Today I was chatting with an entrepreneur whose company is in ecommerce; it sells other company’s brands to consumers. He does seven figures in revenue. He’s been affected—not too badly—by the pandemic. He’s concerned and trying to plan for different scenarios.

As I asked more questions about the business, I realized it’s a low-margin business that depends on volume. Product pricing is determined by the brand owner (i.e., it’s the MSRP or MAP), competitors offer the exact same products, there are low barriers to entry, discounting to maintain volume is common, and front-line workers are paid little.

For this kind of business, it’s grow or die. The customer wants to pay less (competitors offer the same product) while costs—shipping, wages, rent, etc.—creep up every year. So, of course, margin percentages gradually go down. Most entrepreneurs compensate by growing revenue.

Let’s look at an example.

• Year 1 – Margins are 10% and the company does $1M in revenue. That’s $100,000 in margin dollars.
• Year 2 – Margins decrease to 9.5% and the company does the same $1M in revenue. That’s only $95,000 in margin dollars.

If the owner wants $100,000 in margin dollars in year 2, he needs to grow revenue 11% to $1.11M in year 2. In other words, he essentially needs to do 11% more work to make the same margin dollars. As the years pass, it begins to get really tough. If margins drop to, say, 5% (that’s an extreme drop), he must do $2M in revenue to make the same $100,000 in gross margin dollars. He’s forced to grow the business or die a slow death because he won’t have enough margin dollars to afford the things he needs to run the company. (Of course, the example is purposely simplistic to make a point. It doesn’t differentiate between gross margin and net margin and it features a massive 50% drop in gross margin percentage.)

This kind of business is in a tough spot when the economy shifts from growth to contraction. I pointed all these things out to this entrepreneur and he agreed. We discussed ways to transition his business to healthier margins (for instance, value-added services, his own branded products) and making the best of this difficult period by renegotiating some of his fixed costs.

Are you an entrepreneur just starting out? Are you building a low-margin business? If so, do you understand the long-term implications of that decision?

Today I met with an entrepreneur who’s preparing to solicit investors. As we walked through his pitch deck, he detailed his advantages over competitors. One of them jumped out at me: lower price.

To be fair, there’s nothing wrong with providing a service or product that adds substantially more value than a competitor’s at a lower price. Companies that can do that are usually employing superior technology. But if your product or service is similar to your competitors’ and you’re differentiating yourself on price, you’re on a slippery slope.

Why? Customer loyalty. If the deciding factor for a customer is low cost, that probably won’t change. If a competitor undercuts your price, you will lose that customer. Bargain hunters don’t tend to be loyal to a brand. OK, you might ask, why not just find a new customer? Well, the number of customers is finite, so you want to keep the ones you have. Then there are customer acquisition costs. Marketing to snag a customer is expensive. The cost is justified when the customer will keep coming back over the long term (Amazon and Walmart are extreme examples) or when a one-time transaction has an extremely high profit margin. But when you spend a lot to acquire a customer who buys only once and your margins are low, you lost money on that relationship.

At CCAW, I learned early the importance of charging a fair price. We redid our pricing strategy in 2011. I was betting that consumers were moving away from a recession mindset and were open to paying full value. As predicted, we lost some customers. However, a foundation of healthier margins allowed us to bootstrap our growth from then on.

Venture capitalists can be reluctant to invest in a company where price is the competitive advantage. I encourage new entrepreneurs to be mindful of what kinds of customers are likely to be loyal.

What lessons have you learned about low prices?