In early June, Groupon filed its initial public offering application amid plans to raise at least US$750 million. Although still operating at a loss, the Chicago company, founded in 2008, has attracted more than 80 million subscribers to its group buying web sites around the world and has been valued at around US$20 billion. On the other side of the Pacific, meanwhile, a frenzy of investment activity is surrounding Groupon imitators. Since April, three group buying companies in China received more than US$100 million each from venture capital firms, while a new joint venture between Groupon and Tencent, the biggest Internet company in China, has now become part of the local group buying landscape.

It looks like China has a consumer hit on its hands. China's hundreds ofgroup buying web sites, which sell cut-price deals to subscribers for myriad goods and services, registered RMB 650 million (US$100.3 million) worth of transactions in April, a 71% increase over the previous month, and the market size is forecast to exceed RMB 20 billion by the end of this year, according to Tuan800, an analysis firm.

Among the swarm of group buying sites in China is, a subsidiary of Beijing-based, NYSE-listed, the biggest pure-play social networking service (SNS) site in China. Celebrating its first anniversary on June 23, Nuomi said two million of the four million Chinese bargain hunters who have registered on its site are paying customers, helping the firm generate US$900,000 in revenue in the first quarter of 2011, while operating expenses reached US$4.6 million over that period. In disclosing its first financials since its IPO earlier this year, Renren reported that it has invested US$9 million in Nuomi over the past 12 months, with more heavy investment likely as it aims to claim more of China's booming group buying market.

Since its launch, CEO Shen Bo Yang, an ex-Google senior manager, has been in the middle of the fray. In a recent interview with China Knowledge at Wharton, he shared his thoughts on the sector's state of flux and Nuomi's strategy for staying ahead — and staying rational.

An edited transcript of the conversation follows.

China Knowledge at Wharton: How do you view the group buying market frenzy right now?

Shen Bo Yang: Group buy is a business model with a lot of potential, so it is no surprise that many investors are betting long on it. Don't forget, even though online video companies in the beginning had much higher start-up capital thresholds and barriers to entry, there were still hundreds of players in that market. The barriers to entry in the group buy industry are much lower.

The industry is also largely driven by capital, which has quickly pushed up the barriers to entry. Essentially, more than anything else at the moment, it's the amount and speed at which funding is flowing into fledgling group buy sites that is influencing the direction of the entire sector.

But compared with SNS or instant messaging sites, the “user shifting cost" of group buy companies is low [as customers move easily from one provider to another]. There's a growing view that one of the best ways a group buy company can defend itself against competitors is to have an abundant cash reserve. My view is that majority of our efforts should be spent on the back office, including building strong sales and service teams, to offer quality service to both users and business clients. Big investments in marketing and advertising are necessary to enter the market, but that’s not sufficient to ensure that you offer better service.

China Knowledge at Wharton: Istoo much money making the sector irrational?

Shen: In the short term, capital is making the market impatient. There is intense competition now in terms of how much to invest in advertising, which I personally don’t agree with. Before January, Nuomi's marketing spend was almost zero. We hadn’t spent one penny on TV advertising or on search engine marketing. But since the beginning of this year, competitors with huge amounts of cash injected into them tried every means possible to promote themselves, and we have had to catch up. Although our parent company, Renren, can help with word-of-mouth marketing, our organic growth has not been fast enough. To stay a part of the market growth, we have also had to spend money on advertising.

The market is expected to still be able to attract huge sums of venture capital this year, as everyone needs new rounds of financing. But some players will definitely find it difficult to maintain their capital positions. However, we don’t need to worry about financing from third parties, since our parent company has abundant cash reserves.

China Knowledge at Wharton: What do you expect this year's marketing spend to be for the whole sector, and for Nuomi?

Shen: The marketing spend for the whole industry for 2011 will definitely be more than RMB 1 billion. Nuomi has a budget of RMB 200 million for marketing, and we will soon launch a cooperation agreement with Focus Media, the biggest digital media firm in China. will spend at least RMB 200 million and other players are spending aggressively as well. We are marketing ourselves both online and offline, with the [success of the] former measured by conversion rates, and the latter by how well we build up our brand image. The ultimate outlay for advertising will depend on how competitive the landscape becomes. By the way, online advertising rates are already now double what they were last year.

China Knowledge at Wharton: What value does a group buying business model create?

Shen: Simply put, it creates value in two areas. On the one hand, it is a promotional and marketing platform for businesses [whose products or services appear on the site]. On the other, it’s a cost-effective purchasing platform for consumers.

Demand is strong for group buy platforms among local businesses [like restaurants or theaters] because it is a precise marketing approach to attract consumers interested in their products or services. [Promoting themselves on] mass media — including TV, radio and newspaper — is too expensive and [these are] not effective tools for them.

Compared with search engine marketing — which charges clients according to the number of clicks — the group buy model is much more direct and the return is clear. Customers go to the store or restaurant to make a purchase, so the group buy model is very easy for business owners to understand. The next step is to find a way to get customers coming back, and it is up to the businesses how they do that.

From the point of view of customers with rising disposable incomes, they will gradually spend more on lifestyle items, including dining, cultural events, parties and other activities, than on consumer goods, and this trend makes group buying a lovely idea.

The[original] Groupon concept involves a web site offering discounts to attract customers to a product or service — usually in the lifestyle space. Product or service providers can use the site to promote themselves, and the profit margins of these clients are big enough to support the promotional events they offer. But in China, the concept is a bit distorted at the moment [as discounts are given on every product].

My view is that group buy is more relevant for local service providers. Standard products might not fit the model because they usually have established and specialized sales channels, and suppliers usually have some control over channel pricing — the concern with group buying is that the discounts will destroy their pricing systems. On the other hand, products like home appliances or electronics already have many online sales channels, including Taobao and 360buy, so they are not hungry for new marketing platforms.

China Knowledge at Wharton: Do the big brands feel uncomfortable with the group buying concept?

Shen: Not necessarily. For big brands, group buy is more of a marketing event, rather than just for boosting their top lines. Well-known, influential companies are not worried about the traffic, but they are more concerned about how to attract the next generation of consumers. This younger demographic might not be able to consume this year, but they will grow up and become target customers next year.

More than 50% of Nuomi's clients are big, reputable brands. We are also finding ways to cooperate with big clients, which will not only boost our brand recognition and reputation, but also ensure the quality of a customer's experience at the events in which a client is involved.

Group buy companies are mostly challenged by the fact that we don’t have full control over whether companies hold up their end of the commitment to offer high-quality products or services in a timely way. But well-known brands are more concerned about their reputations and focus more on customer experience, which in turn boosts the confidence of consumers in our service.

China Knowledge at Wharton: Held up against competitors, what is special about Nuomi?

Shen: I joined Renren, the biggest pure-play SNS site in China, last February. We mulled over several ways to develop the e-commerce business, and the group buy concept came out ahead of the others. It requires investing in developing a local sales force, but unlike business-to-consumer models like Amazon, group buy doesn’t need any investment to set up an extensive and expensive logistic system. What's more, Renren has a solid user base. Group buy requires either a strong local sales network or an extensive user base. If you have neither, it will be hard to do.

Close cooperation with Renren is one of our competitive strengths. Renren's killer application is apparent when a user logs on at Nuomi and purchases a group buy item. With his consent, a message appears on his friends’ pages saying that he just purchased something on Nuomi. This sort of typical social network message has a huge impact on user behavior. So when we launch a group buy item, it’s easier to create buzz marketing among users.

Nuomi went live on June 23 last year, with the first deal selling much more than we anticipated. It was for the Jackie Chan Movie Theatre, and the first deal brought it 150,000 sets of ticket and RMB 6 million of revenue, an industry record. Now, it regularly launches group buy events with us, and every deal sells hundreds of thousands of tickets.

China Knowledge at Wharton: What is the profit model of Nuomi?

Shen: Our commission ranges from between 8% and 10% of sales, for both big and small clients. However, vicious competition is leading to lower and lower commission rates. In some cases, group buy sites subsidize deals to offer a very low price and generate revenue.

In recent months, margins for the whole industry have been falling. I expect that when there are only three to four players left in the market, they will stop their decline.

China Knowledge at Wharton: How do you determine a reasonable discount for a group buy deal? Do you use data mining technology?

Shen: The discount is based on communication with a client. We ask, “Do you feel comfortable to do it at this price?” If the answer is no, we will not do it.

In the long term, data mining might be a feasible way to determine a pricing strategy. But in the short term, no one in the market can do it, including Groupon. We determine the discount level based on a client's reputation, our experience and so on. The discount does not necessarily have to be below 50%. We don’t want to offer the biggest discount to customers at the expense of quality, which would not be a good thing for anyone.

China Knowledge at Wharton: Has any group buying company made a profit yet?

Shen: Right now, everyone is operating at a huge loss. No one can claim to have reached profitability yet. The revenue is not even enough to pay for the marketing costs. That's not to say the group buy model has no potential. When competition develops in the next stage, gross margins will gradually climb or there will be other ways of making a profit.

China Knowledge at Wharton: Along with marketing, is human capital a major component of group buying costs?

Shen: Costs mainly fall into three areas: staff, marketing and the third one, subsidizing some deals to offer consumers the best price. A group buy company and Diary Queen (DQ) in China recently is an example. DQ offered a deal for RMB 50, but the group buy company sold it for RMB 29. Generally, these deals deliver the quantity, but they do not generate a lot of revenue.

China Knowledge at Wharton: It is reported that group buying companies are poaching each other's employees, especially sales managers. How do you keep your team stable? How do you evaluate the performance of a sales force?

Shen: When the industry is at a highly competitive stage, poaching employees becomes normal. Whether you can successfully maintain your team depends on the management capability of executives, the leaders' personal charm and company culture. My view is that while money is a necessity, it's far from sufficient to only offer material stimulus, including bonuses and stock options. A cohesive team with vision is more important. We are trying to make every employee feel in their heart that they are joining the team to undertake a journey.

In terms of sales performance, we look at the overall quality of deals, including impact, revenue and user scale. Quantity is not everything. I would like a smaller, but more productive sales team with higher salaries for everyone. If one of our salespeople never drank red wine, how can he negotiate a red wine deal? Our salespeople should have the same standard of living as our white-collar customers, rather than struggling, so they can understand what users really want.

At Nuomi, we try to give a salesperson a second or third chance if he can’t hit a target, as long as it doesn’t hurt other colleagues. I also give sales managers the authority to use their own judgment in managing their teams, rather than just setting a hard-number benchmark.

China Knowledge at Wharton: In how many cities does Nuomi plan to expand this year, and how many new staff do you plan to add?

Shen: Right now, we have more than 50 cities covered. In 2011, we plan to cover 80 cities with teams of 10 staff for every city. But it’s a dynamic plan and every city is evaluated before entering. Not only do we want to run fast, but also run stably. Nuomi is the only large group buy company that has a directly managed operation in all cities, rather than using a franchised model. That’s why we have a particularly big need for good regional managers.

China Knowledge at Wharton: When do you expect the sector to stabilize?

Shen: It will take quite a long time — a similar experience as what other Internet businesses have gone through. The online video market has taken five to six years to weed out dozens of [firms] and now has less than a dozen since the rest all died. With group buy, venture capitalists are still backing their portfolio companies and keep investing the bucks, which is an indication that the market has a long way to go before it stabilizes. In the short term, no one can beat others easily as long as they have money.

China Knowledge at Wharton: What is the competitive advantage of group buy companies? Where would the most innovation be?

Shen: [A good] reputation among the clients and users is the most essential for group buy companies.

In terms of future directions, it's important to explore more about how group buy activities can offer good service. Group buy works in the U.S., and it works in China. If there are any big changes, there will be two possibilities: A new vision emerges that leads the whole industry in that direction, or the whole industry faces a crisis and searches for a restructuring of the business model.

China Knowledge at Wharton: What is your major concern now?

Shen: My biggest concern is that the market becomes too irrational. Every player is thinking of some new way to attract customers, from spending huge sums of money on advertising to sending cash coupons to new users, which means the risk is high that any industry discipline can be destroyed easily.

In the short term, the industry is in a highly competitively stage looking for rapid top-line expansion. But there is a tradeoff with this. We should not search for market share at the expense of fundamentals. The competition is a long-distance race; eventually, you have to rely on your sales force to negotiate better cooperation deals, and [you must] provide better quality products and service for your customers to achieve a win-win. So, the biggest challenge for us is to keep up with the market and keep ourselves as rational as possible.