It’s make or break time for LevelUp. The company is out raising money, just eight tumultuous months after it closed the second half of a $21 million round. And they need to raise quickly.

Though a spokesperson denied that LevelUp is fundraising and claims the company “has plenty of cash runway” and doesn’t need to raise until next year, four separate sources have told BostInno quite the opposite: that the company’s runway extends through spring or early summer. Or, as one source put it, “It’s definitely close to now.”

Can LevelUp raise another round on top of the $41 million it has picked up so far? As with any venture deal, the answer depends on what it has done since the last round. And the last eight months at LevelUp have included several major changes of course, including multiple rounds of layoffs, a major new partnership, and an oscillating pricing strategy.

So what happens next? To find out, I spoke to a number of sources, including investors and entrepreneurs familiar with the company’s strategy as well as several former employees who, for obvious reasons, spoke on the condition of anonymity. Here’s what I learned.

A Brief History of SCVNGR/LevelUp

In 2008, Princeton dropout Seth Priebatsch founded SCVNGR, a location-based mobile game that let users complete challenges tied to businesses and locations. The company picked up $35K in seed funding that year as part of the DreamIt accelerator program, and raised another $750K the following year from Highland Capital.

At the end of 2009, SCVNGR appeared to be on a tear, reporting $1 million in revenue for its first full year in business and raising another $4 million led by Google Ventures on Priebatsch’s 21st birthday. By October 2010, SCVNGR was reporting half a million users. By February 2011, it was reporting a million. In January 2011, the company raised another $15 million led by Balderton Capital, a European VC firm, at a $100 million valuation.

But all this was happening during the heyday of Groupon, which grew from 126 employees at the beginning of 2010 to more than 5,000 by April 2011. SCVNGR was growing, but not like that. The company saw its location-based offering “on a head-on collision course” with daily deals, and so in March 2011, it launched a loyalty app called LevelUp. That July, it launched an updated version that tied mobile payments to its loyalty scheme, the basic value proposition that exists today. (I wrote about why I like the LevelUp app here.)

Since that time, LevelUp has become the company’s sole focus, with SCVNGR put first on the back burner and then finally sunsetted last December. And in the summer of 2012, the startup raised $21 million in two tranches to build its mobile payment network, at a $172 million valuation. Which brings us to our story.

Layoffs at LevelUp

The tail end of 2011 and beginning of 2012 marked a major growth period for SCVNGR/LevelUp (from here on out just LevelUp) in terms of headcount. The company opened offices in Philadelphia, San Francisco, San Diego, Seattle, New York, Chicago, and Atlanta. At its peak, the firm’s headcount was at least 162; today the company says it is around 80.

The company’s sales strategy failed to meet expectations, and by the end of the year it was forced to cut back its remote presence. We first heard about layoffs at LevelUp last fall, when the San Diego office was shut down and a handful of other employees in marketing and implementation were let go in various offices. The next round came in December when the SCVNGR app was sunsetted, to the surprise of the team working on it, who were also let go.

Around the time the San Diego office closed, the LevelUp sales teams were told to start focusing on the company’s new white label product which offered merchants a branded version of its mobile payment app. But multiple former employees tasked with selling the product told me that there was little interest. With sales still slow, the company laid off another round of employees earlier this year and closed the Seattle, Chicago, and Atlanta offices. Finally, a source with direct knowledge tells me another 30 people were let go last Thursday.

The pessimistic case, made to me by multiple former employees, is that the demand for LevelUp just isn’t there on either the merchant or the user side, and that the white label product has been a particular letdown. “People just aren’t using it more than once,” one source told me. The more optimistic case, made by LevelUp when I first inquired about layoffs last fall, is that it is simply shifting away from an outside sales strategy.

Matt Harris, a VC with Bain Capital (not invested in LevelUp), finds such a shift credible, citing the lessons of the Groupon era to explain LevelUp’s necessary change of course. “It was very fashionable to build these huge outbound sales forces,” he told me. “That’s a really inefficient way to build a business.”

That justification got a boost last month when the company announced a partnership with credit card processor Heartland Payments in which its team of 800 national reps will begin selling LevelUp. The impact the Heartland deal will have on LevelUp remains one of the biggest question marks for the company.

Building a Network

Even if sales haven’t materialized fast enough to justify LevelUp’s rapid geographic expansion, the company’s external metrics still tell a story of substantial growth. LevelUp claims a network of one million registered users and more than 5,000 merchants. Its current transaction volume is over $5 million per month, according to the company, up from $1 million just over a year ago.

“I’m highly impressed with the progress they’ve made,” Harris said. “It is one of the most ambitious things you can do; building a two-sided network is basically impossible.”

This network is the company’s greatest asset in raising money, however four separate sources raised doubts about the one million number, claiming that a substantial portion were actually SCVNGR users. LevelUp disputes this claim, but acknowledges that inviting SCVNGR users to join LevelUp has been a part of the company’s strategy. A source with direct knowledge of the matter told me that there is no way to know what percentage of the SCVNGR users who have been invited to join LevelUp and are counted in the 1 million number have actually downloaded the app. That same source pointed out that the timing of the SCVNGR sunsetting corresponds to a dramatic increase in LevelUp users, from half a million last November to 1 million at the end of February, at a time in which the company was cutting its sales force. For its part, LevelUp did say its user base has recently grown faster than its active users, due to signups in cities without active merchants. LevelUp declined to share a breakdown of active vs. inactive users.

How LevelUp Does (and Doesn’t) Make Money

Perhaps the biggest change at LevelUp since the company’s last financing has been its pricing. Until last summer, LevelUp was charging merchants 2% on each transaction, which then was passed along to pay the payment processor. That almost certainly meant a loss for LevelUp on credit cards, as fees paid to the processor exceeded 2%, but the lower fee for merchants helped the company get in the door. (Different legislation governs fees on debit cards, so it’s conceivable that LevelUp could have made money there.)

Last June, LevelUp made a big shift to “interchange zero,” meaning a zero percent processing fee for merchants. Rather than charging merchants the equivalent of swipe fees, LevelUp would take a cut of the new and returning business generated by its loyalty programs. (While it was no longer charging merchants a transaction fee, it still had to reimburse the payment processor.)

There are two basic kinds of campaigns offered by LevelUp: new customers and returning customers. In both cases, the merchant offers up a reward – say, $1 if you spend $5 – for the new or returning customer. LevelUp charges the merchant 40 cents on that extra dollar. This model works if those rewards are redeemed; one analyst’s back-of-the-envelope math puts the overall fee for LevelUp on these transactions at around 5 percent. But LevelUp only makes money if the rewards are redeemed, which Business Insider reported happens about 40% of the time.

When interchange zero first launched, it came with a monthly fee to cover hardware costs. But merchants bristled at the fee, and in September it was removed. Then in January of this year, LevelUp reintroduced the 2% option, for reasons that aren’t clear to me. Today, merchants who simultaneously run both new and returning customer campaigns get interchange zero, and are charged 40 cents on the dollar for the rewards. Those that aren’t running a campaign, or are just running one of the two campaign types, are charged 2% on transactions. The company’s latest shift, introduced to users by email last week, involves bundling transactions so as to pay less in batch fees, a move I’m told is being touted internally as significant but which depends on regular transaction volume from users.

What’s Next?

Based on half a dozen conversations with former LevelUp employees, it’s clear that it has been a hectic year for the company. Rapid expansion has been followed by significant cutbacks, and the company’s ability to make real money remains unproven. Morale is understandably low for those who remain.

Another round isn’t the only option, of course. It’s possible there’s an acquirer out there that would be interested. But in my conversations I heard nothing specific about that possibility.

So can the company raise the funding necessary to keep going? That depends on how investors view the Heartland deal, and how significantly they weigh the company’s substantial progress building out a mobile payment network.

“This is a company that has proven that it can build a two-sided network,” Bain’s Harris told me. “But it hasn’t yet proven that it can do so and make an economic profit at it. At this point I don’t think we can bet against them figuring that part out, too.”

When I pushed Harris for a prediction, his best guess was that LevelUp would raise money on a flat valuation. After all, he pointed out, they don’t have to convince every VC. “It really only takes one.”

UPDATE: Seth responded to me on Twitter. Here’s what he said: