“I run an ecommerce business because it’s easy and the money flows in.”
– Said no one ever
Everyone that starts an online store hopes one day to live the magic five hour work week, where they sip a fruity drink on a tropical beach while their online money printing machine chugs along seamlessly. With the constant media attention on the growth of online shopping and supposed death of the brick and mortar business model, it’s no wonder that every person with an entrepreneurial spirit begins thinking of selling online. Amazon.com might be huge, but even they are only so big, so that much mean there’s still ample market share up for grabs.
That’s what my business partner Mike and I thought when we ventured into our first ecommerce business. We both had over a decade of business experience each and had already established online businesses that brought in millions in revenue within years. I am also a partner/owner of a store franchise and Mike was once even an eBay Power Seller back in the heyday. I mean, how hard could something as simple as ecommerce be, right?
We were about to find out.
The Wild West: The Roots of the Ecommerce Fantasy
I got my start online in 2003, over a full decade ago. At that time, the dot com bubble was in a heaping pile of flames, with the entire online industry awash in doubt, guilt and fear on what was to happen. The dream of everyone going online to do everything from purchasing toilet paper to funding fair trade eskimo shoes had been crushed, with the sour reality that actually, no, there wasn’t actually enough demand…. yet.
The tragic story of Pets.com became the de facto case study for Harvard Business School and the metaphor of the excess of the bubble for years to come. Over $300MM in total losses in a mere two years. It’s first years of revenues were a mere $619,000 while the margins were -27%. To put that in perspective, when Mike and I opened the doors for Treadmill.com, we made roughly the same amount in sales our first year, minus the multi-million budget advertising campaign.
The executive team made a calculation that based on the rate of growth in online shopping, coupled with the multi-billion dollar pet industry, that if Pets.com could break $300MM in annual sales in 4 to 5 years, they would be able to be surpass the headwinds and create a wildly successful company. This thinking led them to go on a wild advertising bonanza, spending over $15MM each quarter.
In some regards, Pets.com was successful in that they had acquired a 570,000 customers. The problem? It cost them $158 to acquire each customer.
As a quick mental exercise, let’s make a conservative guess at how much a pet owner spends per month by saying $60 in food and treats, $10 in litter, $30 in grooming, $30 in vet bills plus $10 in miscellaneous. That’s $140/mo. Half of that is in services while the other half are products that can be purchased. So per year, the total spend of a consumer is around $850/year. Again, we’re estimating here.
In retail, COGS (cost of goods) are normally 50% or lower, as the store needs at least a 100% mark-up to generate enough profits to offset labor and rent. For modern ecommerce stores, you can expect shipping to be 20% of that margin, let alone Pets.com model of selling heavy items like food and litter, which would realistically put it closer to 30%. Let’s put it in a table:[table id=1 /]
These margins don’t include overhead such as labor, warehousing and marketing, but at over 30% margins, Pets.com was probably flying high thinking they were going to destroy those backward brick and mortar stores operating on 2% to 4% net margins. However, by having an customer acquisition cost of $158, Pets.com was willingly giving up an entire year of profits for a captive customer just to get them in the door. The game plan was to hold out long enough for acquisition costs to drop, their conversions to improve and finally ride out the wave until they could hit profitability.
Unfortunately for Pets.com, the promised land of ecommerce where customers not only regularly bought online never materialized. Until…
Ten Years Later: The Second Wave of Ecommerce
Among the biggest hurdles to ecommerce in the past was the technological barriers to entry. Unless you had the resources to hire an in-house team of developers that could link your systems to various carriers, logistics companies, vendors and a hodge podge of API and EDI calls, you were out of luck. Now, within 5 minutes, you can instantly create an online store that will upload product feeds into Google Shopping, route orders to a third-party fulfillment centers, syncs it all up with your inventory management system and gracefully connects with your accounting back-end. All for less than the cost of a developer consultation just 5 years ago.
The rise of not just consumer technology, but business technologies has flattened the logistical playing field. In the parlance of economics, the supply side has simply exploded. Whereas there was only a few shopping cart platforms before, now there are dozens of different options, each touting superiority over another. On top of the platforms, come a dizzying array of integrations, each promising to draw in customers from the mythical pool of infinite wealth. If this sounds eerily familiar, then it should, because these were the exact same promises made in the early days of ecommerce. The difference is whereas you were once being offered up as prize, the prize is now being offered to you. If history shows us anything here, it is caveat emptor.
Let’s go straight into the familiar model of selling pet food by using many of the same assumptions as the Pets.com chart earlier:[table id=2 /]
In this example, we’re using round numbers to simplify things, but you’ll notice one of the big differences is competition. And it’s ugly. Because while you were day dreaming over the last few paragraphs of how to potentially make hand over fist by operating a lean one-person garage operation by selling cat food with 30% margins, the reality is that there are major challenges to a small store owner. Without economies of scale, you are already running into dangerous territory on your margins.
One of the most important lessons of getting into ecommerce is finding an industry with healthy net profit margins. Aim for at least 15%.
Now this is not to say that you shouldn’t sell cat food or bag stuff out of your garage, because there’s a certain rite of passage that all small business owners go through to break away from the initial business inertia, but it’s important to be aware of what the future holds. If your business model relies on you always being in charge of fulfillment, you might as well have bought yourself a job as a warehouse worker.
The Three Barriers to Entry in Selling Online
1) Competitive Pricing
Remember the feeling of insanity in your head when I mentioned Pets.com having a negative margin? And you wondered why would anyone fund such a business? What would you do if I told you that the biggest online store in the world was practically doing just that. Because it is, and it’s name is Amazon.com.
Trying to compete against Amazon.com on price is essentially an exercise in futility. When we approached one vendor for a price list, they actually listed their wholesale price for under 100+ units was more than what we could have bought it from on Amazon.com. Obviously, this shows that the price list was highly negotiable, but it was also clear that Amazon was buying in 1,000+ units if not in the tens of thousands. Not only that, Amazon.com is more than happy to operate at slim margins based on its sheer volume of sales.
While some vendors and manufacturers set MAP (minimum advertised pricing), both rouge sellers and Amazon.com will routinely break MAP. So while you think your swank $30,000 website with wonderful photos and fantastic service will win customers over, the more common outcome is someone takes one look at the 5-10% savings that Amazon.com gives them and ignores your website completely.
The important lesson here is to not compete on price sensitive products (common goods, commodities) against big name competitors, unless you have an irresistible offer to your customers.
My partner Mike and I essentially look at shipping as rent for online businesses. It’s simply a cost of doing business and you have the manage the percent that shipping eats into your margins just like you would with rent. If you are entering a business with inherently high shipping percentage cost (think over 20%), you’ll need to rely on another facet of your business model to offset the costs, whether it be repeat customers, economies of scale or simply high volume.
Trying to establish businesses where your shipping costs are a low percentage of your gross profits is the ideal situation, as it gives you room to absorb hikes in shipping, COGS or other expenses.
Last but not least, acquiring customers will be one, if not the toughest task of running an ecommerce business. As noted earlier, Pets.com paid a full year of profits just to get a customer. In modern affiliate models, service based companies can pay up to a 50% of sales for a lead, while online retail stores pay 5% to 15% of sales per lead. Assuming your profit margin is 10-30% to begin with, this could be giving up half or more of your profits to bring in a new customer, just on an affiliate model.
While there are also options like pay-per-click advertising, that is extremely treacherous waters for a new business. It’s very easy to get caught up in buying clicks via PPC and not knowing if that traffic is performing or not. In my early days, I had no idea what I was doing with PPC and just saw the leads being generated and was happy. Only after doing rigorous analysis did I realize I was wasting 30% of my monthly spending and in fact was losing money in the end. Eventually I would be able to run campaigns with $30,000 monthly budgets that would make a decent return on investment, but it took months, if not years, to have a good grasp of PPC. Even still, I regularly kick myself when I discover areas that I’ve been wasting money.
It may be tempting to hire an outside consultant, as there are no shortage of PPC experts and consultants, but the industry is not well regulated and you’ll find the rates are not cheap. Much like the dot com boom, anyone can declare themselves a consultant and start charging $200/hr if they toot their own horn long enough. The minute anyone promises you returns of 50%, 100% or even 200% on your PPC, you should just run in the other direction as fast as you can. Unless you are in virgin industries, those ROI figures simply do not exist.
Lastly, the biggest myth of easy customers is the magical term SEO, or search engine optimization. For the mere price of $500, someone will use their secret technique to propel you to the number one position on Google and you’ll be flooded in organic traffic. And if you believe that, I’ve got a plot of land on the moon I would like to sell you. I can say this unequivocally, because my background is actually in search optimization. In fact, I was one of the top producing affiliates in an extremely competitive industry and routinely turned down consulting roles because it was more worthwhile to work for myself than for someone else. Let me repeat that:
Any SEO expert worth his or her salt makes more money working for themselves or for equity than working for you.
This is not to say that all search engine marketers are bad, but the vast majority of them are. Anyone that can promise you top rankings on Google is flat out lying and a con. There is no such thing as guarantee and if the person could actually pull it off, they would know how to make so much money that they wouldn’t be working for you. Period.
What does this mean for your changes for SEO and organic traffic? It means that you will need to learn how to do your own SEO or hire a B-team SEO producer that hopefully doesn’t destroy your business with improper or spammy techniques that gets you banned from Google.
Still Want to Open a Store?
If you’ve made it this far, I congratulate you because you’re obviously among the few that are actively looking out for the risks and pitfalls. If there’s any take away from this post, it’s that an ecommerce store is not easy. It’s hard work and it’s a real business, like any other.
The landscape is ever evolving and the one thing you can count on is that you will be forced to adapt to new technology paradigms on ever shortening cycles.[table id=3 /]
The trend that you will notice here is that many of the difficult things become easy, and easy things become difficult. What has happened is the accessibility of ecommerce coming to the masses and the easy arbitrage opportunities becoming harder to exploit. There once was a time that your competitors didn’t know how to PPC, you could write garbage content and have it rank well for SEO and drop ship your way to the bank on healthy margins. Those opportunities are rare and hard to find now, especially as your customers keep changing their minds on where they want to hang out and congregate.
At the same time, it’s also challenging, fun and exciting. And hopefully, it will be rewarding if you should set down this path.
Just don’t say I didn’t warn you.
Grant currently owns and operates two ecommerce businesses selling kitchen products and clothing. He is also a partner in a restaurant franchise with two locations and has over a decade of experience as an entrepreneur and web developer.
He lives in the beautiful city of Seattle, Washington, and when he’s not at his laptop with a coffee, will be found skiing or hiking in the mountains .