A two-sided network is defined as one where an increase in usage by one set of users increases the value to and participation of a complementary and distinct set of users, and vice versa. In the case of Groupon the two sides required to make its business model work are (usually bargain-hunting) individuals willing to purchase deals online and (usually small and local) businesses willing to sell their products or services at a discount.
Two-sided value creation
The way a traditional Groupon transaction typically works is for a local business to first substantially reduce their price and then agree to give Groupon a large portion of their remaining revenue (often north of 50 per cent). For example, if a local SPA usually charges $100 for a back massage, Groupon will convince the salon to offer it for $50, and then take half of the remaining $50 as “commission”. The value proposition to the bargain hunters is clear: they have just saved 50% on a massage. The value proposition to Groupon, or its investors, is quite clear too: they have just pocketed $25 for intermediary services. It is the SPA salon for which the value proposition is less clear: after all it has sold a service for 25% of its face value. So why would anyone ever do that? Two reasons: first, Groupon offered to pay the cut of the often cash-strapped SPA immediately after customers made the payment on the website, and second, it promised long-term benefits from each deal in the form of repeated business. Many small businesses bought into this value proposition: after all, certain cash now is better than uncertain cash in the future, and hardly ever before one marketing platform has delivered so much new customer traffic.
The death spiral of reverse network effects
This business model was fun while it lasted: Groupon was crowned as one of the fastest growing companies of all time after its revenue grew from tiny $94,000 in 2008 to much over $2 billion three years later. It also gave rise to a new group of deal-hungry consumers who almost enjoyed the process of hunting more than the treasure itself – great news for Groupon which saw the very thing they promised to their merchants: recurring purchases from active users. However, this great news was not-so-great for the merchants who hardly saw any repeated business as customers moved on to the next best deal. They also quickly realized that they originally priced their services at 4x the Groupon price for a reason, and the revenue they were getting was not enough to cover their costs – and not worth the up-front cash. With both incentives gone, more and more of the merchants exited the Groupon platform, leading to reverse network effects: the more of them left, the fewer deals enticed customers to be active on the platform, leading to even lower revenues from deals for the merchants, making them exit faster. Before long, Groupon was stuck in the “death spiral” and 80% of its IPO market value vanished.
The pivot: too little, too late
Groupon’s 2015 plan includes a significant shift in the business model, transitioning away from daily deals and towards becoming “a leading mobile e-commerce destination”. It’s focusing on emerging markets by acquiring existing e-commerce players such as Korea’s Ticket Monster. The plan assumes 15% topline growth and as much as 20-25% EBITDA growth by 2017. Feasible? I would argue not. Even if the new strategy is in line with mobile trends, Groupon has significant issues to overcome. The merchants will think twice before they decide to re-join Groupon. Many customers consider it “a thing of the past”. The capital providers lost faith in Groupon’s integrity after it was accused of “funny math” and “stretchy accounting” to meet the analyst estimates. And finally, the top talent necessary to deliver on the new strategy, both within the potential acquisition targets of Groupon and outside, may not want their resumes stained with the dubious Groupon brand.
Prove the business model first, get greedy later?
Is there anything Groupon could have done to prevent this calamity? For starters, it could have proven its business model before going public. Maybe it would have anticipated a high refund rate on big-ticket items which caused it to restate earnings and sent its stock price plummeting. What is more, it could have sacrificed the speedy growth by leaving higher share of each transaction with the merchant. Lastly, it could have incentivized the repeated business by offering progressive discounts for several purchases in a row. Or maybe it could have given more thought to the $6 billion buyout offer Google put on the table in late 2010.