How does Groupon work?

Don Dodge · June 6, 2011 · Short URL:

Is the business model sustainable?

Groupon is the fastest growing company ever. From nothing to a stunning 7,000 employees and billions in revenue in just two years. Groupon just filed for an Initial Public Offering (IPO) and revealed the financial details behind the media hype. TechMeme is ablaze with negative stories on Groupon. Minyanville says "Groupon is Effectively Insolvent". MG Siegler calls it "Grouponzi". Yipit says "Groupon S-1 Reveals Business Model Deteriorating". Not a single positive story to be found. Naturally my contrarian nature perks up.

How does it work? The core of Groupon is 50% off deals from retailers of all kinds, sold via email directly to consumers in a "one day only" sale offer. For example, a $40 hair styling for $20. The consumer pays $20 to Groupon and gets a certificate to redeem at the hair salon. The certificate may expire in one year or less. Groupon keeps 50% of the revenue, $10 in this case, and remits $10 to the hair salon. So, the customer gets a $40 hair styling for $20. Groupon keeps $10 and the hair salon gets $10.

Isn't this a 75% discount? The way the Groupon model works the retailer is effectively disounting their product or service by 75%, the consumer gets 50% and Groupon takes 25%. The retailer gets new customers, and is betting they come back and become loyal customers. In this way Groupon is a customer acquisition cost, much like advertising. 

Groupon's customer acquisition cost - Groupon itself, just like its customers, is spending huge sums to acquire new customers. Groupon lost $102M in the first quarter of 2011 on revenues of $644M. Analysis of some "older" markets show that while revenues are still increasing in total, the revenue per subscriber is dropping. I recall Amazon when it went public back during the dot com bubble. It was unprofitable for 6 years, but eventually turned the corner and is now very profitable. Can Groupon do the same thing? Will investors be as patient?

Can retailers survive 75% discounts? It depends on their business model. Companies that have high fixed costs and low variable costs may be able to afford 75% discounts. For Groupon to succeed long term the retailers must find the Groupon service attractive and come back for more deal offers. If they can gain loyal repeat customers it might make sense for them. 

Buy one, get one free - Retailers and restaurants have used "buy one get one free" offers for years. The difference is that they ran these offers themselves. They brought people into the store. And, they kept 50% of the revenue, not just 25% like the Groupon case. In restaurants the "buy one get one free" offer might apply just to the entree, not the drinks or deserts, so those were full price and profitable. Or, it might be "get $10 off a check of $20 or more" so they were only discounting the first $20...the rest was regular retail price.

Who can make money with Groupon? Consider health club memberships, yoga classes, harbor cruise boats, music concerts, sporting events, classes, theater productions, etc. Software, Music, Movies, and DVDs are the classic high fixed cost, low variable cost businesses. Every additional customer is almost pure profit once the fixed costs are covered. Any business that has a low variable cost might find Groupon attractive.

High margin businesses might also like Groupon. Jewelry, perfume, wines, and high end fashions are a few examples of very high margin businesses, where the retail price bears little resemblence to the actual costs. Believe it or not there are some businesses where the retail price is 200% to 500% the actual cost. A Groupon 75% discount could work in these businesses.

Gift Breakage is 100% profit - Most people forget about what the industry calls "breakage", a paid certificate that expires unredeemed. The consumer just forgets to redeem it, or doesn't care. Gift card dealers make a fortune on unredeemed gift cards. In the United States each state could have different laws concerning gift cards, certificates or discount coupons. For example, in California gift cards can not expire. In other countries there are no laws concerning unexpired certificates of cards. If just 10% of the consumers don't redeem their certificates that could mean hundreds of millions in profits for Groupon.

Is Groupon sustainable? No one knows for sure. Time will tell. Competitors are sprouting up everywhere. Margins are likely to tighten. Competitors will offer the merchants better deals with lower discounts. Will consumers become loyal repeat customers after using a Groupon? If not, the whole concept doesn't work. On the other hand, as we have seen with Facebook, Twitter, YouTube, Amazon, Google, Skype, and many other iconic brands, once a huge customer base is established, it is very difficult for a competitor to lure them away.

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