Groupon Gone Wrong! A Warning to Investors

After Groupon’s IPO announcement earlier this year, Market Platform Dynamics CEO Karen Webster wrote that the company’s valuation is extraordinary for an organization that is essentially a huge email list with an expensive sales operation. Following on the heels of a piece that suggested that Groupon is $300 million in the hole, we reached out to Robert Wheeler, a Fellow at the Harvard Business School, to get his view of the major risks associated with Groupon’s business model. His view: aspire NOT to be Groupon. Explain what is meant in your article on Harvard Business Review when you state, “Groupon’s fundamental problem is that it has not yet discovered a viable business model.”

ROBERT WHEELER: Groupon’s strategy is to make massive upfront investments in customer acquisition based on assumptions that lead it to conclude that the lifetime value of (or profit from) the average customer is going to be greater than cost of acquiring the average customer.

There are two risks that such a strategy faces.

The first, and most troubling, is that there are very real reasons to believe that the assumptions on which those calculations are based may prove to be overly optimistic. People have cited everything from subscriber inbox fatigue and lack of entry barriers to complete merchant dissatisfaction with Groupon as potential reasons that the company’s margins could crater. Additionally, the company assumes that it will be able to scale back its marketing spending at scale. None of these assumptions have been tested in a mature market. None of these assumptions have been tested in a market saturated with competitors, especially those who do not need to expend massive resources on customer acquisition (think Facebook). Groupon has not proven its business model – that is, the way that the company utilizes its resources (productive assets, workers and capital) to make a profit. But it is scaling regardless. Thus, the first risk is that Groupon has not established a viable profit formula.

However, even if Groupon’s assumptions prove to be right, there is another reason to be cautious. Businesses that are not profitable require infusions of cash to continue operations and fuel their growth (for a good commentary on Groupon’s cash situation, see here). Even if Groupon’s assumptions are correct, its choice to grow before being profitable leaves it at the whim of the venture capital and public equity markets. If markets lose faith in Groupon before it is profitable on a standalone basis, the company will be unable to bridge the gap to profitability and will have to shudder operations despite having gotten those assumptions right. Pursuing growth before profit adds an element of risk to an already risky endeavor – the risk that you may run out of time.

I have a lot of friends that work at Groupon and other daily deal sites. I know that Main Street Americans are going to invest in the IPO. I hope that Groupon nailed its market assessment and that it beats the clock to profitability for the sake of those people. But if Groupon succeeds, the lesson we should take from it is that the company made a very risky bet, and it paid off. What entrepreneurs should NOT do is go out and emulate Groupon by trying to build their companies as large as they can as fast as they can. For every shining success that followed such a strategy (and there are not many), hundreds of businesses have doomed themselves by pursuing growth before profit. I want to make sure that investors and entrepreneurs don’t take the wrong lessons from the Groupon story.

PYMNTS: What should Groupon have done, in your view, to have scaled more successfully?

WHEELER: Groupon had a great idea. I give them credit for that. Used correctly, for some types of businesses, daily deals can be a great promotional or utilization management tool. And what consumer doesn’t like getting 50-90% off his or her favorite stuff? I give the company credit for launching an industry, but building successful growth businesses is about more than having a great idea. It is about embedding that great idea in a business model that can sustainably generate profits.

Quite frankly, it is amazing how much remains unknown about the daily deals business model. Reading all of the comments on my article and having talked with a few CEOs of daily deal sites now, there are a ton of opinions out there regarding what the right approach to this market is and what a profitable business model will look like when the daily deals marketplace is mature. My contention is that companies need to figure this out before they invest hundreds of millions of dollars of other people’s money in growth. Such an approach is better for the company and better for investors.

Now, most startups begin with a nugget of a great idea. The most important task they have is experimenting with their business model until they validate a set of assumptions that will allow them to operate profitably at scale. Clayton Christensen calls such an approach to developing a winning business model, “executing and emergent strategy.” For more on this topic and plenty of examples, see chapters 8 and 9 of his book, “The Innovator’s Solution.” My view is that Groupon should have executed an emergent strategy by staying in a single local market, Chicago, to understand what the daily deal business looks like at scale. The company should have saturated the Chicago market and worked with merchants and customers to ensure it was sustainably profitable before growing. Had Groupon done this, it could have scaled confidently, knowing that greater profitability awaited it at greater size. If this were the case, we would be having a much different conversation right now: one about Groupon’s being a case study for how to build a new growth business.

PYMNTS: What can be done now to right the ship, so to speak?

WHEELER: The one great thing for Groupon about being in so many different local markets is that each one can serve as a petri dish for the company. Groupon can test out different business model innovations in different markets and find out which ones drive profitability. And since they are already so big, they can disseminate the ones that work throughout the whole company quickly. This is how I would approach finding the right business model and beating the clock to profitability at this stage in the game.

If I were Groupon, I would be experimenting with a high-touch consulting practice in one location, working with businesses every step of the way to structure daily deals that are fundamentally beneficial for the merchant. I would be experimenting with an all-digital sales interface in another location, focusing on low-cost service and operating efficiency to operate profitably in a market that is becoming hyper-competitive. In another location, I would be experimenting with a subscription model to generate customer lock-in. Groupon Now would be one of many initiatives that I was testing in the mobile space to see if a business model built around instant, location-based deals was the ticket to sustainable profitability for these companies.

The defining test would be: which business model is profitable over time and in the face of hostile competition? Once I found such a business model, I would implement it aggressively across the company.

In short, finding profits and then pursuing them voraciously is the best way for Groupon to right the ship.

PYMNTS: Groupon announced earlier this month that it will remove the controversial accounting metric called Adjusted Consolidated Segment Operating Income (ACSOI) from its financial statements. What reason did the company offer for this change, and in your opinion, what’s really going on behind this move?

WHEELER: The ACSOI metric basically calculated Groupon’s net income excluding its customer acquisition costs and certain stock-based compensation for new employees. In its most recent filing, the company downplayed the importance of this metric and advised investors to evaluate the company based on “whatever metrics make you comfortable.”

My opinion is that Groupon removed this metric from their financial statements under pressure from regulators and the investor community. And I think it probably frustrates the hell out of the company. At the end of the day, this is a metric that Groupon uses to run its business and that the company believes is very meaningful. The reason is that the company views its customer acquisition costs as an investment – they see these marketing expenses as costs that will be incurred one time to acquire customers and that the company will extract value from this investment well into the future. As such, they believe that the ACSOI metric reflects the true state of the underlying business and that the measure of GAAP profitability does not truly reflect the fact that they are investing for growth. I think the company truly believes in the metric, and that is why they included it in their prospectus initially.

However, given the magnitude of these customer acquisition costs, reporting ACSOI can give an incredibly skewed sense of the company’s financial status, especially to unsophisticated investors who don’t know the difference between “net income,” “free cash flow,” “operating income,” “EBITDA,” and “adjusted consolidated segment operating income.” At the end of the day, retail investors – the savers and retirees of America – are going to be asked to invest in Groupon’s IPO and finance its continued losses until it, hopefully, reaches profitability. These investors deserve a transparent and accurate account of the profitability of the business and the investment they are making. That measure is GAAP profitability, especially in light of the fact that it is highly unlikely that Groupon’s ACSOI metric can be sustained given the margin and cost pressures that we identified earlier.

PYMNTS: What spurred you to write that HBR article in the first place?

WHEELER: I wanted the article to serve as a warning to two groups of folks: entrepreneurs and retail investors. Entrepreneurs need to be aware that pursuing rapid growth before establishing a viable business model is a sure-fire way to sink your business. I want to emphatically recommend to those seeking to start a business: be impatient for profit and patient for growth.

Secondly, I wanted to sound a warning for the retail investors out there who are going to be asked to provide the capital that will allow an unprofitable business to continue operations. Despite Groupon’s dramatic growth and touted prospects, the fact remains the company is not profitable and there is little in the way of a guarantee that it will be profitable anytime soon. The company’s business model is unproven, and it is highly likely that many of Groupon’s early investors and employees are looking at the IPO as a way to cash out of the business, as they did in previous financing rounds.

My mom and dad are two of the people who asked me whether or not they should invest in Groupon. They heard about the company’s potentially bright future and were wondering if it made sense to get a piece of the action. Whether they or any other Main Street Americans invest in Groupon is their own decision. But they at least deserve to know what they are being asked to finance.

Bio: Robert Wheeler is currently a Fellow at the Harvard Business School’s Forum for Growth and Innovation.  He was a member of the Harvard College Class of 2005, where he played varsity baseball and graduated cum laude in Applied Mathematics and Economics. (Read More)


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