Catalog Start-ups: What You Need to Know

by Stephen Lett

What does it take today to start a catalog? Deep pockets, that’s what it takes. It is expensive to start a catalog and it takes time. Building wealth by starting a catalog is what you read about in the tabloids. The reality, however, is much different. Not having adequate financing from the start is a blueprint for failure. Yet, having adequate financing and deep pockets does not guarantee your success either. It is a risky business. Cataloging is fun. It’s exciting. And, it can be very rewarding. It is not my intent to scare readers away from the prospects of starting a catalog from scratch. The purpose of our column this month is to make you aware of what it takes to start a catalog today and the best strategy for doing so.  I want to give you some idea what it will cost and how long it will take to achieve profitability before you begin your venture. We will also discuss spin-off catalogs and how they can leverage your house file.

Why is it difficult to start a catalog from scratch? Because there is no house file to leverage and response rates to outside lists are lower today. It takes a long time and a sizeable investment to grow a house file to the point of breakeven.  Most entrepreneurs under estimate how long it will take and how much money will be required to reach profitability. When entrepreneurs approach me about starting a catalog, I like to ask them the following questions:

  • Why do you want to start a catalog?
  • What is your appetite (and tolerance) for risk?
  • Do you have at least $1.0 to $2.0 million dollars in the bank that you are willing to risk in this venture?
  • Are you willing to wait up to 5 years to achieve profitability?
  • Do you have something unique (a niche) to bring to the marketplace?
  • Do you have the right people on your bus (reference: Good to Great by Jim Collins)?
  • Is the prospecting universe large enough to support your product offering?

Financing a start-up catalog business is extremely difficult because there are no tangible assets. Banks will not fund the money. Obtaining seed money from venture capital firms is unlikely. About the only way to finance a start-up catalog company is to leverage personal assets like real estate or to find an “angel” investor, i.e., a friend or relative (Be careful borrowing money from relatives. This can lead to family problems and complications). Not having enough financing in place will most likely cause the business to fail before enough time has passed to adequately grow the house file.

A catalog business starts with the “right” merchandise. Most often, the entrepreneurs who start catalog businesses have a passion for the product. They are merchandise-oriented individuals who eat, sleep and breathe the product. I started teaching a second year MBA course on Direct Marketing at Indiana University in 1997, and I always told my students that if they did not know the answer to a question, to simply put down “merchandising” and I would give them 50% credit! The product is king. Hats off to those entrepreneurs who have a true love for the product they are selling. Assuming you have the right product, why do start-up catalog companies fail? Let’s look at a few reasons:

  • Under Capitalized – As we have discussed previously, catalog start-ups   tend to lack adequate financing. Red ink will flow for a minimum of 3 years, probably longer.
  • Lack of Management Skills – Often times, the entrepreneur lacks the management skills to weather the storm. We all have strengths and weaknesses. Knowing your weak areas is just as important, or more so, than knowing what you do well. Often times, start-up catalog companies lack a strong financial person and marketing/circulation expertise.
  • Lack of Financial Controls – Spending tends to get away from many start-up entrepreneurs and funding runs out ahead of schedule.
  • Product Differentiation – The product and “reason for being” must be unique and stand out from the competition.

Much of the expense of starting a catalog company results from having to grow the house file from scratch. The number of buyers needed on the file before breakeven and profitability is achieved will depend on several factors, such as average order size, response rates, the gross margin ratio, overhead costs, etc. We have prepared a scenario, for example only, of a start-up catalog company in order to determine (a) how long it can take to achieve profitability and (b) how large the house file needs to be.

START-UP CATALOG 5-YEAR SUMMARY *
STARTUP.xls
LETT Direct, Inc. - Date: 12-30-02
  KEY
RATIO
TOTAL
YEAR #1
TOTAL
YEAR #2
TOTAL
YEAR #3
TOTAL
YEAR #4
TOTAL
YEAR #5
Circulation:            
House File   54,600 249,514 573,569 1,062,290 1,784,354
Prospects   1,500,000 2,757,305 4,073,796 5,732,239 8,065,837
Total Circulation   1,554,600 3,006,820 4,647,365 6,794,530 9,850,190
             
Size of House File   15,925 48,016 97,800 171,354 280,026
Revenue/Catalog   $0.87 $1.05 $1.23 $1.42 $1.60
Gross Sales   $1,350,960 $3,148,386 $5,717,432 $9,628,595 $15,808,066
Less: Returns 6.00% $81,058 $188,903 $343,046 $577,716 $948,484
Net Sales   $1,269,902 $2,959,483 $5,374,386 $9,050,879 $14,859,582
             
Cost-of-Goods 48.00% $609,553 $1,420,552 $2,579,705 $4,344,422 $7,132,600
Gross Margin 52.00% $660,349 $1,538,931 $2,794,681 $4,706,457 $7,726,983
Less:            
Direct Selling Exp. $0.65 $1,010,490 $1,864,228 $2,788,419 $4,076,718 $5,910,114
Cont. to Profit &
Overhead Expenses
  -$350,141 -$325,297 $6,262 $629,740 $1,816,869
Cum Gain or (Loss)
at Contribution Level**
  -$350,141 -$675,438 -$669,176 -$39,436 $1,777,433
    ** NOTE: THIS IS BEFORE ANY OVERHEAD EXPENSES.
             
ASSUMPTIONS
Response Rates            
- House File   4.00% 4.10% 4.20% 4.30% 4.40%
- Prospects   1.30% 1.37% 1.43% 1.50% 1.58%
Average Order Size          
- House File   $65.00 $68.25 $71.66 $75.25 $79.01
- Prospects   $62.00 $65.10 $68.36 $71.77 $75.36

* This chart is for example only; actual experience will depend on your own key ratios & costs. This is an aggressive plan that assumes adequate funding. Overhead expense would typically represent 18% of net revenue in year 5; much higher as a percent of revenue in the prior more start-up years.

In our example, this company is approaching incremental breakeven in year #4. Keep in mind, however, that this is before any overhead expenses such as rent, labor, telephone, etc. True profitability will not be realized until at least year #5 when net revenue reaches almost $15.0 million. This start-up had to mail over 25.8 million catalogs over a 5-year period in order to achieve these results. It also assumes outside list rental universe counts are large enough to support this aggressive growth.

Key ratios on our income statement are returns at 6%, gross margin at 52% and our direct selling expense to sales ratio. Note how high this ratio is in year one at 69% of net sales. This ratio for a mature and profitable catalog company should range from 25% to 30%. Why is this ratio so high for a start-up catalog company? Simple, there is no house file to leverage.  By the end of year #5, this percentage comes down to a more reasonable ratio of 34%; not as low as it should be but it is at least beginning to trend in the right direction.

RETAILERS WHO START CATALOGS
There are also challenges for retailers who decide to start a catalog. For one thing, they do not have a house file to leverage. Perhaps they are capturing names and addresses at the point-of-sale. But, these names are of little benefit since retail buyers are not necessarily mail order catalog shoppers. Typical problems associated with retailers starting catalogs are as follows:

  1. Retailers, especially apparel retailers, tend to be so restrictive, it is difficult to rent names from competitors.  Before starting any catalog, it is important to do a universe study and find out what the challenges are going to be obtaining rental names for your given market.
  2. Typically, a retailer’s internal politics stop the catalog division from offering their products at a competitive rate and therefore the price value equation is not present.  It is important for the catalog and retail to have the same price and merchandising story if you want to build the catalog (partially) off of the retail file.
  3. Retailers tend to create a “walk by” retail business by opening stores in high traffic areas.  There is no real loyalty to draw from in their retail house file.  Therefore, their retail file does not respond like a typical catalog house file responds.
  4. Retailers are not emotionally prepared for the catalog expenses coming so far in advance of the sales. They do not understand the ratios or the catalog business.
  5. Retailers are smart to outsource their call center and distribution, but if they try to bring the distribution in-house it can create serious problems and higher costs.  Primarily, this is problematic due to the vast difference in distribution methods retail vs. catalog.

SPIN-OFF CATALOGS
“Spin-offs” are catalogs which are started by existing catalog companies. The odds for success are much greater. This is due to the fact that the company is already in the business of catalogs with at least one title (assuming the spin-off title is related to the existing catalog). In other words, they have a house file, which can be leveraged. Finding segments or pockets of your current house file that can support another catalog title will add incremental revenue to a company without increasing your fixed costs. A gift cataloger might notice, for example, that a particular product category continues to grow after it has been expanded a few times. Once a company has at least 10,000 customers purchasing from a particular product category, they might be in a position to start another title. This assumes they can merchandise the new book with at least 300 SKU’s (stock keeping units). Starting new titles and leveraging your house file can be a great way to grow your business!

In summary, starting a catalog on your kitchen table is a risky business. It takes time and money. Spin-off catalogs are less risky if and when the time is right to start a new title. Be sure to do your homework. And most importantly, be certain you have enough funding to get you through several years of red ink on your income statement.