Last year’s forced stay-at-home experiment pulled forward many trends, the most notable of which was eCommerce adoption, which today accounts for 23% of total retail sales in the US, up from 16% last year.

Given this, you’d be inclined to think that any eCommerce company would have at least doubled its stock price in 2020. You’d be wrong!

It’s the restaurant-food aggregator saga all over again: While eCommerce platforms (i.e., Shopify) and aggregators (i.e., Amazon) heavily benefited from increased traffic, many pure eCommerce players (i.e., Casper) did not do as well, as the dual punch of high customer acquisition costs and low barriers to entry made it very difficult for these players to turn profits.

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As I wrote last year: “low barriers to entry, coupled with low switching costs and the proliferation of service providers across the value chain, make setting up an eCommerce [company] relatively easy. Don’t take my word for it; check how many players are doing grocery delivery in the UAE. As more players enter the space, gross margins drop (given limited differentiation), customer acquisition costs increase, and the number of orders per customer per platform drop.”

So does that mean that pure eCommerce players don’t make money? Not exactly. A lot of players in this space will continue to generate superior returns for their investors. But doing so will gradually become harder, and successful founders will need to get a few critical things right.

Throughout this newsletter, I plan to uncover what eCommerce founder need to do to build successful businesses:

Product Strategy

Financing

Marketing & analytics

  • Blueprints of a winning marketing plan (upcoming post)
  • Data strategy: When less is more! (upcoming post)

Distribution

  • Distribution strategy and channel diversification (upcoming post)

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Selecting an appropriate category

At HBI, the first question we ask ourselves before embarking on a new eCommerce venture is: How attractive is the category/ industry you want to play in?

That’s because, along with ‘team’ and ‘execution fitness,’ the category you play in is the most important predictor of your startup’s success. As Warren Buffet once said:

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”

Last year, I wrote about the IPO filing of Casper, one of the most iconic DTC brands in the US, highlighting:

“From the outside, [Casper] looks great:

  • 5-star team: Five co-founders with complementary skills and past startup experiences
  • Impeccable execution: A lot has been written about their best-practice product launches and ‘genius’ marketing campaigns
  • Off-the-charts brand equity: 31% aided brand awareness!
  • Fantastic customer experience: 80% positive brand sentiment and 60 in Net Promoter Score!
  • Great partners: Since its inception, the company has raised a total of $339 million from Northwest Partners, Target, and IVP.

Yet, six years in, Casper, like many other DTCs, still loses money.”

The operating losses and poor stock performance can be attributed to many reasons, but one stands above all: Mattresses are not an attractive category to sell online!

So how do should you evaluate whether a category is an interesting one to play in? Here are the five elements we look at (the below image showcases the framework applied to a range of categories)

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It’s important to note that category assessment is just the first step of our evaluation process and does not lead to a direct Yes/ No answer. We also typically explore innovation potential in the category and other aspects.

The market

Direct-to-Consumer companies enjoy high gross margins, given their ability to cut out intermediaries (distributors and retailers). However, these margins rapidly erode under the weight of high SG&A and customer acquisition costs. Therefore, a startup’s ability to scale (i.e., sell many products) is critical to its survival, making market size and growth two essential factors to keep in mind.

Tip: Start with global market size/ growth (easier to access figures online), but quickly narrow down on the addressable market (TAM). Precision is not required here, what matters is a high-level perspective of size

Customer lifetime value

As more and more companies compete for our attention, customer acquisition costs (CAC) have spiked, further increasing the importance of customer lifetime value (LTV) for a business to be sustainable. As a business matures, maximizing LTV becomes one of the most critical components of a company’s strategy. Great marketers pay special attention to this metric, regularly running cohort-specific analyses to understand the impact different products/ actions/ discounts have on LTV multipliers across different customer cohorts. Such visibility unlocks the team’s ability to optimize return on marketing spend and maximize revenues.

Generally, you can achieve a high LTV in two ways:

  • High average order value (i.e., Casper and their mattresses)
  • Frequent or repeat purchases (i.e., Dollar Shave Club and their blades)

Tip: To be profitable, you should target an LTV/ CAC above 1. As a rule of thumb, aim for 1.2–1.5x during early growth stages and 3x as you approach maturity. If you don’t see such figures, revise your product/ market fit.

The incumbents

The most crucial factor in a startup’s ability to disrupt a specific category is the strengths/ weaknesses of incumbents in the category. When looking at market incumbents, we look at two things:

  • Market concentration: We generally like concentrated markets where choice is limited because that’s where customer experience and product innovation are deprioritized. Another advantage: Concentrated markets typically enjoy high gross margins.
  • Unmet needs/ pain points: We also look at specific unmet needs and customer pain points in the industry. We like companies that are solving a particular pain point felt by a large group of customers. The more specific the problem, the bigger your chances of success are.

Tip: When structuring your problem statement, think of answering three questions: 1) What is the problem you’re solving? 2) Who does your problem affect? and 3) why does the problem exist (or what are the structural issues within the industry that are leading to these pain points)?

Barriers to entry

Casper disrupted the mattress industry with its innovative business model and best-practice marketing, but so did 174 other companies. The low barriers to entry in the industry created a high influx of new players, making it almost impossible to turn any profits.

On the other hand, Hubble went after a category with high barriers to entry: FTC mandates that lenses are fitted and prescribed by optometrists, a highly fragmented market with 35,000 practices and non-transferrable prescriptions. These are incredibly high barriers to overcome. It took Hubble a while to penetrate the market (they did it by tracking Zocdoc-listed optometrists and offering them a similar referral service for free). However, once they entered the market, they sustainably grew with a limited threat from new entrants.

That’s why we like categories with high barriers to entry. They’re harder to disrupt but more protected from me-too products and, most importantly, more protected from Amazon! Barriers to entry come in three shapes:

  • Regulatory, mostly prevalent in food and medical categories
  • Manufacturing complexity, generally linked to product type, available patents, number of components (or suppliers) required
  • Product/ brand affinity (or emotional switching costs) This usually refers to the attachment consumers feel towards the product and the brand and their propensity to switch to a competitor. We typically see a high affinity for externally visible products and stand for specific values (i.e., cosmetics, fashion). Unfortunately, this is not the case for mattresses, so Casper needed to continue spending a lot to attract new customers.

Tip: Barriers to entry are a great way to build a value proposition and avoid commoditization of your product. Your ability to figure out a way around them is directly proportional to your chances of building a great company!

Supply chain

The final element we evaluate is the distribution/ supply chain structure, and we look at it from two angles:

  • Supply chain complexity: We like complex supply chains with multiple intermediaries (distributors and retailers). D2Cs that manage to simplify the supply chain can structurally cut costs and share savings with their customers (i.e., Away Travel with their suitcases) while having better control over their products (i.e., Everlane and their ‘Radical Transparency’ effort).
  • eCommerce friction: The second component we look at is friction, which covers two elements: 1) the inclination of customers to buy the product online and 2) the cost of shipping the product( i.e., value to weight ratio). We are generally more attracted to products with smooth eCommerce operations. However, we are always impressed by companies that creatively solve these issues. For example, Warby Parker overcame high eCommerce friction in the eyewear industry by shipping its customers five pairs of glasses to try and return the four they don’t like!

Tip: Supply chain used to be a black box for new startups. However, the proliferation of logistics services (Logistics-as-a-service models) is making it easier than ever to overcome with a little bit of creativity.

That’s it for today. I hope you enjoyed this piece and, at the very least, learned something. If you feel someone might benefit from this piece (or learn how to build online businesses), please share it with them!

Imad El Fay

Imad El Fay

Partner & Venture Builder @HBInvestments | @McKinsey alumn, @Harvard alumn