Notes on Groupon

By Felix Salmon
September 26, 2011
DigitalK conference.

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I’m in Sofia today, where I gave a talk on Groupon at the DigitalK conference. This post isn’t the speech that I gave, which was much shorter and more conversational; the slides I used are here.pdf. There’s not much new in this post, for those who have been following what I’ve written on Groupon over the past few months; I basically wrote it to get a feel for how I wanted my speech to flow. But here you go anyway.

It’s almost universally known, among people who live or work anywhere near the intersection of technology and finance, that Groupon is the fastest-growing company the world has ever seen. Technology companies are often fast-growing, of course, but Groupon’s growth rate is astonishing even by tech standards. Check out this chart:

groupon growth compared.jpg

Starting at zero, Groupon got within shouting distance of $1 billion in revenues within a single year. It took Zynga two years to get to that point, it took Amazon three years, and it took Facebook four years. eBay hadn’t even got there after five years. This isn’t entirely or even mostly a function of Groupon’s business model; much more important is the massively increased willingness of people to buy things online now than when the likes of eBay, Yahoo, and Amazon launched in the 1990s.

And it’s possible to quibble over terminology here, too: in its latest filing, Groupon now calls this number “billings”, with “revenues” being about half of what we see here. But whatever you call it, it’s a monster stream of cash which is flowing into the company, and you can add to these revenues some $1.1 billion in new equity capital, which is also helping to fuel expansion. Groupon isn’t just growing fast: it’s also raising money at a rate that no other company has ever dreamed of.

Importantly, the stream of cash flowing out of the company is even bigger. Half of Groupon’s billings go to merchants, usually small local businesses. Much of the rest goes towards Groupon’s rapidly-growing payroll, and to fund expansion into new cities and countries. And then there’s more than $900 million which has been used to cash out early investors in the company, including CEO Andrew Mason — a man who is now extremely wealthy even if Groupon stock goes to zero tomorrow.

Groupon is a very innovative company, and this is one of its most important innovations — the idea that the founder can and even should be able to cash out to the tune of millions of dollars very early on in the company’s lifecycle, while it is still raising new VC funds.

The argument here makes a certain amount of theoretical sense. VC investors are looking for home runs, and they’re willing to see a reasonably large percentage of their portfolio investments fail to achieve that end. Essentially, they want the CEOs they’re backing to take on as much risk as possible.

But there’s a problem with this model: CEOs are human, and humans are naturally risk-averse. When Andrew Mason first saw that he’d built Groupon into an inherently highly-profitable Chicago company, he could have decided to fund further expansion only out of the company’s profits, while keeping some portion of those profits for himself and his investors. Groupon would have grown at a much more normal pace, and would certainly never have generated eye-popping charts like this one.

yay_groupon 1.gif

Over the course of one year, from the first quarter of 2010 to the first quarter of 2011, Groupon’s subscriber base increased 24-fold; its revenue increased 14-fold; its sales rate increased 15-fold; and it swung from a profit of $8 million to a loss of $146 million.

These are the kind of figures which make eyes go wide — with greed, if you’re a VC, and with fear, if you’re an businessman trying to build a company which can deliver a reliable long-term profit stream. By cashing out a significant portion of the CEO’s stock, his backers essentially turned him from businessman to VC — they aligned his incentives with theirs. He won’t want for money ever again, so he’s no longer the type of person who would look at a company making $8 million a quarter and think that was pretty good. Instead, he wants to take risks, grow at a breakneck pace, and create a company which is likely to go public, later this year, at a valuation somewhere in the neighborhood of $15 billion. He wants to change the world.

That’s the idea, anyway; we’ll see how it works out. Historically, VC rounds have been about providing capital to companies which need it; in Groupon’s case, they’re more about finding a way to cash out early investors. And so a lot of people who own Groupon stock today didn’t really put money into the company, so much as they simply bought pre-IPO stock on the secondary market. If they end up making a fortune in the IPO, then other companies will certainly start looking at the Groupon model as something maybe worth emulating.

What’s sure, however, is that the kind of growth and ambition exhibited by Groupon is catnip to journalists looking to puncture something which looks very much like a bubble. Going public before you’ve achieved sustainable profitability? Using seemingly made-up measures like Adjusted Consolidated Segment Operating Income instead of generally-accepted accounting principles? Becoming a billionaire before the age of 30, while refusing to play according to the spoken and unspoken rules of both Wall Street and Fleet Street? It’s a recipe for getting the press to turn on you.

But in fact the conventional wisdom on Groupon is narrow-minded, a little bit silly, and largely based on journalists kidding themselves that “everybody” thinks Groupon is a huge success, and that therefore it falls to them to debunk the myth. In reality, the huge-success meme was extremely short-lived, and stems largely from the fact that Google attempted to buy Groupon for $6 billion at the end of 2010. Ever since Groupon turned Google down, there’s been a steady drip of stories saying that they were idiotic to do so and that valuations of Groupon in the $15 billion to $25 billion range are utterly ridiculous.

Now, I’m not going to take a position on how much Groupon is worth; I’m neither an investment banker nor an equity analyst. But what I’d like to do is run down a few reasons why a stratospheric valuation could conceivably be justified, and then look at a few of the potential potholes which face Groupon in its attempt to justify that valuation.

First of all, Groupon has cracked local, in a way that pretty much nobody else has been able to do. We spend most of our disposable income at merchants located within easy striking distance of where we live — but until Groupon came along, those merchants had no good way to reach us online. Everybody’s interested in what’s going on locally, and Groupon worked out that a steady stream of daily emails, each one touting a great local deal, would be hugely attractive to millions of people. This is advertising you want to get.

Second, Groupon has created advertising that is guaranteed to work. By setting a minimum number of people who need to sign up for a deal before it’s activated, merchants can be sure that the needle will be moved and their effort won’t be wasted. This is something of a holy grail in advertising and marketing circles, and it absolutely helps to explain Groupon’s spectacular growth. Merchants hate to spend money on marketing because they fear they’re being swindled by fast-talking sales reps. With Groupon, they know exactly what they’re signing up for, and they won’t end up spending huge amounts of money on nothing.

Indeed, those merchants are not spending any money at all: they’re being paid. This is another great Groupon innovation: create a form of advertising which merchants not only pay nothing for up front, but which they actually get paid. Yes, there’s a cost to providing their goods or services, and in many cases that cost is greater than the amount of money they’re getting from Groupon. Merchants who get too greedy for a big up-front paycheck can end up ruining themselves when those coupons get redeemed. But anybody who’s ever run a small business knows that the promise of money in hand is always going to be incredibly attractive when compared to advertising or marketing which has to be paid for.

In fact, Groupon gives advertising away for free. It has an astonishingly valuable email list, and many merchants would pay good money to be able to send out wittily-written ads to local Groupon subscribers. But they don’t need to do that. Groupon makes its money from the tiny minority of customers who actually pay for a deal. But that leaves millions of people every day who read ad copy which is targeted directly at them. That targeted advertising is extremely valuable, and Groupon isn’t charging a penny for it. Because it has an alternative source of income, Groupon doesn’t need to charge merchants for the privilege of being included in its emails. And so a merchant who values that exposure is well ahead of the game as soon as the email goes out.

But another Groupon innovation goes one further than that — it’s the Groupon commitment device. A commitment device is the way the people force themselves to do something which they know they want to do, for fear that for some reason or other human weakness might otherwise mean they wouldn’t do it. The classic commitment device is marriage: it helps people stay together when otherwise they might drift apart. A mortgage is also a commitment device, which forces you to spend a large sum of money every month slowly building equity in your home, until after 30 years you own it outright. A Groupon, of course, is nowhere near as important as marriage or a mortgage. But it has a similar effect. I see a Groupon in my email — let’s say it gives me $50 off a meal at a restaurant I’ve been meaning to try down the street. By buying the Groupon with a click of my mouse, I force myself to go to that restaurant — something I might well never have got around to, otherwise.

Groupon forces its customers to buy its products using something which isn’t very innovative at all — the hurry-it-won’t-last-long sales pitch. By making sure that offers can only be bought for a day or two, Groupon forces people to make a decision now as to whether they want to do this thing. And that non-innovative part of the Groupon model is one of its big potential weaknesses, as I’ll come to in a minute. But first of all there are some potential strengths to Groupon.

What we’ve seen up until now is the way that Groupon has worked and grown to date. But looking forwards, optimists see lots of other great promise in the company. I don’t want to dwell on these, because forecasting the future of any tech company is always a mug’s game. Some of them are likely to work, others will probably fail. There’s Groupon Now, and the mobile applications which are nascent but growing fast. There’s the move from services into products. There’s the Getaways travel product. And there’s targeting — the crucial way in which Groupon promises to be able to target customers according to their purchasing preferences and a myriad of other factors, rather than just going on what city they live in. It hasn’t happened yet, but I suspect that over the medium term, Groupon will succeed or fail based on whether it manages to crack the targeting nut. Having a huge subscriber base is a necessary condition for targeting, but it’s far from sufficient.

I have no idea what any of these businesses might be worth, or what kind of probability to apply to them succeeding. But looking down this list, and looking at the kind of money which Groupon is bringing in without these businesses, it’s definitely possible to see how this could be a $20 billion company, potentially.


There are also risks to the Groupon model, and we’re already seeing some of them materialize.

One risk is that merchants stop wanting to play ball. Maybe they move their business to to a Groupon clone which offers them a bigger cut of the proceeds. Maybe they don’t return to Groupon because it turns out that too many Groupon buyers are only coming because they bought the Groupon, and don’t become valuable repeat customers. Or, conversely, maybe it turns out that too many Groupon buyers are people who would have come anyway, and so the merchant is simply taking a big haircut on their normal revenues. Or perhaps — as we’ve seen happen a few times, according to press anecdote — merchants simply get overwhelmed by Groupon traffic, and thereby alienate their existing customers.


If you look at the established market of Boston, the trend here is not good. As markets mature, they won’t be as white-hot as they were in their youth. But one big problem for investors is that none of them really have a clue what kind of revenue per merchant is necessary for profitability.

The other big risk is that consumers stop wanting to play ball. The novelty wears off, they find too many Groupons sitting unused in their desk drawer, they get burned one too many times by a deal which seemed really good in the email but which turned out in real life to be disappointing.

Already we’re seeing signs that this is happening: according to a guy called Sam Hamadeh, Groupon’s revenue per customer has fallen from $15 per month to $3 per month. Now the number of customers is still growing fast, but clearly profits are going to be hurt if those customers don’t spend nearly as much as they used to. Here are the numbers for Boston, again:


And there are other risks, too, including big possible legal risks. There are lots of laws governing coupons, in all 50 states and around the world, and Groupon seems to be happily violating dozens of them, while doing its utmost to fob legal responsibility off onto merchants who can’t possibly know what the law says.

But the biggest risk of all, which pretty much encompasses all of the other ones, is simply that Groupon will develop a bad reputation. If people don’t trust Groupon, then it’s all over.

In the beginning, Groupon got away with a lot, thanks partly to how innovative it was and partly because of the jocular tone to its emails. But at this point everybody knows what the model is, and the humor is hardy surprising any more. And increasingly consumers and merchants are asking just how good Groupon’s deals are, really. Not in terms of save $X if you spend $Y, but in terms of the intrinsic quality of the merchants being featured.

It seems to me that if Groupon wants the Yipit charts to start going up and to the right, if it wants to delight consumers, and if it doesn’t want to become shorthand for desperate-and-crappy merchants resorting to a last-ditch effort to get people into their otherwise-empty stores, then it’s going to have to start imposing more editorial control over its sales team.

In the long run, people will buy coupons only from those sites they trust to send them to great merchants. Groupon has first-mover advantage, but consumers are fickle, and will happily switch their allegiance to smaller companies they think are cooler, if Groupon makes them feel a bit unwashed every time they buy into an offer.

How can Groupon ensure that it features only merchants its email list will love? I haven’t a clue. But that’s the single biggest task facing the company. If it wins at that, it’ll be fine. If it fails, I fear it will slowly wither away.


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