It may seem daunting to think about starting a company like Amazon, Zappos, or Shoedazzle* from scratch. But at its core, ecommerce is a simple business. If Lifetime Value (LTV) > Customer Acquisition Cost (CAC), then you have a business. If not, you don’t. Simple!
Calculating lifetime value properly can take a bit of work. It is a function of purchase rates, average order size and contribution margin.
In most cases, larger companies have a real advantage over smaller ones on both LTV and CAC. Because they can leverage economies of scale in buying or manufacturing, large companies have higher contribution margins than startups. This in turn leads to a higher lifetime value. Large companies may also take advantage of stronger brand names, which can translate into higher loyalty (less churn, longer lifetimes, higher LTV) or lower customer acquisition costs.
In a steady-state environment, lifetime value is reasonably constant, and well understood by all competitors in an industry. Customer acquisition is also reasonably constant. Most advertising markets are efficient, so most competitors acquire customers at about the same cost. The companies with a higher LTV can afford to pay more, and this can enable them to hold the greatest market share.
So where is the opportunity for a startup? If this bleak analysis is correct, how come we have seen so many ecommerce startups break through over the last few years?
The answer is that the environment has not been steady-state. We’ve seen a lot of change in the last few years, driven mostly by Facebook’s unprecedented growth. This created new scalable customer acquisition channels where the markets are NOT efficient. Nimble startups were the first to take advantage of these new customer acquisition channels, and they were able to grow fast before incumbents even noticed. That is how ecommerce startups can break through.
Before we look at the present in detail, it’s useful to look at the past. There have been two prior periods when ecommerce startups were formed and succeeded in great numbers.
The first period was in the late 90s. Back then, the scalable acquisition channel was portal distribution deals. An example would be when AOL sold their Travel channel to Preview Travel (now Travelocity) or MSN launched Expedia as its travel channel. These deals allowed Expedia and Travelocity to grow to scale.
Even mighty Amazon grew and benefited from these portal deals. It struck deals with AOL in 1997 and again in 2001 to power SHOP@AOL. These portal deals were inefficient markets by their very nature. Few companies could bid for them. Even so, prices quickly rose from the mid-90s to the early 2000s, when deals were regularly going for 9 figures. At this point, portal distribution deals were well out of reach of startups. Ecommerce leaders were built for each of the big portal channels; travel (Expedia, Travelocity), jobs (Hotjobs, Monster), dating (Match), and so on.
The second period was from 2002-2005, right after Google launched Adwords. This was, once again, a new, scalable customer acquisition channel. In the beginning this was an inefficient market, one that was largely ignored by most big retailers. Small startups from Lending Tree to Zappos to LegalZoom to Diapers.com to BlueNile* all took advantage of the cheap, performance-based customer acquisition. They made search engine marketing (SEM) a core internal competence, and grew to scale in that period. The companies that prospered lined up well with Google’s intent-driven search model — mortgages, shoes, wills, diapers, and engagement rings in these examples. This was non-discretionary shopping, where intent started with the user and demand was fulfilled through search. You don’t shop for mortgages on a whim.
Eventually companies like Marin Software and Efficient Frontier emerged, making the SEM market efficient and leveling the playing field. Ever since, it’s been hard for a new ecommerce startup to break through by relying on SEM.
Now, let’s come back to today. Over the last few years, Facebook, both through viral channels (invites, notifications, and the feed) and also through its CPC advertising platform, provided two new, scalable customer-acquisition channels. And in the beginning, both of these these were inefficient markets.
But other industries soon followed, including online dating (Zoosk, Chirpme*), Daily deals (Groupon, LivingSocial*), Flash Sales (Gilt, Zulily, OneKingsLane, Fab and others) and social commerce (Shoedazzle*, Modcloth, JustFab, Bonobos*). They built up meaningful in-house expertise in customer acquisition on Facebook, and they grabbed lots of new customers while these channels were relatively inefficient.
All these companies have something in common: They make shopping fun. They provide discretionary purchases that are as fun to shop for, as to buy. That is because Facebook is a place for entertainment, and the shopping use case must match the channel. At the end of 2010 I predicted that making shopping fun was going to be one of the key drivers of ecommerce going forward. This is in contrast to the Adwords driven ecommerce era. At that time, the key channel was Google, and intent-driven non-discretionary purchases were the fastest growing categories. As I said earlier, you don’t shop for mortgages on a whim. But you do shop for designer clothes, deals on sushi restaurants or fabulous shoes on a whim, because it is fun to look.
Now, just a couple of years later, companies like Nanigans and AdParlor provide expertise in managing Facebook ads as a service, just as Efficient Frontier and Marin did for SEM. They have leveled the playing field, made the Facebook ad channel extremely efficient (and much more expensive), and have allowed the brick and mortar retailers to catch up. You’re as likely to see a JC Penney or Nordstrom ad in Facebook’s right rail now, as you are a new ecommerce company’s. The window for startup ecommerce companies to take advantage of social platforms is starting to close. Those that have achieved scale are safely through the window, but those starting today and hoping to grow through the Facebook ad channel will find it much harder going than the first generation did.
In each era, a new, scalable, and inefficient customer acquisition channel has emerged, and it has spawned the growth of a wave of new ecommerce startups. Once service providers emerge to make the channel efficient, the window closes for new startups. So is this the end of the current wave of ecommerce startups? I don’t think so. I believe there is a new, scalable, inefficient customer acquisition channel that is beginning to emerge and will explore that topic further in my next post.
[Disclosure: Those marked with an asterisk are Lightspeed Venture Partners portfolio companies.]
[Image courtesy mikeyskatie]