VC & Digital Commerce 101
As the new generation of digital/social commerce brands are growing up, there is an ongoing discussion on whether these should be seen as ‘new retail’ or tech startups.
The answer is most likely ‘neither’, but let’s take a step back first to understand why the question is important. At first glance it may seem irrelevant and philosophical, but for a growing number of companies it is fundamental. Just ask The Honest Company what impact this question has had on their employees, shareholders and general trajectory.
Following up on my previous post about digital commerce brands, this post focuses on what founders should consider when thinking of raising early stage venture capital from investors. It also lays out what VCs need to assess when evaluating an investment in this space to ensure founder-investor alignment.
The typical e-commerce company is not as scalable and does not have as high margins as a pure software company. This means that an investor will value each dollar of revenue lower for the typical e-commerce company compared to a software company. However, a type of companies often referred to as digital commerce companies (or social commerce companies) have worked around the gross margin issue by starting out with a direct-to-consumer (D2C) model. While still having to work out the scalability, this model allows for higher control and higher margins. This type of companies have shaken up all kinds of product categories, from glasses (Warby Parker) to razors (Dollar Shave Club), luggage (Away), mattresses (Casper, Simba Sleep) and underwear (Mack Weldon). Some of the up-and-coming brands from the Nordics include Daniel Wellington, NA-KD, Tom Hope and Happy Plugs.
What unites these companies is their razor sharp focus on the customer experience, starting already pre-launch. They’re operating on the insight that it’s better to get ten people to absolutely love your brand than get 100 to ‘just’ like it. Obsessing on customer experience means paying meticulous attention to detail on everything from social media posts to product packaging and personalized post-purchase reinforcement. Finding and keeping a unique voice is key to creating memorable experiences — which is rapidly becoming a key part of total perceived value. As the customer is always in focus, these brands are very nimble and adapt their marketing and sales strategies as they go. Many start out as D2C through an online store only, but later experiment with brick-and-mortar and traditional retail as they grow and increase bargaining power.
The fast-changing consumer landscape has over the years burned many investors and founders, as the speed gives very little room to maneuver if there is a need for a repositioning or pivot. Just increasing the scale is not at all a silver bullet either as it inevitably reveals any cracks in the foundation. A manageable customer acquisition cost can quite abruptly increase if there is no viral effect or if the product is a fad. But if carried out successfully, the model is extremely powerful as customers can be turned into a community of loyal fans and ambassadors by combining data-driven customer insights with a personal approach.
Digital commerce startups typically look for funding as they realize the challenges of strong growth. While strong growth for a Software-as-a-Service company often means hiring a lot more account managers and customer success reps, strong growth for digital commerce startups mainly implies having to manage working capital. Manufacturers and warehousing & logistics partners will most often require new customers to pay upfront, which is a huge challenge for fledgling startups. Also, with initial traction comes copycats. It’s therefore obviously not only about time to market but about ability to scale up quickly while remaining true to the brand post-launch. Bringing in a VC can provide the necessary funding, guidance and (if you’re lucky!) also help scare off some competition.
Investors in this space know that growth comes at a different price than for a pure software company, given the characteristics of selling physical goods. This means that the founders must be able to show a realistic and yet highly ambitious plan of scaling the company in all aspects. As early stage VCs look for a very high potential return multiple (a quick intro to VC math can be found here), a large part of the conversation will center around the growth journey. More traditional tech startups can achieve a very good exit even with limited sales, thanks to valuable product innovation and IP. For digital commerce brands, the underlying technology or product is seldom groundbreaking enough to be sold on the underlying innovation value alone. While some digital commerce companies will be acquired for a premium by incumbents who mainly want access to their skills-set in digital marketing, this will still be the result of fast growth as a proof point.
This all means that most digital commerce brands, regardless of exit strategy, need to prove that they can achieve rapid sales growth — while maintaining high margins. Another consequence is that investors need to evaluate more intangible economic moats than they are used to, such as branding and supply chain. Below are some key questions on these topics that will often arise early on in the process:
With a setup rigged for scaling and a target group that embraces the brand, these companies can become great investments. The trajectory of companies like Warby Parker, Daniel Wellington and Dollar Shave Club goes a long way to show this. Are you building the next one? Feel free to reach out or comment below!
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