D2C 101: Why the Future of Retail is Vertical Commerce and D2C Brands

For as long as humanity has existed, so has commerce in the form of sharing, bartering and selling resources. Even before currency in its most rudimentary form has come into existence in Mesopotamia in 3000BC, economies were created through bartering where people would exchange goods/services based on perceived value (Person A would want to sell Item A to Person B who finds Item A valuable in return for Item B which holds more value to Person A than it does to Person B).

Retail in a more modern form started to take shape by around 800 BC in Ancient Greece when merchants started selling goods in Agora's city center. Agora's city center formed the hub for the entire society as people would come there not only to buy essential items but also to socialize and participate in government.

Taken from bigcommerce.com/blog/retail/#what-is-retail

Fast forward a generation or two, the retail industry has gone on to occupy a core vantage point in modern society as it provides a lot of basic necessities which individuals need. It governs of humankind consumes virtually everything they need or want and is the blood that pumps literally all of our lives.

When the internet (and Amazon) came along, retailers started creating an online presence to compete with Amazon and consumers started making consumer goods based purchasing decisions purely on what they see on a website. In recent years though, what's been happening is that the traditional retail/e-commerce model has been upended.

A fancy word for this new wave of retail is vertical commerce - digitally native consumer brands that are vertically integrated by selling directly to consumers. They forego the involvement of retailers, distributors, wholesalers, and other outlets by being responsible for manufacturing, distribution, and selling.

After reading this article (and then this one) while at work one day, I became fascinated by how $4B has been invested in this space since 2012. As a venture investor, we're trained to have an opinion on basically everything. In true VC fashion, I set out to know everything there is to know about D2C brands (we like to be fancy and call this a deep dive) to figure out how they have & will continue to change the way we consume.

But first, some context on why the existing model isn't working anymore...

Changing Customer Demographics

Taken from Statista 2019

As the largest population segment in North America, we saw that millennials and GenZ'ers were largely left out of the retail narrative even though they had more spending autonomy and purchasing power than ever before. I think there are a couple of reasons why this is the case.

When a survey of approx. 1000 consumers aged 22-37 was conducted, they found that over 62% make their purchases online. The survey also found a massive growth in mobile shopping where millennials are mainly driven by price sensitivity, convenience, and access. What we've seen with GenZ's is that over 40% purchase over 50% of their apparel and consumer electronics online where 2/3rd purchase items over social media directly.

While millennials grew up around the same time that technology started growing up, Generation Z grew up in a world where technology and social interactions using it are the center of their lives and make up much of the social fabric of the generation. Building a technology-enabled business that can optimize for and speak the language of this generation is the key and this is something that traditional retailers just haven't been able to create the infrastructure to do.

Millennials and GenZ's have grown up differently than any other generation because they had technology and the internet become ubiquitous to how they learn, interact with others and make decisions. World views started expanding and opinions started being formed and agency grew in decision making at a much younger age than ever before.

Millennials and GenZ's like myself have grown up with having the entire world at our fingertips leading to massive influencing ability and purchasing power and as a result, higher expectations of their purchasing experience. The problem here is that traditional retail isn't built to cater to the changing social, economic and technological habits of these younger generations, thereby, falling short of their expectations, and ultimately losing the sale.

Increasing churn and wavering brand loyalty

Inspiring brand loyalty should be top of mind for any consumer brand regardless of its distribution channel because lowering churn by 5% can increase profitability by 25 to 125%. We all know churn is important but the reason why is proven by a survey which showed that 73% of customers are willing to consider shopping and buying products from new brands. My theory is that this is driven by two main factors: low switching costs and lack of favorable shopping experiences.

Switching costs are the costs that the end consumer incurs because of their decision to switch products, brands or suppliers. When I think of traditional retailers and e-commerce leaders having low switching costs, the central place theory comes closest to explaining why that is the case. First, let's take a look at what the central place theory actually is:

Introduced by German philosopher Walter Christaller, the Central Place Theory says that settlements and market towns (called central places because they are, as you may have guessed, centrally located) are there to provide goods and services for the surrounding market areas. Because the theory assumes that central places are distributed over a uniform plane of constant population density and purchasing power (read: the areas where they are located have the same amount of people living per sq.mile/sq.km and enjoy the same amount of disposable income), we can conclude that consumers act rationally by going to the nearest location to minimize costs.

When customers are motivated primarily by cost and convenience, they will go shop at whatever retailer gives them that. Lower order places (which are most department stores and retailers) of economic activity tend to cluster together to take advantage of high foot traffic and serve customers who are closest to the "central place".

This is why you see multiple gas stations near traffic lights and other areas where there's a lot of activity and multiple department stores and retailers clustered together in malls. When retailers and brands don't give customers anything else to be excited about (which we will talk about in a second), retailers and brands become disposable in the customer's eye and they will go to whatever retailer is closest to them and is cheapest.

This is why I argue that traditional retailers have low switching costs: it costs the customers literally nothing to walk 100 feet to the next retailer to check out the same products for a potentially cheaper price especially when all retailers are concentrated in the same area.

The other piece that's been driving the high churn and low brand loyalty is a lack of favorable shopping experiences. As I mentioned before, the problem is that millennials & GenZ's purchasing decisions are significantly driven by whether their values align with who they are purchasing from.

With this shift, having an authentic hyperpersonal brand becomes will ensure whether your company lives (by getting users who love your brand unequivocally) or dies (by not having enough people who live, love and breathe your brand). But, when we have low switching costs due to excess supply to a cost and convenience conscious consumer, they're looking for a brand that resonates with them and their value systems enough in a deeply personal way to pull them in for a purchase.

An interesting data point that is top of mind when I think about this is that emotionally connected customers bring in 4x as much life-time value to a brand than those who only shop based on cost and convenience constraints. What we're seeing is that this is a huge market need that existing retailers and e-commerce players are currently not filling that D2C brands can optimize for.

The price vs quality tradeoff

A common tradeoff we're used to making as consumers is that of quality vs. price. High prices are driven by the number of intermediaries (manufacturers, distributors, wholesalers, retailers) in the supply chain, marketing spends and the brand tax in traditional retail. The number of intermediaries in the supply chain also eats away at margins average net profit margins for general department stores average around 3.2% according to Fortune magazine.

When it comes to competing against e-commerce, D2C brands have significant margin expansion as compared to traditional players. Balderton Capital, a prominent venture firm headquartered in London, estimates that D2C brands enjoy 2x higher gross margins and 4x higher contribution margins than e-commerce counterparts.

What this shows is that by vertically integrating and removing intermediaries in the supply chain, brands can pass these savings onto consumers and enjoy significantly higher margins. The savings that are being passed to the end-user by avoiding these crazy markups would, in theory, also offset the premium you would normally pay for a "luxury brand".

Hopefully, this makes the case for why the future of retail is D2C brands. By focusing on hyper-personal, hyper-experiential commerce - D2C brands can completely optimize their product, pricing, brand, and supply chain for the consumers of tomorrow.

Stay tuned for Part 2: Secret Sauce and Crystal Balls: Lessons learnt from studying today's most successful D2C Brands and their future

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