Drop It Like It's Hot
Something that most people don’t know about e-commerce companies is that, in their natural state, they are generally not healthy economic businesses. That might not be intuitive given that there seem to be an endless pool of new e-commerce merchants in your Instagram feed and that Amazon is one of the most highly valued companies in the world! It is true that they are often playful marketers, and true that they run endearing adverts on SiriusXM, and they do make you laugh on the subway – but those are controllable variables. Underneath the hood, they are continually fighting a losing battle against their own supply chain, a seemingly unwinnable battle for customer attention, and dealing with an increasingly complex ecosystem of reverse logistics.
Actually, there’s more. Most of today’s direct to consumer brands (or DNVBs) also have to deal with managing inventory, which traditional software businesses and third party marketplaces do not. The good news is that the Shopify boom has cultivated a growing ecosystem of third party logistics providers (3PLs) who can assist with warehousing, packaging and shipping. The bad news is that tangible inventory still costs money. And, of course, it takes a while to actually sell it. Oh, and then there are returns which you need to reserve cash for. And so part of why e-commerce operations are difficult businesses is because they have pretty terrible cash conversion cycles. This is because they pay a manufacturer for the inventory in say, January, it arrives in March, they get paid for it by a customer in May (after a lot of hard work!) and that is, we can all agree, a pretty terrible risk/reward profile.
So because cash conversion timelines suck, commerce businesses are continually looking for innovative methods to solve their working capital constraints. One method that you may recall are flash sales. Which basically serves to liquidate lots of latent inventory, all at once, at reduced prices, and generate quick cash. Another one you might remember are subscription boxes, which help to solve this issue as well because you know how many subscribers you have in advance, you therefore only buy as much inventory as is needed for that cohort, and you ship it out soon after it lands in warehouse (there were plenty of other difficulties in this business model that made them ultimately unpopular.)
Over the past several years, nearly every commerce brand of scale has adopted some product drop strategy. Product drops are typically defined as limited edition, often individually numbered, exclusive products marketed mostly to existing customers in a time constrained format. The history of drops, according to WWD, originated in the mid 1990s with Japanese streetwear brands, but by the late 2000s had been adopted by streetwear all-star Supreme, and more recently by pretty much everyone, including aging luxury brands such as Burberry. And over the past 36 months, they have increasingly become a staple of D2C brands. The questions of course are: why is that - and - are they good business?
One of our Starting Line portfolio companies who have run multiple successful drops agreed to allow us to share the economics of a recent product drop and you’ll see why they are so popular. It is one of the strongest cash protection + generation mechanisms you’ll find in the digital commerce world:
The summary of the chart is: minimal cash outlay, inventory in warehouse for less than a week, and all sales generated in a 24 hour period. Here’s why each of those matters and the leverage e-commerce companies gain through this model:
Minimal Cash Outlay: In this example, Company’s only negative cash position was $11k to suppliers and some portion of their $20k in marketing costs on direct response ads days and hours ahead of the drop (the rest of the $20k was a pro rata share of marketing team salaries who worked on the drop.) That is a material amount of leverage when you consider it drove $63k in gross margin (revenues, net of COGS) – greater than a 5:1 ratio on its working capital.
In this example, Company sat on a negative $11k position for 3 months, but spent little on marketing and all other costs – their net terms with supplier and free shipping subsidies – were paid for by cash they had already received from the end customer.
Compare this to a traditional inventory cycle. Given an industry average retail turn of 3-4 (90-120 days), even if a seller is able to negotiate net-60 terms with its suppliers, it is sitting on much of its negative net cash position for a full two months. During that period, the merchant would also be outlaying warehouse costs for that inventory as well as spending aggressively on customer acquisition to find buyers for their inventory.
Inventory Turn: Carrying inventory is expensive and complex. But in this example, every single unit in this limited edition drop was received in warehouse from suppliers and shipped out to the end customer within 48 hours. That creates strong efficiencies from an operations perspective but also enables an advantageous cash conversion cycle for the retailer. Instead of having to pay out all inventory costs months before they can expect to recoup those COGS, this retailer actually now has 28 days (assuming net-30) to leverage that balance sheet cash before having to remit payment to supplier. That is an unprecedented amount of operating leverage for a commerce company.
Last, because product drops are largely accounted for by high affinity existing customers, returns are negligible, mitigating the need for retailers to carry a liability burden on their balance sheet.
Overall, building an audience large enough and loyal enough to consume a scaled up product drop schedule offers a step function economic change for online retailers. And perhaps more importantly, unlike predecessors such as the subscription box, they have the added benefit of making loyal, high affinity customers feel special and exclusive – and therefore likely to purchase more frequently, not less.
Reaching the requisite scale where drops become economically viable becomes its own operational calculus, and brands may be willing to unprofitably pay forward for customers today in order to share in the profitability of this platform in the future. But - buyer beware - product drops demand a high affinity set of customers, not a high churn audience. And affinity demands both brand equity and product quality. It’s a reminder of a refrain we often utter inside Starting Line: it’s all about the product.