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Groupon claims that they are on target to make over $1 billion in sales faster than any other company. They have purchased similar one-day deal sites around the globe and re-branded them as international Groupon sites. In June of this year they filed with the SEC to raise capital for an IPO they claim will be in the range of $25 billion dollars. With this fantastic buzz touting the wonders of the Groupon business model, why are their whispers of its possible failure?

The main reason could be because their business model is the foundation for sustainable growth. Successful companies are able to grow from the inside out, and this includes all members of its value chain.   What is Groupon’s business model weak link? The very businesses it founds its daily deals business on.

If you visit Groupon’s website and look at their series of videos pitching businesses to join Groupon they make some very interesting claims. They say that 97% of businesses that sign up with Groupon once come back. They say that their customer base is young urban women who love to spend money, college educated and Internet savvy. They say that there is no money necessary upfront and that they take their share from the profits to limit the business’ risk. With all of that information available, who wouldn’t sign up?

But looking below the surface of sales spin and there is a layer of possible issues with their sales method. The strangest one being the more successful Groupon’s business model is the more trouble the business owner could be in?

How is that for a twist? Problems that arise when advertising works, how can this be? Taking a look at Groupon’s business model is the first indicator of the problem.  Every day, Groupon has a featured deal from one of its businesses. In order for customer’s to be able to receive that deal they have to find a specific number of customers willing to sign up for the deal that day. If the set number isn’t reached, the customers don’t get the deal and the business has lost nothing in the venture.

The target market for Groupon, young female urbanites, is indeed Internet savvy. They are on Facebook, twitter and other social media sites where they communicate constantly with others in the same market. A 21 year-old woman sees a great deal and what does she do? She tells everyone and they tell everyone and so on. So the ability for a Groupon customer to reach the required number of interested people to sign up for the deal isn’t as out of reach as it may seem.

Here is the second part of the business model that leads to potential problems: this is a one day deal. In order to receive the discount, the customer has to reach the number of set members and each one has to participate that day.

For a large company that has created a national offer, that isn’t a problem because the rush of customers is spread out among many different outlets. Most of the businesses that participate on Groupon, however, are small businesses, and this sudden influx of customers can cause serious problems indeed. The company may not have enough staff or product to handle the rush, customers may experience long wait times, and the potential for customer service issues is ripe. This negates the benefit of the service, the potential of new customers who become lifelong customers.

If businesses manage that hurdle, there are other things to consider.   According to Groupon’s business model, these customers receive large discounts and not just once, but for the next year at that location. In order to meet this claim, the businesses need to offer deep discounts that cut into their profits. Volume helps offset this issue by how much, especially when the S-1 Agreement between Groupon and the business is considered.

Groupon doesn’t charge businesses upfront to have their ads run on the site; instead, Groupon takes half of the profits generated by  the promotion. So, if  you charge a customer $60 for an item and you offer a 50% discount that leaves $30, Groupon takes 50%, so that leaves you $15 to cover all of your expenses. Even a large volume of customers doesn’t always offset that discount.

Then you need to consider the way Groupon pays you. The way it works is Groupon receives the full amount from the sales upfront. Then they pay the first 33% in five days and the rest by the end of 55 days. Another words, they get all of the money upfront and take 60 days to pay the business back.

This may make Groupon’s business model look like it will help the company succeed at the expense of its suppliers. And that is partly true, but there are other factors to consider. First, as of March 2011, Groupon owed businesses $290.7 million dollars.  Any business that uses proceeds from some suppliers to pay others is headed for disaster; especially if the businesses start to demand a faster repayment turnaround, which they might do as a prerequisite to resigning with
Groupon. Other similar businesses, such as Google, pay their businesses 80% in four days, a much better deal.

Also, large companies are staying away from Groupon for the most part. Most small businesses aren’t able to justify such terms, in fact it can seriously hurt rather than help their bottom line. Without better payment terms businesses can’t afford to work with Groupon, which decreases the potential for renewals.

So if you are a small business and looking for methods of advertising to increase revenue, can you afford to sign up with a company whose business model creates an advertising deal that equates to an upfront loan with only a 50% return?  What are your thoughts?

This post was written by Wendyann Lewis.