In just over five years, daily deal company LivingSocial went from D.C. technology start-up to one of the District's largest employers, with the backing of marquee investors, including the heavyweight champion of e-commerce, Then, last October, the company announced a massive $566 million third-quarter loss as revenue declined and it was forced to take heavy writedowns on prior acquisitions. The following month, the company laid off roughly 10% of its workforce. What went wrong, and what happens next?

The rationale for a bubble
At this stage, the evidence is pretty well overwhelming: There was a bubble in social networking companies and shares, and LivingSocial was no exception to that phenomenon, even though it remains a private company. We know this now because the business fundamentals of many of these companies were unable to support the wildly inflated public and private market valuations they achieved early on.

When LivingSocial completed its most recent financing round in February, it did so at a valuation of just under $1.5 billion, a decline greater than two-thirds with respect to the previous round less than 15 months earlier. LivingSocial's publicly traded competitor, Groupon (GRPN -5.41%), has seen its shares fall by three-quarters from the end of its first trading day in November 2011.

Bubbles are not born of euphoria; every speculative mania has a rational element at its root. At least two conditions are required: First, an important market opportunity and second, a narrative describing how a company will tap into that market. Often, the latter involves a new technology, or a new form of business or commercial organization.

Both conditions were present in the mania that propelled LivingSocial and Groupon upward, providing them with hundreds of millions of dollars of capital. LivingSocial's story can't be understood without reference to its larger rival. In the following discussion, I'll sometimes refer to "GroupingSocial" as shorthand for both companies.

The opportunity
The market opportunity was local advertising and the basic enabling technology was the Internet and, more specifically, social networking. As LivingSocial's CEO Tim O'Shaughnessy told Business Insider's Henry Blodget in an interview in May 2011:

There hasn't been a disruptive model in the [local advertising] space for literally decades. And so you had all this demand for a more efficient marketplace to occur and now that a more efficient marketplace is here, people are rushing to it, which is why I think you've seen such aggressive growth in the space.

He wasn't wrong. Consider, for example, that, in 2011, publishers in the U.S. distributed 422 million telephone directories -- a mainstay of local business advertising -- for which they received a total of $6.9 billion in ad revenue (including digital operations, directory companies collected nearly 8% of total U.S. ad spend in 2011.) Phone books! There had to be a better way to bring together consumers and businesses.

Google (GOOGL 0.93%) revolutionized the advertising market for businesses selling online with paid search, but even a company with its resources, know-how, and innovative culture hasn't really cracked local advertizing and commerce. Group-buying looked like a new model that had a legitimate chance of upending traditional practices in this marketplace. Google itself must have believed that or the company would not have offered $6 billion to acquire Groupon at the end of 2010.

Two's company, three's a crowd
Here's how the group-coupon model works. In every city in which it is present, LivingSocial sends offers to purchase goods and services from local businesses at a sizable discount (typically, 50%) to its massive email list. The user pays for the product/service via the website, which then shares the revenue with the business. The benchmark split in revenue is 50:50 for Groupon. LivingSocial reportedly practices less onerous terms, keeping approximately 30% to 40% of the revenue.

As Tim O'Shaughnessy described it:

Every single offer that we run has three people involved: It has LivingSocial, it has the merchant and it has the member. And, you know, ninety-plus percent of the time -- I don't know what the exact numbers are -- but over a huge percentage of the time, it's a win-win-win for all three parties. When that happens, you have a pretty healthy ecosystem. I mean, every person is happy in that triumvirate at the end of the day.

That sounds wonderful, but Sucharita Mulpuru, a vice president at Forrester Research and an expert on e-commerce, multi-channel retail and consumer behavior, offers a less rosy assessment: "What was good for Groupon and the daily deal companies was not good for the merchants and vice-versa. There's only a fixed amount of margin there and either it goes to Groupon or it goes back to the merchant; if it goes back to the merchant, Groupon makes less money," adding: "They never figured out -- and they still haven't, I'd argue -- how to get to that balance of win-win -- it was always a zero-sum game."

Here's how the deal works out for the three parties:

  • Users: The advantage is not hard to spot here; what's not to like about a 50% discount on goods and services?
  • Deal site: The group-buying website acts as an intermediary in matching consumers with local businesses. Here again, the benefits of this model are clear: The company carries no inventory, it gets paid upfront and, as we saw above, it earns massive gross margins.
  • Merchant: When it comes to the third party in this transaction, the upside -- or "value proposition" in marketing-speak -- is slightly more nebulous. Depending on the marginal cost of the product/service in question, some businesses may still be able to earn a profit in the deals they offer. However, given that they get hit by a double whammy in the user discount and the revenue-sharing with the deal website, that's not the base case. Instead, most businesses accept that the deals are a form of advertising with a cost that ultimately needs to be recouped through repeat transactions at non-discounted prices.

Where's your marginal profit?
A simple concept from economics, that of marginal profit, is enough to illustrate why the economics of the group-buying model for the merchant can vary wildly, depending on the sector in which they operate. Let's take two types of businesses that are superficially similar: A boutique hotel and an upscale restaurant. Both are part of the hospitality industry and may appeal to heavily overlapping sets of consumers; however, they differ vastly in terms of incremental profitability.

Consider the marginal cost associated with one additional booked room at the hotel; it's close to zero. Essentially, you just need housekeeping to clean the room – an hour of work, tops, at little more than minimum wage. Given those numbers, the hotel can still earn a marginal profit on a $250 room (or even a $150 room), even when it pockets just 25% of the standard room rate (after the 50% discount and the 50:50 revenue share with the deal site.)

Now consider the case of the upscale restaurant. In fine dining, the cost of the food to the restaurant represents, on average, 40% of the menu price. That cost alone would eat up nearly the entire price the customer pays for the meal under a 50%-off deal, wiping away any hope of a marginal profit once revenue is shared. As such, the restaurant can only justify the transaction as a form of advertising that is expected to generate recurring revenue beyond the initial deal.

Survivors of another meltdown
That's a textbook discussion. In the real world, when it comes to some of the businesses that generate the highest marginal profit on every additional unit sold (including hotel rooms or airline seats), the marketplace is already pretty efficient. Also, the opportunity is well covered by companies that survived the collapse of the first Internet bubble in 2000, including (BKNG 0.08%) and Expedia.

Priceline, which arguably came up with the most disruptive model with its "name your price" offer, earns very high margins and terrific returns on capital. It doesn't position itself as an advertiser because the hotel rooms and airplane seats it fills are profitable for the hotels and airlines it does business with.

Outside of the sectors that share this property, group couponing can only be analyzed as a form of advertising, rather than distribution. Unfortunately, the evidence that consumers who participate in a deal are willing to return to a merchant and pay full retail prices is underwhelming. Manta, a small-business online community and service provider, recently surveyed 1,080 such companies, with only 3% of respondents reporting that daily deals produce repeat patrons.

Big wow, half-price
Here again, a basic economic concept helps to explain that figure. The price elasticity of demand is the percentage change in demand for a good or service in response to a 1% change in price. Demand for a good or service is said to be elastic when the change in price has a relatively large effect on demand, and inelastic when the change has a small effect.

Logically, demand for discretionary items tends to be elastic, while demand for necessities, such as consumer staples or health care, is inelastic. When it comes to the type of offers deal sites put together, you're combining huge changes in price (a 50% discount) with goods and services with highly elastic demand. Indeed, deal sites like to entice their users with offers on unusual leisure products, services or experiences, as there is no "wow factor" in staple goods (for example, LivingSocial advertised a deal that combined a horseback ride with a wine tasting). Put huge discounts together with high elasticity and presto! it's no wonder these deals generate explosive demand.

Unfortunately for the merchant, when it comes to repeat purchases, the converse mechanism takes over. Compared to the terms of the discounted deal they snapped up initially, full retail price represents a doubling of the price on a product or service that the consumer can do without. Under that framework, it's easy to see why the rate of repeat patrons might be abysmal. The initial discount is so substantial that it creates massive demand for goods and services for which consumers would never dream of paying full retail prices. Faced once more with ordinary prices, one would expect shoppers to revert to their behavior prior to taking advantage of the deal -- in short, they abstain from buying.

The fundamental flaw
That reversal is really at the crux of the contradiction in the deal site model: Demand generation occurs due to the huge discounts. When the discount disappears, the demand evaporates with it. For most merchants, the only thing that justifies doing a deal in the first place is the promise of repeat demand at full retail price, which is a mirage.

The executive managements of GroupingSocial missed that contradiction because in choosing to focus on delighting users, at the expense of satisfying merchants, they misunderstood who their customers are. The deal site gets paid out of the merchant's pocket, with the user paying nothing to access these deals. In other words, the deal site's true customer is the merchant, not the user. Remember the adage that if the service is free, you're not the customer, you're the product (the same applies to Facebook -- if you're on it, you're their product).

Groupon's 2010 initial public offering prospectus provides plenty of evidence of this misunderstanding:

Our investments in subscriber growth are driven by the cost to acquire a subscriber relative to the profits we expect to generate from that subscriber over time... We spend a lot of money acquiring new subscribers because we can measure the return and believe in the long-term value of the marketplace we're creating.

The irony here is that Groupon appeared to be completely oblivious to the fact that its merchant customers would think about customer acquisition via Groupon in the very same way, i.e. on the basis of a hard-nosed, return-on-investment estimate:

Our strategy
Grow the number of merchants we feature: Our merchant retention efforts are focused on providing merchants with a positive experience by offering targeted placement of their deals to our subscriber base, high quality customer service and tools to manage deals more effectively.

When it comes to the merchant, there is no mention of profitability or ROI, as if a "positive experience" could replace cash in the till. Furthermore, Groupon confused growth with value creation:

Our metrics
We believe revenue is an important indicator for our business because it is a reflection of the value of our service to our merchants... First, we track revenue -- our gross billings less the amounts we pay our merchants -- because we believe it is the best proxy for the value we're creating.

That's plainly false. For an early stage business with an unproven business model, revenue is no indication of whether or not of the business is creating value. GroupingSocial had long waiting lists of merchants who were willing to experiment with this new model for customer acquisition. Revenue growth could easily be "bought" through the juicy deal discounts (who doesn't like 50% off?) and through high-priced acquisitions of smaller deal sites; revenue isn't proof a business is creating value on a sustainable basis -- the dot-com bubble of the late 1990s provided numerous counter-examples.

If you're looking for evidence of value creation, a much better metric -- which neither Groupon nor LivingSocial make public -- is the rate of repeat business from merchants.

Going "all in" on growth
Nevertheless, GroupingSocial made a strategic choice to focus on growth through user acquisition. They did this for two reasons, in my opinion. First, it was easier for the young entrepreneurs at the helm of these businesses to identify with their users, who are typically young, digitally active, and ready to pounce on a good value -- particularly when it comes to treating oneself or experiencing something new.

Second, creating user interest and mobilizing demand online was something both organizations knew how to do and the founders found the process tremendously exciting -- much more so than trying to pin down the formula that would produce a "win-win-win" for all three parties to a deal.

The choice to focus on users wasn't completely without merit. "It's a chicken-or-the egg problem, because if you don't have the consumers, then the merchants aren't interested, so they focused really heavily on 'How do you create a great customer experience?'" Mulpuru explains. Furthermore, achieving scale gave the deal sites greater leverage over businesses -- all the more so when the group-buying concept was brand new and merchants were signing up to do their first deal.

Betting the farm -- twice
At LivingSocial, the quest for growth was integral to the company's identity -- it trumped everything else, including permanence of the business model. In fact, the company's four co-founders effectively reinvented their company twice in the pursuit of growth, in order to arrive at the group-buying model.

In 2007, four young, bright and ambitious IT workers -- Tim O'Shaughnessy, Aaron Batalion, Eddie Frederick, and Val Aleksenko -- started a consulting company that would ultimately become LivingSocial. The company, called Hungry Machine (a name that broadcast its insatiable appetite for growth), had two activities: Major IT consulting projects for big-name companies such as ESPN and creating applications for Facebook.

The latter, which began as tinkering with ways to exploit and monetize the Facebook platform, eventually cannibalized their more conventional activity. Indeed, the popularity they achieved on Facebook with products like Visual Bookshelf, which enabled users to share their reading lists, convinced them to jettison their consulting gig. That practice was already successful, so it was a bold decision -- some might say reckless. However, they believed that the social web could produce explosive growth and profitability that would eclipse anything they could achieve in consulting, and they had the confidence to put that belief to the test.

As Batalion, who was known to be particularly hard-charging, later explained: "We decided, in essence, to cut our wins and try something else. It was a hard decision, but consulting doesn't have a growth curve that's interesting."

In March 2009, LivingSocial scored a huge hit with its Facebook app Pick Your Five, which had users selecting their favorite books, bands, drinks, etc. Within 30 days of its launch, the app had attracted 80 million users. But even though they had the hottest app on Facebook, the associated revenue from advertising and Amazon referrals amounted to crumbs. The trouble was that commercial activity associated with Pick Your Five was "pull demand" -- entirely at the user's initiative.

From crumbs to cake
During the month that followed Pick Your Five's launch, LivingSocial acquired, and the Internet and social media could enable them to generate demand, not just facilitate it. Or as Don Rainey of Grotech Ventures, LivingSocial's first VC investor, put it to the Washingtonian at the end of 2010: "That was a light bulb -- that you could drive 20, 30, 50 people to show up at a place with online media." Generating demand would enable LivingSocial to command a bigger slice of the transaction pie, rather than just feeding on crumbs.

Three-and-a-half months later, on July 27, 2009, the company launched its first group coupon, for sushi restaurant Zengo in D.C.'s Chinatown neighborhood. LivingSocial 3.0, the third iteration in terms of business model, was born.

Nearly four years on, LivingSocial and Groupon provide a critical lesson for individual investors who like to look at growth-oriented IPOs, particularly those that tout disruptive business models. When an untested model appears hugely successful, investors shouldn't conflate hypergrowth with sustainable growth and long-term value creation. One may follow the other, but, more often than not, the business never makes the transition from one state to the other, or not sufficiently to justify a frothy valuation, in any case. For every Google, there are hundreds of Ask.coms (or, worse, Pets.coms.)

Where does LivingSocial stand today?
On Feb. 20, a research firm called PrivCo released a breathless report on the financing round LivingSocial had completed the previous day, suggesting that the financing was not estimating the probable company valuation at $330 million -- a 93% decline relative to the prior financing of December 2011. Privco also predicted the company would file for Chapter 11 bankruptcy by the year's end.

LivingSocial CEO Tim O'Shaughnessy immediately rebutted the report in an internal memo on the financing that highlighted some inaccuracies. For example, the memo revealed enough information to deduce the valuation, $1.5 billion (a two-thirds decline from the prior financing round.)

However, the memo, while almost certainly accurate, is incomplete and, I believe, misleading. For example, in discussing the terms of the financing, it refers to the possibility of an IPO. This is entirely legitimate in the context of a theoretical discussion, but mentioning it in a memo that went out to employees looks disingenuous, as O'Shaughnessy and LivingSocial's board must surely be aware that an IPO is no longer a realistic prospect at this stage.

The window is shut
"LivingSocial's window of opportunity for going public is long past -- they should have gone public probably before Groupon, and taken advantage of that window in which there was uncertainty, and hope, and hype, as a result," says Mulpuru. "That's long past and having an events management space is not something that's going to give them any insulation from being lumped in with the daily deal space. The daily deal space is not where you want to be right now," she adds.

The endgame for LivingSocial probably lies somewhere between the PrivCo and O'Shaughnessy's assessment. An IPO is certainly out of the question, while I don't think one can rule bankruptcy out. However, it's also possible that LivingSocial could be acquired or it restructures in order to continue as an independent going concern.

One veteran's view
As CEO and then-chairman of VerticalNet from 1997 to 2001, a host of business-to-business trading platforms, D.C.-based technology executive and investor Mark Walsh has seen this movie before. Walsh led a company that experienced hypergrowth, as well as investors' adulation and, later, repudiation. Founded in 1995, VerticalNet grew to 3,000 employees at its peak, with a valuation that went from $8 million to $13 billion in a period of roughly two years.

While he and O'Shaughnessy are currently co-investors and advisors to a start-up company, Walsh is careful to emphasize that he has not discussed LivingSocial's fortunes with him. Nonetheless, he thinks the young entrepreneur may ultimately face a difficult decision:

If he sticks to his knitting and there ends up being two or three winners, Groupon, LivingSocial, maybe one other and the business stabilizes as a way for healthy vendors to find new customers on a regular or seasonal basis, [LivingSocial] could be a great business. Or he may say: "I'm going to jump off this island and swim to this bigger island," which is trying to make a business out of the data I have, out of the vertical relationships I can carve up and try to get into some higher-margin businesses that aren't so discount-driven. I would argue that, at some point, he's going to have to choose one or the other.

O'Shaughnessy and his co-founders have twice demonstrated they were capable of jumping from one island to another larger, seemingly more attractive island. In the immediate future, however, it appears that time is running short for the company to achieve stable profits and, for the first time in its existence, LivingSocial's executive team needs to prove that it can see the company through a slimming regimen, instead of managing a Hungry Machine.