Is Groupon subject to network effects?

As virtually everyone with a computer knows, Groupon turned down Google's acquisition offer, said to total $6 billion, last Friday evening. Parties who claim to have been close to the negotiations say that Groupon didn't want to risk its culture as part of Google, and that the company believes that it's following in the path of Facebook, which turned down several acquisition attempts. (For that matter, it's following in the path of Google, which tried to sell itself to Excite in 1999 for $1 million, without success.)

Critics of the Google/Groupon deal say that it's easy to create a "daily deals" service, and in fact, there are dozens of them in the U.S. alone. The technical barriers to entry are very low. The same was true in the 90s, when eBay became the dominant Internet auction site. There were dozens of other auction sites, some of which focused on vertical niches, and others that took eBay head-on. However, eBay became dominant because it took advantage of network effects, where the value of a product or service increases as the number of people using it increases. (Bob Metcalfe argued that the value is roughly the square of the number of users.)

In eBay's case, as more people used the service and more people posted products for sale, it generated a "virtuous circle" that made it more popular and gave users ever fewer reasons for using other auction sites. Groupon, however, is a different animal. Most Groupon users don't go to the site to find deals; instead, they get daily deals via email. Groupon's value comes in cornering the market for daily deals, and there are simply too many retailers out there for that to happen. Even Groupon realizes that it can't add enough salespeople to grow its business fast enough, so it's implementing a service that enables merchants to post their own deals.

Groupon may get to the point where consumers no longer pay attention to other daily deals and merchants no longer bother to post deals with other services, but it's not there yet and may never get there. That doesn't mean that Groupon won't continue to grow and won't be successful enough to eventually IPO, but it does mean that the "low barriers to entry" argument is credible. It's far too early to say whether Google dodged a bullet or Groupon made a brilliant decision, but either way, Groupon is no eBay.

Startups: Tentpoles and pollination

One of the most effective mechanisms for creating startups is a successful startup that turns into a big business. eBay is an excellent example of s startup that became successful and made a lot of people rich. Those people turned around and invested their money in their own startups and those of other entrepreneurs, which created a new generation of startups. I call these big, successful startups "tentpoles", the same term used in the movie business for a motion picture that's expected to be wildly successful and to spin off a series of sequels. In Silicon Valley, Hewlett-Packard and Fairchild Semiconductor were two of the earliest tentpoles; Apple and Intel sprung from them, and the current generation of tentpoles includes Google and eBay.

Tentpoles go through their own lifecycles, however. Early in their lives, they tend to attract engineers who are likely to go off and do their own startups. As they get bigger and more bureaucratic, however, they attract employees. Employees don't want to be entrepreneurs. They want a steady paycheck and good benefits with no risk. Employees crush the startup spirit of the tentpole with bureaucracy and hierarchy. Potential entrepreneurs who do join tentpoles by the time they reach this stage either leave quickly or get trampled down in the organization. As the Japanese say, "The nail that sticks up gets hammered down."

There's another model for startup creation, and perhaps its best exponent is Jason Fried, the co-founder of 37signals, the Chicago-based company that offers Basecamp, Backpack, Campfire, Highrise and other web applications, and that developed Ruby on Rails. Fried and Ruby on Rails developer David Heinemeier Hansson recently wrote Rework, a book about creating and growing small, sustainable businesses. Rework has gotten a lot of attention, and Fried often speaks about his concepts to groups of business founders and potential founders.

Companies that apply the concepts in Rework are unlikely to ever become tentpoles, and that's just fine with Fried. He believes that companies should grow organically from their own cash flow, and shouldn't depend on venture capital. Companies following the Rework model are likely to look a lot like 37signals itself--small (almost always under 100 employees), virtually organized (utilizing team members wherever they're located), very efficient, extremely flexible and a little bit opportunistic.

I call this model "pollination", where a set of concepts, or even a single idea or meme, can pollinate startups around the world. It doesn't depend on a tentpole, local universities or an active venture capital community; all it needs are motivated people who want to start their own businesses. The companies that develop out of this pollination are unlikely to ever get big enough to go public and score huge paydays for pre-IPO founders and employees, so they're probably not going to spin off lots of startups themselves. But, if they're successful, they encourage others to follow in their footsteps.

The tentpole model is the way the startup environment has grown for the past 50 years, but when it costs less to start a new technology business today than ever before, and when more resources are available in more places around the world than ever before, pollination makes more sense. It doesn't depend on the existence of a local tentpole to spin off more startups, and it doesn't rely on a local concentration of resources. People have been trying to build Silicon Valleys in their regions for decades, largely without success. Perhaps the Internet and its related technologies have made it unnecessary to replicate Silicon Valley, but it also means that there's not likely to be another concentration of tentpoles in one area like Silicon Valley in the future.