End of discount financing
George Santayana said “Those who do not remember the past are condemned to repeat it”. We are in December of current year and this would be a good time to reflect on the year and what can you learn.
The first interesting phenomena I’m going to mention is end of discount financing. In last few years, we saw huge venture capital money going into discount financing in different consumer internet businesses such as retail, food, hyper local, travel, transportation. There was some rationale to it but it had its share of criticism. However as we are ending the year, there are clear signs of end of discount financing era. The most visible of this sign is recent statement by Lee Fixel, of Tiger Global. Tiger has invested $2 Billion in 35+ companies including Flipkart and Ola, and have been really aggressive in discount game based plays.
What is discount financing?
Let me give you a quick framework to understand discount financing. Take an example of an e-commerce Company. It sells products to a customer and earns revenue whenever this customer buys any product. Their costs for every sale are cost of product, delivery, payment etc whenever any product is bought. Beside this cost, it also incurs some cost in marketing and sales to acquire the customer for the first time. For better visualization, let’s assume the cost of acquiring is Rs 1,000. Average product price is Rs 800, and average costs are Rs 700. Hence, company makes Rs 100 whenever a customer buys a product. Since company has paid Rs 1,000 to acquire this customer, they will need to sell at least 10 times to this same customer in his life time to make profits from this customer. If this customer buys more than 10 times, company will make profits from her otherwise if customers buy less than 10 times, it is not profitable for the company.
So, this simple framework shows that company invests money to acquire customers and try to increase gross margin and frequency of purchase to recover the acquisition cost and make profits.
Now, what changes in discounting based models is that company gives discount to customers to attract them. In the previous example, if company gives Rs 200 discount on product, the average price changes to Rs 600. Hence, the company loses Rs 100 on every purchase. This doesn’t make sense as the company will end up losing more on every purchase and will never make profits. Right? So why discount based models work? Well, the hope is that you give discounts first few times to attract more customers to increase adoption exponentially. Once they are aware of you and hopefully impressed with your services, they will continue to buy even without discount. The other benefit is increased adoption will help reaching scale quickly that can reduce the cost to service customer significantly.
Acquiring a customer is always a challenge and discount can make life easier for companies. The downside is that you need huge capital to sustain discounts. The risk is that your customer may not be loyal and leave you if your competition provides more discounts.
So, what went wrong?
Aggressive strategies such as discount based models demands aggressive results. Lee Fixel of Tiger was quoted saying ““We have been investing in the discount game for the past five years and realised that there is still no clear winner in those markets”. Many critics would say that return to business fundamentals was bound to happen. Also, when you have multiple deep pocketed investors in market, discount based models will always be vary of competition. It may turn out to be a race to the bottom!
So, if you are an entrepreneur and planning to build a business model around discounting, you need to be far more cautious. The investor frenzy is over and you would need solid unit economics to back your model. As an entrepreneur, you will try to reduce customer acquisition cost as you grow, not because you are giving more discounts, but because your will be able to optimize your marketing, build brand credibility and demonstrate high quality service.