Funding Direct-to-Consumer Brands: Venture, debt, or a hybrid?

The last few years have seen an explosion in niche brands that focus on selling one high-quality product direct to consumers online.

A unique set of circumstances has enabled these brands to exist:

1. The dominance of aggregators like Google and Facebook, who let tiny brands compete on the same footing as behemoths like Unilever. In the past, large brands controlled retail distribution, however today brands can sell online through targeted ads and the barrier to entry no longer exists.
2. The ability to prototype designs cheaply through factories in China. It is now easy for anyone to find a high-quality factory on Alibaba’s marketplace, send them designs and receive prototypes in a matter of weeks. With those prototypes, entrepreneurs can test quality, take product photos, and quickly test online demand through $50 of Facebook Ads.
3. Crowdfunding platforms like Kickstarter and Indiegogo enable entrepreneurs to both gauge demand for their niche product and provide the initial funding to fund the first production run.

The most successful of these companies know how to target their marketing and storytelling at a particular niche and build communities of devoted fans who act as brand ambassadors spreading the word amongst their target market.

(I wrote more about building tribes around your product here)

This is a structural trend — the number of entrepreneurs building niche brands and targeting consumers through social media will only increase in coming years.

However, these companies continue to have trouble getting access to capital to help scale their brand.

So how should they be funded?

Some venture capitalists believe that by scaling these direct-to-consumer brands they can achieve the necessary 10x return on their investments. Forerunner Ventures has had some great success so far, funding Warby Parker and Bonobos in their early days.

However, there are some unavoidable facts that mean venture capital is not the right source of funding for these brands:

1. The early mover advantage has gone. Warby Parker, Bonobos and Casper had huge success by being the first to market 8–10 years ago, and by fixing markets that were obviously broken. Today the easy wins are gone, and the market is exponentially more competitive.
2. When using online advertising, customer acquisition costs increase with scale. These brands start niche, targeting consumers who love their brand ideals, so the cost to acquire customers is low initially, but once you expand past early adopters the costs can increase dramatically.
3. These are atoms not bits, so the cost of replication is much higher. These brands are lower margin than software, and so any increase in customer acquisition costs can have a huge impact on the bottom line.
4. These are mostly one-time sales. The shift to subscription revenue through software-as-a-service has been extremely effective in scaling the lifetime value of software products. It also meant that once startups get a decent understanding of customer lifetime value as a multiple of acquisition cost, they simply use venture funding to acquire customers as quickly as possible knowing that the subscription revenue will lead to profitability over time. However, most direct-to-consumer brands involve one-time sales, so each sale needs to have positive unit economics, meaning that venture funding isn’t as effective in bearing the upfront cost required for scaling.

You can start to see venture-backed direct-to-consumer startups failing everywhere — Birchbox’s early investors were recently wiped out in a desperate funding round, while press darling The Honest Company recently lost its unicorn status with a down round.

Huge funding rounds mean young startups like AllBirds and Away are under enormous pressure to scale rapidly. This involves expanding beyond the initial product set consumers loved, and pushing into retail to try and cross the chasm as quickly as possible.

I expect in a few years we’ll hear stories of these startups doing too much too quickly, and wasting millions of dollars of venture funding on ballooning acquisition costs that don’t convert to lifetime value.

So what’s the alternative?

These are still great businesses that can scale to tens of millions of dollars of revenue, so how should we fund them instead?

Debt is the obvious choice, however many traditional banks still use antiquated models to assess credit-worthiness and likely won’t fund a 6-month old backpack brand.

Revenue-based funding

One of the newer funding models that has emerged over the last few years is revenue-based funding. Lenders will lend an amount of money, and over time the company pays a multiple of that amount back out of revenue.

This takes away the stress of worrying about monthly debt payments in low season and means companies know exactly how much they have to pay back.

Shopify provides tailored offers to its merchants through Shopify Capital, while Clearbanc plugs into any e-commerce platform to provide tailored loans based on revenue data, business metrics and market data.

But what if a startup is looking for the company-building help that comes with venture capital, with the investment profile of debt…

Hybrid Funding

Indie.vc is pioneering a new way of funding startups, focussed on allowing people to build profitable businesses they can keep forever. The homepage of their website states:

Real businesses make products and sell them for a profit. They focus on customers, revenue and profitability not investors, valuations and the next fundable milestone. Real businesses prioritize their customer’s needs over their customer’s eyeballs. They have a functioning business model, not a believable financial model. Real businesses want to stay in business, not run for the exit. They create their own source of funding and don’t have to ask anyone for permission to exist. We believe real businesses make really great investments.

They do this by combining debt-style funding that focusses on cash distributions from revenue, with an equity option.

Investments scale based on revenue and business needs from $100,000 to $500,000. The equity option is only applicable if you raise extra funding, or sell the business, at which point Indie.vc will become a shareholder in the company based on a pre-determined percentage ownership.

If the entrepreneur chooses to run the business forever, Indie.vc will receive cash distributions out of revenue from month 36 of the business, up to 3x their initial investment. The investment has no maturity dates, financial covenants and they do not take a board seat or require a personal guarantee.

What I love about this model is that the company receives all the benefits of equity funding — an injection of capital they don’t need to pay back immediately and mentoring from experienced investors — without the downsides that result from VCs demanding speed, scale and sale.

While Indie.vc is focussed on tech or tech-enabled businesses, there could exist a version tailored specifically for direct-to-consumer brands.

Along with hybrid debt/equity funding, the company would receive mentoring from experts in branding, digital advertising, production and supply chain.

These are just my initial thoughts, but with the explosion of data in recent years, there’s ample opportunity for innovative ways of funding young companies across a range of sectors, and I look forward to exploring more of them.