Member Exclusive   //   February 13, 2020

Why the VC-DTC calculus is changing

There is an increasing pullback in the VC-DTC relationship. For VCs, it is less clear if they’ll get the return on investment they need. For founders, VCs may cause them to grow at rates they simply cannot sustain.

This is a big shift, given the influx of venture capital over the last few years. According to numbers from CB Insights in early 2019, DTC brands received a cumulative $3 billion in venture capital funds since 2012 — $1 billion of that was allocated in 2018. With recent less-than-stellar exits from companies like Casper, Peloton and Harry’s, brands are being asked to prove profitability, and VCs are questioning their prior beliefs that scale can fix any business model.

Now that early pioneers of the DTC model are reaching maturation, a shift has occurred — one that demands growing brands prove out profitability while being able to scale. Before, consumer entrants were able to acquire customers very cheaply — thanks to low-priced real estate from Facebook and Google — and believed that with more customers comes thinner margins. While this is somewhat true, retail products still cost money — a lot more than any software proposition — thus the theory of scale leading to instant profit didn’t quite prove out. Instead, early brands like Casper and Peloton and raised boatloads of capital from investors and have little to show for it, and certainly some less than pleased late-stage investors.

“There will be a VC cooling,” said Web Smith, the co-founder of men’s brand Mizzen + Main and founder of 2pm Inc, to Modern Retail a few weeks ago. “Retail is not a VC-fundable proposition, in my opinion.”

This doesn’t necessarily mean VC-funding for DTC companies is dead. But it does mean that a strategic shift has arrived. Increasingly, investors are going to be more prudent about who they add to their portfolio and whether or not they will be able to deliver a return on investment. On the other side, founders will likely think twice before raising a huge round. Here is how the conversation has shifted in light of some unicorns losing their luster (and valuations).

When is VC worth it?
Obviously, startup brands need capital to grow — and every founder wants to build the next $1 billion business. Increasingly, there’s been a refocus on the basics. “What ends up happening is that a lot of brands” — even though they have the scale — “haven’t thought through either the growth margins or EBITDA margins,” said Bain Capital vp Magdalena Kala.

Essentially, in an attempt to undercut competition brands have lower prices. Theoretically, a DTC brand has a more direct relationship with suppliers — which makes it possible to do some price cutting. But a physical item is still being sold, meaning there will be a wall companies will hit when it comes to margins. While a seed round may be helpful to get a startup off the ground, there’s an increasing realization that very few companies will be able to grow at the rate of technology companies like Facebook.

Similarly, it’s less important to have a lot of customers and more important to be making money profitably. The companies that have figured out both the scale elements as well as have healthy margin profiles are the ones that stand to benefit from sizable VC rounds, said Kala.

Another important element of the VC puzzle is how can the relationship be mutually beneficial. The most successful large brands are the ones that are vertically integrated, explained Sumeet Shah, a portfolio support associate at Swiftarc Ventures. Investors with connections to helpful agencies or supply chain resources help a business lower their margins even more. “This shift is putting a lot more pressure on investors,” said Shah, “in terms of what makes a true value-add investor.”

The world beyond VC
Still, there’s an overwhelming realization that large venture capital rounds may not be the answer for all DTC brands. Some companies raising debt or using other alternative investment structures to acquire funds for specific growth needs. Brands, said Shah, are making sure they have “the right capital, the right transparent use of funds.” Most importantly, they are asking “what is the maximum amount of capital they need?” This is a shift from earlier VC firms that raised huge funds in the hopes of throwing large sums on growing brands, hoping that one of them will see a 10x exit.

Much of this behavioral change stems from a realization about retail business models. Early brands believed they could acquire customers cheaply and keep them forever. But, as Kala pointed out, “general loyalty of consumers is declining over time.” As a result, brands are having to up their marketing costs to continually re-acquire customers. “I don’t love the grow at all costs model,” she said.

The largest mindset shift is the realization that though DTC brands are selling online, they are not tech companies. As a result, investors need to understand the realities of the business and that costs won’t shrink even with millions of customers.

All eyes on the exit
The problem ends up simply being one of profitability: Many growing DTC brands, said David Marcotte, svp of cross-border retail at Kantar Consulting, “are not there to make money — they are there to make revenue.” Which is to say, the proposition they gave investors was about growth at all costs — but the investors are still going to demand something tangible in return. 

Speed is another important element. Venture capitalists will likely tell anyone who will listen that they are looking at things longterm, but their idea of a longtime may differ from others. The largest consumer-facing brands, for example, took decades to build; Nike was founded in 1964, Lululemon in 1998. Their paths to dominance involved meticulous and slow brand building while growing a community of users. With companies like Casper and Bonobos (founded in 2014 and 2007, respectively), explained Richie Siegel, founder and lead analyst for retail consultancy Loose Threads, the plan was “raising a lot of cash and spending it quickly.”

This creates an inorganic pressure that is different from the older brands. “What we’re understanding now are the implications of when you’re trying to rush,” said Siegel.

If an acquisition is off the table, and a company needs to raise more cash, an IPO is likely the only option. This is where things come to a head. The companies now that focused on growth rather than sustainable profit are the ones slashing valuations and seeing rocky stock prices. “Public markets are not dumb,” said Kala. “You have to have a certain profile to get a certain multiple.”

This comes back to the biggest realization brands and investors have come to: physical retail and software cannot be judged the same. “Not every company is a tech company,” said Kala. “When you are selling actual physical goods, it’s a much more linear relationship.” Which is to say: “the more you grow, the more you spend.”