In a stable environment, well-established retailers hold a significant advantage over emerging startups. With their strong brand names, cash reserves, and economies of scale, these retailers can easily crush potential competitors.
However, over the past 20 years, numerous ecommerce startups have risen to challenge these powerhouses. Jeremy Liew, a partner at Lightspeed Ventures, explains this apparent contradiction:
“In most cases, large companies have a clear advantage over smaller ones regarding both customer lifetime value and customer acquisition cost. Large companies have higher contribution margins due to their economies of scale, resulting in higher lifetime values. Stronger brand names can also lead to higher loyalty (less churn, longer lifetimes, higher lifetime value) or lower customer acquisition costs.
In a stable environment, lifetime value and customer acquisition remain constant, understood by all industry players. Most advertising markets are efficient, so competitors acquire customers at similar costs. Companies with higher lifetime values can afford to pay more, enabling them to dominate the market.
So, how do startups find an opportunity in such a challenging landscape? The answer lies in the fact that the environment has not been stable.
Facebook’s rapid growth has driven significant change, creating new scalable customer acquisition channels where markets are NOT efficient. Agile startups were the first to capitalize on these channels, growing quickly before incumbents even noticed. This is how ecommerce startups can break through.”
Ecommerce Startups Come in Waves
Over the past two decades, four distinct waves of startups have emerged, driven by the rise of nascent platforms that startups have used to acquire vast numbers of customers.
Successful customer acquisition arbitrage of these emerging platforms is short-lived. As a market matures and trends towards perfection, it becomes increasingly difficult to find significant opportunities to exploit. Thus, when an opportunity arises, successful startups must quickly seize the moment.
In 2020, the fourth wave is in full swing, powered by customer acquisition on social networks like Facebook, Instagram, Snapchat, TikTok, and others. Digitally native vertical brands (DNVBs) are capitalizing on this wave by developing direct relationships with their customers and bypassing traditional wholesale distribution methods.
Before examining the present and future, we should reflect on the past. History may not repeat itself, but it often echoes.
Ecommerce 0.1 – ISP Channel Partnerships
In the late 1990s, dialup portals such as AOL and Prodigy helped bring the world online. These portals, in search of engaging content for their users, created channels for shopping, travel, dating, jobs, and more. Early ecommerce startups like Amazon, Expedia, Match, and Monster powered these channels. While these partnership deals weren’t cheap, they were relatively affordable compared to their impact, and several massive ecommerce companies were built as a result.
Ecommerce 1.0 – Harvesting Demand
In 1998, with the introduction of goto.com’s auction-based search results, pay-per-click search engine marketing emerged. Store owners could drive interested customers to their websites for as little as a penny per click. In 2001, Google adopted goto.com’s model, converting Adwords to a pay-per-click system, which led to the rapid growth of thousands of ecommerce businesses.
In my experience, I started selling barbecue grills in 2001. Our initial goal was to generate $30,000 in revenue in our first full year, 2002. Surprisingly, we had a $30,000 day in 2002. We quickly built a business with $10 million in annual revenue, all thanks to the power of PPC advertising.
When a user searched for a product-related keyword, they indicated their intent to purchase. To run a successful ecommerce company in the early days of Adwords, businesses needed to capitalize on this existing demand from Google. Although the online store itself was simple, the ability to acquire interested customers for a nickel or less allowed us to grow rapidly.
With a profit of 4 or 5 dollars from every visitor and an acquisition cost of 4 or 5 cents, the growth of an ecommerce business in the early 2000s on Google’s platform was a breeze. In the initial days of 1 cent clicks, the return on ad spend (ROAS) sometimes exceeded 100-fold.
This highly lucrative pay-per-click (PPC) arbitrage facilitated the launch of several well-known brands, such as Zappos, Legal Zoom, Diapers.com, Wayfair, and Blue Nile. Additionally, Amazon and eBay used PPC arbitrage to solidify their leadership positions.
After a few years of seemingly easy profits, the cost per click began to rise significantly, and the first-mover advantage started to fade.
In the grill market, for instance, Lowes, Home Depot, Amazon, and Walmart entered the PPC auctions. Their participation drove the cost per click higher, making it difficult for new ecommerce startups to gain traction.
As a market moves toward perfection, the ability to exploit inefficiencies decreases. Companies with the best and most efficient business models can bid the highest amounts and essentially price out weaker competitors. Lowes, Home Depot, and Walmart had a much greater customer lifetime value than our small grill company, so we were eventually priced out of the market.
Some businesses that launched during this PPC revolution succeeded in dominating their markets, such as Mark Lore’s Diapers.com. By using Kiva Robots to power his highly efficient logistics operation, he exploited millions of monthly searches for diaper-related keywords, quickly gained control of the online diaper market, and sold Diapers.com to Amazon for $540 million.
While we ultimately did not conquer the global grill market, we built a highly profitable niche business that lasted for almost two decades.
Ecommerce 2.0 – Creating Demand
In contrast to ecommerce 1.0 companies that primarily focused on harvesting demand from Google for essential products, ecommerce 2.0 businesses built their foundations on generating demand from Facebook by offering enjoyable and often exciting shopping experiences.
From 2009 to 2011, Facebook’s budding ad platform provided cheap clicks, access to millions of users, and incredibly powerful targeting options. The first wave of ecommerce companies to employ Facebook as a scalable customer acquisition method were “daily deals” sites, including Living Social, Zuliliy, Gilt Groupe, Groupon, and One Kings Lane.
Unlike with Google, where around 98% of transactions occur on the day of the first visit, Facebook visitors are less likely to purchase on their initial visit. Harvesting pre-existing demand is typically a fast, one-touch process, but creating demand often requires multiple interactions. As a result, it was essential for these businesses to gain permission to send marketing content to potential customers over extended periods. Instead of transacting directly through Facebook ads, most daily deals companies used the platform to collect potential customers’ email addresses, enabling them to send offers via email daily.
With permission to send marketing messages without incurring extra costs, immediate customer conversion wasn’t a priority. Instead, maintaining engagement and encouraging repeat visits were the primary concerns. A user who enjoyed browsing pictures of shoes, dresses, or home decor would eventually find something they wanted and make their first purchase.
My own company, Country Outfitter, was not a typical daily deals company, but we made shopping enjoyable through a viral giveaway strategy. Within six months, we acquired 11 million email addresses and built 9 million Facebook fans through our popular weekly giveaways. We could obtain a new email subscriber for just 6 cents, and by using daily emails and an aggressive event-driven remarketing strategy, 12% of these giveaway entrants would eventually purchase from our site, resulting in a remarkably low 50-cent cost to acquire a paying customer.
Leveraging the affordable, abundant clicks from Facebook, we expanded our business to $100 million in annual revenue, raised $100 million in venture capital, and sold the company to a private equity firm in under a year.
One notable aspect of the daily deals model was its inventory-light or inventory-free approach. Unlike traditional retailers, these stores wouldn’t buy inventory until a customer had already purchased the product. They would reserve excess inventory, run the sale, and then buy only the inventory required to fulfill the completed customer transactions.
Browsing these daily deals sites was an engaging, novel, and enjoyable experience, similar to flipping through glossy catalogs in the past. However, despite these benefits, many ecommerce 2.0 companies failed to achieve long-term viability. Daily deal emails increasingly landed in spam folders and were ignored by users.
While Groupon and Zulily achieved scale and successfully launched IPOs, the collapse of companies like Fab, Gilt Groupe, One Kings Lane, and even my own Country Outfitter demonstrated that relying too heavily on push content without other compelling features was ultimately a flawed strategy.
Ecommerce 3.0 – Digitally Native Vertical Brands
As the ecommerce 2.0 daily deal sites started to decline, a new generation of ecommerce companies emerged – the Digitally Native Vertical Brands (DNVBs). Unlike their predecessors, numerous ecommerce 3.0 companies rapidly developed, achieved sustainability, and were valued at over $1 billion, including Warby Parker, Dollar Shave Club, Harry’s, Glossier, Juul, All Birds, and Casper.
Andy Dunn, founder and CEO of Bonobos, penned a seminal article that defined the characteristics of a DNVB, sparking a movement and an influx of venture investment in new brands. I met Andy at Sara Lacy’s Pandoland conference in Nashville, where we both spoke alongside other ecommerce visionaries like Tristan Walker, Bill Ready, and even Al Gore, who “invented the Internet.”
At the time, I was an Arkansas entrepreneur selling millions of cowboy boots, while Andy, a stylish Stanford graduate, was building a trendy yet accessible brand for men. Despite a clumsy red wine spill on Andy’s pristine white outfit, we quickly became friends. It was at that conference that I first heard his elegant thesis on digitally native vertical brands.
Though it made perfect sense, it was the first time I had heard DNVBs described as a distinct category from ordinary ecommerce retailers. In many ways, the DNVB business model is far superior to traditional ecommerce retail.
DNVBs differentiate themselves by establishing direct relationships with consumers from the outset. Margins are generally higher, as there is no “tax” paid to retailers, at least initially. Although they are digitally native, these brands can expand into retail distribution through their own stores or traditional wholesale arrangements with established retailers.
Andy called traditional retail distribution “contribution positive customer acquisition,” as the retailer bears all customer acquisition costs and introduces their customers to the digitally native brand. Instead of paying hefty sums to Google or Facebook for customer acquisition, the retailer pays the DNVB to acquire new customers.
Bonobos ingeniously utilized direct mail for customer acquisition and introduced their often-imitated guide shops. These small stores limited inventory; customers couldn’t buy items directly but would order them to be shipped from warehouses fulfilling online orders. The shops only had representative sizes for fitting and colors for comparison.
Customer loyalty in today’s ecommerce world is predominantly with the brand, not the retailer (with some exceptions, like Amazon and Zappos). As a cowboy boot retailer, we experienced this firsthand. Customers were loyal to their preferred brands (Ariat, Lucchese, etc.), but not to the retailer. They would search for the lowest price for their desired brand.
When brands like Ariat started selling directly to consumers, we lost sales. Direct sales from these brands exerted significant pressure on our business model, forcing us to sell to our largest competitor, who had access to almost unlimited public market funds and an even more efficient “pipe.”
Bonobos also employed creative PR strategies, such as limited runs of unique pants for holidays, like Valentine’s Day and St. Patrick’s Day. While perhaps not the first to adopt this approach, Andy Dunn’s Bonobos became the face of this new business model.
Although DNVBs have significant gross margin advantages over traditional ecommerce sites (often over 60% vs. around 30%), the DNVB business model is not without its challenges. Unlike daily deals sites that carried no inventory, DNVBs are often inventory-heavy. While daily deals sites enjoyed a virtuous cash flow cycle, DNVBs face notoriously non-virtuous cash flow cycles, paying for inventory weeks to months before sales.