Understanding Shopify's business model

Shopify has become a northern darling; a made-in-Canada success story, evidence that the Canucks can get into e-commerce and the California-dominated startup world. Its Ottawa headquarters has played host to Prime Minister Justin Trudeau more than once.

But ask the average passer-by of Shopify’s Elgin Street headquarters, downtown in the nation’s capital, and few would be able to tell you exactly what the business does.

Half of their enterprise is pretty straightforward, and more recognizable. The company offers various subscription plans for small-and-medium-sized companies. A monthly subscription could run you anywhere from under $10 to over $2,000 — each level of subscription is designed for the size and needs of the business.

But it’s the other half of the business that is increasingly coming under focus of investors and which, if one short-seller is right, may attract the attention of American regulators.

Critics say the firm is massively overvalued and is potentially operating a pyramid scheme, an unlawful business model where returns for older investors are paid by new investors, rather than from legitimate business activities.

We delved into allegations that Shopify is an elaborate multi-level marketing scheme; signed up for Shopify’s referral program; and sifted through the company’s financial disclosure documents to try and get a sense of where the truth lies.

What does Shopify do, exactly?

For those not intimately familiar with the Ottawa-born start-up, figuring out what exactly Shopify sells can be indecipherable.

At its core, the company sells out-of-the-box e-commerce solutions — from the secure payment forum to inventory management, shipping logistics and customer support.

That original product has now grown wildly. Surfers of the world wide web likely see Shopify’s software daily — from their “buy now” button installed on a plethora of blogs to their integrated Facebook store which lets social media users pay for goods without much of a second thought.

But Shopify goes beyond just a platform to hawk trinkets and art. It powers advanced marketing software for giants like Budweiser and Red Bull, and connects big-business clients with designers, advertisers, marketing specialists, and social media managers.

Competitors, big and small, are in high supply for Shopify. And their economy of scale is not enough to make their product cheap enough to undercut the rest of the industry. Their sleekly-designed software may be popular, but it is not the only game in town, nor does it beat the simplicity of Amazon.

So the company has gone another route: Ubiquity.

Their plan unleashed an aggressive native marketing campaign, offering incentives to new and existing Shopify users to recruit new customers. While it’s not clear whether Shopify’s growing user base is organic or due to this expansive advertising scheme, the online retail engine does boast some 500,000 subscribers.

[Clarification: In a statement sent after this story was published, Shopify took issue with VICE Money’s characterization of the company as “small,” saying that it is the leading commerce platform. While Shopify is smaller than retail giants such as Amazon or eBay, they don’t make for a direct comparison].

How does Shopify make its money?

In the first six months of 2017, Shopify earned $279 million in revenue. That, industry watchers opined, was soft but not dismal for a company that has a market capitalization of close to $12 billion.

That revenue came, nearly equally, from two sources, according to interim financial statements filed this summer to securities administrators.

On one end is subscription revenue. That’s the money Shopify raised from its 500,000-strong subscriber base. Most of those subscribers pay less than $50 per month to run Shopify’s proprietary e-commerce platform, point-of-sale system, and various apps.

Some 2,500 subscribers run Shopify Plus, a more expansive set of tools that helps larger businesses run full advertising and marketing campaigns. That subscription plan generally starts at $2,000 per month.

The other half of the business is murkier. In corporate filings, Shopify calls the other half “merchant solutions,” and reports that it is actually slightly more profitable than its subscription plans, pulling in roughly $145 million in the first half of 2017. And it has grown faster. Subscription revenue grew by more than 62 percent in a year, while merchant solutions revenue jumped nearly 90 percent.

So what are “merchant solutions”?

The most simple is Shopify Payments, a platform which allows merchants to process credit card payments. For those who don’t use the platform, Shopify takes a fee, ranging from two percent of the transaction total for cheaper plans to 0.5 percent for higher-end plans.

Then there’s Shopify Capital, a subsidiary registered in the state of Virginia, which offers cash advances to subscribers using the Shopify platform to buy inventory. Shopify then taxes a “fixed percentage of their daily sales”.

Shopify also reports that some of its revenue comes from referral fees, earned when it directs business to partners.

You can also buy the Shopify hardware package, which comes with an iPad holder, a cash drawer, a barcode scanner, and a receipt printer. The whole thing can run you from $850 to $1,100 (CAD.)

What’s the problem?

Last week, a report put out by an online investment newsletter, Citron Research accused Shopify of padding its numbers, essentially setting their bottom line by convincing gullible entrepreneurs that the future is in Shopify-powered online marketplaces.

They pointed to the very core of Shopify’s business: Its subscriber base.

“Out of the claimed 500,000 websites, Shopify has about 2,500 ‘Plus’ clients and maybe another 20,000 ‘Advanced,’” wrote Citron Executive Editor Andrew Left, a prominent activist short-seller whose claim to fame includes the beleaguered Canadian pharmaceutical company, Valeant.

“So where are the other 450,000?” Left asked.

The other 450,000, of course, are those users paying relatively little per month — perhaps just $9.99 — who may or may not have an existing or even marketable product.

Recruiting those members, Left correctly notes, is a big priority for Shopify: Boosting its paying subscriber base is crucial for its growth. Remember that half of Shopify’s revenue comes from those monthly fees, while the other half are add-ons and upgrades from those subscribers.

Even if every one of those 450,000 lower-end subscribers were signed up for the Shopify Lite (the cheapest plan, at $9 per month) Shopify could still count on about $48 million a year, plus whatever they earn from selling add-ons and apps.

Left says while the Shopify software is good, maybe even the best on the market, its shares are wildly over-valued because the company has ballooned its valuation through this potentially-precarious way of attracting new members.

It’s also a practice that may break securities rules. Left points out that Herbalife, a health supplement company, was admonished and fined by the Federal Trade Commission just last year for running a multi-level marketing scheme, which can be a type of pyramid scheme.

The U.S. commission noted that Herbalife tricked customers into a get-rich-quick scheme that “rewards distributors for recruiting others to join and purchase products in order to advance in the marketing program, rather than in response to actual retail demand for the product, causing substantial economic injury to many of its distributors.”

On the other hand, Left has something to gain, here. His role as one of the foremost short sellers on Wall Street means that he places financial bets that stocks will go down. It is in Left’s interest for Shopify’s stock to plunge.

Colin Sebastian, an analyst at Robert W. Baird & Co., told Bloomberg News that Citron’s report is “largely off-base”, and that the falling share price creates a buying opportunity.

Shopify CEO Tobias Lütke, for his part, calls Left a “troll.”

A statement from the company sent to VICE News, however, does not really refute any of Left’s points. It does say that “we vigorously defend our business model and stand resolutely behind our mission and the success of our merchants.”

An interview request with the company was declined.

Are the comparisons to Herbalife fair?

Left alleges that Shopify’s business model involves aspects of multi-level marketing.

A slideshow prepared for investors, posted to Shopify’s website, is upfront about the fact that the foundation of the company is built on “entrepreneurs” — those paying under $50 per month to use a basic version of Shopify.

The company offers a variety of avenues to keep those customers around, even if they really have no business to speak of.

Shopify Capital, for one, provides short-term cash advances that essentially lock-in subscribers until they can sell enough merchandise to pay off the principle.

The company’s “partner” program, meanwhile, promises subscribers they will earn 20 percent of the subscription fee for anyone they bring in under the Shopify umbrella. If the partner recruits new users with an affiliate link (Shopify recommends handing out your affiliate link to coworkers and friends) they’ll receive a “bounty fee” — the first two months of the new users’ subscription fee will be paid to the partner directly.

It has a bevy of recommendations as to how attract possible recruits.

“Be mindful that if you choose to post political or controversial posts, they could alienate many of your followers,” reads one tutorial.

“Offer 14-day free trial handouts at your place of business featuring your link,” reads another.

The site has a variety of tutorials, step-by-step guides, and gurus to boost their recruitment drive.

At the same time, the tale of the tape shows that — at least in aggregate — Shopify’s subscribers are growing faster than Shopify itself.

In the first two fiscal quarters of 2017, while the company’s subscriber base grew 65 percent, the total output of its subscribers grew 70 percent; those running Shopify moved $10 billion worth of goods in just that six months.

And Shopify isn’t the only business to leverage affiliate marketing. Amazon bills its program as the largest in the world, although its affiliates push customers to its products — Shopify wants subscribers to buy their platform and sell their wares, even if they have no wares to sell.

To that end, there’s Oberlo.

Shopify bought the platform earlier this year for nearly $16 million. Oberlo is, in essence, a reselling app that can be plugged into Shopify. It allows subscribers to pick items from Ali Express, the China-based Amazon competitor known for its cheaper wares sold by independent retailers. From there, Oberlo facilitates the importation and reshipping of those items, and lets Shopify subscribers mark-up the prices — either by a fixed amount, or by multiplication.

It’s a practice called “drop-shipping.” It allows would-be shop-owners to sell goods without ever seeing the products themselves.

So what’s the verdict?

Shopify, in order to continue boosting its earnings and show progress to its shareholders, needs to continue expanding its subscriber base. To do that, it’s clear they’ve become increasingly reliant on affiliate marketing.

What really matters is whether or not Shopify is deceiving customers to do so.

This is something Left specifically takes aim at in his report on Shopify.

There are certainly a slew of posts on the website, promising everything from: “11 ways to be a millionaire before you’re 30” to “5 actionable ways to become a millionaire.” Those posts, however, never seem to actually encourage would-be customers to sign up to Shopify. Most just contain empty platitudes like “work harder…NOW” and “begin with something that can be executed.”

Baird analyst Colin Sebastian, who covers 25 of the biggest technology stocks claimed that when he surveyed Shopify sellers, more than 90 percent of them said that hadn’t seen an ad saying they could become millionaires.

Left, however, characterized those how-to-become-a-millionaire posts as official company missives promising to rocket customers to fortune.

“Indulging in misconduct that Herbalife could never dream of, Shopify goes so far as to offer a sample resignation letter to your boss on its corporate website,” Left writes.

The post he’s pointing to, however, doesn’t actually encourage readers to join Shopify — the post is emblematic of a strategy for online businesses to pad their sites with content aimed at would-be entrepreneurs who may be searching for, amongst other things, how to write a resignation letter.

Left is not entirely off-base: Shopify does suggest its customers could become rich off their product. On one page they brag about their native Facebook client as “the online store for someday millionaires.”

Generally, however, Shopify does not seem to encourage the notion that its platform or technology will make you rich.

Regardless of whether he’s got Shopify right or not, Left has already done damage.

Since he first took aim at the company, Shopify’s stock price has shed more than $25, wiping out more than $1.5 billion in market value.

Lütke, however, says his company is waiting for their next earnings call to address the allegations.

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Correction: An earlier version of this article incorrectly stated that “Shopify’s business model is, without a doubt, heavily dependent on multi-level marketing.” It has been updated to clarify “Left alleges that Shopify’s business model involves aspects of multi-level marketing.”