by Bryan O’Connell
I’ll let you in on a secret about venture capital investing – often the decision to invest isn’t as complex as most VCs would have you believe. Despite all of the smoke and mirrors, the litany of meetings, the endless diligence – it often comes down to a couple of simple metrics.
Let me caveat that. Some decisions can be incredibly complex. Figuring out whether Snapchat is a fad, or which encryption technology is going to win, is no simple feat. But for transaction businesses, such as ecommerce marketplaces, raising their Series A or B, the decision can be relatively simple. Once you get over some hygiene factors (e.g. market size, credible team, nothing “funky” going on in the cap table) there’s really three things an investor will want to know: what is your Customer Acquisition Cost (CAC), how much do your customers spend when they transact (your Average Order Value or AOV), and how often your customers come back before they churn out (your Repeat Purchase Rate or RPR).
The reason investors focus so much on these three components of the unit economics is understandable. It is assumed that every other part of the cost structure can be estimated somewhat accurately for a company at scale, and, in most cases, this is true. If you produce clothing, you should know how much a garment will cost to make once you get to a certain order level. Similarly, you can forecast with a high degree of certainty how many customer service reps a company doing $100 million in sales will need. There are well-established comparables, and nothing to suggest that these numbers should vary widely in the case of your company.
However CAC, AOV, and RPR can be difficult to estimate, especially when selling a new product to a new market (as is often the case with startups). And these numbers can often look very different in the early days. Your cost of acquiring customers might be close to zero until you burn through all of your family and friends. Good investors look at how these numbers have developed over time and, based on their experience and faith in the market, make a judgment about whether the company will have sustainable at-scale economics.
Luckily, most entrepreneurs have a good sense of the three metrics above. However, when looking at marketplaces (especially those with large numbers of sellers) there is another metric that is often overlooked but is of critical importance. I call it Supplier Acquisition Cost and define it as the cost of finding new supply. Note that this is not the same as COGS, which is the wholesale cost of the actual units. As an investor, this was one of the first things I looked at when “diligencing” a marketplace. And now as an entrepreneur building an online healthcare marketplace, figuring out supplier acquisition cost gives me great clarity on the viability of different verticals.
To illustrate more broadly what I mean, consider the following examples.
Think about what happens when Amazon wants to source a new sofa to sell on its site. First, a buyer will call or meet with the supplier and negotiate a price. Once this process is complete, reorders may be automated, and this one SKU for the sofa may end up selling millions of units. The amount of resource that Amazon needed to expend to source this unit for its site will be pretty much negligible, as they will likely sell many units.
Unit economics of a new sofa sold online
Retail Price: $300
COGS: $150
Gross Profit: $150
less Supplier Acquisition Cost: ~$0
Now consider two-sided marketplaces like Chairish, an online marketplace for pre-owned furniture, or ThreadFlip, an online fashion consignment shop. Every item on these sites is used, and therefore Threadflip and Chairish have thousands of unique SKUs. A buyer can’t simply call up Gucci and order 3000 handbags – each unit on the site has to be sourced individually. Whether it is done using an individual sales rep or by advertising for supply, this can be an incredibly expensive proposition.
Lets see how the unit economics may differ for an online marketplace selling used high-end furniture. For simplicity, we assume that the marketplace advertises to find new sources of supply, and that $50 in advertising dollars yields one used sofa.
Unit economics of a used sofa sold online
Retail Price: $150
Less COGS: -$45 (30% commission paid to seller)
Gross Profit: $105
less Supplier Acquisition Cost: -$50 (advertising dollars used to find the supplier in the first place)
Generally speaking, supplier acquisition cost can be a significant component of a company’s cost structure. While it can be mitigated to an extent if suppliers are also customers (as is the case with eBay), this is not always the case, especially where dedicated sales forces are used to source supply. Having a good sense of this metric will give you an idea of the viability of your marketplace, in addition to providing clarity on which channel you should be using to source supply.
Bryan O’Connell is the VDC’s first Global Entrepreneur-In-Residence. Originally from Limerick, Ireland, Bryan is an MBA from Harvard Business School, a former VC for BV e.ventures and the founder of FirstLine.