Overblown Commerce Models, Part III: Subscription Commerce

Published on June 29, 2012
by Brian O'Malley

The third wave of e-commerce is officially here, and it may have already jumped the shark. Just as we saw the proliferation of flash sale sites in 2009 (first wave) and daily deal sites in 2010 (second wave), there are now subscription offerings for women’s apparel, artisan food and pet treats. In fact, there are more than a dozen companies playing into these three trends, and a Web site to keep track of them all. The cost to launch an offering has gotten so low, and angel money so plentiful, that anyone can pop up a new site … subscription coffee anyone? Oh, wait … I think that already exists. Subscription tea? Never mind.

Investors love the concept of repeatable revenue, but with high churn rates and the ability in several models to skip deliveries, retention may be only a function of how hard sites make it to cancel. To understand why some sites will work and others will fade away, we need to look closer at three elements: Type of subscription model, category of purchase and merchandising strategy.

There are three different types of subscription models, each with a unique value proposition.

  • First, there are those that offer a better price on a product because someone is committing to a recurring purchase relationship. Let’s call this the “Columbia House” model, after the short-lived direct-distribution CD subscription business. Why do customers sign up? They’re lured by a bargain price and the reassurance that they can cancel/skip anytime in the future. Businesses know that negative opt-out will drive some repeat purchase and increase the Lifetime Value (LTV) of customers. This is key, because many of these businesses have become professional fundraisers. It is easier to justify high customer acquisition spend off an LTV versus most (nonsubscription) e-commerce businesses, which look at payback on an initial order.

    The challenge, however, is that consumers are not fools. Even though they see something they want to buy, they may not sign up, because they don’t want to have to worry about canceling later. Others may game the system to their advantage. For example, circa 1994, I signed up B. O’Malley, Brian O’Malley, B. Patrick O’Malley, etc., all as subscribers to Columbia House, so I could continue to receive free CDs. After watching what people will do for a free T-shirt, this behavior should not come as a surprise to anyone. Some of these challenges are forcing players to adjust: Some, like ShoeDazzle, are moving away from subscription, while others are making it more opt-in versus opt-out. Other players in the shoe category, like ShoeMint, JustFab and Sole Society have continued to run with their original model.

  • The second model for subscription commerce is sampling. Merchants pick items they think you will like, and send them to you. Since you rarely know what is coming, let’s call this model, “Mystery Box.” Birchbox pioneered this model with a combination of beauty and lifestyle products all offered for $10 a month. Other companies leveraging this sampling model are Blissmo, Foodzie, Club W, Citrus Lane, etc. This is great for brands looking to drive new customer awareness and consumers looking for a little something fresh and different. Consumer packaged-goods companies tend to be forced into either television commercials or in-store displays. Sampling offers a more effective bridge to the customer, while providing deeper insight along the way. If the price point is low enough, customers will stick through months of poor selection, in the hope that next month is better. While curation is key in all these models, this is the only one where the merchant tends to have 100 percent liberty to send you what they have available. This is helpful, because some of these vendors (think artisan food) are limited in the supply they can direct toward samples. For them, variety is key to sustainable growth.
  • The final model is specifically focused on consumable products: Flowers, razors, diapers and, yes, even condoms. For the right category, this model makes the most sense. Not only do consumers receive a discount by buying the product direct, they also should receive more product just as they’re running out. Let’s call this category the “Sushi Boat,” because whenever you run out, more automatically shows up. Kiwi Crate and BabbaCo, for example, sell subscription craft projects for children. Right when Johnny has finished last month’s project and you’re searching for some way to entertain him, a new box shows up with fun projects to reengage him. This model has been around for decades through mail-order prescriptions and diet plans, but only in the last couple years has the supply chain become specifically catered towards online distribution. There is a real-time content angle to these subscriptions, so not only do you get your eco-diapers from the Honest Company, but you can pick which pattern you want on the diapers each month.

While these different models will get just about any business school student excited enough to do an extra keg stand, the models are not what’s most important. Subscription is based on the idea of repeat purchases, but the category of product determines the repeat purchase rate more than the stated business model.

For example, check out the charts (below) showing cohort retention (what percentage of every dollar customers spend in Month 1 will be spent in Month 2, Month 3, etc.) for two of Battery Ventures’ portfolio companies, H. Bloom and Relay Foods. H. Bloom is a subscription flower business that delivers fresh, hand-cut flowers on a weekly basis to those who want flowers in their home at all times. This falls into the “Sushi Boat” category, because new flowers show up right as the old ones are starting to go. Relay Foods is a grocery delivery service that delivers food from local merchants to common drop-off points (office, gym, school, etc.) to avoid last-mile issues of most grocery delivery services. Both of these businesses have great retention, with roughly 50 percent of each dollar retaining in perpetuity, but only H. Bloom is actually a subscription business.

They both fare well, because consumer behavior around fresh flowers and groceries has a necessary replenishment model. Food is consumed, and flowers spoil. The subscription model has one additional benefit for H. Bloom, which is rarely discussed. Most flower merchants have to guess at demand on a weekly basis, and therefore have upward of 50 percent spoilage, while the predictability of the subscription model enables H. Bloom to almost perfectly measure demand, dropping the cost of wasted flowers. While it is no easy feat to change the behavior of where people buy flowers and groceries, once they do change, they tend to stick, and in Relay Food’s case, actually buy more over time.

Why is this so important? Besides viral adoption, retention is the only variable available to retailers that drives geometric growth. Despite the importance placed on initial order size, cost of customer acquisition and gross margins, great retention will trump all of these. As long as customers stick indefinitely, you can pay a ton to get people, have low contribution margins and, as they say, make it up in volume. It may take several years to reach scale, but you will end up with a sticky base of customers where you can accurately predict demand and not suffer the leaky bucket problem so common in all e-commerce businesses, subscription or not.

Subscription makes a ton of sense for the right categories of spending, where it is viewed as a service offered to the consumer. It is no secret that I appreciate businesses that play off people’s innate desire to be lazy; however, time will separate the Columbia House models that exploit laziness from the “Sushi Boat” businesses that cater to laziness.

Brian O’Malley is a General Partner with Battery Ventures, and leads the eCommerce practice.

Disclaimer: Battery Ventures is an investor in Groupon, H. Bloom, Relay Foods and Send the Trend (acquired by QVC). Elements of this article have also been discussed at http://gigaom.com/2012/02/14/subscription-commerce-startups/ and http://labaraka.tumblr.com/post/19452076036/please-stay-classy-and-stop-copying-birchbox and http://pandodaily.com/2012/05/11/subscription-commerce-isnt-a-revolutionary-business-model-its-a-smoke-screen/.

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