The Fatal Flaw of The DTC Playbook & The Search for Internet Diamonds
Part II: VC x DTC and Learning Cycle Dissonance
Precursor: The Fatal Flaw of the DTC Playbook & The Search for Internet Diamonds — Part 1: Origins of a Movement. Part 1 examines the optics of three successful late 90’s DTC businesses and their impact on modern DTC brands. Part 2 will explore how the optics of their success and the shifting of capital markets created optimal conditions for supercharging the modern DTC playbook
Setting the Context for VC x DTC
Successful Direct to Consumer businesses in the late 90s and early 2000s (Blue Nile, Zappos, GAP) created sparks for a digital revolution, but these sparks needed a meaningful fuel source to become a flame.
The 2000s were bookended by the bursting of two significant market bubbles: The Dot-Com Bubble of 2000/2001 and the Housing Bubble of 2008. These macroeconomic events amplified the consumer wins noted above, in contrast, the destruction of value elsewhere in the market, which fostered an optimal environment for the marriage of modern DTC and Venture Capital.
The chart above highlights the degree to which Venture Capital as an asset class had been extraordinarily exposed to technology in the Dot-Com era. The crash wiped out considerable equity value in both private and public markets and left a bias towards VC diversification away from over-exposure to tech investments.
The Housing Bubble crash and the recovery efforts that followed impacted capital liquidity. Federal Interest rates were dropped to historically low values, which made cash extraordinarily cheap to borrow and had an indirect effect on other key interest rates (mortgages, loans, government bonds, etc). These low rates created a disincentive for investors to funnel cash into interest-bearing securities.
Venture Capital as an asset class is tiny in comparison to these interest-bearing securities and investments, such that any decrease in exposure to these types of investments resulted in a significant influx of capital to VCs (in relative terms).
Venture Capitalists generate returns for themselves and their Limited Partners by investing in startup businesses that turn the capital injection into significant enterprise value and ultimately return back some multiple of the original investment via a liquidity event (M&A, IPO). Most of start-ups will ultimately die on the vine, few will survive, and even fewer (about 1 in 10) will yield a significant liquidity event.
Given these odds, the competition for top-tier investments, the distribution of investments required to provide returns to the fund, and the limited number of startup companies that have the capability of creating enough value to return on the investment, VCs have a disincentive toward sitting on any capital they have available to deploy. It is an asset class where winners are defined by access and speed.
The conditions described above resulted in a record run-up of VC investments since 2009. Some $132B was invested by VCs in 2018 alone
Though tech has historically been the dominant avenue for VC Capital, there has been a growing inequality between the influx of capital into the VC asset class and the volume/quality of tech startups entering the marketplace. With capital on the sidelines and saturation of the tech startup scene, VC firms in 2010–2019 needed to fund verticals that had a proven track record of Venture Scale liquidity events.
The optics of successful liquidity events for Blue Nile, Zullily, Chewy and Zappos, and the incredible traction in the 2000s of The GAP as a public vertical consumer brand established meaningful consumer business outcomes. These potential to repeat history through a new crop of Direct to Consumer upstarts paired well with the pent up venture capital seeking multiples of growth.
Development of DTCs Fatal Flaw
Learning to Grow
The most critical path towards sustained growth is through Learning Cycles. The most well-known example of a learning cycle is the Scientific Method, which is the cornerstone for the perpetual elevation of scientific knowledge.
Businesses and Humans also leverage learning cycles (whether they know it or not) for constant improvement. Below is an example of what one such learning cycle looks like. It begins with a question and follows through researching/gathering insights, building a hypothesis from understanding, experimentation, measuring of results, reacting/recalibrating and finally lands back upon the same question to repeat the cycle.
Each time the cycle iterates, the outcome is improved. The faster the cycle iterates, the more dramatic the improvement is over time.
The Product Development Learning Cycle
No two DTC brands do this exactly alike, but below is a graphical representation of the standard DTC product development lifecycle (PDLC)
The milestones of the Product Development Learning Cycle roughly follow the steps of the learning cycle chart above: It starts with product questions and ideas that are shaped by consumer insights/research and translated into a design (hypothesis). From there, the design is passed through sourcing and development (prototyping, sampling, etc), and ultimately commercialized (experiment). An investment is made by the company when the commercialized item is procured and the Go to Market process begins. Once the product is launched, sales performance is measured, and various actions/reactions are taken to optimize the execution phase of the product. The lifecycle wraps up with a post-mortem or hindsight of the end to end PDLC (re-question), which feeds back into the product roadmap as the cycle is renewed.
Pre-DTC Product & Marketing Cycles
In the pre-DTC era, Legacy and Catalog brands would resource heavily around the PDLC. Rooting the business in the process of optimizing the physical product was successful for brands like Lands End, LL Bean, Gap and Michael Kors, because the process put customer product preferences and needs at the heart of every action. Merchants were often the highest-ranking executives in pre-DTC C suites.
The marketing learning cycle (MLC) in the pre-DTC era was forced to align itself with the PDLC due to the length of time required to coordinate the downstream execution of the product. Demand was created by upper-funnel brand focused advertisement, and captured largely by virtue of distribution (retail stores, catalog circulation). Physical catalogs require creative assets, planning, printing, mailing, etc. Physical stores require coordination, marketing collateral, visual merchandising, to execute on a particular product or set of products, all of which require considerable time.
Both the PDLC and MLC moved very slowly and in tandem during the pre-DTC era. This resulted in an alignment of execution and limited volatility with respect to the fundamental underpinnings of the Go To Market gameplan. When done properly, this also insured proper alignment with respect to sales and margin targets, marketing investments, sales channel investments, catalog circulation, and inventory investments.
The result was steady and predictable growth for a narrower number of brands.
The Digitally Native Shift
In 2007 Andy Dunn, a Stanford MBA grad and Bain alumn launched Bonobos alongside his co-founder Brian Spaly. Their thesis incorporated elements of Zappos (hospitality, culture), Blue Nile (LTV, product knowledge), GAP (vertical integration), and Lands End (storytelling) among others. The belief was that a vertical brand could be born online and those digital roots would allow the brand not only to move more quickly but with greater data-driven sophistication and a tighter 1:1 relationship with the customer. Additionally, by eliminating retail, brands would be able to keep a larger share of contribution margin and free cash flow by shedding retail OpEx and CapEx.
Many brands followed in Bonobos’ footsteps: Warby Parker, Casper, Everlane, Allbirds, and Harry’s were all part of the DTC 1.0 crop, and all of whom raised tidy sums of VC Capital.
Facebook & Instagram Ads
2007 was also the year that Facebook introduced its advertising platform, which as it turns out, was a happy match to the DTC VC Capital war-chests that had been assembled.
The success of the early disruptors in each vertical category — apparel, mattresses, razors, shoes, beauty, etc — attracted competition and Shopify, which launched in 2004, lowered the hurdle to build an eCommerce brand.
By 2012 Facebook was the dominant force in digital advertising as evidenced by its $500B market cap at IPO. That same year, Facebook doubled down on social media advertising, with a $1B purchase of Instagram, which launched it’s own advertising platform just 18 months later.
Facebook and Instagram now controlled both the captive audience and the supply of digital ads which set off a bidding war between brands for access to the coveted attention of consumers.
This meant that they had become the gatekeeper to the paid customer acquisition channels that offered near unlimited supply as well as a high degree of customer attribution and data analytics visibility.
The results of the monetization efforts of Facebook and Instagram have been historic, as evidenced by the run up of Facebooks stock from the Acquisition of IG in 2002 through late 2018.
Resource Allocation & Harmony
Direct to Consumer brands deploy their resources in many ways in their push towards revenue growth and profitability, but typically the three biggest P&L investments that a consumer products business makes are (1) Product Cost / Inventory, (2) Marketing Spend, (3) Personnel — not necessarily in that order, but this rank often is the case at scale.
To the extent that a brand can deploy its resources in a harmonized manner across these three buckets, the brand will grow successfully and profitably (assuming product-market fit, and brand affinity).
When the investments and allocation of resources fall out of harmony, growth will stagnate and profits or future profitability will deteriorate.
Basis of The Fatal Flaw
The heavy flow of capital into the DTC industrial complex and the covenants that come along with that capital resulted in a shift in focus from the traditional product-driven organizational structure of the pre-DTC era, towards a growth hacking and lower funnel marketing playbook.
Digitally native marketing platforms arm DTC operators with robust customer and transactional data. A swarm of performance marketing SaaS companies and digital agencies offer under-pressure marketers a landing spot for their growth capital.
In order to gain leverage and efficiency, DTC marketers employ a test-and-scale approach across a broad set of ever-changing paid demand channels with near real-time feedback loops. To combat rising Customer Acquisition Costs within channels, the MLC must be ever-accelerating, which requires testing every aspect of the digital ad unit: Copy, Creative, Product, Messaging, Call to Action, etc.
Closing the Curiosity Gap
The varying ad units and creative treatments that are repeatedly served to customers creates dissonance between the brand, product, and creative, as these elements are constantly in flux.
The primary intent of these varied and veiled messages is to foster the Curiosity Gap — a marketing term used to describe a consumer’s craving to close the gap between curiosity and knowledge. The goal of a marketer/creative is to keep this gap open long enough to foster engagement.
In a vacuum, this makes practical sense, but in the current DTC competitive climate, this is a losing tactic. As one brand leaves its curiosity gap open for a particular consumer, another comparable brand is able to swoop in and fill the gap quickly thus acquiring the customer away from their competition.
Over long periods this dissonance and operational thrash fracture both the customers’ contract and affinity with the brand. The consumer optics diverge from their original onboarding message and the dissonance dissolves any harmony between the PDLC and MLC and the resource investments brands make behind each.
To skirt this whack-a-mole approach, newer DTC players have pivoted towards activation driven marketing. This would include influencers, events, and earned PR, among others. Even when successful, each of these activations creates further volatility with respect to the operation of the business as these demand events come and go as time-bound demand ‘shocks’.
Many brands have chosen to rally behind a single product in order to simplify this alignment between marketing/growth capital and product investments. This approach has proven to provide brands with efficient and scaleable acquisition channels, though once new customer acquisition in those single product verticals is exhausted, growth can also stagnate quickly as hindsight has shown us is the case for those DTC brands.
Brands that either bootstrap or take little capital are forced to play by the same rules as their well-capitalized competition, as they are media buyers in the same supply-constrained marketplace competing for the same consumers.
Throughout this marketing revolution, consumer PDLCs continue to plod upon the same slow, labored, and careful path. Nascent are the Saas companies that will power the acceleration of the PDLC and until that acceleration occurs, the ever-changing demand streams and shocks result in uneven and chaotic supply chain execution.
The outcomes have been apparent across the DTC industry: Lower than anticipated LTV, weaker unit economics, higher CAC, fewer product iterations and improvements. All of which have compromised long term growth and profitability for both VC backed players and bootstrapped insurgents.
