"Cutting out the middleman"

If I had to pick one phrase that best sums up the current state of ecommerce startups, “cutting out the middleman” would be it. Almost no other phrase has been uttered so much while simultaneously being the founding pillar of so many soon-to-be venture-backed startups.

Cutting out the middleman means many different things. Most of the time, it means a brand is cutting out third party retail distribution. Warby Parker, probably the most famous example that it's now a meme—"We're the Warby Parker for x"—cut out third-party retail and sold directly to customers, online and now in-store. (Warby Parker is not the first to do this—dozens of brands sell only in their own stores and online, such as Zara, H&M, Gap and others—but it remains the most prominent to do so post-internet, especially since it started on the internet.)

The middleman fallacy

There is no single path to launching a business today. But the default towards direct to consumer or nothing has done plenty of harm. These startups, and the entire premise of cutting out the middleman, are predicated on a misunderstanding that is verging on a fallacy: that cutting out the middleman is inherently a good thing that makes it easier and cheaper to build a scaleable business. Many companies have been founded on this premise without considering the potential benefits or disadvantages of cutting out middleman—and the additional work doing so now requires. Additionally, the lack of specificity about which middlemen were being cut fueled the "Warby Parker for x" gold rush that was wildly misunderstood.

This meme-driven fallacy has had two major effects. First, it demonized the actual benefits of middlemen; and second, it undersold the challenges of starting a direct-to-consumer business and scaling it.

Two types of middlemen

There are two general types of middlemen for ecommerce companies who sell physical goods. The first and most common middleman is the third party retailer. This middleman has been the go-to one to eliminate, as evidenced by brands such as Warby Parker, Bonobos and Everlane, which sell their products exclusively through their own channels. Doing this, however, requires a vastly different skill set and cost structure than a traditional retail brand.

The other type of middleman is the back-end middleman, such as fabric mills, sewing factories, dye houses, logistics network and agents who tie all of these pieces together. These middlemen are entirely hidden from the consumer, but they add costs at every stage. The more middlemen involved, the more expensive the goods will be. Each of these middlemen deliver value, but some brands take care of these steps themselves, while others try to own the entire process and the infrastructure that powers it. These middlemen are most used when a brand outsources all of its operations, and are mostly ignored when a brand is vertically integrated.

Good middlemen and bad middlemen

Middlemen are not inherently bad. They are often very important because they bring tangible value to the table. I've written extensively about the exaggerated death of wholesale, the channel that has built hundreds of lasting brands. Retailers who buy products from brands at wholesale provide very real benefits. First, the retailer has an audience that a brand instantly gets access to. Second, the retailer (usually) takes responsibility for selling the product. This relieves the brand of this burden, and it can now focus on designing and producing excellent products, while the store manages the selling. This relationship continues to be very powerful, and we will continue to see many brands built this way, such as Vetements, because it works when everyone's priorities are aligned.

A retailer, in this case, is a net good middleman. It is providing more value than it is costing, which keeps the relationship going. Yes, it’s causing the prices of products to double—a brand sells a retailer a shirt for around $45 and then the retailer sells it for $100—but everyone should be paid for the value that they provide. Real estate, marketing, customer service, and sales staff all come out of the retailer's margin, which is why it marks up products accordingly. The value that middlemen capture is (often) not arbitrary. Yes, sometimes it is overpriced, but middlemen often deliver value—otherwise they wouldn’t exist.

Default to direct to consumer

The last few years have been riddled with a bias towards every brand starting by default as direct to consumer. The first half of this decade, starting with Warby Parker's founding in 2010 and continuing until probably the end of 2015, cutting out the middleman was all anyone could talk about. VCs pumped money into the space and every month a new startup popped up that promised to "cut out the middleman" and “offer prices at half of the cost of its retail” competitors.

I find this bias illogical, since not every business should exist as a direct to consumer brand. Wholesale has often been left out of the entire conversation. This is unfortunate because wholesale has a lot of great benefits. It’s far from perfect, as I’ve written about extensively, but it is not inherently bad. It is just different.

The type of business one builds should be informed by one’s skill set and interests. If you want to start a design-driven fashion brand today, wholesale, or some combination of wholesale and direct, is probably your best bet. This allows you to focus on designing while someone else focuses on selling. If you want to be influential in the fashion world, a niche, wholesale brand remains very viable. Look no further than Vetements.

However, if you want to start a brand with simple products that really scale, direct to consumer might be the answer. Everlane, Bonobos and Dollar Shave Club all fit this framework. There is a tension, however, between being truly fashionable and design-driven while being a strong and scaleable brand. Why? Because of focus.

Middlemen and focus

The single biggest benefit of a middleman is what it lets a business focus on. To use a wholesale brand as an example, having a retailer take care of the merchandising, selling and servicing of the product enables the brand to focus on designing and producing the best product possible. The retailer charges the brand for taking care of the end selling by buying the product at the wholesale cost, which is half price. The retailer gets to double the wholesale cost and capture this margin because it is providing a valuable service and has a specific skill set that enables it to succeed.

If a brand wants to cut out a wholesaler and sell to the end customer, that's totally fine. But now the brand has to pick up the retailer’s slack, which includes both a cost and a skill set gap. To capture the full margin, the brand now has to thrive at marketing, merchandising, customer acquisition, and customer service, all on top of designing and producing great products.

This is not impossible, but the brand has just doubled the number of tasks it needs to master, which objectively leads to a loss of focus. Regaining focus and mastery is far from easy, which is why we've seen many “we’re just cutting out the middleman” startups spin their tires: saying you're cutting out the middleman is very different from having the skill set to actually do so.

Through this lens, it's been very interesting to listen to Vishaal Melwani, the CEO and co-founder of Combatant Gentlemen, a direct to customer men's suiting business, talk about his work to cut out the middleman on many levels. Melwani talks a lot about growing up in a family of tailors and factory owners, but one part stood out from a recent interview in the Wall Street Journal:

We go all the way down to raw materials. We buy raw cotton for shirts. We have grown our own cotton in the past, but we scaled past that point. Now we can buy full bales of cotton and produce shirts. Then we go directly to the mills … in China and Turkey, some denim in the U.S. We tell them that you are just sewing. They cut, make, trim. We supply all of the raw material. All they do is sew. Usually, you go to a factory and say, hey, this is the suit I want, figure it out and make the whole thing. We tell them you are just sewing, because we know you are going to put in extra cost for the buttons, and for the wool. We know where all of that comes in. And that is something I learned from the trading firm days. They would never let the raw material and the final production meet and procure each other, because that is where middleman costs come in.

We have a robust system of raw materials and final production, and we are constantly moving goods all of the time. There are 30 factories in total, from raw materials to final production, and they are all basically linked together through one infrastructure, which we call Tower.

Melwani is describing a very deliberate decision to start from the raw materials and cut out as many middlemen as possible along the way. He is entirely correct that there are many middlemen involved when making a single garment, which adds costs that are passed on to the consumer. Yet it's clear that Melwani has a fundamental understanding of supply chain and sourcing, and built this understanding into his company.

That said, everything he described in Combatant Gentlemen's supply chain takes an immense amount of work to coordinate and perfect, on top of building an excellent brand. There are less opportunities for focus here. The structure of the company, according to Melwani, reflects this. From the same article:

We look at it as tech first, fashion second. I think that as a digitally native brand, you have to be, these days. We have more engineers than we do people in fashion. It’s intentional. For today’s user interface, user experience, you really need to understand how the consumer thinks. And that is why we do it this way.

Combatant Gentlemen's focus is on perfecting the supply chain and the brand experience, not necessarily on designing the best fashion out there. This is perfectly fine, but it's important to understand that Melwani made a conscious choice to do this and arguably has the skill set to back it up. He's able to cut out many middlemen in the supply chain because he knows how to thread the pieces together. But Combatant Gentlemen won't be the most design-driven brand as a result.

Middlemen and vertical integration

Interestingly, few direct to consumer brands are vertically integrated. Zara isn’t, contrary to popular belief. Harry’s, the men’s grooming company (from a Warby Parker co-founder) is the first that comes to mind, since it bought a razor blade factory and only sells through its own channels. Even the idea of a Digitally Native Vertical Brand (DNVB), the term claimed by Bonobos founder Andy Dunn, is far from true vertical integration. In this case, only the brand itself is vertically integrated, but the company uses middlemen to facilitate everything below the actual branding and distribution.

Through this lens, Dollar Shave Club (DSC) is a fascinating case worth discussing. The company, which Unilever just bought for $1 billion, is one of the few successes in direct to consumer subscription businesses. (I'm going to leave the analysis of the subscription part of out of this piece and instead focus on where specifically DSC cut out the middleman.)

DSC was not vertically integrated. Quite the opposite, actually. DSC did not make its own blades. It bought them from a Korean manufacturer called Dorco, a middleman. DSC likely runs on Amazon Web Services, and uses a third-party fulfillment provider, yet another middleman.

DSC actually has very little to do with vertical integration. Instead, DSC’s move is about one thing: focus. Outsourcing parts of the core business that would not set it apart—supply chain, logistics and fulfillment—allowed DSC to focus on one key differentiator: the brand. DSC became an expert at marketing, customer acquisition and customer service, while everything else, including production of the core product was outsourced—to a middleman.

The return of middlemen

Vertical integration for direct-to-consumer brands might not be the answer. Instead, the way to become a Digitally Native Vertical Brand might be to use middlemen very wisely behind the scenes—the opposite of true vertical integration.

If I had to bet on one thing powering the next generation of Digitally Native Vertical Brands, it would be the continued growth of middlemen. There are so many services that brands can now tap into, from fulfillment services to credit card processing services to packaging services and so on. These middlemen are crucial for getting a brand off the ground and scaling it, all while enabling the company to focus on building the brand and making the best product.

Middlemen are crucial to a successful outcome, and we will continue to see more middlemen pop up to fill different holes in the stack. Brands should not shy away from them and try to replicate their services, as doing so will cause them to lose focus on their core differentiator.

Brands that smartly take advantage of many of these middlemen will prosper. The ability to focus on what actually makes the brand and the experience special is what sets the best brands apart from the pack. Not all middlemen are created equal and cutting out middlemen for the sake of it is futile.