Shopify’s goal is to build a global operating system for retail. To understand what this means, think of Shopify as a website anyone can visit to sign up for a store—prices start at $29 per month for a full online store experience including unlimited product listings—and get up and running in a few minutes. It is software delivered as a service, substantially lowering the barriers to entrepreneurship. Shopify is a beneficiary of the explosion in cloud computing, like many of our other holdings.
Shopify’s founder Tobi Lütke grew up in Germany. About his early years, he reminisces:
I got my first computer when I was 6, and I was part of that early generation of children who grew up with computers always being around. I fell in love with them early on.
I never cared a lot for school. I categorized school as a history lesson because it was so obvious that computers were different. My parents didn’t understand them, my teachers didn’t. You can imagine the authority problems that stem from a situation where the people you know don’t know anything about the things you care about.
This is probably why I had to start a company at some point, because I don’t think I could have worked for anyone else. So I taught myself programming, and picked up an apprenticeship when I was 16 as a programmer at Siemens. I never went to university.
I also have a weird obsession with optimizing things. Even when I was walking to elementary school, I counted the number of steps on different routes so I could figure out which one was shortest.
I’m always trying to think of ways to make something more efficient. If I have to do something once, that’s fine. If I have to do it twice, I’m kind of annoyed. And if I have to do it three times, I’m going to try to automate it.
In 2004, after moving to Canada, Lütke started Shopify out of frustration: he was trying to sell snowboards online, and existing software packages just didn’t cut it. Back then, everything about selling online involved friction. To obtain a merchant account and accept credit cards online, Lütke had to post a $10,000 bond, fax his driver’s license and password to Utah, and wait 30 days. Implementing one of the existing ecommerce software packages took hundreds of thousands of dollars and many months.
Today, setting up a store and accepting payments on Shopify takes minutes and costs a few lattes. I’ve been following Shopify and Lütke for quite a while; Lütke is one of the smartest and most thoughtful founder/CEOs today.
Given Shopify’s young age and enormous market—commerce—the company faces meaningful competitors: Magento (acquired by Adobe in 2018), Demandware (acquired by Salesforce in 2016), BigCommerce (a SaaS-based solution) other offerings from enterprise software giants Oracle and SAP and point solutions like WooCommerce (an open-source plugin for WordPress). However, by all accounts, Shopify has been taking market share from incumbents and outpacing challengers by offering a better user experience and faster innovation, at a substantially lower price.
At the high end, for instance, Shopify Plus, which is Shopify’s most expensive tier and suitable for large merchants, costs only $2,000 per month plus 0.25 percent of gross merchandise volume (GMV) sold above $800,000. BigCommerce, which has inferior solutions for multichannel commerce and point of sale, charges 0.5 percent of GMV; Demandware (now called Salesforce Commerce Cloud) starts at 1 percent of GMV, 4x pricier, with an unlimited tier closer to 2 percent of GMV. For a shop selling $20 million in yearly GMV, the difference between Shopify Plus and the lowest Demandware tier amounts to $150,000 per year. Magento is similarly expensive.
“Demandware is a great place for a very large retailer who wants to outsource their ecommerce and have a massive services team come in, embed in their company for six months and build it. That is not really who we compete with,” says Shopify COO Harley Finkelstein. As Shopify continues to invest heavily in research and development, any product and feature gaps with Demandware will continue to shrink, at a substantially lower price point.
Despite the enormous resources of Salesforce ($16.9 billion in revenues compared with $1.6 billion for Shopify), Shopify is eating Demandware’s lunch:
Most striking is Shopify Plus’s lower total cost of ownership. Competitors such as Magento and Demandware not only have much higher ongoing fees in terms of take rate (percentage of GMV), they also require heavier maintenance and costlier hosting. Magento in particular has been such a weak competitor, Lütke jokes they think of Magento as a great place to find merchants to onboard onto Shopify Plus.
In textbook Innovator’s Dilemma style, Shopify began at the low-end and moved up market with Shopify Plus. The goal is to save the merchant the hassle of replatforming, or switching ecommerce platforms. Accountants might start with Excel, then move to QuickBooks and finally to Oracle as they grow and require more sophisticated features. Shopify wants to keep the merchant throughout that whole journey, and Plus is the answer: they call it “cradle to scale.”
In true disruptor style, it’s not giving up the low-end. If all a merchant wants is to sell on Facebook, Shopify Lite does it for $9 per month. With all the features, security, hosting and constant improvement, nobody can undercut Shopify on price.
Shopify doesn’t market itself as an operating system for retail, because as Finkelstein points out, “no merchant is looking for that.” Shopify provides a central hub for the increasing complexity in today’s commerce world: there are multiple sales channels (online store, offline store, and integrations with marketplaces like Amazon, eBay, Instagram, Facebook and Pinterest). In the future, there will be an augmented reality channel, and very likely, a virtual reality channel. “The advantage of Shopify is that it all feeds back to one centralized place,” Finkelstein notes.
One common misconception about Shopify is that the company has “high churn,” which means that a lot of the customers it signs up end up leaving the platform. This is a misconception because while it’s true, it’s a feature of Shopify, not a bug.
The cost of onboarding a merchant onto Shopify is effectively zero—it’s the cost of making a database entry. Therefore, Shopify should onboard as many merchants as possible, because you never know who is going to achieve product/market fit and hit it big. The unit churn doesn’t matter; what would be concerning is if there is a leaky bucket problem, or dollar churn. Here, Shopify shines, with positive revenue cohorts every year. The higher up one goes in Shopify’s tiers, the less churn there is; at the highest Shopify Plus level—its most valuable merchants—churn is de minimis.
Key to Shopify’s success is its partner ecosystem. These include developers of applications that plug into and enhance the functionality of Shopify; designers of themes that Shopify merchants can use for their stores; and other types of partners such as agencies that help build and manage Shopify stores. This ecosystem acts as a distributed sales force for Shopify. The company doesn’t employ any salespeople at all, relying first on frictionless onboarding through its website (Shopify does have salespeople for the Plus offering, which is a higher touch product for large merchants). In terms of customer acquisition, the top channels for Shopify are organic (Shopify runs the world’s most popular ecommerce blog), paid advertising channels (like Facebook ads), and finally, partner referrals.
Over the past year 23,000 of these partners—most of them agencies that help merchants set up, design and manage their stores—referred merchants to Shopify. Whenever a partner refers a merchant to Shopify, Shopify pays out 20 percent of that merchant’s subscription revenue for the life of that merchant back to the partner. This is a great way to build partner loyalty. In international markets, where Shopify has been growing faster, the revenue share is 30 percent, spurring the growth of a thriving partner ecosystem.
There are currently 3,200 apps available on the Shopify App Store. Whenever a developer sells an app on the Shopify App store, Shopify pays out 80 percent of the economics to that developer (this is more generous than the Apple iOS app store, which pays out only 70 percent).
Shopify is in the early days of building a valuable platform, and by platform, I mean something very intentional: a structure on which others can stand and build something even larger. Some of the world’s largest platforms—with millions of developers earning multiples of what the platform-maker earns—include AWS, Microsoft, Apple’s iOS and Google’s Android. It took about nine years for Shopify to pay out its first $100 million to developers, but then it only took twelve months to pay out the next $100 million.
Partner and developer ecosystems reinforce the flywheel advantages of the business: the more partners there are, the easier it is to get started on a complicated Shopify project. The more apps available, the more powerful and adaptable are Shopify’s features. In ecological terms, we can think of Shopify’s developer ecosystem as a distributed immune system, helping the host fend off competitive incursions. It’s an army tasked with widening Shopify’s moat.
There are two main drivers of Shopify’s value over time. First is GMV growth. How quickly can the sales volume of Shopify’s merchants grow over time, and how big could GMV get?
We know that ecommerce adoption in the US is about 10 percent of total retail sales. It is lower still in most countries outside the US (with some notable exceptions like the UK and China). There is a long-term adoption curve expanding sales from offline to online and multichannel, and this benefits Shopify.
Second, Shopify is winning business from its competitors. Every large merchant who drops Demandware or Magento and moves to Shopify Plus grows GMV for Shopify. The result: if we look at online GMV only, Shopify is currently the country’s third largest “retailer,” behind Amazon and eBay, and with larger ecommerce sales than Walmart and Apple. With 51 percent GMV growth (year-over-year) last quarter, Shopify will soon overtake a shrinking eBay.
Finally, with each pain point that Shopify eliminates for merchants, it lowers the barriers to entry for would-be online vendors. It grows the pie to encompass entrepreneurs who might never have been merchants otherwise. Two examples here are instructive.
At the high end, even established CPG companies like Johnson & Johnson, Unilever, Proctor & Gamble and General Mills are now Shopify Plus customers. CMOs wishing to experiment with a new direct-to-consumer concept can pull out their credit card and get started in a few hours. Here’s how Finkelstein thinks about this:
So every year, we have been changing or at least adjusting the pricing plan for Shopify Plus. If you think about the price-to-value ratio of Plus, it is very much weighed on the side of value. And so we have not necessarily optimized for revenue maximization.
What we're trying to do right now is, we see a massive opportunity in the enterprise e-commerce space. Everyone has been acquired effectively. Most of them have been acquired by companies that want to sell other products to those customers, whether it’s Adobe or it’s Salesforce.
And we're not seeing great innovation. And the pricing is still kind of out of whack. And so the idea is, let's make Shopify Plus too good to ignore, so that anyone who is even thinking about enterprise e-commerce, whether they're a new CPG brand, first time going direct-to-consumer, or they're a migration from one of the other major players, that Shopify Plus becomes a no-brainer. And that's kind of what we're doing with pricing.
And so I think there will be room to adjust that longer term. But fundamentally, we like the fact that all roads lead to Shopify Plus right now in the enterprise world.
At the low end, Shopify grows the pie by enabling entirely new types of merchants to emerge. One obvious example is the celebrity merchant, like Kylie Jenner, who built an enormous business on Shopify, Kylie Cosmetics, into a business worth $800 million in less than two years.
A more recent example is Jeffree Star Cosmetics, created by YouTube stars Jeffree Star and Shane Dawson. Within minutes of the site’s launch, it had crashed; which is surprising, because Shopify is hosted on Google Cloud and engineered for highly demanding workloads. But nothing like this, as Web Smith, an ecommerce analyst, wrote:
According to Business Insider:
In the latest episode, "The $20 Million Dollar Deal with Jeffree Star," Star told Dawson their upcoming eyeshadow palette could earn him $10 million.
In a meeting, the team discussed the idea of an initial launch of one million palettes, which Star said would be his biggest purchase order ever. For comparison, Star launched his debut "Blood Sugar" palette with 100,000 units.
Clearly bemused and in shock by the numbers, Shane said he had never sold that much of anything and it was "impossible" to fathom.
"The thought of that many people actually buying something, I can't," he said. "What if people don't buy it?"
When the site came back up, they sold their one million palettes in 30 minutes.
The second driver of Shopify’s value over time is its take rate, which is simply “how much in revenues can Shopify earn out of the GMV it enables?” Recall that Shopify costs $29 per month for an entry-level store, but 0.25 percent of GMV at the high end for Shopify Plus. To simplify, if all of Shopify were just Shopify Plus and the only revenues Shopify earned were those 0.25 percent of GMV, then Shopify’s take rate would be 0.25 percent of GMV.
Yet Shopify earns a lot more than just a take rate on Shopify Plus. Recall that Shopify earns 20 percent of revenues of each of the 3,200 apps on its marketplace. It also earns monthly subscription revenues for Shopify Plus and every tier beneath it. In addition, Shopify keeps creating new solutions to solve merchant pain points, and each of these increases their share of merchants’ wallets: Shopify Payments (credit card acceptance and payment processing), Shopify Capital (loans made against merchants’ sales) and Shopify Shipping (software that calculates rates, prints labels, and enables access to discounted rates for various shipping partners, saving time and money).
These additional revenue streams raise Shopify’s take rate to about 2.6 percent of GMV. eBay has a take rate approaching 9 percent. Etsy has a take rate of 15 percent, and Amazon’s is even higher. These comparisons are unfair: marketplaces will by definition have higher take rates because they solve the problem of customer acquisition. Shopify merchants must spend significant time and money in sales and marketing, whereas a seller on eBay has an enormous pool of buyers ready to transact. Still, further offerings should allow Shopify to increase its take rate over time.
A recent example: Shopify announced Shopify Fulfillment Network (SFN), which allows merchants to eschew warehouses and delegate logistics to Shopify’s network of partners.
Over time, two things should happen: Shopify will be able to exercise pricing power at the high end (Shopify Plus) and will continue building more solutions for merchants (like Payments, Capital, Shipping and now Fulfillment). Gradually, the take rate will rise.
Shopify has said many times that it aspires to operating margins of at least 20 percent, which seems reasonable given the company’s gross margins and cost structure. Using these inputs—GMV growth into Shopify’s expanding addressable market, take rate and operating margins—we can build and sensitize our discounted cash flow model and take a stab at valuing the business. Depending on our assumptions, the stock will deliver a different set of returns, but it’s unlikely we’ll lose money over the long run. Hopefully the outcomes are such that our more optimistic scenarios end up looking conservative. The ambition of Shopify’s founder and executives, and their speed of innovation, hopefully will see to that:
[Note: this post is an excerpt from one of our letters to investors, originally published on December 2, 2019. To learn more, check out our investors section.]
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