Table of Contents
For the better part of the last three decades, venture capital (VC) has underwritten many of the most significant innovations in our industry. Business disruptors such as Amazon and Instacart, and technology juggernauts like Google and Stripe all benefitted from substantial VC support during their formative years. This risk capital has enabled thousands of entrepreneurs to build and refine industry innovations without near-term pressure of turning a profit, in return for long-term value creation.
The VC funding model
is evolving
Tom Furphy
Over the past one to two years, we’re witnessing a trend that is potentially concerning for retailers. There has been a distinct shift in venture capitalists’ (VCs’) criteria for early-stage investment.
Historically, VCs are willing to lean in with relatively patient investment once a company has demonstrated functional technology and shown early indications of product-market fit. Then, as long as the company continues to prove the efficacy of the technology or model and shows good unit economics and strong customer adoption, more VC will flow to help the company scale and reach profitability.
Over time, the industry has benefitted dearly from the VC model. It has allowed retailers to focus on their core business of being retailers, while off-loading the risk and cost of developing speculative capabilities to entrepreneurs and VCs.
Now we are broadly seeing VCs raising the bar on required market proof and often looking for profitability before making second and third investment rounds into companies. They are looking for completed pilots, with supporting ROI and performance data, and expecting to see the technologies rolling out broadly. They are looking for companies to be profitable so the funding can be used to support scaling versus subsidizing development-phase losses. We saw the beginnings of this in 2022, and it was exacerbated with the run on Silicon Valley Bank in 2023.
A challenge is created for entrepreneurs and retailers
While companies absolutely should be built to be enduring, profitable enterprises, this puts early pressure on entrepreneurs to prioritize the company’s path to profit over innovation. In my investing and company-building experience, I’ve found that striking a balance between innovation, expanding the product road map, proving the model and reaching profitability is the best formula for success. Magic is found when you’ve shown the model can be massively profitable and you have patient capital to allow you to innovate and lean in on behalf of your customers. In many cases with nascent retail tech, this involves time spent working with retailers to change go-to-market and/or operating procedures to leverage the new capability. Pushing the timing to reach profitability can lead start-ups to optimize for economics at the cost of stunting innovation.
At the same time, we see VC firms pulling back on retail and consumer investments. When discussing a promising company of ours, which was already serving thousands of customers nationwide in the U.S., I once heard a prominent venture capitalist say, “I love your technology, have confidence in the team and am impressed with the value proposition. But I don’t trust your customers.” Other VCs have cited similar concerns among a variety of reasons to pull back from retail and consumer investments, also mentioning fickle consumers, too-long sales cycles, jammed retailer product road maps, unending pilots and an inconsistent rollout track record. As a result, we’ve seen several power VCs, led most recently by Andreessen Horowitz, pulling back or closing its consumer/retail arms altogether.
Does this pose an
existential threat?
With the formula changing for venture investment and many firms turning away from the space, should we be concerned that these developments could scare away entrepreneurs and stifle innovation for the sector? What will happen if the steady flow of new technologies dries up?
First, it will allow the large, well-capitalized, alternative disruptors and technology providers — such as Amazon, Microsoft, Door Dash, Uber and Instacart — to dominate the delivery of innovation to the industry. This would put even more power in their hands and have implications for retailers of all sizes.
Second, in this future state, the very biggest retailers that have scale, reasonable cost of capital and capacity to innovate will be able to build new capabilities themselves and will have substantial bargaining power with tech providers. They certainly could persevere, but might have a narrower range of innovations to consider without the external flow of new tech ideas coming their way. And they will have to become extremely adept at doing this while also running their core business.
Some retailers could seek innovation via acquisition of budding companies. However, for the best technologies they would have to compete with the purchasing power of the larger tech companies. Retailer acquisition caps the return to founders and investors, as retailer multiples are typically lower than those of strategic technology acquirers. Retailers purchase companies to be captive to the acquiring retailer. Tech companies do so to merge into their high-multiple business that serves multiple customers. If this becomes commonplace, it could become less interesting for entrepreneurs and investors to take risks, given the lower upside.
This all potentially amounts to an existential threat that could lead to a gradual slowing of start-up innovation and increasing costs of innovation to retailers. This won’t happen suddenly. But it could gradually stifle the pace of innovation across the industry.
Might this prompt a new
innovation model?
Management teams and boards across the industry are having conversations about a potential new innovation model. One that can maintain competitive boundaries and can be tapped by retailers of all sizes. A model that encourages entrepreneurial risk and is supported by adequate funding, while igniting industry innovation and giving retailers a seat at the table. And, most importantly, it is an innovation framework that can delight our customers with new breakthroughs and help them solve problems.
If this model can become reality, maybe this existential threat could prompt the industry to do things better. Perhaps necessity can be the mother of the industry’s (re)invention. Is your company thinking about this? Are you considering new innovation models? If not, should you be?
Tom Furphy is chief executive officer and managing director of Consumer Equity Partners.
