From Content to Commerce: VCs flocked to e-commerce as entrepreneurs found the key to –

Kevin Appelbaum came to a realization in mid-1997: he was purchasing all of his airline tickets online and found himself reading more books because of Amazon.com.

“If I could avoid going to the store by going online and finding what I needed, I was doing it,” says the entrepreneur, who at the time worked with a number of seed- and early-stage venture-backed companies at Critical Mass Consulting, a marketing and management advisory firm.

Mr. Appelbaum, who created Critical Mass in 1995 partly to help him scout entrepreneurial management opportunities in young companies, found his opening in the form of a flailing client who had planned to build a cooking community Web site solely supported by advertising revenue. He believed that if electronic commerce could work for travel and book retail, why should it not also apply to gourmet food and kitchenware?

Mr. Appelbaum soon folded the company, took six employees, moved his operations to California’s Napa Valley and in October 1997 founded Digital Chef Inc., a comprehensive online source of gourmet foods, wines and cooking accessories. Just one year later the company received more than $10 million in a first round of venture capital financing from well-known firms such as the Sprout Group and Marquette Ventures.

Digital Chef’s short history is a prime example of a key Internet trend: a shift from business models based on content to those based on commerce. Venture capitalists are definitely on board, increasingly sinking their dollars into young companies like Mr. Appelbaum’s, which cleverly blend content, “enthusiast” community features and commerce in a way that is all but impossible in the traditional brick and mortar retail world. But doing so can be an expensive proposition – building a consumer-driven business from scratch requires millions of dollars in marketing and promotional expenses, initially resulting in operating losses that outweigh company revenues. Yet judging from the amount of venture-backed companies aimed at improving different facets of electronic retail, such as credit card security and transaction processing, e-commerce has emerged as one of Internet investors’ top areas of focus in 1998.

A New Trend Emerges

Several years ago, most people thought the future of the Internet was in content-oriented Web businesses. Subscription and advertising sales, the reliable bread-winners for traditional publishing models, were expected to produce big revenues for their e-business

brethren.

However, says Ken Cassar, an analyst at Internet researcher Jupiter Communications Inc.’s Digital Commerce Strategies group, consumers became more reluctant to pay subscription fees for Web content because the Internet offered so much free information. Additionally, sales of Internet banner advertising have lagged behind the experts’

projections.

VCs have witnessed the same phenomenon. “Over the last two years, there has been a migration [of e-businesses] to more of an e-commerce focus,” says Dan Nova, a general partner of Highland Capital Partners, a Boston-based venture firm focusing on early-stage health care and information technology companies.

Mr. Nova attributes this transition to several factors: consumers are more comfortable with the Internet, in large part because of improved credit card security; e-commerce sites are more content-rich, providing customers with a more practical and enjoyable shopping experience; and e-retailers have a new target audience as the percentage of women using the Internet has increased greatly in the past four years.

It is difficult to pinpoint an exact moment at which Internet investors’ interest shifted from content to commerce. One good candidate, however, is Amazon.com Inc.’s May 1997 initial public offering (VCJ, July 1997, page 50).

Amazon Leads the Way

Amazon is to the e-commerce industry what Ford Motor Co. was to automobile manufacturing soon after the turn of the century: The company has set the standard for how electronic commerce is conducted, spawning a wide variety of imitators in a multitude of other retail sectors.

“You don’t know how many people I talk to that say, We want to be the Amazon of … whatever,'” Mr. Cassar notes. “[Amazon’s] success is driving the dreams of many others.”

Neil Weintraut, a founding partner at Internet-focused venture firm 21st Century Partners in San Francisco also notes Amazon’s significance in igniting an industry. “Amazon was the first one that got it,” he says. “It’s not just about doing business digitally, it’s about doing business differently.”

E-commerce evolved in three stages, Mr. Weintraut contends. At its most primitive level, e-commerce sites were little more than “electronic storefronts,” which offered consumers inventory available at and shipped from actual brick-and-mortar stores. (More than 100 such e-booksellers existed at the time Amazon was founded, he adds.) Amazon’s innovation was to tie directly into traditional distribution channels, eliminating overhead costs associated with store real estate, providing greater selection and selling books at a lower cost to the consumer. Finally, Amazon now is in the process of moving to the third stage by removing one more layer from the distribution process and building its own supply chain.

Amazon’s growth has been nothing short of spectacular: The company increased its revenues to more than $357 million in the first nine months of 1998 from $81.7 million at the end of 1997. At press time, its market capitalization was more than $10 billion.

And as Amazon grew, so did e-commerce. According to Jupiter, online sales quadrupled from 1996 to 1997, jumping to slightly more than $3 billion from under $706 million. Continued rapid growth is indicated in Jupiter’s projections for 1998 and beyond, with more than $7 billion in sales anticipated in 1998 (last year’s holiday season was expected to generate a huge boost in online sales) and more than $11 billion in 1999. By 2002, Jupiter projects e-commerce sales to top $41 billion.

This is the type of growth story that attracts venture capital. Amazon’s success certainly helped, as well as the Internet’s continued expansion into the everyday life of a wider population of users. A host of new e-commerce businesses began to emerge, and VCs have been quick to provide financing to these cash-intensive, early-stage companies.

VCs Take Notice

Don Kendall and Eric Budin, co-founders of San Francisco-based online nutritional supplement and wellness store GreenTree Nutrition Inc., were looking for a way to ride the e-commerce wave in 1997 by creating a site that “married content and commerce on the Web.” After the two men evaluated several retail sectors, Mr. Budin’s father, a marathon runner, suggested they look into the nutritional supplement market. Finding a very fragmented industry with a 15% compounded growth rate, in December 1997 they decided to pursue the idea.

The start-up quickly raised $1 million in angel money, which helped the business get up and running, develop a prototype and make a few initial hires. By May, the company had attracted investors for its first round of venture financing, securing more than $2 million from 21st Century Partners and Health Business Partners. In late October 1998 – less than a year after starting the business from scratch – GreenTree closed a second, $11 million round of financing that attracted new investors such as Softbank Technology Ventures, Rho Management and HealthCare Ventures.

“The best VCs find you,” Mr. Kendall, GreenTree’s chief executive, says. The company set out trying to raise between $4 million and $6 million in its second round of financing and ultimately had to turn investors away after nearly doubling that target. “It’s not really the money that’s important,” he says, “But the value [investors] contribute.” For example, HealthCare Ventures brings a wealth of experience in the pharmaceutical market, while GreenTree can leverage its relationships with Softbank and 21st Century for advice in the Internet field.

Similarly, Digital Chef, incorporated with a $1 million angel round in 1997, collected $2.3 million to bridge the gap between its seed-stage and the Web site’s launch, before collecting its first, $10 million round of venture financing in October.

And there are dozens of other e-commerce or related businesses which, in 1998 alone, have attracted venture capital. Mr. Nova estimated that more than 30% of the $250 million Highland Capital Partners IV, the firm’s latest fund, will be dedicated to e-commerce investments. Two of 21st Century Partners’ eight current investments are straight e-commerce plays, a ratio that Mr. Weintraut expects to increase. Peter Mills, a partner at the Internet venture investor CMG@Ventures in Menlo Park, Calif., says that about one-third of the $200 million CMG@Ventures III is focused on electronic retail.

How to Attract Capital

What exactly do VCs look for in these early-stage companies, most of which have very limited operating histories? Apart from cliches such as “experienced management teams” and “leadership in a market niche,” sources offer some interesting insights.

“Commerce on the Internet is profoundly different from commerce in the physical world,” Mr. Weintraut says, explaining that e-commerce allows consumers to customize their shopping experience in a way in which the physical world could never compete – at the same time delivering products cheaper and faster.

Mr. Weintraut’s point is echoed by many of his colleagues. “E-commerce sites have to be content-rich,” Highland’s Mr. Nova notes, explaining that customer service components such as price comparison features and product reviews are important in making e-consumers’ shopping experience a pleasant one. The August 1998 merger between CitySearch Inc., an online provider of comprehensive city and entertainment guides, and Ticketmaster Online illustrates Mr. Nova’s point: CitySearch, a content site, writes about concerts and events; Ticketmaster sells tickets to them. Why not put the two together?

Greater bandwidth capabilities – which will enhance video and 3D offerings by e-retailers – will provide a better shopping experience for consumers and provide new investment opportunities, Mr. Nova adds.

However, not every retail business will be able to make the transition from brick and mortar to e-retail. “Some markets just aren’t big enough,” Mr. Nova explains, declining to name which retail segments he believes will not work well on the Web. Some companies, he adds, target a population segment that is not Internet-savvy or a market segment that is already too crowded.

One area that several sources deemed promising is business-to-business e-commerce plays that consolidate buying opportunities for industries that in the past have had to contend with a myriad of suppliers. In many cases, opportunities in these areas have been resisted by resellers – middlemen that sell products through traditional means such as catalogs – whose hampering effects just now are beginning to be overcome.

New York-based Flatiron Partners, a prominent Internet focused fund founded in 1996 and backed by Softbank and Chase Capital Partners, is conspicuous in its absence from the list of venture investors throwing money at e-commerce companies. The firm has seen a lot of business-to-consumer deals come across the board, but there’s been nothing that’s really “blown us away,” says Jerry Collona, a partner of the firm.

“Retailing seems to be a game of managing razor-thin margins,” he says. “It probably makes us less interested in [the business-to-consumer e-commerce] sector.” However, Mr. Collona adds, the firm does expect to see better deal flow in business-to-business e-commerce.

A variety of other businesses also have capitalized on the increase in e-commerce: software, security and database companies have emerged in an answer to consumers’ demands for better service.

An Expensive Proposition

Despite the ample availability of capital, e-commerce business have by no means had an easy time getting up and running. “When we decided to do this and sat down with some venture capitalists, John Sculley [of Sculley Brothers L.L.C.] asked us, Are you prepared to spend $40 million building a brand?,'” GreenTree’s Mr. Kendall says. “E-commerce is very expensive. You need to go the VC route.”

“Brand building is critical,” Highland’s Mr. Nova adds. “A brand is defensible.”

Amazon, e-commerce’s standard-bearer, certainly has illustrated this point. While the company increased its revenues more than four times in the first nine months of 1998, it also increased its net losses to $78.1 million for the first three quarters of 1998 from $20.2 million at the end of 1997. The company has been widely reported to aspire to expand into many other areas of retail besides books and CDs, which it is already selling. Amazon is aggressively promoting itself to be better positioned for this undertaking.

The announcement earlier this year of the merger between e-commerce compact disc retailers CDnow Inc. and N2K Inc. is another example of the high costs involved with establishing an e-commerce business.

“They’re going to have to try to consolidate capital to keep down losses,” says Jupiter’s Mr. Cassar, explaining that the companies, both of which went public in the last two years, have spent tremendous amounts of capital promoting themselves and may have felt the need to become larger in response to Amazon’s move into CD retail. “Sales and marketing [for e-commerce companies] have been more expensive than anyone expected.”

The Big Fish Take Notice

Yet the hurdles posed by thin margins and large marketing expenses have not seemed to dampen the enthusiasm of e-commerce investors and entrepreneurs. And traditional retailers certainly have taken notice of their online competitors. In October 1998, Wal-Mart Stores Inc. sued Amazon, alleging that a former executive-turned-Amazon-employee had shared Wal-Mart trade secrets with his new employer (VCJ, December 1998, page 5).

Many observers see the lawsuit as a thinly veiled attempt by Wal-Mart – which has its own e-commerce site, Wal-Mart Online – to curtail Amazon’s widely reported aspiration to one day be the “Wal-Mart of the Web.”

“The last companies we’re worried about are the established retailers,” 21st Century’s Mr. Weintraut says. “Amazon is 10 times bigger than Barnes & Noble. Yahoo leads Time-Warner in media.

“A good VC is paranoid about everyone,” he continues, “But we’re more worried about two engineers in a garage in Palo Alto than a multi-billion dollar company.”


1997-98 Venture-Backed E-Commerce IPOs

Market

Offer Capitalization

Name IPO Date Price at offering

Amazon.com 15-May-97 18 429,456,636

CDnow 9-Feb-98 16 248,720,832

Computer Literacy 20-Nov-98 10 106,427,880

Cyberian Outpost 31-Jul-98 18 396,308,394

eBay 23-Sep-98 18 715,303,314

GenesisDirect 7-May-98 15 445,929,900

ONSALE 17-Apr-97 6 98,298,360

N2K 17-Oct-98 19 222,426,920

Peapod 10-Jun-97 16 266,744,272

Pilot Network Services10-Aug-98 14 192,439,604

Preview Travel 19-Nov-97 11 128,198,048

software.net 17-Jun-98 9 238,918,068

cont’d

Highest

close Business Description

233.125 Online Bookstore

39.25 Online MusicRetailer

24.5 Online Technical Books Retailer

29.75 Online Computer Retailer

234.125 Online Internet Trading

16.25 Online Catalog Retailer

108 Online Electronic Retailer

34.625 Online Music Retailer

16 Online Grocery Shopping

14.75 Secure Electronic Commerce

44 Online Travel Services

29.625 Online Software Reseller

Source: Venture Economics Information Services