Why Investors Who Bought Groupon's IPO May Be Disappointed

After a barrage of Hollywood-worthy hype, shares of Groupon started trading last Friday. Priced at $20 per share, the stock ended the day at $26.10, resulting in a $15.7 billion market valuation.

The crux of Groupon's business model involves offering highly-discounted deals to subscribers by email. Consumers, of course, love big discounts. But for Groupon to prosper, participating businesses must find these deals rewarding too.

As a price strategy consultant, it's common for managers and sales people to enthusiastically pitch me on a strategy of "let's get them in the door with a big discount, they'll love our product or service, and then return to pay full price." My typical response involves casually asking, "So how often has this strategy worked out for you?" The usual response is dead silence.

While there are limited instances when 50%-off deals may be profitable, a "get them in cheap and they'll pay full price later" strategy rarely works out in practice. This is because drastic discounts devalue a product and are often viewed as acts of desperation. Value—the key determinate of the price consumers are willing to pay—is in the eye of the beholder. In other words, the price that each customer is willing to pay is subjective. It's a psychological challenge for consumers to pay a highly discounted price one day, then return a few days later and pay double the price for the same product or service.

If Groupon is counting on this "get them in cheap and they'll pay full price later" strategy to continue deal flow from businesses as well as impress investors, the people who paid $26 for its shares on Friday may wind up disappointed. In addition, with little differentiation and a bevy of rivals, marketing costs are skyrocketing. The future does not seem rosy.

The real innovation of deal sites such as Groupon and Living Social is that they have garnered millions of consumers who are interested in receiving deals on a variety of products and services. Just as important, it's cheap to communicate via email. These sites have a unique opportunity to morph into innovative digital versions of Sunday circulars. To accomplish this, they'll have to tweak their business model in two key ways:

Deemphasize 50%-off deals. Participating in deal sites needs to generate healthy ROIs for businesses. Many of the companies making deep-discount offers via Groupon wind up disappointed. My experience is that discounts up to 20% can inspire trial without devaluing a product or service. Yes, "50%-off" is catchier. However, it's probably more profitable and appealing to consumers to have three strong 20%-off deals instead of one drastic discount at a nail salon located 15 miles away.

Embark on a "content is king" differentiation strategy. By content, I don't mean funky prose and pictures of an eccentric cat. Instead, focus on what consumers want most: exciting deals. Accomplishing this will require a change in mindset. Discounts at local restaurants or for run-of-the-mill services like car detailing aren't enough to "wow" subscribers. Deal sites need to adopt the"treasure hunt" mentality that retailers like Costco and Trader Joe's utilize: pepper the offerings with unexpected, unusual or memorable goods or services, instead of the same-old same-old. To do this, Groupon will likely have to waive fees to offer deals from marquee companies or even pay for opportunities to provide limited quantity "treasure hunt" deals. Think of these fee concessions as "content loss leaders" that generate strong buzz. The goal is to get consumers to think, "I better open this deal right now because I don't want to miss out on an exciting opportunity."

The lesson that managers of all businesses can learn from Groupon is that while seemingly logical, a "high discounts will lead to full price purchases" strategy is generally flawed.

So what do you think? Will Groupon's current business model generate wild future growth? Have you ever offered deep discounts in hopes that it will lead to repeat full price purchases? If so, how did it work? 

Harvard Business Review