Let me first say that Groupon filing to go public is not proof of a tech bubble. There is no tech bubble, just a micro bubble here or there. Nor is the Groupon story even particularly interesting or important compared to what’s happening in Europe right now. But since it has filed for IPO and since all of us in the tech economy now must spend the next years hearing the breathless gossip, IPO hysteria, and requisite recriminations over the inevitable implosion — let us briefly examine the tulip mania that is Groupon.
Why is Groupon not merely a tech-bubble datum but a Ponzi scheme? Simple: Groupon has found that you can get local merchants to try anything once if it brings them new customers. A few local merchants in Chicago get them started, and Groupon shows good revenues. In fact, Groupon immediately remits half of those “revenues” back to the local merchant — they were never Groupon revenues in any meaningful sense of the word. But, optically, Groupon revenues look high — which they use to raise a financing round at a high valuation. Then they use the proceeds to hire vast armies of salespeople to dig deeper into Chicago’s local merchant community and repeat the trick in other cities.
Meanwhile, many early-adopting merchants find that the burst in customers immediately disappears, and since they can’t perpetually discount 75%, those merchants stop using Groupon. But Groupon’s sales force adds many more new merchants than it loses (for now). And Groupon goes out and raises another round at an even higher valuation; they hire even more salespeople and expand into even more virgin territory. Lather, rinse, repeat.
The model is only sustainable if it pays off for local merchants — and to justify Groupon’s current size, it now must pay off for local merchants ubiquitously and flamboyantly. If not, Groupon is mostly a Ponzi scheme.
Groupon argues that it helps merchants attract new customers who become loyal patrons, and that pays for the expense of winning them via Groupon. This is the fundamental argument Groupon’s sales force uses to close local merchants. Let’s get past the sales speak to what this really means. The typical Groupon “deal” is 50 percent off retail, with half of the proceeds going to Groupon. So the merchant gets 25 percent of the revenue s/he would have received if the same number of customers had arrived via walk-in traffic. Except that all that Groupon revenue is unprofitable — so more and more Groupon revenue is actually bad.
The vast majority of local merchants can’t discount more than 10 percent. Some can go maybe 25 percent in special situations. But 75 percent is a wholly unsustainable number. If all local merchants begin using Groupon then it can’t send loyal customers to anyone; Groupon can only send discount chasers to merchants. Which means that as Groupon grows, both local merchants and their competitors will find that Groupon’s main argument no longer works (if it ever did) — Groupon simply can’t send them loyal new business. So they all stop using Groupon in its current form.
Perhaps Groupon management thinks it is creating a sustainable Prisoner’s Dilemma, one that ultimately destroys value for the local merchant ecosystem but benefits Groupon. In other words, Groupon could grow so big that local merchants have to use it, even though it ultimately hurts them. In game theory terms, Groupon creates an equilibrium point at “All Local Merchants Defect,” and then, having forced merchants into this value-destroying equilibrium, takes a cut for having rigged the game. Obviously, Groupon couldn’t share this thinking publicly. They would just continue to use the attract-loyal-new-customers argument even though it no longer makes any sense for a ginormous Groupon.
This may sound cynical. But if this is Groupon’s game plan, it isn’t cynical. It’s naïve. Most local merchants simply don’t have enough value in their collective ecosystem to share anything remotely like this much value with Groupon. This isn’t a stable equilibrium, it’s a suicidal one. The local merchants will have to stop using Groupon en masse not long after they first start experimenting with it.
Due to its size, Wal-Mart can squeeze its suppliers on price and its suppliers will comply. Lower prices create value for Wal-Mart’s customers. But it’s sustainable only because it also creates value for Wal-Mart’s suppliers who are large enough that they can find efficiencies in their manufacturing processes (generally by outsourcing manufacturing to low-wage economies like China). That’s bad for American workers. But it’s value-creating for Wal-Mart suppliers because they get to sell stuff through Wal-Mart (which means they can sell more of it) at margins that are acceptable due to reduced manufacturing costs.
But most Groupon local merchants are nothing whatsoever like Wal-Mart’s suppliers. They generally have no margin to spare or wiggle room in their operating costs. Therefore, they cannot continue using Groupon.
Let’s consider the exceptions because there are some. A local merchant with huge gross margins — 70 to 90 percent — can use Groupon sustainably (though it still isn’t clear that they should). Or, a large local merchant who does a lot of expensive customer acquisition (i.e., local television) can use Groupon sustainably but only if Groupon is better than its traditional customer acquisition methods (doing both and doubling customer acquisition costs will not double the local market size).
This is why Groupon must ultimately implode — there just aren’t that many business that fit either of these descriptions.
Groupon’s management publically avers that “local merchants come back” — well, sure, some of them do. For a while. But what do the audited numbers look like? Just what percentage of local merchants come back? How many times? Do local merchants show a strong tendency to decline in participation over time?
Groupon management won’t release these numbers, and certainly won’t release thoroughly audited and vetted versions of these numbers. Instead, what Groupon management is doing is withdrawing an astonishing amount of cash out of the company. It’s also creating a new class of B shares so that it can keep control of the company in the hands of management — all the better to keep the Ponzi scheme going for as long as possible.
Again, there isn’t a bubble in tech. High valuations for many of the big tech companies like LinkedIn, Facebook, and Twitter make sense due to those companies’ incredible network effects and the fact that, fundamentally, these companies are creating value and will get better over time at monetizing that value. Net-net, Groupon is unsustainably destroying value and will implode sometime in the next five years. When that happens, it will almost certainly, and totally unfairly, wreak havoc throughout the tech ecosystem.
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