Digitally native brands (DNBs) are attracting significant investor attention these days—and for good reason. DNBs make up an increasing share of disruptive players in the market, comprising 15 percent of the new unicorns funded in 2020, up from 10 percent in 2019 and 5 percent in 2018.¹

They are growing, on average, at triple the rate of overall e-commerce,² while the fastest-growing among them have scaled from $50 million in revenues to $1 billion in four to eight years.³ The most successful consumer-facing brands, including food-delivery apps, tech-enabled exercise equipment, and hair-coloring systems, are innovative category disruptors that enjoy intense customer loyalty.

DNBs’ online origins give them two important competitive advantages: deep knowledge of their customer base and extensive control over the customer file. Whether a DNB is a product, service, or a product-service combination, what sets them apart is the fact that brand owners know exactly who their customers are, what online behavior led them to their initial contact with the brand, and what they’re likely to buy next. This insight creates opportunities to build deep and lasting relationships with customers. It’s an advantage that can carry over even if, later in their life cycle, DNBs branch into brick-and-mortar.

Today, low barriers to entry have encouraged an explosion of DNBs, flooding the market with the fruits of creative entrepreneurship. However, DNBs that break through with outsize investor returns are rare. Over the past two decades, fewer than 0.5 percent of DNBs have reached $100 million in revenues. In fact, more than 90 percent of businesses that originated through e-commerce earn less than $1 million in annual revenues (Exhibit 1).⁴ Investors face the challenge of sifting through concepts to determine which are worthy of the capital required to scale a business or buy into an existing company at high multiples.

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There are ways for investors to gauge whether DNBs are equipped for growth and future profitability, which are primarily grounded in understanding how attractive their customer file is and how much it will cost to acquire new customers. There are four critical factors to consider when assessing whether a DNB has the potential for outsize performance:

1. six key metrics
2. categories with the most potential
3. essential capabilities
4. pitfalls that can derail success

By applying the criteria outlined in each of these sections to the research and diligence underlying a potential deal, investors have the best shot at the golden ring of DNB investing: identifying a brand that was born digital but ultimately lives in the imagination of the world’s consumers.

Four critical factors to consider when assessing a DNB investment

Step one in finding a DNB with “superstar” potential requires developing a baseline understanding of the core health of the customer file: how well a business retains and drives spend in its customer cohorts, how much it costs to acquire new cohorts, and how much potential there is to improve in both areas. These bedrock principles of DNB investing are relatively straightforward. Then comes the hard part: assessing how well these pieces fit together and, crucially, how well they underpin a brand with a genuine raison d’être in the DNB landscape.

Six key metrics

Ultimately, there are a few ratios investors can look at based on these metrics that have strong predictive value for future success. One of the most common is the LTV:CAC ratio. This measure is essentially the marginal return on investment for acquiring every new customer. Cross-industry averages dictate a 3:1 LTV:CAC ratio as satisfactory⁵ ; however, the optimal ratio depends on the category dynamics and business model, with early-stage players focused on customer recruitment tolerating levels as low as 1:1.⁶

Another important metric to understand is the overall size of the TAM to the size of the current business. This figure indicates how much runway the business has with its existing offering within the target customer base. Before expanding the TAM into new categories, geographies, and customer groups, a good ratio that indicates further runway is below 5 to 10 percent, though the degree of competition and the size of the market can make the ideal ratio lower.

In addition, for any business that is still unprofitable, tracking how losses change with revenue scaling can indicate whether it is gaining any operating leverage over time, in particular ensuring that the loss ratio is gradually shrinking.

Categories with the most potential

The original generation of DNBs, which began emerging in the 2000s and early 2010s with brands such as Warby Parker and Everlane, often focused on cutting out the middleman to proffer goods at reduced prices or on selling a unique product, or both.

Today, to stand out in the marketplace, DNBs must offer even more compelling propositions to differentiate themselves from traditional brick-and-mortar players or e-commerce offerings. The most successful brands typically play in categories with distinct dynamics, such as predictable and routine consumption patterns, personal and gift-buying tendencies, strong gross margin profiles, favorable size/weight ratio for shipping, and low likelihood of returns (Exhibit 2).

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Some of the magic of DNBs is their ability to quickly shift direction and fine-tune assortment, product variety, pricing, shipping, deals, product combinations, and marketing messages to retain and grow their customer base. Successful DNBs monitor tiny shifts in consumer browsing and purchasing behaviors (for example, trial and switch propensity, length of the purchase cycle, responsiveness to new offers) to be able to constantly refine their value proposition to optimize demand and minimize churn.

Over time, it is essential to move from start-up to grown-up and find sufficient scale to leverage core infrastructure and build on an active customer base. The path we typically see begins with expanding beyond the current assortment (for example, add-on items, adjacent categories, or products geared to new customer segments), which expands customers’ share of wallet while also attracting potential new consumers. The next step is making a move to new geographies (often guided by early signs of cross-border purchasing), and ultimately entering brick-and-mortar to gain greater access to cheaper traffic (Exhibit 3).

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A good example of a DNB following this playbook is Peloton, which has pulled nearly all the aforementioned growth levers on its path to $4 billion in revenues in the 2021 fiscal year.⁷ It began by growing across different distribution channels (for example, brick-and-mortar shops) and categories (such as treadmills and accessories), and then pursued new customer segments (for example, app-only customers) and new geographies (such as Canada and the United Kingdom).⁸

These actions can expand the TAM for a given brand, allowing them to tap into new pools of customers, spending, or both. Successful brands approach expansion strategically, using a test-and-learn approach to experiment with opportunities (such as digital pop-up stores or new products offered on a limited basis) before committing to full-scale implementation.

Essential capabilities

Successful DNB teams rely on four key capabilities: they build great relationships with customers; they offer these customers compelling reasons to shop with them; they pursue avenues to reduce customer acquisition costs and, ultimately, the payback period; and they use the best and latest technology to drive loyalty. DNBs are often better positioned than traditional brands to do this because of their origins and infrastructure; those that embrace more of these best practices will have the best chance of outperformance.

• Community engagement: The most successful players aim for a relationship with consumers that goes well beyond traditional brand loyalty. Instead, they cultivate satisfied customers as influencers who foster brand trust and community participation, driving engagement online through both company-driven and user-generated content.

  Brands pursuing a high level of engagement must provide excellent customer service, including rapid resolution of issues (both directly reported and encountered through “social-media listening”), loyalty programs, and bonus content. For example, Gymshark built a large, engaged, self-reinforcing community online and offline through grassroots marketing and experimen­tation across new channels, from Spotify to Instagram, and adapted its approach with the rise of newer platforms, such as TikTok.⁹

• Performance marketing: To manage CAC and LTV effectively, high-aspiration DNBs test and learn to determine optimal channels for acquiring customers. They develop analytics that enable them to predict and prevent churn (for example, flagging and reengaging dormant customers). They use targeted and personalized ads, promotions, and referrals to increase awareness, traffic, and conversion. Strong conversion-rate-optimization capability is another hallmark of a thriving DNB. Successful performance marketers take a surgical approach to optimizing click-through rate, cost per acquisition, paid media (for example, paid search, paid social media, display advertising, and video advertising), and earned media (such as organic search results).

• Predictive analytics: Winning DNBs capitalize on opportunities to grow their current customer base by leveraging the deeper data that they can collect relative to their brick-and-mortar peers. Using this data, DNBs can personalize recommendations and offer bundled products and services that delight their customers. Based on extensive testing, DNBs can provide incentives (such as free samples, shipping, and returns) that increase spending.

  DNBs often begin their operations in a lean, “scrappy” manner, employing low-cost marketing technology stacks that can easily be modified to promote experimentation and adapted to changing customer or business needs. To do so, DNBs often rely on open-source technology solutions for managing site content. Content-management systems and flexible cross-channel campaign-management platforms automate and personalize customer communication as well as content and product offers across the customer journey.

  More sophisticated brands may leverage predictive analytics to learn how customers use their websites. This insight helps DNBs identify the most promising “next-best product” or “next-best offer” to offer a specific customer, either to recommend products for their next purchase or replacements if they are not able to buy the exact item for which they were originally searching. This level of customization requires DNBs to create a unified view of each customer, often using a customer data platform or similar technology solution.

Pitfalls that can derail success

Investors should be mindful of both conceptual and operational risks that can limit growth and profitability.

• Constrained total addressable market: DNBs that are positioned in narrow niches may face challenges growing beyond early-stage levels. Investors must look at whether the business segment is large enough or expected to grow rapidly enough to make scaling feasible, or else be willing to bet that the company can expand successfully into new market segments.

• Undifferentiated value proposition and innovation: DNBs that don’t offer customers a compelling reason to take a risk on a novel, online-only product will struggle to gain traction. No matter how well-made the product, if it could just as easily be sold at the corner store, it is unlikely to become a game-changing DNB.

  Brands stand out from the pack by delivering products and personality that turn customers into staunch and vocal loyalists.¹⁰ This requires a fresh point of view that customers don’t see in staid brands. For example, Madison Reed turned hair-color buying on its head, so to speak, by offering custom color kits that arrive on a recurring basis; consumers can request free online color consultations designed to imitate sitting in a salon chair. Brands that offer highly novel solutions sometimes need to overinvest in generating an initial trial so that customers get used to the idea.

• Poor unit economics: Few DNBs turn a profit for their first three to five years, and many fail to turn a profit even after a decade of growth. Over the past 20 years, fewer than 0.5 percent of DNBs have reached the $100 million revenue level. Even some large, publicly traded DNBs reinvest all earnings into additional marketing and capacity expansion and fail to turn a profit. While DNBs don’t need to be profitable to be an attractive investment, investors must be wary of DNBs that don’t provide evidence of a path to profitability and the potential to improve margins as they scale. To this end, strong DNBs work to optimize the value chain by increasing their buying power, economies of scale, and operational efficiencies.
• Lack of focus: If DNBs expand their services or products to capture a wide customer base before first understanding how to win the core, they risk building an unsustainable customer model with trial but low loyalty.

To be sure, investors must beware the “halo effect,” whereby a prospect appears golden because it checks off a series of boxes. While the factors outlined in this article are indeed associated with successful DNB performers, finding a winner is more complex than simply verifying that these steps are followed. The most compelling DNBs started online not because of an advantageous customer file or a wide customer base but because the product or service itself genuinely belonged there and, by existing online, solved problems for customers. Investors should remember that this core authenticity must be in place for the specific approaches outlined in this article to contribute to success.

DNBs represent some of the most intriguing consumer concepts on the market and provide ample opportunity for investors that succeed in identifying winners. There is significant risk, however, of getting stuck funding companies that can’t overcome obstacles to growth. Investors can approach DNBs wisely, however, by using the ideas presented in this article to help identify high-potential concepts. The reward: participating in a brand born of the virtual world that grows up to make a mark on the real world.