DTC Briefing: As VCs get more selective, startups face a bifurcated fundraising process

Anecdotally, DTC founders have been reporting since last year that deals were taking longer to close and valuations were dropping. Now, new data makes it more clear just how steep the fundraising decline is: a Pitchbook report from earlier this month found that the number of VC deals dropped to an estimated 15,852, compared to 18,521 deals completed last year. 

DTC startups in particular face a number of challenges that are making it harder for them to close rounds. Some investors that previously focused on consumer brands have started to focus more on consumer tech and enterprise software. Others are placing a greater priority on profitability compared to growth. In turn, many investors said that the startups that are best poised to raise capital right now are those that can convince investors that they will be able to still grow, profitably, no matter how market conditions change this year. 

“People want to invest in companies that don’t need cash right now,” Kiva Dickinson, managing partner at Selva Ventures said. “The ones that don’t need cash are the ones that have [good] margins and repeat purchases.”

In practice, what that looks like is more investors are backing repeat founders and seasoned executive teams, to the detriment of first-time founders and those from underrepresented backgrounds. Those brands that have trouble closing rounds right now may resort to more bridge rounds, and tap existing investors more frequently. Meanwhile, brands that have some unique service or capability that encourages repeat purchasing are in a more favorable position right now.

But as Jackie Dunklau, partner at consumer growth equity firm Aria Growth Partners, put it, it’s going to take any startup that doesn’t seem like a “no brainer” to investors longer to close a round right now. 

“There is more of a bifurcation now,” Dunklau said. Aria Growth Partners’ investment thesis is one that is becoming more common among consumer investors: it is focused on “efficient” businesses. Ones that grow, say, 30% to 50% each year while remaining profitable, versus growing 100% year-over-year unprofitably. 

But what that looks like — and how investors try to find these businesses, especially at the earlier stage — varies depending on which investors you talk to. Caitlin Strandberg, partner at early-stage VC firm Lerer Hippeau, said that the firm is looking for “consumer companies that can go through maybe 1 or 2 founds of financing and have a really compelling path to get to positive EBITDA.” 

At Aria, which typically invests at later stages, Dunklau said that the firm looks at repeat purchase rates and customer acquisition costs to evaluate the efficiency of a business, as well as gross margin. Aria takes a minority stake in brands that have reached anywhere from $5 million to $30 million in revenue.

“If there isn’t a good gross margin to start from, it doesn’t matter how big you get, your P&L is not going to work… we spend a lot of time analyzing that and making sure there is a viable business model just from the gross margin standpoint,” Dunkalu said. 

The shift away from DTC-only business models is also impacting things. In the early 2010s, brands like Bonobos and Warby Parker were attractive to investors largely because of their DTC model. Nowadays, more brands are looking at DTC as a channel, rather than a business model, and are ramping up expansion to channels like Amazon or physical retail.

At Lerer Hippeau, Strandberg said the firm is “shifting away from a focus on brand to real, technical differentiation,” when evaluating deals. She cited startups that have some kind of proprietary tool that help people evaluate their health, as well as consumer applications of buzzy tech like ChatGPT as some examples of technical differentiation. 

In certain categories where wholesale is becoming more important, like food and beverage, sell through rate at retail is becoming more important. And, certain categories that may have an easier and more efficient time selling through big-box retailers are attracting more interest. 

“Consumer products companies that are more capital efficient are more attractive to investors, and typically food and beverage is less capital efficient than say, beauty and personal care,” Dickinson said. 

In turn, Dickinson said that CPG startups that sell shelf stable products, as well as those that sell vitamins or other products that are “very ritualistic in nature,” seem to be attracting more interest right now. 

Mike Duda, partner at Bullish, said that one type of business he’s currently interested in is consumer startups that also have a “strong service component” to them — such as a marketplace or telehealth component.

This newfound focus on profitability, strong repeat purchase rates and proven traction is a complete 180 from the FOMO-driven mindset that dominated venture investing during the pandemic. In 2021, as venture capital financing reached record highs, more investors were worried about missing out on the next big startup and scrambled to write checks in hot new sectors like crypto or 15-minute delivery.

But, some of those investments didn’t pan out. One-click checkout startup Fast was perhaps one of the most notable poster children of this era of excess, going out of business roughly a year and a half after raising $120 million from investors

Now, as Duda puts it, investors are “looking for reasons to do something, rather than reasons not to do something.” 

What this means is that even the consumer brands that on paper seem well suited to this new, somber fundraising environment may not always have an easy time fundraising. Duda, for example, said that three of his portfolio companies are out raising Series B or later rounds. Of those three companies, he said that one that is profitable and should be a “home run” isn’t getting the valuation he thinks that company deserves. Meanwhile, another one of the companies that is “not profitable but has super strong growth, great repeat [purchase] rate — they are going to be oversubscribed.” 

Many of the investors I spoke with said that they expect this more somber fundraising environment to continue through 2023 — and that, in turn, founders should plan accordingly. 

“If you can cut burn, do it sooner rather than later,” Dickinson advised. Don’t invest in things that take more time to pay back than you have in cash runway, and remember that investors won’t value growth as much in 2023 as those who come out alive and healthy.” 

“It’s not a favorable environment for entrepreneurs,” Duda said. “That doesn’t mean there’s not opportunity out there, it is just going to take three times longer.”

What I’m reading

• Some Glossier fans are upset that the brand has tweaked the formula for its Balm Dotcom lip product, to make it vegan, Retail Dive reports. The saga presents an interesting case study for how brands may have to manage tension with some of their oldest customers as they evolve. 
• Thingtesting looks at how brands like Plink and Function of Beauty redesigned their packaging as they prepared to launch into retail. 
• Business of Fashion looks at what’s next for Everlane, after the DTC apparel stalwart ook on more debt last year, and announced layoffs at the beginning of January. In turn, Everlane is rethinking its merchandising strategy and looking to do more capsule collections. 

What we’ve covered 

• Brands like Poppi and Bubble report that TikTok seems to be driving more in-store sales for them, thanks to a mix of “haul” videos by loyal followers, as well as their own organic efforts. Now, they are trying to quantify exactly how much of an offline sales lift the app is driving.
• Sleepwear brand Lunya is the latest DTC brand to launch its own marketplace. Called The Rest Shop, Lunya is now carrying more than 30 products from other, sleepwear-adjacent brands. 
• Apparel brands like Eby are expanding to Amazon to take advantage of the e-commerce giant’s huge reach. But while they are seeing more sales, they’re also seeing increased returns and fees, which in turn is hurting their profitability.