Arbitrage is “the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.” Once the arbitrage spread closes, the profit is made and the opportunity no longer exists. According to Austrian Economics, entrepreneurs’ profits “derive from the services he performs in detecting and eliminating arbitrage opportunities, thereby allowing supply and demand for a given good to meet.” By recognizing and acting on opportunities, the entrepreneur moves markets toward equilibrium. So entrepreneurial arbitrage is a low-risk way of exploiting gaps between what the market demands and what it’s being supplied until the spread closes.
There is very little “invention” involved—startups imitate or slightly modify someone else’s idea and only introduce breakthrough products or new business models many years later. This is what Peter Drucker calls creative imitation. The technology and market demand already exist, but the creative entrepreneur understands what the innovation represents better than the original innovators. This also includes packaging current technologies into new business models. Paul Graham calls this an idea that’s “a square in the periodic table”—if it didn’t exist now, it would be created shortly.
Continue reading “Entrepreneurial Arbitrage”
As widely reported, Groupon filed their first S-1 today in preparation for an IPO. They’re raising $750 million on top of the $160 million they have already raised from angel & venture capital investors so far. The likely valuation range will be $20-25 billion (or possibly more after what happened with the LinkedIn IPO).
The hefty valuation, along with the youth of the company (2.5 years) and the reported operating loss may lead observers and the media to cry “bubble.” While I think that $25 billion is a very rich valuation and wouldn’t pay that amount if it went public today, I think people in general underestimate the potential of Groupon’s business model. In other words, they were probably right to turn down Google’s offer of $6 billion (even if they don’t cash out during the offering).
Before going into Groupon’s business model and competitive advantages, here’s a quick run down of some of their customer statistics from the S-1:
In the above equation, those 5 metrics are multiplied to arrive at Groupon’s net revenue amount (the amount Groupon gets to keep after giving merchants their cut). So in the first quarter they made $270 million before expenses.
First the market, then the moat
Before Groupon and all the other deal sites began, local businesses had many lackluster options for advertising their product. They could send coupons in the mail; pay for ads in a local newspaper; pay for outdoor advertising; or pay for online advertising via Google, local news sites, etc. Most of these options (Google less so) are what Seth Godin calls interruption marketing. They are made to interrupt what you are normally trying to do. And because of that, people usually don’t like them, and they have a very low hit-rate in acquiring customers. Continue reading “Underestimating the Groupon Model”