eBay, one Internet business model that works

This case study looks at how eBay proved to have one of the most compelling and economically viable business models of any Web-based company.

During the dot.com bust, countless companies went under precisely because the business models they had created were simply uneconomic. One dot.com stood out, however: eBay. Why?

eBay was founded by Pierre Omidyar in September 1995. Omidyar and his team did many things right, but the most dramatic of these was the business model they created. The table below shows how eBay’s business model matches the basic criteria for economic viability. Let’s direct some attention to each of these items.

Adequate revenue

eBay generated revenue by way of various fees and commissions. ‘It’s a very clean model. There are not many risks’, said eBay’s chief financial officer Rajiv Dutta. To start with, eBay charged an insertion fee based on the opening price of the merchandise. Sellers paid between $0.30 and $3.30 per product listed on eBay’s site. An additional fee was charged to those interested in a tenday auction option. Other fees were charged if a seller wanted to promote their own auction. eBay also allowed businesses to auction merchandise. In this space, eBay charged fellow companies $9.95 per month to have what it called a ‘storefront’. For items that were not up for auction (fixed price), eBay charged its sellers another fee. And, in what was called a ‘Dutch Auction’ scenario, where sellers sold more than one item per auction, eBay established yet another special fee.

While the fees accounted for some of eBay’s revenues, commissions were its bread and butter. eBay charged a commission on each sale. The commission percentage was based on a sliding scale, depending on the sale price of the merchandise. In 2001, the company generated $300 million in commissions. In January 2002, the company raised its commission rates, or what it called its ‘final value fees’. For items selling for $25 or less, the company charged a 5.25 per cent fee. For items that sold for between $25.01 and $1000, the company charged 2.75 per cent. And for those that sold for over $1000, eBay received a 1.50 per cent commission.

The best news was that sellers and shoppers were plentiful. In 1998, a mere 3 years after its launch, eBay had 1 million shoppers, some 600,000 items for sale, and $6 million in revenues. By 2000, there were over 3 million items for sale at any given time.23 By 2001, with almost 40 million users, eBay commanded more than 80 per cent of the Internet person-to-person auction market. Sales were expected to surpass $1 billion in 2002. No longer a site to exchange stuffed dolls, eBay users bought cars, jet planes, computers, printers, cameras and more.

Customer acquisition and retention costs, time to attract a customer

As good fortune would have it, more than half of all eBay users were referred by other users, which means eBay had to spend relatively little on marketing. Aside from an occasional advertisement and deals with major portals like AOL to deliver customers, it cost eBay little to win a customer and even less to retain them. As tech writer Rick Spence wrote, ‘Last fall I fell in love with eBay . . . It’s all there. I was hooked.’

Adequate gross margins to cover the cost structure

Best of all, because eBay is nothing more than a series of software applications placed on servers, the actual cost of doing this business is extremely low – certainly much, much lower than the cost of running Amazon’s business. eBay does not buy products that it then has to package and sell. Instead, eBay lets its sellers bear these costs. As BusinessWeek’s Robert Hof notes, ‘Customers are eBay’s de facto product-development team, sales and marketing force, merchandising department, and security detail – all rolled into one.’

The net result of all this is gross margins above 85 per cent. True, eBay must invest in software, server technology and customer service. But factories? No. Distribution centres? No. Delivery trucks? Not one. That twentieth-century business model is an expensive one. eBay simply enables the resale of things that others own and takes a small cut of each sale.

Operating cash cycle characteristics

Most entrepreneurs have to worry about how much cash they’ll have to tie up in working capital like inventory, how quickly their customers will pay, and how long they can wait to pay their suppliers. Not the case for eBay. Since the real transactions were carried out between eBay’s buyers and sellers, eBay didn’t have to worry about any of these things. Sellers paid to list what was for sale and they paid again when the transaction was done. If they didn’t pay, they lost their ability to use eBay again. It’s a self-policing system, and it works. These favourable cash cycle characteristics meant that once eBay got started and went public, it was able to grow without needing to raise further capital.

Sparkling results

eBay’s business model offered something for everyone: buyer and seller were happy when they reached a deal, and eBay got its cut. And eBay’s cut was nothing to sneeze at:

• In 1998, there were 2 million items for sale on eBay. Those 2 million items sold for $746 million, of which eBay generated $47.1 million in revenues. That came to $687,000 in revenues per eBay employee.
• In 2001, the company hosted $5 billion worth of transactions, more than any other dot.com.

The real story, though, was eBay’s profitability. For 2002, analysts were projecting that eBay’s sales would rise by 40 per cent, to $1 billion, and profit would be up 56 per cent, to $150 million. Rivals were in awe: ‘These guys have done a killer job’, admits amazon.com Chief Financial Officer Warren C. Jenson. Financial analyst William Harnisch, president of Forstmann-Leff Associates, says eBay is one of the few companies that can sustain speedy growth even in a sluggish environment. He points out that eBay has been growing at 50 per cent a year. He sees eBay earning 48 cents a share in 2001, 75 cents in 2002 and $1.15 in 2003. Not a bad business model!

Lessons learned from eBay

Put simply, if your business model doesn’t add up, your business won’t last. If it costs you too much to do what you want to do – regardless of how innovative you are – then your business will die. eBay’s economics worked.

An economically viable business model is not a panacea, but it does serve as table stakes. Without a viable model, you really cannot expect a seat at the table for very long. Before you write a business plan, examine whether you can claim a genuine sustainable advantage. If your economics aren’t viable, then move on.