Is Groupon a financial train wreck waiting to happen?

Ever since Groupon turned down a $6-billion takeover offer from Google earlier this year, the markets have been eagerly awaiting an IPO filing from the group-buying sensation, one of the fastest-growing companies in recent memory. But not everyone liked what they saw when Groupon filed a prospectus for its initial public offering — which could value the startup as high as $20 billion. Some critics say the company is close to being insolvent and that its business model is a kind of elaborate Ponzi scheme, disguised by accounting tricks. One thing seems clear: The pressure is mounting for Groupon to prove that it isn’t just a late-1990s-style hype machine.

There’s no question that Groupon is growing at an incredible rate when it comes to both revenue and subscribers: In its most recent securities filing, the company said its revenue in the second quarter rose by 36 percent, to $878 million, more than twice what it generated in the same period a year earlier. Producing almost a billion dollars in revenue in a single quarter after less than five years in existence is almost unheard of. If Groupon continues to grow at that rate, it could generate revenue in 2011 of more than $5 billion. And the number of subscribers is also growing rapidly: The company now has over 115 million, or twice what it had in December of last year.

Profitability remains a question

That’s the good news. The bad news, as more than one critic has pointed out, is that Groupon’s ability to actually make any money on all of this growth remains a gigantic question. In a recent post at the Harvard Business Review site, Rob Wheeler — a fellow with Harvard’s forum for growth and innovation — said that Groupon’s business model doesn’t appear to be viable, in the sense that it may never actually make money, despite all the growth in revenue and subscribers.

If anything, the fact that Groupon is witnessing decreasing revenue per merchant and fewer Groupon purchases per subscriber in its maturing markets suggests that growth may actually decrease Groupon’s value to its customers.

The company has also received a lot of criticism for painting its business with too favorable a brush by using its own customized accounting methods. When Groupon filed its S-1 regulatory documents, critics quickly latched on to the company’s use of an unusual financial metric it called “adjusted consolidated segment operating income,” or ACSOI. This effectively allowed it to exclude subscriber-acquisition costs, including the hundreds of millions of marketing dollars that are spent to promote Groupon deals.

The impact on the company’s financial health was miraculous: Using its own benchmark, Groupon said it had operating income of $60 million for 2010 and $81 million for the first quarter of 2011. Using standard financial methods, however, the company actually had an operating loss of almost half a billion dollars in 2010 and lost a further $100 million in the first quarter of this year.

“Fairy-tale” accounting and big cash payouts

After some discussion with the Securities and Exchange Commission and a substantial amount of criticism of what some described as its “fairy-tale” accounting methods, Groupon filed an amended prospectus that played down the more favorable benchmark — which CEO Andrew Mason admitted was “unconventional” — and substituted generally agreed-upon standards. The company has also been criticized for paying out more than $800 million from a recent financing round to early investors and Groupon management when the business is still losing money at a tremendous rate.

Former Wall Street analyst Henry Blodget — who played a key role in the first tech-stock bubble in the late 1990s and now runs the site Business Insider — argues in a recent blog post that Groupon is only going public because it is close to running out of money and needs the cash. Blodget says that while the company is technically cash-flow positive, it is operating under a “working-capital deficit,” meaning its assets are insufficient to meet its obligations, which amount to $680 million and include close to $400 million that it has to pay to the merchants who signed up to offer Groupon discounts. Says Blodget:

As long as Groupon sells enough new Groupons in one quarter to pay all the bills it racked up in the prior quarter, it will not need additional cash. But if the company’s growth stumbles, or if competitive pressure leads to Groupon’s gross profit margin getting squeezed, look out.

Fans of Groupon, of which there are still a few — including David Pakman, a venture capitalist with Venrock — argue that there are other companies that have also lost money for a considerable amount of time and gone on to become business powerhouses. Facebook, for example, spent a long time growing its user base and expanding into different markets, and there was a lot of speculation that it would never make money, as there was with Amazon. Google is another famous example of a company that had many skeptics and no obvious business model, until it discovered advertising based on search keywords (an idea pioneered by Bill Gross at Overture).

But Groupon does have a business model. The question is, is it a model that takes time to prove itself, like Facebook’s, or is it a flawed model?

A lack of network effects?

So is Groupon a similar kind of business? Wheeler doesn’t think so. In his HBR post, he argues that Facebook and Amazon were able to focus on growth and then generate profits later because they benefited from network effects — in other words, early adopters helped the business grow, and the value of those services increased with more users. Although it is a “group-buying” business that relies on user numbers to trigger deals, Wheeler says that Groupon doesn’t really benefit from network effects at all, and there are growing signs that its value may actually be decreasing rather than increasing as it gains more users. He even makes a comparison to, the poster child for dot-com bubble excess.

Groupon CEO Andrew Mason has said that the hundreds of millions of dollars being spent on marketing and expanding the user base are not a loss but an investment and that this will start to pay off once Groupon achieves a certain scale. But that is looking to some like an increasingly risky bet. Will Groupon be able to prove the doubters wrong, or will it become the new millennium’s version of

Post and thumbnail photos courtesy of Flickr users Groupon and Refracted Moments