(Lack of) Capital Efficiency in Brick and Mortar

23 May

Life is a game of tradeoffs. You want to get shredded? Hit the gym like a fiend and don’t ingest candy again. Be a great guitarist? Rock the strings for hours a day, even when your scabs rip off. Die rich? Win the lottery. Or work hard. Something like that.

Investors must also dive into mental calculus when deploying their limited funds. It’s not unlike the rigors we plebeians face when choosing what to order off the dollar menu: which of these items is going to give me the greatest satisfaction for the least amount of coin? Obviously our choices are harder, but the concept is the same.

Achieving rapid growth in brick and mortar is a very tricky proposition. In fact, as you muse your way through this drivel, you’ll see how it might be one of the least capital efficient investments you can make. That’s not to say there can’t be relative breakouts. But there are so few, I wonder why investors put money into the space at all. Why blow a crisp, $1 bill on a single french fry when you might get a whole burger down the street?

First things first: brick and mortar requires real work. There is no “build it and they will come” phenomenon like there is in social media (at least the right product hasn’t shown it yet). Mark Zuckerberg would have crapped the bed if he had to leave his dorm room and talk with prospective customers.

Brick and mortar requires sales. Sales to people whose email you can’t just find online. Sales to businesses who use so many different systems there’s nothing close to 80/20. Literally millions of sales to proprietors who do not care to understand your product but are worried about making next week’s payroll. Your product might solve the payroll problem, but it’s hard to get their attention.

Distribution in brick and mortar is 80% of the cost structure. At least. Building software is easy. That’s why you can routinely find thousands of merchants using products that look like a kindergartener high on rubber cement fumes patched it together between a macaroni necklace tutorial and finger painting. There are way better products out there but without someone picking up the phone the merchant will never know about them. As cloud POS app stores have unequivocally shown: merchants do NOT do any self-discovery. Yet.

Because it’s so hard, investor dollars have an easier time finding a return elsewhere. For instance, ecommerce and B2C companies can produce greater returns in far shorter times because there’s no sales cycle; virality in non brick and mortar companies is exponentially more common. Looking at Fortune’s list of Unicorns, there are questionably 6 out of 174 entrants that serve SMB brick and mortar: Zenefits (which is imploding), Delivery Hero (which has raised $1.39B at a market cap of ~$3B), Powa (just declared bankruptcy), Zocdoc (sells to well-educated doctors), Gusto (no idea if market cap is justified), and Zomato (uses third world labor in India to scale).

If we go about it the other way, we can see that none of the most valuable technology companies in the last two decades got there by serving brick and mortar. What are the “wins” in brick in mortar, then?

Intuit is the most successful SMB (small/medium business) product that I can think of. They’re in over 5M merchants across the globe with a market cap of $25B. They were started in 1983, which means they accomplished this over a 33 year history. Their success starts before the internet, and this may have been a crucial ingredient: small businesses had to go to the bank a lot more frequently than today. Intuit partnered with banks to help sell their software to SMBs. With some initial successes, Intuit started partnering with accountants to further move the needle. Intuit is a real outlier in this regard.

Constant Contact is another win, though remarkably smaller. They took early venture money and struggled to find a scalable distribution model for years. Gail Goodman, their CEO and founder, shares a wonderful talk about how they crossed that chasm. Because Constant Contact contact took so long (10 years) to reach 9 figure annual revenues, they went through a demoralizing down round. Beware VC money!

ZipRecruiter is a new entrant that has ballooned to $50M in annual revenue in under 4 years with zero external financing. My understanding is that ZipRecruiter primarily sells their job posting/management platform to SMBs. I’m not as educated on this company, but it seems they scraped data across job posting platforms. They then took a hack from Airbnb and posted their own services on places like Craigslist, getting SMBs to sign up. After initial bills are paid, hit the marketing budget for rinse and repeat.

Two other wins are Opentable and Groupon. OpenTable effectively held restaurants captive: they raised a lot of money (because it was the 90′s) and built a marketplace. Restaurants, convinced OpenTable drives most of their traffic, fork over > $600/mo for the product – an amount unheard of by brick and mortar standards. Groupon capitalized on merchants’ desires for “butts in seats” at any cost. After 5 years the merchants that were still alive realized Groupon’s model was a sham and Groupon has had to make several pivots since.

There are a bevy of other brick and mortar service/product companies that are awesome in their own right, but not quite the $B company: Belly, LevelUp, FiveStars, Womply, Swipely etc. Of course, don’t forget the cloud POS companies making a run: ShopKeep, Revel, Toast and Lightspeed. Again, the sales cycles and contract value for a brick and mortar merchant is so low that it’s ridiculously hard to become a $B company on true financials.

Brick and mortar takes work. Work takes time. Time kills ROI. Some investors will still put money into brick and mortar for either lack of market understanding, or financial engineering at the expense of the founders. Many, however, rightly avoid the space altogether. If commerce continues its shift from offline to online, that may be a prescient move.