VC and Ecommerce: The Billion or Bust Deathpact

Alan Keegan
Mar 6 · 11 min read

I Don’t Know What Happened to Outdoor Voices, But I Can Guess

Coming out of Parsons school of design, Tyler Haney had an idea for an activewear brand more about fun than performance. The young entrepreneur scraped together a design, started Outdoor Voices, made a few samples, got into some trade shows and even got a couple small orders. Before she knew it, J Crew came in with a huge order of 11,000 units to feature the brand in their “Discover” series in 2014.

That’s pretty much a dream start to a brand. Now you’ve got a whole bunch of free exposure through J.Crew, and a bunch of cash on hand. Since then, the company has raised $64 million in funding and expanded massively.

But, over the past couple years there have been a couple examples of high-profile people coming on board, then quietly getting the heck away (J.Crew CEO Mickey Drexler joined as chairman of the board in 2017, but stepped down in 2019 — ex-Under Armour and Nike executive Pamela Cartless joined as COO and left after five months). The last round of funding was a down round, and this past month Tyler was replaced as CEO, then left the company altogether. Apparently, the company is doing 40M in sales a year, and losing 2M a month (more details here).

How did we get here? How is a 40M revenue clothing company that has a great brand (including good attendance on community events like fun-runs etc.) losing 2M a month? It makes you wonder why they have 300 employees. It also makes you wonder why they have 11 brick and mortar stores, and what kind of ad spend they’re doing (not to mention how high the customer acquisition costs are on that ad spend).

The decisions that would lead here don’t make any sense, unless you have some wonky incentives going on.

Enter the “Billion or Bust Deathpact.”

How Does Billion or Bust Happen?

Tyler Haney (co-founder) now owns ~10% of the company in (and on this last bit I’m guessing, no info on share type) non-preferred equity. She probably took some money off of the table in one of the rounds (given how much she raised), maybe a million-ish dollars, as a nest egg (this is also a guess, and I hope it’s true).

Now, the rest of the company (outside of an employee equity pool and maybe an early common equity friends and family round of some kind) is probably owned in preferred equity by investors. The investors probably also control the board.

What does this do to incentive structure?

From the VCs perspective, this company needs to scale massively or it’s not a needle mover in their portfolio. VCs invested in the company at a valuation it would have to earn post-hoc, and if the company continues to be a middling earning business it is roughly equivalent to not existing in the VC’s portfolio. The VC’s incentive is to have the company shoot for the moon, run at a loss, and go billion or bust. In the payout profile most of these portfolios, the majority of companies don’t work out at all, and the few that do need to work out huge to carry the bad investments that are in the nature of high risk startup equity.

This means you’re encouraged to spend and build toward that big win, which often means you create unnecessary fixed costs (like employees) and become willing to push the CAC into near-unprofitable — or even unprofitable (Bonobos? Casper?) — unit economics, in order to hit growth targets from your investors. You may even find yourself watering down your brand, and creating more generic products to reach a broader audience (a la Bonobos or Nasty Gal), because your initial, loyal, fan base isn’t a big enough market segment to satisfy your investors’ desired outcome. You’ve turned what could be a profitable business serving a loyal community into a business that is losing 2 million dollars a month, without much runway for that left in the bank, and running out of affordable growth opportunities.

Founder Incentives

This makes sense from the VC’s incentive structure (this thing being profitable and throwing off a couple million a year is not what they signed up for — they are willing to risk the company’s existence for a shot at a billion dollar exit one day).

But, as long as the founder is CEO, why would they run the company to the ground trying to achieve the growth the investors want? If you’re running just a $10M annual revenue business that you own 50% yourself with 20% margins, you could be clearing $1M/year in dividends — even with no growth.

Well it’s too late for that. Your company is now 70–90% (let’s say) owned by investors who, also:

  1. Control the board (can fire you)
  2. Have no interest in dividending out cash (they are trying to optimize chance of big payout)
  3. Would get the majority of dividended cash, even if there were any (they own the equity)
  4. Will also get all the money from an exit, unless you exit above the valuation they invested at

Let’s talk about #4 for a second. If they have preferred equity, any profits from a sale go to them until either they’ve recouped their initial investment, or even made a fixed return.

For the founder, now, the only way for you to make money outside of your salary at the company is to exit at a valuation higher than the valuations at which your investors invested. And, investors tend to invest in private companies at valuations that would require massive growth to retain in public markets (and often even in private acquisitions). Your incentive to look for a big high valuation exit is now even stronger (and at an even higher valuation) than the investors’ incentive — and it’s going to take a wild shot at some extreme growth to get there.

For someone with a profitable new ecommerce startup that’s getting some traction, your company could be a mid-sized profitable independent business that makes you a lot of money. The first round you just signed, and are bragging to your friends about, might actually just be a billion or bust deathpact that leads to your business’ survival and profitability into a coinflip on mass adoption. All of a sudden it makes sense for you as an individual decision-maker for the business, based on your incentive structure, to break your unit economics and start spending more than you make.

This, obviously, will make you reliant on then raising a next round (functionally pre-committing you to sell more equity), but it also means that instead of being forced to find low-cost CAC avenues or raise LTV before you have money to scale, you’re more likely to just pump money into your existing channels because you’re optimizing for hitting your goals, you have the money to do it, and you know your rough conversions from dollars to acquisitions there. Often the easiest place to pour money into acquisitions is paid social, and paid social is especially attractive to companies with VCs on their board because you have such detailed stats on your conversions.

This raises CAC as you go from your “low hanging fruit” audience to your “I guess this is technically profitable” audience to your “I’ll lose money to sell to them and figure out a way to raise LTV later” audience, until, eventually, the proverbial “tree” is stripped bare and you haven’t planted any others in your orchard, because you could afford to get to the top of this one. Oops.

But if the VC/Ecommerce death pact is creating businesses that take good brands and ideas, then mess up the incentive structure so that the CEO/Founder is incentivized to run the business to the ground, disregard profitability, and raise money in an endless and desperate bid to become massive and have a super high valuation exit, that also creates an opportunity. Specifically, it creates an opportunity for PE firms who can buy in, replace the leadership, clean up the company’s unit economics and balance sheet, then come off as the “adults” in the room (even though the founder’s “mismanagement” of the company may have been the rational strategy given the incentives laid out before them). In this case that PE firm is Interluxe, and that PE leadership replacement is Cliff Moskowitz (the new CEO of Outdoor Voices). I don’t know if Interluxe makes a habit of targeting this specific kind of VC/Ecommerce Deathpact Loss Spiral, or even if that was their intent here, but I do think it’d be a damn good business and there are plenty of opportunities.

Know the Path You’re Going Down

I don’t know if Tyler Haney saw where this path was leading when she took her first $1 million from General Catalyst and started spending aggressively to hit growth targets, running at a loss that would take her right back to the next funding round

And if she did, I don’t think there’s anything wrong with that. If this is the path you want to take, take it. Just be aware of what path you’re taking, and think deeply about what you want.

Switching your risk exposure to “Billion or Bust” can work out (Dollar Shave Club comes to mind). What I fear is ecommerce entrepreneurs out there not fully considering the alternatives, or what VC money can do to your incentives. Tyler Haney is a talented entrepreneur, with enough grit and drive to get her startup off the ground to some solid traction before even taking any investment, and I think really could have done this either way she wanted to.

Someone offering to invest in your business feels really good. As an entrepreneur, the personal and public validation that provides for a vision that most of the time lives only in your own head is an alm to some of the most persistent negative emotions of self doubt and insecurity that haunt an entrepreneurial lifestyle (not to mention the practical concern of unstable income).

But, unlike some of the tech industries that have made VC huge over the last 30 years, ecommerce is almost never a winner take all market the way social networks, as an example, are — and it might not make sense to run a huge loss at a ridiculous valuation, burning tens of millions of dollars for a chance at glory. If you have 0.1% of the global clothing market (for example) you’re doing over a billion dollars of revenue a year.

There are of course many shades to investment and growth, and I don’t want to pretend this is a binary choice. Middle of the road funding can also work out. YC incubated ecommerce brands (like FREY) often go down this road without losing sight of their original brand promise, or running their business to the ground. In general, a second generation of ecommerce companies, in part thanks to VC’s being more reticent on ecommerce after lackluster exits like Bonobos, are doing a better job prioritizing profitability and sustainable growth (Buck Mason comes to mind).

Does this mean you should never raise money if you’re an ecommerce brand? No not at all. It just means you should know what you’re signing up for, and there are a few general principles I would want to keep in mind. And, at the end of the day, it’s your company; do what you want with it.

But, I’ve been studying the space a bit for a new company I’m starting with a friend, and thinking a lot about ecommerce (join us on Reddit if curious).

Here are some take-away principles we’ve identified that I think may be generally applicable:

Be the company your biggest fans think you are: by way of example, my business partners’ girlfriend used to spend 100s of dollars a year on Outdoor Voices, and has stopped (before any of this drama went down). She’d found their designs had begun to lack creativity and felt generic, which makes sense given they were trying to appeal to a wider audience. They stopped doing what she loved, and they never asked what it was she loved about them. For your brand, the people who love your brand already are the ones who know what you’re doing right. Which brings me to my next point:

Your existing customers matter more than your new customers: you would do well to make sure you keep doing what makes your early fans love you. If you don’t know what that is, ask them. If you do know what that is, ask them anyway to be sure. You should have a constant, intense level of engagement with existing customers. If being an existing customer of your brand isn’t awesome, new customers won’t have a reason to stick around even if you get them in the door. Solving this first makes every new customer you acquire much more valuable in the long term. This leads to the next idea:

Growing well is better than growing fast: create your own content, foster your own community, don’t rely completely on paid advertising. To quote a new-gen ecommerce founder, “I’d rather have a billion-dollar company 25 years from now than a billion-dollar valuation five years from now.” (Maggie Winter of AYR, from this article). Badass.

Profitability matters: don’t break your unit economics without knowing how they’re going to un-break later. It’s easy (especially if you have a few million dollars of VC money burning a hole in your bank account) to fall into a trap of “we need to get the exposure and get them in the door, and we can figure out how to raise LTV later.” But, sometimes you don’t figure that out, and then you’re in real trouble.

Investing time in “investment for investment’s sake,” is a bad investment: if you’re doing the work to find investment, be conscious of how much, from whom, and why. Don’t take it for validation. Know what it’s uses are. Don’t do it because it’s “just what people do” when their startup is doing well. Make sure whoever is investing in your company shares your vision for its future, which will align your incentives.

If you have any thoughts on this stuff, let me know. I’m having a great time learning about the space, and there’s a lot more to learn.

— — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — If you’re interested in hearing how we’re navigating this stuff, join the conversation at /r/meritstore.

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I hope some of my thinking on this was helpful, here are a couple articles I read when making this, many of them different reporting on the Outdoor Voices situation.

Fastcompany

Entrepreneur.com

Business Insider Outdoor Voices Annoucement 1

Business Insider Outdoor Voices Annoucement 2

BizJournals

RetailDive

TechCrunch

GQ

Alan Keegan

Written by

Curious About the Future, Finance, Poetry, History and Political Theory… @misterkeegan

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