Are Four Words Worth $25 Billion for Groupon?

(Corrects spelling of SCVNGR.)

On a frigid Chicago morning in early March, Andrew Mason stood on a street corner outside his company's offices to reveal his ambitious plot to eradicate that age-old human conundrum: where to eat lunch.

Mason is the 30-year-old chief executive officer of the digital couponing comet known as Groupon, the Google-spurning, Super Bowl-flopping startup that sends deal-of-the-day e-mails to more than 70 million subscribers around the world. He's wearing a heavy winter coat, a lime-green track jacket embroidered with the Groupon logo, sneakers, and garish red Christmas socks. ("Only clean socks I could find," he says.) Holding his iPhone before him like a tricorder, he logs into the new service, called Groupon Now, and shows off two simple buttons that have the potential not only to transform humankind's lunchtime habits but also to alter the topography of the multibillion-dollar market for local commerce.

The two buttons: "I'm Hungry" and "I'm Bored."

It's only 11 a.m. Mason clicks the "hungry" button, and his phone transmits its location to Groupon's servers and then displays a list of deals from nearby restaurants. Across a bridge spanning the Chicago River, the Asian fusion restaurant Thalia Spice is testing Groupon Now by offering $20 worth of food for $12. A block to the north, an eatery named @ Spot Café is dangling a $10 coupon for $6. Each restaurant has specified that its discount is good only during select hours on that particular day, when a few of their tables would otherwise be empty.

And that, Mason declares as he taps his phone and purchases $8 of savings from Thalia Spice, could turn Groupon into a combination Yellow Pages, Valpak coupon packet, and price-conscious concierge for millions of consumers. "People could end up being driven to eat by what they find on Groupon and when they find it," he beams.

Andrew Mason commands a lot of attention these days. In a little over two years the former rock band keyboardist has managed to build what could be the fastest-growing company of all time. Yes, you read that right. Groupon's deal-of-the-day business is set to generate $3 billion to $4 billion in revenue this year, up from $750 million in 2010, according to two people familiar with the upstart's finances. Groupon was valued at $1.4 billion last April, sought funding at a $3 billion valuation in November and snubbed a $6 billion offer from Google (GOOG) two months after that. The company has been meeting with bankers to discuss a potential initial public offering that would value it at up to $25 billion, Bloomberg Businessweek has learned from two sources close to the negotiations.

"Starbucks and eBay were standing still compared to what is happening with Groupon," says Howard Schultz, the Starbucks (SBUX) CEO and former eBay (EBAY) board member who joined Groupon's board in February and invested in the company. "I candidly haven't witnessed anything quite like this. They have cracked the code on a very significant opportunity."

As avid deal hunters know, Groupon's daily e-mails promote discounts on everything from meals to massages from merchants in their city. Customers pay upfront—$50 for a $100 coupon for sky-diving lessons, for example—and Groupon splits the resulting upfront bounty with the merchant, taking 40 percent to 50 percent.

Deal hunters are also well aware that Groupon isn't the only game in town. There's a long and growing list of daily-deal services, from scrappy startups such as LivingSocial, Tippr, Bloomspot, Scoutmob, and BuyWithMe, to more established Internet companies such as review site Yelp, restaurant-reservation king OpenTable, Google, Facebook, Yahoo! (YHOO), and Microsoft (MSFT). All those companies have exploited a glaring weakness in Groupon's model: The business is pretty easy to copy. The technology involved isn't especially sophisticated; you mainly just need a bunch of salespeople to cold-call as many restaurants and nail salons as possible. Local business owners, looking at Groupon's cut, certainly don't mind having more than one coupon vendor to work with.

Groupon Now is Mason's attempt to build something that's much more difficult to replicate: a huge, liquid market for consumer foot traffic. Mason not only wants to change people's dining times, he wants to embed Groupon further into the daily routines of consumers and merchants. "We want people to think about Groupon every time they walk out the door," he says. Adds Harry Weller, a Groupon investor and adviser who persuaded Mason to simplify the Groupon Now interface from dozens of options down to the two "hungry" and "bored" buttons: "It makes Google's market look quite small if we get it right. It's really tapping into the largest part of commerce in the U.S.—local."

Groupon occupies parts of six floors in the former headquarters of Montgomery Ward, the erstwhile catalog retailer and department-store chain that along with another Chicago merchandiser, Sears Roebuck, defined retail during much of the 19th and 20th centuries. Aaron Montgomery Ward might not recognize much of the building he put up in 1908. Groupon employees are jammed in practically elbow to elbow. Doodles and cartoons festoon walls and whiteboards. Shelves are strewn with cartons of bagels and coffee. Adding to the flavor, blue yoga balls, which the company gave to every employee at an all-hands meeting in December, clutter the office and sometimes substitute for desk chairs. A conference room on the sixth floor, the "war room," is the launch pad for Groupon Now. A whiteboard is covered with giant maps of the initial target cities, with tallies of the number of merchants who have signed up in each Zip Code. The company plans to go wide with the service in early April.

Before Mason became the world's trendiest purveyor of coupons, he had loftier ambitions: He wanted to help solve the world's most intractable problems. Mason was pursuing a master's degree in public policy at the University of Chicago when he left school to form The Point, a "collective action network" in which people would combine their voices to lobby companies and public officials to make policy changes such as asking the federal government to make Election Day a national holiday. The Point went nowhere—consumers never joined en masse, and the targets of action generally didn't budge—but the idea translated nicely to the field of local commerce. A company might not listen to a few hundred agitators, but it would gladly offer a 50 percent-off discount to get that number of people through its doors for the first time.

Groupon was born out of The Point in November 2008. Mason determined that the battle for local commerce would be won on the ground with actual salespeople calling mom-and-pop stores and signing them up. As Groupon gathered steam, it raised $1.1 billion from investors in 13 months. Soon it began adding employees and making acquisitions overseas at a blistering pace.

Other startups had attempted group-discount sites before; several, including a Paul Allen-backed venture called Mercata, arose and blew up during the dot-com era. Groupon's timing was better: It launched in the age of Facebook and the iPhone, when it became technologically possible for startups to advertise with surgical accuracy, and for coupon clippers on the move to share bargains easily with friends.

From the beginning, Groupon's deals have been known for one thing: being funny. The company employs 70 comedy writers, led by Aaron With, a longtime friend of Mason's and frontman for the pop band Volcano!, to churn out absurd write-ups that accompany each deal e-mail. (Example, from an art-show ticket offer: "Artists always want muses without realizing they are a big responsibility, demanding regular walks, a ticket to every sunset, and smoothies made of old pastels and greek yogurt.") In a play on loyalty programs, Groupon has been known to reward its best customers with mouth guards, shoe trees, and other things they wouldn't want.

In 2009, when Groupon had only 120 employees, it was sending out 30 of its non sequitur-enhanced deals a day in 30 cities. Now, Groupon has more than 5,900 employees and sends out more than 900 deals each day in 550 markets. "The numbers got crazy a long time ago, and they keep getting crazier," says Eric Lefkofsky, Groupon's chairman and Mason's mentor, waving a whiteboard marker in the air as he speaks from his spacious office, which features an Impressionist painting from contemporary artist Christopher Wool. (Mason works from a rotating set of cubicles.)

As revenues climbed, so did outside interest in the company. Google has its own aspirations in the local advertising market and started talking to Groupon early last fall. The proposed $6 billion acquisition, say two people with knowledge of the discussions, failed in part because of fears that an antitrust review would slow Groupon's momentum—and because Groupon's revenues were expanding so rapidly that its investors believed the offer was too low. When talks began, Groupon had monthly revenue of $70 million. By January, sales were $200 million a month.

After rebuffing Google, Groupon raised $950 million in venture capital from Kleiner Perkins Caufield & Byers, Andreessen Horowitz, and other top-flight firms; much of that money went to early shareholders, who cashed in parts of their positions. Groupon is now gearing up for an initial public offering, likely for later this year. "It's inevitable that at some point we all go public," Lefkofsky says about Groupon and other new-generation Internet powers such as Facebook and Twitter.

The rapid growth has led to some dramatic missteps. Groupon paid $3 million to run a 30-second commercial during the Super Bowl that tried to make a gag out of repression in Tibet. ("The people of Tibet are in trouble ... but they still whip up an amazing fish curry.") The spot bombed, Groupon pulled the ad, and stopped working with its ad agency, Crispin Porter + Bogusky. Mason apologized publicly. The CEO says he placed too much trust in Crispin Porter "to be edgy, informative, and entertaining, and we turned off the part of our brain where we should have made our own decisions. We learned that you can't rely on anyone else to control and maintain your own brand."

The ad furor died down, but Groupon has more persistent problems—for one thing, that long and growing list of daily-deal wannabes. The competitor with the most momentum is arguably LivingSocial, a Washington (D.C.) company that was founded a year before Groupon. LivingSocial started out developing applications used on Facebook, then pivoted into daily deals after seeing Groupon's success. In December the company landed a $175 million investment by (AMZN) and is close to finishing a deal for an additional $300 million to $400 million in venture capital and institutional-investor funding, according to two sources who are familiar with the negotiations.

Then there are all the other lurking concerns about the deals-of-the day business: that consumers often buy Groupons and never get around to using them and that while the coupons provide a quick influx of cash to merchants, they ultimately prove unprofitable. Even merchants who say they use Groupon profitably express ambivalence. "A lot of people just come for the deal, and very few become regular customers," says restaurateur Filippo Caffari, owner of The Butcher Block in Minneapolis, who began using Groupons this year as an alternative to newspaper ads.

In the past, Mason and his team have vigorously defended the company against those arguments, saying most merchants are satisfied and that a vast majority repeat the experience. With the approaching introduction of Groupon Now, they sound less defensive. "We had this realization probably a year into launching Groupon that this was highly copy-able," says Lefkofsky. Adds Mason: "We have always been thinking about how to solve these fundamental problems of our model. We have known since very early on that some form of real-time deal optimization is where this had to go."

Groupon Now will be different in a variety of ways from the original service—which Mason and his colleagues almost dismissively refer to as Groupon 1.0. The daily deals, for example, present an invitation to get people to do something they ordinarily wouldn't—dine at a new restaurant, take sky-diving lessons, get their backs waxed. Groupon Now "is a carrot that gets them to turn left or right," Mason says. Unlike Groupon 1.0's goofball prose, Groupon Now's real-time come-ons get right to the point—they're basically dots on a map. And instead of receiving them via e-mail, users will see deals only when they enter their location into the Groupon website or smartphone app.

While there's a possibility that Groupon Now could confuse its customers and interfere with its highly profitable franchise, Mason doesn't seem to care. "The company I admire most is Netflix (NFLX)," he says, referring to the movie-streaming company that purposefully disrupted its original DVD-by-mail business. "They have figured out a way to be successful and cannibalize their core business. Nothing is more romantic to me."

Unlike Groupon's daily deals, which tend to generate a flood of customers, Groupon Now might lure just a few, but at the right time. Rob Solomon, Groupon's president, says the true promise of Groupon Now is to help eliminate perishable inventory—food ingredients, labor hours, and anything else that's wasted if not used immediately. "If we can eliminate 10 percent of perishability, we can change the dynamics for small business owners," he says. Small businesses would become more like airlines, matching supply against demand to maximize revenues. "If we get this right," Solomon says, "we are going to influence what tens of millions of people are buying at a frequency that we have never seen before."

Piece Brewery & Pizzeria, in Chicago's fashionable Wicker Park neighborhood, gets two kinds of phone calls from Groupon. Employees regularly call the restaurant to order its New Haven-style thin-crust pizza. And sales reps regularly call to exhort its owner, Bill Jacobs, to do a deal-of-the day offer. Jacobs has always declined. "Fortunately, we're very busy," he says, citing two- to three-hour waits on weekend nights. "There really isn't any benefit for us in doing the typical Groupon."

Early this year, though, Andrew Mason himself called Jacobs to pitch Groupon Now. The restaurateur was intrigued—the service could let him draw customers to empty tables during its few slow hours midweek. Jacobs says he's preparing to use Groupon Now to sell a $30 coupon for $20; the deal will be good only on Tuesdays, Wednesdays, and Thursdays from 11 a.m. to 3 p.m. "We can run it for a while, we can change the deal, change the times, and tweak it as we see fit," he says. "The new program is a good fit for us."

Mason envisions all kinds of establishments using the service. A spa might send out a deal on a massage because a customer canceled at the last minute, leaving one masseuse free for an hour. Or a gym could run a few days of coupons to fill the class of a new yoga instructor. "For merchants," says Mason, "the daily deal is like teeth whitening, and Groupon Now is like brushing your teeth. It can be an everyday thing to keep your business going," he says. And Groupon gets to be the well-paid dentist: The company will take its customary 40 percent to 50 percent cut of all deals, at least at first. And Mason expects that to add up quickly: In an internal company memo sent to the staff in January, Mason wrote that he hoped for $1 billion in revenue from new products in 2011. He was referring to Groupon Now.

The world may not embrace the new service in the way Mason hopes. Consumers might find Groupon Now's deals unappealing—discounts to bars in the morning, for example, or lunchtime deals from the worst restaurants. ("It's naturally the bottom-of-the-barrel stuff," says Seth Priebatsch, CEO of location-based service SCVNGR, talking about real-time deals based on perishable inventory.) As for business owners, Groupon Now requires them to enter offers on a website or smartphone app, then wait for passersby to find the deals. To sweeten the deal for merchants, Groupon staffers will help them get up and running, and the company has begun sending free smartphones with the app preinstalled to local establishments without Internet capabilities. But small business owners already have a lot on their plate; managing Groupon Now might be too much of a chore.

Some local merchants also fear that active discounting could dissuade their customers from ever paying full price. "I don't know if it would be beneficial to have an ongoing deal," says Nick Pinelli, who manages Capri Restaurant in Raleigh, N.C., and recently sent out its first Groupon. "There's no reason for customers to come in all the time if they can always get a discount. That's the reason we like Groupon; it's only a one-time deal."

As for whether Groupon Now is any harder to replicate, that's an open question, too. Groupon Now may be more technically advanced than the daily deals, but that's not stopping other companies from trying to get into real-time bargaineering. LivingSocial recently started a test run of its own real-time project, LivingSocial Instant. Location-based "check-in" startups such as Foursquare and Loopt hope to play in this field as well; Foursquare just announced an agreement with American Express (AXP) that will let users get credit-card rebates when they check in at a store and spend money. And looming on the horizon: Facebook, which announced plans in March to collect daily deals from a variety of Groupon's rivals and present them all in once place.

Groupon is preparing for the onslaught. It's filing a patent around its method for serving up deals based on people's location and time of day. (It's also applied for a patent on its deal-of-the-day service, which has not yet been approved.) Mason believes his army of sales reps and their existing relationships with merchants give his operation an insurmountable advantage. Since stores and restaurants probably won't have the time to administer such deals on more than one or two services, Groupon Now could conceivably yield the kind of merchant lock-in that Groupon 1.0 did not. "You need the two wings of the butterfly," says Weller, the Groupon investor. "You need the users, and you need the merchants. Why do you think we have thousands of salespeople?"

Mason and his team profess a carefree attitude toward the growing competition, but it's clear they resent the rivals more than they let on. On a Monday evening at the recent South by Southwest Interactive festival in Austin, Tex., Mason joined Weller, his investor, onstage at a party hosted by Weller's venture capital firm, NEA. As the crowd swayed and held up glow-sticks, the duo performed a rendition of the Billy Joel ballad Honesty, with Mason on the keyboard and Weller crooning the altered lyrics:

Honesty is such a lonely word,
Everyone is so untrue,
Originality is hardly ever heard
Copycats, I'm crushing you-ooo.

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