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Just when you thought the Group Buying space couldn’t heat up anymore, Groupon goes and gets a $135 million investment from DST and Battery Ventures at a more than $1 billion valuation. Groupon has proved how incredibly lucrative this business is as it has achieved a $1 billion plus valuation business in less than 18 months. In my last blog post, I discussed how the Gold Rush was over for Social Games. Well, it just moved over to the Group Buying business! A lot of things are happening in this space and the big question is how is all of this going to shake out?

There will soon be hundreds if not thousands of Group Buying sites

There are now over 80 group buying sites in the U.S. alone. I predict there will soon be thousands. Let’s talk about the barriers of entry. A service like Groupon which has scale in audience can go to merchants and ask for exclusives by guaranteeing high minimums and they will get them. However, their value proposition is about being selective and curating deals that they think are the most relevant. So in a city like NY where they feature 2 deals per day, they can only lock up about 800 merchants per year. NY has nearly 2 million small businesses and I suspect a good percent would be a good fit for a group buying service. Unlike flash sales sites like Gilt which have more scarcity in brands that they can work with, group buying sites have a much longer way to go before they actually really start stepping on each others toes.

So selling to merchants is not much of a barrier, how about the technology platform? Well, that is even more commoditized. These platforms have proven to be pretty simple thus far and are quickly becoming a non issue. New companies such as Group Commerce, Offer Foundry and AdBlade are already offering white label solutions to partners and only asking for a revenue share. I am sure there will be more solutions in the market with even lower costs. Some of these platform plays are also building out their own salesforce to bring in merchant deals. That way they package both commodities – merchant sales and the platform. The partner just needs to bring the audience. So with merchant sales and the platform not being much of a competitive barrier, what is the competitive advantage?

Race to the Inbox and staying there

At the end of the day, the only main competitive barrier is distribution in the Inbox. Email is proving to be the most effective way of delivering these deals. From a user’s perspective, signing up for more than 2 to 3 of these services is just too overwhelming. So the main goal for all of these players is to get users to subscribe to your email and to have them keep it there. Who will win in this race to the inbox? Well, those that can acquire email subscribers the fastest by either raising the capital to aggressively acquire users or who have existing audiences that they can get to sign up. But once you have them, you need to keep them. If you lack relevancy, the switching costs are so low that you will easily see them move elsewhere. Relevancy will be based on how well you match up the deals to the taste and preferences of the user. These services will offer greater filtering technology to show you relevant deals. I think this will be led by aggregator services like Yipit, who ask users for interest preferences such as sporting events, restaurants or spas and comb through the 80+ sites to show you the most relevant deals. The other route to go is for these services to be much more verticalized by demographics or psychographics. An example of this is Gilt City which caters to more luxury offers. So instead of offering the pizza place that Groupon features, Gilt City will feature the Michelin star restaurant.

So get ready for a new gold rush! There will be an unbelievable amount of competitors in the space. For consumers, great news as you will benefit from so many great offers. As for the competitve players, it’s all about execution……..good luck!

I have written a good amount about the success of companies like Zynga and how these apps should be called Viral Games and not Social Games. It was the ability to utilize the different FB communication tools (Feed, notifications, wall posts, invites, etc.) that drove the massive scale of these apps. Eventhough social games are only able to monetize at Lifetime Values of about $.40 per user, they made the economics work because the virality and scale of Facebook gave them a path to become large and profitable businesses. This created the Social Game Gold Rush as companies were raising money and game developers were emerging left and right. Well, I have news for you:

The Gold Rush is Over!

So what has happened? Well Facebook has completely curtailed all of the viral mechanics that made these games successful. To give you an idea of some of the practices that were stopped, here is an example. Game developers were building aggressive practices such as showing a friend invite screen to anyone that first joins the game and then defaulting the invite so all of your friends are checked. So you were defaulted to opt in to invite all your friends on Facebook. People would mistakenly hit “Continue” not knowing that they just sent an invite to their hundreds of friends and then their friends would go through the same experience as they checked out that game and most likely fall for the same viral trick. Facebook obviously found this “spammy” which they should and made a rule to all developers that they were no longer allowed to mass invite your friends to a game when you first join or they would be shut down. This is one of many changes made by Facebook and some people would argue that reason why they are shutting down these viral channels is to force social gaming companies to spend money on advertising via Facebook. That may definitely be true but I think the bigger motivator was that it just added a lot of “spam like content” on Facebook and users were getting fed up. When you have a Facebook fan page titled “I dont care about your farm, or your fish, or your park, or your mafia!!!” and it has over 6 million fans, pretty much proves the point that these virality mechanics were definitely getting spammy.

So where does it leave us. Well, if you are a game developer without a hit game/app that has achieved scale then you are pretty much toast. There were 3 legs of the marketing stool to FB apps/games – viral, cross marketing and paid. If you are not already one of the bigger boys then you are now left with just 1 leg of that stool – paid marketing. And unless you have figured out how to monetize your app or game so much better than everyone else, it is pretty impossible to make the economics work when your marketing costs are now so high. For the companies that have already achieved scale, they survive for now by having the 2 legs of the stool they need to explore other avenues of distribution. And from recent announcements from Zynga such as the distribution deal from Yahoo, it sounds like they are doing just that.

So I recently read Lessin’ Lessons written by Bob Lessin. Bob is an investment banker and investor with an incredibly accomplished career including being the youngest partner (at 31) at Morgan Stanley and former Vice Chairman of Smith Barney and now currently Vice Chairman of Jeffries. I have had the opportunity to get to know Bob over the last few years and from every encounter I always feel like I take away a little nugget of wisdom. So I am glad he got to write some of his thoughts about what he has learned in life.

Well, lesson #27 in Lessin’s Lessons is :

“27. There are no new ideas, just recycled ideas whose time has come.”

He talks about how before Facebook there was SixDegrees.com which he was a first round investor in. SixDegrees was launched a few month prior to AsianAvenue.com and I have also got to know the founder and CEO, Andrew Weinreich, over the years. The concept of SixDegrees had so many similarities to Facebook but failed to dominate the digital world as Facebook has because of reasons that were really out of its control. Whether it be the fact that digital cameras were not pervasive (do you think Facebook would be that interesting without photos), the lack of an online ad market to support it or because technology costs were 100x more expensive as they are now. As Bob states in his book “Ultimately, like most great concepts, they ran out of money”. The success of Facebook has less to do with truly innovative ideas but more on taking the lessons learned in the past and taking advantage of market changes that make the business much more viable.

Compare a business like Gilt.com. People in the U.S. think that this flash shopping site was a great innovative idea. The truth as reported in New York Magazine was how Kevin Ryan, former Doubleclick CEO and head of New York incubator Alley Corp, just mimicked an overseas success story. “Ryan was aware that a French company called Vente Privée was raking in money by selling fashion overstock, and he thought its business model could work just as well in America.” Trying to launch this type of business during good economic times would have been impossible because you could not get luxury brands to “play ball”. This type of discount play was perceived to be too risky in terms of damaging their brands. However, the recession and how fast it hit us left these luxury brands with tons of excess inventory and in desperate need of cash. The time for Gilt had come and they took advantage of it. It is reported that Gilt.com is expected to generate over $400 million in sales this year. Pretty good for a business that is only about 3 years old!

So the lesson learned for me? Look for recycled ideas that time has come. These type of businesses tend to be a lot more capital efficient and therefore much more likely to succeed.

So I just read an ebook titled “Early Exits” by Basil Peters. The book argues that VCs are spurring on companies to go for the “home runs” when it may not be in best interest of the entrepreneurs or angel investors . The book argues that companies should be wary of taking VC money as their business models are reliant to go for huge return exits versus going for “singles” or “doubles”. These singles and doubles can offer very rewarding returns for their shareholders payed out much earlier and with greater probability.

To illustrate the point about the VC business model, he writes the following:

“An Outline of the VC Math

Peter Rip of Leapfrog Ventures describes the math behind VC funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken—It’s About Time.’ This is a high level summary of
how the math works for a VC fund.

In a typical VC portfolio, all the returns are from 20% of the investments. These are the two out of ten investments that are winners. A minimum respectable return for a VC fund is a 20% compound return. For a ten-year VC fund, the fund needs to pay investors 6x their investment to generate a 20% compound return. So those two winners each have to make a 30x return on average to provide investors with the 20% compound return—and that’s just to generate a minimum respectable return.

This math is simplified but it’s more than accurate enough to illustrate this important point. If you are not familiar with the math behind an investment portfolio, I hope you will spend a few minutes with a spreadsheet so you feel comfortable with these numbers.

Even more interesting is that a traditional venture fund is usually a limited partnership. This means that the fund managers only get to invest the money once. So if they make an investment and exit for a 3-4x return, they give the principal and gains back to their institutional investors. They don’t get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.”

This is probably a bit exaggerated. In speaking with some other friends that are either VCs or been VCs there are plenty of situations where they would be very content to take a 3 or 4x return. This is especially true if they are a later stage venture capital firm where that type of return would be considered a home run. However, for early stage VCs, I do believe that their model definitely has them put on rose colored glasses if they see that their portfolio company may be able to achieve that home run. This is because the personal risk/reward scenarios for the stakeholders involved.

Think about it this way, for a basic “single” or “double” exit, you can see entrepreneurs making single digit millions of dollars and angels would make anywhere between 3 to 5x from their original investment. Each of them would probably be pretty happy with that. As for the VCs personally (not the funds investor but them personally), it is a very different story. Let’s say they put $3 million in and could exit with a 3x exit. That would mean that they had a $6 million gain ($9 million for original investment of $3 million). The VC would take 20% of the carry being about $1.2 million ($6 million x 20%). Split that among 5 general partners and that is less than $250k each. After tax, that is really not much at all for them personally. So if they have a chance to go for a home run which they could make millions or tens of million of dollars individually and all they had to risk is something like $125k after tax. I think they are more inclined to “go for it”. This is the danger of taking VC money. The shareholders may not be aligned given the very different economic incentives. So bottomline, if you do take VC money, be ready to realign your personal incentives to more closely match theirs or set your terms so they don’t get to completely control your destiny.

So, in my previous post I went over Life Time Value (LTV) of a user of a social game and how the Facebook ecosystem dramatically improves it. However, this LTV is not exceptionally high given that only 1 to 2% of Monthly Active Users actually pay each month. LTV of a user for these games is only about $.40 which is actually low but the great thing about Facebook is that the marketing costs are so low and you can a ton of volume therefore you are able to scale. There are two factors that makes marketing so efficient on Facebook:

1. Paid Marketing is really Cheap!

So there are 3 paid marketing channels if you want to advertise your social game on Facebook. The first is on other social games that have a virtual currency system. These social games allows you to buy virtual goods either through actual payment (credit card, paypal, etc.) or through offers. Offers consists of getting virtual currency for actions such as signing up for Netflix or a credit card. It also consists of installing another Facebook application. You can advertise with companies that power these “offer walls” on a cost per acquisition basis. A social game without any targeting with a basic sign up would pay about $.25 to $.40 per install. Warning, these are incentivized offers and the quality of the users may not be that good given that they are not doing it primarily for the interest of your game. However, if they are already thinking about paying for virtual goods on a social game one could argue that this would actually be a very attractive customer.

Another paid marketing channel are Facebook application ad networks. These ad networks represent the ad inventory of many app publishers that serve up advertising within their app. Given the explosive growth in Facebook and app traffic, the supply of inventory is greatly larger than demand so this inventory is very cheap. This inventory is not incentivized and is served up as standard display ads. You can also cut CPA deals with these ad networks mitigating your risk. You should expect to pay about $.70 per install.

The third paid marketing channel is buying Facebook ads themselves. These are the ones that you see on the right hand column while you are on Facebook. If you haven’t seen the power of the Facebook ad platform, you are missing out. You can buy on a CPC basis and the level of targeting is amazing. Not only can you target by incredibly detailed demos but you can also base your targeting on specific psychographics whether it be interests and even more interesting if that person uses specific apps. This type of marketing may be the most costly but you can still achieve $1 CPA or less with good execution.

So if the LTV of a user of a social game is only $.40, how do you make the economics work since your CPA costs from paid marketing is between $.25 to $1? Well, this is when the Facebook Viral Loop kicks in.

2. Facebook Viral Loop Makes the CPA much better!

Successful social games know how to leverage all the viral marketing channels on Facebook by building incentives in the game. Let’s take a look at how Farmville uses the Facebook viral loops.

- If you add more “neighbors” which consists of inviting your friends, you get to expand your farm.

- As you “level up” in the game they prompt you to post to your Newsfeed for all your friends to see.

- They constantly offer virtual gifts that you can give to your friends in order for them to join.

These are just a few of the game mechanics to get users to share the game with their friends. The main benefit here is that this is free marketing that really makes your marketing efforts much more efficient. How well a game is at this viral marketing is measured and represented as a Viral Coefficient. By effectively using the Facebook viral loop, an effective social game can reduce their effective CPA cost down to $.10 or less.

So let’s recap on wht the economics looks like:

If Life Time Value of a User > Cost per Acquisition then the game will be financially successful.

So based on my estimates:

$.40 LTV of a user > $.10 CPA of a user = SOCIAL GAME GOLD RUSH!

As you can see the Social Game Gold Rush has less to do with any real paradigm shifts in game play or design. Where the paradigm shift has happened is in Facebook being this incredible distribution system that allows the games to be viral.

What does the future entail? Well, the economics of this distribution will change. Cost per Acquisition will increase as it gets more competitive. However, the quality of social games and apps will improve and monetization will become more effective. This industry will be experience some serious growth over the next few years.

I recently read a great blog post at Gamasutra that examined how social games like Farmville and Mafia Wars are not really social at all:

“It’s also important to understand something about ‘social games’: Most of them are not social. They tend to be single or multi-player games that use social networks (mostly Facebook) as an easy way to drive player adoption. What the industry is calling ‘social games’ are more accurately described as ‘viral games’. “

When you dig into the success of these games, you realize why Facebook has been such an incredible opportunity. Facebook offers incredible distribution for these games, making the formula for success much more viable. Let’s take a closer look:

If Life Time Value of a User > Cost per Acquisition then the game will be financially successful.

This is the basic formula for the financial success of any social game. The interesting part about it is when you realize why distribution on Facebook has made the economics so much more favorable. Let’s break down the components. The first is Life Time Value of a User (LTV). This is driven by 2 key factors. The first is retention of the users. In order to make money, you need to get that user coming back and coming back often. A successful social game on Facebook is able to get over 15% of their Monthly Active Users coming back each day. An extremely successful game gets that stat above 30%. Facebook is so successful at driving high retention because it already gets their users coming back. With over 27 billion minutes spent and nearly 45 billion page views per month, Facebook has quickly become for most people, their home on the Web. You add the fact that as a social game application developer you can integrate your game into the Facebook core UI with communication points such as News Feeds, notifications and wall posts, you have this incredible opportunity to increase your retention rates by folds versus what they would be as a standalone web site. Of course, you need a game that is also compelling to play. However as important as good game play, your social game needs to be well integrated into Facebook’s communication system.

Lifetime value of a user also depends on your ability to monetize game players. A good social game will convert about 1 to 2% of its Monthly Active Users to paid users who spend on average about $20 per month. It doesn’t sounds like a high conversion rate and it isn’t. However with such large scale from the massive distribution on Facebook, it can add up pretty quickly. I think one way that this may improve is when Facebook rolls out its own payment platform to streamline purchases as how Apple has done with apps on the Iphone.

I have estimated that the LTV of a fairly successful social game is somewhere around $.40 to $.50. That type of LTV is actually pretty hard to make work if you were a standalone web site because of the Cost per Acquisition of that user is usually significantly higher than the LTV. However in the case of Facebook distribution, the LTV is actually much higher than the incredibly low CPAs that can be found on Facebook. To be discussed in the next post.