The future of Groupon’s business model

By Felix Salmon
August 27, 2011

Has Groupon created an inherently profitable industry? Or is it one of the most effective means ever invented of taking investors’ money and setting fire to it? Since I wrote my big post on Grouponomics in May, the optics surrounding Groupon have changed considerably. Jeff Bercovici, for one, is convinced there’s nothing there:

Could the fastest growing company in history sputter out just as quickly? At this point, the better question may be: How could it not?

Jeff quotes Rob Wheeler, who’s equally adamant:

Groupon’s fundamental problem is that it has not yet discovered a viable business model. The company asserts that it will be profitable once it reaches scale but there is little reason to believe this…

Groupon’s venture investors and executives need a way to cash out before everyone realizes that the emperor has no clothes. I will probably buy a Groupon every now and again — I have no problem letting investors finance my cheap consumption. But as far as an investment goes, Groupon is looking about as profitable as giving away your merchandise for 90% off.

But the problem here is that neither Bercovici nor Wheeler seems to understand what Groupon is doing. I have my own doubts about whether Groupon will be able to achieve long-term success without running into a short-term liquidity crunch, but there’s nothing inherently illogical about Groupon’s cash-burning drive for growth.

For smart analysis of Groupon, you’re much better off reading Vinicius Vacanti and especially Henry Blodget — but be sure to read them carefully. Both of them are being quoted by the likes of Bercovici and Wheeler, who are drawing broad and simply false conclusions from what they’re reading.

At heart, what Groupon is doing makes sense. Its core business, I’m pretty sure, is profitable — although no one knows just how profitable it’s likely to prove over the long term. If you give Groupon a large number of subscribers in some given city, and a team of sales people in that city, those sales people will be able to sell deals to local merchants in such a way as to more than cover their own costs. That’s the model at the heart of Groupon’s business, and historically it has worked spectacularly well. It’s worked so well, in fact, that Groupon has found it incredibly easy to raise new equity capital and to grow faster than any other company in the history of the known universe.

Groupon has used all of its profits from selling deals to expand aggressively — to sign up new customers and launch in new cities and countries. This costs money, but it makes sense, given the substantial first-mover advantages available in the space. Groupon wants to be first to any given market, and it aspires to become a kind of corporate shorthand, like Hoover or Kleenex or Xerox, where the company name is used to refer to the whole class. Growing as fast as Groupon has done is expensive, but Groupon is convinced that the more money it spends up front, the more money it’ll ultimately end up making in any given market.

All this makes a lot of sense, and nothing we’ve seen with respect to Groupon’s losses invalidates any of it: there is no reason to believe that Groupon is in an inherently unprofitable business. Contra Wheeler, Groupon did discover a viable business model. And it’s just silly to think that when you buy a Groupon, that in some way Groupon’s investors are financing your cheap consumption: the cost of your cheap consumption is borne wholly by the merchant in question.

In fact, one of the two problems with Groupon is that its investors aren’t financing Groupon’s growth. As Blodget points out, of the $1.1 billion that Groupon has raised from equity investors, fully $942 million has been used to cash out its early investors and executives. If Groupon had held onto that cash and used it to finance its growth, it wouldn’t be facing a cash crunch right now. Groupon should be able to use the proceeds from its IPO to cover any potential cashflow crunch — but it’s nice to have the option not to IPO, if the market’s looking weak. Groupon should be able to tap its current private investors in the event that its IPO gets postponed or canceled — but right now they’re looking to make money on their investment, rather than throw more cash at it.

The other problem with Groupon is that its fundamental business model is looking less profitable than we might have once thought. This is Vacanti’s point: in mature markets, Groupon is making less money per subscriber, and less money per merchant, than it has ever done in the past. The latter decline is particularly precipitous:

boston-merchant.png

Now this isn’t necessarily as bad as it looks. The number of merchants that Groupon has in a town like Boston is a cumulative number: we’re looking at quarterly revenues, here — a flow — divided by a steadily-growing stock of merchants. Even if you haven’t done a Groupon offer in years, you’re still part of the denominator; my guess is that even merchants which have closed down entirely are included.

What really matters, in Boston and elsewhere, is whether Groupon can stay substantially profitable in such mature markets. And that’s why it’s a little sad and indeed a little worrying that Groupon is getting rid of its ACSOI profitability measure — something which is at heart, as Groupon CEO Andrew Mason explains, was always an attempt to try to work out the steady-state underlying profitability of the company’s operations. Maybe Groupon got rid of it because of all the criticism — but it’s also possible that Groupon jettisoned ACSOI because it was worried that it was falling sharply and maybe even headed into negative territory.

Over the long term, I suspect that Groupon will succeed or fail based on the perceived quality of its offers. It has grown fast based on the simple tactic of offering great deals to consumers — giving them things for much less than they would normally pay. But at some point, it would do well to start concentrating more on quality rather than just price. Here’s Ryan Sutton:

Have you ever heard of Amber on the Upper East Side or Mambo in the West Village? Nope. Yeah, well neither have I. They’re just two random sushi joints. But Groupon ran a special on both last week, and they sold over $85,000 in California rolls, tuna rolls and other fake forms of sushi. That in itself is a travesty…

What’s going on here with Groupon, a national brand is giving national attention to a local joint that doesn’t deserve it, and as a result, a lot of people’s money is being misallocated. It’s anti-economic. Groupon is the invisible hand of capitalism sucker punching good restaurants that deserve to succeed and helping out mediocre venues that deserve to fail.

The thing to pay attention to here is the perception of Groupon: that it’s a desperation move for mediocre merchants. If that reputation spreads, then Groupon will find it increasingly difficult to move its product, no matter how wittily-written its emails are. So if I were thinking of investing in Groupon, one thing I’d be looking out for would be the quality of the merchants being featured. If it’s high or rising, that’s good news; if it’s low or falling, that’s bad news.

Qualitative judgments, of course, aren’t particularly tractable, or easy to chart; analysts hate them. But ultimately the success of great companies like Apple comes down to precisely the quality of their products. And that’s something that might well end up determining the long-term fate of Groupon, too.

Comments
30 comments so far

If you look up Pnzi scheme in the dictionary or even google it, you will get a description of the scam first made famous by a guy named Ponzi. I’m guessing one day there will be definitions of the term “groupon scheme” found in similar places. Investors will use it to describe a company with fast growing revenues and no visible means of profits.

Posted by KenG_CA | Report as abusive

What percentage of groupon merchants do repeat groupons (only the ones that don’t go out of business)? What if merchants that *do* groupons *tend to* go out of business?

If merchants feel groupon is an effective way of advertising and generating repeat customers, this is a sustainable model. The more you can invest to get people signed up, i.e. getting first to a market and dominating it, the better for you.

If on the other hand, groupons attract cheapskates who follow the groupons and not the food or they tend to so highly concentrate around groupon expiration dates that you have no hope of building the capacity to accommodate them then you don’t have a viable business and you don’t have merchants coming back to groupon because the cost is high and the benefits are low. What if that is what we learn in the “revenue per merchant” chart?

Maybe that would just mean the model needs refinement to fit the needs of customers. Just as the ad-targeting model will in theory actually be useful at some point, tweaking the timing, size and discount amount will make this viable for businesses (particularly upscale vs. cheaper businesses).

But “is this a long-term good system for businesses,” as evidenced by their repeat participation, seems vitally important.

Posted by Piesmith | Report as abusive

Merchants that you’ve never heard of will probably have to be Groupon’s bread-and-butter; ideally it will be high quality merchants who hope to become heard of by giving customers a favorable risk-reward scenario for coming and giving them a try. The only merchants that are well-known for which groupon might make any sense would be those that people have heard of, think of as too pricy, and decide that they’re worth returning to when they’ve found out just how good they are. A lot of Sutton’s criticism seemed weird, but the implication that groupon should be doing businesses with merchants that everyone has heard of seemed particularly bizarre.

Posted by dWj | Report as abusive

dWj makes a good point. Groupon is likely to be seen by quality start-ups (or at least start-ups that think they’re offering quality) as a good way to kick-start brand recognition. If they eventually move away from Groupon as a means of advertising it doesn’t mean the quality of their product has changed (for the better or worse), it means that Groupon has worked for them.

Posted by ottorock | Report as abusive

“or they tend to so highly concentrate around groupon expiration dates”

That could easily be fixed by staggering the expirations…

Posted by TFF | Report as abusive

Unfortunately, my opinion of Groupon sinks week by week. And while I am not an egomaniac, I do see the fortunes of the company traveling along the same lines.

I have zero interest in receiving multiple daily Groupons in my email–but there they are! Home and Garden, Travel and GrouponNOW have all joined the original. I look at almost none of them. I am increasingly turned off by the faux-clever ad copy that is often absolutely tone deaf to the company or product being promoted.

Do I want a clever joke about the Holocaust (local Holocaust Museum discount–bad idea to begin with, made worse by snide tone)? How about snarky ad copy about liposuction or cosmetic surgery (who buys a coupon for such things anyway??!!)?

More is not better, and these guys are really wearing out their welcome. Shoulda sold to Google. And don’t forget, Felix, Chicago’s last mayor, Daley, gave these guys a sweet deal on their digs and taxes, without which their cash crunch would be more severe. Taxpayers foot the bill. A billion dollars in equity gets pulled out (way too early) by the founders and investors. This really sounds too damn familiar!

Posted by LadyGodiva | Report as abusive

people who are in this industry understand that Groupon is basically using money owed to the merchants for as long as possible to finance their own growth, and this is no problem provided the merchants are willing to wait and there is endless opportunity to keep growing the business

but the problem is that merchants will not allow Groupon 60 days to pay them for a barely profitable offering if Living Social can run the same deal and pay in a week…and when Google begins paying merchants in 48 hours, its lights out on this ponzi scheme

Posted by ReformedBroker | Report as abusive

The problem for Groupon is that it has no “real” assets.
Most successful business models are based on ownership of valuable physical or intellectual property assets. Groupon has neither…just an easily copied business method (which cannot be protected by patent under current law). Many other entities can and are doing the exact same thing that Groupon is, which is why it’s going to be very difficult for them to become consistently profitable over the long run.

Posted by mfw13 | Report as abusive

@LadyGodiva

Do as I do: I have them on RSS feed in my Google Reader. It makes it much easier to quickly scan and just look at the ones that might seem interesting. And I can easily subscribe to multiple cities (three in fact) without cluttering my inbox.

Posted by GRRR | Report as abusive

Any more details on the execs and investors cashing out? If it continues, maybe that will eat up all the profits, the way it’s eaten up all the cash until now.

Posted by AngryInCali | Report as abusive

Felix — The one thing I’d criticize in your post is the ample credence given to “first mover advantage.” As a lasting source of competitive advantage — which is what allows a company to get away with charging above the cost of capital — it’s pretty weak.

This is a different matter than branding, the advantages of which can last decades accompanied by a bit of spending. It’s why Americans are content to vastly overpay for one of a handful of toothpaste brands.

But that same pull doesn’t exist with Groupon. Do you give more credence to groupon offers than to Village Voice Daily Deal offers? I don’t. Do merchants? Not if they’re smart — they’re paying for foot traffic. In every sizable groupon market, there are endless numbers of competitors willing to charge merchants far less for the privilege of offering overly generous deals. Being the first mover just means that Google got to briefly enjoy the market to itself.

I remain flabbergasted that Groupon turned down Google’s offer. While it’s risen in theoretical value since then, I don’t see how it thinks that as a standalone entity it’s got something unique. And having that is the one element that ends up making a company real money.

Posted by jeff12345678 | Report as abusive

I’m already sick of Groupon, LivingSocial, ScoutMob, Facebook Deals. Even OpenTable is doing the same thing now.

It’s basically junkmail at this point. Crummy restaurants, teeth whitening, massages.

Is there some sort of profitable business model in there? Probably, but a very modest business model.

I don’t think Groupon is going away but I do think investors will lose a lot of money.

Posted by petertemplar | Report as abusive

Quality!?! Come on Felix you know that old “good, fast, cheap, choose two” adage. There is no way you can emphasize discounts and grow at anything remotely like groupon has and even think about “quality”…

Groupon may or may not survive, but I keep thinking of Michael Mace’s superb breakdown of RIMs situation last fall. Describes a different industry entirely but the dynamic may well be relevant to Groupon. The amount of energy needed to gain a customer at some point is likely going up, and that means spending more to chase the late adopters. And at some point in at process you either switch up or slam into a wall…

Posted by AbeB | Report as abusive

When I hear “spectacular growth” and “cash out its early investors and executives” anywhere near each other, I think fraud. Just saying.

Posted by lambertstrether | Report as abusive

One thing I just learned is that Groupon is in China.

Groupon shouldn’t even be thinking about trying to take on the China market now. That’s just bull hockey. They will throw money down that hole for awhile and then presumably find some face-saving way to get out.

Sorry that’s a huge red flag for me. Ebay had millions of dollars in profits and still failed in China. How is Groupon expecting anything different?

Posted by TonnyDZ | Report as abusive

“Even if you haven’t done a Groupon offer in years, you’re still part of the denominator”

This is not true. From the S-1: “Featured merchants. This metric represents the total number of merchants featured in a given time period.” As compared to “Cumulative customers. We define cumulative customers as the total number of unique customers that have purchased Groupons from January 1, 2009 (the first date we began tracking unique customers) through a specific date.”

Posted by mattm | Report as abusive

Could be that I am missing something. I understand business models quickly for a living, but I have missed things before. This “business model” of Groupon’s? I think my local alt-weekly rag is right and it’s basically “put together an e-mail list and sell to it.”

If you are in NE Portland, please visit Wayne’s Chicago Red Hots, which has declared Mondays “Poop On Groupon Coupon Night” in hopes of capturing the value of discounting to a targeted list of customers for itself.

Also I have seen no evidence that “group buying” exists in any meaningful way. It’s a moot point, since at this point everyone, their family, their friends, and their animals is already signed up on Groupon, Living Social, and a few others, and ignoring 99% of the offers.

Posted by SelenesMom | Report as abusive

Yikes! Please someone delete the two triplicate comments!

Posted by SelenesMom | Report as abusive

Groupon has successfully genericized itself, I think. Everybody I know who uses these types of deal will say things like, “I have a groupon for that place,” even if they got the deal from somebody else.

In any case, I don’t see how being the generic term helps them. If, say, FourSquare, or Facebook, or local newspapers can provide deals that seem more desirable to users, at a lower cost, because they have more granular information on where users are at specific times, then Groupon is toast.

The quality issue is really more relevant to whether ANYBODY should be in this business. My experience with these coupons is that every now and then they prompt me to try a new place (which is obviously the goal of the merchant offering them). I can’t actually think of a single place that I discovered via a deal and then went to again. I can think of a place that keeps offering groupons more often than I actually want to eat there. I might go and pay full price some time, if they didn’t keep offering me opportunities to pay less. So this is clearly a money-losing proposition for them, and I can’t figure out why they keep doing it. The most common thing, though is for a groupon to save me money on a place I already liked, or to prompt me to try a place I’d been hearing about meaning to try for a while (and probably would’ve tried within 3-6 months even without the deal). In this case, there may be some advantage to the place in question in terms of moving my spending there earlier in time (though I very much doubt any reasonable discount rate would find an improvement in the NPV of my spending). There’s also a question as to whether the deal may cause me to shift some spending away from similar places, to the deal-offerer, but with so many places offering deals, this looks like a race to the bottom, not a source of competitive advantage.

In any case, I think the whole deal market is pretty clearly unsustainable. Somebody may emerge making money from offering coupons, but the size of the deals is going to shrink, and/or they’ll become shorter term. Restaurants offering $25-for-$50 coupons (on which they may only be collecting $12.50), that last 6-9 months, are IMHO slashing their own wrists. For the places I like, I kinda wish they’d stop doing this, because I suspect that it actually harms their future prospects.

Posted by Auros | Report as abusive

With national competitors like Livingsocial and regional ones like the Capitol Deal, I’m not sure if Groupon’s going to thrive. Anecdotally, the quality of their local deals has generally been in decline (which is the point Sutton tries to make). Increased competition is going to make it harder and harder to succeed. And since Groupons and similar deals are similar to advertising, another factor in Groupon’s success is going to be how many merchants stick with this form of advertising. Are cheaper forms of advertising available?

Ultimately, if Groupon and its peers all die, I’ll be sad but I can live without it. I’d be more concerned with Zipcar’s fate – Zipcar is a car sharing service that’s also going to IPO soon and is, iirc, unprofitable at present. But this service really enables urban residents to forego the large fixed cost of having a car – they can convert it to a variable cost, and for the folks who don’t drive much (like me), this is a huge advantage. Here’s hoping that Zipcar makes it. When my car dies, if we’re in a big city we’re going Zipcar.

PS, after the ACSOI fiasco, I coined a summary of Groupon’s IPO filing: we’re losing money on every sale, but at least we’re making up for it with volume!

Posted by weiwentg | Report as abusive

The business model may certainly be profitable (coupon books have been around forever), what people are ignoring is that the barrier to entry into this business is low (competing is easy) and network effects are also not much of a factor (no customer lock-in).

Look at Groupon in light of what it can actually offer long term to justify it’s valuation, there is no real first mover advantage, Wheeler did not ‘discover’ anything, this idea is hundred of years old, and has been tried online hundreds of times, what Groupon has is a ton of cash, once this is gone, well, have you heard of WebVan?

Posted by inboulder | Report as abusive

Restaurants lose money on each Groupon customer and hope the exposure will generate return business. So Groupon is essentially a marketing expense for restaurants. As such, it will be judged against other marketing channels in terms of expense per acquired diner. Chain restaurants are good at crunching numbers and they won’t hesitate to drop a channel that isn’t working.

Ultimately Groupon’s real competition are all the other marketing opportunities that restaurant operators have. If Groupon isn’t cost-effective for restaurants, restaurants won’t offer Groupon discounts, and Groupon’s revenues will dry up, regardless of how popular the service is among consumers.

Posted by 2contango | Report as abusive

Felix,

You have to substantiate your first mover claim for any of this to make sense. That claim is mos def spurious, nahmean?

Posted by jtemujinw | Report as abusive

First mover advantage only exists when the product/service/business model is difficult to replicate (Ebay & Amazon, for example), thus making it difficult for competitors to enter the market.

When the product/service/business model can be easily copied the first mover advantage becomes almost negligible because it expires very quickly as competitors enter the market.

Posted by mfw13 | Report as abusive

The part that I am most dubious about is whether Groupon’s model supports them taking the high chunk of dollars per groupon purchased that they currently are.

If, as suspected, the conversion rate is pretty low for the typical groupon-buying consumer to toggle to a LOYAL customer at a given establishment, then the business that signed up with Groupon will either not be repeat business for Groupon or expect to pay A LOT less for what amounts to a heavily discounted one-time customer.

Having talked to a bunch of friends in food-related and exercise related businesses within San Francisco, they report that the groupon (and Living Social) buyer converts to long-term customer at a pathetically low rate.

True, it’s intoxicating to see the wave of business march through the doors, but hugely expensive to snare it, and a complete buzz kill when it proves illusory.

This is not to suggest that Groupon’s sales force has no value or that it’s mailing list has no value, or even that these issues are unique to Groupon.

It just suggests that rather than finding a way to turn lead to gold, Groupon is selling a promise of delivering gold, but yielding only pennies for dollars, which over the long haul will force margin contraction.

By contrast, I think of Amazon back in the day. For the longest time, people were dubious about Amazon’s path to profitability, but the difference there was that they HAD built a better mousetrap, you could SEE it in terms of customer loyalty, repeat buy patterns and the durability of their relationship with manufacturers.

Are there segments or shining examples where businesses are seeing the long-term durability of what Groupon is selling them? I don’t see it, although conceptually love the category.

Posted by hypermark | Report as abusive

A few days after this was posted, I got Amazon’s daily deal: for $25, I can get $50 worth of foam headgear (“cheeseheads”). I think this is the moment where the Groupon / LivingSocial / etc might have jumped the shark.

Posted by Machev | Report as abusive

I have to wonder how many of these commenters have ever actually run a Groupon deal? I’m guessing zero.

Yes, there are many business owners that lost money on Groupon deals, possibly because they sold more than they expected and couldn’t meet demand, neglected their existing customers or simply suck at customer service or maybe they just made bad business decisions with their pricing…is any of that Groupon’s fault?

Nope.

Having experienced several successful Groupon deals first hand, I can tell you without a doubt that it can and does work. Maybe not for every business (I agree, many local restaurants will have a hard time pricing or planning effectively), but if you provide a great service or product, price correctly, plan for the up-sell and treat the customers wonderfully, most or them WILL come back.

Posted by sunnydave | Report as abusive

You can’t deny Groupon’s business model however I have found that I receive much better customer support through a competitor called BranchBark – check them out, http://branchbark.com/ Nothing wrong with saving people big money during dire economical times in this world!

Posted by coolcatJ | Report as abusive

Agree with Felix, I think another Amazon will be their future, Groupon will be not Groupon, but it can maximise their traffic! Some of their deals have been beaten out by much smaller daily deals websites, like http://www.Hey-Deals.com

Posted by Dealson | Report as abusive

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