The decline in the price of Carbonite stock since it announced it was dropping its longstanding advertising on the Rush Limbaugh show is not the real story of the damage done to Carbonite.

The price of Carbonite stock has been dropping since October for reasons unrelated to this controversy, although it did fall off a small cliff this week.

The real problem for Carbonite and its shareholders is that in leaving behind 15 million Rush listeners, Carbonite has shot its business model in the foot.

Carbonite went public in August 2011.  According to CEO David Friendly, the IPO almost never happened, and was saved at the last minute by institutional investors.  Those investors, it turned out, included the early Venture Capital investors, which some argued were not not fully and timely disclosed:

As the IPO market fell out of bed in August, one company, against all odds, squeaked onto the market.

To get the deal done, online storage company Carbonite not only cut the offer price significantly, but it also sold nearly half of the new shares to existing investors. But these investors didn’t fully disclose their larger ownership stakes for weeks, meaning the level of genuine, external interest in Carbonite’s shares wasn’t nearly as high as some may have thought….

The IPO was saved, a person familiar with the matter says, thanks to a large mutual fund agreeing to buy nearly a quarter of the shares for sale at a 40% discount to the original target price. Even so, the underwriters still needed Carbonite’s venture capitalists—including Menlo Ventures, Crosslink Capital and Institutional Venture Partners—to buy another 44% of the for-sale shares.

Carbonite remains essentially a venture capital investment which never quite cashed out.  Based on this week’s events, it appears the VC investors, not to mention public investors, may never see the payoff.

Carbonite’s business model, as many small IPO’s, depends on the company growing rapidly in terms of revenue and in Carbonite’s case, subscribers.  While retaining current subscribers obviously is important, getting new subscribers is key to the growth model.

In its February 27, 2012 Form 8-K/A Current Report, Carbonite touts its rapid annual the growth in subscriber base and revenue.

But getting new consumer subscribers is difficult and expensive, and getting more so as new competitors — including possibly Google — enter the field.  A key part of getting new subscribers, according to the Prospectus, was through radio personalities.

According to the Prospectus for the August Initial Public Offering, Carbonite depended heavily on radio personality endorsements to grow its customer base (p. 13, emphasis mine):

We generate substantially all of our revenue from the sale of subscriptions to our solutions. In order to grow, we must continue to attract a large number of customers on a cost-effective basis, many of whom have not previously used online backup solutions…. Currently, we rely significantly on advertising endorsements by certain radio personalities. The loss of one or more of these endorsement arrangements or our inability to obtain additional effective endorsements could adversely affect our advertising and customer acquisition efforts and our operating results.

Carbonite reiterates this dependency on radio endorsements in the Form 10-K Annual Report it filed yesterday (h/t commenter Eliot Ness) (p. 12):

Currently, we rely significantly on advertising endorsements by certain radio personalities. The loss of one or more of these endorsement arrangements or our inability to obtain additional effective endorsements could adversely affect our advertising and customer acquisition efforts and our operating results.

While Carbonite does not name which radio endorsers it relies on most, looking at the list of Carbonite’s “trusted spokespersons” it is obvious that Rush was Carbonite’s single most dominant radio presence by far.

Based on rankings by Talkers.com, Rush dominates the other Carbonite “trusted spokespersons” on the top 12 list (Beck, Ingraham, Schultz, Komando) and almost equals the rest collectively:

When Carbonite in its public filings warned of the risk of loss of “one or more of these endorsement arrangements,” what it really must have meant was the risk of loss of Rush’s endorsement.

It gets worse for Carbonite.  In the Prospectus (p.14), Carbonite warned of declines in retention rates.  This makes sense because it is so hard and expensive to gain new customers that Carbonite needs to retain those customers and to increase revenues from existing customers:

If our customer retention rate decreases, we may need to increase the rate at which we add new customers in order to maintain and grow our revenue, which may require us to incur significantly higher advertising and marketing expenses than we currently anticipate, or our revenue may decline. A significant decrease in our customer retention rate would therefore have an adverse effect on our business, financial condition, and operating results.

There has been no public disclosure yet as to how the controversy over dropping Rush affects Carbonite’s new subscriber and retention rates.  It may be a number of weeks before the full effect is felt.  Annectodal evidence from the commenters here and around the internet indicates a backlash.

It is significant that Carbonite not only lost access to Rush’s audience, it angered that audience by deviating from its previous non-political advertising policy and seeming to take sides by continuing to advertise on liberal talk shows where the personal invective is more frequent and more pronounced.

As Investors Business Daily puts it:

In expressing his own opinion about Limbaugh, Friend put Carbonite out front in a way that now has it in a delicate balancing act between forces who endorse and oppose its actions.

If the history of newly issued small capitalization high-growth public offerings is any guide, if Carbonite misses its sales, retention or revenue goals even by a little, the market reaction may make this past week’s decline seem like the good old days.

At that point, VC and public investors will have to ask, did our CEO put his own political leanings ahead of the interest of the shareholders?  And if so, was it worth shooting Carbonite’s business model in the foot?