Events reserved for year-end or federal-holiday seasons became regular occurrences last month. Retailers announced 30%-off storewide sales. Vendors offered early payment discounts. Companies renegotiated annual contracts.
Demand across society has changed. Layoffs, furloughs, and salary cuts reduce our ability or willingness to pay for items. Shelter-in-place orders shift our behavior, reducing our need for clothing, gas, sports equipment. General uncertainty delayed other purchases.
(In contrast, demand increased for products and services in a minority of industries.)
In Econ-101, we simplify this overarching reduction in demand as a shift in the demand curve (D0 to D1). The supply curve remained unshifted, in the very short term. We are seeing this change as we enter May but most of what we purchased in March and April was already in the supply chain. When you consider non-tangible goods like software, supply is almost infinite.
If suppliers do not react to shifts in demand, they sell less (Q1) but maintain a price floor. This is common for premium brands. Some would rather burn product than undercut themselves.
But, there is a lot of space between commodity and luxury. Here, pricing can be tricky. Revenue = price x quantity. Since P0 x Q1 = P2 x Q0, optimizing revenue can get confusing… How does one choose whether to discount?
In these times, it might feel obvious. Customers are struggling and may need a reprieve. Providing one feels like a good thing to do.
All three of the major public cloud providers are under pressure from customers for financial relief as a result of the pandemic. Amazon Web Services so far has not been flexible, unlike Microsoft and Google. How each one deals with the crisis could affect its dealings with customers long term. — The Information (paywall)
The misalignment among cloud providers’ approaches shows how difficult this decision is.
Businesses discount for three reasons:
How a company leverages discounting largely depends on their revenue model. This has shifted as the demand and ability to pay for goods and services has changed quickly.
Companies that collect revenue repeatedly and periodically fall into this category. These transactions tend to happen monthly, quarterly, or annually. Ideally they continue indefinitely.
Example business models: SaaS and consumer subscription business models. For example, Quibi, Dollar Shave Club.
Typical use of discounting: 📉 The primary driver for discounting here is lowering CAC. Freemium models, trial periods, 25% off initial purchases all exist to get customers.
Once a customer is in the door, there is little incentive to offer more discounts. Good customers tend to become a consistent and reliable source of revenue.
📉 Discounts for pre-payments decrease a customer’s payback period. These tend to come in the form of a monthly subscription offered at a discount if you purchase a year upfront. An added benefit is a positive impact on a company’s working capital position.
Post-COVID: ⚠ Companies are discounting or providing payment flexibility as a customer retention tool. A few in our portfolio have even offered the ability to forego payment for a period of time (100% discount).
So, even though there will be revenue contraction for a period of time, there will be less logo churn. In theory, it will be easier to reactivate those customers than bring them back had they left.
Or, this flexibility might be hiding or delaying the inevitable. If your customers only have the ability to pay 50% for your product… what will happen when you raise prices again? How long do you offer discounts?
It is difficult to predict which customers will regrow and which won’t. Depending on your cost to service, that could make some customers wildly unprofitable. (Refer to cash flows in the above.) There may be some signals — what your receivables are on an account-by-account basis — but it might not matter. This decision is part economics, morals, and branding.
Companies that receive orders over and over again have re-occurring sales. Different from recurring models, purchases do not need to happen at regular intervals. Transaction size can vary too.
Example business models: Marketplaces and sellers of non-durable goods are good examples.
Typical use of discounting: 📈 Companies use discounts to incentivize consumers to buy more, and more frequently. Think about the notification from UberEats that delivery fees were in half. How often does that prompt you to open the app?
📉 Discounting can also shorten the payback period or decrease CAC. Think about the marketing email from Nike for 25% off your next purchase. Or the referral program for $25 off your first order.
Post-COVID: ⚠Re-occurring models are like recurring revenue but with the added complication of timing. They fall on the wrong side of the status quo bias. If my credit card is set up to bill every week, I have to take action to cancel it. But if I have to proactively buy something every week, it is easy to skip.
Though parts of our supply chain are under strain, others may have a build-up of inventory. For example, if you were a retailer preparing for the spring season, you would already have goods on hand. Your customers that spent $100 last year may only want to spend $75 this year. But with no urgency to spend $75 (hello PJs!)… how do you get them to? Run sales, maybe offer the same clothing for $50… enough consumer surplus that they will buy!
Here we see a risk of over-discounting. If you get it wrong, two things can happen. You acquire unprofitable customers or put existing customers at risk.
Cost of acquiring the wrong customer. Discounts too big may attract unprofitable customers. These customers only buy when you have big sales. Pay attention to acquisition cost and payback period for these cohorts. (E.g. cost per click has decreased recently, but so has conversion. Make sure to stay on top of the math!) Otherwise, a good chance that you’re trying up capital on customers that will never return it:
Disappoint current customers. Unprecedented sales drive unprecedented behavior. This is especially true for premium brands that rarely discount (IronMan, Everlane, etc.). Customers who are financially stable may smell a once-in-a-longtime buying opportunity.
Can you service that demand? And if you can’t, can you communicate well with customers?
My guess is the middle category “delayed but knew before buy” was negligible in pre-COVID times. When service is disrupted, loyal customers may become at risk. At the same time, an opportunity arises to build loyalty if communicated well. For example, read the tone between to retailers that each experienced fulfillment delays:
Customers will be understanding if you communicate.
Digital businesses may think these risks do not apply to them. Even so, we need to be aware that fulfillment is not only physical. Implementation, development, and customer success are all parts of fulfilling a digital order.
Many industries produce goods or services that we consume once or very infrequently.
Example business models: Marketplaces and sellers of durable goods. Think of companies like Casper and GoPro. They sell high-ticket items and struggle selling accessories and related items.
Typical use of discounting: 📈 At the very least, these companies want consumers to buy as much as possible in any transaction. Over the long term, they may discount to incentivize add-ons over time.
Post-COVID: ✔ If they have a build-of of inventory, these companies are looking to liquidate. So much of a customer’s LTV is recognized upfront.
The most productive use of cash is to generate more cash, and quickly. A discount is a cash payment to a customer that turns into cash in the form of revenue. But, not all discounting has the same impact on cash.
Produce revenue. The most productive discounts enable you to recoup cash fast. Easiest to measure in the form of reducing the payback period. Strategies that fall into this category include prepayment discounts ($10 per month or $100 per year). Reactivation discounts (save 25% off your next purchase) and retention discounts (if you stay, we’ll offer 30% off) can impact payback period as well.
Protect revenue. A customer that pays full price is optimal. But a customer that pays a reduced price is better than a customer that pauses purchases*. And a customer that pauses purchases is better than no customer at all. (*As long as marginal cost is less than marginal revenue!)
Acquire revenue. Even in the midst of a crisis, many companies are under pressure to grow. And using cash to acquire customers is a large reason VCs exist! But, if a company is under pressure due to the crisis, they are wise to use cash to keep customers instead of aquiring new. It is expensive to keep filling a leaky bucket.
🤝 All said, providing support for your current and future customers at this time is the right thing to do. It will build loyalty for months and years to come.
Originally published at https://jaydimonte.substack.com.