Shopify: Seducing Service Entrepreneurs
Shopify, the leading multi-channel e-commerce platform for entrepreneurs, has rocketed to success since its founding in 2004. With humble beginnings as a platform for the founders’ snowboards, Shopify now has more than 500,000 customers (merchants) using its software to develop their own e-commerce businesses. However, Shopify’s success masks a major long-term concern for the business regarding the quality of its customer base. The company can address this issue and create a new opportunity for itself simultaneously by increasing its focus on growing merchant solutions and targeting service-based businesses. If Shopify fails to act, it may lead to deterioration in its core business down the line.
How Shopify Satisfies Their Partners
By servicing previously neglected merchants with enterprise-grade infrastructure, Shopify has developed a substantial customer base of primarily small business clients. Merchants use Shopify’s fully-hosted e-commerce solutions, which handle the backend technology setup associated with online product sales. Services provided include payment processing, inventory management, shipping logistics, and customer support, among others. Moreover, Shopify’s partner ecosystem of third-party agencies and freelancers offers additional services surrounding technology integration, solutions development, and creative services for Shopify merchants. The company’s competitive advantage is ultimately derived from the simplicity and robustness of its platform and extensive partner ecosystem, which allow anyone in the world, regardless of technical expertise, to use Shopify to sell products online.
The e-commerce industry is a fast-growing business with increasing economic dynamism, set to grow to 15.5 per cent, or a total of $4.5 trillion, by 2021. In addition, it accounted for 8.7 per cent of global retail sales in 2016. Shopify’s rapid customer acquisition strategy took advantage of this market trend to generate average quarterly revenue growth of 17.9 per cent over the last two years. Moreover, gross merchandise value (GMV) for the third quarter of fiscal year 2017, a metric commonly used to measure the growth of an e-commerce business, was reported at $6.4 billion. The results show an increase of 69 per cent over the same period in the year prior. However, Shopify’s earnings metrics deflect concerns regarding the drivers that have fueled growth to date.
A Long-Term Problem
Shopify’s core product leveraged a customer acquisition strategy focused on accessibility. Ease of adoption has persisted as one of the most prominent factors driving new customer growth. However, while it works in the short term as demonstrated by Shopify’s rapid revenue growth, the same acquisition strategies will face diminishing returns if recent trends continue to exert downward pressure on customer lifetime value. These trends are primarily as follows: low barriers for vendors to exit and merchants’ over-reliance on increasingly restrictive channel partners to generate sales.
Operational innovations like drop shipping reduce barriers to entry for prospective vendors. The practice allows retailers to transfer order and customer details directly to the manufacturer or wholesaler, who then ships the goods directly to the customer. By effectively eliminating inventory holding costs, retailers can better manage liquidity since they have less cash held in inventory. It is important to note that the concept is promising for traditional brick-and-mortar retailers who provide additional value beyond the sale of the product through customer service, sales and marketing. Their value proposition adds to the sustainability of their business model.
However, drop shipping has also been adopted by certain digital merchants with less sustainable business models. These merchants use drop shipping to sell products that are often low-quality imitations purchased from foreign manufacturers at low cost. The products are then marked up for sale through advertising on high-traffic websites like Facebook and Google. Facebook has received a large number of complaints from dissatisfied buyers who feel like they have been misled by certain advertisements, and has in turn updated its Low Quality & Disruptive Content advertising policy to screen out deceptive sellers. The change in tone is concerning for Shopify businesses that rely on channels like Facebook to sell their products. If digital advertising partners continue to clamp down on their policies, it could reduce the economic viability of many Shopify storefronts, escalating the customer churn issue for Shopify. While these merchants have played a significant role in Shopify’s rapid customer growth, the company cannot exclusively depend on them to generate reliable, long-term revenue.
Volume vs. Value
Shopify currently segments its revenue into two different streams: subscription solutions and merchant solutions, which includes all revenue from value-added services on top of the base platform subscription fee. Monthly subscriptions are tied to the total number of merchants on the Shopify platform, while merchant solutions revenue is earned as a percentage of GMV processed through these merchants. The company traditionally focused on maximizing subscription revenue by attracting as many small merchants as possible. This represents a stable stream of income relative to payment fees which fluctuate with the volume of retail purchases made through Shopify. Subscription fees also contain a gross margin of 81 per cent, compared to 37 per cent for payment fees. However, although subscription fees from new customers represent a more profitable and stable revenue stream, they also consume the majority of research and development and sales expenses, which are fixed costs that are not included in the gross margin.
In 2014, subscription fees represented 63 per cent of Shopify’s revenue, but that number has declined to 48 per cent this past fiscal year, highlighting the increasing importance of growing merchant solutions revenue by increasing GMV instead of simply acquiring more customers. The majority of Shopify’s GMV is processed through its high-end clients that subscribe to Advanced and Shopify Plus plans. Specifically, Shopify Plus customers, such as Tesla, Nestlé, and GE, represent 2,500, or 0.5 per cent, of the total 500,000 customers on Shopify as of fiscal year 2016. In addition, retention rates are often higher in these higher-end segments. Customer acquisition costs are substantially higher than costs associated with renewals. Considering that higher churn is often typical in the core part of Shopify’s customer base, Shopify is spending more and gaining lower customer lifetime value from the majority of its customers. As such, it is in Shopify’s best interest to attract customers with more sustainable business models. In addition to its existing base of high-end clients in Advanced and Shopify Plus plans, there is a portion of the market that Shopify has overlooked that fits this customer profile.
In Canada, 78 per cent of small businesses are service-based. While Shopify has succeeded in developing its app store solutions for product-based businesses, there is a significant opportunity to expand its offerings to address the rest of the market. Specifically, service businesses can provide a reliable, long-term revenue stream to complement Shopify’s small product-based merchants, reducing the company’s overall risk. Unlike the product-based model that allows virtually any individual to enter and engage in retail arbitrage, service-based businesses inherently require an investment in human capital to perform the service at a level at which it can be sold. This acts as a barrier to entry that encourages partnerships with longer-term businesses, thereby providing more revenue stability. Furthermore, the business models of many service companies rely on recurring revenue from repeat business. Small accounting firms, country clubs, and software-as-a-service (SaaS) providers are examples of companies that would create long-term relationships with their own customers and generate ongoing GMV for Shopify. By selling to businesses with recurring revenue models and stickier end customers, the company would deliver sustainable value that aligns with management’s long-term goals.
The current platform contains payments processing at its core, but is optimized for the sale of physical products. Shopify’s competitive advantage stems from the simplicity and robustness of its platform coupled with its extensive partner ecosystem for product-based businesses. However, Shopify’s current solutions are not optimized to transition a service-based business online because the company’s current ethos is inherently biased toward selling physical products. Shopify’s service business offering has yet to offer the proper features to support this customer segment. Features that strengthen Shopify’s value proposition, such as inventory tracking and transfers, are core to physical products. However, Shopify loses this advantage in the context of service-based businesses, which are more differentiated in their business model and would require more customization. Ultimately, the friction caused by these difficulties on the current platform would prevent potential businesses from joining Shopify.
The pursuit of the service business opportunity will require a shift in existing management preferences. Broadly targeting service-based businesses would require resources to not only develop a platform designed specifically for services, but also to support businesses that require additional customization. By encouraging third-party development for service businesses in its partner ecosystem and having a support team to aid those that require customization, Shopify can enter this market more effectively without sacrificing its existing competitive advantage.
By targeting service-based small-medium businesses (SMB) in Canada, amounting to more than 900,000, Shopify can pilot a new Shopify Services product before expanding worldwide. Shopify has the expertise and scale to capture at least five per cent of the service-based SMB market in year one, which translates into an additional $22 million in subscription and $14 million in merchant solutions revenues, assuming a monthly subscription fee of $40. Expanding market share to nine per cent and 13 per cent in years two and three respectively yields $63 million and $92 million in total additional revenue. Applying current gross margins yields a combined $121 million in additional gross profit over the first three years.
With the changing trends, Shopify must broaden its definition of “entrepreneur” to include service businesses. Shopify also needs to focus on its most profitable customers instead of feverishly working to acquire more small business clients. Launching and marketing a refined Shopify for Services product will help the firm achieve this sustainable long-term growth.
Shopify’s simple yet differentiated website design, robust payments processing system, and extensive developer network give it an advantage when targeting customers. However, there are limitations and risks when focusing solely on product-based SMBs. Shopify has the opportunity to address concerns around customer churn and to develop a new revenue stream that leverages its core competitive advantage. It is within Shopify’s ability to provide the functionality needed, and it is in the merchant’s interest to opt for the solution with e-commerce built into its foundation. The company could very likely follow through on investor expectations by broadening its current strategic vision. However, if Shopify fails to deviate from the current status quo, it risks becoming the next cautionary tale in a Canadian technology ecosystem littered with companies that also once had a shot at global tech stardom.