Will reading OE make you rich?

OK, I'll admit that a lot of people saw this coming.

More on the growth fetish -- Facebook vs. Groupon

There is a worthwhile exchange going on between Felix Salmon and Pascal-Emmanuel Gobry. I've already quoted Salmon, but Gobry makes some good points as well. Still, the part I found the most interesting is the part I think he got wrong.

Breakthrough technology startups are different from other kinds of businesses in that they either create a new market or violently disrupt an existing one. This means that they almost invariably require to spend lots of capital in order to stake out a defensible market position against their numerous competitors. In particular, many technology markets have winner-take-most or winner-take-all dynamics, either because of network effects or economies of scale…

Felix writes that Groupon had a profitable Q1 2010 and “it’s easy to see how it could have grown steadily from that point onward.” Except that given the characteristics of the daily deal business, particularly the need for scale, what would have happened if Groupon had tried to “grow steadily” and profitably, is that the company wouldn’t be around anymore.

It’s LivingSocial that would have raised over a billion dollars and be worth $10 billion today, Groupon would have been sold for scrap like BuyWithMe and plenty of other daily deals also-rans, and Andrew Mason would be back to doing yoga on YouTube. Groupon would be a footnote.

This illustrates (at least for me), a common error among growth fetishists -- overgeneralizing valid arguments for growth-at-all-costs. The first paragraph above is absolutely on target. There are situations where establishing dominance and critical mass as quickly as possible is incredibly valuable. Cases like Facebook. To make a bad pop culture reference, when it comes to mainstream social networking sites, there can be only one. Once Facebook was in place, all that was left was niches.

Put another way, it would cost more to unseat Facebook than it did to build it. Under those circumstances, Zuckerberg's bury-the-problem-in-money approach to running a business made sense (even if it was aesthetically lacking).

The first mover advantages for Groupon are far less obvious. There's no reason why we couldn't have two online gift card businesses. Consumers would get a wider selection and the merchants would almost certainly see lower fees (there's no way Groupon could charge those rates in a competitive market). Nor are the economies of scale that significant, at least not for the part of the business based on arranging deals with local merchants.

A potential competitor would have to spend a lot of money building a mailing list but probably not that much more than Groupon spent on its list. In short, if a potential competitor were to spend as much money as Groupon has, it might just catch up (particularly given the fact that Groupon is not a very well run company).

In terms of lifetime value, I suspect that the money Groupon spent on explosive growth was badly invested. However, in terms of buzz and stock price, it may have been money well spent as far as the backers were concerned.

"Just when I thought I was out... they pull me back in." -- another Groupon post (merchant relations edition)

I keep meaning to move on from this subject, but Groupon keeps giving us new reasons to suspect that they aren't that interested in the interests of their merchant partners.


For the latest nail in this coffin, Felix Salmon sends us to this extraordinary post by Benjamin Edelman and Paul Kominers:

Voucher services typically seek to cast themselves as mere marketing vendors that are not responsible for the conduct of the corresponding merchants. For example, Groupon’s Terms of Sale claim that “The Merchant, not Groupon, is the seller of the Voucher and the goods and services and is solely responsible for redeeming any Voucher you purchase.” On this view, a voucher service avoids liability for merchants’ shortfalls.

But a voucher service is the merchant of record for the charge to the customer’s credit card. As the entity officially responsible for charging the consumer, the voucher service thus faces increased responsibility to see that the consumer receives what was promised. Furthermore, the voucher service, not the merchant, writes the promotional text touting the merchant’s offering. As Rakesh Agrawal points out, Groupon’s financial disclosures even count the entirety of the consumer’s purchase price as revenue to Groupon. In this context, a consumer naturally looks to a voucher service for assistance if a merchant fails to perform. We think it is probably an unfair and deceptive practice, under the FTC Act and state equivalents, for voucher vendors to attempt to disclaim liability in such circumstances.

More generally, we are struck by Groupon’s attempts to push all responsibility to merchants. On every relevant question — discounting alcohol, honoring expiration dates, providing cashback — Groupon’s historic contract and current Merchant Terms of Service claim merchants are responsible. In our view, this approach invites confusion and non-compliance. Voucher services are far better positioned than merchants to determine what the legal system requires: Voucher services can research regulations centrally, once for each state in which they operate, then notify affiliated merchants of applicable requirements. In contrast, Groupon’s current approach asks each individual merchant to conduct its own research. If merchants actually conducted such research, it would be duplicative and potentially wasteful — thousands of small businesses re-researching the same questions. But in fact merchants typically ignore the questions, rationally concluding that these questions are too difficult for them to address on their own. Thus, by pushing merchants do to the work individually, voucher services virtually assure that the work is not done at all.

Importantly, the legal and regulatory questions flagged in this article are questions that arise distinctively in the context of discount vouchers: a merchant would never confront such questions were it not for discount vouchers. Having created the transactions giving rise to this regulatory complexity, we think discount voucher services should be expected to achieve compliance.

The real problem with Groupon

If you've been reading this blog over the past few days you've probably picked up on the fact that neither if us is a big fan of Groupon as an investment. We've talked about issues with priming and adverse selection, the company's oddly primitive approach to targeting and its curious indifference to customer data. We didn't even get around to the difficulties with running a business based on so many merchant partners.

But as serious as these things might be, they are fixable. A management shake-up, a few smart people in the right places. I've seen business lines with bigger problems turned around and by companies with fewer resources than Groupon.

Problems with business plans are different and when you look at the bare bones core of Groupon's business plan, stripped of all the hype and obfuscation and needless complexity, Groupon is based on bringing together customers and merchants and convincing both to do something they normally hate doing: respectively, paying up front and taking a loss.

A Groupon offer is not a coupon; it's what we would normally think of as a gift card, a really crappy gift card at an exceptionally good price. How crappy? It can be used at only at a specific business (sometimes only at one location). You have to buy it on their schedule. Many if not most have expiration dates. Some even have blackouts on holidays. Finally, it can only be used one-per-visit with any unused balance being sacrificed.

People purchase these terrible cards partly because of the considerable (and non-sustainable) level of advertising and buzz; mainly, though, they buy them because the discount, both nominal and effective, is huge. (Felix Salmon has argued that the effective discount can be much smaller, but based on the offers I've received and reports from other users, it's generally easy to keep a purchase close to the offer amount.)

In other words, Groupon has huge revenue because, even when you take into account breakage, its merchant partners are offering huge discounts and certainly, in some cases, taking a loss.

What do merchants get in exchange for these discounts? The stated reason is to bring in new customers, but if that's your goal, Groupon is a terrible choice. Its customer list is enormous but of poor quality and the company hasn't even bothered to gather the data needed to do the most basic of targeting. There are any number of options using the internet and/or traditional media that will bring in a much higher percentage of the right kind of customers.

But merchants keep coming to Groupon despite its mediocre list and the fat slice it takes out of every deal (from Wikipedia):

As of 2010^[update], it is difficult for local merchants to get Groupon interested in agreeing to a particular deal. According to the Wall Street Journal, seven of every eight possible deals suggested by merchants were dismissed by Groupon.

Just to be clear, merchants spend time and effort putting together offers that will probably be rejected and, if they're not, will probably bring in a lot of customers they don't want. They do this because Groupon has successfully branded itself as the next big thing.

This is not something the company stumbled into. Groupon has aggressively pursued fast growth, generated ubiquitous buzz and has done its damnedest to portray itself as part of the social media movement. The 'social' aspect of Groupon's business has always been trivial to the point of cosmetic but it plays a large, even dominant role in the public image of the company.

In one sense, Groupon's strategy has worked very well. After all, the people who started the company will almost certainly walk away with a great deal of money. Eventually, though, the company will have to make the transition to former next big thing and since being the current next big thing is an essential part of the company's model, that transition is not going to be pretty.

(Probably) OE's penultimate Groupon

From the the easily impressed Wall Street Journal:

Yet for Mr. Lefkofsky, Groupon wasn't a one-off in the lottery of high-tech wealth. It was an extension of a lifetime of starting and selling companies-- sometimes with mixed results. The process has led him to a set of guiding business principles: Enter big, fast-growing markets, change course when things aren't working and use data as your guide.

"In our current environment, business and customers are changing so much faster than in the old days," he said in an interview. "You need access to information to figure out what to do next."

Just for future reference, a lot of fast moving, information-based companies start collecting data on customers as soon as they launch.




(I'm still having trouble believing this is a new feature.)

Adverse selection, misaligned interests and Groupon

[Sorry about the all-Groupn-all-the-time blogging. We've got some more varied posts in the queue.]

As you might have guessed, we here at OE are starting to get a bad feeling about Groupon's business plan, particularly given that the company's success relies on targeting customers but the company has badly mismanaged the collection of the most rudimentary of customer data.

Another challenge the company faces is adverse selection. In order to be sustainable, Groupon has got to connect merchants with the right kind of customers. If the people who reply to offers are mainly bargain hunters, merchants will realize that these huge discounts aren't worth the money and the whole system will collapse.

You would expect Groupon to try to target 'future regulars' with pitches like "Looking for an excuse to try something new?"

Instead we get this:



This is, admittedly, a small thing, but it shows, at the very least, an inattention to detail and, at worst, a willingness to prioritize getting another email address over protecting the interests of Groupon's merchant partners.

The people behind Groupon have proven extraordinarily adept at running up big numbers and generating hype, but they have shown remarkably little interest in setting up a sustainable, profitable company. Their targeting strategies would have been considered somewhat primitive a decade ago. Their attitude toward customer data is nonchalant (see here for examples of both). They've used a carpet bombing approach to advertising (including the inevitable Super Bowl ad) which generates large email lists but seldom produces high quality ones.

All of this makes me wonder if these people are more focused on the stock price in 2012 than in the solvency of the company in 2020.

Sawdust in the transmission

I was thinking about companies designed to look good long enough for the investors to get safely past the IPO and the sawdust analogy hit me.

Which gave me an excuse to dredge up another favorite bit of Southern pop culture...

[if you have trouble viewing this on your browser -- and thanks to Blogger you probably will -- you might want to view or download it at Internet Archive]



Trivia bonus points: Griffith has said this was his favorite episode.

p.s. This is a public domain copy that doesn't include rights to the theme. You might want to mute the first thirty seconds or so.

Yeah, n = 1, but based on this sample, I can't see Groupon doing any targeting at all

After finishing the last post, I got to thinking about the emails I'd gotten from Groupon and I decided to go through them and try some back-of-the-envelope reverse engineering on their targeting methods. Obviously, I just had one account to look at but that's often enough to let me make an educated guess at things like what sort of data they might be looking at.

There was just one problem. In order to reverse engineer a model there has to be a model and I couldn't a trace of one. There was no indication that Groupon was using any information about me when they sent me an email. Here's an amusing but not unrepresentative example:

$125 for 24-Karat-Gold Specialty Facial and Chocolate Foot Scrub at Chocolat Day Spa in Arcadia ($260 Value)
$125 Value $260 Discount 52% You Save $135

The Company Chocolat Day Spa

Locations 107 S 1st Ave. Arcadia, California 91006 Get Directions

Of course, it's possible that I might give something like that as a gift (though I honestly don't think I know any women who would want a chocolate foot scrub -- the whole thing sounds disturbingly like a front for a fetish website), but when you have offers that the email recipient would never consider buying as anything but a gift, You can't really call it targeted marketing.

For further evidence that Groupon is not that sophisticated (or even that serious) about targeted marketing, check out the following:



The scary word here is "New." Did it really take over two years to add a feature that should have been fully operational the day the first website launched? Has Groupon actually neglected to gather rudimentary data on tens of millions of customers?

This might not be as bad as it looks (I don't see how it could be worse). Perhaps there's a level of sophistication that I'm missing. Unfortunately, as mentioned before, people who are betting on Groupon are assuming that the company will successfully pull off some extraordinarily difficult tricks with data. The apparent inability to manage simple tasks like gathering customer level demographics does not make these bets look all that smart.

p.s. Felix Salmon seems to mean something completely different by 'targeting' (though it's possible his definition is broad enough to include what I'm talking about here).

What's the best investment you can ever make? (another Groupon post)

Answer: a winning lottery ticket.

Just think about it for a moment. The returns are fantastic. There's almost no risk. The minimum investment is trivial. Your money is only tied up for a few days. You get your picture taken holding a big check. What's not to love?

Now, I can hear some of you negative types out there complaining about the difficulty of distinguishing between winning tickets and losing tickets (which are notoriously bad investments), but people routinely ignore these concerns when looking at the business plans behind IPOs. Why should you have a lower investing standard when dealing with your broker than you have at the 7 Eleven?

Take promises of targeted marketing. While it's true that almost all marketing is targeted to some extent and a few companies have been able to take that targeting to a relatively high level,* identifying customers who have a high likelihood (rather than a slightly higher likelihood) of buying something remains an extraordinarily challenging business problem. Most of the proposals you'll read that rely on solving that problem fall into the winning lottery ticket category.

Even with the recent explosion of consumer level data, the vast majority of plans to use targeted marketing run into one or both of the following problems: the lift provided by the selection method won't be large enough; the list produced won't be large enough.

Let's take the Groupon example. As pointed out here by Kaiser Fung, the merchants want new customers who are likely to become regulars. How would you go about targeting this segment? You might try matching the offer with the demographics of website the customers came in through, for instance, high end restaurants for people who came to Groupon through a New Yorker ad, but you'll still get lots responders who are already regular customers and more than a few bargain hunters (yes, even from the New Yorker). Or you could make offers only to people who have been identified as new to the area and are on the mailing lists of similar businesses in their old town, but I can tell you from experience, the number of names you'll get probably won't be large enough to bother with.

And Groupon has to thread an extraordinarily fine needle here. In most business situations, we might have a few customers who end up costing us a little money (for example, someone who just gets the loss leader at the drive-thru), but we're probably talking about fairly trivial amounts. In these cases, it's usually enough to build a model that distinguishes between responders and non-responder and fortunately, response is generally a quick and easy variable to measure reliably.

Groupon has to worry about non-responders (who are still associated with some costs), and about bargain hunters who use the offer then never come back (who cost Groupon's partners a substantial amount), and about regulars who use an offer for a visit they would have made anyway (who represent a double loss).

Separating all this chaff from the customers you want would be daunting even with the best of data and you will not have good data. How do I know? Because I've been there. I've dealt with third party data and I've written the hundreds of lines of SAS code needed to produce clean, usable data-sets. And I was only dealing with data from four or five sources, not trying to tease out a badly defined target variable from data collected from thousands of merchants. (remember, we're trying to identify customers who made their first visit using a Groupon offer and have since returned on their own dime.)

On top of all this, we're talking about a targeted marketing strategy that would have to work with everything from family pizza parlors to upscale wine bars, from pricey spas to summer camps, from teeth whitening to Scotchguarding (all of which have been recently offered by the company).

It's possible that Groupon will get around these problems but, until then, you might be better off with a scratcher-based portfolio.

* Of course, some people have proven pretty good at picking lottery tickets too.

Salmon/Fung cage match -- Did Salmon use a representative example?

Felix Salmon is one of the sharpest business and finance bloggers out there but I've never quite shared his enthusiasm for the Groupon business model. Disagreeing with Salmon on business matters makes me a little nervous, so I feel a bit better to have Kaiser Fung on my side.

Fung (who shares my high opinion of Salmon's acumen) has a good take-down of Salmon's analysis. You should probably read the whole thing but there's one particular aspect that strikes me as requiring additional attention.

Here's Fung:

Let's start with [Salmon's] neighborhood restaurant example:

At Giorgio's, for instance, diners paid $15 for their Groupon -- which gave them $30 of food. But dinner for two at Giorgio's, with some kind of alcohol, can easily run to $100 or more. So even after knocking $22.50 off the bill (remember that Giorgio's kept $7.50 of the proceeds of Groupon), the restaurant would often still make money.

This is a bit complicated. We can trace how the cash flows. For Groupon, diners pay them $15, and they keep half of that, $7.50. For the diners, they paid Groupon $15 (now worth $30 spending), and so they pay Giorgio's $70; in other words, they paid $85 out of pocket for a meal worth $100 without Groupon. Giorgio's take in $70 from the diners plus $7.50 coming from Groupon for a meal worth $100.

...

So, I don't think the Groupon model is the kind of slam dunk Felix seems to think it is. Only if certain conditions are met will the merchants gain anything from Groupon:

• the value of the coupon has to be a fraction of the total spending at the merchant; in this example, the diners spent more than 3 times the face value of the coupon. What if the diners spend exactly $30? Then Giorgio’s loses $22.50 on each regular customer and earns $7.50 on each new customer, meaning that every 3 new customers pay for each regular’s discount. Not very attractive numbers at all.

Of course, that $7.50 doesn't take into account the cost to the restaurant of preparing and serving the meal (which would further help Fung's case), but putting that aside, how likely are customers to overshoot by a factor of three?

Looking at the offers currently on Groupon, I see three restaurants, Beto's Grill ($20 for $10), Stefano's Pizzeria ($20 for $10) and Henry's Hat ($35 for $15). Of the three, I'm only familiar with Henry's Hat (a game themed bar that, last time I was there, had Kruzno in its library), but, based on the information online, it would be fairly easy for two people to keep the tab down to close to the amount of the Groupon offer in all three.

Obviously, there are plenty of places in LA where you should plan on paying big money for your dinner, but I haven't noticed those places on Groupon. Instead I've seen a lot of moderately priced spots, and I doubt you've got a lot of couples running up a $60 dollar tab on three buck a slice pizza.