Explaining Groupon’s Losses…Organizational Optimization

August 18, 2011 § 3 Comments

So much has been made recently about Groupon and LivingSocial’s large financial losses.  Yesterday, a friend forwarded an article that claimed, “Groupon’s fundamental problem is that it has not yet discovered a viable business model.”  Imagine that, the company that Forbes dubbed the fastest growing company in the history of commerce doesn’t have a business model.  They went from $0 to $3+ billion in annual revenues in 3 years.  Yet still do not have a viable business model?

The reason that the financial blogs/sites and academics love to rail on Groupon is the huge loses that they are generating creating those revenues.  But with everything….you have to peel back the layers to understand it properly.

There is no debate that spending $4 billion to generate $3 billion is not sustainable.  The author of the HBR article goes so far as to compare Groupon to Pets.com, the internet bubble poster child.  However, it is important in any analysis to understand the drivers of the short-term losses and the long-term unit profitability.  I guess those small points slipped his mind.

For example, after looking at the large loses on Groupon’s P&L, what if you then come to understand this point buried in its filing:

the company spent $18 million to add about 3.7 million subscribers in the second quarter last year. By the first quarter of this year, those individuals generated $145.3 million in revenue and $61.7 million in gross profit.

hmm…that seems like a good return to me.  And a viable model.  Of course, in the second quarter of last year, it looked ugly.  That being said…someone smart enough to be a Fellow at the Harvard Business School’s Forum for Growth and Innovation can’t get past the current-year losses.  Either he (along with the Groupon bears) is missing something or the Groupon bulls (myself included) are missing something.  He states his argument in the HBR article, here is mine…

  • High growth companies (and start-ups) can only optimize one thing at a time.

Boom…there it is.  That’s the answer.  Good night…tip your waitress….

…Not convinced?  Continue reading below:

Right now, Groupon (and LivingSocial) are focused on optimizing to gain subscribers at a price below an estimated CLV (customer lifetime value).  Of course they can not know the real CLV because they are such new companies.  But they do have some benchmarks to estimate (as noted above).  Because this is their focus, these companies have built their organization around this focus.  They are pumping huge sums of money into marketing to gain a dominate and defensible position in new markets.  They are doing this because in their business, there is limited supply of quality product in a given market.  Meaning in the daily deals business, there are a limited number of quality deals in any market.  Far lower than the 365 days in a calendar year.  Revenue follows the 80/20 rule.  So you need to get those high quality retailers.  And the high quality retailers will work with the vendor who has the most scale and brand cache.  Thus winning the scale war in the market, becomes a self-fulfilling prophesy.  Therefore, both companies are in an all out blitz to “win” a market.  If you have ever worked for an uber-growth company, you know what this is like on the inside.  It is a full speed, all hands on deck, maniacal focus on growth.  If there is a conflicting decision to be made – growth wins.  If you are not sure if something will work, you try it.  If it fails, so what?  Move on.  Go…Win..Do it and ask permission later.

Then comes maturity:

When markets mature, companies shift from optimizing for growth to optimizing for profitability.  As the daily deals market matures, you will see Groupon (and LivingSocial) change their focus and thus their organizational optimization design too.  They will do basic stuff like:

1. Launch new products to get a higher share of wallet from existing customers.  Note both companies recently started doing this.

2. Scale back marketing in maturing markets, which I am sure they have already started doing (but do not have any inside information on so I have no idea if LS or Groupon are doing this yet).

3. Optimizing internal operations for profits, rather than growth.  I.e. you revisit those decisions where growth won over profitability and process.

4. Change pricing.  See Netflix

5. Offer premium services to niche customers.  See LinkedIn.

A firsthand example…

I know this process because I have seen this a few times from the inside.  One relevant example was maturation of DoubleClick.  I joined DoubleClick in 2000, when the company was growing 100% per year.  By 2001, it was clear the business was changing dramatically.  Our client base was dwindling with the .com bust.  So in 2001, David, the President of DoubleClick, started the Business Operations team in the Technology division.  He asked Neal to run the division and asked me to join as well.  We then hired this guy and Neal also brought on Nicole.  The four of us focused entirely on profitability.  And within a few weeks, it was obvious that there was so much low hanging fruit.  There were so many easy things that could be done to improved the profitability of the business.  We used the same maniacal focus to push through operational changes, and the results were that DoubleClick maintained profitability throughout the entire .com bubble burst…largely on the backs of the Tech Division.

When I first joined the group, I remember being amazed that no one had done these “obvious” things before our group did them.  But after more reflection, the answer was obvious…because no one was focused on those things.  Prior to the crash, DoubleClick was growing 100% per year.  It was an all hands on deck situation just to maintain the growth rates.  Growth was the only way to beat competitors.  And since Ad Serving was a winner take all market, we needed growth to win.  The organization was optimized to growth and that metric always won internal debates.

But when that changed, so did the focus.  And thus the organizational optimization.  Keep in mind, high-growth companies already have people who enjoyed a maniacal focus on one thing.  We just shifted the definition of winning.

Important lesson for entrepreneurs:

I wrote about this topic for two reasons:

1. I am a significant shareholder in LivingSocial and believe its model is getting a bad rap from people who don’t understand it.  LivingSocial’s acquisition of my company has been credited by the LivingSocial management team as the pivot point that got them into the daily deals business.  I was a General Manager and VP of Sales of LivingSocial when we started the Daily Deals biz.  So I understand the economics of the business.  Once they make the shift, I think they will start generating great operating margins.  I think it will ultimately look like a search business.  Every incremental conversion will cost nothing.  In the mean time, they are doing the right thing by investing heavily ahead of demand to gain a dominate position in new markets.  But I am a bull on LivingSocial, so feel free to discount the Daily Deals specific points in this post.

2. Unrelated to my ownership in LivingSocial, I think there is an important lesson for entrepreneurs….Focus your limited resources on one big thing.  Optimize your entire organization for that ONE thing.  Do it better than anyone in the world.  Tell your investors what you are doing and what the ride is likely to look like.  If they are good investors, they will support you while you are in-pursuit of those milestones so long as they understand what achieving these goals will lead to.  If they are professional investors, they will support you even if it looks ugly along the way.  Ignore the outsiders.  Focus on executing.  Hit milestones.  There is time to optimize on other key metrics later.

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§ 3 Responses to Explaining Groupon’s Losses…Organizational Optimization

  • David Pakman says:

    Great post, Steve. I am with you. These companies are simply optimizing for growth today because there is a customer and local business land-grab going on. After building huge audiences, they will be able to optimize for profitability, if they want to. Incidentally, I don’t believe anyone at Amazon has ever “optimized for profitability”. They optimize for customer satisfaction and they believe profit will follow. They are a low gross margin business perhaps because of this, but they are also worth more than $80B. Most of these analyses we are seeing are from short-term thinkers. If you believe you are building a business to last 50 years, you think much differently.

  • Aimee Heilbrunn says:

    Hey Steve – Agreed good post with lots of great data. Your points to make it seem viable; the question is, are these companies and is the industry sustainable long term?

    They are all built around local commerce and the word on the street (and from actually talking to business owners here in Chicago) is that these deals are at best mediocre and at worst harmful to their businesses. Most of the businesses that participate are not large enough to handle the scale and don’t understand that these are “marketing” opportunities not sales opportunities – no doubt something omitted from the pitch: http://techcrunch.com/2011/06/16/groupon-sales-merchants-freaking-out/.

    In addition I’m sensing SO MUCH deal fatigue. Much like the Daily Candy and Tree Hugger newsletter that we were all so excited to get a few years back (both business sold to Disney and National Geographic respectively) this feels at times very flash in the pan.

    Also this business model relies so heavily on e-mail which is only getting more and more difficult to count on as a clear channel of communication. Both companies (groupon and living social) have clearly infiltrated social media but their reliance on e-mail is definitely an achilles heel.

    So you have frustrated merchants and an over saturated marketplace. An interesting combination for sustained growth.

    • v1again says:

      Good thoughts Aimee. On your points:

      1. Merchants.
      – Everything is relative. If you are a small merchant with a local presence, what alternatives do you have that are better? or less risky? What are better alternatives for merchants to drive traffic?

      Keep in mind, this is priced at a no-cost, no-risk advertising.
      – No Risk: because it is a guaranteed CPA.
      – No Cost: True they don’t make margin on these deals. But they don’t lose money either all things considered (breakage, etc.).

      2. Consumer deal fatigue.
      – The data does not support this IMO. While your anecdotal conversations might suggest that your circle is bored with saving money on restaurants and massages, the overall numbers are escalating, not decreasing. And your friends will come back in a few months after burning through their deals. There is always consumer demand for low cost products.

      3. Over-saturated market.
      – This is true, but is in the process of taking care of itself. There are a few leaders. All of the others will die soon.

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