E-commerce has been the latest big thing in the region with successes and acquisitions. For the many new daily entrants out there, the business model innovation you bring to the table will determine how successful you will be (unless you’ve somehow developed a teleportation technology to replace shipping, then I will sell my house and invest in you). This is very generic advice we hear every day and in order to genuinely understand what that means, entrepreneurs and investors really need to understand the underlying metrics.
The most common misconception we see amongst e-commerce entrepreneurs is confusing between Gross Merchandise Volume (GMV), Revenue and Gross Profits. A simple Google search will bring up many articles explaining the jargon. The Right Way to Calculate Revenue and Margins by Mahesh Vellanki explains it very well. Being able to distinguish these is fundamental, not because I’m OCD or I want to audit financial statements as a hobby. It is because this is how one understands and explains business model innovation.
Let’s go back to e-commerce. The basic attractiveness of e-commerce as a business is minimizing capital costs and maximizing profit margins. It starts with not having retail stores and, the more you innovate, the more you cut down on capital costs. Because I come from a consulting background, here’s a simplified spectrum to spice up your life.Between the brick and mortar shop and the hands-off marketplaces/classifieds, there are 50 shades of business models (more or less). The way you translate these models to numbers will tell an investor and, most importantly an entrepreneur, if the business is innovative in a way that makes sense:
- A brick and mortar shop, say a D&G designer clothes store, will sell a t-shirt in its shop. Selling that shirt is their revenue and their cost of sales are design, manufacturing, warehousing, etc. This is why they tend to have lower economies of scale than marketplaces (they don’t normally follow the hockey stick growth).
- A convenience online marketplace will sell the same D&G clothes but will package them with everything else you bought from other retailers and send them in one package at the same time (like Souq). They are not designing and manufacturing any of these products themselves. The cash flowing in from the sales is not all revenue. A portion of it is GMV and the revenues are the commissions or markups on the sales. The cost of sales are what they spend in-house to get this product to the customer such as putting this item on their website, temporary warehousing, packaging, and delivery. The innovation here is that as the company grows, their expenses grow at a slower rate (they have economies of scale).
- A hands-off marketplace is taking this one step further and leaving it up to sellers to upload their products, price them, sell them, package them and deliver them. Like classifieds. So the cost of sales here are brought down even more to remove the packaging, temporary warehousing, and shipping. The economies of scale are larger. The gross margins should get higher.
Obviously, this is simplified but this is really meant to emphasize why it is important that entrepreneurs and investors get their understanding of metrics right. From an entrepreneur’s personal point of view, it is important to understand if there are ways they can gain more scale and, from an investor’s point of view, they need to understand why this specific entrepreneur’s business model is more unique than that other e-commerce business they saw 10 minutes ago.
For an early startup, GMV is important and a high GMV means they have good usership or engagement or both. Using GMV as revenue, however, is flawed and bloats metrics in ways that are misleading. It could tell an entrepreneur that they are making money when they are not. Acquiring users, when they are not. Achieving economies of scale, when they are not. Competing, when they are not.
Call me boring, but this distinction is important and, frankly, thrilling to break down! Give it a shot.