eBay: Gross Margin Nirvana
16 October 2009 John Mullins
In their new book Getting to Plan B, authors John Mullins and Randy Komisar address how truly great entrepreneurs have made radical changes to their initial business models, become household names, and delivered huge returns for investors. In this exclusive excerpt they focus on how eBay moved from Plan A to a business model that worked.
What if you could create a company with no costs of goods sold at all? Recall our equation:
Gross margin = Revenue - Cost of goods sold (COGS).
If there were no COGS, every $1 in revenue would generate $1 in gross margin. This is a very nice daydream, unattainable for most companies. Unlike most of our other case studies, which evolved their business models over time, eBay launched a revolutionary business model that came close to gross margin nirvana from day one.
What prompted Pierre Omidyar to start AuctionWeb (the eBay name came later) was not what most people think. He was not trying to find a way for his fiancée to get rid of unwanted trinkets in her basement. He was not even trying to strike it rich. As nerdy as it might sound, he wanted to create a 'perfect market'. In this market, buyers and sellers could interact freely. Buyers would have access to perfect information, sellers would have equal opportunity to sell their goods. He thought the internet would enable just such a market.
So, in 1995, over a fabled Labor Day weekend, Omidyar developed a little auction website. Called AuctionWeb.com, it allowed users to list, view and place bids on items free of charge. As he described it: 'Instead of posting a classified ad saying I have this object for sale, give me a hundred dollars, you post it and say here's a minimum price. If there's more than one person interested, let them fight it out ... The seller would by definition get the market price for the item, whatever that might be on a particular day.'
He proved to himself that his model worked by listing his own broken laser pointer on the site. The broken item even got him $14, enough for a couple of lattes and scones at the nearest Starbucks. Omidyar proved that his concept had promise, receiving 10,000 individual bids by the end of 1995.
Making AuctionWeb into a business
By February 1996, Omidyar's website was getting so much traffic that his internet service provider (ISP) decided he must be doing more than just maintaining a personal website. The ISP began charging him $250 per month. To pay his ISP bills, Omidyar started charging the site's users. Whether they would pay and if so, how much was a huge leap of faith.
Omidyar decided that, for his new revenue model, it made sense to keep the service free to buyers and charge sellers if and only if they successfully made a sale. His 'final value fee' to sellers was based on a percentage of the item's sale price.
Later, listing fees were added when a seller listed an item, calculated on a graduated scale based on the cost of the item. These various fees were AuctionWeb's revenue.
Unlike other auction websites at the time, AuctionWeb never took possession of the goods being sold on its site. And AuctionWeb did not stand in between buyers' and sellers' exchange of money. Instead, the buyers and sellers were responsible for coordinating the payment and shipment of goods.
By the end of 1996, Omidyar quit his day job to focus on AuctionWeb, and that year it took in $350,000 in listing and transaction fees. But AuctionWeb's costs were minimal, with COGS including only expenses for moving bids and responses - just electrons, really - over the web and hosting and operating the website on which its customers' items were listed.
The rest of its costs - office rent, salaries, computer hardware, and software development - were operating expenses and thus didn't impact gross margins. AuctionWeb's gross margin exceeded 80%. Compared with the complexity of a manufacturing business, this gross margin model is so simple, and so lucrative, it hurts!
By using the web, AuctionWeb eliminated the need to set up a physical store, procure and ship goods, manage inventory and deal with returns. At the time, Faye Landes, an e-commerce analyst at Sanford C. Bernstein & Co., said: 'AuctionWeb is the only e-tailer that really fulfills the promise of the web. And the key is its virtuality.'
Let's compare AuctionWeb's virtual business with its rival at the time, Onsale. In 1996, Onsale was the biggest online auction site. It had a solid revenue model, charging sellers both for transactions and a percentage of the sale itself. But, unlike AuctionWeb, Onsale took possession of the auctioned goods to inspect and ship them. In doing so, Onsale had a lot of COGS that AuctionWeb did not: payroll for employees managing the inspection, shipping and receiving, the shipping costs themselves, and so on. These expenses made Onsale far less profitable than AuctionWeb - while AuctionWeb's gross margins were hovering around 80%, Onsale's were just under 10%. Onsale was using the wrong gross margin model.
In 1997, AuctionWeb received its first and only round of venture funding. Benchmark Capital invested $5 million for 21.5% of the company, one of the best venture capital investments ever made. That year, the AuctionWeb name was retired and eBay (for Echo Bay Technology Group) was born. Growth took off - by the first quarter of 1998 eBay was collecting $3 million per month in revenue.
Almost two years after Omidyar sold his laser pointer, eBay went public, valued at $2 billion on the day of its offering. At that time, eBay had gross margins of 88%; Amazon.com, the other 'big' internet company, had 22% gross margins. In 1999, three years after its inception, eBay employed 1500 people and supported $5 billion in transactions. By comparison, it took Microsoft 19 years and 16,000 employees to generate that same amount of economic activity.
Like any smart company, eBay continued to find new ways to generate revenue and a stellar gross margin. To increase its average selling price, it launched eBay Motors.
Although it seemed hard to believe at the time, people felt comfortable buying and selling cars online. For $25, a seller could list a vehicle on eBay. If it sold, eBay collected another $25. Simon Rothman, who was in charge of eBay Motors, once said: 'Our profit margins are so high it's almost impossible to have higher margins.' After all, it didn't cost eBay any more or less money if a seller was listing a toaster oven or a Lamborghini. However, the revenue generated from the two listings was totally different. eBay's gross margins, in both percentage and absolute terms, grew better still.
By the end of 2000, revenue - from listing and transaction fees - was $431.4 million, a 92% increase over 1999. The company had 22.5 million registered users and $1.6 billion in merchandise sales. And, unlike brick-and-mortar companies, COGS were minimal. The only costs incurred to make a sale were for payment processing - which eBay had begun to facilitate - plus customer support and website operations. As CFO Gary Bengier put it: 'I've been in technology for 19 years and I've never seen a business model as simple or as elegant as this one. How many companies can say their business model is characterized by the things they don't have to do?'
From the eBay story, we've seen the sheer power of a gross margin model where COGS approaches zero. Best of all for Pierre Omidyar, its Plan A was right on the money from day one, and iteration - to eBay Motors, with even higher gross margins, for example - came much later, after success was already in hand. The internet makes this possible, though, for far more than trading the unwanted goods in your basement.
By enabling the transmission of books, music and who knows what else as mere bits and bytes of digital data, sellers are now able to sell all kinds of things with a cost of goods sold far less than if these things were sold in their more physical form. That's exciting, on one hand, if customers prove willing to pay physical prices for digital goods. On the other hand, in competitive markets, sooner or later, high gross margins inevitably come under pressure, as later entrants join what looks like a profitable party, driving prices downward toward cost.
Will the internet create new high-margin opportunities? Or will it ultimately simply make buying and selling more efficient in category after category? Perhaps your company will make its mark in one of these ways.
Reprinted by permission of Harvard Business Press. Excerpt from Getting to Plan B. Copyright 2009 John Mullins and Randy Komisar All rights reserved.