Steep discounts on purchases a boon for online customers but a big gamble for start-ups

Introductory discounts that don’t lead to repeat business are not adding up in the longterm for start-ups

Jet. com, a well-funded new shopping site, opened to the public last week and celebrated the debut by sending reporters a big box of swag. I got a T-shirt with a company logo, fuzzy socks, stickers and $1,400/€1,281 in oversize, fake $100 bills.

Jet is a discount site, so I suspect the funny money was meant to illustrate the cash I’d save by shopping there. But the faux bills immediately evoked a more cautious reminder – of all the money Jet plans to spend to become the next force in online shopping.

It isn’t just Jet. On a venture-capital high, tech start-ups are burning through vast cash reserves to offer rock-bottom prices, and to sign up new customers with discounts, giveaways and other deals that may sound too good to be true.

Jet, a members-only discount company that has raised more than $225 million from investors before opening its doors, is only the largest such example.

Marc Lore, Jet’s chief executive, predicts that it will take the company five years to grow to a point where it is not losing money on every shipment – a threshold it says it will cross once it has signed up about 15 million members and is selling about $20 billion in goods annually.

Losing money on every sale

In addition to losing money on every sale for the foreseeable future, the company has budgeted about $100 per person for advertising and other discounts to acquire its hoped-for millions of paying members. That price is justifiable, Lore said, because once they sign up, customers will pay $50 per year – making a profit for Jet after two years of membership. Forget the fake bills; for Jet, as well as for many of its smaller start-up kin, giving away real money is a key part of business.

This sounds fishy. But there’s an upside: While investors’ cash lasts, consumers could be in for a boon. After all, from the perspective of customers, what’s so bad about companies giving away their venture-funnelled cash?

Whether these start-ups will survive the rampant spending is less clear. The deployment of vast sums by start-ups has drawn comparisons to the tech boom of yore, when companies around the turn of the century poured billions into marketing and giveaways to run businesses whose fundamental economic models could never work. Remember Pets. com and its Super Bowl-crashing sock puppet? Many in the industry, such as Lore, say this pat comparison is overdrawn because start-ups today are more intelligently managing their new-customer offers and per-unit-economic models to give away just enough, but not too much.

Tech founders and investors argue that because of a constant connection with customers via mobile apps, and with access to a mountain of data with which to analyse people’s spending patterns, companies have created smarter ways to use discounts to drive up demand, dynamically alter price and target only the most attractive new consumers.

"It's more sophisticated because there are better tracking mechanisms of consumers, and more established methods of analysing cohorts of customers in slices," said Dan Levitan, a co-founder of the venture firm Maveron, which has backed e-commerce and delivery companies including Zulily and Peach.

If the boosters are right, there could be huge benefits to the free spending. I’ve previously criticised companies for offering services that target the ultra-rich, but it is also true that because of venture dollars flowing into start-ups, customers can now enjoy convenient services at low prices.

In San Francisco, New York and several other cities, you can use apps such as Luxe or Zirx to contact valet parking attendants who will pick up and park your car, and then return it when you're done, all for less than you'd spend in a city parking lot. There are start-ups promising food delivery for just $1, and home-cleaning firms offering to tidy your apartment for less than you'd spend on a night at the movies.The assurances of tech insiders about all their spending may well turn out to be blindly optimistic.

This is Silicon Valley, where sunny forecasts are undiminished by the cautionary tales.

Homejoy, a firm that offered cleaning services, recently announced that it would be shutting down. Though the founders did not respond to interview requests, former employees and others with knowledge of the company’s operations have said that Homejoy died of overdiscounting. It offered too many cheap cleanings, and didn’t get enough full-priced recurring business in return.

A similar pattern of high customer acquisition costs and an inattention to margins have hampered a string of start-ups over the past few years, among them the flash-sales site Fab. com, which was sold this year for $15 million after raising $330 million, and the local discounter Groupon (still limping along after going public in 2011).

Start-up founders say they’re aware of the risks of overdiscounting and underpricing, and are moving swiftly to manage them.

"You're absolutely right that we don't make money on certain customers on day one, but on the average customer, on day one, we make money," said Oisin Hanrahan, co-founder and chief executive of Handy, one of the largest on-demand home cleaning start-ups.

Hanrahan said the firm is making money on new orders and on recurring customers, though that is not enough to cover the company’s overall costs.

Like Homejoy, Handy offers some steep discounts for new customers: A two-hour cleaning normally sells for $54, but online coupons can reduce that to $29 or even $19.

Until about six months ago, Handy was losing money on new customers. But Hanrahan said Handy had been able to reduce discounts as its service grew more popular, because it was getting many new customers who searched for its service without first looking for a discount.

Because it can track and study user response, Handy also cuts off discounts after one cleaning, and it has found savvy ways to push customers to join a subscription programme that sells recurring cleanings at full price, he said. The company now does more than 100,000 cleanings a month, and in any given week, 80 per cent of bookings come from these subscribers. On average, these customers pay $70, of which Handy takes $14 (the cleaners take the rest).

Handy’s approach of terminating discounts after one or two uses seems widespread.

A few weeks ago, I tried to get free meals by signing up for some on-demand food-delivery firms and passing around referral codes to friends. I didn’t get very far; after a few heavily discounted dinners, I found the only way to get another meal was to pay full price.

Some on-demand firms have even found that after hooking users, they can raise prices.

Luxe, the parking start-up, began offering valet parking in San Francisco last year for $5 an hour, with a maximum daily rate of $15.

In April, the company – which has since expanded to several other cities – added a surge-pricing plan, which charges users close to double that price at busy times. Curtis Lee, Luxe's chief executive, said he was surprised by a lack of outrage."We noticed when we did peak pricing, we didn't see a massive decline in demand," he said.

There are still some audacious pricing schemes out there. Postmates, a fast-growing delivery company, has announced a plan to charge $1 for some orders. The company declined to explain how that could work, but several people in the delivery industry told me that $1 deliveries would be impossible to make profitable at any scale.

Intense competition in the delivery space may be prompting such offers. According to one venture capitalist, “some of these companies are forced into making moves that they know don’t make long-term economic sense, but they could make short-term economic sense if they end up winning the customer’s loyalty.”

Another pitfall for the start-ups may be how the demographics of their customers change as the firms grow. “Not all of the US is willing to spend the way early customers in Silicon Valley spend,” one investor told me.

Undercutting Amazon

Jet’s prices may be the most ambitious. In May, I found the company was vastly undercutting Amazon, and

The Wall Street Journal

recently ordered a basket of goods from the site, for which it calculated that Jet lost nearly $243 on a single order. In an interview, Lore was unfazed by these numbers, because, he said, they were already baked into his projections.

“We understand really well what these costs are now and how they’ll come down over time, and it’s simply a matter of understanding how much capital it’s going to take,” he said. In fact, he added, losing money on each order isn’t his biggest worry; instead, it’s failing to grow enough orders to get to scale.“

The hard part is, can you get to $20 billion in five years?” The only way to get there, Lore said, is to keep spending. Whether or not he’s right, enjoy it. – © New York Times Service