Venture capitalists (VCs) are known for being selective about the industries they invest in. Lots of tech startups and software-as-a-service (SaaS) companies. E-commerce businesses, not so much.

Whether or not you agree, there are important reasons why VCs are generally bearish on e-commerce. It has to do with the mechanics of venture investing and the specific challenges faced by e-commerce ventures.

The VC investment model

At its core, the venture capital model is all about high returns. VCs invest with the hope of achieving significant multiples on their money. We’re talking returns of 100x or more in early-stage investments. Why so high? Because venture investing is risky business, where many investments fail. The successful investments have to not only cover the losses, but give substantial profits.

Let’s say an investor enters a company at a $5 million valuation. A 100x return would need a $500 million exit. But this number must account for dilution from subsequent funding rounds, meaning the actual required exit could be closer to $1 billion.

So you can see why VCs would be especially interested in the scalability and potential market size of the businesses they back.

The perks of being a SaaS company

When you compare e-commerce to SaaS, it’s easy to see why VCs prefer the latter:

1. Revenue multiples: SaaS companies usually have high revenue multiples because of their recurring revenue models, eg monthly subscription fees. These companies can rake in revenue multiples ranging from 5x to 10x—even higher in some exceptional cases. E-commerce companies are a very different story, with multiples closer to 1x revenue because their sales are mostly one-time transactions rather than recurring, meaning less predictable revenue streams.
2. Margins: SaaS businesses generally have high gross margins, often around 80%, since their primary costs are development and customer acquisition. But e-commerce companies face higher costs of goods sold (COGS) and substantial marketing expenses, resulting in lower margins.
3. Scalability and predictability: SaaS products are easier to scale because it’s pretty straightforward to distribute software globally with minimal additional costs. But e-commerce companies have to manage inventory, shipping, and logistics. This is capital intensive and less scalable. SaaS companies also benefit from predictable subscription revenue, while e-commerce companies must keep attracting new customers to maintain sales levels.

Overlooked opportunities in e-commerce

Despite these challenges, some investors believe that the current market dynamics present unique opportunities in e-commerce. As the space is less crowded with investors, there are potentially undervalued e-commerce companies with strong growth potential.

For example, bootstrapped e-commerce companies generating over $1 million in annual revenue might be valued around $5 million post money valuation, offering attractive entry points for investors willing to take the risk.

One investor notes, "When investors vacate a space, often the low-hanging fruit—companies growing rapidly with strong market pull—are overlooked because there just aren’t enough investors."

Strategic acquisitions & value propositions

Acquirers purchase companies for various reasons, including technology, intellectual property, brand, customer base, product offerings, and strategic positioning. While e-commerce companies may not have the same revenue multiples as SaaS firms, they can still achieve significant exits through strategic acquisitions.

Brands like Warby Parker and Eight Sleep are proof that successful e-commerce companies can reach unicorn status.

But the path to big exits requires considerable effort. E-commerce businesses must excel in multiple areas, from supply chain management to customer acquisition, making them labor-intensive compared to their SaaS counterparts.

Reflections

The VC industry's preference for SaaS over e-commerce is rooted in the fundamental differences in business models, revenue predictability, and scalability. While that makes life a bit harder for e-commerce founders seeking investment, it also opens opportunities for those willing to navigate the challenges and capitalize on overlooked market niches.

Understanding these dynamics can help founders determine where to seek capital, and investors spot opportunities that aren't obvious right away.

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Happy scouting!

Elizabeth

This article was written by Elizabeth Yin, our Co-Founder, General Partner, and lead hippo enthusiast at Hustle Fund.