[By Justin McCarthy]

Andrew Mason is the young, fresh-faced founder of Groupon, the fastest growing start-up in history. Fresh-faced youngsters running tech start-ups are hardly a rare breed in Silicon Valley, but Mason is a native of Pittsburgh and Groupon is based in Chicago, both a far cry from the sunny Californian climes. This hardly hindered his drive and appetite, and with just US$1m in seed capital from former employer Eric Lefkofsky, he started Groupon with a two-for-one pizza deal at the bar downstairs from what is now Groupon’s HQ. Twenty-four deals were sold that day.

That was October 2008, less than three years ago. In that first quarter of operation, the company turned over $94 000. This ballooned to $30m in 2009 and $713m in 2010, and in the first half of 2011, Groupon raked in $1,5bn, making it a remarkable phenomenon in the history of capitalism.

The growth was achieved through an incredible rate of expansion as Mason quickly realised that aggression (via acquisition) and speed to market were the only way of keeping the hundreds of copycats snapping at his heels at bay. From the single bar serving pizza a short 34 months ago, Groupon has closed millions of deals in 60 countries and has a claimed database of 86m active punters.

This growth and scale attracted a great deal of interest from the investment community, and with a technology stock bubble arguably expanding, Groupon began lining up an initial public offering that could see its market value rise to $35bn, or 33 times its 2010 revenue.

Recent market turbulence has probably applied some coolant to the overheating engine, with tech stocks have taken a beating along with almost every other sector. LinkedIn, which listed at $45 in May 2011, rocketed past $122 within days at 45x revenue until its stock plummeted 27% on the market turmoil in recent weeks. It’s anyone’s guess how this script will unfold, but there’s still plenty of hungry cash around hunting for hot returns.

Groupon, a hybrid of the words “group” and “coupon” works quite simply. A merchant offers a product or service at a heavily discounted price (usually around 50%) which is then advertised on the Groupon website (and pushed via e-mail subscription) to the company’s database, defined by geo-location. Groupon subscribers can elect to receive offers in their home city or offers that span a national universe, or both.

The company pumps out between two and 10 offers a day per location. Each deal has a tipping point — confirmation of a minimum number of buyers — before the deal is active. Once a deal is active, buyers are billed and the deal runs until it hits expiry — a predetermined date and time and/or a predetermined number of buys. Revenue from the deals is split between the merchant and Groupon on a pre-agreed basis, but it’s not uncommon in many categories for that to be 50:50. This is where the catch lies.

Buyers simply print their vouchers and redeem the deal at the merchant before the coupon’s expiry date. This is the sizzle in the business model — subscribers can get fantastic value on quality goods and services across a wide variety of merchants provided they’re prepared to travel a little or take the odd gamble with a previously unknown or untested merchant. Buyers seldom lose, unless they fail to redeem their voucher before expiry or greed gets the better of them and they overindulge in goods they simply don’t need.

The risk lies with the merchant, and this is where the model gets properly tested. Considering that Groupon launched within weeks of Lehman Brothers’ collapse and the ensuing crisis, it’s not surprising the model experienced such growth. Businesses heavily geared or with tight cash flows were desperate for survival, and Groupon mopped up millions of dollars of business that might otherwise have hit the wall.

Yet the base model is plainly unsustainable, as it relies heavily on small and medium enterprises so desperate for business they cut right through the muscle. A cursory look at the typical Groupon or equivalent merchant tells a story about the SA version that mirrors most other markets: health spas, beauty bars, independent restaurateurs, jewellers, confectioners, lodges and hotels — the types of businesses that have fixed overheads and unsold inventory. You won’t find a major retailer, hotel chain or service provider on offer — the significant majority of deals are offered by small, independent businesses that need the foot traffic.

That’s the attraction of Groupon, but the reality is the merchant derives little benefit. Thousands of businesses across the US and 60 other markets are speaking out about the one-sidedness of the deals.

Consider the numbers for a moment: a hairdresser sells a service for R200 on regular rates. That’s discounted to R100 to drive traffic, but R50 goes to Groupon and the salon ends up with R50, a quarter of its regular revenue. This works to a point, but overtrade it and you’ll be out of business or will have seriously damaged your reputation with your regular customer base before the mousse sets.

Some 500 or more copycat start-ups hit the market within the first two years of Groupon’s arrival, fuelling the hype and mopping up business from alert and cash-strapped consumers and wounded and even more cash-stressed merchants. In SA, there are already four major players vying for the low-hanging fruit that is stressed merchants: Groupon (which snapped up local start-up Twangoo in January 2011), Avusa’s Zappon, Naspers’s Dealify and, of course, the two 8 000-pound gorillas, Facebook and Google.

Google just bought Dealmap, which it may fold into Google Offers, another geo-location service supported by Google Maps. Facebook Deals operates on a slightly different model and, with the largest customer base on the planet (now 730m), it appears probable it’s biding its time in this space and learning from the early adopters before settling on a single model (or not).

Andew Mason — Andrew Mason (image: Aaron Fulkerson)

The gorillas might be the only winners in this space, particularly if they can monetise the geo-location mobile model that Foursquare and Groupon could never sign the nuptials over.

Yet Groupon’s meteoric rise has come at a considerable cost. Buying up competitors and expanding from a handful of employees to over 8 000 has obliterated margins. The company posted a $331m loss in the fourth quarter of 2010 alone, followed by a further $220m in the first half 2011 — during which time it also sank $379m into advertising. This is hardly unusual in any business let alone hot tech stocks and will not in itself trouble veteran investors, but if the well begins to dry and the scale doesn’t pay big dividends there will be blood.

Clearly, Groupon doesn’t have this space to itself. Aside from hundreds of direct copycats in a low-barrier-to-entry category, Facebook and Google both lurk with the gigantic muscle and customer databases to turn the heat up at will. Yet Mason’s already snubbed Google’s advances when in November 2010 the Web search giant bid $6bn for Groupon. One can only assume that Mason and his backers are holding out for a much bigger pay day on the back of a triumphant listing.

With 7,7% of the company’s stock, a listing of $30bn would turn him into an instant multibillionaire. This is the stuff of Silicon Valley wet dreams, yet the players don’t appear to have the unshakeable confidence that Zuckerberg famously showed in declining $1bn from Yahoo back in 2006. The company used $930m of the $1,08bn in series F&G funding to cash in shares with Mason realising $28m and partner Lefkofsky $380m.

Though it’s not unusual for shareholders to liquidate some of their positions ahead of a listing, it does raise some questions as to their intent.

So, too, does some of the terminology used in their S1 filing with the US Securities & Exchange Commission (SEC): the invented acronym Acsoi appeared no less than 50 times – adjusted consolidated segment operating income, which basically means income before all manner of undisclosed expenses. It’s the kind of inventive accounting designed to cloud reality and fudge profitability.

But the investment community has seen this movie more than once and a brouhaha erupted which saw the SEC send Groupon back to the abacus. It re-filed on 9 August noting that “while not a valuation metric, [Acsoi] provides us with critical visibility into our business”. Perhaps, but some may see it as a critical reduction of visibility for investors, also known as bullshit.

Meanwhile, back at the beauty parlour, the independent merchant is weighing up the value of the type of custom daily deals attracts. Numbers revealed in the S1 filing show a decline of merchants in Groupon’s biggest market (US and Canada) from 20 233 in the first quarter to 20 041 in the second quarter. This is a key metric that points to the sustainability and robustness of the business model. Additionally, several national US retailers have jumped on the train but only at discount levels they can sustain.

Groupon, understandably, is coy about these deals, but reports of the company only getting somewhere between 5% and 20% of the voucher value are regularly leaked, suggesting that revenues might not be as robust as many predict. Clearly there’s the volume: value equation to consider when dealing with a national chain such as Gap over a pizzeria in downtown Chicago, but the variables are enormous.

Then, of course, there’s the frequency and extent to which national retailers are prepared to discount. Every seasoned retailer knows only too well that loss leaders are a double-edged sword and are not conducive to building any kind of repeat purchase or intent beyond the offer.

At a time when margins are tighter than the cork on a recently bottled First Growth, retail chains will think long and hard about whether they want to climb aboard this merry-go-round and, if so, whether they shouldn’t do it themselves within their own database of customers.