LinkedIn to $4 billion: Join my network

May 18, 2011: 5:00 AM ET

By Kevin Kelleher, contributor

After its IPO this Thursday, LinkedIn will prove the adage that non-paying users of its social network aren't the customers, they're the product.

FORTUNE -- Here's a dirty little secret about social networks: No matter how much they talk about designing their sites for users, it's not true. Social networks are about making money off their users. Facebook makes money when it gets users to interact with big corporate brands on their site. For any successful social network, users aren't the point -- they are useful only insofar as they can be monetized.

It's much the same for LinkedIn, the professional social network that is expected to go public Thursday. The prospectus has lots of high-minded rhetoric about its vision "to create economic opportunity for every professional in the world" and how it's "transforming the way people work by connecting talent with opportunity at massive scale." It almost sounds like LinkedIn is going for a Nobel Peace Prize, not an initial public offering.

But make no mistake. LinkedIn is going public, and that means it needs to be profitable, especially with its surprisingly large $4+ billion valuation. So while the site's home page may be designed to entice working stiffs into using its site as a platform for career networking, the company's income statement shows who the true customer is: 49% of LinkedIn's revenue comes from companies looking to hire talent. Only 21% comes from members who are paying subscription fees to the site. (The other 30% comes from ad revenue.)

That's pretty close to a mirror image of LinkedIn's revenue breakdown in 2008, when premium subscriptions made up 45% of net revenue, versus 22% for the hiring solutions it offers to companies. LinkedIn is finding that helping companies post jobs and recruit talent is a faster growing business than helping jobless candidates find work.

In principle, this isn't such a bad thing. If LinkedIn can help match companies and talent in competitive sectors like software engineering, then both sides benefit. But it does point to a potential vulnerability for the company. LinkedIn's prospectus doesn't say how much its growth relies on the competitive hiring market in Silicon Valley. But if something unexpected happens -- say a bursting of the web 2.0 bubble, or a renewed recession -- the company's job-recruiting revenue could be hit especially hard.

In that sense, LinkedIn really isn't much different from the first generation of job sites like HotJobs or even Craigslist, which makes the bulk of its revenue from job listings. Its main difference is that it built its job-recruitment business on a social networking platform. Users signed up to connect with each other, and LinkedIn thanked them by serving ads and letting companies parse through their profiles.

Investors in LinkedIn's IPO may care less about where the revenue comes from than how fast it's growing. And there's plenty for them to like on the top line. Last year, revenue rose 102% to $123 million. In the first quarter of 2011, the growth picked up steam: Revenue rose 110% from the same quarter a year earlier to $19.4 million.

On the bottom line, the growth isn't quite as encouraging. LinkedIn swung from a $4 million loss in 2009 to a $15.4 million profit in 2010. In the first quarter of 2011, net profit grew 14.5% from the year-ago quarter to $2.1 million. The main drag on profit growth was the increased spending on marketing. LinkedIn's sales and marketing expenses last quarter was equal to 31% of revenue, up from 23% a year earlier, largely because of an increase its sales force headcount to 493 from 159.

LinkedIn was planning to go public with a $3.3 billion valuation, but as a hot IPO, it's already raised its price at the 11th hour to take advantage of strong demand. The valuation at the high end of the new range, $4.25 billion, is 17 times the company's 2010 revenue. That ratio is much higher than those of older web giants (Amazon (AMZN) is trading at two times its sales, and Google (GOOG) at five times), but it's closer to the ratios of recent web IPOs, such as RenRen's price-sales ratio of 17 and OpenTable's  (OPEN) ratio of 20.

When it debuts, LinkedIn's valuation will seem especially high given some controversial governance policies that Dealbook's Steven Davidoff has detailed: LinkedIn is designing its board to resist takeover attempts, and it's adopting a dual-class share structure, a relatively rare measure that, as Davidoff says, "could become a corporate governance nightmare."

None of that is likely to slow down this IPO, however. LinkedIn is a web startup with fast growth, even if its track record is erratic and unproven. It's a clear reminder that web IPOs in 2011 are very different from their 1999 counterparts in that they are profitable and well managed. But like 1999, investors are a little too willing to overlook details that could come back to haunt them later on.

In LinkedIn's case, the details aren't terribly troubling, but they raise important questions about its future success. Will the company's gamble on a bigger sales force translate into stronger revenue growth ahead? Will the site turn into a tool for corporate recruitment and marketing, alienating users who came to it as a career-networking community? How long will investors want to hold shares that have no corresponding voting rights?

These questions won't be on investors' minds as LinkedIn heads toward what will likely be a warm initial reception. But they may become issues for LinkedIn, and its investors, in the future. Much like the site itself, the LinkedIn IPO isn't quite what it appears to be on first glance.

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