Proof and Profitability
Balancing profitability and growth as a consumer brand during COVID-19
There has probably never been a more confusing time to be the CEO of an emerging CPG brand. A worldwide pandemic has confined consumers to their homes, 30 million Americans have filed unemployment claims, GDP declined 5% in Q1 with inevitably more severe declines to come in Q2; and yet for most, sales are…up. Nearly every CEO I’ve spoken to since mid-March has confirmed the same trends: declining ad costs, increasing conversion rates and overall greater consumer willingness to spend on wellness products. The optimism is cautious though; they are mindful that a recession could be different (and worse) than a lockdown and many will need to fundraise at some point during that time. This is where the investment community has added to the chaos by saying we now care more about profitability than growth.
To be fair, the investors’ “shift to profitability” did not begin with the virus. There was a feeling in the industry that perhaps began with WeWork’s public struggles last summer and gained steam as Casper filed their S-1 and showed that profitability did not just sort itself out with enough scale. Even before lockdowns relating to COVID-19 swept the country we had news of Outdoor Voices having raised $97 million to date despite only $40 million in annual sales, and then of Brandless shutting down after raising $158 million in equity capital. The investor community was inevitably going to correct for this, pandemic or not, in how they choose which companies to back. What changed is how quickly and dramatically that correction has happened in the face of such an uncertain economic outlook.
Let’s start with why this is confusing: for most brands with under $10 million in sales you can be growing responsibly without being net profitable. The scale just isn’t there yet, which means you can be doing all the right things and still need to raise equity capital in the next 12 months. You have likely heard from investors that they “don’t want growth at all costs” and that “profitability matters more than growth in this environment”, but you would likely struggle to attract venture financing at the end of 2020 if your sales were up 25% and you broke even. Investors might not be saying it explicitly but they still very much care about growth.
So what do you do in that position? What’s the right balance to strike between cash investment in growth and cash preservation to ensure the next fundraise goes smoothly? To answer that, let’s unpack why startup CPG brands spend on growth into four key buckets.
1. Attractive return on investment
The most obvious and quantifiable reason to spend on growth is if it’s profitable to do so — no new insight there. What makes this tricky is that many CPG brands are not profitable on first order; their average order value and margins aren’t high enough, meaning they rely on repeat purchase to achieve their target lifetime value (LTV). Usually that isn’t much of a problem, as the chart below of a hypothetical brand’s unit economics shows.
This brand spends $35 to acquire the average customer, is paid back by month 5 and has achieved a 1.4x LTV/CAC by month 12. Not bad in normal times, but during COVID-19 the numbers might look a little bit different. CAC for the majority of CPG brands has been down since mid-March as ads are cheap and conversion is high, but we don’t yet know whether those customers will come back the way they have historically. The chart below shows the same brand, post-COVID-19, with CAC down from $35 to $30 and three different scenarios for LTV based on changing retention.
If a recession is deep in the second half of the year brands may see retention fall dramatically, which could mean not breaking even on ad spend after 12 months (LTV3). Nobody has a crystal ball and that may feel unlikely, but even in a best case scenario where retention stays flat (LTV1) a CEO may decide they don’t want their scarce and valuable cash wrapped up in a 3–4 month conversion cycle to payback. As we learned in March, it’s good to have cash on hand.
2. Build and exploit first mover advantage
Brands in 2020 rarely have defensible IP. Their competitive moat can take many forms: distribution, brand recognition, audience, talent, partnerships, among others — all some form of first mover advantage. Don’t be fooled into thinking that makes for a weak moat; if exploited properly a brand can take a lead of only months and make themselves synonymous with their solution to a consumer problem. So should brands be trying to build that lead during the pandemic? It could be tempting to play offense while your competitors are all on their heels, but I would argue that preserving cash while others do the same means you won’t lose ground. Right now you’re at lower risk of being caught by someone behind you or of a lead in front of you growing too wide. If you plan to spend for this reason you must have high conviction it will work.
3. Proof of product market fit
Investors at the Series A stage and later are looking for “proof” before they invest: proof that it’s working, proof that it could be big, proof that their thesis is en route to becoming a reality. Until recently, growth was the most effective form of proof; after all, what could be more convincing than rapid adoption of your product? Casper, Outdoor Voices and Brandless gave investors a new insight: if profitability is not in your DNA early it may never be, and no amount of scale can fix that.
Now to the average emerging CPG brand those three case studies have limited relevance. Raising over a hundred million dollars is very rare in CPG, and when it happens the brand has no choice but to grow fast enough to justify the valuation. What is relevant, however, is how those three companies have changed what investors view as proof. No longer as impressed by sales driven by paid social, investors want to see a brand build organic awareness through an audience, community and word of mouth. They don’t want ad spend to fund sales, they want it to fund a flywheel of virality. The best way to prove that is to show early signs of organic growth, so if you’re spending on paid growth to prove yourself to investors you won’t achieve your goal.
4. Forward momentum
Slowing down, if that’s the takeaway, does not come without a cost. Doing so could affect your team’s culture and morale in a way that can’t be ignored; after all, young, talented and motivated people likely joined you to move fast and build something big. There is a line that always stuck with me from one of my favorite TV characters, Taylor Mason in Billions: “I need forward momentum above all things, even money”.
Cash preservation makes providing that forward momentum to your team more challenging but no less important. It’s times like these that uniting around a short or long term initiative can be very effective to driving that positive engagement. In the current crisis Liquid I.V. has made a massive push to donate product to healthcare workers, while Haus’ Restaurant Project is helping restaurants create co-branded products to provide much needed cash flow. If effective, these types of initiatives are engaging not only to your team but to your consumers.
The Takeaway
Now is the time to move beyond what worked last year. Coming off a decade of lowering barriers to entry and growing interest in wellness we have witnessed a rising tide for emerging consumer brands, but high tide doesn’t last forever. I predict that when we look back on this time, we will see that those who won approached this as more marathon than sprint and used creative methods to connect organically with consumers.
Lean on your team for ideas on that approach — empowering them to innovate on your marketing strategy can provide the forward momentum they crave. Test aggressively before spending heavily, so you’re not surprised by recessionary retention trends that don’t resemble the past. Pull any lever you can to come closer to first-order profitability. Don’t worry about the competition right now, only worry about doing more with less and giving yourself as much time as possible to show proof.
When it’s time to fundraise next, and your proof is up for evaluation, nobody will expect you to be cash flow positive. They will expect sound unit economics and a road map for how a little bit of their cash will go a long way. They will be impressed if you control your own destiny and won’t need to show proof to the next investor for at least another 18 months. After all, the best proof you can give to investors is proof that you don’t need them.
