[By Alistair Fairweather]

When Google offers to buy your two-year-old website for as much as US$6bn, you’d have to be crazy to refuse, right? But that’s what Groupon did. A surge of rumours last week had Google opening its offer with $2,5bn and reaching $6bn before eventually being rebuffed by Groupon’s board.

Refusing an Olympic swimming pool of cash was probably easier than we think. Groupon will make about $2bn in 2010 (if you believe the rumours) and will probably double that next year. How does a two-year-old business make that kind of cash? Weirdly enough, it does so by offering enormous discounts — at least 50% off on all its deals.

It works like this: a local business, like a coffee shop, offers Groupon users a discount of 50% or more, but only if a minimum number of people buy into the deal. Groupon then sends an enticing e-mail to its users in that city, collects all the cash upfront, takes a cut, and passes the rest on to the coffee shop.

In other words it handles all the mechanics of the special offer — leaving the coffee shop owner to do what they do best. Anything the coffee shop owners might lose in revenue per customer they make up for in volume, and they have a chance to convert these new customers into regular clients.

One of the great strengths of Groupon is its integration with social media. All of its deals are limited by time, so a certain number of people have to participate to unlock each deal. If a user really wants that spa treatment for half price but the deal expires in four hours, and there are three slots left to fill, you can bet they will rope their friends into the deal.

And the best way to broadcast something to your friends? Social media, of course. Groupon just makes this natural tendency easier. Instead of having to manually copy and paste links, and then laboriously message all your friends, Groupon allows you to share your latest purchase on Facebook with a single click. So Groupon has managed to turn its own customers into its biggest marketers — every business’s dream.

This is a large part of why Google is so eager to buy Groupon. Google is increasingly desperate to add a strong social media service to its stable. Its attempts so far have either failed miserably (like Google Wave) or are puttering along without making much impact (like Google Buzz). Even its initial success with Orkut in Brazil is under threat by Facebook, which is swallowing up millions of users a week across the globe.

Why care about the upstarts?
But why would Google, undisputed king of the Web, care about what upstarts like Facebook, Twitter and Groupon do? There a three main reasons.

The first issue is remaining relevant. Google’s core business is still search, which it has turned into a global money-making machine. But it has realised that people are even better filters than its most cunning search algorithms. After all, who do you ask for advice about buying a new car, or watching a new movie? Your friends of course.

Social media focuses and directs people’s attention in much the same way as search does, but arguably more efficiently. If more than 90% of your business was in search, and Facebook had nearly 600-million users, you would be nervous too.

The second enticement Groupon offers is a way into another market Google has never quite been able to crack — the “hyper local” market. Groupon divides its deals by city, establishing relationships with local merchants and focusing deals to ensure they are as relevant as possible to local customers. It even splits larger cities, like Los Angeles and Washington, DC, into districts.

This allows it to make revenue simultaneously from literally hundreds of thousands of businesses across the world, all without annoying its users with unwanted or irrelevant offers. So it gets the benefits of local knowledge and reach, and the benefits of scale and centralisation all at the same time.

The third reason is the most simple: money. Groupon is already making more than $2bn a year, from about 250 cities in the US, Europe, Asia and South America. Imagine when it reaches 1 000 cities? Sure, Google made nearly $24bn last year, but another $5bn or $10bn a year is still attractive — not least because it shifts income away from advertising revenue, which accounts for 99% of its cash flow right now.

Has Groupon made the right choice? I believe so. Facebook refused $1bn from Yahoo back in 2006, and it is now worth nearly 50 times that. As attractive as cashing in may be, you get the sense that the founders of Groupon have only just started to have fun.