What Caused the Rise of Giant Consumer Startups That Said No To Venture Capital

"There are no network effects in consumer retail."

Applying the same old growth model to every startup may no longer be sensible. JL


Jason Del Rey reports in Re/code:

Companies in this category have capitalized on changing consumer habits, new marketing channels like Instagram, and software vendors like Shopify that lowered the cost and technical hurdles to setting up and growing a professional online shop. Venture capital saddles consumer brands with unrealistic valuations — and expectations. There are no network effects in consumer retail. “There are a lot of companies with unsustainable marketing budgets and extremely high customer acquisition costs.”

When Moiz Ali launched his startup Native, the maker of a natural deodorant brand, he couldn’t help but be self-conscious when mingling with other Bay Area entrepreneurs.

“In Silicon Valley, it’s often embarrassing when you haven’t raised money,” Ali told Recode recently. “When I’d go to parties or dinners, entrepreneurs would talk about how many employees they had. But for me, it was just me.”

Native eventually secured $550,000 from professional and individual investors, a relative pittance in the startup world where $100 million funding rounds and billion dollar valuations are discussed in a way that could sound like the norm.

For Ali, the limited funds meant cautious spending on marketing, a staff size that never rose above 10 and, even rarer, the need to turn a profit on each sale. In the earliest days, Ali and his small team also followed up with every disappointed customer — an education that eventually led to what’s called “product-market fit,” or the creation of a good that a large number of people in a certain market want.

So when Native sold to Procter & Gamble last year for $100 million in cash — just two-and-a-half years after launching — Ali could laugh last; he still owned more than 90 percent of his business and was worth a fortune. As important to him, he kept a strong grip on the brand’s destiny by remaining its CEO.

I wish Silicon Valley didn’t glorify those massive fundraising rounds as much as they do,” Ali said. “People don’t respect how much one person can do.”

(Fools) Gold rush?

Over the last five years, venture capital and private equity investors in the U.S. have rushed to fund a new breed of company, dubbed direct-to-consumer startups. These DTC startups, like Native, are typically defined as companies that sell their own branded products online, most often through their own websites and apps.

In recent years, many of the biggest in the sector — the shaving company Harry’s, the mattress maker Casper and the clothing brand Everlane — have also expanded their reach by selling goods in physical retail chains like Target or by opening up their own brick-and-mortar stores, as the cost to acquire new customers online has increased.

Native deodorant

Native

Companies in this category have capitalized on a cocktail of changing consumer habits, new marketing channels like Instagram, and software vendors like Shopify that have significantly lowered the cost and technical hurdles to setting up and growing a professional online shop.

Along the way, many of these retail brands have convinced venture capital investors — or been convinced — that their fast growth and digital DNA could result in value creation on par with tech companies. But does faster growth just mean a faster path to market saturation?

In the first eight months of 2018 alone, investors have committed $1.2 billion to these young companies, almost triple the $426 million spent on similar startups in 2013, according to CB Insights. In one deal alone, SoftBank paid $240 million to buy less than half of Brandless, a startup, just one year old, that sells its own line of packaged foods and household products.

But a funny thing has happened over the past 12 months: There’s been a series of big acquisitions of direct-to-consumer startups that have raised little or no venture capital money.

With it, a blueprint for a new path for ambitious direct-to-consumer entrepreneurs has emerged, one that has turned recent conventional wisdom in tech circles on its head even as it follows old-school business rules: Sell differentiated products for more than it costs to make and market them, and reinvest the profits in the business if you want to grow faster.

Little VC, big acquisitions

Two weeks ago, watchmaker Movado announced its plan to acquire the direct-to-consumer watch startup MVMT for up to $200 million, with $100 million coming upfront. MVMT’s management team and 40 employees own 100 percent of the startup, with the company’s two founders holding the vast majority of company equity.

And just last week, mattress giant Serta Simmons said it intended to merge with Tuft & Needle, a six-year-old startup that makes and sells a line of foam mattresses that it folds into boxes and ships directly to customers. The startup’s founders will oversee the e-commerce operations for all of the combined company’s mattress brands.

Tuft & Needle was profitable last year on $170 million in revenue — all without taking any outside investment. The founders started the company with $6,000 of their own cash, and later took out a $500,000 loan. Terms of the merger were not disclosed, but industry insiders believe that a fair deal could have valued the startup between $400 million and $500 million.

Tuft & Needle founders JT Marino (left) and Daehee Park (right) with Serta Simmons CEO Michael Traub (center)

Tuft & Needle

The MVMT and Tuft & Needle deals, plus P&G’s purchase of Native last November, raise important questions about how the next generation of great consumer brands will be built: Why are many DTC entrepreneurs ceding large ownership in their company to investors in exchange for capital, when there are now blueprints for a different way?

Why are investors continuing to pour huge investments into these startups when the only real example of a big, successful outcome is Dollar Shave Club, which sold to Unilever for $1 billion in 2016 after raising $160 million-plus from investors?

And will there be more direct-to-consumer outcomes like Dollar Shave Club’s, or will it live on as a very rare exception?

Sky-high valuations

Ryan Caldbeck, the founder and CEO of CircleUp, sees several factors at play. CircleUp uses proprietary algorithms to evaluate and identify consumer startups to which it should offer equity investments and working capital loans, typically to companies with $1 million to $15 million in revenue.

As investments in pure technology companies have gotten more competitive, venture capital firms that have historically focused on tech have expanded into new categories like consumer retail in search of new ways to spend their money. Caldbeck argues that a combination of competition, arrogance and a lack of deep industry knowledge has led to venture capital investments that saddle consumer brands with unrealistic valuations — and expectations.

“Many VC firms are not doing the work to think through what is the realistic exit potential of this company and who are the buyers who have ever paid nine times revenue for an acquisition,” Caldbeck said. “They are evaluating the next ketchup company the way they’d evaluate the next social media company.”

A big reason why tech companies like social networks are valued highly is because they benefit from a network effect; the more people that use them, the more valuable, in theory, the service becomes. There are no network effects in consumer retail.

Rebecca Kaden has similar concerns as Caldbeck — and she’s a venture capitalist. Kaden is a partner at technology-focused Union Square Ventures and invested in several direct-to-consumer brands, including sneaker startup Allbirds, at her last employer, consumer-focused Maveron Capital.

“We don’t have good evidence at all that [incumbent retailers and brands] value high-growth, physical-product startups the way venture capitalists do,” she said.

Kaden believes there will be exceptions, but many more disappointments.

“Once in a while you get an Allbirds — the growth is so fast and the love of the product so deep that you make the bet that every decade has a handful of defining brands and they might be one of them,” she said. “Those, I think, you can put VC money behind. But there’s not going to be many of those.”

Building by bootstrapping

MVMT’s LaPlante and Kassan

MVMT

When Jake Kassan and Kramer LaPlante dropped out of college to start MVMT in 2013, they had no clue what venture capital was. Instead, the duo raised around $300,000 in preorders through Indiegogo, the crowdfunding site, to create their first line of watches.

MVMT’s minimalist aesthetic, accessible price points and messaging about cutting out traditional retail middlemen appealed to a segment of millennial shoppers more willing than past generations to try out new brands and not equate high prices with quality.

“Watches are marked by flashy brands and millennials reject that idea,” Kaden, of Union Square Ventures, said.

Tuft & Needle’s founders took similar approaches with the company’s pricing and marketing messaging, calling out what they saw as greedy mattress stores and overpriced traditional brands in the startup’s early forays into advertising.

“We were running very polarizing ads that were resonating, and our growth just exploded,” co-founder and CEO JT Marino said.

With limited capital compared to venture-backed players, MVMT’s founders treated Facebook and Instagram as their most important connection with customers instead of side hobbies, and the visual appeal of their product helped. The rapid growth of Instagram has been a huge boon to consumer brands whose goods photograph well.

MVMT watches

MVMT

MVMT was also an early mover in podcast advertising and marketing on Instagram at a time when the media formats were growing in popularity but advertising demand hadn’t fully caught up.

It didn’t hurt that they had picked product categories in watches and sunglasses that boasted big profit margins. Tuft & Needle did, too.

By the end of 2017, MVMT had managed to cross $70 million in annual revenue, mainly through its own website but also dabbling with sales on Amazon.

Along the way, its founders did learn what venture capital was — watching the press attention grow for heavily backed consumer startups like Warby Parker and Harry’s — but still kept their distance. Cautionary tales like that of Jessica Alba’s Honest Company — which raised too much capital at too high of a valuation, while convincing itself it was a tech company — spooked the founders.

“Once you do it one year, you have to do it next year; it becomes this bad cycle,” Kassan, its CEO, said. “I think having the discipline and flexibility was just the secret for us all along.”

In the months leading up to the Movado deal, the MVMT founders did explore conversations with investors. But they worried the terms of such deals would value the company at a price that would be too expensive for an incumbent to surpass in an eventual purchase of the startup.

“There would be way fewer strategic [acquirers] that could acquire us then,” said MVMT co-founder and chief operating officer Kramer LaPlante. The other bet, they then knew, would be on an IPO, which would be a very high-risk bet indeed.

LaPlante’s rationale here is, well, very rational. But it’s also rare to hear an entrepreneur talk this way publicly. Silicon Valley has convinced many that real entrepreneurs are supposed to talk only about the desire to remain independent or the belief that if the company performs, it will have all sorts of options in the future.

“Why should I pay for their VC’s new Tesla?”

But the downside reality is what companies like Honest Company end up suffering through: If you don’t think long and hard enough about how much capital you are taking on and whether your valuation is reasonable, your best shot at an acquirer — in Honest’s case, it was Unilever — will choose to buy a disruptor like Seventh Generation at a price that makes more sense.

It’s hard to fight back after being overvalued. For Honest, the company was forced to raise new investment money under terms that valued it well under its previous valuation. A so-called “down round” can hurt internal morale and recruiting. It also makes it more likely that founders and employees will earn less in a potential sale.

The other dirty little secret that heavily funded startups don’t always realize and VCs don’t often discuss? If you talk to enough big-company CEOs, you’ll find many who hate the idea of paying a high acquisition price simply because the startup’s investors have to make money on the deal.

As one public-company CEO once told me: “Why should I pay for their VC’s new Tesla?”

Other CEOs are skeptical about the outcome when a brand that was propped up by VCs has to change the way it operates.

“There are a lot of companies out there with unsustainable marketing budgets and extremely high customer acquisition costs,” said Michael Traub, CEO of Serta Simmons, which plans to merge with Tuft & Needle. “What happened if we integrated a company that was based on that philosophy? It’s pretty clear it would collapse.”

What’s next

When Andy Dunn started building his direct-to-consumer menswear brand, Bonobos, in 2007, he saw no great options for e-commerce software. As a result, he estimates that Bonobos spent tens of millions of the $120 million it had raised from investors on building, supporting and tweaking the Bonobos technology stack over the years.

But a decade later, Dunn was able to turn to e-commerce software company Shopify as the platform for Allswell, a mattress brand that Dunn helped incubate in his new role at Walmart where he oversees the company’s digital-native consumer brands.

“Shopify is the absolute game-changer,” Dunn said. “At least 75 percent of the digital brands I talk to today are on Shopify and many of them are now saying we don’t need to invest that much in tech.”

Shopify’s overall success corroborates Dunn’s anecdotes. The company’s revenue grew 73 percent last year to $673 million. Shopify, which is publicly traded, is now valued at more than $15 billion.

From his vantage point, Shopify Chief Operating Officer Harley Finkelstein says he is not surprised by the rise of fast-growing, self-funded, digital-native brands.

“I’ve been watching stores, and stories, like MVMT happening almost every single day,” he said.

Not surprisingly, he believes Shopify has played a big role. Startups can use the company’s software from launch and stay on it even as they approach $1 billion in annual sales, as a brand like Fashion Nova has shown.

But he also sees the growth of online enthusiast communities as important — not only within the mass social media channels like Instagram and Facebook, but also content-plus-commerce marketplaces like Houzz for furniture and home decor sellers, and even sub-sections of the giant online forum Reddit.

“One thing that often gets neglected are the more niche places,” he said. “The right entrepreneur will figure out where the customers are.”

But some of the same forces that are knocking down barriers to entry are the ones that could be used to make the case that, all things being equal, venture capital can be used strategically to separate from the pack — whether through aggressive marketing, hiring, expansion into brick-and-mortar retail or, in some cases, taking complete control over the manufacturing of your product or investing in technology that truly differentiates.

Harry’s, the shaving company, believed it needed to own its own razor blade factory to control its own fate, so it raised more than $100 million several years ago to buy one of the best in the world.

Dollar Shave Club’s 2012 launch commercial, featuring CEO Michael Dubin, has been watched more than 25 million times on YouTube.

Glossier, the fast-growing beauty brand with a fanatical customer base, recently secured $52 million in new investment money, on top of the $38 million it had already raised, in part to develop digital products that it believes will keep its customers engaged with the brand even when they’re not in buying mode.

Of course, there may be other good reasons to work with investors. Some entrepreneurs don’t have a financial safety net to take the startup plunge on their own. Others, like those who run apparel startups, may need outside capital to support a large catalogue of styles.

But for the founders of Native, MVMT and Tuft & Needle, they’ve shown there is a different path — one that has been lucrative for them and their teams while letting them remain as leaders of their brands.

“Over these next year two years, you’re going to see brands that have been very disciplined have these very successful exits,” MVMT’s Kassan said. “They may not be flashy, billion dollar deals, but will actually be more successful for the founders and their teams.”

“I don’t imagine people will know Jake’s name or my name like they do [Dollar Shave Club founder] Michael Dubin’s,” Ali, of Native, said. “But Jake and I will lead fun lives.”