By Matt Vella
October 12, 2011

By Alex Konrad, reporter

FORTUNE — Daily deals firms have had a rough few months. Barely known two years ago, companies like FourSquare and Groupon are now practically household names. With the attention has come a barrage of criticism: Groupon’s creative accounting came under fire amid a backlash from some consumers and small businesses that claim the services aren’t all they’re cracked up to be. Indeed, getting the right mix — savings for merchant, rewards for consumer, and a sustainable business model for providers – has proved complicated. Smaller rival SCVNGR thinks it’s found the answer.

The Cambridge, Massachusetts-based company is expanding access to its new product LevelUp, a twist on the daily deals scheme that offers credits and rewards the more users spend at a given merchant. CEO Seth Priebatsch says the product is ready for prime time. Today, after a summer testing phase with some 500 merchants in Boston and Philadelphia, LevelUp hits New York City and San Francisco –meccas of connected, deal-savvy users.

The concept is simple: users sign up for free, linking a credit or debit card to their account. Then, when shopping at participating merchants, they can scan a smart phone with a unique code. Users get credit the first time they use it, say a $10 discount toward their purchase. The improvement over other daily deals? Going back to the same store repeatedly earns users’ even more credits, displaying progress along the way. The incentive is clear, to keep users coming back — a habitual problem that has had Groupon and FourSquare users and merchant crying foul.

The company calls this its “inverted deal” and progression dynamic. It’s largely aimed at keeping merchants happy. Priebatch says that, during LevelUp’s pilot program, 45% of customers returned to a given merchant within 30 days to pay for something full price, higher than his estimates for rival services (Priebatch claims Groupon, which is in its quiet period and declined to comment, only brings back 1% to 2%). What’s more, the company claims that users increase their spend by 38% on the transactions that put them over the top for earning a reward. The company also boasts that its average consumer tips waiters 21%, slightly above the normal range of about 15-18%. LevelUp thinks it’s solved the common complaint of Groupon merchants that users buy one discounted product and walk away for good.

LevelUp is set to hit 50 locations in New York initially; there are about 250 locations equipped with the Android phones to accept purchases in its pilot cities right now. That’s still a small foray when compared to the scale of Groupon or Foursquare, both of which have aggressively expanded. But, those firms face serious challenges. Andrew Mason, Groupon’s founder and CEO, wrote employees in a recently leaked memo that its heavy marketing expenses were to gain users, then “convert these subscribers into customers and to make sure our customers keep buying from us.” That, however, is easier said than done, as reports now suggest many of Groupon’s 115 million subscribers follow deal to deal, without building any merchant loyalty.

FourSquare, on the other hand, faces difficulties with local advertisers and numbers that suggest check-in based services have lost overall popularity. From May to November last year, when Foursquare and Gowalla led the market, the number of people using a so-called geosocial service on a daily basis dropped in half, according to a William Blair & Co. Report. That drop drove Gowalla into a different business and threatens Foursquare. Tat company’s product chief, Alex Rainert, admitted the company is looking to new forms of engagement in an attempt to go beyond the physical in-store check-in to offer photos, comments, and “Explore” to suggest locations to its users.

Priebatsch and his joint SCVNGR/LevelUp team think they’ve already found the solution to engaging users. SCVNGR, a FourSquare rival that works with brands such as Coke (KO), Forever 21 and Gamestop (GME), offers mechanics in the social space, through challenges and other game elements that can unlock rewards such as a free coffee in a Dunkin’ Donuts (KO) campaign. Priebatsch sees LevelUp as its natural sister project in the transactional space.

LevelUp had a rough start. Priebatsch admits the company needed a relaunch to figure it out. The product’s first iteration operated closer to the Groupon discount model. Merchants didn’t like the effect constant discounting had on their brand. “It created the perception that the brand might be flagging,” Priebatsch says. “Once we launched it, that became apparent. That’s why we created the inverted deal concept.” This concept, based on participation incentives and credit, not a discount, could avoid the discounting issue.

Some aren’t buying it. Rajat Paharia, founder of game mechanics platform provider BunchBall, is vocal. “[A new launch] indicates to me that SCVNGR is just a flop,” Paharia says. “Jumping into that daily deal space, I don’t get it.” Clearly, LevelUp disagrees. If the company, which says SCVNGR revenue was greater for September than the first six months of last year combined, can keep LevelUp users at their twice a week clip, Priebatsch might be right. “Give us six to nine months, and just see how the two interplay,” he dares.

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