19 Sep 2016 13:11 IST

Six questions for e-com start-ups

The answers will help angel investors understandthe business model of the firm they plan to buy

If you are starting out as an angel investor, chances are that, seven out of 10 start-ups you evaluate will be from the B2C internet space. It would, therefore, help your cause to be conversant with some key metrics used to evaluate such businesses.

The first thing you should ask is orders processed per month, and their historical trend. And the other key number related to this is average order value (AOV). Between the two, you now have a good handle on the monthly sales trends. If it is an e-commerce market place, this number is also referred to as gross merchandise value or GMV.

Monthly sales should be a growing number. A month-on-month (m-o-m) growth rate of 10 per cent or more is desirable for an early stage company; 10 per cent m-o-m sales growth will mean revenues will grow three times in one year. On the other hand, order size should be stable, though it need not be growing at this stage.

Contribution margin

The next figure to look for is contribution margin of an order. This is order value less variable costs. The latter will typically be cost of material (purchase cost) plus delivery cost.

Several e-com businesses, including so called ‘unicorns’, were operating at a negative contribution margin till last year.

Normally, no business should have negative contribution margin; this aberration was caused by companies trying to drive consumers to purchase online by giving massive discounts.

However, not any more, since investors in these companies have now decided to focus on making profits. If you still run into any business talking about negative contribution margin, rejecting it outright would be a good idea. Let’s assume the contribution margin is positive. You can check next about CAC or customer acquisition cost.

CAC can be calculated by dividing all advertising and marketing spends for a month by the number of new customers acquired for the month. Some people prefer to use only digital spends in the numerator.

We would suggest using all spends, unless the business has an offline component. CAC is not to be confused with discounts, which will not show up in the company’s profit & loss account. What should come in the denominator is not so straightforward either. In e-commerce (it is easier), any order from a new person can be taken as a new customer.

But for social media sites, like, say, a dating platform, where users sign up for free, what number to take as a ‘new customer’ can be tricky.

An app download does not necessarily mean a customer. Once you arrive at a number for CAC, you should subtract CAC from the contribution margin. This number will most likely be negative.

This means, most internet businesses will not make money from a customer who orders only once. Let’s explain this with some representative numbers. Assume CAC is Rs. 300, AOV is Rs. 600 and contribution margin is Rs. 150.

This means, a customer needs to order around more than two times on an average for contribution margin to exceed CAC.

Only after that will there be something left over to cover for head office costs like accounts, CRM(customer relationship management), IT and promoter salaries.

Repeat orders

This brings us to repeat orders. In a repeat-transaction-oriented internet business, this is hugely important and determines if the business will ever make money.

In a single transaction business like, say, a car or home market app, this won’t be relevant. In a business which is just a few months old, figuring out if repeat rate is good enough can be tricky.

A simple metric to ask for is repeat orders as a share of total orders, and the trend in that. However, this number can be low if the business is spending a lot of money on advertising, and therefore on-boarding (or attracting) a lot of new customers. By the same token, if you cut spending, new orders will go down, and the share of repeat orders will look good. You can evolve some thumb rules of what is the minimum per cent of repeat orders you want to see in a business in which you may invest.

Cohort analysis

A more involved method of understanding repeat behaviour is ‘cohort analysis’. An example of cohort behaviour is to analyse how customers ‘on-boarded’ in a given month have behaved in subsequent months.

Let’s assume a business got 1,000 new customers in January ’16; with an AOV of Rs. 600, their aggregate business for January would be Rs. 6 lakh. In cohort analysis, you check how much they ordered in subsequent months. If, say, this set of customers gave orders of another Rs. 6 lakh in the next six months, then the business is perhaps doing well. If all you want is a single order from a customer, then the contribution margin should be much higher than CAC. The range of these numbers will vary with the business. CAC can swing based on competition, which can change advertising rates. How smartly the company spends its advertising money is also important.

When companies spend more, CAC tends to go up. So, several parts may determine the final outcome — profitability or cash burn. As long as you have good filters on some of these metrics, you may be able to make good investment calls.

(The writer is a partner at Wisdomsmith Advisors LLP, a financial advisory firm, which also runs an angel platform Wisdom Angels.)

Recommended for you