Are the Billions Justified for Groupon?

Are the Billions Justified for Groupon? originally published in VC Journal

Groupon’s potential $15 billion valuation may seem astronomical, but its high price tag may be justified. Groupon is one of only a handful of companies that has seemingly built a viable model for serving the massive local online ad and marketing opportunity. The opportunity is substantial, with about 25 million small and medium-sized businesses in the United State, most of which market their business in some way online. By 2014, companies are expected to spend $145 billion annually on local advertising, representing half of all ad spending, according to BIA/Kelsey. And while spending on traditional advertising such as yellow pages, print ads and TV commercials will decline, spending on local online marketing is forecasted to grow from $15.2 billion in 2009 to $36.7 billion in 2014. This means that over the next few years, millions of plumbers, boutiques, salons and other local businesses will seek out or expand their Internet advertising and marketing.

One plumber told me that before setting up a Web presence and marketing online, he missed out on 80% of potential jobs because nearly every consumer starts their search for local products and services online.

Having an online marketing strategy is now critical for these businesses, and companies such as Groupon that help connect merchants with local consumers will benefit from this expanding market. But while there is no shortage of local services—paid search, mobile search, social media, banner ads, daily deal coupons, mobile check-in services, and more—not all of these “local” companies will survive, let alone reach a Groupon-level valuation.

In fact, while VCs have invested more than $2 billion in locally focused Internet companies over the past 10 years, many never turned a profit.

Getting local right can be tricky. Small businesses can’t afford to spend much on marketing, as price points are typically low, while the cost of sales are typically high. It usually takes a lot of door-knocking and cold-calling to sign up local businesses for new tech services. Once you’ve got a customer signed up, you then have to contend with high churn, because many small businesses go out of business within two to three years. Which brings us to Groupon. While a $15 billion valuation might seem excessive for what’s basically a coupon site, the company has solved the two main challenges that have plagued online local marketing for years—low price points and the high cost of sales. Groupon gets half of every sale, which solves the problem of low-priced, fee-based marketing. And while they have a large sales staff and a stable of copywriters, they don’t have to “go out and knock on doors” to sell the service. Their early focus on virality spurred growth and helped their brand become popular with target audiences. Local businesses are now waiting in line to be the next deal of the day for a chance to get paying customers through the door. Many things have aligned in the online economy to position the current wave of local companies for success. For one, search has become central to people’s lives. Local search is the evolution of the Yellow Pages, which was once the only “local search engine” in the home. While Groupon deals “come to you” via email, many local companies are leveraging search today. Publishing and advertising technologies that help local businesses get “found” by Web searchers are positioned to become massive success stories. Groupon gained early traction in the space by acquiring an extensive email list and deploying a substantial sales force. So far, the company’s economic model is working. As we look to the future, new models will arise that could one day eclipse even the exciting valuation numbers seen recently. A tech company that cracks the code on empowering small businesses to create a search-optimized online presence and launch mobile and social programs by themselves could easily reach a multi-billion valuation. Add to that a limited sales team, a self-service model, and a search-driven technology platform, and that company could essentially become the “Google of local.”

Ben T. Smith, IV is the chairman and co-founder of MerchantCircle, a Mountain View, Calif.-based social networking site for local businesses. He can be reached at ben@merchantcircle.com. By Ben T. Smith, IV, MerchantCircle