Grouponomics

By Felix Salmon
May 4, 2011
said to be worth as much as $25 billion. What's going on here?

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

18 months ago, Groupon didn’t exist. Today, it has over 70 million users in 500-odd different markets, is making more than a billion dollars a year, has dozens if not hundreds of copycat rivals, and is said to be worth as much as $25 billion. What’s going on here? There’s obviously something clever and innovative behind Groupon — but what is it? Given that customers with Groupons are saving lots of money on goods and services, how can this possibly be good for merchants? Is there a catch somewhere? Is TPG’s David Bonderman right when he says that “Groupon doesn’t do anything that four of us with a phone couldn’t do”? Or is there actually something very special about the company?

Bonderman’s thesis is basically that the value of Groupon lies in the company’s business model, and that since barriers to entry are basically zero, there’s therefore no value there. But I don’t buy that. There are significant network effects at play here: the more people Groupon signs up, the more targeted its deals can be. And there’s another social aspect to Groupon’s success I’ll come to in a minute.

But first it’s worth looking at the innovation in the name of the company: the idea that coupons only become activated once a certain minimum number of people have signed up for them. This is essentially a guarantee for the merchant that the needle will be moved, that their effort won’t be wasted. With traditional advertising or even with old-fashioned coupons, a merchant never has any guarantee that they will be noticed or make any difference. But with a Groupon, you know that hundreds of people will be so enticed by your offer that they’re willing to pay real money to access it. That kind of guaranteed engagement is hugely valuable, and more or less unprecedented in the world of marketing and advertising.

Then there’s the twist in the “coupon” part of the name. No longer do merchants pay money for the privilege of giving coupons away for free in local newspapers. Instead, they receive money — half of the total paid up front. There’s something extremely gratifying about being paid to offer discounts to new customers.

But there’s a lot more to Groupon than just groups and coupons. Groupons behave differently for different types of merchants, so let’s just look at one sector, which I think is Groupon’s biggest: restaurants. (One of the reasons that OpenTable’s share price is so high is that there’s a lot of hope it’s going to make serious inroads into this space, where it has certain advantages over Groupon, like being able to target people according to where they’ve eaten in the past.)

The most important aspect of a restaurant Groupon is probably that it’s local. Before Groupon came along, there was no effective way for merchants to reach consumers in their area, while excluding everybody else. If you’re a neighborhood restaurant, you don’t want to entice people who live miles away: you want to reach locals. And while Groupon isn’t quite there yet — especially in New York, where a restaurant more than a few blocks away can feel like a schlep — it’s orders of magnitude better at targeting than anything which came before it. And it’s improving every day.

(Incidentally, one of life’s great mysteries is why the New York Times is spending tens of millions of dollars building and promoting its easily-circumventable paywall, when it could have built a first-rate Groupon clone instead. The NYT has the exact home addresses — and the associated email addresses — of hundreds of thousands of well-heeled newspaper subscribers in a rich city of tiny neighborhoods. It also has a sales force which talks to local businesses regularly. It should own this space in New York City, instead of ceding it to arrivistes from Chicago who have much less specificity as to where exactly their subscribers live.)

Beyond that, there’s an uncommonly large number of ways in which participating in a Groupon deal can benefit a restaurant or other merchant. For one thing, the offer will go out to a targeted group of people in exactly your neighborhood — which means that even if none of them sign up for the deal, they’ll still have seen customized advertising for you, from a company (Groupon) which they trust.

And when a few hundred people have signed up for your deal, you get a huge amount of mindshare from them. Many will redeem the Groupon very quickly, but a lot of them will wait a while, thinking about you in the back of their minds all the time. If a friend asks whether they know a good local restaurant, they might well think of your name even if they haven’t been yet. And after they’ve been, they know exactly where you are and what you serve — information which you want locals to know but which can be very hard to broadcast.

More generally, of course, Groupons provide an important nudge to jolt people out of their day-to-day habits and try something new. A lot of us might see a new place open up and think to ourselves that we should try it some time; a Groupon turns that vague sense into something we really must do if we don’t want to lose the money we spent on the Groupon. By forcing people to pay for their Groupon, restaurants lock in new customers in a way that old-fashioned coupons never could.

In that sense, from the consumer’s perspective, a Groupon is a commitment device: it’s a way of forcing yourself to do something you really want to try at some point, but know that you might otherwise never get around to. The merchant persuades the consumer to make that commitment right now by making sure that the offer only lasts a very short time — usually only a day or two. The consumer knows that if they don’t buy the Groupon now, they’ve missed their chance.

Groupons can very good at driving traffic during slow periods: I spoke to Will Sanders, of Giorgio’s of Gramercy, and he told me that he timed its Groupon “to create a surge of business in an otherwise soft couple of months after the holidays.” For any kind of business which needs a certain amount of volume to keep ticking over in fallow times, Groupons can be exactly what the doctor ordered.

And although Groupons can be very deeply discounted, merchants can still make money on them. Indeed, in one survey by Utpal Dholakia of Rice University, 66% of merchants offering a Groupon said that the offer was profitable for them in and of itself — not including any subsequent repeat business from new customers.

At Giorgio’s, for instance, diners paid $15 for their Groupon — which gave them $30 of food. But dinner for two at Giorgio’s, with some kind of alcohol, can easily run to $100 or more. So even after knocking $22.50 off the bill (remember that Giorgio’s kept $7.50 of the proceeds of the Groupon), the restaurant would often still make money.

According to one Groupon survey, diners spending their Groupon at a restaurant averaged a check 80% greater than the face value of the Groupon itself. That’s no coincidence: the value of a Groupon is — or should be — carefully calibrated so that it’s hard to spend just the Groupon with no extra cash on top.

Merchants who get that calculation wrong can suffer greatly as a result: if you sell goods for $40, and you send out a Groupon offering $40 of goods for $20, then you’re likely to lose a lot of money very quickly. On the other hand, if your goods cost $100 on average, then you can make money on every redemption.

Does this mean that from a consumer point of view, we should look for deals where we can spend only the amount of the Groupon, and nothing more? Certainly that’s the route to greatest savings, on a percentage-of-total-spend basis. But that doesn’t mean it’s the sensible thing to do.

After all, if you spend good money on a Groupon and then have a meal you don’t like, that’s never going to be much of a bargain. On the other hand, if that Groupon helps you to discover a new neighborhood gem where you go on to become a regular, then that’s a genuine and highly valuable service that it has performed, no matter how much money you spend on your first visit.

If you’re already a regular somewhere, of course, then buying its Groupon is a no-brainer. And the restaurateur won’t begrudge you the savings, either: all restaurant owners want to treat their regulars as well as they can.

But if you don’t know exactly what you’re getting, then the risk is higher — and it’s not just the risk that you won’t like your meal. There’s also the risk of the restaurant being overcrowded with newbies bearing coupons — for that reason, it might be a good idea to wait a couple of weeks before redeeming your Groupon. On the other hand, there’s the opposite risk that your Groupon will expire unused, as you always mean to get around to redeeming it but never do. In which case it’s wasted money for you, and the restaurant doesn’t even get the opportunity to show you what it’s capable of. The only real winner in this case is Groupon itself.

Groupons are particularly attractive for restaurants, where the fixed costs are reasonably high and the profits start arriving only when you reach a certain level of volume. For merchants, by contrast, the deals can be less good: if you’re a bookstore, say, there’s a real risk that people will redeem their Groupon once, with the bookseller losing money on the transaction, and then simply revert to ordering books on Amazon thereafter.

On the other hand, as Giorgio’s Sanders notes, Groupons don’t work for all restaurants. “There are questions of prestige,” he says. “For Daniel, it would raise questions. For us, we’re a neighborhood restaurant, so it works well.”

Which brings me to the other important social aspect of Groupon’s success. For all that digital-marketing types love to talk about creating viral social-media campaigns and the like, social media is at heart a fantastic way for companies to compete on quality rather than marketing glitz. Social media is all about turning word-of-mouth into a tool which is much more powerful than it has ever been from a marketing perspective. And the best way to get great word-of-mouth is to deliver fantastic service. For a small company or even a large company which is great at what it does and never does any marketing per se, social media is a godsend.

And when it comes to the Groupon space, the quality and sophistication of the Groupon or Groupon clone matters a great deal. (One of the downsides, to a merchant, of running a Groupon is that the owners are then inevitably pestered by dozens of Groupon clones, all trying to sell a similar service.)

Groupon’s CEO, Andrew Mason, attributes his company’s success not to the genius of the idea itself, but rather to Groupon’s ability to execute — to keep both consumers and merchants happy. According to Groupon spokeswoman Julie Mossler, more than 95% of merchants would run their deal again or recommend Groupon to a fellow merchant. (Dholakia’s numbers are lower, but still high.) Keeping that number high is not easy: the company needs to be able to give good quantitative advice to merchants on issues such as where to price the Groupon, where to set the minimum and maximum number to be sold, how to avoid being overwhelmed by a huge influx of bargain-hunters, and the like.

It’s very easy to screw up these things, and if Groupon and similar companies like Gilt Groupe end up having a lot of long-term success, it will be because they put enormous amounts of effort into ongoing customer service, rather than just putting four sales guys in a room with a telephone and putting them on commission. Those brands will get slaughtered by the social-media word-of-mouth machine.

In the popular imagination, then, the idea behind a Groupon is that it attracts new customers to a restaurant, some of whom become regulars and therefore very profitable. Long-term profits from the few, in this model, make up for short-term losses from the many who will never return.

And that is indeed a central part of how Groupon works — it’s just not the only way that restaurants get value from the site. In that sense, restaurants are much like Groupon itself. It makes money on every sale — but it will only see its margins start to rise impressively if and when its merchants start coming back on a regular basis. At that point, the cost of setting up and selling a new deal comes down dramatically, and Groupon’s profits on the deal — after accounting for the cost of their salesperson’s time — rise substantially. Groupon itself, as much as its merchants, is counting on repeat business. And that comes from having a positive reputation which can spread like wildfire over Facebook and other social networks.

 

34 comments

Comments are closed.