Will merchants still feel the love for Groupon a year from now?

High-flying internet startup Groupon has been in the news lately. First, its well-publicized rejection of Google’s almost $6 Billion offer this past December stunned most observers in terms of the valuation (and Groupon’s response to the offer). Second, it’s been reported by Forbes Magazine that Groupon’s internal projections are “that the company is on pace to make $1 billion in sales faster than any other business, ever".  And finally, Goupon now serves over 40 million customers who, by most accounts, love the service and are lusting for even more money-saving deals.

Groupon’s business model is relatively simple. In its over 150 different geographic areas (everything from big cities like Chicago and Boston to smaller cities like Tulsa and Syracuse, to the suburbs like Central Jersey and Ventura County), Groupon offers a ‘daily deal’ which allows consumers to buy discount vouchers (usually about 50% off but sometimes worth up to 90% off) that can be applied to a local business. Groupon then charges the merchant a (roughly) 50% cut for every voucher sold. Goupon sets a predetermined minimum number for the deal to go into effect - if a certain number of people sign up for the offer, then the deal becomes available to all; if the minimum is not met, no one can take advantage of the deal. This minimum amount is an especially important incentive for merchants who can then frame the use of these coupons as quantity discounts - something they couldn’t do with regular coupons. And unlike traditional classified advertising, it doesn’t cost the merchant anything to participant.

But how do Groupon’s retail merchants--the various clothing stores, spas, coffee houses ranging in size from The Gap to small mom-and-pop retailers--use Groupon services? And more importantly, how will they view Groupon a year from now when the hype surrounding Groupon has died down?

To answer that question, merchants need to weigh the benefits of the service versus the downside risks. According to a recent Harvard Business School Working Paper titled, To Groupon or Not to Groupon: The Profitability of Deep Discounts, the are two major benefits of the service for merchants.

First, discount vouchers can provide price discrimination, letting merchants reach customers who value the merchant less than the merchant's ordinary customers do. For instance, some customers are willing to pay full price for a given restaurant—great! The restaurant would like to keep charging those customers full price, while charging a lower price to new customers who aren't willing to pay as much but who are still willing to pay something above the restaurant's costs.

Second, vouchers can provide an advertising benefit—announcing a merchant's existence to thousands of consumers en masse, and potentially building buzz among consumers above and beyond sales to the consumers who actually buy the vouchers. This effect is more difficult to measure, but many merchants perceive it to be real. Where it exists, it's an important source of value that a discount voucher service can deliver.

And correspondingly, the risks to using Groupon are also significant.

One risk is that once new customers use the vouchers, they will never come back to pay full price. Whether they wait for the next deal or try and “game the system” by opening multiple accounts to purchase multiple vouchers, the risk is real that these new customers will either not come back as repeat customers or that if they do buy again, they will only do so at a discount. Having never paid full price for the product or service from the start, they will always reluctant to pay anything close to full price going forward.

But the greater risk is that existing (and profitable) customers somehow migrate to Groupon which would then strip the business of its primary source of profits. Similar to what happened to the American auto companies who offered discounts to lure new customers but didn’t erect high enough barriers to prevent their existing customer base from taking advantage of these same discounts, the risk here is that profitable customers become conditioned to wait for sales and discounts--reluctant to ever pay full price again.

It will be interesting to see how Groupon grows over the next twelve months. In order to continue their existing growth, they will need to cultivate sustainable and repeat business from their merchant customers. And once the initial hype of Groupon is over, these same merchants will need to measure the pluses and minuses of doing repeat business with Groupon.

Here’s the takeaway: In order to continue its torrid growth, Groupon needs to cultivate repeat business with many of its merchant customers. And the only way this will happen is if these merchants become convinced that the benefits of doing business with Groupon outweigh the significant risks that exist with both its new and existing customers.