Group Discounts, Small Businesses and Unfortunate Valuation Practices

The success of startups like Groupon and LivingSocial, and the courting of the former by Google to the tune of $6 billion, is not a result of a brave new business model that connects the masses to small, local companies but rather a result of a deluge of struggling small companies that see the promise of increased foot traffic without knowing how to truly capitalize on and maintain said increase. Further, the resulting valuations of these startups seems not be be based on sustainability but instead based on short term income.

The business model of these group discount sites is as follows: a small business agrees to sell a voucher at a major discount, often upwards of 50% of the voucher’s face value, through one of the group discount sites like Groupon or LivingSocial. The sale of the vouchers is both time limited and requires a minimum number of users to agree to purchase the voucher before the voucher is actually sold. In exchange for the publicity the offering business receives from the sale and the increased foot traffic that hopefully follows, the group discount company pockets 50% of the proceeds from the sale. The small business is left with only 25% of the money they would have brought in from a normal sale of their goods or services. For a 50% off voucher, the small business is actually taking a 75% cut on their usual rate.

The hope is that, despite this deep discount, the small business will be able to make up the loss in volume and new customers will, after their voucher is used, return and pay full face value.

However, without the proper tools and strategies in place, the small businesses do not know if these deep discount offerings are actually being made up in volume and if customers who buy the voucher once return later and pay full price and thus do not know if participating in services like Groupon and LivingSocial is truly advantageous.

In fact, the only protection for the small businesses offering vouchers that exists is the quota of users that must agree to buy a voucher before the sale is final. Without a quota, the small businesses offering the vouchers would be even less likely to eventually make money on the deal. If only four vouchers sold for Company Y, for example, and 25% of voucher buyers become regulars then Company Y only gets 1 new regular customer after the headache of setting up the voucher and the lost profits of offering the voucher. However, if a quota of 1,000 is set on the voucher sale then Company Y can count on 250 new regular customers – perhaps enough to overtime offset the cost of the voucher.

From my experience, businesses make no attempt to track customers who use the vouchers and thus have no data on how many once voucher customers become regulars. A recent Harvard Business Review article says

… merchants will find discount vouchers most profitable when the population claiming vouchers differs greatly from the merchant’s typical clientele. We explore two areas of difference: either voucher users must be more price-sensitive than the population as a whole, or they must be particularly unfamiliar with a participating merchant’s services.

While I cannot speak for other group discount site users, I fall in neither one of these categories. The largest type of vouchers I have purchased are for cafes and dessert places: two types of establishments that, for the most part, I am not price-sensitive to and am far more familiar with their services than I care to admit. Especially the dessert places.

If all of the above is true and small businesses really are not benefiting as much as they should given the considerations they are required to put forward then why are firms like Groupon not only getting $6 billion offers from Google but passing on them? The answer is twofold.

Firstly, the amount of media buzz being generated by these group discount sites is deafening. An amalgamation of what, at first blush, appears to be a business model where everybody wins and large numbers (both in income and number of users) and the continual appeal and sexiness of Internet companies to the layperson causes the thick media coverage over the last two years. This attention brings more users which in turn brings more buzz – a cycle culminating in nine figure buyout offers.

The second reason why firms like Groupon and LivingSocial are thriving is simple: there are vast multitudes of small companies looking to increase foot traffic and revenue that go wide-eyed at the thought of more customers for not all that much effort. If there are five major players in the group discount market each offering ten new vouchers a day, it would take 1,353 years to work through all 24.7 million small businesses in the US. Quite a resource.

Small businesses will need to be more cognizant of the big picture and the effort required to make a profit on offering discounts (which, at its heart, is perhaps an oxymoronic paradigm) if they are to benefit from these group discount sites. Without tracking customers to gauge how many turn from voucher buyers to regulars, these small businesses are simply inflating the valuations of the group discount sites by agreeing to sell vouchers.

As it stands, the valuations of these group discount sites in recent months point to a valuation based on income over the next few fiscal years and not based on actual business model sustainability.

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01. April 2011 by Chris
Categories: Business, Thought Experiments | Tags: , , , , , | Leave a comment

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