About Me: I’ve spent the last 5 years scaling my holding company of direct-to-consumer brands from $0 to 10’s of millions in annual revenue with just a bit over $1m burned. I also spend a lot of time investing, advising, and consulting businesses across the commerce ecosystem. You can reach me at haris@nameless-ventures.com
The current era of direct-to-consumer brands — or, if you’re a tool, you call them digitally native brands — was born around 2007 with big promises. DTC was meant to be a far better, far more efficient distribution channel than traditional offline retail.
15 years later, that couldn’t be farther from the truth.
The biggest challenge with the DTC model is that it fundamentally operates with an inverse distribution model — the more your business scales, the more you get punished; with retail and amazon, the opposite phenomenon exists — the more you scale, the more you get rewarded.
It’s important to look at 3 core pillars of product distribution — ad networks, 3rd party ecommerce marketplaces (Amazon, etc), and offline retail (Target, Walmart, etc) — as effectively auctions and bidding networks. With ad networks you bid against other brands on the auctions with cash, while with marketplaces and retailers you bid with sales velocity and conversions. The latter is effectively more bottom funnel than the former, which aligns incentives with the arbiters of distribution, because the more efficiently you make money the more they do as well. With ad networks, that’s not as much the case. Let’s dissect that a bit further:
Let’s break down how things work on Amazon…generally speaking, thousands of variables impact your product’s rankings, which then impact the traffic you receive to your product listing — but the most important are sales velocity (the speed at which you sell-through), reviews (review rate, number of reviews, and positive reviews), and PDP conversion rate. Amazon compares these (and many other) factors against other product listings in your category that you compete with. The faster your sales velocity, the stronger your review rate and quality of reviews, and the stronger the conversion rate of your product listing, the higher up you move in the rankings and as a result the more traffic you receive. This aligns your incentives with Amazon’s — Amazon wants to maximize the efficiency of their revenue and the satisfaction of their customers, and as a result they reward the merchants who have provided a product in their ecosystem that results in higher converting and higher satisfactory customers.
Now let’s jump into retail…just like Amazon, retailers have a number of variables they assess to determine your product’s place in their ecosystem. The most important variable really is sales velocity (turnover of units per week) along with other key metrics like sales value per cubic inch, which tells retailers the efficiency of your revenue volume relative to the amount of shelf space your product takes up (as a result, sometimes an innovative product with more compact packaging could be compelling to retailers because they can fit more units on the shelf and take up less room). Similar to Amazon, retailers use these variables to understand how you stack up relative to other products on the shelf — everything is a competition for shelf space, and retailers want to maximize revenue as efficiently as possible. The stronger your product performs i.e. the stronger it sells-through relative to competition, the more you get rewarded —> retailers will make larger purchase orders and give you more shelf space. You are providing them more revenue for every person that walks by, than the competitor next to you — as a result, they have an incentive to provide you more distribution.
Now finally, let’s get into DTC…the central distributors of traffic are ad networks and search engines, whose incentives are fundamentally misaligned with merchants. Retailers and Amazon have an incentive to reward you for efficiency — the stronger your sell-through relative to your competition, the more money they end up making. With ad networks, the challenge is you are bidding in an auction network against other brands who don’t have the same cost structure or goals as you. Mercedes-Benz is not bidding on CPA, they are looking for reach, impressions, and awareness. As a result, the ad networks are focused on simply maximizing revenue across inventory — whether or not you drive profitable sales is not what determines their business model. With retail & amazon, your cost structure is extremely similar to the competition in your category, and so you can’t really get fucked in a way where the margin structure is completely misaligned from the others in your category who are bidding for the same space.
At the end of the day, there is a bit of an incentive for ad networks to make sure the ads are still effective for you as CPA-driven merchants. But the reality is that they have an incentive to make you just efficient enough so that you continue spending money, but not too efficient where they leave money on the table. An influx of venture funding has made their business model even better, because just efficient enough is actually “unprofitable but not TOO unprofitable” for many brands. I bet Facebook likes the sound of that.
The way that I look at the just efficient enough concept is the IPO analogy, which is really just an analogy on markets. The goal of a company and its bank in an IPO process is to price the market just right, where it’s not too overpriced because they need investor demand, but not too underpriced where the share price pops in its first day, because that means you left money on the table. Similarly with Facebook, they need to make sure you are going to continue spending on ads and bidding up inventory — but they don’t need to make you highly profitable. If your break-even point is a $50 CPA, and currently you’re at $30 — if FB drives up your costs to $45, you’re going to keep spending the same amount of money because in either scenario you are still generating a profit. So when you’re scaling at $30, technically Facebook is losing money. The market i.e. you, the spender, is still willing to spend the same amount of money at $45 — so why charge $30? Do you see how this misaligns incentives, compared to retailers and Amazon?
Even outside of the incentive problem, you’ve got quite a lot of factors going up against you in the game of driving traffic: 1) Big brands are driving up media spend and subsidizing the ad networks’ abilities to not give you profitable ads, 2) ad networks outside of TikTok have an attention problem and so inventory is becoming more scarce which drives up the price, and 3) the Great Privacy War of the 2020’s is driving away your attribution and making your ads more difficult to run effectively. This level of platform dependency, in a system that is already misaligned with your incentives, creates a dangerous and unsustainable business model.
But to bring it all back to the core message - the internet sells eyeballs, while retailers sell purchases. Eyeballs are not directly correlated to sales, while purchases are directly correlated to sales. Whether 10,000 people walk by your product on a shelf does not matter, you didn’t pay a single extra dollar for those 10,000 people. But 10,000 people seeing your ad or clicking through to your website costs you money, and it may not have equated to a sale. If no one buys in a retail shelf, Walmart doesn’t make money — but if 10,000 people visited your website and no one made a purchase, FB & Google still made their money.
A lot of the above is why I tell most investors & brands that the direct-to-consumer model is not fundamentally meant to be a channel of massive scale, and is instead meant to be 1 of several key channels to distribute a consumer good (with retail and Amazon being the other 2 critical channels). Now, that doesn’t mean the entire DTC model is terrible or can’t work — you just have to figure out how to solve the inverse distribution problem.
One way is through incredibly strong retention metrics — every purchase after the first is not something you are paying for. So inherently, if you can really crack retention, then you have solved the inverse distribution problem for yourself and you are now compounding more revenue over time through a customer cohort that drives more revenue without additional incremental spend.
Another is through finding traffic sources online where your incentives are aligned with that of the distributor. For example, a brand that I founded / own generates about $10m a year of revenue through a sort of quiet affiliate network at a fixed CPA. Regardless of what traffic is driven, the only thing I am paying is a fixed dollar amount for every sale driven. And given its an affiliate network, the incentive model is somewhat similar to retail/amazon - they are incentivizing me to create an offer and page that is more efficient than other products in the network, so that its affiliates choose to redirect their dollars and traffic to my product over others, thereby creating a flywheel that compounds the growth of my revenue if I make my page more and more efficient.
Lastly, another method is if you’re building your traffic off the back of organic levers, and so you are no longer paying for each eyeball. Content-commerce businesses like Gear Patrol, Food52, and Milk Street are good examples. They’ve built organic distribution through other means like SEO traffic, TV distribution, community-building, etc. The great thing about this is it’s similar to the retail eyeball analogy — if a piece of content is distributed through organic means, like search engines, then each new eyeball driven to that piece of content does not add an additional cost to the business. As a result, if 10,000 people view that content and no one converts into a sale, you don’t make money but you also don’t lose money — similar to retail shelves, where if 10,000 people walk by your Walmart shelf you don’t lose money.
With retailers, inefficiency is your loss and theirs. With ad networks, inefficiency is your loss and their margin.
-Haris