It took a lot for Rob Solomon to leave sunny Silicon Valley for wintry Chicago, but it’s a change he was happy to make. The e-commerce veteran moved to the Midwest to become president of group buying site Groupon, spotting the company’s potential to be the next eBay. Named by Forbes magazine as the fastest growing company in web history, Groupon leverages consumers’ penchant for online bargain hunting with the power of social networking to build a business with skyrocketing sales. “The Internet has never been really very good at bridging the gap between traditional commerce and the web,” Solomon, ex-CEO of travel search site SideStep, says. “Then we came along.”

Groupon — from the words “group” and “coupon” — negotiates deeply discounted deals with mainly small businesses and alerts its legion of e-mail subscribers to the offer, such as half off on a Swedish massage. The deal is triggered when a minimum number of users buys the voucher, and consumers are rewarded if their friends purchase as well. The discounts run from around 50% to more than 90%, but the deal must be purchased within a limited time, usually 24 hours. To entice buyers, Groupon’s writers craft a zany ad in keeping with the Internet zeitgeist. “Creating a masterwork of art can be like wandering through a maze: After a lengthy period of reflection and contemplation, you’ll still probably starve,” reads the 50% off ad for the Absolute Abstract art gallery in Philadelphia. “Appreciate an artist’s risks and transcendent joys with today’s Groupon.”

The deals and the drama have propelled Groupon into the e-commerce stratosphere. Founded in 2008, Groupon now reaches 25 million subscribers in 29 countries. The Chicago-based company serves more bargain-hunters than its biggest rival, LivingSocial, which has more than 10 million subscribers in the U.S., Canada, U.K. and Ireland. Dozens of similar sites have sprung up to tap the group-buying trend as well, including BuyWithMe, Dealster, SocialBuy, HomeRun, Tippr, DealOn, TownHog, MyDailyThread, CrowdSavings, Bloomspot, Scoop St., Twongo, EverSave, YouSwoop, You’ve Gotta Get It, TwoBuckDuck, DealPerk, FlyCoupon and many more. Other websites, such as restaurant reservation site OpenTable and companies like AOL and Cox Media Group are getting in on the act by launching their own Groupon-like services. (OpenTable focuses specifically on eating establishments.) In a fragmented market with low barriers to entry, Groupon is by far the largest — for now.

But are group buying sites just a passing fancy that will end as quickly as today’s 70% off deal? “I don’t think it’s just a fad,” says Kartik Hosanagar, a professor of operations and information management at Wharton, noting that social commerce sites tap into the needs of both small businesses and budget-conscious consumers. The deep discounts and social nature of the deals appeal to the Internet-savvy, while local shops get mass exposure without the upfront marketing costs of newspaper ads or TV and radio spots. Groupon markets the deal and shares the sales with the business. “Customer acquisition costs for small businesses are very high,” Hosanagar adds. “Groupon allows small businesses to acquire customers in a fairly efficient manner.” Moreover, the business model “leverages the power of social networking and collective buying in very natural ways — that’s here to stay as well.”

Back to the Future?

Group buying sites are not new, but previous incarnations failed to gain much traction with consumers. A high-profile flameout was Mercata, backed by Microsoft co-founder Paul Allen. The Bellevue, Wash.-based company opened its online doors in 1999 to people who wanted to band together for discounts on products such as kitchen appliances. The items would start out at one price and as more users clicked to buy, the price dropped. But two years later, the company closed shop. Mercata founder Tom Van Horn said at the time that poor market conditions contributed to the firm’s demise. It didn’t help that social networking had yet to take off. Consumers weren’t familiar with the idea of online group buying, and Mercata also had to compete with discounted prices on the same goods from other e-retailers.

What makes group buying sites click today? For one thing, consumers are more comfortable with socializing and sharing information online, as the popularity of Facebook, LinkedIn and Twitter attest. The new sites also offer deals that usually cannot be found elsewhere on the Internet, such as 45% off cupcakes at the corner bakery. Another difference: Groupon and similar sites reveal the amount of the discount upfront (although it’s only triggered if enough people sign on to buy the item.) Mercata’s customers, however, weren’t told the final discount until a certain number of people agreed to buy the product. Such tweaks to the business model make the latest iteration of group buying sites more likely to last, experts say. (In February, venture capitalist Martin Tobias bought several group purchasing patents from Allen’s Vulcan Capital and launched

That doesn’t mean there won’t be an industry shakeout. It’s already claimed SwoopOff, which merged with HomeRun. “There are a lot of copycat Groupon models and it’s not clear all of them will survive,” Hosanagar notes. Consumers probably will pick a few good sites to follow instead of signing up for dozens of them. To rise above its rivals, a group buying site needs to have a good brand name and reputation, he says. Small businesses will naturally want to partner with the site that has the biggest following; in turn, the greater diversity of deals will attract even more consumers. Meanwhile, the remaining sites will have to fight harder to get market share. “The question is, which [site] will brand itself well?” Hosanagar says. “Groupon has a significant head start there. The others are going to struggle with the issue of very few differentiators.”

LivingSocial CEO Tim O’Shaughnessy isn’t quite ready to crown Groupon the leader yet. “The space is very crowded but it’s all about scalability, and those that can scale their business will succeed in the end,” he said in a statement. “LivingSocial intends to stay in the game, even as smaller players drop off.” But the dynamics of the market could change, and observers expect small businesses to begin crafting more profitable deals for themselves — possibly at the peril of profits for partnering social commerce sites.

For example, Groupon negotiates with a small business to offer steep discounts, usually half off or more, and then takes 50% of the resulting sales. That leaves the business with at most 25% of sales to cover overhead and product or service costs. For many shops, that means the business will barely earn a profit or even lose money. If a spa offers 50% off a $100 massage, for example, sales would be $50 per customer and Groupon takes $25. That leaves the spa with $25. Let’s say after paying the massage therapist and covering overhead and other costs, the spa loses $20 per customer. If 200 people bought the voucher and 70% redeem it, the spa’s loss would be $1,300.

Blinded by Big Discounts?

The next time Tom Block, owner of the Naked Chocolate Cafe in Philadelphia, works with a social commerce site, he plans to design a more profitable deal. Block recently partnered with Groupon to offer a $10 voucher good for buying $20 worth of goods at his dessert and chocolate shop. Groupon took half of the sales, leaving Block with $5 in sales per customer for selling sweets worth four times more. His shop sold 2,500 vouchers and expects about 80% of them to be redeemed. While “I’m sure it’s not a money-maker,” Block notes, “it certainly keeps the awareness going, and that’s why we wanted to do it.”

He is willing to offer another coupon, but “I might offer something more specific, like hot chocolate, instead of blanket gift certificates.” Still, Block is not sure that he will ever make money off the steep discounts required to put out an offer attractive to users of Groupon and its competitors. Two-thirds of businesses surveyed nationally said their Groupon deal was profitable, says Utpal Dholakia, a marketing professor at Rice University. However, fewer than 15% of consumers who used their vouchers came back.

According to Solomon, Groupon encourages small businesses to slash prices steeply to make the deal compelling enough that consumers will be willing to try something new. “The traditional methods [of acquiring customers through newspaper ads or The Yellow Pages] have failed pretty miserably over the last 10 years.”

But what happens once masses of consumers are trained to expect big discounts? If they don’t find a compelling deal at one site, they will hop to the next one. The result is erosion in profitability for businesses in an area as bargain-hunters shift from shop to shop or deal to deal. “You train customers to do things that are not ultimately that attractive,” David Bell, a Wharton marketing professor, points out. “I think it’s important for these businesses not to give away the farm” for the sake of a short-term surge in business.

If deals are crafted to bring in new customers, Bell says, the one-time loss on the promotion could be worth it in the long run. For example, if a clothing store that mainly attracts female shoppers wants to boost its male patronage, the business could launch a 60% off sale on men’s shirts. “This is almost a necessary condition for it to work — pulling in people who might not otherwise have thought of using your product or service. If you only get the regulars, it won’t work.”

Offering a deep discount also could pay off if a business employs the markdown to introduce a new product, suggested Eric Clemons, a Wharton professor of operations and information management. For example, when Procter & Gamble’s Gillette unit wanted to introduce consumers to Trac II, the first two-bladed razor in the market back in the 1970s, the company offered the product at a discount. According to Clemons, consumers at the time didn’t realize the advantages of a razor with two parallel blades, and the discount motivated them to try it. Once people get to know a particular product, businesses should end the promotion, Clemons adds, noting that similar discounts don’t make sense for existing products because the same customer pool will buy them, just at a lower price.

For a small business to justify a deep discount on existing products or services, Clemons says, the management has to believe that the product or service offered is better than what the market currently believes. For instance, a nearby Italian restaurant suddenly offers a tasty group discount deal: $15 for $30 worth of food. The business has not been doing well and believes the promotion will improve sales. Management is willing to take a loss on that deal, thinking the influx of new customers will be worth the expense in the long run. But if the eatery doesn’t have a good reputation in the city, the restaurant will get a rash of bargain-hunters coming in for that cheap meal and most won’t be back until the restaurant offers another good deal. “The question is: Why would the market not know how good you are on an existing product? Why will it fall in love with you after the promotion?” Clemons asks. “For you to win, your product has to be better than what the market thinks it is right now.” The deal could work, he suggests, if the restaurant in question has hired a new chef or wants to introduce a revamped menu.

Personalization and Scale

As the online group buying market gets more crowded, look for sites to try new things, experts say. For one, deals are likely to become smarter and more focused, Hosanagar notes. Instead of blasting everyone with the same deal of the day, for instance, a discount for dentures would only hit senior citizens, while a 60% off voucher for children’s clothes would be targeted to married couples in their early 30s. Group buying sites could also send users some deals based on past purchases. If a consumer bought photography lessons, for example, he or she might be offered a deal on cameras.

Groupon is already trying to tailor its offers more closely to particular users. Deals are now customized according to a consumer’s age, gender, location and interests, Solomon says. Instead of sending out one deal per day to all users in a particular city, the company now crafts 10 to 20 offers. Subscribers continue to receive one discount offer per day, but the deal they are sent is based on the information they provide the site. Groupon also has partnered with eBay and newspaper publisher McClatchy to offer its vouchers on those companies’ websites. Solomon declines to comment on sales, but The Wall Street Journal reported that revenue is on track to hit $400 million this year — no small feat for a two-year-old company. According to a Bloomberg report, Groupon is seeking venture funding that may value the company at about $3 billion. Asked if any buyers have come calling for Groupon itself, Solomon would only say that “people are very interested in our model.”

With an increasing number of competitors banking on that same model, Hosanagar suggests that the key to long-term viability for Groupon will be improved personalization and leveraging its scale. “If customers are flooded with e-mails from group-buying sites and private sales sites, the key question is which ones they will bother to read,” he says. “Groupon needs to become as good as Netflix in terms of understanding customer preferences, segmenting them and personalizing their experience.”