LivingSocial: Things are going to get worse

November 29, 2012: 4:11 PM ET

The hype surrounding the initial growth of the online-coupon business closely resembled the hype of the late-90s tech boom. Now we're seeing the result.

FORTUNE -- The news that LivingSocial will lay off about 400 employees shouldn't come as much of a surprise at this point. The online-coupon business has never made much sense -- at least, not enough sense to justify the incredible hype and vast piles of investor cash companies like LivingSocial, Groupon (GRPN), and others once drew.

But it took a long time for people to realize this. If you look back through the foggy mists of Internet time -- to 2009 and 2010 -- you'll find that that the tech media, particularly the outlets that tend to be the least discerning about what gets covered and how, couldn't resist the temptation to enthuse over the sector. In 2010, Groupon -- the darling of the sector before it became the whipping boy -- won a Crunchie for "Best Social Commerce App." The Crunchies are awards given out each year by TechCrunch and other tech blogs to the companies they cover. Groupon CEO Andrew Mason also won as "CEO of the Year."

From a cynic's perspective, the timing of the awards couldn't have been more perfect. Almost immediately, the backlash ensued, even as Groupon announced that it would go public. In 2011, several top executives bolted, and Mason came in for some heavy criticism when it was alleged he violated the IPO "quiet period" rule and, later, that he had approved some skeevy accounting procedures both before and after the IPO. The November 2011 IPO went gangbusters, valuing the company at $12.7 billion. A year later, its market cap is about $2.9 billion. The stock has lost about 80% of its value.  Groupon's board is reported to be considering replacing him.

MORE: What's next for LivingSocial

LivingSocial hasn't fared much better. The layoffs represent about 9% of the company's 4,500-strong workforce, and are mainly made up of sales and customer-service personnel. The company last month reported a $566 million loss on revenues of $124 million (which was double the year-earlier period's sales, if that matters). It took a $496 million charge on the loss of value of acquisitions, many of which were made because the company's core business -- online coupons -- is so terrible. Meanwhile, Amazon (AMZN), which owns 30% of LivingSocial, took a $167 million charge on losses on that investment, which it made in 2010 when it laid out $175 million.

In a memo to employees obtained by Bloomberg News, CEO Tim O'Shaughnessy last month seemed to be digging hard for positive news when he wrote that cash flow in September was postive for the first time in the company's history. "We ended the last month of the quarter with more money in the bank than we had at the beginning of the month, marking an important milestone on our path to profitability and long-term success," he wrote.

What was missing from all the hype a couple of years ago was the bedrock fact that online coupons don't make for very good business. People who use them (and whose numbers are fast-declining) get often-huge discounts from local businesses, but too often don't ever go back to those businesses to pay full price, which is supposed to be the whole idea for offering them. Even worse, there are few barriers to entry -- anybody could do it, and for awhile there, it seemed as if everyone did, as companies packed into the space. That means that no company can have any real market power, and network effects -- people using a service because other people are using the service -- are minimal.

Sadly, very few investors or observers of the tech business thought of any of this when the sector was new. They just looked at the (initially) fast-growing use of coupons and decided it represented the future of online commerce. As investors are now painfully learning, it doesn't.

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