June 2, 2014, 3:59 PM

Think big

That’s the first of five tips for online retailers seeking to take the venture capital route to success.

Lead Photo

Don't bother Warren Lee with small ideas. You have a concept for an online business that can generate $10 million in annual sales? Good luck. But that's not likely to interest a venture capitalist like Lee.

"We're looking for retailers that can grow to over $100 million in sales in three to seven years, reach profitability and have competitive differentiation," says Lee, general partner at Canaan Partners. Size is key, he says, because a company has to be at least that big to go public or get acquired by a large online retailer. Those are the two main ways venture capitalists "exit" their investments, that is, get back their money—and, they hope, much more.

This is a good time for online retailers to get acquainted with venture capitalists because these investment firms are flush these days. The investors that commit money to venture capital firms—largely university endowments, pension funds and wealthy individuals—benefited from last year's stock market growth and the strengthening economy. That leads to venture capital firms having more money to invest, and they are: Venture capitalists made $9.5 billion in U.S. deals in the first three months of the year, an increase of 61% from the same period a year earlier, according to PricewaterhouseCoopers LLP and the National Venture Capital Association.

And venture capitalists are more than willing to consider investing in online retailers, as demonstrated by the chart on page 58. In fact, venture investors are heavily focused on high-technology sectors like software, biotechnology and the Internet. Of the $9.5 billion in first quarter 2014 deals, $2.3 billion, or 24%, went to Internet-specific companies. Companies not involved in technology are a harder sell for these growth-oriented investors: all but three of the 24 U.S. venture-backed initial public offerings of stock in the fourth quarter of 2013 involved high technology- related companies.

But just because venture capitalists are ready to write checks for millions of dollars doesn't mean an e-retail entrepreneur should rush into their arms. Venture capitalists expect something for their money, namely a share of the business. And often they only provide enough money to keep the company growing for the next 18 to 24 months; then they evaluate how the company is faring before deciding whether to invest more. That is why venture-backed companies often raise several rounds of funding—with the first significant investment called a Series A round, with B, C and D rounds not uncommon for companies that demonstrate growth.

In each of those rounds, the venture capitalists take a bigger share of the company, and it's not unusual for them to ultimately own more than half. In the case of zulily Inc., one of the most successful recent examples of a venture-funded online retailer, founders Mark Vadon and Darrell Cavens raised $138.6 million in four funding rounds and wound up owning 51.2% of the company when it went public in November 2013 at an initial value of $2.6 billion. Not that the founders did poorly: zulily was valued at nearly $4 billion in early May even after a steep drop in share price in recent months following a sharp increase following the IPO.

But for every success like zulily, there are failures. For example, ideeli Inc., an online limited-time retailer of designer apparel and shoes, raised $112 million in venture capital, but ultimately was sold for $43 million in January to Groupon Inc.

To minimize their risks, venture capitalists look for certain types of online retailers. E-retail entrepreneurs that give them what they want can raise plenty of capital and, they say, get lots of useful advice and contacts from venture investors. But it's best to know how to play this high-stakes game. Here are five strategies for e-retailers on how best to woo—and work with—venture capitalists.

Tip 1 – Think big

Venture capitalists look for big exits, like zulily's $2.6 billion IPO, and that's why they search for companies that have a shot at building really big businesses. Lee of Canaan Partners believes he found one in NatureBox Inc., an online healthy snacks retailer that Canaan and other venture investors funded to the tune of $28 million in April.

How big is the opportunity? U.S. consumers buy about $110 billion in snack food every year, according to the Snack Food Association trade group. And they're not yet buying much of that online, says NatureBox CEO Gautam Gupta, who says consumers buy 98% of their snacks in bricks-and-mortar supermarkets and other food shops. What's more, Gupta says, he develops his own products, so the items he sells are not available anywhere else.

To Lee, that ticks off two important check boxes. "NatureBox is a pretty differentiated product attached to a large market opportunity," he says.

Another venture capitalist that has invested in what he views as large opportunities in e-retail is Donn Davis, a co-founder of Revolution Ventures. His Revolution partners include America Online co-founder Steve Case, and Ted Leonsis, the former vice chairman of AOL who now owns several professional sports teams.

Revolution in the past year put money into two online retailers—CustomInk, which lets consumers customize T-shirts, and Lolly Wolly Doodle, which sells customized clothing for girls. What interests Davis and his partners is less about the two companies' current businesses and more about the possibility that each company can become a platform for offering a much wider array of products.

The customers sending in designs and logos for T-shirts that CustomInk produces are often groups—for example, a fraternity celebrating Greek Week or a charity organizing a fund-raising walk—who may be willing to buy more from CustomInk that just shirts, Davis reasons. That explains the e-retailer's average order value of $600, Davis says. If they're happy with the T-shirts, Davis says, these organizations may be inclined to buy other products from CustomInk, or even services, such as fund-raising assistance.

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