For online food startups, a challenging recipe for success

July 16, 2013, 2:03 PM UTC

FORTUNE — In May 2011, just weeks after raising $138 million in financing from investors including Goldman Sachs (GS) and scoring a valuation of “roughly $1 billion,” Gilt Groupe unveiled its latest sale site, Gilt Taste.

Foodies celebrated the return of Ruth Reichl, who had been forced to abdicate her throne as editor in chief of Condé Nast’s Gourmet when the magazine folded in November 2009. With Reichl as editorial advisor, Gilt promised a site offering “artisanal hard-to-find foods” for ethical eaters with limited access to such products — e.g. “people who live outside New York City” — as well as the kind of editorial content that made Reichl famous.

But unlike the heavily discounted, limited inventory, real-time flash sales that brought New York-style sample sales to the world — and made Gilt Groupe famous — Gilt Taste was built to be a self-described “luxury brand,” selling high-end food at high-end prices. This model, it turned out, didn’t work, and Gilt Taste quietly folded on May 24 this year.

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But as a bevy of established, growing, and up-and-coming food-tech startups are making clear, Gilt Taste’s failure is not proof that local food economies can’t get a piece of the $225 billion e-commerce industry. It is a sign, though, that selling food online is different than peddling designer handbags, and understanding those differences is key to success.

What went wrong at Gilt?

There are a number of explanations for Gilt Taste’s demise, as well as failed e-commerce food sites like Webvan, an early online grocery startup, and Foodzie, an online food marketplace and subscription service.

The very nature of food, at least as the food movement envisions it, is directly at odds with the startup model. No farm, city, region, or state is going to have the same local food system, so scaling can’t be computed with a simple — or even not so simple — algorithm. Patrice Perkins, owner of Lifestyle Zen, a law firm for creative entrepreneurs including food-tech startups, sees this as a common misunderstanding among tech types looking to jump into the food space. “You have a team of talented programmers and creative people, and if you have the right team in place, you literally can get something from ideation to execution overnight.” But, she adds, very often, “there’s not enough market research to really make sure there’s a need for the product that you offer.”

Gilt faced other challenges as well. Despite its respectable site traffic — averaging 100,000 unique visitors every month — editorial content did not translate into high sales. A foodie may happily gorge herself on articles about new salts or the best prosciutto, but that doesn’t mean she is going to buy those products. Unlike groceries, artisanal foods are generally considered a niche market. They make great gifts, as well as delicious occasional treats, but most people — even foodies — aren’t buying high-end truffle oil too often. And the customers who are in the market for these products are usually buying them somewhere they can see, smell, and taste the goods first: at the farmers market, at Whole Foods, or at the artisan’s own brick-and-mortar shop.

With notoriously low profit margins, any food-based business is going to face the built-in challenge of showing a healthy bottom line. That was the reason Gilt Groupe gave in September 2012 when it announced it would be cutting back Taste’s offerings. Gilt did not respond to a request for comment for this article.

The special challenges of bringing artisanal food to the masses, however, have not discouraged techies and investors. As the June launch of Amazon’s grocery service, AmazonFresh (AMZN), in L.A. — expanding a service it had piloted in Seattle in 2007 — makes clear, as well as the proven success of FreshDirect, which says it had 2012 revenues over $400 million and that the business has been turning a profit for the past few years.

Amazon brought in Webvan alum to learn from the startup’s failures, while FreshDirect CMO John Leeman attributes the company’s growth to convenience and quality. While online shopping is “fundamentally a convenience business,” it’s the company’s “overkill in the quality area” that keeps its customers returning, he claims. “The high quality and trust in the sourcing,” Leeman says, “is what our business model is anchored on.”

All about distribution

There’s another special problem for a business trying to sell food: distribution. According to Danielle Gould, founder of research firm Food+Tech Connect, it’s the most difficult part of creating a viable business model. “That’s where so many people have failed.”

Besides the typical distribution requirements — warehouses, trucks, labor — food has a perishability component. “That adds levels of complexity and constraints on delivery for companies, particularly as they scale,” she says. “As you start to grow and as demand grows, you’re a distribution company, a fulfillment company,” so if you can’t keep up, you won’t survive.

Good Eggs, a San Francisco-based online farmers market led by tech veterans Rob Spiro (a co-founder of Aardvark, which sold itself to Google (GOOG) for $50 million in 2010) and Alon Savant (co-founder of software design company, Carbon Five), came to the same conclusion. After tinkering with a number of ways to deliver local food “the last mile” to their customers, they eventually built their own infrastructure to bring groceries right to their Bay Area clientele’s doorsteps. However, unlike FreshDirect, which buys food in bulk and then sells it to customers, Good Eggs built a logistics platform for artisans and farmers to sell their food directly to customers. By working with producers to design their own online sales platforms, the Good Eggs team is able to cater to different food producers’ needs in a way that Gilt Taste simply wasn’t set up to handle.

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“What’s cool about it is that it feels like an online grocery, in that you order exactly what you want and you get a home delivery. But it’s actually structured extremely differently,” Spiro says. The approach also removes the perishability and waste components from the system. “Everything that is brought to our warehouse has already been bought and made for a customer. So at the end of every day our warehouse is empty.”

The company is currently on its ninth iteration, and the latest model seems to be working. Good Eggs is expanding. It’s got operations in Brooklyn and New Orleans, with Los Angeles next in line.

Distribution is key to FreshDirect’s profitability as well. Unlike regular grocers, whose reliance on multiple middlemen can lead to spoilage and waste, FreshDirect uses one, temperature-controlled distribution center to cut the amount of wasted food. According to Leeman, this model allows the company “to pay a fair price to farmers and charge consumers a fair price for superior quality fresh food and be more profitable than other grocery models.”

So are former Gilt Taste shoppers out of luck when it comes to buying specialty, non-perishable food items online, if they don’t live in an area with FreshDirect, Good Eggs, or a similar business? Not quite. Delicious Karma, which launched in August 2012 and offers nationwide delivery, may be poised to fill that gap. Like Gilt Taste did, it offers curated, hard-to-find food, but it’s balancing such items with day-to-day necessities and operating with lower overhead costs.

And by adding a social media component to food shopping, for example with its Pinterest-like Craves board, Delicious Karma co-founder Michelle Ritchie is trying to capitalize on the social nature of food itself. “Food is something that people share,” she says. “When we entertain, see our friends, and socialize, food is always such a big part of that.” Whether the site’s current 6,000 members will share it enough to escape Gilt Taste’s fate, though, is unclear.