As traditional media options fade away, mom and pop merchants are desperate for new, effective marketing avenues that build their business and their brands. Groupon and the other daily deal sites appear to be the answer by bringing in new clients with no upfront expense. All you have to do is say “Yes!” to the sales representative. However, Groupon’s business model has inherent flaws. (Read More:Cohen: Groupon Is Good for Business)
Groupon built its business working for consumers, not small businesses. Groupon’s sales team works hard convincing merchants to accept offers that meet its standards for “deal quality.” To Groupon, a “high quality” deal translates into money for them, regardless of its effects on the merchant. Before Groupon’s IPOit was revealed that it needed to grow each month, just to meet its obligations to merchants. Post IPO, Groupon’s public status has Wall Street demanding unprecedented growth. Consequently, Groupon’s goals are to create as many deals as possible to drive more revenue. Its original mantra of one deal a day per city has been completely abandoned and replaced with a segmented subscriber base allowing Groupon to offer multiple deals every day in most markets. This has resulted in deal-fatigue among subscribers and tremendous price pressure on local merchants. (Read More:Groupon Launches Credit Card Payment Business)
Groupon’s pitch is brilliant: a merchant pays nothing up front and has no responsibility for crafting or delivering an offer. The company takes care of all that work and actually pays the merchant after the promotion is deployed. The catch is how much Groupon takes from the merchant. Groupon board member Ted Leonsis loves to say that his company helps small businesses use their margin as “currency” to buy promotions from Groupon. What he generally avoids explaining is that 100% of the gross margin is wiped out by the offer and another approximately 25% goes to Groupon for its fee.
The classic Groupon deal requires a discount of 50%, after which the merchant and Groupon basically split the revenue (after the merchant pays the credit card fees and waits around for its check). This arrangement ultimately gives merchants about 23 cents for each dollar after discount and fees. If the merchant starts out with a 50% gross margin that means it loses 25% for each voucher redeemed. While 75% off seems like something many merchants do a few times each year it’s important to understand that most daily deal users are service businesses. When a retailer offers 75% off it is generally blowing out a portion of remaining inventory. For example, in April, you can buy winter coats at 75% off because the retailer has already sold 90% of them at a reasonable margin - and the business would rather have the money to invest in swimsuits. (Read More: What’s the Deal with Groupon’s Stock?: Greenberg)
A service business does not have these opportunities. We estimate that for every 100 Groupons a restaurant sells it will lose almost $1,200, while the average day spa loses about $2,250 on Groupon deals. If the deal goes “well” and sells 500 Groupons, the spa would lose about $11,250 while Groupon puts the same amount in the bank.
"Sucking value out of the small business market will ultimately damage the local merchants that are the bread and butter of Groupon’s base. Groupon’s model is not sustainable. In a race to the bottom everyone drowns."
The classic defense of the Groupon’s financial arrangement is that it’s a reasonable cost to bring in new customers. There is data however that doesn't support that argument. Groupon’s own research once estimated a return rate of just 22% while others have estimated a number much lower. But focusing on return rate is a deceptive number. What merchants should be buying is a visit by a brand-new customer who then returns to make subsequent purchases at full price. A study by Lightspeed Research shows that 63% of Groupons are purchased by existing customers. Just 2% of buyers who returned had never purchased from the merchant prior to the Groupon. So the merchant essentially gave away 75 cents for each dollar of business from the other 98%.
The other problem with Groupon is that the bigger it gets the less it can help small businesses. The theory behind Groupon is a small business can get new potential customers to try them out by offering a really great deal. So if a pizza place offers a 50% off deal to a broad list of people in theory some new prospects might give them a try. If the coupon buyers like what they get they might become a regular customer at regular price. But Groupon’s growth makes that result unlikely. Once the first pizza place runs a Groupon every other independent will do the same and Groupon’s targeting algorithm will make sure that the buyer of any one pizza deal will be offered many more. Rather that gaining some new customers for those that offer deals Groupon effectively lowers the price of pizza, haircuts and other services in all its markets. After all, if a pizza place sells 500 vouchers for cheap pizza they have effectively presold meals that otherwise would have gone to the other local pizza joints in town. Groupon does not really create more haircuts or meals served; it just rearranges who gets those visits and sucks 75% of the value away from the local merchants. (Read More: Investors Question If Mason Is the Right Person to Run Groupon)
If Groupon really helped small businesses there should be some aggregate growth from its core markets. Even if there is not a net growth in purchases, the type of businesses that Groupon helps should be benefiting, but this is not the case in arguably Groupon’s biggest category: restaurants. According to Local Offer Network, daily deal revenue growth increased approximately 140% in 2011.
However, in the same period, visits to independent restaurants were down 4% according to the NPD Group. All the daily deal providers accomplished is to make $280M disappear from the restaurant industry by charging that amount in fees.
Sucking value out of the small business market will ultimately damage the local merchants that are the bread and butter of Groupon’s base. Groupon’s model is not sustainable. In a race to the bottom everyone drowns.
Bill Bice is the CEO of SpaBoom and CoverBoom, which delivers custom social media, e-mail and promotion marketing for local, independent small businesses. In his role, Bice works with 5,000 spas and restaurants around the country, the top two verticals for daily deal companies like Groupon.
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