Group Off?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

I received a daily deal e-mail from Open Table a few weeks ago. It was an offer for Roti, an Indian restaurant three blocks from my house in San Francisco. The deal was $25 for $50 worth of food. Their food is great and given the proximity I probably dine there once a month. I considered buying a dozen coupons, which is a like going to Costco to buy a year's supply of paper towels, essentially financing their inventory by transferring it to your garage. But if they were selling $50 bills for $25, why not pick up a couple? So I did.

There are at least 167 local deal-of-the-day Web sites. At least that's the number listed on localdealsites.com. The leaders, LivingSocial and Groupon, are planning to go public soon. Groupon filed their S-1 on June 2. LivingSocial pre-announced their IPO on July 8, by announcing that they had picked bankers for their deal. This may have been an attempt to dampen Groupon's first mover advantage, encouraging some investors to wait for LivingSocial's offering.

All this excitement had us wondering about this new business model. In essence, the daily deals are not much different than any other retail discount promotional technique. Groupon jumped into the lead using a social attribute; the deal was not effective unless a minimum number of people bought the deal. (Call your friends, now!) This was sort of like a Dutch auction with volume as the variable rather than price. Typically, the consumer gets a 50 percent discount and half of that goes to the deal company. The merchant is selling its products and services for 25 percent of list in the hopes of acquiring new customers.

In our Web 2.0 world the barriers to entry for a business model like this are pretty low. Anyone with a Web site with some traffic can get in the game simply by signing up a couple merchants. The folks at Yelp must have felt funny when they read that Groupon was using their reviews to pre-qualify merchants for their telemarketing call list. I think it took Yelp about 12 minutes to launch their deal-of-the-day offer. In the highly socialized Web, aggregating a few million e-mail addresses is child's play, so getting the consumer side of this business nailed down is not that difficult. But what about the merchants?

Groupon employs an army of telemarketers to sell their deals to local merchants. There are dozens of anecdotes chronicling the results. For some, the promotions are highly successful, helping a new restaurant get attention or a beauty shop expand its clientele. Others may feel that they gave up big discounts without attracting many new customers. Or, in the case of my neighborhood Indian restaurant, they simply gave discounts to loyal customers who were more than happy paying full price. Thank you very much.

In typical fashion, there are a number of derivative businesses feeding off the daily deal activity. The startling speed of their arrival on the scene is also a function of the velocity of our Web 2.0 world. Yipit, for example, will help organize and present to you all the local daily deals so you can eliminate 35 e-mails from your in box. They are also compiling high quality statistics on this new industry. The May version of the Yipit Data Report covers 115,968 deals from 581 sources. The gold version of the report is only $9.99 per month. So far we haven't discovered any daily deals to get a discount on Yipit's report.

Most of these daily deals seem to focus on service businesses. A service business by definition does not have much operating leverage. Costs are fixed by the number of staff on duty. Unsold time is lost income without any commensurate reduction in costs. If you normally cut hair in 20 minutes, the capacity for each barber is 24 heads in an eight-hour day. Doubling capacity by cutting a head in 10 minutes is an option, but quality and customer satisfaction might suffer.

Excess capacity for most services is also time sensitive. The barber chairs are full with a waiting list on Saturdays. On Monday afternoon the shop is empty. Selling 100 haircuts for $7.50 (net) instead of $30 may not be such a great idea unless you can use up that excess capacity. More importantly, selling $15 haircuts to existing customers willing to pay $30 is just plain dumb.

The technology behind the daily deals is advancing rapidly to solve this problem. If you launch the Vouchercloud iPhone app in London, it will tell you all the restaurants that have discounts on offer within a five-block area. As the manager of the Bulls Head Pub you can scan the dining room and launch an instant discount to bring 16 more customers across your portal on Tuesday evening. Dynamically filling time-sensitive, excess capacity is the dream of every service business we know.

This brings us to the critical success factor for all these daily deal companies. Getting repeat customers from the 5 million strong e-mail list is easy. Making your real customers, the merchants, successful with the product is the challenge. If Roti maintained a customer list, it could have asked Open Table to e-mail the offer to everyone who was not its customer. Once the new diners started showing up, they could compare the total revenue for these new customers over some period of months against the cost of the deal. The advertising industry calls this ROI. Most small merchants have little or no understanding of this concept, and as far as we can tell solving this problem seems to be a low priority for the deal companies.

We think a winning formula is sitting in front of anyone who has strong relationships with these local merchants — especially a firm that has a history of helping them with Web marketing and promotions. Whoever teaches the merchants to use these new techniques will own this market. It will not be easy because it means changing their business processes in a fundamental way. Further, they are small companies and cannot pay much for advice and guidance. Someone who has signed up a few million merchants to multi-year daily-deal service contracts would be able to put their deals out to bid with the 581 daily deal providers obliging them to compete on price and quality. That would be an interesting turn.

Update 

We were blasted by our readers some years ago after a commentary on the Social Security system titled, "Ponzi's Revenge." We had the temerity to question the quality of the assets in the trust fund. We also joked about the "lock box" nature of its status to quote recent Presidential Candidate Al Gore. Many informed us that the Social Security money was invested in the safest securities on the planet: U.S. Treasury bonds. Now the topic has returned to prominence with analysts wondering why Social Security payments might suffer as a result of the current debt limit impasse in Congress. Why not just sell some of those bonds in the market to get the money our retirees need? The reality is that there are no bonds to sell, only bookkeeping entries or IOUs. In order to redeem the IOUs the federal government would need to borrow money from the Chinese, just like every other payment they want to make. The bottom line is Social Security does have more substance than Ponzi's pyramid — Ponzi didn't have the Chinese.