Act 3: The Rise of the Natively Integrated Company
Meet Natively Integrated Companies
What’s old is new again. Companies being built today are able to apply lessons learned from Linear Businesses and Aggregators to create a hybrid of the two. They have control over the products they create and direct, two-way relationships with customers, enabling them to provide more seamless and delightful customer experiences.
A Natively Integrated Company (NIC):
Leverages technology to integrate supply, demand and operations from day 1
Builds relationships with customers to build products that resonate
Takes principal risk to achieve 1) and 2) and capture larger share of profits
Quick clarification: There is certainly some overlap between Natively Integrated Companies and Digitally Native Vertical Brands, but DNVB is typically used to describe only CPG or apparel brands. NICs cross into categories as diverse as real estate, music, travel, auto, and beyond, but also includes many of the companies on Dunn’s list. All DNVBs are NICs, but not all NICs are DNVBs.
In this post, we will examine some case studies that illustrate what goes into operating a NIC and what makes them unique. Operating a NIC is not for the faint of heart. NICs need to excel at a wide range of competencies, manage unprecedented amounts of complexity across the digital and physical worlds, and commit capital to achieve their visions, all while maintaining close relationships with customers and cultivating valuable brands.
The companies that get all of that right, though, will beat the companies who try to get away with taking an easier path.
Leveraging Technology to Integrate Supply, Demand and Operations from Day 1
NICs start with the customer experience. To ensure continuously positive customer experiences, NICs build direct relationships with customers and iterate on product based on customer feedback. NICs work with agile third parties and have flexible operating principles, in order to execute on this customer feedback in a low-risk manner.
NICs combine the Aggregators’ direct relationship with customers and Linear Businesses’ supply chain and operational capabilities to deliver a delightful end-to-end experience.
In The Theory of the Firm, Ronald Coase cites a natural limit to what firms can integrate due to increased overhead and overwhelmed managers making resource allocation mistakes. Coase points out, though, that technological advancements can enable larger firms, or allow them to increase the number of capabilities they can integrate. Coase was largely writing about the supply chain, but a new spate of technologies now enable firms to integrate more of their value chain.
Today’s companies use technology to modularize the backend pieces of their value chain, allowing them to integrate the pieces that matter most to their customers. A business launching a new product can use Stripe, Zendesk, Anvyl, Flexport, AWS, and more to plug in non-core functions that it would have previously needed to hire teams to focus on. Instead, they can put their focus on building direct relationships with customers, using data and conversations to understand customer needs, developing better products and delivering better service - the things that customers care most about.
Customers don’t care whose fault it is when something doesn’t work perfectly. Customers care about the overall experience. And unless you control and can dictate the overall experience, you can’t optimize it. So the only way to create an awesome product is to dictate all the specs and all the component pieces. You’re always making compromises if you don’t fully integrate.
Zeus Living: Integrating the Short-Term Apartment Rental Value Chain
Kulveer Taggar founded Zeus Living in 2015 after a series of pivots and false starts. So when he had the idea for Zeus - making short-term housing for business travelers simple by renting, designing, furnishing and operating apartments - he wanted to be sure that he was on to something before investing his time and his investors’ money.
Before launching its first unit, Zeus tested seventeen different landing pages for positioning, value proposition and language. They spent six weeks testing conversion, and a few weeks talking to potential users before launching a 10-unit pilot to answer whether homeowners would let some startup manage their homes.
Because of the number of things that Zeus would need to do well to succeed, Taggar couldn’t just launch an MVP to test his idea like he could if he were running a pure software company. On The Twenty Minute VC, Taggar says, “The output for Zeus is someone living in our home for a few months and having a great stay. If you think of the surface area of inputs that go into that end product, that’s a huge surface area.”
In order to deliver its customers a great stay, Zeus has to be really good at “identifying real estate, pricing real estate, assessing the quality of real estate, designing it, furnishing it quickly, marketing it effectively, providing awesome customer service, in addition to the normal marketplace effect of matching supply and demand well.”
Trying to do so many things well simultaneously should raise red flags for any good strategist. But as Coase predicted, technology has allowed Zeus to increase the amount capabilities it can integrate.
According to Taggar, “Zeus uses software to streamline a non-digital activity. We treat it like a software optimization problem. Whenever we hit a bottleneck, we will use software to break through the bottleneck. There have been countless things where we write some code, and something that was a very manual process that a human had to do, we’ve now given them 3x - 5x leverage.”
In other words, Zeus leverages technology to simplify backend processes so that their people can focus on improving the many things that matter to their customers. Zeus Living is a Natively Integrated Company.
Build Relationships with Customers to Create Products that Resonate
Just as Taggar tested landing pages, language, and conversion rates and spoke to potential customers before launching Zeus Living, NICs use their direct relationships with customers to create products that resonate.
The relationship between NIC and customers provides a host of benefits, According to Rebecca Kaden of USV, benefits include:
More efficient customer acquisition
Ability to find organic growth channels through passionate users - people tell their friends about the products they love.
Building a brand and relationship means that customers come directly to the NIC instead of starting at a Google search.
Customer-centricity instead of channel-centricity means that NICs can put the customer first and reach specific target customers in the most efficient and effective way possible.
Ability to create products that resonate with people on individual and community levels
Build brands that create an emotional connection and become an identifier for a customer. The product says something about the people who use it.
Ability to create more personalized stories, brands and products.
People don’t just want great products, they want products built for them.
Why Harry’s Bought Feintechnik
We now have the context to understand why Harry’s bought Feintechnik, and why, more broadly, NICs are able to take principal risk to unite supply and demand in a positive feedback loop to create better products and experiences and improve profits.
In May 2019, Harry’s sold to Edgewell for $1.37 billion, one of the largest DNVB acquisitions to date. In the week after the acquisition, 2PM’s Web Smith wrote about why Harry’s was successful even as he remains bearish on many of the DNVBs who aren’t true NICs:
Raider and Katz-Mayfield believe the key to Harry’s growth lies in this vertical integration, or what they like to call v-commerce. Simply put, the company now owns the entire process—from R&D to manufacturing to selling direct to the consumer. “It creates this virtuous cycle that makes for really happy customers, and then they become our best advocates,” says Katz-Mayfield.
When Harry’s acquired their manufacturing partner, the company became one of the few truly vertical brands of the DTC era ... it allowed them to iterate their core product quicker and streamline product iteration for their sourced products like skincare, soaps, and shaving additives ... By designing appealing products in other product verticals, Harry’s gained an advantage. This leverage helped them to amass over 2.4% of the entire razor market. In short, Harry’s wasn’t just great at marketing and design – they disrupted their industry.
To get a visceral understanding of the difference between NICs’ and Aggregators’ approach to customers, try getting in touch with Uber’s customer support team, and then try getting in touch with Harry’s customer support team. The Aggregators have weaponized their customers. The NICs work hand-in-hand with theirs.
Harry’s was built from Day 1 with an eye towards integrating their supply and demand strategies. They leveraged the quality of their product experience to build demand, then leveraged that demand to iterate on supply, which built more demand. Importantly, that demand gave investors enough confidence to allow them to take the principal risk of acquiring of a 93-year-old German razor factory, which enabled them to spin the feedback loop even more quickly. That gave them power over distribution and ultimately enabled them to disrupt their industry. Harry’s, one of the most successful DNVBs ever, is a Natively Integrated Company.
Taking Principal Risk to Achieve Better Margins at Scale
Platforms lock themselves into fixed margins on every transaction - Uber takes 25% of every fare, Airbnb takes a 15% cut on rentals. Building a sustainable business on small margins requires tremendous scale - Uber needs to pay off billions of dollars in upfront costs, and billions more in marginal costs, $3 at a time.
NICs take a different approach. They place a smaller number of concentrated bets by committing their capital to creating their own supply, capturing more of the upside if they succeed but losing their principal if they fail. They trade downside protection for the potential for higher returns.
For example, if an Airbnb goes empty for a month, Airbnb misses out on their 15% cut, but they don’t lose money on the specific unit. If a Zeus Living apartment sits empty for a month, Zeus misses out on the revenue, and they also lose money - the rent that they have to pay the property owner. On the flip side, if an apartment is booked for the month, Airbnb is limited to a 15% margin, while Zeus takes home the entire difference between rent and operating costs and what a customer pays, resulting in potential margins of 40-50% or greater.
Let’s dive deeper by examining how a Swedish music licensing company takes principal risk to simplify a complex process and generate excellent economics.
Epidemic Sound and the Value of Owning Supply
If you’ve watched a Pewtie Pie video or listened to any of the Focus playlists on Spotify, you’ve heard Epidemic Sound’s music. Founded in Sweden in 2009 to take the pain out of music licensing, the company has focused on making it easier for content creators to license music while ensuring that musicians can earn a decent living. They started with a narrow audience: Swedish TV and commercial producers.
To fulfill their mission of soundtracking the world, Epidemic commissioned artists to create music, paid the musicians for the rights to that music, and then provided content creators with a subscription to use the music in their content.
They took the principal risk: losing money if the music didn’t sell, reaping the benefits in the form of higher margins if it did. In the process of working with Swedish TV and commercial producers, they were able to learn what their clients liked, and were able to get smarter about what they commissioned.
Armed with a growing catalog of owned music, they began selling to Multi-Channel Networks (MCNs), which are studios that work with digital platforms like YouTube to help them create content. They quickly grew to become one of the largest sources of music for MCN-produced video. As Epidmic CEO, Oscar Höglund, describes in the video above, they created a flywheel:
The quality of Epidemic’s music and the ease with which creators could license it led to Epidemic’s songs soundtracking videos that are viewed billions of times.
People discovered their songs on YouTube and asked where they could find it.
Because they owned all of the rights, they were able to easily upload the music to Spotify and link to it from the original YouTube page.
Spotify listens led to a new revenue stream, which they split 50/50 with artists (which they could decide to do since they owned the rights).
The opportunity for more income and visibility led more musicians to apply to work with Epidemic, which led to greater quality, which led back to the top of the flywheel.
Epidemic built a much simpler product for a specific audience, Swedish TV and commercial producers. They took principal risk from the outset in order to better control the product and produce outsized margins. They leveraged the quality and ease of their product to attract demand, used that demand to build more quality supply, and used that supply strategically expanding into new verticals. Epidemic Sound is a Natively Integrated Company.
The “easy” wins made possible by the internet have been taken. The Aggregators have achieved a level of scale that makes defeating them unlikely enough that the expected return from trying is tiny.
Entrepreneurs who are willing to use technology strategically, build relationships with customers and do the hard work that comes with working with both bits and atoms have the opportunity to build great, sustainable businesses. As Rabois puts it, “The companies that have more control, and take more risk, will ultimately prevail over those companies that try to be a superficial layer on top.”
As we have seen with Harry’s, Epidemic Sound, and Zeus Living, building a Natively Integrated Company gives startups more control over their products and experiences, resulting in a virtuous cycle in which supply begets demand begets better supply begets more demand.
NICs have shown early success, as evidenced by the number of NICs that have raised at billion dollar+ valuations over the past two years. This will inspire a new generation of NICs who will build on the lessons from the early pioneers. Just as NICs have built on the lessons learned from Linear Businesses and Aggregators.
NICs may also hold the key to unlocking the largest consumer spending categories that have not been dominated by an Aggregator. Companies like Redesign Health in healthcare and Lambda School in education may be able to crack previously fragmented industries by combining strong customer relationships with a deep understanding of the markets in which they operate, and by leveraging technology to scale what have previously been very local interactions.
The success of these companies should also give early-stage investors the confidence to invest in businesses that would previously have fallen into the “not scalable enough / too capital-intensive / too-low ROI” category. Peloton’s IPO, which is expected to price above its last private market valuation of $4.15 billion, will provide a strong signal on how public markets value NICs.
Once we accept that the chances of hitting on future Uber for X unicorns are slim-to-none, we can put capital and creative energy towards building companies who deeply understand their customers and build products, services and experiences tailor-suited to their needs.
Some potential critiques and ideas for future topics
If you’ve made it this far, thank you! There is no way I got everything in these past three posts correct, and there are still so many angles to explore to more fully flesh out Natively Integrated Companies. Below are some potential critiques to address, and ideas for future exploration. If you would like to follow along, you can subscribe to my newsletter at the link below:
Below are some critiques of NICs that don’t fit in this post (we’re at nearly 8,000 words!), but that I would love to hear your thoughts on and address in future posts. If you have any further critiques, please let me know by reaching out on Twitter @packym! I want to poke holes in this together.
NICs make sense in a cheap capital, easy money environment. How does it work in a downturn?
Integrating supply and demand? Isn’t that just… a business?
How do you scale NICs? How do NICs get scale effects / increasing returns to scale?
I am looking forward to continuing to develop the ideas in this post, and have jotted down a few ideas for future topics below. What else would you be interested in exploring? It would be great to do co-posts on related topics with some of you.
Why NYC is the NIC Capital of the World
Tesla, or Why Building a NIC is So Damn Hard
Taking Public Markets for a Spin: What Peloton’s IPO Will Tell Us About Investors’ View of NICs
The Defensibility of NICs
NIC Valuations Over the Past 5 Years
Startup Studios and Shared Learnings
How Sonder is Growing while Hotels are Doomed and Airbnb has Won
WeWork and Losses as Investments
How and why NICs use retail locations to build brand and lower CAC
Healthcare, Insurance and Education: The Final Unaggregated Frontiers
Natively Integrated Product Development
Lambda: The World’s First Natively Integrated School