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I recently blogged about the “Series A Crunch” and recommended ways for entrepreneurs to try to avoid its ugly clutches.

But I soon discovered a glaring omission in my recommendations.  I had addressed strategies like raising more money, structuring the round to include more institutional money and investors, cultivating these investors after the raise and resisting the temptation to raise prematurely.  But one strategy that I failed to detail was to make the money last as long as possible, affording the entrepreneurs the maximum amount of runway on which to demonstrate results.  And no company demonstrates the effectiveness of this strategy more than our most recent investment, 500px.

Oleg Gutsol and Evgeny Tchebotarev started 500px in late 2009.  They bootstrapped the business for almost two years and finally raised their first outside money in 2011—a very modest half a million dollars.  They added additional capital in 2012, bringing total outside capital in the company to a just a couple million dollars.

500px is a site for photographers to display their work, enabling it to be viewed, engaged with and even sold.  Oleg and Evgeny have been hard at work on 500px for about four years.  What did they accomplish during this time with only a couple million dollars?  Check this out:

  • 500px is one of the most visually stunning sites I’ve ever encountered.  I love photography, and I find browsing through the highest rated pictures on 500px to be a mesmerizing experience.  No more need to trek to museums; 500px brings some of the world’s best photography to you online.
  • They have experienced very rapid user growth.  The site currently has 2.5 million registered users and over 10 million monthly active users.  And these users are global.  It turns out that gorgeous, world-class photography speaks a universal language.
  • The 500px community is passionate about and phenomenally engaged with the site.  The site currently gets over a billion page views each month.  This photo of the Milky Way over the Himalayas, for example, received over 3.6 million views.  And looking at it, I think you can understand why.
  • They have started to build products that drive monetization but are highly complementary to the user experience.

This level of progress on just a couple million dollars is extremely impressive.  We can’t wait to see that they can accomplish with the additional resources from this round.

And no blog post about gorgeous photography would be complete without a bit of eye candy.  Here’s a quick homage to San Francisco courtesy of the 500px community:

We are delighted to be partnering with my very good friend Michael Dearing of Harrison Metal on this investment.  Michael will be joining the board of directors.  I can’t think of anyone better to support the efforts of Oleg and Evgeny to build one of the world’s leading photography brands.

It seems like there has been a veritable explosion of companies that are leveraging technology to build “people marketplaces” that provision various services.  On one side of these marketplaces, consumers are afforded a new channel to procure needed services.  On the other side, individuals are empowered to earn money performing the services.

These marketplaces come in two general flavors.  There are horizontal platforms like Zaarly, TaskRabbit, Gigwalk and Fiverr that let consumers find providers of a wide variety of services.  And there are vertical platforms that focus exclusively on one service vertical, such as Lyft and SideCar for hopping a ride, Homejoy for house cleaning, Instacart for grocery deliveries and DogVacay for boarding your dog.

I am a huge fan of the concept of economically empowering a community of users.  eBay has done this for 15 years in goods (and that mission is what most attracted me to the company), and these new companies are now doing it in services.  And this economic empowerment is critically important: It’s becoming obvious that the concept of permanent employment is waning, and the resulting persistently high unemployment rate creates millions of people who need economic opportunity.

After meeting with scores of these companies, we’ve been drawing a few hypotheses in the space:

Vertical vs. Horizontal Plays

While many of the horizontal platforms are doing interesting things, we tend to think that the vertical approach is resonating more with consumers.  Most of the companies that are showing early signs of breaking out tend to target one vertical.  Our hypothesis is that the horizontal plays may suffer from a potential “paradox of choice”: Consumers could be getting overwhelmed by the seemingly infinite array of potential service options presented by horizontal platforms, but consumers can easily understand the highly specialized value proposition of a company offering services in one vertical.  When you use the Lyft app, for example, it’s immediately obvious that you can get a ride from where you are to where you want to be.

My partner Chris Dixon points out that vertical approaches have additional advantages.  From a product perspective, the vertical apps can tailor their workflow to the unique characteristics of that vertical—the best way to find someone to clean your house is different than the best way to find a ride.  And from a marketing perspective, a narrow focus on one vertical lets the company do things to potentially accelerate each side of the two-sided marketplace.  For example, some companies work to jumpstart their business in a new market by initially subsidizing their early service providers to ensure that the marketplace has liquidity for consumers when it launches.

Convenience vs. Value

There seem to be two high-level value propositions emerging for these services:

  • Some position themselves as primarily a convenience and typically charge a premium for it.  There have been mobile car wash services that will come to you to wash your car, but they would typically charge you more than a physical car wash would for that convenience.
  • Others position themselves as both a convenience and a value, typically by disrupting an inefficient legacy supply chain.  YourMechanic will come to wherever your car is to perform any of a wide variety of car maintenance and repair services, and will charge you less than you’d normally pay if you were to drop your car off at a garage.  It turns out that the service department at your car dealer has become their only segment that earns decent returns, and service typically subsidizes other less profitable auto segments.  Not surprisingly, these garages then pay mechanics a very small share of what they charge consumers.  Their bills get so bloated that YourMechanic can charge significantly less than garages for a service, pay their mechanics higher wages to perform it, and still earn attractive returns.

It appears that the early breakouts in the space are those that offer both convenience and value.  It’s clear that the market size of people who are willing and able to pay a premium for convenience is much, much smaller than those who are attracted to both convenience and value.  For example, a service that charges a premium to come to you to wash your car may work well on Sand Hill Road, but it’s unlikely to have broad national appeal and disrupt the physical car wash industry.

We believe that some very interesting companies are in the process of emerging in this space, and we plan to remain active in it.

(Note: a16z has a venture investment in Lyft and is a seed investor in DogVacay, Homejoy, and YourMechanic).

The venture industry is awash with talk of the “Series A Crunch”, where it’s getting progressively more challenging for seed companies to land follow-on financing.  In my short two-year tenure as a full-time investor, I’ve seen this crunch hit very hard at a number of quality early-stage consumer companies.

Why is this happening?  A number of factors are coming together to create this crunch:

A significant supply/demand imbalance has emerged between seed and Series A financings coming out of the economic near-meltdown of 2008-2009.  In 2009, there were about the same number of seed and Series A financings, but the number of seed deals have exploded since then while the number of A-rounds grew only modestly.  In 2012, there were 2.5x as many seed financings as A-round financings, whereas historically these were more in balance.  This suggests something like 60% of seeds could be stranded.

Investor expectations have expanded substantially.  It’s become steadily less expensive to launch many consumer-oriented Net businesses over the years due to things like Moore’s law, improving programming tools, the cloud and the ability to access users from multiple large platforms.  Now we often see the kind of traction that we used to expect from Series B companies in Series A companies, and from Series A companies in seed companies.  For example, a number of our recent Series A investments built multi-million dollar revenue run rates on their seed round.  We’re getting spoiled.  Combine this with the above supply/demand imbalance and you’ve got a situation where the bar is being raised exactly when the competition for the A-round is becoming particularly fierce.

The source of seed capital has been changing.  In recent years, the amount of seed investment from non-traditional institutional sources has increased dramatically.  More and more seed capital is coming from sources like angels, “super angels”, micro-VCs and incubators.  To under-score this point, we have close to a thousand separate angels as co-investors in the consumer companies in our less-than-four-year old portfolio.  This influx of new capital has arguably had an inflationary impact on seed valuations, which obviously has an initial attraction to many entrepreneurs but can create challenges in a “crunch” scenario.  These non-institutional sources of capital are not inclined or structured to potentially help a company secure additional capital in a crunch.  And the higher valuations provide a higher hurdle that must be overcome by potential new investors in a crunched company.

The number of potential Series A investors appears to be contracting.  The venture business is showing early signs of a significant consolidation.  The amount of capital invested has trailed the amount raised for a number of years, and the capital that is being raised is increasingly consolidating among fewer, larger firms.  The number of investors who can write that Series A check is starting to fall.

The impact of these factors is playing out before our eyes.  We’re seeing more and more potentially promising companies who have spent much of their seed round to generate solid early traction, but not the kind of traction that sets them up well for a Series A financing these days given the higher bar.  These companies face a brutal situation.  They are running low on money.  Prospective new investors want more proof, particularly given the higher seed valuations.  And many of the existing investors, particularly on the angel side, become “tapped out” or “want to stay diversified” when approached for bridge financing.  These companies’ futures are rapidly called into question.  It’s been very painful to watch.

So here are a few suggestions for entrepreneurs who are trying to start consumer-oriented Internet businesses:

Raise more money in the seed round to give yourself runway to make the progress you’ll need for a Series A, along with some contingency if things don’t go perfectly along the way.  The size of seed rounds has increased substantially in our firm’s short history, from under $1 million a few years back to almost $2 million this year.  But I’d argue that even these larger new rounds are often too small given the rising Series A bar.  Increasingly, a $1 million to $2 million raise requires absolute perfection on the part of the entrepreneur.  You should consider suffering a bit more dilution early on to secure the resources to deliver the metrics that will attract the more demanding Series A investors.  Things like up-and-to-the-right user and revenue results, deep engagement, compelling cohort economics, and a proven ability to acquire users with a positive ROI on their marketing spend.

Structure your round differently.  I’d suggest getting more institutional participation in your seed round, as institutions are more likely to support a high potential but not-yet-ready-for-Series-A company in the event it encounters the crunch.  That in no way suggests that follow-on financing from institutions is a certainty or even more likely than not, but my observations suggest the odds are higher.  Similarly, consider structuring your seed deal in a way that doesn’t scare off potential new investors in the event that you’re facing a potential crunch.  Obviously these recommendations can be interpreted as self-serving given my role as an institutional investor, but my motivation for writing this is in the hopes of helping even one entrepreneur avoid the pain and suffering I’ve been witnessing by those who have been caught in the crunch.

Raise from multiple institutional investors.  This can help accomplish a few things.  First, it brings more deep pockets to the table that can fund a Series A or a bridge if needed.  Second, it can fire up the competitive juices of the participating VCs, who don’t want to risk losing out to a rival on the A round at a hot seed company in which they’re both invested.  Lastly, having multiple VCs can diminish any potential negative signaling issues down the road if an institutional investor in your seed round does not do the A.

Cultivate these institutional investors as you launch the company, updating them periodically on your progress and learning.  Some entrepreneurs do this extremely well, managing to stay top-of-mind with investors and building a relationship, a track record and credibility.  These can come in very handy with investors if you find yourself potentially entering crunch territory.

Resist the temptation to raise too early.  We often encounter companies who come to us saying that they had inbound interest from another/other firm(s) and elected to use this as a signal to start broader fundraising conversations.  But there’s interest and then there’s interest.  One of the jobs of a VC is to network broadly with potentially interesting companies, and their “interest” more often than not does not result in funding.  And if you swing and miss at an early round, it can be much harder to create positive momentum behind an A round once you go out again.  You need to be disciplined.  Wait until you have multiple months of metrics moving in the right direction before you start fundraising.  Resist the temptation to talk to every prospective investor who calls when you’re not fundraising.  Ironically, nothing piques the interest of an investor more than an entrepreneur who remains relatively inaccessible.

There are signs that the startup ecosystem is already correcting to mitigate the crunch going forward.  The number of new seed financings is down meaningfully so far in 2013, which would help to correct the supply-demand imbalance.  And capital is starting to be attracted to the gap between seed and traditional A rounds, which some term “mango seeds”.  But higher investor expectations earlier in a startup’s life are here to stay, and the smart entrepreneur will take steps to mitigate follow-on financing risk.  On each and every financing, they should ask themselves one key question: What do I need to prove in this round to get the next round?

Note: I’d like to thank my partner Chaz Flexman for his many insights on this post!

Amazon and Google are on a collision course.

When I was at eBay, we had a belief that no one was going to compete with us by replicating exactly what we were doing.  We had first mover advantages and network effects.  Amazon and Yahoo! both launched auction marketplaces in response to eBay’s strong growth, and both businesses were essentially DOA.  What did concern us was that someone would compete with us with a new, disruptive approach—a completely different take on the business.

Early on, we came to believe that Google’s emerging search business was the biggest threat that eBay faced.  eBay helped users find hard-to-find, unique products.  Google’s goal of organizing the world’s information also helped users find hard-to-find, unique products.  The mechanisms and models were different, but the overlap was clear and we came to view Google as our top competitive threat.

This thought was validated after the fact by then-Google executive Sheryl Sandberg.  We both were guest speakers at the same Intuit event a few years back, and I stayed after my talk to listen to Sheryl.  In response to a question, Sheryl said something along the lines of, “We knew early on at Google that our key competitor was eBay.”  I almost jumped to my feet shouting, “I knew it!”  It did not make me feel any better that eBay was one of Google’s very top advertisers at the time, and that we were paying them tons of money that they were in turn using to compete with us.

In Google’s case today, I am becoming increasingly convinced that their most challenging competitor isn’t another search engine like Yahoo!, Bing, Baidu or Yahoo! Japan.  It’s Amazon, which is bringing a completely different take on search—in this case, product search.

Amazon is a vertical search engine focused on helping users find products.  The overwhelmingly dominant way to find things on their site is the search box.  Users enter a keyword phrase and are presented with results that match his or her query.   The order of the search results is determined by algorithms that seek to optimize relevance and monetization.  Sound familiar?

In my personal website use, I increasingly find myself searching for products on Amazon instead of Google.  Shopping on Amazon is a superior user experience and it runs the table on the magical retailer formula of selection, price and convenience.  It has an increasingly comprehensive product assortment, with their ever-expanding direct sales supplemented by third-party merchants who sell on the platform.  Prices are almost always extremely competitive, so much so that I have pretty much stopped using Google to comparison-shop at different merchants.  And it offers the fastest and most cost effective shipping solutions, particularly in Prime (which has the interesting impact of making me want to buy goods on Amazon to make sure I get the most out of my $79/year Prime membership).  I can buy an item on Amazon in a minute, secure in the knowledge that I’m likely paying the lowest price while getting free shipping and fast delivery.

Contrast that with the shopping experience on Google.  Shopping on Google is work.  It has infinite selection…if you can manage to find what you’re looking for amidst the forest of search results.  You have to work to find the best price, typically by pogo-ing in and out of different search results to check both prices and shipping costs.  And when you find a product you want to buy from a new merchant, you need to enter all the payment and shipping information from scratch.  Buying on Google takes chunks of an hour, not an Amazon minute.

Apparently, lots of consumers are behaving like me.  Amazon is on a growth tear and is rapidly gaining share of e-commerce.  A quick calculation suggests its $35 billion of 2012 net sales in North America represented a whopping 16% market share of total North American e-commerce.  And this probably understates their true position.  Amazon’s revenue recognition policies allow them to record only the commission and shipping fees on sales by third-party merchants as revenue.  If you were to consider the actual consumer spend (comparable to eBay’s Gross Merchandise Volume number), then their share would be substantially higher.

E-commerce merchants now also have a very viable advertising alternative to Google: they can list their products for sale on Amazon through the Amazon Marketplace program.  Amazon is currently generating billions of dollars in sales for these merchants, and these third-party sales are growing significantly faster than Amazon’s direct business.  Merchants typically migrate to where customers are, and the customers increasingly are on Amazon.

This has to be a very big deal for Google.  Virtually all of Google’s revenue comes from advertising ($44 of $46 billion in 2012, excluding the Motorola acquisition), and the majority of that comes from search.  And possibly their largest advertising category is shopping.  Google doesn’t release information on their largest advertisers, but it’s become a sport for third parties to reverse-engineer the results.  Take a look at a recent effort by Wordstream in the chart below.  They report that four of Google’s largest 10 categories are different segments of retail in which Amazon competes, and that many of Google’s largest advertisers are retailers:

Wordstream

Given this context, it’s not surprising that Google has been hard at work on product search.  They recently completed a revamp of their product search results and have significantly enhanced its prominence.  Check out this search for a Canon EOS 7D, a high-end camera.

They have also announced new initiatives that at first blush appear atypical for a search company:

  • In the past few months, Google has launched a test of a same-day delivery service called Google Shopping Express in San Francisco.  It’s free for the first six months, and already includes merchants such as Target, Staples, Toys-R-Us and Walgreens.
  • Through Google BufferBox, Google has plans to place secure boxes in convenient locations throughout a city to which you can have parcels shipped to for easy pickup.  They just launched their first location in San Francisco, with many more likely to come.

These initiatives are not about organizing the world’s information, they’re about enhancing the shipping experience on products bought through Google.  It’s part of Google’s effort to shore up their start-to-finish shopping experience, trying to bridge their rapidly growing gaps with the hyper-aggressive Amazon and protect their multi-billion dollar advertising business with retailers.

Interestingly, this competition could be used to help explain one of what I initially considered to be Amazon’s more unusual efforts, A9.  According to their website, A9 “manage(s) critical capabilities – high availability, cross-platform, scalable products search and an advertising platform that serves advertisers and publishers alike – for our parent company Amazon and other clients.”  If I’d read this statement without the company being identified, then I’d have assumed they were describing Google.

E-commerce is clearly the future of retail and there is a growing battle brewing for dominance in this new world.  Amazon is bringing a vibrant alternative to product search and they’re threatening one of Google’s core businesses.  Google’s market cap as of this writing is $272 billion, while Amazon’s is $113 billion.  Godzilla is going to war with Mothra and it promises to be very interesting to watch!

For those of you who don’t yet know this about me, I am a basketball fanatic.  Twice a week for the past 10 or so years, I’ve organized a basketball game at Stanford.  At the end of the year each year, I ask the participants to chip in so we can buy gifts for the Stanford folks who provide the logistics that enable us to play.  And truth be told, this has been a pain-in-the-butt every year: asking people to pay, keeping track of who paid, reminding folks who haven’t yet paid. Invariably, I end up covering the shortfall from people who neglect to pay (and to make myself feel better, I stop passing the ball to them for a while as a result!).  But a while back, I realized that the shortfall wasn’t because of the monetary cost—it was because the manual process is inconvenient for all parties involved.

This experience is one of the reasons why Crowdtilt resonates so strongly with me.  It’s a simple concept, with powerful potential.

Now crowdfunding is not a unique idea, but we found Crowdtilt to have a unique approach: They are building a horizontal platform that can be used by groups for virtually any kind of fundraising.  The type of campaigns ranges widely and include day-to-day things like funding a tailgate before the football game, chipping in to buy a wedding gift, collecting for a fantasy football league or paying for concerts tickets.  But the company is also hosting campaigns that strongly reinforce the potential breadth and impact of the uniquely simple and effective Crowdtilt platform:

  • Residents of the town of Edwardsville, Illinois, helped keep the Once-Upon-A-Toy toy store open by raising $82,450—more than the $75,000 the business needed to stave off liquidation—in only two days.
  • Parents at the Weilenmann School of Discovery in Park City, Utah, raised $36,478.56 to keep the science program at the Lower School in just about a week.
  • Students at Vanderbilt University in Nashville, Tennessee, along with a few good Samaritans, raised $10,331.30 in less than 24 hours to enable their classmate Ayodele Sonupe to make a $10,000 tuition payment and continue his education in the States instead of having to return to his native Nigeria.

At a16z, there are a couple of key characteristics that we love to see in a founding team.  One is what we call “product/founder fit”—where the business is the obvious calling of the founder, so much so that we have a hard time imagining anyone else doing it.  We found James to be a poster child for this.  James studied development economics at Wake Forest due to his passion for the role that microfinance and micro-insurance could play in alleviating poverty in the developing world.  While in school, he received a research grant from Wake Forest and the Atlantic Coast Conference that enabled him to get on-the-ground experience in this area in post-conflict regions of Africa.  Upon graduation, he opted to move to South Africa and took a job as a loan officer at the Kuyasa Fund, where his job literally was knocking on doors to collect microloan repayments.  While there, he started a microfinancing blog and news aggregator called MiFi Report, which over time became the number one result for microfinance news on Google.  He eventually got the idea to apply his love of technology to his love of international development and morphed his blog into a poverty alleviation-focused, crowdfunding platform called Dvelo.org.  Unfortunately, regulatory changes following the banking crisis of 2009-2010 made that original business untenable and he had to shut it down.  He quickly returned to the States and started another crowdfunding platform with co-founder Khaled Hussein, this one with an eye towards helping any group collect money for anything.

Another key founder characteristic that we value very highly is determination, and Khaled is a poster child for this.  He grew up in Alexandria, Egypt, and first saw a computer in his senior year of high school when he was 18 years old—and he went nuts!  He started an offshore development company in Egypt before coming to the United States.  Within just five years, he earned a M.S. degree from Virginia Tech in Computer Science and Human Computer Interaction and entered their Ph.D. program.  He then put his education on hold to join a startup called Webmail.us that was sold to Rackspace—where he would later help lead their corporate strategy at the age of 26.  After Khaled was introduced to James, he joined him quickly to found Crowdtilt (James can be very convincing).

A third characteristic we hold dear is a big vision.  And the Crowdtilt that James and Khaled envision is massive.  Better yet, they can make you believers within just a few minutes!

We have come to share their belief that Crowdtilt has almost unlimited potential.  There are tons of places where groups and money interact in a fragmented and disconnected mix of both online and offline ways.  The Crowdtilt team recognized this, and earlier than most startups, built and released an API that allows other online services to take advantage of their collaborative payments engine.  And their small team has only scratched the surface of extending the Crowdtilt experience.  Imagine that you’re on a site where you’re planning a trip, and you’re able to to book your vacation rental with the four other friends going on the trip.  Or imagine that you’re viewing a wedding registry, and you and other guests can collaborate on purchasing an expensive item for the bride and groom.  It’s collaborative payments for an increasingly collaborative Web and world.

The company is off to a great start.  They are growing rapidly and building a killer team.  Their metrics are “way up-and-to-the right”, they are in the process of working with a number of online businesses to debut collaborative payments to their sites, and TechCrunch named them one of the five best startups of 2012.

We are thrilled to be supporting the efforts of James, Khaled and the team.  And I personally look forward to deploying Crowdtilt to collect the gift money for my hoops games.  Hey, maybe I could even use it to collaboratively fund the combined tuition payments of my twins as they enter college!  I wouldn’t be the first to use the young service in this way.

We at a16z believe we are seeing the “creative destruction” of traditional physical retailers by their online competitors.  At a high level, this is happening for two reasons.  First, e-commerce companies are substantially advantaged in terms of cost structures, particularly in areas like real estate, labor and inventory.  Second, we believe that we’re seeing an explosion in innovation among online retailers that we refer to as “e-commerce 2.0“—where companies are innovating across numerous dimensions including sourcing, curation, distribution models and social marketing.

On Thursday, Julep, a fast growing online beauty brand out of Seattle, announced that Andreessen Horowitz led their $10.3 million Series B round (here).  There’s a whole lot we like about Julep:

  • They are participating in a very attractive market: the beauty category.  The market is huge, with global sales estimated at $160 billion, and we believe it’s ripe for disruption by online competition.  Offline beauty moves slowly and is expensive.  Brands are distributed largely through department stores, where the brands must rent real estate, hire staff and fill the space with inventory.  Product refreshes typically happen twice a year, and retailers demand the brands support their products with large marketing campaigns.  Online beauty competitors are freed from these costs and constraints of their offline rivals.  Julep sources their own products and their ability to deliver new product constantly help them stay current with fashion trends.  And their direct-to-consumer relationships help them largely avoid the very expensive offline channel costs.
  • Julep is run by a very determined team.  Founder and CEO Jane Park and Chief Experience Officer and COO Kate MacDonald started the business by operating four nail polish parlors in the Seattle area to get hands-on customer knowledge and feedback.  They managed to secure physical distribution through Sephora and QVC for their early stage company to help establish their brand.  They are well along the way in building out a vibrant Web presence.  Jane and Kate are completely driven to develop a world-class beauty brand.
  • They have developed a very innovative business model, selling both subscriptions and a la carte product side-by-side.  This is hard to do.  Typically, many people won’t sign up for the commitment of a subscription if the same product is available without that commitment.  But Julep provides meaningful discounts on their products through the subscription channel relative to a la carte pricing, providing an incentive for women to delight themselves with their monthly Julep care package.

The company is off to a very strong start.  The products are great—as my 18-year-old daughter Ali tells me constantly.  Part of my diligence was bringing her home a care package of Julep products—I was a very popular father that evening!  Their brand is out-sized to the stage of the business.  For example, they were selected as one of Oprah’s “Favorite Things” of 2012, a highly coveted endorsement for any brand.  As a result, their growth trajectory has been extremely impressive.

Julep is a perfect example of an e-commerce 2.0 retailer:

  • They source their own product, which allows them to offer consumers strong value while retaining attractive margins.
  • They carefully curate the product assortment in their monthly subscriptions, tailoring them to the different style preferences of their customers.
  • They adroitly leverage the subscription business model.
  • They empower their passionate community of users to spread their enthusiasm through social channels, helping to build their brand and customer base.

We believe the next generation of great retail brands will be built online, and we believe Julep is well on their way to becoming one of these brands.

I’m also delighted to announce that Spencer Rascoff will join the Julep board.  Spencer is CEO of Seattle-based Zillow, one of the largest Internet real estate businesses.  I first met him when I served on the board of Hotwire, an Internet travel business that Spencer co-founded. He is an experienced, extremely talented Internet executive and a very good guy.  We’re delighted to have the benefit of his talents at Julep.

Online is clearly taking share from brick and mortar…this is likely to continue
—International Council of Shopping Centers, last week

America has too many malls.

I’ve recently blogged that many traditional brick-and-mortar retailers are being threatened with “economic destruction” by their advantaged online competition.  In an interview with Bloomberg TV, anchorwoman Nicole Lapin asked about the implications of this dynamic on retail real estate.  I said I hadn’t studied it, but I thought the ramifications would be very big and very negative (I believe the phrase “apocalyptic” was used).

I’ve since had the opportunity to spend some time looking at this issue, and I believe we’re seeing clear signs that the e-commerce revolution is seriously impacting commercial real estate.  Online retailers are relentlessly gaining share in many retail categories, and offline players are fighting for progressively smaller pieces of the retail pie.  A number of physical retailers have already succumbed to online competition including Circuit City, Borders, CompUSA, Tower Records and Blockbuster, and many others are showing signs of serious economic distress.  These mall and shopping center stalwarts are closing stores by the thousands, and there are few large physical chains opening stores to take their place.  Yet the quantity of commercial real estate targeting retail continues to grow, albeit slowly.  Rapidly declining demand for real estate amid growing supply is a recipe for financial disaster.

There are very few thriving physical retailers these days outside of the daily consumables markets.  I did a quick analysis on the high-level health of the National Retail Federation’s list of the Top 100 retailers in 2012, focusing on merchandise retailers that would likely be located in malls (removing grocery, drug, restaurant and online retailers).  I looked at three measures of retailer health: total sales growth, comp store sales growth and number of stores.

Stores.org Top 100 Retailers

The analysis doesn’t paint a very pretty picture regarding the health of the leading physical retailers in the United States.  Total sales growth is mixed and is negative for 20% of the sample.  Comp store sales growth—arguably the key measure of retailer health—is also mixed and a quarter of the sample is negative.  And note that many of these sales results include the retailers’ online segments, so the picture for their physical stores is even worse.  Lastly, store counts are simply stagnant—about as many top retailers shrank their store count as expanded it, and precious few are expanding aggressively.  The largest retailers in the U.S. do not look very healthy.  And if they’re struggling, it’s likely that their more marginal physical competitors are struggling even more.

I went back to the Top 100 retailers in 2007 to see how that crop had fared five years later and found that four of these top retailers had already gone away through Chapter 11.  Interestingly, the picture of these four doesn’t look that different than the 2012 list.

2007 chart

Source: Stores.org Top 100 Retailers

This declining retailer health is directly impacting malls and shopping centers in the form of very high vacancy rates and sluggish rents—exactly what you’d expect to see where supply exceeds demand.  Both factors deteriorated quickly during the economic crisis of 2008-09, but they’ve shown virtually no improvement since in spite of improved economic conditions.  The recession was the catalyst, but competition from online retailers can only be the continued driver.  The mall business isn’t very healthy either.

Regional Mall Trends

Neighborhood and Community Center Trends

These trends are hitting the market capitalizations of most of the largest owners of retail real estate.  Simon, General Growth, DDR and Kimco between them own over 600 MILLION square feet of U.S. retail real estate, according to nreionline.  Simon’s stock has performed strongly, but the other three stocks have created virtually no value over the past decade.

Stock Performance

Source: Yahoo! Finance

Most real estate professionals understand that profound changes are afoot.  Don Wood, CEO of Federal Realty Investment Trust, says  “there is too much retail supply in this country.”  The Wall Street Journal reports “Green Street Advisor, an analysis firm that tracks REITs, has forecast that 10% of the roughly 1,000 large malls in the U.S. will fail within the next 10 years and be converted into something with far less retail.  That’s a conservative estimate; many mall CEOs predict the attrition rate will be higher”.  And Daniel Hurwitz, president and CEO of DDR, observes, “I don’t think we’re overbuilt, I think we’re under-demolished.”

I agree with the above perspectives, although I believe they likely understate the eventual impact on malls.  A report from Co-Star observes that there are more than 200 malls with over 250,000 square feet that have vacancy rates of 35% or higher, a “clear marker for shopping center distress.”  These malls are becoming ghost towns.  They are not viable now and will only get less so as online continues to steal retail sales from brick-and-mortar stores.  Continued bankruptcies among historic mall anchors will increase the pressure on these marginal malls, as will store closures from retailers working to optimize their business.  Hundreds of malls will soon need to be repurposed or demolished.  Strong malls will stay strong for a while, as retailers are willing to pay for traffic and customers from failed malls seek offline alternatives, but even they stand in the path of the shift of retail spending from offline to online.

This in turn creates further opportunity for online commerce.  If I were thinking of starting a new retail brand right now, I would unquestionably start it online.  And many very talented entrepreneurs are doing just this! I personally shop at Bonobos for pants, J.Hilburn for sweaters, Ledbury for shirts and Warby Parker for eyeglasses.  All of these brands design and source their own goods.  They historically would have started in the mall but they now are starting online, a trend that will undoubtedly continue.  There clearly will be fewer new offline retailers to take the space vacated by the disappearing brick-and-mortar chains, further pressuring malls.

And in an ironic turn, many of these online brands are experimenting with offline stores—but typically with some important twists.  Bonobos and Warby Parker have built showrooms in their New York offices where consumers can come in and try on samples.  But if the consumer wants to purchase items, then the companies fulfill the product from their warehouses—they don’t stock inventory in their “stores”.  Bonobos has expanded this concept into a few additional locations, but not mall locations.  Instead, they are selecting lower cost, non-mall locations and using emails to their online customers to drive folks to these locations.  They do this because a consumer’s purchasing typically expands after a visit to their physical store, and the costs are not high given the lack of inventory and lower rents and staffing costs.  If this trend expands, it will provide further challenges to malls.

In researching this post, I came across a fascinating (and slightly morbid) website called deadmalls.com, a site that chronicles the tales of hundreds of already or soon-to-be dead malls.  Co-founder Brian Florence writes, “I started deadmalls.com with my friend Peter Blackbird in 2000 when we both realized that Pete had mountains of data about dead and dying malls stuck up in his head.  Why keep this information to yourself?  And, realizing the burgeoning power of the Internet and its ability to draw in more information, the site was created to harness stories of woe and merriment from others.  It’s been a great success.”

Unfortunately for mall owners, the content on deadmalls.com is about to expand substantially.  There just are too many malls in America, and this will only get worse.

Competition, send ‘em south.
If they’re gonna drown put a hose in their mouth
Mark Knopfler, Boom Like That

If you’re a physical retailer and you sell the same SKU’s as Amazon, you will not have a Happy Holiday this season.

Starting with the hoopla around Black Friday and Cyber Monday, the media has been full of stories on how physical retailers plan to beat back the competitive pressure from online retailers (for example, Wall Street Journal and CBS News).  They detail a number of strategies, such as expanding their hours, guaranteeing to match lower online prices, offering customized shopping apps and trying to build up their own online businesses.  Unfortunately, these strategies are destined to fail for many of these physical retailers.

The reason?  They are burdened with an inferior business model.  I’ve described in a previous blog post how creative destruction has happened in retail in recent decades, with independent retailers giving way to chain store retailers, who in turn gave way to big box retailers, who in turn are in the process of giving way to online retailers.  Physical retailers are not inept; they’re cemented to a business model that is uncompetitive.

It’s long been conventional wisdom in retail that the keys to a retailer’s value proposition are how they deliver on three core tenets: price, selection and convenience.  Let’s compare physical retailers to their online counterparts on each metric.

Price

Selling through brick-and-mortar stores is substantially more expensive than selling through online channels due to multiple factors.  Let’s compare one of the most economically efficient physical retailers, Best Buy, with its most significant online competitor, Amazon.

  • Real estate expense: Best Buy sells primarily through over 4,000 brick-and-mortar stores (as of the end of their 2012 fiscal year) that cost them billions in capital costs and over a billion a year in rent.  Amazon avoids store investment entirely.  Cost advantage: Amazon.
  • People expense: Best Buy needs to staff all of these stores with employees; their total headcount as of year-end FY2012 was 167,000.  Amazon doesn’t.  Best Buy’s revenue per employee in 2012 was $0.3 mil, whereas Amazon’s was $0.9 mil.  Cost advantage: Amazon.
  • Inventory: Best Buy needs to fill each of these 4,000+ stores with inventory, whereas Amazon keeps their inventory concentrated in a network of 70-80 fulfillment centers.  Best Buy turns their almost $6 billion of inventory an impressive 8.7x per year, but Amazon’s centralization enables them to do it at an even more impressive 10.3x.  Cost advantage: Amazon.

Each of these is a multi-billion dollar item, and Best Buy is disadvantaged on every one.  There’s no way they can compete with Amazon on price if Amazon is motivated to have the lowest price.  And Amazon is maniacally committed to having the lowest prices.  They scour their online competitors constantly throughout the day, dynamically adjusting their prices in response to competitors’ changes to make sure they are the lowest (see: New York Times).

Amazon participates in a number of business segments.  They sell physical products and digital downloads themselves, get commissions/fees on the sale of physical product by third parties, sell advertising and promotions on their site, offer Amazon Web Services, manufacture hardware like Kindles, etc.  They report a consolidated gross margin of 22%, but provide scant financial detail beyond this.  A few different equity analysts have made noble attempts to disaggregate Amazon’s reporting into its component parts.  They’ve observed that many of their ancillary businesses are quite high margin, which Amazon in turn uses to aggressively subsidize their core business.  These analysts estimate Amazon’s gross margin on physical products to be between 12-16%, an astonishingly low number.  As a point of comparison, Best Buy’s gross margins last year were about 25%, as were Wal-Mart’s.  The net result: Amazon’s gross margins on apples-to-apples products are about half of the gross margins of two of the most price competitive physical retailers.  Amazon is a brutal competitor—and I mean that as a compliment!

The strategy of physical retailers trying to price-match Amazon is absolutely doomed to fail.  A physical retailer loses lots of money charging the same price as a substantially cost-advantaged, ultra-price-competitive Amazon.  Any incremental sales will likely be offset by cannibalizing the prices paid by their “loyal” customers.  Pricing is a battle that physical retailers cannot win.

And what’s more, their higher physical cost structure completely hamstrings their efforts to compete online.  I haven’t yet met a physical retailer that is comfortable offering products at lower costs through their online channel than through their physical channel.  They are doomed before they even start.  It shouldn’t be surprising then that Best Buy’s online business in the U.S. accounts for only 5% of their total, nor that it’s 1/18th the size of Amazon’s.

Selection

A physical store is constrained in the breadth of inventory they can carry by the size of their store.  An online retailer is constrained on breadth by the size of their warehouses.  Amazon can keep a staggeringly large breadth of inventory in their 44 million square feet of fulfillment space, and they even supplement that through a network ofthird party merchants that list their inventory for sale on Amazon.  Selection advantage: Amazon.  They truly offer the “Earth’s Biggest Selection”.

The strength of the selection advantage of online retailers really hit home when we were doing diligence on our investment in Fanatics.com, a large online business that sells licensed sports apparel and merchandise.  If you search online for licensed sports stuff, you’ll likely encounter a Fanatics-owned website.  Fanatics.com has the ability to stock a vastly broader range of sports apparel and merchandise than virtually any physical retailer possibly could.  Take the example of my hometown San Francisco 49ers.  One can often buy the player jersey of a few of the 49ers stars at the local mall.  But on the Fanatics-run NFL Shop, you can buy the uniform of every player on the team—in multiple colors and most every size (see: 49er Uniforms).  They have 11 different jersey styles for star running back Frank Gore— including men’s, women’s, youth and even newborn styles!  There’s no physical store in the Bay Area that can hope to match this selection.  And if you cheer for a team from another city, you haven’t got a prayer of finding your favorite player’s jersey at physical retail.

Convenience

The one area that physical retailers have historically had an advantage over their online rivals is in convenience.  If you want or need something today, your only option has been to drive to your local store.  Physical retailers typically open multiple brick-and-mortar stores to make that drive as short as possible.  Convenience advantage: Best Buy.

But this advantage is eroding, again driven by Amazon.  With their Prime service, you get free two-day shipping and discounted one-day shipping for a flat annual fee.  Prime helps to close the convenience gap, and its share of Amazon’s sales is growing rapidly.  Other e-commerce companies are following suit, many aided by Shoprunner.com.

And online companies aren’t stopping there—they’re shooting for convenience parity.  A number of very large companies are trialing same-day delivery of online orders.  Amazon (again) is being very aggressive here, building out a distributed network of fulfillment centers near major population hubs from which they’re starting to test same-day deliveryUSPS has announced a test in San Francisco.  Other companies are trying to leverage the locally-held inventory at physical stores to also offer same day delivery.  eBay has debuted an application called eBay Now, and Wal-Mart is testing same-day delivery from their stores in a number of citiesConvenience advantage: Best Buy… for now.

Online retailers have a greatly advantaged business model, and it’s little wonder they are rapidly gaining share of the retail pie.  Early holiday sales forecasts for online retailers seem to imply year-over-year growth rates in the mid-teens.  But the overall retail pie is not growing very fast of late; most holiday sales forecasts for this year are in the low single digits.  The piece of the pie left over for physical retailers is rapidly shrinking.  And what’s worse for them, competition from their online counterparts is starting to push them towards suicidal tactics like matching the prices of competitors that have much lower costs.  For many, this might be their last holiday season.

We at a16z could not possibly be more bullish on the prospects for e-commerce, and we believe growth is poised to accelerate.

Part of the reason for this is due to competitive market dynamics.  As I’ve blogged before, e-commerce players have substantial cost advantages over their physical competitors.  They are massively more efficient in terms of real estate and labor costs in particular, and as a result hold a significant pricing advantage over physical retailers.  Online is rapidly gaining share of retail spend across the majority of specialty retailing categories, shrinking the portion of the marketplace available to physical retailers.  These physical retailers have very high operating leverage and their P&L’s cannot withstand shrinking revenue.  The result has been physical stores dramatically downsizing or going bankrupt, which we believe will only increase going forward, clearing the playing field for their online rivals.

But another part of the reason is a renaissance in innovation among e-commerce players.  At a16z, we often refer to the early development of e-commerce as either “e-commerce 1.0” or “e-commerce for nerds”.  The typical shopping experience at both is that the user enters a keyword phrase into the search box, and the company tells you what they have that matches your query.  This era ended up being dominated by two on-line behemoths, Amazon and eBay.

At a16z, we’ve been delighted of late to see a surge in e-commerce innovation that we refer to alternatively as “e-commerce 2.0” or “e-commerce for everyone else”.  Talented entrepreneurs are trailblazing entirely new approaches to e-commerce, and many of these companies are being rewarded with explosive growth.  Some examples:

Direct Sourcing

E-commerce 1.0 consisted almost exclusively of retailers that distributed other companies’ goods.  These days, more and more e-commerce companies are designing and sourcing their own goods.  Often they are collapsing inefficient legacy supply chains by cutting out multiple intermediate layers.  One of my favorite examples of this is prescription eyeglass retailer Warby Parker.  They are bypassing a bloated, antiquated industry supply chain to offer high quality, high fashion eyeglasses that they design and source themselves at a fraction of the typical market cost (the mark-up on glasses sold at physical retailer in the U.S. can be 10-20x the cost of manufacturing).  Other examples are Bonobos in men’s pants, Bauble Bar and Chloe & Isabel in women’s jewelry, and Ledbury in men’s shirts.  We believe that new retail brands going forward will increasingly be built online, not in your local mall.  It’s just so much more efficient financially.

Curation

E-commerce 1.0 players typically display their available product as a search result, typically depicted as page after page of small product snapshots.  But many of their 2.0 counter-parts are re-inventing classic physical retail merchandising into the online space.  One of the leaders in this is Fab.com, one of our portfolio companies.  They do a phenomenal job of picking beautifully designed product and presenting it in a highly compelling way and in a consistent voice.  I’m not a big shopper but I love receiving my daily Fab email, and the steady flow of boxes from them delivered to my home is a running joke among my family.  Others who do a great job on this include NastyGal for young women’s apparel and AHALife for luxury lifestyle products.

Alternative Distribution

Innovative companies are developing alternative ways of distributing their products.  Selling physical product through subscriptions is becoming increasingly common and provides retailers with a fantastic way to keep consumer mindshare each month.  Companies like Dollar Shave Club typically send you a monthly shipment of product that they design and manufacture.  Others like Birchbox or Citrus Lane include products in their monthly shipments from companies that are interested in having you sample their wares.  Alternatively, companies like Stella & Dot and J. Hilburn are distributing their product through a network of representatives, who they support with technology.

Engagement

Many e-commerce 2.0 players strive to build very strong consumer loyalty and engagement, going above and beyond the specific commerce transaction.  They seek to delight their best customers by offering free shipping and returns and doing things like providing unexpected gifts in shipments.  Many consider their consumers as a “community”, and engage with them well beyond their orders, hosting meet-ups, providing supporting content, and doing real-world promotions and events.  One of my favorite community executions is RentTheRunway’s new “Our Runway” feature.  It allows their users to upload pictures of themselves wearing the dresses they rented onto the website, where they can be browsed by new users as part of the dress rental process.  Their community members have become their models!  And lastly, all of the 2.0 players seek to have contextually relevant integrations with today’s leading social platforms—Facebook, Pinterest and increasingly Instagram—taking their content into the daily lives of their users.

Event Sales

There’s been a proliferation of companies that offer online “flash sales” events, often offering significant savings on designer brands that have surplus inventory.  French Retailer Vente-Privee is usually credited with pioneering the category about a decade ago, and aggressive retailers like Gilt Group and Rue La La quickly followed.  A number of entrepreneurs took this concept and applied it to specific target markets, like One King’s Lane in home furnishings.

We believe that all of this innovation will only improve the competitive position of online players relative to their offline counterparts, contributing to accelerating e-commerce growth.  Consistent with this belief, a16z has made a number of investments in these e-commerce 2.0 retailers, including Fab and ShoeDazzle.  And today we’re proud to announce that we’re leading an $85 million round in zulily, an event sales site that offers daily deals for moms, babies and kids.

There are a number of things that attracted us to zulily:

  • The very talented founding team of Mark Vadon and Darrell Cavens have pulled off a singular feat: They are in the process of building their second, large, highly successful e-commerce franchise.  Mark was the founder and former CEO of Blue Nile, the largest online retailer of certified diamonds, engagement rings and fine jewelry, and Darrell was his head of technology and marketing (an intriguing combination of functions that I had never before encountered as an Internet executive).  At their encore zulily, Mark is chairman and Darrell is the CEO.
  • zulily is one of the fastest growing businesses we have ever encountered.  What is even more impressive is how they have done this: The company spent minimal capital to achieve this result.  But maybe that shouldn’t surprise us—they achieved similar results at Blue Nile.
  • zulily participates in enormous markets.  They started out offering kid’s apparel that moms bought.  But as they grew, they also realized that moms were interested in women’s apparel and hardline goods (e.g. housewares), and they now sell large quantities within these categories as well.
  • We are impressed with zulily’s strategic positioning.  One reality in e-commerce today is that you want to avoid trying to compete directly with Amazon, who is hyper-aggressive in leveraging their enormous scale and cost advantage to offer the largest selection and lowest prices on the Internet.  Like Fab, zulily does this by aggregating a long tail of talented designers who typically lack extensive national distribution.  These designers offer consumers strong value, but almost always make money on their zulily sales and highly value the channel.
  • We are also impressed with zulily’s execution.  They are as data-driven as any company we’ve encountered, and use it to great advantage in both marketing and merchandising.  They leverage technology adroitly to optimize the business.  And they’ve rapidly developed operational capabilities that have enabled their hyper-growth.

We believe we’re in the early stages of a revolution in retail, where inefficient physical businesses are giving way to highly efficient, innovate online ones.  We’re delighted to have the privilege of supporting the zulily team’s efforts to build (yet another!) iconic e-commerce franchise!

Now it seems strange
How we used to wait for letters to arrive
But what’s stranger still
Is how something so small can keep you alive
Arcade Fire, We Used to Wait

It’s election season.  And since Candy didn’t use my question in the second debate, I thought I’d ask it here: “President Obama and Governor Romney, the United States Parcel Service is forecasted to lose $5.5 billion in 2012, and also has defaulted on scheduled payments of $11 billion.  What would you do to fix it?”

Since the debates are now over, let me take a shot at answering it.

We have a thesis at Andreessen Horowitz that “software is eating the world”, such that analog businesses in a wide variety of sectors are being crushed by rapid digitization.  In my last blog post, I discussed how this was playing out in retail, where market share gains by online retailers at the expense of offline retailers are threatening the long-term viability of many offline merchants due to their high operating leverage.  This same dynamic is playing out in communications.  The USPS is an analog business being rapidly consumed by digitization.

According to the Postmaster General, “The core function of the Postal Service is the physical delivery of mail and packages…to every address in America.”  Physical = analog.  Here is the USPS product mix in 2008, just four years ago:

It was an analog cornucopia.  Half of their revenue (and even more of their profits) came from first class mail, but this personal and business correspondence is being rapidly replaced by digital email, texts, social networks, and online statements and bill-pay.  Similarly, catalogs, magazines and newspapers are being replaced by commerce and content websites, supported by email marketing.  I had a front row seat at eBay as money orders started getting replaced by PayPal.  The only growth business that USPS has is packages due to the explosion of e-commerce.  But unfortunately, this business has been relatively small for them (representing only about 14% of 2008 revenue) and highly competitive vis-a-vis UPS and FedEx.

So what has happened to the volume of USPS deliveries?  It’s been decimated:

I have to give the USPS management credit—they saw pretty early on that a freight train was coming right at them.  When I was managing eBay in the early 2000’s, the USPS management team organized a session with select Valley executives on what they could do to mitigate potential disruptions to their business due to digitization (I was likely invited because the eBay community in aggregate was one of their largest customers).

Any business that encounters disruption on this scale needs to respond decisively to remain viable.  And the Postal Service is essentially a business: They are “an independent establishment of the executive branch that does not receive tax dollars for its operations.”  But unlike privately owned businesses, “…the Postal Service is nevertheless restricted by laws that limit its ability to control costs and grow revenue in the way a business would.” (2011 Annual Report)

What are some of these restrictions?  The USPS…

  • Has a “universal service” obligation that mandates the delivery six days per week to a national footprint of 151 million homes and businesses
  • Has labor agreements that specify cost-of-living wage increases and contractual benefit plans for employees and retirees
  • Faces limits in raising prices
  • Is “restricted by law from taking certain steps, such as entering new lines of business that might generate additional revenue…”

USPS management has attempted to navigate these restrictions to mitigate the financial impacts of digitization.  They have been trying to control the costs they can, rapidly consolidating mail-processing facilities and adjusting their employee counts down in line with falling mail volumes.  And they have raised prices.  Unfortunately, the biggest price increases have been in packages and shipping, their most competitive market:

So what’s the net outcome of these actions?  Massive and growing losses.  Revenue is eroding rapidly as the price increases have only partially compensated for plummeting volume.  And they’ve made very modest progress on lowering expenses:

And unfortunately, their situation is even worse than this.  The USPS historically has not accrued for the cost of retiree health benefits; they’ve booked them on an as-spent basis (governmental entities are allowed to do this, unlike the private sector).  And the costs they were spending paled compared to the costs they should have been accruing.  Congress in 2006 mandated that USPS catch up on these obligations over a 10-year period, a process called “RHB Pre-Funding” (RHB stands for Retiree Health Benefits).  They were able to make these Pre-Funding payments between 2007 and 2010, but their economic meltdown has caused them default on their recent obligations (Josh Barro of Bloomberg provides an excellent explanation of this issue here).  The $11 billion in defaults, combined with their operating loss of $5.5 billion, is resulting in the disastrous $16.5 billion 2012 deficit.

USPS management has presented a plan for how they potentially can navigate their way out of this mess (USPS “Plan to Profitability”).  It involves significant savings from changes in benefit plans, decreased service levels (e.g., moving from six to five-day delivery), some post office closures, and continued headcount reductions.  It also involves continued price increases and identifies some revenue-boosting initiatives.  It’s an ambitious plan, but it has a few big issues:

  • About half of the financial improvements require require “significant legislative change”, and Washington hasn’t been very good lately on that front.
  • It ignores the issue of the under-funded retiree health benefit costs.
  • Most importantly, it assumes that their revenue erosion moderates significantly going forward.  This just won’t happen; that digital “genie” is out of the bottle.

On the current course, we’re destined to see ever-larger losses as revenue continues to fall and expenses are only tweaked. The Postal Service is effectively becoming a taxpayer-supported entity, with ever-growing losses subsidized to maintain the “common good” of physical mail delivery.

But there are alternatives to mitigate the pain of this digital transformation:

Stem the Bleeding:

There are some very highly leveraged ways that you could improve USPS economics.  But all require political will, so they’re not likely to happen any time soon:

  • Re-invent the post office.  Operating and staffing 36,000 physical post offices is hugely expensive.  And these post offices are being hollowed out, as volume going through the average post office is down 19% in the past four years alone.  USPS needs to steal pages from the UPS and FedEx playbooks.  Most physical post offices should be closed and replaced with self-service kiosks, supported by proven technology tools.  These kiosks could be located in retailers, who would gladly trade a little space in exchange for foot traffic and possibly a revenue share. Closing post offices would save a fortune in operating and staffing costs, and the proceeds from selling the real estate could fund the benefits shortfall.
  • Deliver mail less often.  Your local mail person is delivering 23% less mail to an average location today than four years ago.  It doesn’t make sense to keep delivering progressively less mail with the same frequency.  Cutting delivery down to three days a week, say Mondays, Wednesdays and Fridays, would halve delivery trips, but the average time to deliver something would increase by only a half day.
  • Restructure comp and benefits.  Postal Service employees and retirees are expensive.  I calculate current USPS manpower costs at $84k per employee (excluding those RBH pre-funding costs), compared to $67k and $70k respectively for UPS and FedEx workers (who have a higher proportion of skilled jobs like airline pilots and mechanics).  It’s not intuitive to me why USPS labor deserve a 21-25% premium over their private sector counterparts.  An enormous 80% of USPS costs are labor-related.  If they paid the same labor rates as UPS (and that of course is a BIG “if”), their current $5.5 billion operating loss would swing to a multi-billion dollar profit.
  • Selectively raise prices.  The cost of mailing a first-class letter was in the U.S. was $0.44 in 2011; comparable figures in other countries include Great Britain at $0.74, Germany at $0.77, Japan at $1.06 and Norway at $1.63.  Giving the USPS more flexibility to raise selective prices could mitigate near-term financial pain.

Compete:

Package delivery is the only one of USPS’s market segments that is growing.  But the packages business is very competitive, and USPS is getting its clock cleaned by UPS and FedEx.  In my experience, many businesses start out using USPS given its ubiquity and low rates, but switch to UPS and FedEx as they grow due to their volume discounts and superior service.  USPS needs to focus on packages, improving their service and having the latitude to offer volume discounts.  They actually should have a cost advantage competing for an incremental package since they already make a trip to each destination each day.

Innovate:

A few private sector companies have in recent years explored trying to digitize your mailbox, providing consumers with a website that serves as a secure virtual mailbox to which mailers could send digital versions of the mail. Physical mail is very expensive for businesses—in addition to billions in postage costs, there are even larger costs in paper, printing and processing.  As a business, I’d be willing to pay a fee to deliver electronic correspondence at scale if it saved me big bucks in physical production and delivery.  And as a consumer, I would dramatically prefer to check a website for my mail than make the daily trek to the mailbox.

The challenge in building this service is the classic chicken and egg problem—it’s only interesting to consumers if many businesses use it, and it’s only interesting to businesses if many consumers use it.  USPS may be uniquely positioned to solve this chicken and egg problem with their scale, universal reach, and relationships with both consumers and businesses.  They could charge much lower “postage” rates for this service, but at higher margins as they replace the costs of physical distribution.  And they could provide related services like integrated bill payment, archiving and the like.  In the process, they also save about a zillion trees!

Privatize:

UPS and FedEx currently deliver packages to every home and business in the U.S., just like USPS.  They don’t currently go to every one of these everyday, but they are in every neighborhood every day.  And both of these businesses are operated significantly more efficiently than the Postal Service and turn a profit.  It feels like there would be massive efficiencies from combining USPS operations into one of these companies.  Alternatively, there’s a war that’s starting to brew around delivery to your home from players including Amazon and Wal-Mart, and both are world-class at logistics.  Amazon alone spent a stunning $4 billion in 2011 on outbound shipping costs; they now spend more on shipping than marketing!  Might they be interested in owning delivery to the home?

Software is eating the world, leading to the rapid destruction of many legacy analog business models.  It’s a foregone conclusion that the post office will go the way of record and book stores, as bits don’t require physical buildings to be delivered.  The Postal Service as we know it is well along the path of being obsolete.  Acting on this reality sooner rather than later will save taxpayers very many billions of dollars.