Groupon is at a loss to justify itself

Investors are invited on a wild and unpredictable ride
Image of John Gapper

Andrew Mason, the co-founder and chief executive of Groupon, is an amusing frontman. “Life is too short to be a boring company,” the 30-year-old declared in Groupon’s public filing for an initial public offering last week, and he lives up to that in his personal life, with pranks such as filming himself performing yoga in his underwear.

Behind the scenes, however, Mr Mason and Eric Lefkofsky, Groupon’s chairman and co-founder, are serious about making money. The enterprise was founded only two-and-a-half years ago yet they, plus Bradley Keywell, Mr Lefkofsky’s partner, have already received $560m in share buy-backs before an IPO that could well make them multibillionaires.

Ordinarily, I would not quibble at technology entrepreneurs making billions with a revolutionary idea. Chicago-based Groupon, which Google tried to buy for $6bn last year, has shaken up the way that retailers and restaurants can promote services to consumers using online discounts. Many others, from Google to Facebook, are now scrambling to imitate it.

But, whether or not one thinks Silicon Valley is in the middle of a bubble, Groupon’s IPO is disquieting. The company’s filing is filled with unsettling details about its business model, how much money it is spending to sustain its explosive growth and its accounting methods. Its early investors are seeking another infusion of cash, having allocated most of an earlier $1.1bn in fundraising to themselves.

Even if Groupon is a sound investment, which I doubt on the basis of the filing, despite Goldman Sachs, Morgan Stanley and Credit Suisse having attached their names as underwriters, something smells bad. “This will at times be a bumpy ride,” writes Mr Mason, which is a promise you can take to the bank.

Google was founded six years before its IPO, with LinkedIn the gap was eight years. Groupon was started as a side project in November 2008 and is so young that it is impossible to predict its staying power as opposed to its ability to expand rapidly in new cities and countries by persuading merchants to offer one-off discounts.

The independent evidence is not reassuring. A study by Utpal Dholakia of Rice University last year found that 42 per cent of merchants who had sold group discounts to Groupon’s 16m “cumulative customers” (only a fifth of its 83m registered “subscribers” have paid for a “groupon”) would not do so again. Since Groupon offers discounts of 40 per cent or more and then takes up to half of the face value of its groupons, it is impossible for a business to profit on the offer itself – groupons are a form of marketing. One restaurant owner described groupon holders to Prof Dholakia as “bargain-seekers” who didn’t spend more than the value of the offer and wouldn’t return.

Groupon has countered by spending a lot – in marketing and through buying overseas rivals such as CitySearch in Europe – on growth. It counts the groupons’ face value as “revenues” even though most goes back to merchants, but its “gross profit” – its actual revenues -– rose tenfold to $270m in the first quarter of this year from $20m in the same period of 2010.

The problem is that it is having to pump a growing amount into sales and marketing to maintain its expansion. Its sales, administration and marketing expenses rose to $387m from $11m in the same period, turning it from a profitable business to a massive lossmaker (it has a cumulative deficit of $522m).

Groupon has attempted to comfort investors with its own measure of profitability known as “adjusted consolidated segment operating income” or “adjusted CSOI”, which ignores acquisition and online marketing – much of the expense of achieving all this growth. But that is transparently nonsensical. Without the marketing to find new prospects, it would grind to a halt.

Such manoeuvres to hide costs are spreading among internet companies – Demand Media amortised content creation costs over five years to flatter its bottom line for its IPO in January – but Groupon’s tactic is the most blatant. Bill Gurley, a partner at Benchmark Capital, points out that internet companies tried to get investors to ignore marketing costs in the 1990s internet bubble.

Groupon is an innovative enterprise that has value – the fact that Google wanted to buy it and also that it has spawned so many rivals in the expanding field of local commerce, show that. But it lacks unique technology and its sales force of 3,500 could be matched by others such as LivingSocial or FourSquare. Its biggest assets are its brand and Mr Mason’s ebullience.

This leaves potential IPO investors with a conundrum. As Conor Sen, a private investor, phrased it on the Minyanville investment website: “How do you value a business that could do $3bn in revenue this year but might not be able to keep the lights on in 12 months?”

With great caution, if the behaviour of its founders is anything to go by. Mr Lefkofsky this week appeared to breach the SEC-enforced “quiet period” for IPOs by insisting to Bloomberg that Groupon would be “wildly profitable”. Barron’s reported that Mr Lefkofsky told employees of another of his businesses in 2001 to be “wildly positive in our forecasts” before it went bankrupt.

Mr Mason is inviting investors to come with him on a wild and unpredictable ride filled with, as he puts it, “moments of brilliance and other moments of sheer stupidity”. The founders have already shown their brilliance by extracting half a billion dollars from an unprofitable start-up with an unproven business model. That’s not funny.

john.gapper@ft.com

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