What’s hot to a VC?
While each VC has its own strategy for investing, there are some common themes around the nature of industries and sectors that are attractive to venture capitalists. (This does not include the micro-economics of a company or other elements that make a ‘company’ attractive–just sectors and the nature of their models).
- Large Market- In order for a company to grow into a billion dollar company, which is the idealized hope, there needs to be a lot of potential customers. However, on average, a VC expects to exit a company at least above $100M. Let’s assume a 2x multiple on revenue (multiples could also be based on EBITDA ,take into account growth and a few other factors, and vary by sector, economic environment, etc..). So, for this example, to be doing about $50M in revenue , it would be easier to get 5% of a billion market than 50% of a $100M market. There will be competitors, there needs to be growth opportunity even upon exit, and even despite itself, a company will stumble into customers and get to a decent run rate in a large market. Additionally, VCs invest in large opportunities due to the risk/reward tradeoff (ie if they aren’t going to potentially have a low IRR then, they might as well invest in something of lower risk that would have comparable returns). Most VCs take a portfolio model approach since most companies fail, they need a few big wins to compensate. Lastly, VC funds are typically large and thus need to move the needle hence a billion dollar opportunity is required .
- Market Maturity/Timing- Is the market ready to adopt your product? What is the infrastructural situation that would make your product possible to use and business to scale? Will someone actually be ready and willing to use it or do you have to educate them? Timing is crucial. Most ideas are not new, they are just a new version of something that had already been attempted and failed because people or the infrastructure was previously not ready.
- Macro Changes– What’s happening in the world that might drive adoption of X? This could be deregulation, better infrastructure or adoption of infrastructure, rising or decreasing costs of factor inputs or alternatives, etc…For instance, the rise in cost of oil will drive adoption of alternative energy hence the increase in investment in alternative energy over the past 10 years and more intensively recently. Another example is the CAN-SPAM act scarred investors from investing in email marketing software , which ultimately came back in fashion or at least a new permutation of it.
- High Growth Markets/Models- VCs have maximum horizon on their funds , thus, they have to exit within 10 years–ideally 5. The economics of a business or sector must be such that it has a high growth opportunity. For example, think about the differences required to build and scale a software company vs. brick & mortar retail–capital intensive to setup, operate, and ultimately to scale. Because VCs want to have high growth businesses, traditional retail has inherent challenges to scale quickly, which is why you do not see a lot of venture investing in retail or other capital intensive industries.
- High GM- The nature of certain businesses have higher gross margins than others (e.g. software-high, shipping-low, commodities-low). For low margin businesses, you need volume, and with smaller startups, they don’t have the distribution or volume to achieve financial viability. Higher margins on the sale of the product enables you to have more capital to work with for S&M , and high GM businesses typically have better cash flow.
- Profitable Distribution Model- The ability to acquire customers in a capital efficient way is extremely important to maintain a viable business (ie LTV>CAC) . This is both from a customer acquisition perspective and an operational one. It’s all about growth, so models that can capital efficiently access and acquire customers and scale operations are appealing to VCs.
- Competitive Landscape- Does one or a few winners take all? Is it highly crowded? This also takes into account network effects , switching costs, and the possibility to usurp incumbents . Additionally, barriers to entry , which you can overcome but will be challenging to others, historically were more important than now . Defensibility for a specific company is important but less so for the general nature of a sector . For example, think about the shift in perspective around IP or the interest in GroupOn. GroupOn had a competitive advantage of their distribution to consumers but the nature of the business has low barriers to entry.
- Exit multiples- The market assigns better multiples to certain industries and whether it’s based on EV/Revenue , EV/EBITDA, or other ratios in non-monetized startups. This typically comes down to the financials and economics of a business (with the exception of non-monetized companies with lots of users or a talent acquisition). If you are going to finance a company, and there’s just as much effort to build one vs. another with a higher multiple, you’d go with the latter. I won’t get into the specifics as to why certain industries have better exit multiples here , but this to a degree plays a part in which sectors are attractive and is a result of aforementioned factors.
I’m sure I missed a few sector factors, but those are some key ones.
So, how do those criteria relate to eCommerce…?
Over the last 10+ years eCommerce has gone from boom to bust to diffusion to adoption and over the last few years is just coming out of its nascent stages.
First, to give some historical context, here’s a fun infographic on the history of eCommerce starting in the 1960s…
Infographic on the history of eCommerce starting in the 1960s
Lack of Historical Investment due of a Lack of Interesting Companies…
Below I elaborate on a few of Keith Rabois, Anthony Wang, and other respondents’ points about the lack of VC investments and add a few more thoughts.
1. Taste aversion
There were hyped expectations for ecommerce in the dot-com boom but the infrastructure and market were not yet ready or able to adopt the innovations and efficiencies offered by internet companies. Thus, a lof of hype in the dot com boom and massive burns in the bust left a negative aftertastes. Even though a lot of other areas left a sting, ecommerce had additional complexities and capital inefficiencies pushing VCs away from investing in this area.
~$59bn in 1999 and $103bn in 2000 invested in ecommerce. The scars remained visible over the next few years.
E-commerce Venture Deals 1998-2009
Venture Funding Activity 1st Quarter 2010
Josh Kopelman mentions in his blog that the list of top ecommerce sites from 2005 to 2010 were almost exactly the same , therefore, showing a lack of innovation in the space.
Ranking All Properties VS. E-Commerce Properties
2. Lack of defensibility
- Product: eCommerce historically lacks defensibility from a technology perspective. With software, you can have IP, or it is just difficult to build, which creates some level of market entrance barriers. With ecommerce, you are selling products. Thus, other stores may carry the same items, which gives you limited defensibility. Unless you are also creating the product and selling it only retail (and not wholesale to other retailers) , the most important elements are the assortment , breadth, and variability of the merchandise, and the overall access to it. The access to inventory is relational , which is not defensible unless you have an exclusive agreement with a vendor– in >95%+ cases this does not occur. Thus, because there is a lack of technological and merchandising defensibility, solid metrics around extent of distribution , CAC relative to LTV, overall margins and profitability are required prior to an investment. Thus, traction is important in this segment even more so than software or other internet services. This is still true today, but there are better means of distribution, which I’ll describe later. Most of the interesting technology developments that could add defensibility, were either for large companies with in house solutions, which were very expensive, or companies became software–not E-Commerce companies.
- Network Effects (eBay & Amazon effects): eBay, ‘the world’s pawn shop’, enables anyone to sell online and thus has democratized selling. There was an explosion of small entrepreneurs selling as eBay sellers. VCs always get scared of competing with incumbents that garner network effects. eBay did enable an ecosystem to build ontop of their community with ecommerce tool vendors, but to get buyers’ attention and eyeballs as an ecommerce company, eBay & Amazon were and continue to be challenging and scary competitors.
3. Capital Intensive
VCs love the high gross margins of software because it can get to profitability faster . This historically is not the case with e-commerce. Amazon did not expect to be profitable for 4-5 years (Soure: http://en.wikipedia.org/wiki/Amazon.com).
The startup costs for non-eBay sellers and non-drop shippers were traditionally high not only due to technology costs but also inventory and fulfilment expenses combined with lower margins.
- Buying Inventory – The typical/historical model for a retailer is to purchase inventory that you then resell. This requires capital. [ Brands selling inventory sometimes offer terms and/or utilize ‘factor’ financing , where a factor buys the A/R at a discount, and the risk assessment is based on the retailer’s ability to pay vs. the brand’s assets ]. Thus, this is some protection for a brand, but the retailer is still on the hook to pay. Most often, they will still need to pay prior than when they’ve sold the goods . So, a retailer needs the capital to finance these cash flow cycles.
- Inventory Risk- Not only is it costly to purchase inventory, but then you have the risk of not selling it. Thus, you want high inventory turns to free up the cash to finance your operations. For ‘fashion’ or industries with a trend like nature, there is even higher risk since once a season is over, the probability of selling something at the initial price declines much more dramatically than replenishment items. Thus, you resort to sales/discounts just to free up the capital to finance the next season. Even if an item is a ‘replenishment’ item (one that is inelastic and doesn’t depreciate due to trends or seasons), you still have capital tied up that could be worked elsewhere. So, you ultimately lose money on low-turns (this could be potentially offset depending upon profit ).
- Warehousing- Where are you going to put all that inventory? If you are doing a startup ecommerce site in your garage, you’ll probably use your garage but that will become too small quickly . Storing stuff costs money not to mention figuring out organizational processes for managing the inventory, which can get costly if you don’t have the right structure and workflow in place. [Aside: I ran a storage business back in the summer 2005; having startup resources, we used stickers/color coding+excel, and while you can get away with it, it gets painful fast].
- Fulfillment- Even if you are storing stuff in your in your garage, you’ll need to organize your inventory, pick (select the items that were placed in an order), pack (package the items up into the appropriate shipping container), and then ship the items. You can work with 3rd party logistics providers (3PL), but once again, this is another costly and/or logistically challenging aspect of the supply chain.
To mitigate the above , the drop-shipping model arose . [ Note: Zappos actually started this way ] However, because the brand , retailer, or whoever the drop-shipper is assumes the inventory risk and aforementioned challenges, your margins are not that great. Thus, even though you mitigated that risk, you still have/had the below issues…
- Technology– Historically, like other internet businesses, start up costs were high. Though for ecommerce, any of the tools enabling ecommerce entrepreneurs were either too expensive and often targeted at large organizations or they were lack-luster.
- Customer acquisition and retention- consumers are expensive to acquire and retain. Historically, there were not great channels beyond online advertising, Google, and SEO/SEM to get consumers’ attention. With advertising, good keywords get bid up substantially, and you can hit a wall for customer acquisition where the LTV<CAC . Once you get their attention, to convert them into customers is expensive. Not only this but also re-engaging them to get them to purchase again and not have to reacquire them was extremely expensive. Email marketing in the mid- 2000s had negative connotations due to the CAN-SPAM act until its renaissance in the later part of the decade. Thus, most of the spend was on advertising, and it was harder to develop loyalty let alone incite any viral effects.
- Lack of Seed Financing: The angel environment was not as lucrative or accessible. Thus, there were fewer options to overcome the cashflow hump (drop-shipping was one option). With less seed capital, there was also less experimentation going on in terms of different ecommerce models. Hence, fewer companies were making it to a level that would even be attractive to a VC.
- Chicken-Egg: Because of the difficulty in scaling these businesses based on the lower relative margins and historical CAC/Retention costs, you required capital; however, to get capital, you needed to prove the traction.
4. Market Dynamics
- Market Size: ecommerce is just getting to $197 billion (depending upon which report you read) , which is still only ~8% of US product sales (according to Forrester) . Even though years ago it was large and the potential was/is still huge, it was still smaller and earlier in the adoption phase .
US online retails forecast 2010-2015
- Market adoption & demographics: First, the market was still getting acclimated to the concept of purchasing something online. eCommerce sites were not fully trusted. Especially with the older demographic who were the base consumers back then, it was not only a new behavior but also trusting the payment systems, trusting that a product would actually show up, trusting relationships with ‘new establishments’ , and just generally being comfortable with buying from a ‘virtual catalogue’.
Broadband penetration was not as ubiquitous as it is now and the speed was not nearly as fast as it is today. This, thus impacts the ability to even access these sites let alone the consumer’s experience . Boo.com was a massive failure in the dot-com boom/bust partially (among many other reasons) due to this issue. Previously, it was about proving IF people would buy online. Now, it’s about the HOW people will buy online.
Fewer Female VCs/Entrepreneurs
Another side point, and I don’t want to make this into any kind of gender issue, but the fact of the matter is there are fewer female entrepreneurs and VCs. Thus, it is less intuitive for a dude to understand the buying nature/habits of women, who are the primary consumers (see below). They don’t see the opportunities as much because they are not engaging in the problems associated with shopping. So, they are going to be less inclined to build or invest in areas that are not as obvious.
If you look at Theresia Gouw Ranzetta at Accel Partners and Aileen Lee at Kleiner Perkins Caufield & Byers , they are the partners on most of the eCommerce deals within their respective firms.
Here is a good little article on different consumption habits “Men Buy, Women Shop”
Male Online shopping habit
Females engagement with online shopping