Amazon vs Walmart

Amazon vs. Walmart: Bezos Goes for the Jugular with Whole Foods Acquisition

Key Highlights

  • On Friday, June 16, Amazon announced it was acquiring Whole Foods Market for $13.7 billion, the largest acquisition in the online retailer’s history.
  • Just a few hours later, Walmart announced the completion of its $310 million acquisition of the men’s apparel direct-to-consumer retailer Bonobos.
  • Whole Foods’ prime real estate allows Amazon to finally get into last-mile delivery, something the online retailer has historically struggled to do. Whole Foods has a 456-store footprint in the US, Canada, and the UK, mostly in upmarket, urban areas.
  • The significant implications of the Amazon/Whole Foods deal for the grocery and retail spaces explain why many retailers’ stocks took a big hit after the news (down 5-10%).
  • Walmart is pushing a strategy to buy vertically integrated companies because of higher gross profit margins. Whole Foods has some private label, but it accounts for only around 15% of revenues.
  • Groceries is an important category – a recent report by the Food Marketing Institute (FMI) found that US grocery sales could grow five-fold over the course of the next decade, with spending estimated at more than $100 billion by 2025.
  • The FMI survey highlighted how 69% of shoppers valued the store’s reputation when choosing which store to buy groceries at, making Whole Foods’ brand an important asset for Amazon to leverage.
  • Walmart is the nation’s largest seller of groceries, selling over $170 billion last year, and the category is a key driver of store traffic and customer loyalty. Walmart has invested and tested in click-and-collect programs, stand-alone grocery pick-up sites, and even testing of an automated kiosk for 24-hour pick-up.
  • Many voice concerns that not only do Walmart and Bonobos customers not overlap, but that Walmart’s acquisition may in fact push several away.

In just the space of a few days, the retail world was shaken by two big acquisition announcements from the industry’s goliaths: Walmart and Amazon. The latter grabbed the lion’s share of the headlines, announcing its acquisition of Whole Foods Market last Friday for a whopping $13.7 billion, making it the largest acquisition in the company’s history (dwarfing their $1.2 billion acquisition of Zappos in 2009).

As the markets were still coming to terms with the news, Walmart quickly followed up with its announcement of its acquisition of Bonobos, the direct-to-consumer (DTC) menswear retailer, for $310 million. As Fast Company highlighted, “The move threw into relief exactly how fiercely [Amazon and Walmart] are competing for the American consumer by working to seamlessly integrate online and offline shopping experiences.”

As the dust settles, it does seem clear that Amazon’s move will be far more significant, influential, and disruptive than Walmart’s. With the acquisition of Whole Foods, Amazon is possibly embarking on a radical disruption of brick & mortar retailing in the US, leaving Walmart to play defense.

Amazon Buying Whole Foods Is a Big Deal

Consensus is overwhelmingly that Amazon’s acquisition of Whole Foods is a big deal. “Amazon buying Whole Foods is incredibly interesting, highly strategic, and definitely not standard” said Toptal Finance Expert Josh Chapman. Recalling the video introducing Amazon Go (below) which surfaced at the end of last year, Chapman believes “[it was] Amazon’s vision all along and I believe it is front and center in their vision for Whole Foods. Amazon Go will now become the tech that will engulf every Whole Foods store across the country. I’ll be as bold as to say that Amazon buying Whole Foods is the start of an incredible wave of innovation across the grocery/shopping landscape.”

The belief in Amazon’s capacity to revolutionize the in-store grocery experience (on the tails of Amazon’s other recent foray into brick-and-mortar bookstores), is echoed by several others. Toptal Finance Expert Sebastian Fainbraun, who is an investor and board member of Dolcezza Gelato, a distributor to Whole Foods in the Mid-Atlantic, envisions a radically different in-store experience: “Imagine going to Whole Foods to get fruits, meats, and vegetables, plus other cool impulse buys, but also at your checkout having a bag of your monthly automated items waiting for you. Amazon has the analytics as well as the logistics. It’s going to revolutionize shopping. For Whole Foods, they have prime real estate and eventually can use that space for things other than food. If I were a retail landlord, I would be very worried unless I have those types of properties. Imagine the same model but at a mall with clothing and accessories.”

Putting aside the potential for change in the retail experience, both see implications that go far beyond. Chapman, a former investment banker at Morgan Stanley turned entrepreneur with experience across retail, real estate, energy, and SaaS industries, believes that “after Whole Foods, Amazon will probably replicate this exact acquisition strategy by buying a convenience store (CVS), major clothing retailer (Macy’s), then perhaps a tech appliance retailer (Best Buy). This shift will have enormous impact on job redistribution and will also create a wave of new tech and apps that will be ‘service providers’ for this new shopping experience.”

The view that Amazon’s tie-up with Whole Foods marks the beginning of a bigger push into traditional retail is shared by Fainbraun: “If this works out, Amazon will eventually buy a retailer like Nordstrom as well. It’s all about optimizing retail space with the right items and experience and having delivery options and automation for the rest.”

The widespread potential implications for the grocery and larger retail space might explain why so many retailers’ stocks took a big hit in the aftermath of the news (Chart 1). Toptal Finance Expert Neel Bhargava, whose experience in private equity and management consulting focused particularly on retail companies, points out: “Whole Foods is a major category leader that allows Amazon to enter the brick-and-mortar space in one fell swoop, and they can leverage for a lot of other things. This is why other grocers’ share prices are getting hit. It will be very hard to compete with.”

However, some are a bit more cautious in drawing conclusions too quickly. Toptal Finance Expert Ethan Bohbot, an investment banking and hedge fund analyst turned entrepreneur, says, “I think the initial drop in retailer stock prices is an overreaction and it is still to be determined if that large of a move is justified—Amazon has long tried to break into grocery and has basically admitted they need help by acquiring Whole Foods, so their success doesn’t seem like a guarantee. The market seems to already assume Amazon is going to significantly disrupt the market and take a big chunk of share, when a scenario that the impact is only incremental is not unreasonable, particularly in the near-term. At the same time, if things go well for Amazon, we could look back and say it was an underreaction, but just given the uncertainty, I think the magnitude of the move was excessive (not the direction—this is certainly a competitive threat).”

Walmart’s Acquisition of Bonobos Is More Incremental

Turning to Walmart’s acquisition of Bonobos, most agree that this acquisition is more additive than it is game-changing. Chapman says “Walmart buying Bonobos makes sense just because it’s an extension of Walmart’s clothing portfolio. This acquisition feels much more standard, cookie cutter, and kind of “boring,” honestly. The Bonobos brand will probably remain the same, hopefully not sacrificing quality (who knows), but now it will be integrated in a major way into the Walmart ecosystem.”

Fainbraun agrees: “It’s more like a hedge. Like McDonald’s buying Chipotle. Investing in a new model to learn. Amazon/Whole Foods is to completely change the model or take it to the next level—total sales channel/analytics/logistics optimization.”

Expanding on the strategic rationales of the deal, Bohbot outlines, “This just seems like a bolt-on to their eCommerce business. I understand the strategic rationale in getting talent from a successful online-based retailer, but they have made several similar acquisitions (and at larger scale) in the past that would seemingly achieve the same goal (Jet.com, ModCloth, etc.), so I am not sure the incremental benefit is going to be as great as Amazon/Whole Foods.”

Figure 1: Walmart's Acquisitions in eCommerce

A perhaps underestimated—and certainly underreported—component of the Walmart/Bonobos deal relates to margins. On this, Toptal Finance Expert Tayfun Uslu points out that “it is important to mention that Bonobos is a vertically integrated company and, as a company that is both brand and distributor of its products, this means very high gross profit margins that cannot be easily achieved by buyers and resellers or marketplaces (i.e., Whole Foods and Amazon). Whole Foods has some private label, but it accounts for around 15% of revenue. Walmart is pushing a strategy to buy vertically integrated companies because, in the end, they do have higher gross profit margins.”

Whatever one thinks of Walmart’s strategy of diving into eCommerce via fashion, it is clear that the general trend in this space has been moving towards DTC. Established brands have been steadily increasing their share of sales from this channel as opposed to the traditional retail channels (Chart 2). Building a strong online presence in fashion in many ways necessitates a strong positioning in DTC, something which shines through in Walmart’s recent acquisitions in the space.

Chart 2: Proportion of Revenue from Direct-to-Consumer Segment

Compared to Amazon’s recent move, from a margin perspective, Walmart’s strategy certainly seems more accretive. Bohbot sums it up as follows: “This specific transaction for Walmart is negligible, and given the stage/scale, it may not even impact Walmart’s margins, but the overall goal is to bolster the eCommerce business, which will theoretically have higher margins and provide uplift to the overall company as the mix continues to shift towards eCommerce.”

Bohbot goes on to say: “For Amazon, the Whole Foods acquisition is a different story—brick and mortar channels have a lower margin profile than online channels given higher fixed and variable costs, so by increasing the mix of brick and mortar, Amazon is seemingly diluting their margins. Additionally, across the retail sector, grocers have a pretty poor margin profile, so increasing grocery mix of revenue will further prove to be dilutive.”

The lower margins in groceries were something that Jeff Bezos himself highlighted earlier this year. Turning to Twitter to respond to a NY Post article that claimed that Amazon Go had operating profits of more than 20% and could operate with just three human workers, the Amazon CEO had this to say:

Figure 2: Jeff Bezos on Grocery Margins
Figure 2: Jeff Bezos on Grocery Margins
Source: Twitter

But Bohbot doesn’t seem to be concerned about this latter point. Aside from the fact—as the Wall Street Journal points out—“Whole Foods […] operates at much higher profit margins than other grocers, thanks in part to the higher markups it gets for many of its upscale items” (Chart 3), Bohbot believes “I don’t think you can simply apply Whole Foods margins to the incremental revenue Amazon is acquiring and say that will be the incremental profits – there are undoubtedly synergies (supply chain, etc.), and further, we don’t know what future Whole Foods stores are going to look like once Amazon gets in there. It is possible Amazon cuts the footprint across major stores dramatically, takes out labor, and automates a lot of the day-to-day operations such that the margins are a lot higher than Whole Foods stand-alone (reasonably somewhere in between margins achieved by online-only and brick-and-mortar-only sales channels). How much higher Amazon can drive margins is still to be seen, but I think Whole Foods stores will look very different under Amazon, and likely in a way that cuts costs and improves margins from the status quo.”

Chart 3: Trailing Gross Profit Margins for US Grocery Retailers

Amazon’s Acquisition Has a Strong Strategic Rationale—Walmart’s Less So.

Comparing the two moves from a strategic standpoint, Amazon’s acquisition of Whole Foods clearly comes out on top. Finance Expert Alex Graham, a former fixed income trader who has moved into venture capital, points out, “Walmart wants to buy a brand and get some soft learning from their tactics, backing them up with cash and logistics if necessary but largely treating it as a quasi aqui-hire/financial investment. Amazon probably wants to come in more directly and harness the fixed assets of Whole Foods.”

Important Real Estate Component For Amazon

The importance of the real estate component in the Amazon transaction is widely acknowledged. As Figure 3 below shows, Amazon is acquiring a strong retail footprint in many major geographical markets. Toptal Finance Expert Jeffrey Mazer, a financial expert and lawyer who has served as a transactional and valuation expert witness in the past, weighs in on this, saying, “The Amazon/Whole Foods possibilities are endless. With Whole Foods’ footprint in affluent areas and Amazon’s expertise in supply chain and delivery, they could upend both food retailing and food delivery.”

Figure 3: Combined Amazon/Whole Foods Footprint

In particular, the key benefit that many have pointed to is that acquiring prime real estate allows Amazon to finally get into last-mile delivery, something the retailer has historically struggled to do. Alex Graham delves further into this: “Last mile delivery is a critical component that startups in the grocery space have been able to capitalize in Amazon’s absence. Buying an upmarket chain of supermarkets in upmarket urban areas will allow Amazon to significantly enhance its hub and spoke approach. For that reason alone, the physical assets of whole foods are a key component of this deal (and potentially a future source of contention between the two management teams if their dual use compromises the activity of the other).”

Fainbraun, however, takes a higher-level view: “I’m not so worried about grocery retailers themselves. It’s the other retailers that will be hurting more. People will still go to grocery stores for location and convenience. The ones who suffer will be the Walmarts of the world—Home Depot, big box retailers. Amazon is eating their lunch and will have class A retail location.” He continues, “Retail of the future will be about Class A experiential real estate, and Class C convenience. If Whole Foods ends up working out for Amazon, I think they will buy Nordstrom and Kmart. Nordstrom is the best department store and very efficient with space and creating stores within a store. And Kmart is cheap, good big box real estate. If I’m right, Amazon will have lifestyle center real estate, big box, and inside malls. All as drop off and pick up locations and showrooms for online ordering.”

Strong Move into Groceries

The other major benefit most Toptal Experts see is that the Whole Foods acquisition will significantly help Amazon push into a difficult niche: groceries. Groceries is an important category—a recent report by the Food Marketing Institute found that US grocery sales could grow five-fold over the course of the next decade, with spending estimated at more than $100 billion by 2025. While currently, around 25% of US households shop online for groceries (up from 20% three years ago), that number will grow to more than 70% within the next ten years.

Figure 4: Grocery Market Forecasts

Toptal Finance Expert Ethan Bohbot had this to say on the matter: “I think that the Amazon/Whole Foods tie-up has the potential to prove more beneficial to Amazon [than Walmart’s acquisition of Bonobos] and more disruptive to the broader grocery industry. The general shift of buying groceries online has been happening for a while if you think of platforms like Fresh Direct or Blue Apron, but it has been slow and, based on Amazon’s historical execution across other business segments and now accelerated push, I think that bodes well for them to do something game-changing—but, of course, this is still to be determined.”

Part of the reason why Amazon has had such difficulties in breaking into the online grocery shopping space comes down to trust. The FMI survey highlighted how 69% of shoppers valued the store’s reputation when choosing which store to buy groceries at (Chart 4). Bohbot sees Amazon’s acquisition of Whole Foods as beneficial in this respect, “To me, Amazon is validating the brick-and-mortar channel for grocery and acquiring a quality brand with a large footprint, which is accelerating their push into grocery by allowing them to overlay their insights and supply chain/eCommerce dominance on top of an existing strong foundation.”

Chart 4: Store Behaviors That Make Shopper More Likely to Shop at a Particular Store

Limited Customer Overlap for Walmart and Potential Backlash by Bonobos Consumers

As far as Walmart’s acquisition of Bonobos is concerned, Bohbot thinks that it was motivated by the following factors: “Acquisition of eCommerce retail talent, acquisition of proven hybrid channel (physical storefront + online fulfillment), acquisition of a quality brand, and customer acquisition of Bonobos’ client base—outside of that, I am not really sure. This would certainly expand their eCommerce presence, which theoretically would have higher margins, but given stage/scale, that may not hold true for this acquisition.”

The issue of overlapping (or lack thereof) customer bases comes up several times. Many are concerned that Walmart and Bonobos customers lack overlap, and that Walmart’s acquisition might in fact alienate them. Toptal Finance Expert Jeffrey Mazer says so himself: “I’m a customer of Bonobos, Amazon, and Whole Foods. I can’t see that I would ever purchase anything from Bonobos again. Too many stories of acquirers seeking cost savings and other synergies by cutting quality. Men’s clothing has a lot of players; it’s lower risk to just start buying from someone else.”

And he doesn’t seem to be alone. A Business Insider article recently highlighted similar sentiment by looking at the Twitter-verse post announcement (Figure 5).

Figure 5: Customer Reactions on Twitter to Bonobos/Walmart Deal
Figure 5: Customer Reactions on Twitter to Bonobos/Walmart Deal
Source: Business Insider

Graham says, “Strategically, I think Amazon/Whole Foods will prevail, as it seems like there are more exciting overlaps between the customer bases of the two businesses—i.e., a Whole Foods customer probably shops on Amazon. Not sure if the same can be said about Walmart and Bonobos and that will be Walmart’s issue to contend with. And if Walmart tries too hard to force through some unnatural synergies between these two groups (like moving Bonobos’ online store into their system) they may ultimately jeopardize it all.”

Toptal Finance Expert Zachary Elfman, however, takes a different view. “An oft-cited justification for why an acquirer is willing to pay an above-market price for a target are synergies. Synergies can come in many forms, but it is not immediately clear if any meaningful revenue synergies through complementary customer bases can be achieved through the integration of Whole Foods into Amazon. There are few if any revenue synergies that Amazon is gaining with the Whole Foods acquisition because Whole Foods has a very similar customer base, if not identical. If I were to draw a Venn diagram of the companies’ customer bases, Whole Foods would sit nearly inside the (much larger) Amazon circle. Yes, this makes cross-selling existing products and services easier, but I cannot think of too many existing Whole Foods shoppers that do not already use Amazon. Flipping this around, products from Whole Foods can be sold to the expansive Amazon customer base, but I am not convinced that the Amazon distribution channel is going to really cause much greater Whole Foods penetration in an age when Instacart already allows for online ordering and home delivery.”

The Walmart-Amazon War?

Are these moves clear shots fired in a longer-term retail war between two retail giants? Bohbot takes a more measured stance on the issue: “I don’t really see it this way. Amazon isn’t attacking Walmart; they are attacking the world. Walmart is just included and is seemingly the most likely to fall victim to this specific announcement (given their grocery share), which is why people may be seeing it that way today.”

On his last point, it is important to note that Walmart’s share of grocery is very significant (Chart 5). As Retail Dive highlighted in a recent article: “Grocery is where Walmart really shines. It is the nation’s largest seller of groceries with category sales of $170 billion last year, and the category is key to driving store visits and customer loyalty. Walmart has been investing in click-and-collect programs, stand-alone grocery pick-up sites, and is even testing an automated kiosk for 24-hour pick-up.”

Chart 5: US Food Retail Market Shares

With the above in mind, it’s hard not to see how Amazon/Whole Foods puts Walmart on the back foot. And in fact, other Toptal Experts are more sanguine. Finance Expert Tayfun Uslu thinks that “in the race to become the first monopoly, Amazon is now ahead.” And on the monopoly point, he is not alone. In the wake of the acquisition, several articles have come out assessing the question of whether the Seattle-based retailer has perhaps gone too far. Toptal VP of Business Talent Rajeev Jeyakumar admits, “I already get most of my groceries from either Whole Foods or Amazon Fresh. So they’ve got a lock on my wallet share! Especially if you throw in Alexa ordering and if they acquired Grubhub—I may never leave the couch. I might as well get my Amazon credit card now and let them take that part of the value chain too.”

So perhaps the picture is a far more aggressive one, with Amazon’s move an all-out declaration of war. Finance Expert Sebastian Fainbraun certainly seems to think so: “They aren’t declaring war—they are declaring victory. Walmart has a good web presence but Amazon runs the internet. If they integrate properly, war over. Amazon is the new Walmart and Bezos is the new Walton.”

Post originally appeared on Toptal Finance 


Open Source Software - Investable Business Model or Not?

Open-source software (OSS) is a catalyst for growth and change in the IT industry, and one can’t overestimate its importance to the sector. Quoting Mike Olson, co-founder of Cloudera, “No dominant platform-level software infrastructure has emerged in the last ten years in closed-source, proprietary form.”

Apart from independent OSS projects, an increasing number of companies, including the blue chips, are opening their source code to the public. They start by distributing their internally developed products for free, giving rise to widespread frameworks and libraries that later become an industry standard (e.g., React, Flow, Angular, Kubernetes, TensorFlow, V8, to name a few).

Adding to this momentum, there has been a surge in venture capital dollars being invested into the sector in recent years. Several high profile funding rounds have been completed, with multimillion dollar valuations emerging (Chart 1).

But are these valuations justified? And more importantly, can the business perform, both growth-wise and profitability-wise, as venture capitalists expect? OSS companies typically monetize with a business model based around providing support and consulting services. How well does this model translate to the traditional VC growth model? Is the OSS space in a VC-driven bubble?

In this article, I assess the questions above, and find that the traditional monetization model for OSS companies based on providing support and consulting services doesn’t seem to lend itself well to the venture capital growth model, and that OSS companies likely need to switch their pricing and business models in order to justify their valuations.

OSS Monetization Models

By definition, open source software is free. This of course generates obvious advantages to consumers, and in fact, a 2008 study by The Standish Group estimates that “free open source software is [saving consumers] $60 billion [per year in IT costs].”

While providing free software is obviously good for consumers, it still costs money to develop. Very few companies are able to live on donations and sponsorships. And with fierce competition from proprietary software vendors, growing R&D costs, and ever-increasing marketing requirements, providing a “free” product necessitates a sustainable path to market success.

As a result of the above, a commonly seen structure related to OSS projects is the following: A “parent” commercial company that is the key contributor to the OSS project provides support to users, maintains the product, and defines the product strategy.

Latched on to this are the monetization strategies, the most common being the following:

  • Extra charge for enterprise services, support, and consulting. The classic model targeted at large enterprise clients with sophisticated needs. Examples: MySQL, Red Hat, Hortonworks, DataStax
  • Freemium. (advanced features/products/add-ons) A custom licensed product on top of the OSS might generate a lavish revenue stream, but it requires a lot of R&D costs and time to build. Example: Cloudera, which provides the basic version for free and charges the customers for Cloudera Enterprise
  • SaaS/PaaS business model: The modern way to monetize the OSS products that assumes centrally hosting the software and shifting its maintenance costs to the provider. Examples: Elastic, GitHub, Databricks, SugarCRM

Historically, the vast majority of OSS projects have pursued the first monetization strategy (support and consulting), but at their core, all of these models allow a company to earn money on their “bread and butter” and feed the development team as needed.

Influx of VC Dollars

An interesting recent development has been the huge inflows of VC/PE money into the industry. Going back to 2004, only nine firms producing OSS had raised venture funding, but by 2015, that number had exploded to 110, raising over $7 billion from venture capital funds (chart 2).

Underpinning this development is the large addressable market that OSS companies benefit from. Akin to other “platform” plays, OSS allows companies (in theory) to rapidly expand their customer base, with the idea that at some point in the future they can leverage this growth by beginning to tack-on appropriate monetization models in order to start translating their customer base into revenue, and profits.

At the same time, we’re also seeing an increasing number of reports about potential IPOs in the sector. Several OSS commercial companies, some of them unicorns with $1B+ valuations, have been rumored to be mulling a public markets debut (MongoDB, Cloudera, MapR, Alfresco, Automattic, Canonical, etc.).

With this in mind, the obvious question is whether the OSS model works from a financial standpoint, particularly for VC and PE investors. After all, the venture funding model necessitates rapid growth in order to comply with their 7-10 year fund life cycle. And with a product that is at its core free, it remains to be seen whether OSS companies can pin down the correct monetization model to justify the number of dollars invested into the space.

Answering this question is hard, mainly because most of these companies are private and therefore do not disclose their financial performance. Usually, the only sources of information that can be relied upon are the estimates of industry experts and management interviews where unaudited key performance metrics are sometimes disclosed.

Nevertheless, in this article, I take a look at the evidence from the only two public OSS companies in the market, Red Hat and Hortonworks, and use their publicly available information to try and assess the more general question of whether the OSS model makes sense for VC investors.

Case Study 1: Red Hat

Red Hat is an example of a commercial company that pioneered the open source business model. Founded in 1993 and going public in 1999 right before the Dot Com Bubble, they achieved the 8th biggest first-day gain in share price in the history of Wall Street at that time.

At the time of their IPO, Red Hat was not a profitable company, but since then has managed to post solid financial results, as detailed in Table 1.

Instead of chasing multifold annual growth, Red Hat has followed the “boring” path of gradually building a sustainable business. Over the last ten years, the company increased its revenues tenfold from $200 million to $2 billion with no significant change in operating and net income margins. G&A and marketing expenses never exceeded 50% of revenue (Chart 3).

The above indicates therefore that OSS companies do have a chance to build sustainable and profitable business models. Red Hat’s approach of focusing primarily on offering support and consulting services has delivered gradual but steady growth, and the company is hardly facing any funding or solvency problems, posting decent profitability metrics when compared to peers.

However, what is clear from the Red Hat case study is that such a strategy can take time—many years, in fact. While this is a perfectly reasonable situation for most companies, the issue is that it doesn’t sit well with venture capital funds who, by the very nature of their business model, require far more rapid growth profiles.

More troubling than that, for venture capital investors, is that the OSS model may in and of itself not allow for the type of growth that such funds require. As the founder of MySQL Marten Mickos put it, MySQL’s goal was “to turn the $10 billion a year database business into a $1 billion one.”

In other words, the open source approach limits the market size from the get-go by making the company focus only on enterprise customers who are able to pay for support, and foregoing revenue from a long tail of SME and retail clients. That may help explain the company’s less than exciting stock price performance post-IPO (Chart 4).

If such a conclusion were true, this would spell trouble for those OSS companies that have raised significant amounts of VC dollars along with the funds that have invested in them.

Case Study 2: Hortonworks

To further assess our overarching question of OSS’s viability as a venture capital investment, I took a look at another public OSS company: Hortonworks.

The Hadoop vendors’ market is an interesting one because it is completely built around the “open core” idea (another comparable market being the NoSQL databases space with MongoDB, Datastax, and Couchbase OSS).

All three of the largest Hadoop vendors—Cloudera, Hortonworks, and MapR—are based on essentially the same OSS stack (with some specific differences) but interestingly have different monetization models. In particular, Hortonworks—the only public company among them—is the only player that provides all of its software for free and charges only for support, consulting, and training services.

At first glance, Hortonworks’ post-IPO path appears to differ considerably from Red Hat’s in that it seems to be a story of a rapid growth and success. The company was founded in 2011, tripled its revenue every year for three consecutive years, and went public in 2014.

Immediate reception in the public markets was strong, with the stock popping 65% in the first few days of trading. Nevertheless, the company’s story since IPO has turned decisively sour. In January 2016, the company was forced to access the public markets again for a secondary public offering, a move that prompted a 60% share price fall within a month (Chart 5).

Underpinning all this is that fact that despite top-line growth, the company continues to incur substantial, and growing, operating losses. It’s evident from the financial statements that its operating performance has worsened over time, mainly because of operating expenses growing faster than revenue leading to increasing losses as a percent of revenue (Table 2).

Among all of the periods in question, Hortonworks spent more on sales and marketing than it earns in revenue. Adding to that, the company incurred significant R&D and G&A as well (Table 2).

On average, Hortonworks is burning around $100 million cash per year (less than its operating loss because of stock-based compensation expenses and changes in deferred revenue booked on the Balance Sheet). This amount is very significant when compared to its $630 million market capitalization and circa $350 million raised from investors so far. Of course, the company can still raise debt (which it did, in November 2016, to the tune of a $30 million loan from SVB), but there’s a natural limit to how often it can tap the debt markets.

All of this might of course be justified if the marketing expense served an important purpose. One such purpose could be the company’s need to diversify its customer base. In fact, when Hortonworks first launched, the company was heavily reliant on a few major clients (Yahoo and Microsoft, the latter accounting for 37% of revenues in 2013). This has now changed, and by 2016, the company reported 1000 customers.

But again, even if this were to have been the reason, one cannot ignore the costs required to achieve this. After all, marketing expenses increased eightfold between 2013 and 2015. And how valuable are the clients that Hortonworks has acquired? Unfortunately, the company reports little information on the makeup of its client base, so it’s hard to assess other important metrics such as client “stickyness”. But in a competitive OSS market where “rival developers could build the same tools—and make them free—essentially stripping the value from the proprietary software,” strong doubts loom.

With all this in mind, returning to our original question of whether the OSS model makes for good VC investments, while the Hortonworks growth story certainly seems to counter Red Hat’s—and therefore sustain the idea that such investments can work from a VC standpoint—I remain skeptical. Hortonworks seems to be chasing market share at exorbitant and unsustainable costs. And while this conclusion is based on only two companies in the space, it is enough to raise serious doubts about the overall model’s fit for VC.

Why are VCs Investing in OSS Companies?

Given the above, it seems questionable that OSS companies make for good VC investments. So with this in mind, why do venture capital funds continue to invest in such companies?

Good Fit for a Strategic Acquisition

Apart from going public and growing organically, an OSS company may find a strategic buyer to provide a good exit opportunity for its early stage investors. And in fact, the sector has seen several high profile acquisitions over the years (Table 3).

What makes an OSS company a good target? In general, the underlying strategic rationale for an acquisition might be as follows:

  • Getting access to the client base. Sun is reported to have been motivated by this when it acquired MySQL. They wanted to access the SME market and cross-sell other products to smaller clients. Simply forking the product or developing a competing technology internally wouldn’t deliver the customer base and would have made Sun incur additional customer acquisition costs.
  • Getting control over the product. The ability to influence further development of the product is a crucial factor for a strategic buyer. This allows it to build and expand its own product offering based on the acquired products without worrying about sudden substantial changes in it. Example: Red Hat acquiring Ansible, KVM, Gluster, Inktank (Ceph), and many more
  • Entering adjacent markets. Acquiring open source companies in adjacent market segments, again, allows a company to expand the product offering, which makes vendor lock-in easier, and scales the business further. Example: Citrix acquiring XenSource
  • Acquiring the team. This is more relevant for smaller and younger projects than for larger, more well-established ones, but is worth mentioning.

What about the financial rationale? The standard transaction multiples valuation approach completely breaks apart when it comes to the OSS market. Multiples reach 20x and even 50x price/sales, and are therefore largely irrelevant, leading to the obvious conclusion that such deals are not financially but strategically motivated, and that the financial health of the target is more of a “nice to have.”

With this in mind, would a strategy of investing in OSS companies with the eventual aim of a strategic sale make sense? After all, there seems to be a decent track-record to go off of.

My assessment is that this strategy on its own is not enough. Pursuing such an approach from the start is risky—there are not enough exits in the history of OSS to justify the risks.

A Better Monetization Model: SaaS

While the promise of a lucrative strategic sale may be enough to motivate VC funds to put money to work in the space, as discussed above, it remains a risky path. As such, it feels like the rationale for such investments must be reliant on other factors as well. One such factor could be returning to basics: building profitable companies.

But as we have seen in the case studies above, this strategy doesn’t seem to be working out so well, certainly not within the timeframes required for VC investors. Nevertheless, it is important to point out that both Red Hat and Hortonworks primarily focus on monetizing through offering support and consulting services. As such, it would be wrong to dismiss OSS monetization prospects altogether. More likely, monetization models focused on support and consulting are inappropriate, but others may work better.

In fact, the SaaS business model might be the answer. As per Peter Levine’s analysis, “by packaging open source into a service, […] companies can monetize open source with a far more robust and flexible model, encouraging innovation and ongoing investment in software development.”

Why is SaaS a better model for OSS? There are several reasons for this, most of which are applicable not only to OSS SaaS, but to SaaS in general.

First, SaaS opens the market for the long tail of SME clients. Smaller companies usually don’t need enterprise support and on-premises installation, but may already have sophisticated needs from a technology standpoint. As a result, it’s easier for them to purchase a SaaS product and pay a relatively low price for using it.

Citing MongoDB’s VP of Strategy, Kelly Stirman, “Where we have a suite of management technologies as a cloud service, that is geared for people that we are never going to talk to and it’s at a very attractive price point—$39 a server, a month. It allows us to go after this long tail of the market that isn’t Fortune 500 companies, necessarily.”

Second, SaaS scales well. SaaS creates economies of scale for clients by allowing them to save money on infrastructure and operations through aggregation of resources and a combination and centralization of customer requirements, which improves manageability.

This, therefore, makes it an attractive model for clients who, as a result, will be more willing to lock themselves into monthly payment plans in order to reap the benefits of the service.

Finally, SaaS businesses are more difficult to replicate. In the traditional OSS model, everyone has access to the source code, so the support and consulting business model hardly has protection for the incumbent from new market entrants.

In the SaaS OSS case, the investment required for building the infrastructure upon which clients rely is fairly onerous. This, therefore, builds bigger barriers to entry, and makes it more difficult for competitors who lack the same amount of funding to replicate the offering.

Success Stories for OSS with SaaS

Importantly, OSS SaaS companies can be financially viable on their own. GitHub is a good example of this.

Founded in 2008, GitHub was able to bootstrap the business for four years without any external funding. The company has reportedly always been cash-flow positive (except for 2015) and generated estimated revenues of $100 million in 2016. In 2012, they accepted $100 million in funding from Andreessen Horowitz and later in 2015, $250 million from Sequoia with an implied $2 billion valuation.

Another well-known successful OSS company is DataBricks, which provides commercial support for Apache Spark, but—more importantly—allows its customers to run Spark in the cloud. The company has raised $100 million from Andreessen Horowitz, Data Collective, and NEA. Unfortunately, we don’t have a lot of insight into their profitability, but they are reported to be performing strongly and had more than 500 companies using the technology as of 2015 already.

Generally, many OSS companies are in one way or another gradually drifting towards the SaaS model or other types of cloud offerings. For instance, Red Hat is moving to PaaS over support and consulting, as evidenced by OpenShift and the acquisition of AnsibleWorks.

Different ways of mixing support and consulting with SaaS are common too. We, unfortunately, don’t have detailed statistics on Elastic’s on-premises vs. cloud installation product offering, but we can see from the presentation of its closest competitor Splunk that their SaaS offering is gaining scale: Its share in revenue is expected to triple by 2020 (chart 6).

Investable Business Model or Not?

To conclude, while recent years have seen an influx of venture capital dollars poured into OSS companies, there are strong doubts that such investments make sense if the monetization models being used remain focused on the traditional support and consulting model. Such a model can work (as seen in the Red Hat case study) but cannot scale at the pace required by VC investors.

Of course, VC funds may always hope for a lucrative strategic exit, and there have been several examples of such transactions. But relying on this alone is not enough. OSS companies need to innovate around monetization strategies in order to build profitable and fast-growing companies.

The most plausible answer to this conundrum may come from switching to SaaS as a business model. SaaS allows one to tap into a longer-tail of SME clients and improve margins through better product offerings. Quoting Peter Levine again, “Cloud and SaaS adoption is accelerating at an order of magnitude faster than on-premise deployments, and open source has been the enabler of this transformation. Beyond SaaS, I would expect there to be future models for open source monetization, which is great for the industry”.

Whatever ends up happening, the sheer amount of venture investment into OSS companies means that smarter monetization strategies will be needed to keep the open source dream alive.

This article is originally posted in Toptal.


SaaS - Pricing Tactics That Can Turbocharge Your Business

Pricing is one of the most important financial levers that companies have at their disposal to influence the financial success of their business. However, it is not an easy task.

Firstly, pricing affects multiple stakeholders, both inside and outside the company. Experimenting with pricing is therefore not a task that should be taken lightly. Secondly, finding the right price is notoriously hard. Customer preferences are hard to gauge ex-ante, and internally, it can be difficult to foresee the effects of pricing changes on the financial performance of a company. And finally, of course, pricing doesn’t happen in a vacuum. In any competitive market, pricing changes can often lead to retaliatory actions which end up canceling out the intended effect of the pricing adjustment.

With this in mind, techniques and methods for getting around these challenges are extremely useful.

In my experience, having co-founded a developer tools startup that uses a SaaS model, I have come to appreciate the SaaS business model as being, amongst other things, very pricing-friendly. The intrinsic characteristics of SaaS and its delivery mechanism have important ramifications related to pricing which, in turn, can be extremely useful in the financial management of your company.

In this article, I explore in more detail what these are and how they can benefit your business from a financial analysis and management standpoint.

What is SaaS?

Software as a Service (SaaS) is a software licensing and delivery model in which software is licensed by a third party and delivered to clients through the internet. Compared to locally hosted software models, SaaS clients do not have to install the software, update it, maintain it and integrate it. The vast majority of technical aspects are “taken care of” by the SaaS provider so that the client can start using the SaaS product with little effort.

The ramifications and benefits of SaaS versus other types of services are displayed graphically in chart 1 below. As you can see, with traditional on-premises software, the client has to manage most of the activities related to setting up and running the software. At the opposite end of the spectrum, SaaS takes care of all of this on the software provider’s side. There are shades in between; for instance, Infrastructure as a Service and Platform as a Service.

The pros and cons of SaaS are fairly straightforward. On the one hand, SaaS is much easier to set up and run. It doesn’t require local servers, storage, management, etc. On the other hand, it doesn’t allow the same level of customizability that on-premises software can provide.

The change from locally hosted software to SaaS has been happening for some time, and is part of a more general shift in the IT industry to cloud-based applications. According to FTI Consulting, 69% of businesses today use at least one cloud-based application.

The shift to SaaS from on-premise services can be seen nicely when one looks at Adobe, one of the industry’s most well-known players. As can be seen in chart 2, courtesy of Tom Tunguz, Adobe’s non-SaaS product revenue peaked in 2011 at $3.4 billion and halved to $1.6 billion in just three years. Such a drop in revenue would normally have huge ramifications, but Adobe has also been offering a suite of SaaS products, which have increased in revenue five-fold, from $0.45 billion in 2011 to $2.1 billion in 2014. Adobe’s changing product mix is indicative of the overall industry’s shift away from locally hosted software towards cloud-based software provision, such as SaaS.

All indications are that this trend is likely to continue. Gartner estimates that SaaS application software was a $144 billion market in 2016 and that, by 2020, businesses will be shifting to cloud-based software to the tune of $216 billion a year.

SaaS Is a Pricing-friendly Business Model

As mentioned, the reasons for this shift to cloud-based applications are manifold. Lower setup and maintenance costs are of course a big factor. However, one important benefit that I have found of SaaS-based applications is that they are very pricing friendly. This is win-win both for clients as well as for the businesses providing the service, and I believe it plays an important role in explaining the overall industry shift.

In particular, there are several intrinsic operational characteristics of SaaS as a business model that in turn have implications on pricing, and specifically create and magnify the number of pricing levers that businesses have at their disposal. In particular, I highlight four main pricing-related benefits of SaaS products:

  1. Flexibility: Because of the web-based, real-time nature of the delivery mechanism, SaaS products are very flexible and allow for constant iteration. This affects pricing as well, since changes to pricing can be relatively quickly implemented, and the impact of these changes can be immediately measured. One can keep iterating until the desired price is reached.
  2. Real-Time Usage Tracking: Since SaaS products are in the cloud, usage of the software by the client is tracked in real time on the service providers’ side. This means that SaaS companies are more able to charge on a per-usage basis than traditional on-premises companies. This in turn has several important benefits detailed below.
  3. Network effects: The delivery mechanism and frictionless implementation of SaaS products acts as an enabler of network effects. This has important pricing ramifications in that it makes it easier to both create and charge for these network effects, thus in theory maximizing monetization.
  4. Freemium: Due to near zero marginal costs of delivery and product hosting, SaaS companies are more able to allow clients to use certain products for free for months or even years until they upgrade or cancel the service. Freemium prevents the product pricing from being a barrier to users trying or adopting the product, thus increasing the number of potential clients.

Benefit No. 1: Pricing Flexibility

The first and arguably most important financial benefit of adopting a SaaS model is the inherent flexibility that the model provides. In particular, flexibility refers to the following attributes:

  • Fast iteration: Because of the delivery mechanism, SaaS allows you to iterate quickly on pricing changes so that you can test price points and packages until you reach the optimum mix.
  • Tiered pricing: SaaS lends itself very well to tiered pricing, meaning the ability to price different product offerings differently to address multiple customer sub-segments.
  • No middleman: Since SaaS is delivered right to the client, bypassing any middlemen. This removes a key stakeholder from the equation and again gives the company greater flexibility to test different pricing points and packages

A practical example of this can be observed by analyzing Zendesk’s pricing evolution. Zendesk is a very successful customer service software company that generates over $300 million in yearly revenue. It offers different features of the same product to different customer segments.

As seen in the example below, in January 2015, Zendesk offered five different plans for five different segments. Its cheapest plan was available at $1 per agent per month while its most expensive was at $195 per agent per month. It also directed the users towards the “Plus” plan by highlighting it in green.

Exhibit 2: Zendesk January 2015 Pricing Options

Exhibit 2

Source: Archive.org

In January, 2016, Zendesk must have felt that there was room for improvement in pricing; they decreased the total number of plans from five to four. They also made changes in the pricing of plans where the least expensive plan increased from $1 to $5 per agent per month while its most expensive plan decreased from $199 to $99 per agent per month. The names of the plans were also changed (e.g., “Starter” to “Essential”) and the users were directed to the “Professional” plan by a lighter highlighting technique.

Exhibit 3: Zendesk January 2016 Pricing Options

Exhibit 3

Source: Archive.org

In 2017, pricing changed again and the number of plans increased back to five. While the least expensive plan stayed at $5 per agent per month, its most expensive plan increased from $99 to $199 per agent per month. By removing highlights, Zendesk stopped directing people to any of the plans.

Exhibit 4: Zendesk January 2017 Pricing Options

Exhibit 4

Source: Zendesk Pricing Page

Zendesk unfortunately doesn’t disclose the specific effects that its pricing changes have had. Nevertheless, the more general point that flexibility is useful is summarized nicely in this post: “Finding the right balance between value and revenue – your ability to help customers and be fairly compensated for that help – will make or break your […] company.” No doubt Zendesk’s changes are a reflection of this point.

To sum up, SaaS, as a delivery mechanism, allows for a great deal of flexibility and iterating capacity when it comes to pricing. As Lincoln Murphy of Sixteen Ventures puts it, “Pricing (like pretty much everything) is never a set-it-and-forget-it situation,” so the ability to iterate, test, learn, and improve is a very useful feature of the SaaS business model.

Cohort Analysis

If the results of pricing changes cannot be measured in a definite way, there is no point in iterating. So it is important to set up appropriate data collection and measurement processes and tools from the start.

One of the ways of measuring the results is through a cohort analysis. In cohort analysis, customers are put in different cohorts (i.e., groups) based on a characteristic, typically a selected time period. All of the new customers signing up can be divided into cohorts based on the date they become a customer. For example, there could be different cohorts as customers who joined in January, February, March, etc.

Analytics tools like Mixpanel readily offer cohort analysis based on the data they gather. As seen in the example above (Table 1), retention is being analyzed to measure how many people keep using a fictitious product as time passes. Going into the details, the cohort of April 27, 2014 has a retention rate of 23% at week 6, meaning that 23% of people who signed up in the week of April 27 2014 are still using the product at week 6. The cohort of July 13, 2014 has a retention rate of 9.6% in week 6, indicating a significant drop in retention rates, which means a major problem with this cohort or an action taken within that timeframe.

The critical aspect of cohort analysis is availability of data, so it is crucial that the data that will be the basis of the cohort analysis is collected correctly and available when needed.

Less Is More

In a well-known study conducted by psychologists Sheena Iyengar and Mark Lepper, it was showed that excessive choice can produce “choice paralysis.” As explained in this HBR article:

“[…] shoppers at an upscale food market saw a display table with 24 varieties of gourmet jam. Those who sampled the spreads received a coupon for $1 off any jam. On another day, shoppers saw a similar table, except that only six varieties of the jam were on display. The large display attracted more interest than the small one. But when the time came to purchase, people who saw the large display were one-tenth as likely to buy as people who saw the small display.”

Due to tiered pricing, the absence of intermediaries, and the fast iteration capabilities of SaaS, a product could be offered in hundreds of different ways. Nevertheless, one has to be careful not to create an instance of choice paralysis; thus, it is paramount that pricing be approached from a design perspective as well.

A practical example of this can be observed with Hubspot. Hubspot is an inbound marketing and sales management platform that automatizes and makes email marketing, analytics, and SEO more effective. PriceIntellingently does a nice job of explaining how although Hubspot’s pricing could be displayed in a variety of ways (e.g., a moving bar that shows the increase in pricing as the number of contacts increase), only three different plans were created based on three different value metrics. This makes these plans easier to understand and track.

Benefit No. 2: “Per-usage” Pricing

The second key benefit of SaaS products is that because of the delivery mechanism, SaaS lends itself much better to per-usage pricing. This is because usage by the client can be tracked and measured appropriately since the software is run on the service provider’s side.

Per-usage pricing is a very useful pricing tool for the following reasons:

It creates a lower barrier to customer adoption.

Users face a lower up-front financial barrier to signing up for the service since they know that their expenses will be in line with their usage. In contrast, traditional on-premises software usually charges a flat up-front fee based on an estimated assumption of usage. This estimate may not necessarily correlate with the specific needs of the client in question.

As outlined by Reason Street in this article, “Because of low or no cost startup fees, enterprise customers that typically take six months to a year to make a decision about enterprise software often leap frog this decision and simply begin to try the service. Customers then increase their use based on actual need of the company (vs. paying up front for licensing fees per seat).”

Costs can be better aligned with revenues.

Per-usage pricing also allows the service provider to better align its own costs with its revenues, since the revenue it receives is tied to the costs it incurs to charge the service. As Reason Street again points out, “For software startups, particularly in the SaaS sector, once the initial minimum viable product is built, companies can scale revenue closer to the scale in costs required to deliver the service. Some SaaS companies prefer pay-per-use, because the value relationship is made very clear to the customer, and they are able to prioritize feature and service development based on the customer’s expressed needs.”

Per-usage pricing leads to greater stickiness.

Per-usage pricing often leads to greater customer stickiness for two important reasons.

Firstly, since the customer’s expenses are spread out over a great period of time, their costs at any given point in time will be small compared to other costs that their businesses incur. As a result, they may not be as tempted to cut these. Of course, if the client were to view the costs as a whole (or over a longer period of time) they may well notice that the total cost is much larger, but human psychology doesn’t always follow logic.

Secondly, since per-usage pricing leads to lower barriers to adoption (as explained above), customers are more likely to give the service a try. As they continue using the service, the software may become more embedded in the everyday processes of the company, making it more difficult and costly to switch providers. Andreessen Horowitz sums this point and the related benefits up nicely:

“Once a SaaS company has generated enough cash from its installed customer base to cover the cost of acquiring new customers, those customers stay for a long time. These businesses are inherently sticky because the customer has essentially outsourced running its software to the vendor […]

It’s very difficult to switch SaaS vendors once they’re embedded into business workflow. SaaS customers, by definition, made the decision to have an outside vendor manage the application. In the perpetual license model, in-house IT staff managed all software instances and thus could incur the internal costs to switch vendors if they so chose.”

Per-usage pricing allows for subscription pricing, which helps with financial planning.

To be clear, per-usage pricing is not necessarily always good. There is a clear cash flow tradeoff from switching from up-front licensing to per-usage pricing. This effect is again illustrated nicely by Andreessen Horowitz:

“In the traditional software world, companies like Oracle and SAP do most of their business by selling a ‘perpetual’ license to their software and then later selling upgrades. In this model, customers pay for the software license up front and then typically pay a recurring annual maintenance fee (about 15-20% of the original license fee). Those of us who came from this world would call this transaction a “cashectomy”: The customer asks how much the software costs and the salesperson then asks the customer how much budget they have; miraculously, the cost equals the budget and, voilà, the cashectomy operation is complete.

This is great for old-line software companies and it’s great for traditional income statement accounting. Why? Because the timing of revenue and expenses are perfectly aligned. All of the license fee costs go directly to the revenue line and all of the associated costs get reflected as well, so a $1M license fee sold in the quarter shows up as $1M in revenue in the quarter. That’s how traditional software companies can get to profitability on the income statement early on in their lifecycles.

Now compare that to what happens with SaaS. Instead of purchasing a perpetual license to the software, the customer is signing up to use the software on an ongoing basis, via a service-based model — hence the term “software as a service”. Even though a customer typically signs a contract for 12-24 months, the company does not get to recognize those 12-24 months of fees as revenue up front. Rather, the accounting rules require that the company recognize revenue as the software service is delivered (so for a 12-month contract, revenue is recognized each month at 1/12 of the total contract value).

Yet the company incurred almost all its costs to be able to acquire that customer in the first place — sales and marketing, developing and maintaining the software, hosting infrastructure — up front. Many of these up-front expenses don’t get recognized over time in the income statement and therein lies the rub: The timing of revenue and expenses are misaligned.”

This effect is displayed graphically in Charts 3 and 4 below:

Nevertheless, as can be seen clearly from the chart above, the major benefit of subscription pricing is that it provides a much steadier, more predictable cash flow cycle, which in turn can be of great help when it comes to financial planning. This helps to explains why the vast majority of SaaS products are priced on a subscription/monthly basis.

Benefit No. 3: Create and Charge for Network Effects

Another important pricing benefit of SaaS products is that, since these lend themselves well to network effects, this has useful implications for pricing. To be clear, when we say that SaaS “lends itself well to network effects,” what we mean is that a) SaaS can be an enabler for creating network effects, and b) SaaS as a delivery mechanism is often more practical for activities that benefit from natural network effects already. Before moving on to looking at the pricing implications of this point, we delve a little deeper into how SaaS lends itself well to network effects.

SaaS as a Powerful Enabler of Network Effects

As mentioned, the specific attributes of SaaS products often mean that these can be powerful enablers for network effects. Specifically, there are three reasons:

1) SaaS makes for good collaboration software, since it is delivered over the internet.

By using the internet, rather than locally hosted delivery, SaaS software allows people to collaborate in real time (e.g., Google Docs) and view things simultaneously. It also avoids interoperability issues between different users (perhaps due to their operating systems), again making for easier collaboration.

As pointed out here, the ease of collaboration for SaaS products is “why collaboration is one of the most heavily populated and fastest-changing SaaS categories.” Examples of companies in this space include services like Campfire for team collaboration, Basecamp for project management, AnyMeeting for web conferencing, Vidyo for video conferencing, Box for storage, and Google Apps for productivity.

2) SaaS makes it easier to work with external sources, since there are fewer interoperability issues.

Most businesses have to interact with multiple third parties, be it vendors, suppliers, freelancers, etc. When software is used to work together, interoperability of this software becomes an issue. SaaS solves this by removing interoperability (aside from interoperability at the browser level, which is fairly minimal in most cases). As outlined here, “there is the obvious one which is actually connecting businesses to each other. For instance, if your are in purchasing management and you connect companies to possible suppliers, such as Kinnek does. This creates market place like network effects where more suppliers create more value buyers and vice versa.”

A corollary to this is that, since SaaS is relatively easy to set up and get running, it adds less friction when convincing other parties to run the same software as you, which again makes it easier to create network effects.

3) SaaS allows for data-enabled network effects.

Since SaaS allows for real-time data tracking, it can also lead to so-called data-enabled network effects. In this fascinating blog post by Tomas Tunguz, Venture Capitalist at Redpoint Ventures, he outlines this point (specifically referring to SaaS Enabled Marketplaces) as follows:

“Because SEMs deploy SaaS to both the supply side and the demand side, these companies can develop an exceptional understanding of their market. Access to supplier data and consumer demand provides four key advantages to SEMs.

First, SEMs understand the supply/demand curve at every second […] Consequently, if there is a supply/demand imbalance, the SEM can [step in to] balance the market place.

Second, SEMs understand the operational excellence of their suppliers […] The SEM can better qualify and match supply and demand.

Third, the accumulated data on both consumer demand and supplier performance compounds into a unique data asset that erects a moat around the business.

Fourth, because of the visibility into supply/demand, a deep understanding of supplier excellence, and the ability to identify the right types of buyers and sellers, SEMs benefit from a more efficient go to market.”

The Pricing Benefits of Network Effects

The pricing benefit of the above is that SaaS makes it easier to price products so that network effects are at first encouraged, and later taken advantage of. Specifically, because of the delivery mechanism, SaaS makes it easier to implement pay-per-account or pay-per-user pricing systems.

The benefits of per-user pricing with relation to network effects can be summarized as follows: Since on a per-user basis the cost is relatively low, this introduces little friction for companies to try out a service. If they do so, and assuming they like it, this in turn kicks into gear the creation of network effects. Once the network effects take hold, the companies roll out the SaaS product to the wider organization, which in turn allows the per-user pricing model to “ride” the rollout and capture maximum revenue. In many cases, no discount for large volume is offered because of the “addiction” to the service that the network effect has created.

A good example of the above is JIRA. JIRA is project management and issue tracking software product provided by Atlassian, a $6 billion Australian SaaS products company. JIRA allows developers to document and review bugs and other issues, as well as to perform project management functions. The more people who use JIRA, the more valuable JIRA is to each user.

As a result of this, JIRA’s pricing reflects the network effects. As the number of users using the product increases, the per-user pricing actually increases. For a small team of ten people, per user pricing is $10 while at fifty people, per-user pricing increases to $50, which is a fivefold increase (Table 2).

While the exact effect of this pricing is impossible to know, a quick look at Atlassian’s annual report (page 44 and 49) shows that subscriber revenue increased by 1200% ($12.24 million in 2014 to $146.66 million in 2016) while its customer numbers increased 80% (37,250 in 2014 to 60,950 in 2016). A simple math shows that if pricing stayed same, Atlassian’s revenues would be only $22 million due to an 80% increase in number of customers. In other words, thanks to changes in its pricing, Atlassian generates an additional $124 million ($146 million – $22 million) per year!

The overall point of charging for network effects is summarized nicely in this academic paper: “The presence of network effect also favors pay-per-use over perpetual licensing; if the network effect is strong, pay-per-use will always dominate perpetual licensing regardless of the inconvenience cost or the potential piracy. With more heterogeneous consumers, higher potential piracy, lower inconvenience costs, and stronger network effects, pay-per-use licensing yields not only higher vendor profits but also a higher social surplus than perpetual licensing.”

Benefit No. 4: Freemium – Pricing as a Marketing Strategy

Freemium is a marketing strategy where a part or all of the product is offered with zero pricing for unlimited time. The “-mium” portion of the word “freemium” refers to “premium,” where the user of the free product could upgrade to a premium product, i.e., pay for the product. Freemium is offered in the hope that some of the users of the free product would upgrade to premium, but this offer is for unlimited time, so the users can upgrade whenever they please.

The benefits of freemium are summarized nicely in this Harvard Business Review article:

“Several factors contribute to the appeal of a freemium strategy. Because free features are a potent marketing tool, the model allows a new venture to scale up and attract a user base without expending resources on costly ad campaigns or a traditional sales force. The monthly subscription fees typically charged are proving to be a more sustainable source of revenue than the advertising model prevalent among online firms in the early 2000s. Social networks are powerful drivers: Many services offer incentives for referring friends (which is more appealing when the product is free). And freemium is more successful than 30-day free trials or other limited-term offers, because customers have become wary of cumbersome cancellation processes and find indefinite free access more compelling.”

The pertinence of this to the SaaS model is that freemium only works if the cost of delivering the service for free is marginal. If not, freemium is unlikely to work from a financial standpoint. Fortunately for SaaS, this is one of the inherent benefits of the delivery mechanism (Chart 5).

As such, SaaS lends itself very well to offering freemium pricing. This point is summarized nicely in this post,

“For the freemium model to work out, one specific product attribute must already be in place – low marginal distribution and production cost. Only if you can keep the cost as low as possible, an additional free user will cost you nothing more than a database entry […] this is an inherent characteristic of SaaS products”

A company that has a great freemium SaaS offering is Slack, which has over 4 million daily active users at the moment. Out of these users, 1.25 million are paid but the remaining 2.75 million are using the product for free. Pricing does not prevent them from using the product and makes them potential paid users in the months and years to come. In other words, many leads are acquired thanks to zero-dollar pricing.

Slack seems to be benefiting from its freemium structure, with a 30% claimed conversion rate. In other words, of the 2.75 million users who are using Slack for free, 800,000 are expected to become paid users in the future. That is lots of additional recurring revenue; to be somewhat precise, at $6.67/month/user with its cheapest paid plan, that is an additional of $5.3 million in revenue per month.

Not all products are created equally; thus, each product could have a different freemium offering and conversion rate. For example, while Spotify has a 27% freemium to premium conversion rate, Dropbox has a rate of 4%. Therefore, each company should figure out whether freemium is doable. Nevertheless, as Ben Chestnut, co-founder of MailChimp, puts it, Ben & Jerry’s free ice cream day showed that freemium could be quite powerful and has been for MailChimp since they started offering it, eight long years after they founded the company.


N.B. In this article, Freemium is defined as offering a product to a customer for unlimited time. A free trial is defined as offering a paid product to a customer for a given time. A free trial is not considered freemium, as it cannot be offered indefinitely. To further read the implementation of freemium and free trials, please check out this article from Lincoln Murphy.


On Cloud Nine

As more and more companies switch to cloud-based provision of services, the shift to SaaS from On-Premises software is likely to continue at a steady pace. And we think this is a good thing. Startups will find it easier to offer the same services that larger, more established companies have only been able to do thanks to large investments in in-house capabilities. Consumers will have greater flexibility to find products that balance their needs with their wallets. In other words, SaaS creates win-wins across the spectrum.

As SaaS technology and our understanding of its benefits develop, we expect to see more pricing models emerge to take advantage of this unique model. The examples above are not exhaustive, and are just a reflection of the types of pricing implementations used in the SaaS world, but I hope this article may serve as a guide for continuous pricing challenges and opportunities.

This article is originally posted in Toptal.


Selling Your Business? Stop Leaving Money on the Table

Key Highlights

  • Current market conditions are prime for selling a business. The market is experiencing high multiples due to plentiful dry powder held by private equity firms, record amounts of cash held by strategic corporate buyers, a low interest rate environment, and high prices for publicly-traded equities.
  • The time it takes to sell generally ranges from five to twelve months. The determining factors around timing include the size of your business and the dynamic balance between buyers and sellers in the market.
  • Valuations are more of an art than a science. The best business valuation methods typically involve cash-flow. Still, the three most commonly utilized valuation calculations are the discounted cash flow, market multiples, and asset valuation.
  • The best practices for maximizing shareholder value include the following:
    • Make sure the business can thrive without you. You need a management team or key employees that can continue to drive cash flow, especially if you plan to exit the business or will have limited involvement in day-to-day operations. You should also broaden your customer base so that the business is not at risk if a couple key customers leave post-sale.
    • Learn the dynamics driving acquisitions in your industry. Many business owners spend their time focused on keeping the business running instead of devoting energy to planning for its sale. Stay apprised of the motivations for financial and strategic buyers in your industry, as this can help you negotiate a higher exit value.
    • Hire the right advisors. Don’t do it alone. An experienced M&A advisor can market your company to a larger group of potential buyers than you can access on your own. Early engagement of an independent valuation specialist can provide a market check on valuation and allow you to incorporate value drivers into your pre-sale planning.
    • Examine and adjust operational efficiencies strategically. If necessary, it could be worth adopting efficient operating procedures before the sale. This may involve investments in new equipment or technology or changes in staffing.
    • Factor tax considerations into sale decisions. Decisions around how to sell your business (merger, sale of stock, sale of assets) should consider tax implications carefully. It is also important to anticipate changes in tax law.

Investing in the Sale

For many business owners, their business represents the culmination of their life’s work and a primary source of wealth. The reasons leading one to sell a business can vary—perhaps a competitor has presented you with an unsolicited, lucrative offer. Or, perhaps you are simply ready to retire. Regardless of your motivation, the sale process can prove to be complex, with considerations including the right time to sell, whether or not to employ advisors, which business valuation method to use, and how to maximize the valuation. Therefore, when thinking about how to sell a business, you will want to maximize the value through a combination of planning and timing. Building a solid exit plan can take several years, and business owners ideally should start planning for a sale 3-5 years before they wish to transition out. You’ve invested in growing your business. When it comes time to sell your business, you must do the same.

The following analysis will help you understand the current acquisition market environment, how long it takes to sell businesses (small and large), other major considerations during the sale, how an accurate price is determined, and how to maximize acquisition value.

Current Market Conditions for Selling a Business

Currently, with acquisition multiples at a record high, market conditions are optimal for selling a business. According to PitchBook, the median EV/EBITDA multiple hit 10.8x in 1Q 2017, a significant difference from the 8.1x multiple in 2010.

Chart 1: US M&A (Including Buyouts) Transaction Multiples

The following factors have converged to create a robust market for acquisitions with high acquisition multiples:

Record “Dry Powder” Held by Private Equity Firms

Research company Preqin reports dry powder for private equity buyout funds of $530 billion at the end of 1Q2017, a significant increase from the recent low of approximately $350 billion at the end of 2012. Further, new fundraising by private equity fund managers shows no signs of slowing. In the early part of 2017, Apollo was seeking $20 billion for a new fund, and KKR had raised $13.9 billion for its new fund.

Private Equity Dry Powder by Fund Type and Limited Partners Opinion on Private Equity

Strategic Corporate Buyers are Holding Record Amounts of Cash

According to Factset, US corporations held $1.54 trillion in cash reserves as of the end of 3Q2016, the highest total in at least ten years, and a dramatic increase from the $700+ billion figure reported in 2007. Of this, much is held overseas, and if repatriated, a portion may be used for acquisitions.

For a strategic buyer, acquisitions can deploy cash reserves and generate returns in excess of corporate treasury bank accounts and investments. Corporations also seek acquisitions that create operating efficiencies or bolster their position in consolidating industries. Consequently, strategic buyers often pay a premium for acquisitions compared to financial buyers such as private equity firms.

Low Interest Rate Environment

Those interested in selling a business benefit from low interest rates, as they directly affect acquisition prices. Duff & Phelps, which publishes a widely-used study of the cost of equity capital, incorporates the ten-year trailing rate on the 20-year Treasury bond in its benchmark figure. The 3.5% figure reflects the low yields of the last ten years. Duff & Phelps’ comparable rate at the end of 2008 was 4.5%. At the same time, the equity risk premium also decreased, from 6.0% to 5.5%.

High Prices for Publicly-traded Equities

Business values are often determined with reference to public equities, and with the S&P 500 and NASDAQ at or near record levels, those looking to sell a business benefit from a comparable increase in prices.

All of these factors have led to an acquisition market ideal for selling a business. Large acquisitions have recently been made for eye-popping prices. Over the past year:

  • JAB Holding Company offered to acquire Panera Bread for $7.5 billion, approximately 19.5x Panera’s EBITDA according to Nation’s Restaurant News.
  • Private equity owned Petsmart acquired pet product site Chewy in the largest acquisition of a VC-backed internet retailer. Chewy is one of the fastest-growing eCommerce retailers on the planet.
  • Unilever acquired Dollar Shave Club in 2016 for $1 billion, paying 6.67x 2015 sales and 5x projected 2016 sales.

Despite these favorable conditions, selling a business still requires advance planning and thought. Numerous factors can positively or negatively affect the value of your business. Addressing these issues early can be beneficial when it comes time to sell.

How Long Does Selling a Business Take?

The duration of the sale process varies. One determining factor is the size of your company. As of the end of 2016, the median time a small business was on the market was a little over 5 months (160 days), down from a peak of 200 days in mid-2012. For larger companies, the sale process can take between 5 and 12 months, as indicated below.

Chart 4: Average Number of Months to Close One Deal

As a business valuation expert, my experience is much the same. The owner of a larger business is more likely to employ a M&A advisor to sell the business, and the advisor is more likely to conduct an auction process to maximize the business value. In addition, as the business becomes more complex, the involvement of more people can lengthen the due diligence process. I have led due diligence teams in large acquisitions where we regularly conducted meetings with as many as fifteen people, including specialists from various departments. Inevitably, inboxes became crowded and the frequency of meetings increased. It became more difficult to ensure that everybody involved was on the same page.

The time it takes to sell your business is also based on the dynamic balance of business sellers and business buyers in the market. The importance of this is particularly pronounced in the small business acquisition market, as seen in the chart below. In 2012, fewer buyers had the resources to buy a business, and acquisition financing from banks and other lenders was still negatively affected by the 2008 financial crisis. As the number of buyers and availability of financing increased, the demand by buyers increased, and median time to sell a business decreased.

Chart 5: Median Days on Market over Time

Considerations in Determining When to Sell Your Business

Your Motivations for Selling

In general, the value of a business is equal to the sum of all expected future cash flows. When the value of the offer is greater than your projected future value of the firm, it’s time to sell.

“Value” can have many meanings. For one, the business may hold financial or strategic value that makes it compelling to an acquirer. Alternately, the business owner may have other financial uses for the sale proceeds—if the return on the alternative investment is higher than on the business, it’s also time to sell.

However, there can be non-financial motivations for selling a business. I frequently see business owners who have spent a significant portion of their lives building a business and are simply ready to move on to the next venture. Others sell for lifestyle reasons: a former client sold several businesses over 20+ years to fund his travels around the world. Had he agreed to stay with these companies post-sale, he would have received higher valuations. Still, the flexibility to travel and pursue adventures remained his priority.

This is consistent with seller surveys. According to a 2016 survey, the top motivation for small business owners to sell their businesses was retirement (40%), followed by burnout (21%) and the desire to own a bigger business (20%).

Top Motivation for Selling

Business Growth

Above all else, a buyer wants assurance that the cash flows paid for will be realized after the sale. Selling a business will be easier, and the value received by shareholders maximized, if the business is growing and profitable. The ideal time at which to sell a business is when cash flow, growth, and consequent valuations are going to peak. When a seller or buyer anticipates a decline in the rate of growth, it could result in a significant drop in value. As you might expect, this is not a recommended time to pursue a sale.

The importance of growth to business value and sale timing can be illustrated by the Constant (Gordon) Dividend Growth Model: Value of the Stock = Dividend / (Required Rate of Return – Expected Dividend Growth Rate)

Let’s apply this formula to an example. If a business pays $1 million in dividends, and the required rate of return is 13.5%, a business that has no dividend growth, all other factors held constant, would be worth approximately $7.4 million. On the other hand, if the same business is expected to grow 1% per year, the value increases to $8 million. For a company that does not pay dividends, the same principle can be applied to cash flow. In this example, each percent increase in expected growth leads to an 8% increase in value.

Tax Considerations

Just as the legal form of business at a business’ inception is determined by tax considerations, when it comes time to sell a business, the choice among a merger, sale of stock, or sale of assets should also factor in tax implications.

For example, a sale of assets will likely result in capital gain or loss treatment, whereas an employment agreement results in ordinary income and is taxed at a higher rate. Even in a sale of assets, you should allocate the purchase price among assets in a tax-efficient manner. An allocation to inventory or short-lived assets will typically result in more favorable tax treatment than an allocation to real property or goodwill.

Even expectations of a change in the US tax laws can impact the sale of businesses. If the current presidential administration were likely to simplify the tax code and decrease the capital gains tax rate, business owners would likely wait to sell. When I’ve experienced cases such as these, the running joke among M&A professionals was that business sellers would likely live on artificial life support in order to survive into the new tax year and reap higher net proceeds.

Buyer Motivations

The market for acquisitions is dynamic. An owner or manager seeking to sell a business should be aware of industry-specific developments and direct their selling efforts to leverage those trends.

In my acquisitions work for an insurance company, our growth strategy was to acquire companies in markets that were overseas and less competitive. We also focused on acquisitions that would add internet sales to our existing team of insurance agents. Some of our competitors were seeking similar acquisitions. Business owners aware of those industry dynamics were able to develop a business sale strategy based on these dynamics, maximizing shareholder value.

Here are additional examples of industry-specific strategies:

  • A fast-growing business in a slow-growth industry should focus on strategic buyers seeking high growth. In May 2016, food company Hormel paid $286 million for Justin’s, a fast-growing producer of organic nut butters.
  • Companies with a younger customer base can be good acquisitions for established companies in the same space. Wal-Mart recently sought to expand its customer base to younger consumers by spending $200 million on eCommerce startups with direct-to-consumer models, including Jet.com, Moosejaw, Shoebuy, and ModCloth.
  • For private equity buyers, businesses that lead to increased sales, lowered overhead, and increased gross margins continue to be attractive. These buyers are attracted to assets with considerable scope for optimization and efficiency enhancements.
  • For strategic buyers, decisions about capital investments are often made by comparing build vs. buy options. A business that enables a strategic buyer to reach its financial or strategic goals will always have a pool of potential acquirers.

The Value of Advisors

In selling a business, you may be tempted to cut costs and undertake the task alone. However, the utilization of experienced M&A lawyers is always advisable, as contracts allocate the risk of the transaction between parties, and often contain detailed financial terms. Retaining an M&A advisor can also lead to a higher price for the sale of a business. Additional advisors such as accountants or technology and human resource specialists can also add value in specific situations.

As a financial consultant, I worked with a business owner who initially attempted to sell his business on his own by generating his own list of competitors and other potential buyers. After failing, he assembled a team of lawyers and M&A advisors late in the process. Ultimately, this unsuccessful sales attempt tarnished the sale process and raised questions about the value of the business, ultimately leading to a 25% lower sale price. In addition, the owner, who was originally interested in remaining with the business post-sale, was forced to sell to a financial buyer with a different strategic vision. He was soon forced out of the company. Though this was an extreme case, I cannot overstate the importance of building out an experienced team of advisors.

Financial Intermediaries

The two types of financial intermediaries include a) M&A advisors, and b) business brokers.

Business brokers are generally involved in the sale of smaller firms (typically with values of under $5 million). Many business brokers list businesses for sale in an online database with basic information but do not proactively call potential acquirers. With transactions of this size, the broker faces more difficulty “fully marketing” the transaction and contacting a large number of potential strategic and financial buyers. Compared to business brokers, M&A advisors handle larger transactions and engage in more pre-transaction business planning. They also contact a wider variety and larger number of potential buyers.

The Benefits of Using a Financial Intermediary Include:

  • Reduced time and attention necessary from the business owner. The process of selling a business can often last between six and twelve months. Most business owners don’t have the time or ability to supervise each stage of the process without diverting needed attention away from current business operations.
  • Buffer between buyer and seller. This is especially important in situations where the seller of the business is seeking to keep its plans confidential; an intermediary can solicit interest on a “no-names” basis.
  • A level playing field between novice sellers and experienced buyers. Especially with financial buyers or active strategic buyers, the difference in knowledge of the acquisition process can be vast. Private equity buyers can buy dozens of businesses each year, and the most active strategic buyers, such as Google, can acquire 10+ companies in a year. A business owner selling a business will have trouble competing in knowledge.
  • Network of potential buyers and knowledge of marketing pitches. An experienced financial intermediary with a strong network and marketing knowledge is well-positioned to generate interest in your business. If successful, the price at which you can sell your business will be enhanced by creating competition among buyers in an auction process.
  • Experience with the due diligence process and legal documentation. The due diligence process whereby buyers examine the books and records of the business being sold, can be too time-consuming and complex a task for business owners to undertake themselves. In addition, experienced financial intermediaries help create a transaction structure and collaborate with attorneys on legal documentation.

The Drawbacks of Using a Financial Intermediary Include:

Price

Financial intermediaries can either charge a fixed transaction fee, a retainer, or both. The business seller will also be responsible for the expenses of the intermediary.

  • Business broker fees are generally in the range of 10% of the acquisition price. They typically do not charge a retainer, and fees are only paid upon the sale of the business.
  • Fees for M&A advisors vary more widely. The fixed transaction fee for selling a business generally starts in the $40-60,000 range, and many advisors base their “success fees” on the “Double Lehman” formula: 10% of first $1 million of transaction value, 8% of second $1 million, 6% of the third $1 million, 4% of the fourth $1 million, and 2% of everything above that. According to a 2016 survey, typical middle market transaction fees were as follows (based on percentage of transaction value):
    • $10 million 3.5% – 5%
    • $50 million 2% – 3%
    • $100 million 1% – 1.5%
    • $250 million 0.75% – 1%

You should align your incentives with those of the intermediary. If an advisor’s retainer is disproportionately high, their incentive to complete a deal is lessened. In these cases, the business owner should resist fee arrangements that include a relatively large up-front fee. On the other hand, if the “success fee” is disproportionately high and the advisor only receives significant compensation upon a sale, it creates an incentive for the advisor to complete a deal—even a bad one.

Disclosure of sensitive information

An M&A advisor may contact hundreds of potential buyers and circulate confidential business information in an effort to create a robust auction and maximize business value. The mere disclosure that the business owner is considering a sale can significantly impact customers, competitors, and employees. An experienced advisor can limit the risk of confidential information being disclosed.

Independent Valuation Experts

Retaining an independent valuation expert can maximize value, especially when used in conjunction with an M&A advisor. With a large percentage of M&A advisor fees being paid only if a transaction closes, the M&A advisor experiences an inherent conflict of interest. That is, a business cheaply valued will sell more quickly than one that is fully valued. An independent valuation expert provides the business owner with a second opinion and a market check.

As with employing a financial intermediary, the downside of retaining an independent business valuation expert is price. They can also lengthen the sale process. For many businesses, an appraisal can cost between $3,000 and $40,000 and take 4-6 weeks, although more cost-effective options are available for smaller companies. Valuations of larger or more complicated business can take months and be far more costly.

The involvement of experienced merger and acquisition lawyers is critical. After all, structuring a business sale transaction and negotiating the documents are exercises in risk allocation. These documents ensure that the seller will receive the full amount owed to them and will have limited liability post-sale, while also ensuring that buyers receive the value from the acquisition.

To counter typical buyer protection provisions such as representations and warranties or noncompetition and nonsolicitation agreements, experienced legal advisors can help you obtain favorable terms and secure protections for you. This is especially important if you are selling to a business of much larger size, which would inherently have more negotiating power.

Figure 1: M&A Parties and their Advisors

Determining the Right Price

Over the years, I’ve come to find that business valuation is as much art as science, as evidenced by the fact that 27% of business sale transactions don’t close. Of those that don’t close, 30% fail because of a gap in valuation. However, experts generally agree that there are three primary methods of business valuation: discounted cash flow, market multiples, and asset valuation.

Chart 7: Reasons for Business Sales Engagements Not Transacting

While all of these methods can prove useful in the right situation, valuing earnings or cash flow will generally provide a more accurate view of the value of the business being sold. Even better, a business owner selling a business knows of an identical business that has been recently sold and knows the price that it has been sold at.

Chart 8: Determining the Right Price

Discounted Cash Flow and Capitalization of Earnings Methods

Absent a recent comparable business sale for benchmarking, discounted cash flow or capitalization of earnings valuation methods can be utilized. On one hand, discounted cash flow models are typically used to model growing businesses, and they estimate pro forma projected cash flows for a reasonable period into the future. These are then discounted back to the present using a market-derived discount rate. Capitalization of earnings models, on the other hand, are used for businesses where future growth is difficult to estimate. This method’s valuations take pro forma earnings and divide them by a capitalization rate.

The pro formas are adjusted for unusual or nonrecurring events and are intended to normalize the numbers. For example, with private companies, it’s not uncommon for executive compensation to vary from industry standards. The model should be adjusted to reflect compensation levels that would be more typical. Similarly, private companies may have contracts with other companies also owned by the owner, and the pro formas should include adjustments if those contracts vary from industry norms.

It is important to note that the appropriate discount rate can be difficult to determine. The discount rate always starts with the “risk-free rate,” a long-term US Treasury bond, and is adjusted upward to take into account the extra risk of buying a business. An equity risk premium is then considered, available from sources such as Duff & Phelps, and may create an additional premium for a smaller company or a company in a more uncertain industry. On top of those adjustments, the discount rate may be adjusted even higher on the basis of “rule of thumb” estimates that the business appraiser believes are appropriate to determine the true risk of the company.

Market Multiples

The starting point for a market multiple valuation is a public company in the same industry. Multiples such as price-to-earnings, price-to-sales, price-to-EBITDA, and price-to-book are widely available from sources such as Bloomberg and Google Finance. The multiples for the public companies are then applied to the appropriate data for the business being valued. Adjustments to the resulting number are then applied to account for the difference in liquidity between publicly traded stock, which can be sold easily, and a controlling interest in a company, especially if it’s privately held.

Though high public comparables are great for owners selling their business, they may not reflect the actual value of the company. This is because the prices for public stocks are strongly influenced by general stock market sentiment and investor enthusiasm for sectors that are currently in favor. For example, a technology company will currently have higher market multiples than companies with similar business prospects because of keen investor interest in stocks in the technology sector. In addition, business valuation experts relying on market multiples often find it difficult to develop an appropriate group of public companies. A business valuation that starts with a broad group of comparable companies may not truly reflect the value of the company being sold.

Asset Valuation

The asset valuation method of valuing a company being sold is generally limited to holding companies or asset-rich companies since the value of a business’ assets have little to do with the company’s future cash flow generation. In the case of a holding company, the value of the company is made up of a collection of other corporations or equity or debt investments. Each asset may have its own policy about cash flow distributions to the holding company, so a discounted cash flow valuation is meaningless.

However, exceptions exist with energy or commodity companies. In the case of natural resource companies, cash flow is important, but the value is ultimately determined by the company’s assets underneath the ground. Similarly, a gold company may provide cash to its owners on a regular basis, but its gold is the most important value driver. The price of gold decreasing from $1,850 per ounce in 2011 to $1,200 per ounce in 2017 will outweigh any change in dividend policy by management.

Maximizing Shareholder Value

A significant portion of businesses that are offered for sale eventually don’t sell. As mentioned previously, one of the major causes is the gap between what the owner believes the business is worth and the price the buyer is willing to pay. Oftentimes, this is because an owner has focused too much on business operations, and not done enough to research or plan for its eventual sale. To avoid this issue, implement the following best practices:

Create a Deep Management Team

The common advice for employees is to “make yourself indispensable”—that is, contribute so much that you become irreplaceable by others. However, for business owners, the best course of action is the opposite: you should ensure that the rest of the team can operate without you. Though you may have been the main point of contact with key customers for years, consider delegating and transitioning these relationships to your team. Otherwise, if and when you leave, there is no guarantee that these clients will stay with the company. The risk of losing important sources of revenue or supply can significantly reduce a purchase price or lead to a failed transaction.

Examine and Adjust Operational Efficiencies Strategically

Examine your current business practices and, if necessary, adopt efficient operating procedures before the sale. This may involve investments in new equipment or technology, or it may mean adding or reducing staff. For example, buyers will be less interested in a business that diverts the time of highly-compensated employees towards tasks that can be done more cost-effectively by others.

I have been involved in many transactions where the pro forma financials and resulting purchase price are adjusted to account for needed or excess employees. If a buyer senses a risk that efficiencies and cost savings are not achievable, they will adjust the purchase price downward. Therefore, implementing these measures before a sale reduces can help justify a higher valuation.

Broaden Your Customer Base

For most businesses, sales revenue dictates the majority of its value. Buyers will always examine the business’ customer base and evaluate the risk of customers leaving after the sale. For businesses with a concentrated customer base, the risk of losing of one or two customers can place downward pressure on the purchase price. You should broaden the customer base to reduce reliance on a small number of key customers.

Alternatively, if you are heavily reliant on a single distribution channel, diversifying the distribution of products or services can also help maximize value. Multiple sources of revenue are always going to lead to a higher valuation.

Build Out Robust Financial Reports and Systems

Buyers need to rely on accurate financial statements and systems to assess the financial performance of a business. I’ve seen many large and complex businesses lack robust accounting and financial processes, relying too heavily on basic financial systems. This represents a risk to buyers. Ultimately, if the buyer can’t rely on the seller’s numbers, the buyer will either adjust the purchase price downward or cancel the transaction completely.

Buyers prefer seller financial statements that are audited by a high-quality, independent, auditing firm. Many business owners use local accounting firms when they start their businesses, and stay with them as the business grows. As a result, the numbers may not properly incorporate procedures that would be used by a larger firm specializing in business accounting. The inability to provide comprehensive and professionally-prepared statements to a buyer might reduce the value of the company.

Conclusion

As a business owner, you have undoubtedly devoted a substantial part of your life to building your business. The decision to sell your business can be simultaneously scary and liberating. Richard Branson recently provided an interesting account of his decision to sell Virgin Records:

“Selling Virgin Records was one of the most difficult decisions I’ve ever had to make. But it was also a necessary and calculated risk. I had never even thought about selling Virgin Records. In fact when EMI made their offer of $1 [billion] in 1992 we had just signed the Rolling Stones which was something we’d been trying to do for twenty years. We had begun life as a small start-up, growing on the back of the success of Mike Oldfield’s Tubular Bells. From a tiny start-up, we grew into the biggest independent record label in the world.

But at the time of this offer we were going through expensive litigation in a court case against British Airways (which we eventually won) following their ‘dirty tricks’ campaign. If we had carried on running both companies they both would have closed…[B]y selling Virgin Records we left both companies in strong positions and kept a lot people in their jobs. Both businesses are still thriving today.”

Investing in advance planning for the sale of your business is critical to realizing a return on the resources you have already put into it. It is natural to think that the time to properly position and sell your business is an unnecessary burden. However, this time is crucial for enhancing the sale price and ultimately helping you realize the full value of the business. The combination of the right team and adequate investment of time can be the difference between simply closing up shop and maximizing a source of future wealth.

Like Branson, whether you choose to spend this future wealth on a remote island in the sun or on your next venture, well, that’s up to you!

This article is originally posted in Toptal.


Choosing the Right eCommerce Business Model to Sell Your Product

The shift from offline/brick-and-mortar retail to online eCommerce is a trend that has garnered attention and commentary for much of the last two decades. What was once a niche market focused on selling a few select products and services has ballooned into a nearly $2 trillion industry whose influences dominate the retail industry in more ways than ever before.

Despite the noise, penetration of overall retail sales continues to be in the sub-10% range, particularly outside of the US. Calls for a radical transformation in the retail industry so far have largely not been borne out, and offline retailers have over the last 10-15 years continued to do well. In fact, the list of the world’s largest retailers continues to be dominated by offline retailers, or retailers who were born offline and continue to derive most of their sales from physical retail locations.

However, while evolve-or-die style calls for strategic shifts to eCommerce may have in the past been overblown, recent data and news suggests that this issue is perhaps more pertinent than ever before. A recent article in the New York Times for instance highlighted that “store closures […] are on pace this year to eclipse the number of stores that closed in the depths of the Great Recession of 2008.” Similarly, retailers are going bankrupt at record rates, and “in a little over three months, fourteen chains have announced they will seek court protection […] almost surpassing all of 2016.”

Image of Chart 1

Online shopping has moved to the top spot among the drivers of this change. As Credit Suisse’s Christian Buss points out, “Today, convenience is sitting at home in your underwear on your phone or iPad. The types of trips you’ll take to the mall and the number of trips you’ll take are going to be different.” And the data bears this out. Whilst offline store closures accelerate, eCommerce continues to grow at a steady and accelerating pace. In fact, “between 2010 and 2014, eCommerce grew by an average of $30 billion annually. Over the past three years, average annual growth has increased to $40 billion.”

All evidence points to this trend continuing. Oliver Chen, an analyst at Cowen & Co., claims that “while high-end malls continue to perform well, the exodus away from brick-and-mortar stores is taking a toll on so-called C- and D-class shopping centers […] There are roughly 1,200 malls in the U.S., and those classes represent about 30 percent of the total.”

With the above in mind, retailers—or product manufacturers looking for retail distribution—are looking more than ever before to establish meaningful online distribution channels. Perhaps the best example of this emerged in recent days, when Petsmart announced its acquisition of Chewy, a relatively unknown petcare eCommerce company, for $3.3 billion, making it the largest acquisition of an eCommerce retailer ever.

I recently worked with a client who was facing this dilemma. The client is a manufacturer that sells its products through a number of retail channels, with a large proportion of its sales dominated by one of the top brick-and-mortar retail names in the US. It operates in a market that had been slow to migrate to eCommerce at any significant volume, but now appeared poised to do so at an explosive rate, with venture capitalists funding ambitious new startups and Amazon growing its range in the category. My client was anxious not to get left behind.

This article aims to highlight how businesses considering a shift to selling online should be thinking about their options, primarily from a financial standpoint. Drawing upon the example of my client, I run through the various options and the financial implications each option is faced with. The article is written primarily with producers/manufacturers in mind. If you manufacture a product, and want to sell it online, this article is for you.

The Options

At a high level, there are basically four different options for selling online, and these were the options we evaluated for our client.

Option 1: Direct-to-Consumer

Direct-to-Consumer (DTC) is probably the more commonly known type of eCommerce model. As the name implies, DTC involves selling directly to the end customer, through your own website, thus bypassing any middlemen that would normally enter the retail chain.

In a DTC model, the business in question would establish the website, generate traffic to the site, and have full control over pricing and positioning, enabling them to sell to the customer without having a retailer take a margin. The model is displayed graphically in Figure 1 below.

The DTC model has in recent years been gaining ever more traction amongst product manufacturers and service providers. Household consumer brands such as Nike and L’Oreal are using “‘portable’ eCommerce experiences, mobile apps with in-store beacons, and digital out-of-home digital media networks to extend the engagement started on eCommerce websites into the store and deliver an expanded choice of personalized offerings at the point of sale.”

Option 2: Selling as a Private Label Supplier

Another option would be to sell the product private label to a third party who is either already online or moving online. Shopify provides a nice definition of what private label means:

“A private label product is manufactured by a contract or third-party manufacturer and sold under a retailer’s brand name. [The] retailer […] specif[ies] everything about the product—what goes in it, how it’s packaged, what the label looks like […] This is in contrast to buying products from other companies with their brand names on them.”

This is the simplest option of the four, since it involves no brand building or marketing efforts. All of these are taken care of by the retailer. In fact, depending on the agreement with the retailer, many of the product specifications might themselves be set by the retailer.

Private label is a very successful strategy in many industries, particularly food and beverage. Euromonitor for instance points out that “US fresh milk […] was the largest private label market globally in 2014. With value sales of USD $14.5 billion, it is a large market, and private label accounted for 67% of total sales, or USD $9.7 billion.” Many retailers sell private label products, for instance Walmart’s Great Value brand, or Costco’s Kirkland Signature products.

Option 3: Selling Wholesale to a Retailer

A third option would be to sell one’s product wholesale to a third-party retailer who is already online. This is very analogous to how things are done in the brick-and-mortar space and would probably involve much of the same unit economics for both parties.

In this option, all the marketing and distribution would be taken care of by the retailer, whereas the branding would be the responsibility of the producer. Final retail pricing would also be established by the retailer, but clearly influenced by the wholesale price that the manufacturer charges. Contrary to the private label option, the manufacturer has most of the control over the product specifications and design (although of course, large retail companies may influence these to a certain extent if they hold strong power of the supplier’s sales).

The most famous third-party retailer in eCommerce is of course Amazon. Selling to Amazon at wholesale, in the same way as you would sell to a traditional brick-and-mortar retailer, would mean letting Amazon take care of how many units they could sell to consumers at their retail price.

Option 4: Selling on an eCommerce “Marketplace”

The final option involves selling an an eCommerce marketplace. An online marketplace is a website which puts buyers and sellers together and acts as the platform through which these two parties transact. The Balance provides a nice definition of this:

“Unlike conventional eCommerce websites, marketplaces transfer the burden of maintaining inventories, logistics, images, product descriptions, and pricing to the seller. There is more than one operational model for marketplaces, but the most common method involves marketplaces being merely an order booking mechanism.

Marketplaces display the seller’s wares, collect orders and payments, forward orders to the seller, track delivery, and release payment to the seller after deducting a fee.”

Perhaps one of the most famous marketplaces is eBay. Founded in 1995 as an online auction website, eBay became one of the biggest and earliest marketplace successes in the eCommerce space. Today, there are many marketplaces, including Amazon which operates a dual eCommerce model of “vanilla eCommerce” as well as a marketplace model.

Summary

To summarize, the four options above vary primarily in the amount of responsibility shared between the producer and the retailer in marketing, branding, and distribution. The table below summarizes the options.

Financial Evaluation of the Options

There are pros and cons to each of these options, and the relative merit of each option depends on a number of factors, such as appetite for risk, ability to absorb early losses for long-term gains, and ability to invest in your brand upfront, which depends on access to capital.

Fundamentally though, all options come down to a tradeoff between the following two factors:

  1. The EBITDA and margin assumptions and implications of each option
  2. The volume and growth assumptions and implications of each option

The analysis below runs through the unit economics of each scenario, using my client as a case study for the analysis.

Benchmark: The Traditional Business

Let’s start by looking at the way my client traditionally sells its product to retailers. For sake of our analysis and simplicity, let’s refer to my client as “Manufacturer, Inc.” Obviously, the retailer makes a margin, selling the product to the consumer for more than it pays to Manufacturer, Inc. The principal retailer that my Manufacturer, Inc. deals with is a low-margin, high-volume player so that margin is smaller than you might see in many places.

The other thing worth noting is that this is a business with a fairly high return rate, at 24%.

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Option 1: Direct-to-Consumer (DTC)

Under this model, Manufacturer, Inc. would establish its own website and attempt to drive all its own traffic to that website. It would keep the entire retail price of the product sold. Let’s look at how this affects the unit economics.

Price

There are two elements to this. First, the retail price and the wholesale price are the same. This is the primary benefit of selling DTC. Second, and potentially more important, the producer gets to determine its own pricing and positioning strategy without having to adhere to the retailer’s strategy.

In the case of Manufacturer, Inc., they had a high-quality product that had won lots of praise from consumer magazines, but the retailer was positioning it only to price-conscious consumers. Our market analysis showed “white space” for the quality-conscious young professionals now shopping online. For that reason, we built into our assumptions the strategy of going after the higher end of the market (and therefore a higher retail price).

Unit Production Costs

Overall unit COGS would be about the same as the offline business, but what would change materially would be the retail price (given that we were targeting a higher price segment). Add to that the fact that returns, according to our research, tended to be lower online, and you can see how DTC starts to look very attractive. Manufacturer, Inc. would now be responsible for shipping (whereas in the offline model the retailer picks the product up and ships it to the end consumer), and would have to process credit card fees. But contribution margin still looks attractive.

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Marketing

But if it were so easy, why was Manufacturer, Inc. not selling DTC before now? Or why did they not open their own retail store rather than giving all that margin away? Simply because, as a manufacturer, they did not know how to open a shop and get people into it. That’s what the retail channel partner brought to the table. When selling DTC online, you have to recreate this yourself.

At a high level, there are essentially three types of marketing efforts one can embark on in eCommerce. The following breakdown is an oversimplification of a very complex and multifaceted field, but serves the purpose of illustrating the general approaches one can take:

  1. Paid online advertising: Often referred to as PPC advertising (pay-per-click), this is one of the most commonly used marketing strategies that online retailers employ. There are many types of PPC advertising, and many channels through which you can do it. Some of the more commonly known channels are Google AdWords, Facebook advertising, display advertising, retargeting/remarketing, and video-paid ads such as YouTube advertising. All of these have their specific implications, but generally all share the common factor that the cost of the ads are on a per click (or sometimes per impression) basis.
  2. Organic online advertising: This refers to advertising that is performed through online channels, but where there is no cost associated with impressions or clicks. An example would be social media marketing, where the business in question must build a social media presence, engage an audience, and drive traffic to their site in this manner. Other examples would be blogging and content creation. Finally, one could argue that Search Engine Optimization falls into this category as well.
  3. Traditional brand building:A third type of marketing effort would be traditional marketing aimed at creating brand awareness and loyalty. This could be done either through online channels or through traditional offline channels such as print advertising, television, radio, or billboards. The distinguishing feature here is that these efforts are not aimed at creating direct traffic and referrals to the business’ site, but are aimed at creating brand awareness, and therefore indirect traffic and referrals.

Whatever channel or strategy each business decides upon, the key point is that, in a DTC model, the producer would need to take control of this function. This means that the producer would take on the associated expense, both in terms of direct marketing expense and in terms of indirect expenses such as the cost of labor associated with the marketing efforts.

In the example of Manufacturer, Inc., we determined that PPC advertising would be our primary source of marketing. As such, in order to perform a proper financial evaluation of the options, we had to estimate what the marketing expense would amount to. Below, I run through the analysis we did on this.

We could write an entire separate article on the click economics of this business, but essentially, the cost of each customer is as follows:

cost per paid customer acquisition = cost per click * (1 / conversion rate)

For Manufacturer, Inc., the search words that would trigger the ad appearing, along with clicks related to those words, cost $5.50 per click at the time of our research. But the cost of each paid customer acquisition is much higher than this. Only some of the customers who click through will actually buy anything. If your conversion rate is 20%, you need five clicks to get one sale.

Paid customer acquisitions obviously will not be all of your traffic. If 20% of your customers find you for free, then you only have to pay the above amount for 80% of customers, and for the rest you pay zero directly. So, more generally:

cost per acquisition = cost per click * (1 / conversion rate) * ( 1 – % of free traffic)

For Manufacturer, Inc., the conversion rate benchmark that we found in the industry was 1%, meaning that they would pay $5.50 per click for 100 browsers in order to get one sale, making $550 per paid acquisition. With a relatively unknown brand, we only forecast about 20% free traffic, so they would be paying that $550 on 80% of their customers. Overall then, that’s $440 in paid clicks per customer acquisition.

We also forecast that 1% of customers would refer a customer, for a cost of $150 paid to the referrer, adding 1% of $150 = $1.50, to make a total direct marketing cost of $441.50 per unit.

Remember that this is just to get customers. In the offline world, the retail channel takes care of this, in return for that relatively small retailer margin.

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As one can see, once marketing costs are factored into the picture, the unit economics analysis swings heavily in the other direction. So, given the above, why would anyone want to sell online?

The more eCommerce savvy among you will have noted that nobody does if their cost per acquisition is going to remain at 58% of the selling price. As you build your brand, your conversion rate goes up, and your percentage of free traffic also goes up. You also presumably get better at online marketing and therefore optimize your per-click economics. By exactly how much depends on how successful you are at your online brand-building and paid advertising optimization—all the capabilities that established offline businesses typically have little competitive advantage in.

In our case, we assumed that by buying in the right expertise, we could get the conversion rate up to 3% and the free traffic up to 40% in five years. With more sales also coming in from referrals rather than clicks, the cost per customer acquisition would fall to a more acceptable level.

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You can probably already see, though, how sensitive your profitability is to the cost of bringing customers through your virtual door. In fact, that’s not the end of it, because the way in which you bring your direct marketing cost down has a lot to do with your brand building. “Free” traffic is not really free: You have to pay your social media manager, pay-per-view ads on Youtube and Facebook, and content to be created. The cost of this roughly stays the same in raw dollars, which means it does go down per unit if—but only if—it results in you selling more units.

So let’s bring that into the mix. In the case of Manufacturer, Inc., we estimated about $2.1 million to $2.3 million each year in brand building (“indirect marketing”) spend to achieve the unit sales below.

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In summary, the DTC model is highly sensitive to marketing costs. To get your free traffic and conversion rate up, a lot of capital is required to invest in brand building and in absorbing the initial losses. The rewards, however, can be significant.

Let’s see how the other models compare.

Option 2: Private Label

This option is actually incredibly simple and low-risk. You can supply your product to a brand that is already online and have them sell it under their own brand name. Your profitability is not at all affected by the cost of marketing, because the private label partner takes care of it. However, as a result of this, the retailer takes a larger margin than would an offline retailer selling your branded product. They keep the upside as the marketing costs fall over time. But your investment in upfront brand building is zero.

In this model, we assumed a similar but slightly less high-end positioning to the DTC option.

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Compared to the DTC option, the private label option has both a clear advantage and a disadvantage. If a company does not have capital to commit to building a brand, then private label is an excellent way to participate in a market profitably from the outset. Even for those who may have capital but are concerned about the risks of a DTC model, private label avoids the downside risk of spending significant capital on brand building that may or may not be successful. However, for those with capital that they are looking to invest in maximizing their profits from the growth of eCommerce in a particular sector, private label offers limited upside. The gross margin must still be shared with a private label partner, whereas in the DTC model, once brand recognition has grown and marketing is a lower percentage of the selling price, the margin increment from cutting out a distribution or retail partner can be significant.

Options 3 and 4: Selling to—or through—Amazon

After evaluating the private label option, we can see the benefits of selling to a company that is already in the market place. So why not sell to the company that virtually owns eCommerce? Amazon. There are actually two ways to do this. You can sell your product to Amazon itself, who then sells it on its website for a profit. Or, you can be a seller on the Amazon marketplace, selling your own products and keeping the whole price minus 15% referral fee, but Amazon will not promote you.

There are pros and cons to each model. Let’s start with the positioning and the price: Unlike in the DTC model, you are now beholden again to a retail channel relationship. We could not create a brand with a price premium here. In fact, we found that Amazon’s customer mix and strategy biased us toward a lower end product. And, of course, Amazon would still take a margin. They also charge a “co-op” fee for promoting your product. If you sell to Amazon, they take care of shipping to the customer; if you sell through Amazon marketplace, you pay Amazon’s fulfillment team to take care of it.

The major advantage of Amazon, of course, is its captive market and, in this category, its significant forecasted future growth. There are two major advantages to this: first, volume—this brings sales revenue up and also brings the per unit impact of the indirect marketing spend down; second, the lack of direct marketing costs—so many customers are already on Amazon.

In the model in which we sell to Amazon, we eliminated paid clicks altogether. We ramped up brand building spend to between $3.7 million and $3.9 million each year so that people finding Manufacturer, Inc. on Amazon could Google its name and find something interesting, and so that we could direct traffic from across the web to our Amazon page, but paying for clicks was not necessary. Furthermore, Amazon offers the opportunity to build up a base of customer reviews, which, in our model, was also a significant contributor to growth of our share of the Amazon market (which is itself growing).

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In our model, the storefront (marketplace) option turned out be the least attractive. Because Amazon gives less prominence to marketplace sellers than it does to its own products, we felt that we would have to resort to paid clicks to get comparable volumes—not to the same extent as in a DTC model, but still to some extent. Furthermore, Amazon’s customer mix meant that we could not justify the price points that we were assuming in the DTC model, while the referral and coop fees chipped away at the advantages of a typical direct-selling model and we still retained the shipping and credit card fees.

Conclusion

In our particular model, selling to Amazon proved to provide the optimal combination of risk and return. It was certainly not the lowest risk option: That was the private label option, which required no upfront investment and was EBITDA-positive from the beginning. However, selling to Amazon had the largest upside without having the deep “hockey stick” beginning that the DTC model had. The summary of our analysis is shown graphically in Table 9 below:

Table 9: Summary Scorecard of Options

Option Investment Horizon Alignment with Existing Operational Capabilities Margin Potential Growth Potential
Direct-to-Consumer Long Low High Medium
Private Label Short High Low Medium
Amazon Wholesale Long Medium High High
Amazon Marketplace Long Medium Medium Medium

 

This could easily change, though. One benefit of selling on Amazon is the ability to build a brand, particularly through the reviews that customers write on Amazon. A future DTC venture for this client would hence not be a “standing start” and the cost of each customer acquisition need not be so prohibitive.

Whatever one’s choice, it’s clear that a move into an eCommerce channel is perhaps more relevant than it ever was. Well-known household brands are closing stores at record paces: Sears and Kmart recently announced the closure of over 150 stores, Bebe is closing 180 stores, JCPenney is closing 138 stores, Macy’s is closing 68 stores, and the list just keeps getting longer. But if the cautionary tales don’t sway you, perhaps the more encouraging ones will. An interesting post on the subject from HBR delves into the Nordstrom story, which is illuminating:

“For nearly 100 years, Nordstrom’s purpose has been to provide a fabulous customer experience by empowering customers and the employees who serve them. To fulfill this purpose, as far back as the late 1990s, Nordstrom started looking for opportunities to invest in technologies that would further empower their famously empowered employees. These investments included Nordstrom.com and a perpetual inventory system that allowed Nordstrom to offer a consistent multi-channel experience by 2002.

Then, between 2004 and 2014, Nordstrom made an extraordinary series of investments…First came a new point-of-sale system […] This was followed in quick succession by the launch of an innovation lab, the creation of Nordstrom apps, the introduction of popular social apps that created buzz as well as mobile checkout, support for salespeople texting, and ultimately the acquisition of a cloud-based men’s personalized clothing service.

Because Nordstrom.com and the Nordstrom app are integrated with the inventory management system, customers can find what they want in one place and have it delivered from somewhere else to a third place. Nordstrom’s engagement with popular social apps, like Pinterest, extends what Nordstrom’s employees know about their customers’ preferences. Items popular on Pinterest are tagged with a red tag bearing the Pinterest logo and prominently displayed in the store, linking their online and offline worlds. Their employees, famous for providing customer service, are now armed with information not only about what a customer has bought in the past, but what they like, and even what they shopped for but could not find. Mobile checkout makes it easier than ever for any employee to see a customer through the payment process and thank them, rather than sending them to a cash register[.]

The persistent digitization of Nordstrom’s business has allowed the company to grow revenues by more than 50% in the last five years. The company is growing sales in both full-price and off-price businesses through both online and traditional channels.”

The willingness and commitment by retailers and producers to move online may ultimately decide whether one is found in the increasingly crowded offline retailer graveyard or successfully adapts to go the Nordstrom route.

Article via Toptal.