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The State of the Direct-to-Consumer Market

Online brands were facing profitability challenges before the crisis struck. Now, they must confront dramatically lower valuations and the possibility of being sold in distress — or worse.
Pepper brand imagery | Source: Courtesy
  • Cathaleen Chen

NEW YORK, United States — Pepper, a start-up that sells bras designed for small-chested women, was wrapping up its $2 million seed fundraising round this spring when the coronavirus struck. Governments began to mandate nonessential businesses to close in order to slow the spread of Covid-19, triggering a massive contraction in the economy that has paralysed retailers, brands and their investors.

Pepper was always conservative with spending, said Lia Winograd, Pepper’s co-founder. But now, making cash last as long as possible has become the company’s top priority.

“We were lucky to raise when we did,” Winograd said. “We have to reach a point where we don’t have to rely on equity financing.”

Direct-to-consumer brands like Pepper are getting their first taste of what it's like to operate in a recession. Their predecessors — the likes of Away, Allbirds and Everlane — sprang up in the years after the 2008 financial crisis, tapping a seemingly limitless pool of investor cash to steal market share from incumbents weakened by the worst economic downturn in decades. But consumers today are reserving their spending for disinfectant wipes and groceries rather than suitcases and sneakers.

Some brands may be insulated because of their category — at-home wellness, for instance, is booming — or were lucky enough to raise money right before the pandemic. But for many others, the outlook is grim.

The companies that haven't thought at all about profitability are in deep trouble.

Brands across the board are laying off employees and cutting back on marketing to stretch their dwindling cash reserves. But saving money is especially tough for these start-ups, whose business model is based on prioritising revenue growth over profit margins. That model worked when companies could raise round after round of venture capital. It's not clear what will happen if that spigot turns off.

"The companies that haven't thought at all about profitability are in deep trouble," said Nick Brown, co-founder of venture fund Imaginary, which has invested in Glossier and Reformation, among others.

There were signs of trouble for fashion and fashion-adjacent start-ups even before Covid-19 became a factor. Investors were increasingly wary of pouring more funding into money-losing brands. Outdoor Voices lowered its valuation in an internal funding round with investors late last year, after which founder and chief executive Tyler Haney exited.

The crisis today exacerbates these issues. Some direct-to-consumer brands are already asking their backers and lenders for emergency cash, investors told BoF. But raising new funding comes at a steep cost. One investor told BoF that consumer-product start-ups have seen valuations fall by one-third to one-half. The public market parallels these trends: The RealReal and Casper both saw their stocks fall by more than one-third since the crisis began to escalate in late February.

Lower valuations are disappointing for founders and their investors, who hoped to build billion-dollar businesses that they can sell at a premium to strategic acquirers or private equity firms. These acquisitions will still happen, dealmakers say, anticipating the latter half of 2020 to be filled with a flurry of deals. But price tags will be much lower than anticipated, and the winners will be the buyers.

There will be a moment where VCs are like, 'Uh oh, we have to go up against these suitors' or call it a loss.

“We’ve certainly been approached by brands that are saying, ‘Hey, I know we spoke before and you didn’t think we have the right growth strategy, but now we’ll accept a lower valuation,’” said Ben Macpherson, founder of d.Luxury, a growth investment firm whose portfolio includes accessories brand Cuyana and bedding startup Parachute.

Selling at a lower-than-hoped valuation may be a best-case scenario. Brands that find themselves behind on debt payments or falling far short on revenue goals will see their fate entirely in the hand of their investors, for whom the onslaught of opportunistic buyers outside of Silicon Valley — the private equity vulture funds, or powerful retailers like Walmart or Target that have remained opened amid the crisis — will propel critical decisions: They must identify which startups to continue supporting with additional capital, often despite mounting losses, and for which to throw in the towel.

“Private equity will come in with a mix of debt and cash, get high priority on the stack, and they’ll get their money back before anyone else does,” said Alex Song, founder of Innovation Department, a platform that builds in-house DTC brands and makes venture investments as well. “There will be a moment where VCs are like, ‘Uh oh, we have to go up against these suitors’ or call it a loss.”

Without a lifeline from current investors or outside ones, some brands will not be able to brave the storm at all. But those that survive will be leaner and more resilient, industry experts said. And just as many of the current crop of fashion start-ups emerged from the last financial crisis, new opportunities will arise as the pandemic changes consumer habits

The risk assessment phase is over.

In the first few weeks after most US states implemented lockdowns, venture fund Highland Capital Partners swapped out its normal schedule to focus solely on figuring out how the pandemic would affect the bottom line of the companies they had invested in, and how long they would be able to operate before running out of liquidity.

Brands selling products like skincare and loungewear, for instance, are in a better position than workwear or luggage.

“We saw that we have some businesses that are doing quite well through this and some that are facing a lot of pressure,” said Sean Judge, principal at Highland, which has invested in the likes of Rent the Runway, Harry’s and ThredUp. For the brands struggling, “it’s a matter of figuring out how to cut costs, which may mean headcount reductions.”

The firm is meeting with founders again to consider new investments, with a set of criteria that favour companies immune to the sales impact of the pandemic — an indication that they will perform well coming out of crisis-mode as well, Judge said. “We’ve had to shift and raise that bar, but we’ve been very active.”

In the consumer space, investors say categories slated to outperform post-pandemic include affordable bath and beauty, home improvement and household products.

Funding is still out there for early-stage companies

While deal count in the VC space remains low for now, investors can still make deals happen, according to Song.

According to Crunchbase, the number of venture deals in the first quarter of the year — 7,600 globally — fell by four percent compared to the same period last year.

The investors themselves, their capital is secure.

Imaginary’s Brown noted that looking at deal trends in the aftermath of the 2008 financial crisis, the industry can predict that the number of seed fundraising rounds won’t drop but Series A and B will, because investors will be more discerning about the progress of profitability.

Many investors build their funds with a 10-year plan for returns, so they aren’t as sensitive to temporary setbacks, even severe ones like the current economic crisis, Song said.

“At first, everyone is frozen. They want to get a sense of what people think but no deals happen,” Song said. “But the investors themselves, their capital is secure.”

Virtually every start-up is seeking emergency funding

Even as e-commerce brands may be faring dramatically better than brick-and-mortar-reliant retailers like Gap, overall consumer spending is down. This means that direct-to-consumer players are hurting too. Data from Earnest Research, for instance, show that e-commerce spending on apparel and accessories were down more than 30 percent in the last week of March, and down 5.5 percent in the week ending April 15.

In the face of sluggish sales, many DTC brands are in the process of obtaining emergency financing and equity fundraising, often at a lower valuation than in previous rounds, according to Song.

“It’s a new world of valuations,” he said. Valuations last year, for instance, may have been calculated on a company’s projection of its current annual revenue, or run rate. Now, valuations are more likely to be based on last year’s revenue.

Even that seems generous, according to Macpherson, who has seen some valuations dip by one-third or a half. “It depends on the sector,” he said. “And some just can’t raise any capital.”

The thesis of spending $100 million to build a $100 million business just doesn't seem logical now.

Naadam, a DTC cashmere brand, completed its Series B funding round last May, according to co-founder Matt Scanlan. The fortuitous timing, alongside Naadam’s naturally slow business in the spring and summer (the bulk of cashmere sweater buying happens between September and February), will protect the label from running out of cash, he said.

But not every brand can be defensive against months of lost sales. The most vulnerable are companies that aggressively raised and spent capital in order to buy growth — a trajectory that just isn’t feasible during the crisis.

“The thesis of spending $100 million to build a $100 million business just doesn’t seem logical now,” said Scanlan said.

The pandemic’s full impact won’t be felt until summer at the earliest

In addition to reaching out to existing investors, many start-ups have applied for the Paycheck Protection Program, part of the US government’s $2 trillion stimulus package. The loan program, administered by the Small Business Bureau, allows companies of fewer than 500 employees to seek financial assistance in covering their rent, payroll and interest expenses during Covid-19.

That funding will help DTC brands survive for the next few months, but their problems will resurface as soon as the stimulus money and emergency funding runs out, analysts and investors say.

There will definitely be a smattering of brands where investors are like, 'Just get us out of here.'

Macpherson of d.Luxury said in a couple months there will be more clarity around winners and losers.

“There will definitely be a smattering of brands where investors are like, ‘Just get us out of here,’ either through a distressed sale or basically leaving it in the hands of the founders,” he said.

A private equity ‘field day’ is coming.

Sam Kaplan, a former partner at Burch Creative Capital, left the venture firm last year to make his own investments with the hypothesis that many direct-to-consumer brands were overvalued and would soon be available to buy in fire sales.

He had a few examples to support his theory, including Steve Madden’s acquisition of the sneaker brand Greats last summer. Now, he’ll likely have his own pick of distressed start-ups.

“This is morbid to say, but coronavirus sort of accelerated this [prospect],” Kaplan said. He has yet to make an investment; at the three- or four-month mark is when “I’ll get good deals,” he added.

From there, the playbook would involve dramatically cutting costs, adding wholesale partners and focusing on profitability – the classic private equity treatment. Many DTC brands are well-known to consumers because they spent so much on customer acquisition early on. Once their profit and loss statements are in check, these brands can be very lucrative.

“The path for private equity is ripe,” Song said. “These businesses are still valuable — they’re strong brands that customers care about and relate to, and if they operated on cash flow instead of focusing on top-line growth, you’d actually have a viable business.”

The coronavirus will change the DTC playbook.

Newer brands like Pepper aren’t locked into the cycle of raising and spending venture capital every 12 to 18 months. If they can adapt to the new reality, they stand a better chance than some of their older peers.

Keeping costs under control will be more important than ever for small brands. But there will be winners among better-established brands, too.

“These are the players diversified in terms of channel, thoughtful about building a strong financial foundation, and have winning supply chains,” Naadam’s Scanlan said.

Looking ahead, Imaginary is seeking new categories to invest in, including affordable clean beauty, at-home wellness and products targeted at baby boomers, who were underserved by venture-backed brands in the past.

Investors like Brown are optimistic, pointing to the crisis as a start of something new rather than a spell of demise.

“The reality is that when you look at most recessions, during those periods you see a ton of businesses emerge — great entrepreneurs with great ideas,” he said.

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