany as Telebid and expanded to several countries, including the United States. The self-described “entertainment shopping” company raised $4 million from Wellington Partners in late 2006 and a reported $10 million from August Capital in April 2009.

Swoopo has had its ups and downs. A research paper last December by Ned Augenblick of Stanford University estimated that although Swoopo loses money on more than half its auctions, the company’s average profit margin is 52%, generating 18 million Euros in profits over four years. Swoopo also achieves 98.6% of potential short-term profits on its auctions, according to Augenblick.

Mark Gimien, a journalist who writes for business website The Big Money, last year analyzed how Swoopo makes money and wrote that “it’s the evil bastard child of game theory and behavioral economics” and “the most efficient, addictive way to separate people from their money.” August Capital, which Gimien said “should be ashamed of itself” for financing Swoopo, did not respond to a request for comment. Swoopo also did not respond to a request for comment.

Despite the controversy surrounding penny auction sites, August Capital isn’t the only well known venture firm to roll the dice on the sector. First Round Capital, Foundation Capital and Mayfield Fund came together in February to fund a $10 million Series B round for BigDeal.com, just seven months after the trio funded the company’s $4.5 million Series A round.

Foundation General Partner Charles Moldow says BigDeal.com is expanding beyond electronics into handbags and jewelry and house wares and plans to add more game-like experiences over the next several months. “We want to be the Zynga of e-commerce,” Moldow says. “In a few months, we’ll have a portfolio of games-meets-shopping experiences. This is one of many.”

Why would you ever shop on Amazon? If you want to buy a $200 necklace or an iPod, you can win it here, and if you don’t succeed—because you haven’t figured out how to do it—you can purchase it here for about the same price.”

Nick Darveau-Garneau

BigDeal.com CEO Nick Darveau-Garneau says his company didn’t do as good a job as it could have of explaining to customers how its auctions work, an area he says it has improved over the last three or four months. He also says BigDeal.com customers don’t go away empty handed. They can step out of the auction at any time and purchase the items they’re trying to win—at a price that discounts the money they’ve already bid—and they can earn loyalty points for every dollar they spend on bids, which they can redeem for discounts on products in BigDeal.com’s loyalty store.

BigDeal.com gives bidders the information it thinks they need to figure out the game—there are winning strategies, Darveau-Garneau says—and it has a number of customer guarantees, including no robot bidders.

“Why would you ever shop on Amazon?” Darveau-Garneau asks. “If you want to buy a $200 necklace or an iPod, you can win it here, and if you don’t succeed—because you haven’t figured out how to do it—you can purchase it here for about the same price.”

VCJ looked compared the prices of a few random items on BigDeal.com with those on other electronics websites and found BigDeal.com’s prices to be higher. For example, on Oct. 17, BigDeal.com offered a Panasonic 50” Viera S2 HDTV with Blu-Ray Home Theater system for a “buy it now price” of $1,399.98 (including shipping). VCJ found the same system on RitzCamera.com for $1,338.94 (including shipping). And BigDeal.com was offering an Apple MacBook Pro 13.3-Inch laptop for a “buy it now” price of $1,223.99 (including shipping), but Amazon.com offered the same computer for $1,149 (including shipping).

StuffBuff founder Michael Langer says he considered starting a penny auction site but decided against it because he thought too many bidders felt “buyer’s remorse” when they bid and didn’t win. StuffBuff, which is a year old, runs a twist on penny auctions—the more people who watch the auction, the faster the price falls, but if people leave, the price goes back up. The first person to hit the “buy” button wins. Langer says has self-funded StuffBuff, but is talking to venture capitalists.

We want to be the Zynga of e-commerce. In a few months, [BigDeal.com] will have a portfolio of games meets shopping experiences.”

Charles Moldow

Then there’s U.K.-based MadBid, which raised 4 million Euros from Atomico Ventures in July. CEO Juha Koski argues that penny auctions are a natural innovation in e-commerce, a 200-year-old idea that’s finally gone online. Horses, Koski says, used to be auctioned to bidders who would throw coins in a bucket; the last man standing got the horse.

“We were aware of Swoopo when we launched, and we thought we can do this so much better,” he says. “The name is better. You’re having three or four pints of beer in a pub, and you say, ‘I got an iPod, I won it on MadBid.’ But if you say Swoopo, someone will say, ‘How do you spell that?’”

Besides the name, MadBid is focused on offering better customer service and running its operation better. “We’re looking at those every day and fine tuning, and that’s what it’s all about,” Koski says.

Not all VCs are convinced penny auction sites are a great investment. Josh Hannah, a general partner with Matrix Partners, says they’re not fun enough, and if you offer truly competitive prices then your margins go down.

“I think that someday the right set of features will come along,” Hannah says. “Look at Groupon. It’s not a million miles removed from 10 other things that came before it, but it’s the right features at the right time and it’s an enormous business. I think we would have known by now if Swoopo was it.”

Meanwhile, the Washington State Attorney General’s office is looking at more penny auction sites, a spokeswoman says, and some people in the industry have called for regulation, or at least a set of standards that penny auction sites would use to govern themselves.

Koski says MadBid is working with the U.K. Trading Board on standards for the United Kingdom—no cheating, customer service with a real telephone number where you can talk to a person, shipping products on time and no bids from staff or their families. “It costs money,” he says, “but you have to keep customers satisfied.”