In case you prefer to read this post in Italian or check out the translations ChatGPT wrote for me.
Hello friends! I hope you're having a great week! Before getting into today's post, I have a quick fun fact that surprised me: did you know that ants make up 20% of the total biomass on earth? It's not particularly shocking, but it's incredible, isn't it?
Now, back to the post. The inspiration for today's topic came from a podcast episode I listened to a few days ago. The discussion in the episode revolved around the Direct-to-Consumer (D2C) business model, and the authors had a very robust explanation of why they think this is not a "VC-backable" industry. I really enjoyed the podcast, and it gave me a lot to think about. A few years ago, I spent a lot of time studying the D2C industry both for my job and out of curiosity. Over time, I've seen the space evolve a lot and change dramatically, often moving from ultra-enthusiasm to skepticism. Many people say we're living in a "D2C winter," and I've thought a bit about it.
So, today I'm going to write about Direct-to-Consumer, providing a bit of history and content, and then focusing on the current status of the segment. I'll also offer some personal considerations on how I see it evolving. I hope you enjoy it!
DIRECT TO CONSUMER, WHAT IS IT AND WHY IT MATTERS
The Direct-to-Consumer (D2C) model is a business strategy in which a company sells its products or services directly to consumers, bypassing traditional retail intermediaries such as wholesalers and retailers. While this model has always existed (think about historical brands that had direct stores, such as Gucci or Louis Vuitton), in the past it was usually combined with other strategies where direct sales represented only a small percentage of total revenue, and brands made most of their sales through indirect means (i.e. retailers, wholesalers, etc.).
With the advent of digital technology, a new possibility emerged: brands can create, promote, sell, and distribute their offerings through their own channels, such as online stores, social media platforms, and mobile apps.
Many brands decided to pursue a direct-to-consumer (D2C) strategy mainly for the following reasons:
Enhance customer relationships: By eliminating middlemen, D2C brands have more control over their customer interactions, allowing them to create a personalized experience and build a loyal customer base.
Improve margins and profitability: Without the need to share profits with intermediaries, D2C companies can enjoy higher margins and reinvest in product development or marketing. However, this assumption may not always hold true.
Increased agility and innovation: D2C businesses can respond quickly to consumer preferences, trends, and market changes, fostering innovation and experimentation.
Data-driven decision making: Access to customer data helps D2C brands make informed decisions about product development, marketing, and pricing strategies.
On the other hand, the D2C model has several downsides, namely:
Increased responsibility and cost: D2C businesses must handle all aspects of the customer journey, from marketing and sales to order fulfillment and customer support, which can be resource-intensive. Most brands actually do not want to do this and prefer to focus on other parts of the supply chain, such as product development, intentionally leaving the marketing and distribution component to external parties.
Greater competition: The low barriers to entry for D2C businesses can lead to increased competition and market saturation. This is particularly relevant in recent years, especially as the market has become saturated and it has become very difficult for D2C brands to acquire new customers.
Investment requirement, especially on digital capabilities: A D2C brand has to keep up with market practices on many aspects of the customer experience (e.g., have a state-of-the-art website and app, optimize marketing channel allocation, etc.). These are hard and costly problems that often make this model unattractive for some brands.
THE EXPLOSION OF D2C
The last decade has seen an explosion of direct-to-consumer (D2C) brands. Many new brands emerged in the late 2010s, and many long-established brands adopted D2C models and increased the share of business they conducted directly with customers.
While this trend has many drivers, I believe that the core ones were:
E-commerce maturity: As e-commerce grew in popularity and the infrastructure matured (e.g., logistics to manage fulfillment and last mile became a commodity, and prices materially decreased), going direct to customers no longer meant the high investments that opening a network of physical stores required in the past.
Production-as-a-service: Globalization made product manufacturing, especially in East Asia, very easy and efficient. Brand owners did not have to spend money and effort on manufacturing. They could outsource that very easily, which meant that design, marketing, and distribution became the key differentiating factors.
Digital marketing: The explosion of targeted advertising, especially on social networks, dramatically decreased the complexity and cost of customer acquisition. A cost that was at least in part fixed (setting up a campaign, buying media space, etc.) became, to a very high share, variable. You could put a few hundred euros on Facebook ads and through iteration, experiments, and trial & error, you could validate product/market fit.
Finally, obviously, Covid and a secular shift in customer behavior drove a lot of traction for personalized experiences and custom products. In many categories, the relevance of established brands reduced, and the importance of product qualities increased.
WHAT ARE THE KEY EXAMPLES OF D2C?
Since the 2010s, venture capital investments in direct-to-consumer (D2C) startups have been on the rise. Investors recognized the potential of these companies to disrupt traditional industries and deliver strong returns. In 2018, D2C brands raised $1.6 billion in funding. The trend accelerated even further in 2020, as COVID acted as a tailwind to the secular shift to digital commerce. In Q3'20 alone, D2C startups raised over $2 billion. During this period, several high-profile startups emerged, including Allbirds, which raised over $200 million by 2020.
As I mentioned earlier, I am a bit of a D2C brand nerd. While there are many great cases, I decided to choose and describe in detail three of the poster children of the 2020 D2C wave.
Warby Parker was probably the first truly successful D2C brand. It is an American eyewear company founded in 2010. They disrupted the traditional eyewear industry by offering designer-quality glasses at affordable prices, coupled with a convenient online shopping experience. Warby Parker's business model is the basis of most D2C brands: in-house design and production, arguing that cutting out middlemen allows them to pass savings to customers and ultimately offer high-quality products at affordable prices. WP was the first brand to reach material scale. In 2021, they went public on the NYSE with a valuation of approximately $3 billion. They had approximately $1 billion in revenue, still growing at 50% YoY, and 60% gross margin.
Dollar Shave Club was one of the biggest marketing stories of the early 2010s. The company went super-viral thanks to a very fun YouTube advertising campaign. The company was one of the first very material subscription services. It offered a recurring service delivering high-quality razor blades and grooming products directly to customers' homes at competitive prices ($10 was the initial offer). DSC was really the start of a trend, and it scaled to the point of 4 million+ subscribers, generating $150 million in revenue in 2016, capturing approximately 8% of the US razor cartridge market, and competing with industry giants like Gillette and Schick. Dollar Shave Club was a key player in that D2C wave, also because of its exit: it was acquired in 2016 by Unilever for $1 billion in cash. The “underdogs” had made it in creating a mass brand!
Glossier is an American D2C beauty and skincare brand founded in 2014. The company has gained a loyal following through its minimalist approach to beauty, emphasis on high-quality ingredients, and strong digital marketing strategy, focusing on building a community through social media and engaging content. Beauty is probably the segment of consumer products where D2C currently has the highest share (excluding fashion), and Glossier was the brand that started this movement and showed that it was possible. Beauty was a very concentrated segment with very high marketing costs and established brands with large heritage. Proving that you could build a digital-only brand and acquire substantial market share was no simple task. In 2021, Glossier raised Series E funds at a $1.8 billion valuation, with $100 million+ in revenue growing at 60% YoY (2018 figures) and an impressive 80% gross margin. More importantly, Glossier in 2021 reported having over 5 million customers, which is ultimately the proof that you could indeed build a mass brand in beauty with the D2C model.
All these cases exemplify the power of the D2C business model, with their impressive financial metrics and strong customer base. They have successfully leveraged digital channels, innovative marketing strategies, and customer-centric approaches to disrupt traditional industries and establish themselves as industry leaders. Many celebrities have launched D2C brands, with probably the biggest one being The Honest Company, which Jessica Alba founded and scaled to become a household name.
IS THE MUSIC OVER?
Although the D2C business model has gained significant popularity and success in recent years, there are several challenges and downfalls that may contribute to a cooling enthusiasm in the space. These challenges include:
Increased competition: As more brands adopt the D2C model, the market can become saturated, leading to increased competition for consumer attention and market share. This heightened competition may make it more difficult for new entrants to establish themselves and for existing brands to maintain their growth trajectories.
High customer acquisition costs: The need for extensive digital marketing efforts to reach customers can lead to high customer acquisition costs (CAC) for D2C companies. With rising costs for online advertising and increased competition, brands might find it harder to attract customers in a cost-effective manner.
Supply chain disruption and scalability issues: In recent years, global supply chains have experienced massive disruption due to Covid and its hangover effect on the Asian manufacturing industry. This has caused a material headwind, especially for smaller brands.
Return to offline: While digital commerce boomed during the Covid years, many data sources show that the trend has reverted back to the historical trend. While still growing massively and having huge room for improvement, offline shopping has come back and it is still super relevant for retail. Smaller brands obviously have a large disadvantage compared to established brands in competing in physical retail. While some D2C brands have started to open brick-and-mortar stores or partner with traditional retailers, these strategies may come with additional costs and challenges.
Rather than being a sign of failure or that the D2C movement was a "Zero Interest Rate Policy phenomenon," this is a reality check. The fundamentals are still valid: customers are looking for non-standard experiences, digital is going to be the key asset in any brand-building effort, and many segments have a lot of opportunity for disruption. Having said that, probably this is not an appealing VC play. It's very hard to imagine that investors could get 10/20x returns that their capital allocation models require. Building brands is hard; it scales a lot slower than other segments (e.g. software, consumer internet, AI, etc.) and requires a lot of capital to scale. On the other hand, consumer brands usually build long-term value as customers learn to know and love the brands.
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THE MARKETING DISRUPTION
At the beginning of a podcast I listened to, the speaker made an interesting point when discussing the implications of the Apple privacy policy change. They said, "Many people in the industry argue that Marketing has become fun again!”.
I'm not sure how familiar you are with digital marketing, specifically performance advertising (i.e. paid advertising on Google or social media), but the industry was completely transformed in the 2010s when targeted advertising (i.e. targeting very specific customer cohorts) became possible at a low price. Brands could effectively optimize their customer acquisition cost (CAC). For example, if I built a brand for professional cycling gear, I could easily set up super-targeted campaigns on Facebook and Instagram targeting narrow groups (e.g. people with a bike who use their bike for training, post pictures about it, have a Strava profile, and live in an urban setting), which led to fantastic conversion rates.
Soon, this game became an "automation play". Facebook Ads was so pervasive and well-designed that you only had to set up and fine-tune the rules you gave the algorithm and fix the ceiling of the dollars you wanted to invest. The algorithm did the rest.
Then, in 2020, Apple made a "minor" change in privacy rules. Unless explicitly agreed to by the user, it stopped sharing third-party data across apps, which broke the entire model. Since apps can't share data anymore, it's very hard to have a single funnel to optimize, and we went back to the pre-Facebook Ads world. When managing marketing budgets, you have to go back to the "traditional" job spec: managing different channels and optimizing across different media. Finding the right allocation and spend optimization goes back to being more of an art than a math problem.
This disruption, combined with the growth of CAC due to higher competition from the booming D2C brands, made the entire model a lot harder. If you have to invest a higher percentage of your margin to acquire customers, you either need to have super high gross margins or it's very difficult for you to scale. And in consumer goods, margins usually come from scale (which allows you to negotiate better with suppliers), so there is a bit of a vicious cycle that broke a lot of nascent brands.
THE CREATORS WAVE
As is often the case, a crisis in marketing has created new opportunities. In recent years, the high customer acquisition cost (CAC) in the direct-to-consumer (D2C) industry has led to the emergence of content-based brands. Content creators leverage their existing audience and influence to build and promote their businesses. This approach helps to mitigate the high CAC issue, as content creators already have a built-in audience that trusts and engages with their content.
Content creators like Mr. Beast (Jimmy Donaldson), Kim Kardashian, and Chiara Ferragni in Italy have successfully launched D2C brands by tapping into their massive online following. In addition to the lower CAC, creators leverage their content as "free media" and usually have a very loyal customer base that does a lot of word-of-mouth marketing. Creators also benefit from a perceived trust and authenticity. Fans of content creators often feel a personal connection with them, making them more likely to trust their recommendations and products. This trust can translate into higher conversion rates and brand loyalty.
Mr. Beast, who has over 80 million subscribers on YouTube, launched a virtual restaurant brand called Mr. Beast Burger in 2020. The brand has since expanded to over 1,000 locations across the United States. He then launched a chocolate bar that quickly became one of the most sold chocolate snacks in the US.
Similarly, Kim Kardashian leveraged her 200M+ followers on Instagram to launch several D2C businesses, such as KKW Beauty and SKIMS, and build a massive following. KKW Beauty was valued at around $1 billion in 2020 after a 20% stake was sold to Coty Inc. for $200 million. She has become a powerhouse and one of the biggest brand builders in the world.
Many people believe that in the future, there will not be successful brand building without a strong content proposition. In parallel, all content creators will somehow monetize their base through direct commerce plays. Content is indeed king, also in product marketing!
IS IT A TURNAROUND OPPORTUNITY MOMENT?
As I mentioned in a previous post, one of the reasons I conducted this research and wrote this post was to validate a business consideration I made while listening to a podcast episode: is there an opportunity for private equity (PE) investors to buy direct-to-consumer (D2C) brands and turn them around? While I do not believe this model is suitable for venture capitalists (VCs), I could see PE investors applying their expertise in building operational and capital allocation efficiencies to improve business fundamentals and ultimately monetize these brands. Many brands could benefit from larger marketing scales, access to debt for growth funding, or critical mass for production savings.
Furthermore, the current climate and investment timeframe could mean that many first-wave VC investors may be looking to exit their D2C investments, potentially offering good entry prices.
What is your view? Do you think D2C brands will be a minor share of the market in 10 years, or do you think we are moving towards a less concentrated world where customers spread among many brands?
Hope you have a fantastic weekend!