A simplified assessment model.

COVID-19 had a tremendous impact on accelerating the adoption of eCommerce in our region, creating a perfect storm for the proliferation of eCommerce companies in our region. As I’ve said before, It’s the best time to build a D2C in the MENA region!

So naturally, we’ve been busier than ever, looking at and evaluating investment (and incubation) opportunities. When doing so, we look at multiple critical areas for success, such as the business model, value proposition, and team. However, the first question we always ask 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”

In early Feb, Brandless, the D2C retailer, filed for bankruptcy. A week before that, Casper went public at half the valuation of its latest private round. Both had great teams and spotless execution, but both played in unattractive categories and thus were punished for it.

So how do we evaluate a category/ industry? Here are the five elements we look at (the below image showcases a few examples of the model we use).

Category assessment framework

PS: A category assessment is just the first step of our evaluation process and does not lead to a direct Yes/ No answer. We also look at the startup’s value proposition (source of innovation), and the founders’ plans to improve the category attractiveness.

The market

D2Cs enjoy high gross margins, given their ability to cut out intermediaries. However, these margins rapidly erode under the weight of high SG&A and customer acquisition costs. Therefore, a startups ability to scale (i.e., sell a lot of product) 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)

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 your business to be sustainable. 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 incompetence 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.

Hubble, on the other hand, 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, and 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 thus their propensity to switch to a competitor. We typically see a high affinity for externally visible products and ones that stand for specific values (i.e., cosmetics, fashion). This is unfortunately not the case for mattresses, which is why 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 propotional 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 easier than ever to overcome with a little bit of creativity.

At HBI, we’re always on the lookout for new founders and product developers because we understand how disruptive D2C will be. If you’re a founder or someone with a great idea, I would love to talk!

Imad El Fay

Imad El Fay

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