LaunchTime (the business I am a partner of) is very bullish on the daily deal space. For full disclosure we are investors and are incubating businesses in this space including Yipit, Coupang.com and DoodleDeals.com. We were told about Groupon in the middle of 2009 about 7 or 8 months after they launched. Our initial reaction was that this business was a great idea but the low barriers of entry would force margins of the business to shrink dramatically. This is what happens in markets with tons of competition. Competitors compete for business and when there is not enough of a differentiation, they are forced to drop their price in order to compete to try to win the business. Bidding wars ensue and margins are compressed. This is what happened in Search Engine Marketing agencies. They started off with 30 to 40% margins but tons of them both big and small sprouted up and margins got compressed to less than 10%. So our initial hypothesis is that this would happen to Groupon. Groupon clones would sprout up like weeds and they would start going to the same merchants and ask for much lower revenue shares and margins would be compressed. However, it is now 2 years in the business and Groupon’s margins have been firm at 40% to 50% revenue share on the deals they run. So how have margins remained strong as hundreds of daily deals sites have entered the market?
The reason why the margins of Groupon have held up is because of scale. When I refer to scale, I mean the size of both their audience (consumers) and merchant network. Groupon has over 25 million email subscribers giving them the power of being one of the few “rainmakers”. For businesses that have the capacity and desire to add a lot of new customer, if you are featured on Groupon, they usually deliver enough new customers to completely fill that need. At this time, very few daily deals site can do that. I would argue that LivingSocial may be the only competitor in the same ball park. So when people think that Groupon has a lot of competition, in reality, they don’t. They are working primarily with businesses that want a lot of new customers and the capacity to handle the “firehose” – being featured and getting a ton of new customers. They are not interested in working with the business that wants a handful of new customers such as the popular restaurant that has a little excess capacity on a Monday night at 5pm. They want to work with the large new restaurant that needs a lot of new customers right away so their business can quickly have a loyal regular customer base. If you want the trickle of new customers, you can go to their competitors or just use Groupon Stores. Groupon Stores doesn’t even to plan to make money from a revenue share just on breakage of non-redeemed vouchers. The market for the trickle of customers is competitive and will have low margins. The market for the firehose will not have low margins because it won’t be nearly as competitive.
Will Groupon be the only player with scale? No, there are plenty of companies with very large audiences and customer bases that will tap into this model. However, there are not going to be thousands. There is just not enough consumer attention to have that many at scale. People will go to a small handful of very large general market plays – like having a few major prime time major tv networks. And then there will be a good number of middle tier players that are focused on a certain vertical or niche – like having a bunch of pretty popular cable networks. And then there will be a ton of very small scale players – like having tons of people handing out paper fliers. So the small handful of very big players and the good number of middle tier players will be a more competitive market than what we have now but there are millions of merchants to choose from on who to partner with to be their “firehose”. The most coveted merchants will see more generous revenue shares. However, there are plenty of good merchants to choose from for these larger scale players to choose from who will play ball at these higher revenue shares. So if you want to pick the winners in this market – pick those who can get to scale as the very big players or the middle tier players.