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Posted Date: 2/7/2013

Revenue Share: A Dirty Word or a Cheaper OpEx Cost In Disguise?

As an e-commerce and technology executive with 15 years in consulting and managing e-commerce businesses, I have seen my share of exuberant expectations. Open an online store and sell $100 million… easy right? This hope has a pretty big effect on the decisions made around an e-commerce business. One of the most common knee-jerk reactions is to the revenue share model, where a company shares a percent of its topline revenue for services rendered. The rev share model generates a negative response mostly from owners, CEOs and CFOs. The thought process tends to be, "We'll get screwed when we get to $100 million!"

In many small to mid-cap brands ($10 million to $1 billion in wholesale revenue), the revenue share models for the e-commerce portion of their businesses will end up cheaper than the comparable OpEx costs that are their substitutes or strategic alternatives.

Revenue share history
Revenue share began as a simple way for businesses to get into e-commerce while lowering or eliminating many of the costs that are barriers to entry, such as photography, technology, direct-to-consumer customer service and logistics.

While these functions most definitely exist within a company's wholesale business, the competency required from a direct-to-consumer perspective is vastly different. Warehouses are not accustomed to single-item shipments and 10 percent return rates. Photography for a product detail page differs from that for standard marketing. Even customer service employees differ from a personality and core competency perspective. These costs and hurdles add up quickly and can hurt wholesale performance, which is the majority of a company's business. Bottom line, adding e-commerce capability for the first time can be painful.

Yet if you're tasked with delivering a strategic direction for e-commerce for your company, you'll likely elicit groans if revenue-share solutions are presented as a possibility. CFOs and CEOs see it as permanently eroding their gross margins.

Two types of revenue share models
Revenue-share models fall into two large buckets. Let's discuss both.

"All-in"
"All-in" addresses the cost barriers for smaller companies looking to do $1 million to $10 million in revenue online. These providers would charge 20 percent to 40 percent rev-share for running your e-commerce business from start to finish. You generally consign the inventory to the provider's warehouse, and they take care of photography, platform, customer service, all of it. You receive a check monthly.

This model is used as a launching pad for many businesses before they bring e-commerce back in house. Well-regarded apparel and footwear retailers such as Converse, Target and lululemon all have followed this model.

"Enterprise"
The second model we'll call "enterprise." There is a business model arising among some of the best e-commerce platforms to charge a revenue share vs. selling a licensed piece of software. This revenue share tends to be much lower as it doesn't replace the operational tasks that weigh so heavily on a smaller organization but instead replaces the purchase of enterprise software.

As a business grows, the risk of not having an enterprise-class platform that is truly scalable becomes higher and higher. PCI compliance, privacy, best-of-breed security and reliability all become significant issues very quickly. A great problem to have, of course, but a problem nonetheless. Whether a company started on its own with an open-source platform such as Magento or with an "all-in" provider, it faces the same challenges when graduating to the next level, the biggest usually being the cost of buying and maintaining the platform. The rev-share fees tend to be 5 percent to 7 percent of revenue for access to an enterprise solution.

Cost scenarios
Let's walk through two different hypothetical situations.

A $50-million to $100-million brand that has not executed an e-commerce strategy yet and wants one. Companies this size could partner with one of the many "all-in" e-commerce providers. Most brands of this size would sell $1 million-$2 million in Year 1 and grow by 30 percent to 50 percent year over year. The rev share expense looks to be $300,000 to $600,000 for photographers, warehousing, customer service and merchant processing (of which they eat 3 percent of that rev-share for credit card fees). A hard deal to replicate if you did it yourself.

A $200-million to $1-billion brand that wants an "enterprise solution." With the "enterprise" model, access to the software can be acquired with a nominal revenue share, let's say 5 percent. Now we are talking about a company selling $5 million to $50 million online and paying rev share fees of $250,000 to $2.5 million. The alternative is to purchase an enterprise system for, let's say $1 million, amortized/financed conservatively over 5 years. Here you are paying license fees, software maintenance fees and hosting fees ($200,000, $250,000 and $250,000, respectively, at the lower end and growing quickly as business increases).

Both of these scenarios result in the same conclusion. The revenue-share dollars vs. OpEx costs can be significantly cheaper at the lower end and break even or better at the middle to higher end of the revenue depending on your negotiating skills.

So why the negative reaction?
If you can negotiate a deal that delivers a better bottom line or profitability for the e-commerce P&L, then what's the problem? Revenue recognition and margin are the problems.

Companies, especially public ones, are driven as much by top-line revenue as by bottom-line profitability. In a typical "all-in" revenue share model, the service provider is the merchant-of-record. Which means the vendors pays the brand its share, and that's the revenue the brand can recognize. Brand X sells $9 million in product to the end consumer but can only state they sold $5.4 million (60 percent of the $9 million). It's not a great story.

The same math causes problem for gross margins. Instead of the 70+ percent margins that are typically associated with a brand's own e-commerce business, the company is now working on a close-to-wholesale margin.

*Assumes a 25$ cost, 50$ wholesale, $100 retail and 30% rev share

Sell Direct All-In Rev Share
Cost:25$ Cost:55$
Sell Price: $100 Sell Price: $100   
Margin: 75% Margin: 45%


Not nearly as compelling a story, is it?

On the enterprise side the problem is different, yet similar. It is still a conversation around gross margin but around the long-term, large-scale, impact and opportunity cost at a macro level. If e-commerce grows 400 percent a year, how exposed are we as a company? In the end the margin of a single product is just as exposed at $1 million in revenue as it is at $100 million in revenue. Does the opportunity cost grow? Of course. And that brings us forward to this blunt statement:

Having a well-negotiated rev-share model that truly starts to erode profitability (not margin or topline but true profitability) will be the best damn problem you have ever had.

There always comes a point in time where both rev-share models start to make less and less sense and start to have that significant opportunity cost. Let's hope we all get there.

John Hazen is vice president, global e-commerce for Fox Head Inc, an active lifestyle apparel brand.


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