Normally I don’t do guest posts on my blog, but when I found out my friend Diana House had recently sold her company, I wanted to get her perspective on what she thought her super power was. Spoiler alert: it’s E-commerce Finance.
In this article, Diana shares some really great insight into structuring the finances for your e-commerce biz. Read on to see what you can do to set your business up for success –financially.
The Ultimate Guide to E-commerce Finance
So, you’ve started an e-commerce store – or maybe have been operating one successfully for years? You likely found a great untapped niche and a product that has blue ocean potential or are servicing a segment of the market that you are passionate and excited about.
You’re in business and are making money – or at least making revenue.
In this guest post, I’m going to help you up level your e-commerce finance game and shift the focus from revenue to profit. For background, I’m a lawyer turned award-winning serial entrepreneur who has sold two e-commerce businesses and now along with my private lending company (ffventuresinc.com) and real estate developments and investments teach entrepreneurs how to master their business finances over at Dianahouse.com
I also know that a lot of entrepreneurs have short attention spans and if you want the Coles notes of this comprehensive piece here you go! #cheatsheet
Action Steps and Summary: TL;DR
- Whether you are keeping your business forever or are wanting to sell one day – profit is the most important number.
- Do an audit on your business and assess what your COGS % is. Then figure out if you can do anything to lower that percentage – i.e. negotiate with suppliers, buy in larger quantities to get a bulk discount or maybe switch to a more cost-effective supplier that won’t skimp on quality.
- There are certain “must have” expenses operationally that you can’t really work around in e-commerce but that are pretty much required to do business. I.e. website, e-commerce platform etc. All you can do with these is negotiate the best rates with service providers and find discount codes.
- Find out what your cost of acquisition is and choose whether you are approaching profit now targeting or lifetime value marketing. Once you find channels that work within your approach – double down on the ones that are working.
- Decide about your approach for office, team and whether there are some unique expenses that move the dial within your business.
- Create a model and budget and have someone (if it’s not you) analyze these numbers monthly and reiterate. Lead your business from a financial perspective.
If you’ve got past the summary than I know you are a serious entrepreneur who is ready to make real money in your business. This is a long piece but it is quite comprehensive around the numbers you need to monitor and understand to grow and profit from your business. I’m going to cover a lot of what I’ve learned about e-commerce finances in my decade in e-commerce and two e-commerce exits. So, let’s go.
I know you know this, but I will remind you –revenue is a vanity metric and doesn’t mean that much outside of helping you get on the Inc. 500 list –which is awesome but it doesn’t pay the mortgage. So many entrepreneurs are attached to their top line number and obsessed with growing that without really considering what I think is the most important number –profit or the bottom line as it is often referred to.
Why Does Profit Matter So Much?
There is really no scenario that I can think of where the revenue number matters in the e-commerce space – unless you run a subscription based program that has reoccurring revenue that might help you sell on a multiple of revenue rather than EBITDA– which is very rare but worth mentioning as a possibility.
Sell or Keep?
I see two scenarios for e-commerce entrepreneurs: you either run your business successfully forever and collect profit forever or decide to sell one day for a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization). You need to have as much profit as you can for your multiple as EBITDA is based on profit – so in either scenario profit is the key marker of your success.
The other thing to note is that on average, e-commerce multiples are only around 3x EBITDA unless you have massive reoccurring revenue, so it might be worth continuing to operate your business rather than selling. The other scenario where getting past 8 figures in revenue can help you strategically is that historically exits of this size in the e-commerce space can get higher multiples but there still needs to be profit.
So, if you’re keeping the business forever why not make great profit now (balanced with growth) to be rewarded for all of your hard work and if you’re selling – why not create as much profit as possible to entice your buyer who is probably buying the business for cash flow (not revenue).
Diving Into the Numbers – COGS
Ok, we have already established that revenue is not as important as we may have earlier believed. What’s the next most important number we need to think about as e-commerce entrepreneurs? COGS!
COGS, short for Cost of Goods Sold, is the first number you really need to understand, monitor and pay massive attention to. Cost of Goods is the price of the goods or services that you are
selling (and in some situations both). Things that are often included in COGS is raw materials, finished goods, the labor that is needed to create the products if you are manufacturing yourself as well as sometimes shipping costs (both incoming and sometimes outgoing).
COGS is the most important number to start with because it can be a make or break scenario for a business. If you have good margins on COGS you have a lot of room to operate the business profitably and if you don’t have good margins your financial margin to run the business is tight and sometimes impossible. We all know that a huge percentage of businesses fail – why not give yourself the best chance of success out of the gate?
So, what % should COGS be?
When I started my first e-commerce business – tinydevotions.com I was obsessed with trying to figure out what this number “should be”. What I realized during this process of investigation is that there is no specific number but it really comes down to the whole business model as well as market competition.
If you are creating a product in a blue ocean market your margins are better but as competitors enter the space you will likely have to reduce your prices to compete and your margins will come down.
My approach personally has been to create really high margin offerings and I have often operated business with COGS being at or under 20% of revenue and leaving me 80% gross profit. COGS can be an industry-specific number as jewelry companies for instances can have 8-10x margins and clothing and apparel likely closer to 5-6x.
When I’ve chatted and worked with other e-commerce entrepreneurs many have told me that their margins were less than 5x. It’s definitely possible, but is it profitable? That’s the real question. If you have 5x margins then the product you buy for 10 dollars you sell for 50 dollars.
That would give you 40 dollars of room for each transaction to operate the business, market the product, pay your team and also profit. It sounds like a lot but as we start to explore the other expense you can see that they add up quickly. The other thing to note here is that there is often an economies of scale – as you grow your business sometimes you can afford to have smaller margins to cover all of your operating costs whereas if you are a smaller business – small margins will destroy you.
Another thing that a lot of entrepreneurs struggle with is how to build up inventory. If you are drop shipping than you don’t have this problem but I’m assuming that most entrepreneurs that are reading this are purchasing their own inventory before selling to their customers.
I’ve heard some e-commerce entrepreneurs say that “it’s absolutely impossible” to grow an e-commerce business profitably because of inventory costs. You definitely need some sort of cash or investment at the beginning but after that I would argue that you if you are patient and diligent you can use cash flow to keep investing in more inventory.
My first e-commerce company scaled past 7 figures with only a $3k grant and accumulated a base of hundreds of thousands of dollars of inventory overtime. The higher your margins are the easier it will be to do this.
The other issue with inventory is that it isn’t perfect. Some of your inventory will inevitably be broken or faulty (under 2% seems to be the golden number that a lot of entrepreneurs are comfortable with) and there were also inevitably be some discrepancies or “shrink” as it’s often called between what you have purchased and what you have at any given time due to human error and the unknown.
Gross profit – what is it and why does it matter?
As mentioned – gross profit is a very important number – it is calculated by subtracting COGS from Revenue ex. Revenue – COGS = Gross Profit.
Gross profit is the number that you have to run your business off of operationally. So, if you are doing a million in revenue with 20% COGS then you have 800k in gross profit for operations (yup, tons of room).
That said if you have a lower margin product maybe you have 80% COGS and only 200k to run the business with – it’s much harder to operate and make money the lower the margins are. But, if your margins are too high and there are competitors than no one will buy your product – so you need to test and find the sweet spot.
So many entrepreneurs confuse gross profit with actual profit (or net profit). You still need to pay all of your operating costs (team, marketing, legal/accounting etc.) out of this now so do not stop here. We will dive into operational costs next:
Operational Costs: Must haves
One of the reasons I think so many people are drawn to e-commerce companies is that there aren’t actually a lot of “must haves” on the expense side and a low barrier to entry. You likely need to pay a monthly fee for your e-commerce back end (I used Shopify for many years), website costs, an e-mail marketing service (I love convert kit), and outgoing shipping costs if they aren’t allocated to COGS, merchant account fees for collecting payments, bookkeeping if you aren’t doing it yourself as well as annual legal and accounting fees for year end.
In most cases these are the non-negotiable “must have” expenses and the best you can do with these are negotiate the best rates, shop around and also look for discount codes that can help you get great rates.
Operational Costs: By Design
Nearly all other e-commerce expenses are what I like to call “by design.” One of the most beautiful parts of being an entrepreneur is that you get to architect and create every aspect of your business – including the financials. If you didn’t realize this I hope this empowers you to see the financial aspect of your business as a fluid thing that you get to be strategic around and create rather than simply being resigned to.
Marketing and Cost of Acquisition
There are two ways to look at marketing on the financial side – either growing by cash flow and a “profitable now” approach and then the alternative being a “lifetime value approach.” There are definitely fusions and spectrum to each of these approaches and really depends on your goals, desire to scale vs. profit and risk tolerance.
My personal approach to e-commerce is very conservative and low risk and I have always wanted to be profitable now rather than tomorrow so when I approached things like ROAS I wanted to target 4X “return on ad spend” so I was growing profitably.
This sounds great but can have some shortcomings in being able to scale quickly. I’m also not very technical on the marketing side so this ensured that my lack of great track-ability was insured against a foolproof financial strategy.
The other approach is focusing on lifetime value. Shopify wrote a great piece on calculating your lifetime value. (insert https://www.shopify.ca/encyclopedia/customer-lifetime-value-clv). Here you do a calculation of what each customer you acquire makes you over their customer lifetime. What I don’t like about this equation is I don’t think it fully considers changes in the market and unknown factors in the future.
With each approach calculating your cost of acquisition of clients is a key metric to understand and should drive your marketing efforts. From my experience, calculating the effectiveness of marketing is an art not a science and will never be exact –which deters people from trying to do this analysis at all. I.e. How do you track the results from a billboard, print magazine or even how Facebook ads affect Google organic.
What I can consistently found and heard is that there is an invisible relationship between all the marketing channels and instead of looking for perfect data, track what you can and base your analysis on the imperfect data knowing some analysis and guidance is better than none.
I’m personally not a marketing or paid acquisition expert so I will leave a deep dive here to people like Gary Nealon. Also, I do think this area of e-commerce is getting tough and tougher as channels are getting busier and busier so either learning or hiring out expertise in customer acquisition is key to success for e-commerce in 2019 and beyond.
I asked Gary if he could share some tips for marketing and paid acquisition with us. Here’s what he had to say:
“When I first launched my company, I took a slightly different approach to finances –one that went against the crowd. While I wanted to make sure his business was profitable first –even going so far as to forgo taking a salary for the first two years, as soon as the business was up and running –and making enough money, I began dumping all of the profits back into the company.
“We focused on LTV (Lifetime Value) versus profit on the first order, which allowed us to outspend our competition for the same keywords,” said Gary, highlighting the importance of focusing on customer acquisition –and retention, rather than just short-term profits.
“Equally important to customer acquisition is ensuring that you’re recruiting the RIGHT customers –and making sure you’ve got a way to keep them coming back as repeat customers. I’d recommend that any new business starts by taking the time to identify their target customer, and then taking things just a step further and work up a customer avatar; that is, a profile of a customer that represents exactly who your ideal customer is.
Once you’ve identified WHO your customer is, you can then create marketing and advertising strategies that are designed with them in mind. This extremely targeted approach increases your ad/copy/blog post’s effectiveness; allowing you to ensure that you reach your customers exactly where they’re at.
Another tip that Gary swears by? Facebook Ads.
“Right now Facebook Ads is where it’s at, as far as social media marketing/advertising goes. Organic reach is important, yes, but because the marketplace is so saturated right now –and because social media sites have made it all-but-impossible for brands to get noticed organically; these days, you really have to pay to play.
Set yourself up with a Facebook Business Page, and then get familiar with Facebook Custom Audiences –a tool that’ll allow you to get extremely granular with your ad targeting strategy. With Custom Audiences, you can quite literally create an ad campaign that’s designed to target a very niche audience.
Create a campaign to target people who’ve visited your website and left without buying anything, visitors who’ve abandoned their carts, people who’ve purchased a specific product from you, and more.
“From there, you can go on to create Lookalike Audiences; which will allow you to target an audience of potential customers who are similar to your already-existing Custom Audience. But you’ll need at least 100 email addresses to get started –one reason that using a tool like OptinMonster or MailChimp to collect email addresses from your visitors is vitally important.”
I’ve seen 3 main approaches to team –
- Solo entrepreneurs who try to do everything themselves.
- Entrepreneurs who subcontract and outsource all the functions of their business to contractors or third parties.
- Entrepreneurs who hire employees to do everything and sit in their zone of genius only.
At the beginning, most entrepreneurs have to wear all the hats unless they have a lot of start-up funds or have raised capital. There is a new rise of 7 figure solopreneurs who have successfully architected businesses without a team – it’s possible but these entrepreneurs usually are “employed within the business.”
Although it can be scary to spend money on a team I really think that besides dialing in your COGS and marketing that having awesome people to help you make your vision a reality is key to moving forward in your goals as an entrepreneur. I would argue that if you are doing everything you are likely not going to be able to scale that fast and also will be working beyond healthy productivity levels.
Whether to take approach 2 or 3 comes down to personal preferences and sometimes employment laws. There can be an added expense of having employees as there are additional taxes and benefits that often need to be paid that can be impactful on the bottom line.
On the flip side, contractors can sometimes be more expensive but also more flexible. There is also a fusion model of having some employees and some contractors where necessary. The biggest lesson I see with entrepreneurs and their team costs are the following:
- Waiting too long to hire their first staff member.
- Over hiring in “anticipation” of projections and having more team than you can afford.
- Paying staff members but not paying yourself or paying team more than you pay yourself.
Another debatable expense is the office. Should you or shouldn’t you?
The reality is that you can be successful with or without an office depending about your team structure and operational approach. There are 3PL’s and warehouses that can store and ship your products for you and most functions of running an e-commerce business can be done remotely (outside of things like taking product photos).
I personally have always loved having an office and was okay with that expense being on my books because I loved having somewhere to go when I didn’t want to work at home and really enjoyed having our team all together in one place for creative work and brainstorming.
That said, if you are set on having an office make sure you aren’t paying for more space than you need and consider non-prime locations since customers are likely not coming to you and being outside of the core will be more affordable. Another smart move can be purchasing your own commercial building which we have done multiple times and paying your own rent towards a commercial mortgage and also potentially gaining on co-tenants and appreciation.
There are so many other expenses that you could build in or potentially cut from your business. I think the best approach is to remember what are the must haves and that in general other investments into your e-commerce business are a decision rather than mandatory.
Certain industries have some very large expenses that have huge pay offs – such as my close friend who runs a very successful fashion e-commerce company that has seen huge returns on going to very expensive buying shows in NYC and Las Vegas for many years. Some people think it’s not worth it – but it’s been one of her differentiators for years.
The worst discretionary spending I ever did was hiring a PR firm and spending nearly 60k on what ended up being a no impact campaigns. Other people have done PR and have had huge success so it really depends on product/market fit and the right service providers.
Create a Model and a Budget
Once you understand all of the expenses of an e-commerce business it’s time to create a model and budget. I love working with percentages and creating a moving budget of being willing to spend x % on the different business areas and putting aside your desired profit % right away.
A lot of people suggest “paying yourself first” and having an additional account for profit (The book Profit First goes into this in detail) and this might be a good practice for you if you end up spending whatever is in your business account on the next marketing app or tool.
A lot of entrepreneurs don’t like to be in the numbers and if you are a visionary entrepreneur who cannot force themselves to get keen on this side of the business than you must delegate this out to a team member who has great attention to deal and analysis skills.
You must look at your financials on at least a monthly basis and see how your monthly actuals compared to your budget and constantly be adapting. If you hate digging into the PL (or profit and loss statement) than at least decide on what numbers and metrics you want to run your business on and have a team member send you a monthly “CFO” report that can help you run and make these financial decisions in less than an hour a month.
Diana House (www.dianahouse.com) is a lawyer turned serial entrepreneur with two exits in the e-commerce space. She has been recognized as a top 20 under 40 by Business London and one of the top female entrepreneurs in Canada by the W100. Entrepreneur finance is her passion and she works with entrepreneurs on creating more alignment and profitability.