Groupon: Deceptive Marketing in IPO Spotlight

10/19/2011 06:53 pm ET | Updated Dec 19, 2011

Going public is a dream for most start-ups and their loyal employees and investors. But getting there can be a nightmare.

Before the bell rings to usher in a company's first day of trading at the exchange, it must endure a long and arduous initial public offering ("IPO") process. Beyond procedural complexity, the IPO spotlight can publicize damaging and embarrassing problems. In the case of Groupon, negative revelations in recent months can be particularly damaging, due to intense public interest in the company and its inventive business model.

Groupon's legal problems are no secret. Until this week, the company's most high-profile legal issues relate to the scrutiny of its accounting metrics by the SEC and the press. Among other legal problems are pending lawsuits alleging infringement of intellectual property rights and violation of laws governing the use of gift cards. Compliance with privacy law raises another concern. The regulatory regime governing the way online companies handle private information constantly evolves, and methods used by companies to monitor online users are coming under increased scrutiny.

On the heel of these negative disclosures, a recent report from raises a new and uncertain legal issue for the daily deal giant, perhaps at the most inopportune of times. According to Thumbtack's study, Groupon and its competitor, Living Social, at times use inflated regular prices to make their deals appear more attractive to buyers.

For example, Groupon advertised a deal for home cleaning services in Phoenix for $49, as a 67 percent discount from the regular price of $150. Thumbtack reportedly called the merchant and got a regular price quote of only $80 for the same service as promoted in the deal. The price of $49 offered through Groupon should therefore represent a discount of 39 percent from the regular price, not 67 percent as Groupon advertised. Thumbtack also says that they called five different Groupon businesses asking for their regular rates -- and in each case, the business quoted Thumbtack a price that was less than the regular price advertised by Groupon.

Having recently purchased a carwash deal through Groupon at a 50 percent discount, I contacted the vendor after reading Thumbtack's report. The regular price quoted by the vendor over the phone and on his website is identical to that listed by Groupon. At least for me, the deal remains as sweet as offered.

It is possible that the reported discount inflations are isolated cases, limited only to a few deals in the local service industry where merchants infrequently publish regular rates on their website or otherwise. However, if true, they could raise an issue under consumer protection laws regarding deceptive advertising. For example, the Federal Trade Commission governs federal issues involving "unfair and deceptive acts or practices in commerce," and it may seem unfair or deceptive to raise the "normal" price of a service in order to advertise an artificially inflated discount. In addition, allegations of inflated discounts go to the heart of Groupon's business model and may cause some of its customers to pause before purchasing a deal.

Most unfortunate is the timing of Thumbtack's report. Groupon is in the middle of the so-called "quiet period" of the IPO process, during which communications with the public are severely restricted. The quiet period allows the market to reach a valuation of the company without influence from insiders who have motive to hype the company's stock. It also prevents Groupon from publicly responding to criticism in a meaningful manner.

None of Groupon's current legal problems seems to threaten the company's near-term success. And the new disclosures about potentially deceptive advertising are likely only limited to certain industries. The local service and travel industries, for example, are more susceptible to deceptive advertising in part because merchants in these industries infrequently publish regular rates.

Groupon is rightfully lauded for forging a new marketing model that drives substantial new business to local merchants. Groupon faces many of these legal issues because it has invented a new business model premised on extremely deep, time-sensitive discounts. Any company that creates something new will have parts of its business model challenged in courts.

However, taken together, these legal threats could significantly erode Groupon's profits over time and force Groupon to gradually shift away from its reliance on the "daily deal" model for which it is so famous.