Nov. 19 (Bloomberg) -- As e-commerce companies prepare for the holiday season, their investors are in the market for some discounts of their own.

Fab Inc., a marketplace for luxury wares that was founded last year, raised money at a lower valuation than it had sought after watching Facebook Inc.’s stock plummet. Flash-sale site Gilt Groupe Inc. and subscription retailers BeachMint Inc. and ShoeDazzle.com Inc. are bracing for an increasingly competitive climate after funding rounds in the past 18 months.

After pouring more money into retail startups in the third quarter than in any period since the dot-com bust in 2000, venture capitalists concerned over the formation of an e-commerce bubble are balking at deals they consider overpriced. The valuations in recent funding rounds and executive exits suggest investors are no longer willing to sink cash into online stores that don’t have proven growth prospects.

“There were definitely some inflated valuations chasing e- commerce,” said former EBay Inc. executive Dana Stalder, a partner at Matrix Partners, which has backed fashion startups Gilt Groupe and Just Fabulous Inc. “They’re complex businesses to run. They generally are capital-intensive, have low margins, and therefore the exit multiples are typically one to two times revenue.”

E-Commerce Challenge

Inventory and shipping costs make new businesses hard to build, and those that do attract shoppers can quickly fall prey to clones. That makes it tough for new companies to vie with stalwarts EBay and Amazon.com Inc. in the $226 billion online- retail market. The froth means that later-stage backers may be poised for losses, like those who made costly bets on Facebook Inc., Zynga Inc. and Groupon Inc. And it can hurt returns for venture investors and jeopardize future fundraising.

Until last year, e-commerce businesses had spent a decade struggling to attract capital, because venture backers were having more success with Internet advertising, business software and Web analytics. Those markets have more potential acquirers and command higher multiples than e-commerce. Web companies Google Inc., Yahoo! Inc., Priceline.com Inc. and Facebook all trade for at least four times revenue.

Amazon paid no more than about two to three times sales when it bought online shoe peddler Zappos.com Inc. in 2009, and again when the retailer last year purchased Quidsi Inc. -- the company behind Soap.com and Diapers.com.

More recent e-commerce startups are chasing shoppers with flash sales, customized apparel and subscription services -- all pushed to consumers on smartphones and via social-media sites.

Facebook, Twitter

They use Facebook, Twitter Inc. and Pinterest Inc. to gain fans, communicate with customers and promote products. Tablets and smartphones make shopping more convenient, while advanced analytics tools enable more targeted promotions.

E-commerce made up 4.9 percent of U.S. retail sales in the third quarter, according to the Department of Commerce. Online sales will surge 45 percent to $327 billion in the U.S. in 2016 from $226 billion last year, estimates Forrester Research Inc.

Expecting dollars to keep flowing to the Web, investors turned bullish last year and stayed that way through September. Venture investing in online retail doubled in the third quarter from a year earlier to $242.1 million, according to the National Venture Capital Association. That’s more than venture backers committed in all of 2010.

‘Disruptive Ideas’

“We’ve seen more disruptive ideas in e-commerce in the last two to three years, and more innovation than in the 10 years before that,” said Josh Kopelman, a partner at First Round Capital in Philadelphia, who previously founded Internet retailer Half.com Inc. “Mobile and tablets are changing the methodology of how people shop online.”

Kopelman’s firm was an early backer of Fab, jewelry retailer Chloe & Isabel Inc., eyewear maker Warby Parker and beauty-supply site Birchbox Inc., among other online businesses.

The recent Fab deal suggests investors may be pulling back. Fab has surged in popularity by integrating with Facebook and allowing users to see what their friends are buying. It now boasts 9 million members in 26 countries.

In July, the New York-based retailer raised $105 million, led by London-based Atomico. Chief Executive Officer Jason Goldberg said he had planned to close the deal at a $700 million valuation. In late June, a month after Facebook’s IPO, he sent an e-mail to existing investors, including Andreessen Horowitz and Menlo Ventures, informing them that he was lowering the valuation to $600 million.

‘Fair Valuation’

“I did not take the highest valuation offer and I also made sure that our investors all thought they were investing at a fair and appropriate valuation,” Goldberg said in an e-mail to Bloomberg.

Fab is on track to post $150 million in sales this year, Goldberg said. Some investors, who asked not to be named, said they passed on the round because they thought it was too expensive.

Andreessen Horowitz, which invested in Fab’s last two rounds, is still betting on the industry. The Menlo Park, California-based firm led an $85 million investment last week in Zulily Inc., a daily-deal site for moms. Jeff Jordan, a partner at the firm and former EBay executive, called it “one of the fastest-growing businesses we’ve ever encountered.”

Bloomberg LP, the parent of Bloomberg News, is an investor in Andreessen Horowitz.

Warby Parker, also based in New York, raised $36.8 million in September. That valued the company, which sells eyeglasses online and at some retail locations, at about 10 times revenue, according to a person familiar with the fundraising. Investors were attracted by the company’s gross margin of 50 percent, the person said, or twice Amazon’s profitability.

Abigail O’Donnell, a spokeswoman for Warby Parker, declined to comment on the valuation and margin.

Elusive Margins

High margins and valuations often aren’t sustainable, said Alfred Lin, a partner at Sequoia Capital, who previously ran operations and finance at Zappos. Since joining Sequoia in 2010, he’s mostly steered clear of e-commerce, with one exception -- jewelry marketplace Stella & Dot LLC.

“We certainly have discussed e-commerce in partner meetings,” Lin said. “We’ve gotten to the point where we were doing due diligence and were interested in investing, but valuations have taken over at levels that we think are not sustainable.”

Lin led Sequoia’s $37 million investment in Stella & Dot last year and joined the board. While Lin acknowledged risks to the business, he said he’s a big fan of the founder and was drawn to the company’s untraditional approach to e-commerce. They sell some products at trunk shows or parties featuring stylists.

High valuations deterred Menlo Park-based Sequoia from other investments, Lin said.

‘Not Bullish’

Half a mile down Menlo Park’s Sand Hill Road, Battery Ventures faces the same conundrum. General Partner Brian O’Malley has led investments in men’s clothing maker J.Hilburn Inc., subscription flower-delivery service H.Bloom Inc. and home furnishings seller Serena & Lily Inc. He’s declining to invest in most new deals, because prices have gotten too high.

“Some of these businesses are going after really large markets,” he said. “I’m not bullish on all the companies and I’m not bullish on all the prices people are paying to get into these companies.”

E-commerce startups such as ShoeDazzle, BeachMint and Gilt Groupe have had to reorganize after the emergence of copycats forced them to spend more on marketing to reach customers and, in some cases, to lower prices.

Executive Exits

ShoeDazzle, which sends purses and shoes to subscribers for a monthly fee, replaced former CEO Bill Strauss with founder Brian Lee in September. Strauss had stopped charging subscribers fees in months they made no purchases, deflating sales.

The Santa Monica, California-based company has received more than $60 million in funding from investors including Andreessen Horowitz and Lightspeed Venture Partners. ShoeDazzle representatives didn’t respond to requests for comment.

BeachMint, also based in Santa Monica, sends subscribers shoes and jewelry. The company named a new chief operating officer in July, one month after the departure of John Volturo, the marketing chief. Greg Steiner, the new COO, said the company is hiring “people with traditional merchandise and retail backgrounds.”

Bad Bets

Last month, BeachMint hired a general merchandising manager and is bringing on a few more employees in the same area, Steiner said. The company raised $35 million in January from investors including Accel Partners.

Gilt Groupe, the New York-based operator of a flash-sale site, plans to sell its travel-deals service Jetsetter and replace CEO Kevin Ryan by the end of the first quarter of 2013, a person familiar with the plans said last week.

In May 2011, Gilt Groupe raised $138 million in a round led by Softbank Corp. The valuation: $1 billion.

While the economy is ripe for some emerging companies to succeed, bad bets at irrational valuations will hurt the whole market, said Kirsten Green, a former retail equity analyst who raised a $40 million fund at Forerunner Ventures in July to make early bets in digital commerce.

Her investments include early rounds for Warby Parker, Serena & Lily Inc. and Chloe & Isabel.

“I would much prefer that people keep their heads on straight,” Green said.

--With assistance from Chris V. Nicholson in Paris and Sarah Frier in New York. Editors: Lisa Rapaport, Rick Schine, Reed Stevenson

To contact the reporters on this story: Ari Levy in San Francisco at alevy5@bloomberg.net; Danielle Kucera in San Francisco at dkucera6@bloomberg.net

To contact the editor responsible for this story: Tom Giles at tgiles5@bloomberg.net



