4 ways VCs need to change their approach to consumer companies

I have invested in over a dozen consumer businesses either directly, through SPVs, or through funds I’ve invested in. Some you may have heard of; most you wouldn’t have. I’ve also sat on the other side of the table and built one of my own startups from a kernel of an idea to over eight figures of revenue. Having raised money from others and invested some of my own, I’ve walked away feeling there is something broken about how many venture investors approach consumer companies.

The traditional venture model has always been to invest in technology businesses that are going to absorb significant losses while they focus on product R&D, all with the hope that once the product is built they will reap significant profits as revenues start to catch up to fixed costs and, over time, far surpass them, creating a very high margin business. This works when the unit economics mean those sorts of economies of scale exist, and so, rightly, the investors push entrepreneurs towards scale at all costs.

However, the unit economics in consumer businesses don’t scale in the same way as in traditional tech, so that “grow at all costs” ideology is considerably less well suited for consumer-focused companies.

According to Pitchbook, over 85% of deals in the consumer space take place below a $200 million exit. For almost any layperson, and I’d wager most entrepreneurs, that would be considered an enormous success. But run that figure past many venture investors and they’d view it as a middling, if not disappointing, outcome. Part of that is by necessity. If they have so many zeros in their portfolio, they need investments capable of returning the whole fund or close to it in order to make their return. A 20% stake in a $200 million exit is $40 million. For any fund of size, that’s not a big number.

However, many consumer businesses are simply not meant to be billion-dollar businesses. They may make for profitable, valuable enterprises with exit opportunities to strategic acquirers and private equity players at numbers far smaller. And by trying to scale for the big exit, they severely limit their potential buyer universe. If they are not profitable, they also jeopardize the entire business and can be forced into the sort of financing situation that Casper found itself in, with no willing buyers and neither the private nor public markets valuing them anywhere near what their preceding two rounds of valuation had suggested.

A new kind of consumer investor is needed. One who believes that while consumer has a lower likelihood of the once-in-a-lifetime outcome it also comes with a higher chance of success and the ability to hit profitability at far lower revenue figures than traditional tech, opening up plentiful alternative financing and exit opportunities.

Here are a few of the things that the next generation of consumer investors must embrace:

1. Don’t shame entrepreneurs who hit doubles and triples

Investors often distribute their risk across a large portfolio. They are incentivized to have people go for a grand slam even if that means a lot of strike outs. But given the sobering choice of a $50 million exit or a 10% chance at $1 billion, many entrepreneurs would choose the former. That is not a bad thing. The more businesses that succeed, the less instability in the market. Entrepreneurs that win once will often be eager to get back in the game, now knowing what success looks like. For an investor, a portfolio built of businesses that deliver a 3x or 4x return can still be very productive.

Many good ideas and businesses don’t get the attention they deserve simply because the overall market opportunity isn’t exciting enough. They go underfunded since they remain under the radar for many venture firms.

2. Encourage a path to profitability sooner

It makes sense that a SaaS business takes a while to build it’s software and hit profitability. It makes sense that a marketplace business might take some time to achieve market density and hit profitability. But a luggage company shouldn’t need that long lead to profitability. Nor should a mattress company. These are businesses where the unit economics do not dramatically change when you are a $5, $50, or $100 million business. Not having a plan to achieve profitability simply means you are using capital to fund inefficient growth. It does not a good business make – and clearly the public markets have shown how they feel about that with the Casper IPO.

3. Teach your portfolio companies about other sources of financing

By pushing out profitability for so long, many companies are forced to take round after round of additional equity funding and incremental dilution. That results in severe compression in multiples on invested capital returned. However, if a business hits profitability, it can tap into the debt markets far sooner and scale the business with far cheaper capital sources. This requires fiscal discipline, yes, but it also means all that painful dilution that compresses returns never happens. There are tons of alternative financing sources, including American Express’ Working Capital, Assembled Brands, Dwight Funding, Clearbanc, and Lighter Capital. More are springing up every day.

Investors in consumer companies should be educating them about these options to minimize both dilution of their investment and dilution of the entrepreneur’s power to execute on their vision.

4. Rein in valuation expectations

When consumer businesses that are tech-enabled but not tech-centric start raising mid to late stage rounds at four or five times revenue, something is amiss. It is the investment community’s responsibility to keep entrepreneurs sober about what the right sort of valuations are for their business. This might mean some lost deals, but ultimately it will position these founders for far greater ongoing success.

What now?

Investors in consumer-focused companies need to take the lead in changing the conversation, because they are the ones who have seen the problems arise time and again. Entrepreneurs often place almost undue weight in what their investors tell them to do. If they are told to pursue growth at all costs, many founders who are doing it for their first (and only) time will heed such advice. If they are told equity financing is the only good source of capital, they may never explore alternative financing sources. If they believe profitability doesn’t matter to their investors, it certainly will not matter to them. All of these things result in bad business decisions and more failures than would otherwise occur. The reckoning that has happened in the consumer landscape should serve as a wake-up call. It is well past time to try something different.

Colin Darretta is a two-time entrepreneur and an angel investor. He is founder of WellPath and a co-founder of DojoMojo and has invested in brands like Daily Harvest, Classpass, Ten Thousand, Seed, Lyft and over a half dozen others – almost all in the consumer space.