How retail upstarts are beating Amazon

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How retail upstarts are beating Amazon
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The headlines would make you think that e-commerce is a battle of giants. Amazon, the dominant U.S. player with $78 billion in revenue, has put a choke hold on book publisher Hachette in a dispute over e-book pricing. Chinese giant Alibaba, with sales of $250 billion in China, has just planted a foot in the American market with 11Main and is preparing an IPO that could net $15 billion. And don't forget eBay, the pioneer online auction site, which rang up sales of $17 billion last year.

With such power concentrated in a trio of Goliaths, you'd be crazy to move into e-commerce, right? Not true. In fact, e-commerce start-ups like Birchbox , Etsy , Rent the Runway and Warby Parker are innovating and thriving where Amazon (AMZN) and eBay (EBAY) never dreamed of playing. By distributing beauty supplies, providing a virtual mall for high-quality crafts, renting out designer evening gowns or selling fashionable eyewear cheap, e-commerce entrepreneurs are thriving, building audiences-and raising plenty of venture capital to expand their dreams. According to the National Venture Capital Association, its members poured $236.6 million into retail and distribution start-ups in 2013; they've already spent $256 million in the first quarter of this year.

Investors are not afraid of the giant shadow cast by Amazon, eBay or by Alibaba, which plans a stock offering later this year that could raise $15 billion, the most since Facebook went public. "An Amazon works for commodity products," said Stephanie Palmieri, a principal at SoftTech Venture Capital in Palo Alto, California. "But there are giant niches out there." The niches are big because the Internet is increasingly where America shops. The U.S. Census Bureau reported last month that e-commerce sales in the first quarter of this year totaled $71.2 billion, up 15 percent from the same period in 2013.

Palmeri, whose firm has put money into such start-ups as True&Co (data-driven lingerie design) and Poshmark (used clothing sales), views targeted e-commerce sites as the digital equivalent of specialty retail shops. But unlike their brick-and-mortar counterparts, they can grow really fast and reach a global audience.

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Take Birchbox, which distributes sample boxes of cosmetics to some 800,000 subscribers. Co-founders Hayley Barna and Katia Beauchamp were second-year students at Harvard Business School when they developed the idea for a business that would put sample cosmetics and beauty products into the hands of a young, active audience. "Birchbox solves pain points for both consumers and brands," said Barna. "For consumers, we are helping them cut through the clutter and discover new beauty products they love in a fun, efficient way. For brands, we help them connect to high-value consumers in a high touch, targeted and trackable way."

They launched Birchbox in September 2010 and a men's version in 2012. Customers pay a monthly fee ($10 for women, $20 for men) and get a personalized box delivered each month. In return, the cosmetics makers connect to a young demographic. Satisfied subscribers can order full-price products from the site; Birchbox claims 50 percent do.

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The company has raised $72 million-$60 million in the latest of three rounds of venture funding. Two years ago it acquired a similar, European start-up, JolieBox, to expand internationally. Birchbox has launched its first television ad, featuring women trying out lipstick, perfume and eyelash curlers and a man waxing his mustache. The ad's tagline is "Open for beautiful." Beauchamp told Ad Age: "One of our big goals is to reach new audiences." Barna said the company will open its first permanent store this summer in New York's Soho district.

Etsy doesn't sell or ship anything. The 9-year-old Brooklyn-based start-up is essentially a virtual mall that provides storefronts for sellers of crafts, vintage items and art. The company says it has 40 million members, 1 million active sellers and 25 million items on its site. Gross revenues in 2013 reached $1.3 billion. Sellers pay 20 cents for each item they list in their virtual shop. The listing lasts four months or until the item is sold. Etsy takes a 3.5 percent transaction fee on each sale and also makes money selling shipping labels and search ads on its site.

Etsy has had eight funding rounds and has raised nearly $100 million. CEO Chad Dickerson attributes his company's success to a changing economy and a desire for one-on-one contact. "People want more connection when they're buying things," he said in an interview on CNBC last December.

"Everything you buy has a story behind it and a real person behind it." Dickerson told CNBC last month that the company was expanding to 650 employees at its Brooklyn location. "It's a creative place, and there's a lot of media and fashion; the creative culture really helps Etsy." An added incentive was the $5 million tax credit the company won from New York State.

The next step for Etsy? Helping its small retailers place their products in local brick-and-mortar stores.

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Like a lot of start-ups, Rent the Runway started with an obvious question: Why couldn't women rent a formal outfit for an evening out like men rent a tuxedo? Co-founder Jennifer Hyman (with Jennifer Carter Fleiss, both Harvard MBAs), came up with the idea after seeing her sister agonize about buying an expensive dress for a wedding. The 4 million members have a choice of 200 designers, including Nicole Miller, Kate Spade (KATE) and Carolina Herrera; 50,000 dresses; 10,000 accessories (including handbags) and prices from $50 to $200 for a four-day rental. Two sizes of the dress are delivered to the customer's door, along with a prepaid bag for the return.

Rent the Runway has raised more than $54 million from blue-chip VCs, like Kleiner Perkins and Bain Capital Venture. How did the founders convince notoriously macho venture capitalists to put money into a dress company? "We run a logistics and technology company," said Hyman. "We happen to be renting fashion." She calls her company "a reverse-logistics business because 100 percent of our products come back to us."

Scott Friend, a managing partner at Bain Capital, said he and his partners were intrigued by Hyman's plan to develop relationships with designers. "If she could get the designers aboard, it would be hard for somebody else to duplicate."

It doesn't hurt that women's fashion is a $300 billion industry. One recent investor is Condé Nast, the publisher of Vogue, Glamour and Vanity Fair. Big-name designers have embraced Rent the Runway because they're acquiring a new customer base. "The average age of our customers is more than 20 years younger than a department store customer," said Hyman.

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Rent the Runway is not resting on its designer labels. It has opened three showrooms, including one in Henri Bendel, an upscale New York department store, and another at the Cosmopolitan in Las Vegas. Hyman is tight-lipped about the company's future plans, but she hints at a broader mission for Rent the Runway. "We want to move from a business that's just about special occasions," she said.

Warby Parker was created to disrupt the eyeglass business. The founders concluded that the closely controlled industry was marking up eyeglasses to 20 times their actual cost. The company took orders over the Web for eyeglasses using stylish frames for a flat fee of $95 (which includes special coatings and sunglasses). "It's technology that was invented several hundred years ago, and there's really been little innovation on the product side or the distribution side," said co-founder David Gilboa in a 2011 Inc. magazine interview. "And the reason why there has been such little innovation is because essentially there's oligopoly that controls the industry."

How do you pick the right pair over the Web? You need a prescription from your eye doctor. Warby Parker sends you up to five frames to try and return. There is also an app to help you make the critical measurements, such as the distance between your pupils. For those who don't trust the virtual world or who need an eye test, Warby Parker has opened three locations under its brand (New York, Boston and Los Angeles) and makes its glasses available in a handful of other stores. Warby Parker (the name is taken from two characters in Jack Kerouac's journals) has raised $115 million from VCs and companies, like American Express, including a round of $60 million last December.

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"The e-commerce start-ups that work best are the ones where there are multiple levels of distribution," said Mark McCaffrey, PwC's global software leader and technology partner. Without naming names, he cites disruptions to the book and music industry as examples. Small companies can succeed because the costs of entry are low and the adoption of new technology by both companies and consumers has speeded up. "The little guy has the ability to compete with the big guy," he said.

Some investors believe even the big guys can fall. "I believe there are opportunities to disrupt Amazon at its core," said Bain Capital's Scott Friend. "Amazon is a 20-year-old platform; most of the underlying infrastructure was first architected 20 years ago." A start-up with an updated e-commerce platform could undo the status quo.

Exiting will be the more immediate challenge for those companies not big enough for an IPO: Valuations are currently so high that few buyers can afford to acquire the very successful start-ups. But that could change, said McCaffrey, if the equity markets suffer a major disruption of their own. Until then, these e-commerce pioneers will continue to disrupt and thrive.

FULL LIST: 2014 DISRUPTOR 50

-By Joel Dreyfuss, Special to CNBC.com

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