Why Groupon Looks a Lot Like a Ponzi Scheme

Two state attorneys general and 14 lawsuits are asking whether the short deadlines that Groupon (GRPN) imposes on its customers are legal. The investigations and litigation might go some way to shedding light on how dependent Groupon is on its curious cashflow arrangements: The company makes massive losses on its income statement but is nonetheless cashflow positive.

Groupon takes in a positive amount of cash because it collects payments from its consumers immediately and doesn't give the spas, cafes and yoga studios who made the offers their share of that money until a later date. Groupon gets to keep the "float," in other words. As Groupon is growing quickly, this float allows the company to stay in the black even while it services its consumers and merchants at a net loss.

The way that float is maintained, however, is the subject of interest from Connecticut and Illinois prosecutors, and of some consumers who feel ripped off because after buying Groupons they didn't have enough time to redeem them -- which let Groupon keep their money.

Monetizing procrastination

The lawsuits, at first glance, seem frivolous. In one, Massachussetts resident Jennifer Bates complains that she bought three $8 Groupons for a Charles Riverboat tour on Aug. 1 last year, but didn't try to use them until after Oct. 15 when the offer expired. (Oddly, this episode occurred after she'd procrastinated the same way on a $33 daily deal for a local spa.) Groupon wouldn't refund her money so she reached for her lawyer.

She has one legal argument that makes some sense: The Electronic Funds Transfer Act, she says, prohibits gift certificates that have expiry dates of less than five years. The cases allege that Groupon's business model relies on a portion of their consumers failing to spend their Groupons before their expiry deadlines, which is one reason merchants love them -- they get the money even though nothing was bought.

Groupon, however, is keeping some cash temporarily whether the coupon is redeemed or not, in the form of the "float" that occurs between collecting the money from consumers and paying the merchants whose offers they bought. You can see the effect of that float on Groupon's balance sheet:

Groupon's cash grew from $12 million in 2009 to $119 million in 2010 (see yellow highlights). But look at its liabilities: the company owed $57 million, $162 million and $98 million in various accounts payable. You can see the same thing happening on Groupon's cashflow statement:

Those "accounts payable" items kept a total $294 million in cash in Groupon's coffers simply because Groupon didn't pay it out immediately to the merchants and service vendors it is owed to. But on Groupon's income statement, which records its revenues and expenses as if the two occurred at the same time, we can see that Groupon made a huge loss in 2010, $413 million:

That $413 million loss was, coincidentally, almost the same size as its "cost of revenue," the money it must pay merchants who participate in Groupon's offers.

This business model looks familiar
There is nothing specifically wrong with a business that has the kind of purchasing power that allows it to demand payment immediately but delay fulfilling its expenses; all businesses try to do this precisely because it generates usable cash in the short term.

At Groupon, however, collecting more money in sales and reducing payments by delaying them appears to be a large part of its business model. That's also the "business model" employed in most Ponzi schemes, in which the operator hopes that a greater amount of new money coming will always be available to pay off the older participants who are owed money.

The test will come when Groupon's business stops growing or declines. At that point, there will be no more "float." If the company has not brought its regular operating expenses in line with its gross profits (the money it keeps after it pays merchants) by that point, then Groupon will collapse.

In 2010, Groupon's operating expenses were two and a half times its gross profits. It's a big ask.

Related:

Image: Charles Ponzi's mugshot.

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