Why will GroupOn succeed?

GroupOn’s ability to survive lies solely in its ingenious appeal to the psychology of the consumer and merchant – its valuation is outrageously irrational; its business model equally flawed from “rational” economic players perspective, yet I will confidently say it has high chances to succeed, as long as the psychological game persists and remains unchallenged. In a series of bogs, I debunked the valuation of GroupOn and the deal industry in general; however, why do I still believe they will succeed?

The underlying success of GroupOn is pinned in its appeal to the psychology of the consumer and merchant. GroupOn is the first deals based business model that went viral, even though its business model has been around for decades. Since the advent of ecommerce, retailmenot.com, coupons.com among others, preceded GroupOn inviting far larger user base, but far too small valuations. Then, what is the secret sauce of GroupOn? 

The ingenious strategy of “prepaying” for deals & “framing” of savings is where GroupOn innovated. The prepaid nature of GroupOn creates commitment and anticipation which have viral elements.  

• Commitment – Unlike a 10% coupon which you can let expire, when prepaying for a saving, you commit to make the transaction. While a 10% savings offer may be lost in your memory, prepaying keeps it fresh in the mind …you'd better remember that you have already paid for a service that you have not yet consumed… so it’s on top of your mind to buzz about it at parties, among friends…
• Anticipation - Most consumer research shows that the prolonged period between commitment and delivery of experience creates additional excitement. Moreover, anticipation keeps the excitement of the experience fresh, exacerbating its viral component. Remember that anticipated vacation you were telling your friends months in advance?
• Framing – Even when the deal is ordinary, GroupOn can make it sound exciting by framing it in a way that resonates with the customer better. How would you like to receive a $20 for $10 GroupOn for Old Navy instead of 20% off $50? Cialdini spends volumes talking about the psychological pitfalls framing leads us to, but when manipulated smartly by a marketing company, it can attract consumer’s wallet share.
• Addiction - Studies show the happiness factor associated with an experience decreases significantly at the time of payment…hence; we tend to enjoy prepaid vacations more. GroupOn allows you to partially prepay for your experience, thus mitigating the displeasure of payment associated with a service you bought…making you “enjoy” your GroupOn dining experience more than otherwise, and in turn, causing you to come back for more GroupOns.

  

Well, merchants also like the immediate cash flow infusion, giving them immediate gratification over other long-term marketing investments. In addition, it is a great tool to solve for overcapacity and slow moving inventory. But, is the cost justifiable to a small business? Rice university research states over 32% of merchants find GroupOn deal to be a financial disaster.

However, as long as demand for GroupOn remains strong, merchants will learn the price elasticity of the GroupOn psychology and pass on the cost to the consumer in terms of higher list prices or smarter framing of deals. After all, how do you determine the fair price of a hot air balloon ride? Your willingness to pay for the service is the GroupOn adjusted price - but, what makes you confident that the GroupOn adjusted price would not have been the true price had GroupOn never existed?

Although some myths dominate the GroupOn controversy about its lack of targeting …these are easily solvable. With time, GroupOn will possess enough consumer data to allow it to data mine and target offers to consumer preferences. As for GroupOn fatigue, well, that is no different than any form of direct marketing…

Despite all the controversy, GroupOn has the potential to succeed as its innovation appeals to the consumer psychology and merchants will continue to supply it, as long as consumers are willing to buy.

GroupOn is like “dating in NYC”…therefore, every merchant’s nightmare!

Well, you can replace “NYC” with “LA” or any other major metropolitan city that offers too much of a good thing – a proliferation of single eligible men & women (which is a paradox in itself.) The simplistic theory that explains this paradox is the non-committal factor, since everyone is waiting for the “next best thing.” Why commit to a relationship when you are swimming in a sea of options? Too much of a good thing can be dangerous for commitments.

And this is the story of the avid GroupOn user. For GroupOn to succeed, it needs to generate excitement and loyalty to its business. However, GroupOn loyalty outrightly means non-commitment to a merchant, the merchant that GroupOn is designed to serve … and hence, the nightmare of the small business begins.

Loyalty is what most businesses thrive on. Loyalty makes a business sell not 1, but 100 widgets to one consumer, increasing profits. But, the case with GroupOn is a bit more complex. When GroupOn creates loyalty to its business model, it creates a vulture who thrives on deals…a vulture that is waiting for the next best deal…this vulture is not the ideal customer that the small business had in mind when signing up for GroupOn. The merchant’s viability and interest in GroupOn is to attract a new user base who will eventually become loyal customers of its establishment and not of GroupOn. But, that is in absolute contradiction with what will make GroupOn thrive & explode in success.

The conflict of interests is deepened by competition that has innovated in the deals space to further shape the future phsychology of this vulture to become even fiercer deal hunter. Such recent innovation is the “instant deals.” With instant deals, the consumer can plan its day around the deals available to him on that day.

Although, the instant deal can be a fantastic “just-in-time” inventory clearing mechanism, or extra capacity management for a merchant, when adopted by the majority it will become the merchant’s nightmare. Everyday, one of your competitors, featuring the deal, will be stealing your customer base, who now have become GroupOn loyalists.

Of course, this theory is only valid if GroupOn and the deals industry become really successful. So, let’s revisit the numbers from GroupOn. In my first blog of this series -“GroupOn’s valuation myth debunked!!! A cautionary tale of the deals industry…” I visit GroupOn’s valuation. The $30 billion valuation for GroupOn tells us how optimistic investors are about the industry. For GroupOn to be worth that, it needs to become at least a $15 billion business, therefore, needs to sell at least 600 Million deals a year (based on average revenue of $23 per deal see S-1 filings). Either U.S. will more than double its population or GroupOn will have to create a lot of loyal customers who will buy quite a few deals per year. Now if we add Living Social, Facebook’s deals, we can picture the gigantic success investors expect.

Unfortunately, the small/local business who is the GroupOn user is so fragmented that they will not have the typical power to restrain GroupOn’s empire. The death of the small business will come slowly and ‘unexpectedly’ by the vulture that GroupOn will create. “Unexpectedly,” because a small local merchant will fail to see beyond the short-term effects, meanwhile the downfall will be building up and will be macroeconomic in nature.

GroupOn creates a conflict between its success and the success it promises to the small business. However, GroupOn has a potential to succeed, which is not based on “rational” theory, but the pshychology of the merchant and consumer. Read “Why will GroupOn succeed?” for more.

The myth of the deals industry

To understand the basics of the deals industry, it is important to go back to how and why deals originated in the first place. If we begin from the “rational” player’s point of view, then prices will be set at the equilibrium point where demand equals supply. However, that requires businesses to have perfect information about consumer demand and price elasticity. In reality, such perfect information is non-existent, leading to mispricing of goods.

As economies got more competitive, the problem of mispricing extended to overflooding of businesses. Typically, there is an optimal supply of any good or service that will yield the highest societal utility from pricing and profit maximization perspective.

A third pervasive problem that deals came to solve was the miscalculation of demand and hence, inventory mismanagement. In a perfect world, where information can solve the problem of misprcing, inventory management, and the number of ideal competitors, then there will be no reason for deals. The deals industry will simply vanish.

The wide success of the likes of GroupOn is indicative of a deep rooted problem of over-supply, and inability of businesses to get perfect information. As such, the deals industry is only a primitive attempt to solve the imperfections of the capitalist economy. The advances of information technology, optimization tools, data analytics and innovative crowdsourcing business models are more advanced techniques designed to solve the same problem of imperfect information, and therefore, are a serious threat to the viability of the deals industry.

The simple question to ask is “would Macy’s prefer to split its revenue with the likes of GroupOn or, would it prefer to have a crystal ball, that can help predict with great accuracy how much to produce and how to price to clear all inventory?”

Clearly, that crystal ball has more futuristic movie appeal than immediate implementation, but that time horizon is not far away. Today, predictive polls, using the wisdom of crowds are being experimented. Data analytics has taken a wing of its own. The predictive models still lag behind, but the momentum is driving us in that direction.

So, the question remains…if you had to bet your money in the future, which would you pick, deals or information technology /optimization tools/ crowdsourcing for predictions? It may be a good exercise to revisit the “Wisdom of Crowds” before calling your bet.

But, this is not a solution residing in the faraway future. It is a problem requiring deep soul searching today. Valuations are predictions of the future. GroupOn’s $30 billion valuation is a bet on that future.

THIS IS the cautionary tale of the deals industry.

However, I had opened my earlier blog “GroupOn’s valuation myth debunked!!! A cautionary tale of the deals industry…” stating that

GroupOn’s ability to survive solely lies in its ingenious appeal to the psychology of the consumer and merchant …I will confidently say it has high chances to succeed…

Before I reveal the secrets for GroupOn’s success, read another cautionary tale “GroupOn is like “dating in NYC”…therefore, every merchant’s nighmare!” explaining the conflict between the loyal GroupOn customer and the merchants GroupOn serves.

GroupOn’s valuation myth debunked!!! A cautionary tale of the deals industry…

GroupOn’s ability to survive lies solely in its ingenious appeal to the psychology of the consumer and merchant – its valuation is outrageously irrational; its business model equally flawed from “rational” economic players perspective, yet I will confidently say it has high chances to succeed, as long as the psychological game persists and remains unchallenged. In a series of blogs, I will debunk the valuation of GroupOn and the deal industry, in general.

Since its IPO announcement, a lot of investor mania has surrounded GroupOn. But, is its value of $30 billion justifiable?

The true value of an asset, theoretically, equals how much cash it can generate in the future. Using this simplistic theory, GroupOn’s $30billion valuation assumes that the company soon will grow to at least $15B in revenue (estimate arrived using 10% discount rate, 20% margin and other projections by GroupOn). Given its revenue growth and consumer’s willingness to pay, such projection seems aggressive, but well within the realm of reasonableness. However, the challenge lies on the supply side. $15 billion of GroupOn revenue equates to $45 billion a year that small/local businesses will have to part with and hand it to GroupOn as marketing expense. (GroupOn keeps 1/3rd of the deal)

As all valuation models are based on the assumption that decisions are purely “rational”, a merchant shall accept a deal with GroupOn only if it can generate positive ROI. From the macroeconomic scale, the GroupOn model simply crumbles.

The fundamental question to ask is if GroupOn actually contributes to value creation or redistribution of funds? Are you, as a consumer, spending more of your income or simply allocating your disposable income differently because of GroupOn? The simple answer is the latter. GroupOn has no capacity to create economic value, but it merely redistributes revenue from non-GroupOn merchants to GroupOn merchants. The question that bags itself is: If all merchants participate in a GroupOn offering, then where will the redistribution come from?

Based on data provided by the SBA and Economic Census Bureau, it is estimated that small businesses, at best, in the consumer sector, generate about $1-$2 trillion in annual sales. Assuming 10% profit margin, all consumer small business profits are around $100-$200 billion. For GroupOn to generate the revenue it forecasts, at least, ALL small businesses shall sign a deal with GroupOn and decide to give away $45 billion out of $100 billion profits they make. Wow, that’s a whopping 45%.
If not all merchants participate, the story is even more bleak. The $45 billion will have to come from smaller number of merchants.


Aha, two fallacies in the valuation are exposed. Is it reasonable to assume that ALL small businesses will sign up? And second, will a rational business owner simply give away a quarter, or half, of its net cash receipts to GroupOn, when there is no promise of true revenue growth or positive ROI? Let’s remember that GroupOn’s valuation of $30billion requires that almost all small businesses sign up for a deal with the Company…therefore, no net redistribution of revenue will be possible. Month 1, one merchant will pocket more revenue as a result of its GroupOn deal; however, in months 2-12 it will forgo its revenues to fund the redistribution of industry receipts to its rivals featuring a GroupOn deal.

And of course, let us not forget the copy cats proliferating the market. One might ask if international expansion is their basis for growth…that sounds too optimistic - China alone has already launched over a 100 GroupOn competitors. It’s an industry with zero barriers to entry, and therefore, competition is rampant.

If GroupOn’s valuation appears so optimistic, the entire industry taken together appears highly speculative. I would highly caution any venture capitalist, and investor pouring funds into the industry.

But, where did this all start? The deals industry… The power or bargaining power… The concept of offering a deal to seduce customers… Read “The myth of the deals industry” for more.