Daily Deals And The Potential For Fraud

Editor’s note: Rocky Agrawal continues his in-depth guest series looking at the daily deal industry. Agrawal is an entrepreneur who has worked on local products since 1995. He blogs at reDesign and Tweets @rakeshlobster. Groupon is currently in a quiet period in relation with its planned IPO, but should be able to answer investors’ questions during a roadshow prior to the offering.

In my post about Groupon’s potential for collapse, I talked about the possibility of merchant fraud. Because Groupon pays merchants everything within 60 days, they are exposed to the possibility of fraud or the merchant going out of business. Other deal providers pay even faster. LivingSocial pays out everything in about 15 days. Google Offers pays out 80% in about four days.

Nobody knows how much fraud occurs, or what steps are taken to prevent it.  Groupon’s S-1 identifies refund reserves (which would cover more than just fraud) of $14 million in 2010 and $26 million in the first quarter of 2011.  The first quarter number represents 4% of revenue. The S-1 also mentions both consumer and merchant fraud as risk factors.

Groupon does take steps to mitigate both kinds of fraud.  On the merchant side, the fact that it withholds full payment for 60 days helps it weed out fake or closed businesses (consumers complain directly to Groupon).  Groupon also tries to vet businesses in the first place by looking at online reviews, Yelp, and other sources.

But these measures are not full-proof, and the issue is not only with Groupon.  The structure of the daily deals business makes it ripe for fraud and other abuse: upfront payouts, no recourse if something goes wrong, no collateral and minimal risk assessment. You can take the money and run.

Fair warning: the rest of this post may make your head spin.

One of the things I’ve always scratched my head over is deals at service businesses that sell in very large quantities. A spa or a barber shop or a salon can only handle so much business.

For an unscrupulous merchant looking to commit fraud against the daily deal providers, it is not too hard to imagine how it would go about doing so. Sign up for a deal and sell as many as you can. Then when somebody calls to book an appointment, say you’re overwhelmed by the response and can’t book them right away. (Sounds logical, right? You sold 5,000 vouchers.) Better yet, just leave the phone off the hook. You won’t have to say anything—they’ll get a busy signal and get the message.

After you’ve received your payout, cash it and skip town.

This may sound far-fetched and the chances of this happening admittedly are low, but as the daily deal industry grows, it only takes a small percentage of overall deals to involve merchant fraud or simply going out of business to become a very real issue.  Fraud is pretty common in the payments space. I’ve spent a lot of time studying payments and whenever there is money involved, someone is looking for ways to get it. PayPal nearly went under in its early days because of fraud.

As a risk analyst, some of the key indicators I’d look for are: offering too good a deal, selling well beyond capacity and allowing people to buy multiple units (on something that is supposed to be a user acquisition play).

But the daily deal companies don’t seem to be doing that. In fact, they’re doing the opposite by encouraging uncapped deals. In most organizations, the incentives for sales tend to be around volume and dollar amount of sales. Sales reps would have a disincentive to identify possibly fraudulent merchants. (No sale, no commission.)  Separate research departments are supposed to vet the merchants, but they are often overwhelmed.  Given that markets are valuing daily deal companies on revenue, there is also a disincentive for senior management to make an effort to fight fraud in the short term. The fraud actually shows up as revenue.

It doesn’t even have to be fraud. Just overselling a business can be problematic.

It can be hard to tell which is which. In January, Salon 505 sold more than 3,000 vouchers through LivingSocial for $99 on January 21, with an alleged value of $550. ($550 for a half day spa treatment in Austin? Whatever.) With typical deal terms, that should be about $165,000 in revenue to the merchant. By February 16, there were reports of trouble redeeming vouchers. In that month, the salon redeemed about 120 vouchers. At that rate, it would take about two years to redeem all of the vouchers that were sold. In June, the 34-year-old business closed.

That is just one example. My inbox is full of dozens of stories from TechCrunch readers about businesses that have closed shortly after running a daily deal.

So far, consumers have been protected. Even if a merchant disappears, refuses to provide service or is simply overwhelmed, the big daily deal companies have covered the losses. That’s great for consumers, but it creates risk for investors because returns can be significantly affected by fraud losses.

If the deal companies were doing risk assessment, like a bank would, they would never run deals like this.

Because the deal companies generally require businesses to take a 75% hit off their regular selling price, they also will tend to get riskier businesses in their portfolio. The most stable businesses don’t need to discount their product to that degree. And if they need money for expansion, they can get it from a bank on much better terms.  Whether they know it or not, the deal companies are in the factoring business.

Fraud, chargebacks and customer service

From all of the consumer feedback I’ve received, customers are taken care of when bad things happen. This can be a great thing. Repeat customers are important. Great word of mouth is important for a new company building a completely new business. But it’s really unusual to have so many good customer support stories. I received one email from someone who got her money back from a deal provider because she wasn’t happy with the quality of her cleaning service—a highly subjective complaint.

In addition to the merchant, consumer and the deal provider, there’s another important party involved: the payment system. VISA, MasterCard and others closely monitor what are called chargebacks, transactions disputed by cardholders. If a company’s chargebacks are high, they will require it to keep more money in reserve. If they’re high enough, they’ll stop letting the company take credit cards. Banks don’t want to lose money if a merchant collapses. (As far as the credit card companies are concerned, the deal companies are the merchant of record.) Groupon has merchant liabilities of more than $291 million and an unknown amount of vouchers outstanding.

Groupon mentions all sorts of fraud as risk factors in its S-1:

We may incur significant losses from fraud and counterfeit Groupons. We may incur losses from claims that the consumer did not authorize the purchase, from merchant fraud, from erroneous transmissions, and from consumers who have closed bank accounts or have insufficient funds in them to satisfy payments. In addition to the direct costs of such losses, if they are related to credit card transactions and become excessive, they could potentially result in our losing the right to accept credit cards for payment. If we were unable to accept credit cards for payment, we would suffer substantial reductions in revenue, which would cause our business to suffer. While we have taken measures to detect and reduce the risk of fraud, these measures need to be continually improved and may not be effective against new and continually evolving forms of fraud or in connection with new product offerings. If these measures do not succeed, our business will suffer.

For an e-commerce company, not being able to take credit cards would be a death blow. If you were concerned about that happening, one way around it would be to just issue refunds. A customer has a problem? “Sorry, we’ll give you your money back.” That keeps your chargeback rates low. It also reduces fraud costs because you don’t have to pay bank-imposed chargeback fees.

The payment companies monitor refunds, too. But the thresholds are much higher than they are for chargebacks.

Another payments-related risk the deal companies may face is the perception they “advance cash” to the small business rather than “buy service.”  Merchant agreements typically prohibit giving cash to third parties when processing a purchase transaction. Daily deals companies charge transactions against their merchant accounts and pay a factored percentage back to the merchant providing the service. If the card companies were to consider what deal companies do as a cash advance, that could be a big problem.

It also could be a problem that the daily deal companies are managing just fine. Again, we just don’t know. As the IPO draws near, investors might want to ask for more information.

Photo credit: Marius Watz