Entrepreneurial Finance 6314M0161Y
Honest Tea Case Master Business Administration Dr. V.N. Vladimirov
Prepared by: Bogdan Banica (10839240)
Additional group members: Raphaela Wiertz Xueli Han Tyra van Putten Willemijn Vleeuwen 1. How is Honest Tea (HT) doing? What milestones would you utilize to evaluate performance subsequent to the next financing round? The company is doing extremely well even though it has recorded only loses during its existence. Since it was launched in 1998 it has experienced a tremendous growth every year. They managed to more than quadruple their sales in one year and almost double it the following year. The revenue of the company increased from 1998 to 1999 by 342.46% ($273,557$1,210,401) and from 1999 to 2000 by 75% ($1,210,401$2,118,094) (According to Exhibit 20-10). They took advantage of the market opportunity and managed to create a new beverage category (blue ocean strategy) which made the competition irrelevant (e.g. national brands: Snapple, Arizona Ice Tea, Lipton etc.). They identified an existing gap in the beverage market between the tasteless water and the super sweet drinks and targeted four different consumer segments: disenchanted bottled tea drinkers, bottled water drinkers, diet soda drinkers and tea purists.
Honest Tea was the only company that was filling this gap at that time, they had their own production capabilities (owned 1/3 of the Three Rivers Bottling Inc. with an approximate capacity to support $30 mil in sales – bought in March, 2000) and a great management team that was capable of growing the company at a national or even international scale. Moreover, the customers were so impressed by the product and the company’s vision that they were willing to invest in it. The ready-to-drink tea market was very attractive because it started growing again after a long period of decline (total of 2.67 billion - 9% growth from 1998 to 1999) and some experts predicted that it would more than double in the next decade. The consumption of coffee dropped from 1995 to 2000 by 13.30% ($4,023.80 mil.$3,488.80 mil.), the consumption of cacao mixes stayed almost constant with a small decrease in the same period of 0.11% ($347.80 mil.$347.40 mil.), but the consumption of tea bags/ loose tea consumption increased by 17.95% ($636.80 mil.$751.10 mil.) during this time (Exhibit 20-7). Thus, the market potential of the company was very large. The first milestone I would use to evaluate performance subsequent to the next financing round is an increase in sales by 295,3% in 2001 ($2,118,094$8,373,000) which basically means to deliver on their promise (According to Exhibit 20-11) and start generating profit in the third and fourth quarter of the year 2001. Secondly, another very important milestone would be to expand distribution channels and hire a national sales force. Considering their growth in 2000, they should be more than able to cover the entire country by the end of the year 2002. 2. What does HT need to do to be successful in the future? The first thing that HT needs to be successful in the future is to either reduce operating expenses or increase the sales at a level that will cover all the costs. Furthermore, they need to hire a national sales force to be able to start distributing the products across the whole country. Furthermore, it is not enough just to distribute the products, they must also be promoted by using different merchandising and marketing tools in order to increase brand awareness to support the fast growth of the company. But in order to be able to grow, the HT needs additional financing and that is why another important success factor is the attraction of strategic investors who have the capabilities and knowledge to help with the operational aspects of running a start-up, provide valuable advice when it comes to decision-making and help the company expand at a national level. Even though the expansion of the company is a priority at this time, Goldman shouldn’t compromise his convictions and/or values of the company since these were partly responsible for the company’s success so far. Thus, the expansion shouldn’t be so aggressive that it will sacrifice Honest Tea’s identity and purpose because that’s what made the company and its products so “special” for the targeted consumers segment (especially tea purists) and sustained such a rapid growth. 3. How much financing does the company need? For what purposes? Seth Goldman, one of the founders of the company, estimated that a capital infusion of $2 would help the company to start generating profit. There are several things in the company that need financing, but the most important one is expanding distribution, thus increasing sales. That 1
includes hiring a national sales force, launching Honest Tea in new supermarkets (including Safeway which required an introductory allowance of one case per SKU per store) and purchase marketing and merchandising materials (e.g. coolers and other sales incentives). We can clearly see an improvement by looking at the Income Statement of the company. In 1998 the expenses were higher than the gross profit by 737.6% (e.g. ($415,073/$49,555-1)*100), in 1999 by 251.6% and in first two quarters of 2000 only by 98,63% (Exhibit 20-9). By looking at the trend we can conclude that the company needs more money to finance its operating losses for the next several quarters and help get the Three Rivers Bottling plant to profitability. 4. Who has the company approached for financing in the past? Were they the right investors? How have past financings been structured? Why? The initial investment of the start-up was $300,000 (founders’ money), but they managed to gather an additional $271,500 (external sources) shortly after the launch. The first investors of the company were the family and friends of the founders, Seth Goldman and Barry Nalebuff, because at this point they didn’t want to go to large outside investors to avoid any interference in the way they ran the company at the beginning. This was the right call at that time because they had a vision in mind which could have been altered along the way, had they gathered funds from other sources. Secondly, they had to prove the concept and refine the product first. If they had gone to a large outside investors from the start, before becoming a booming success, the chances are that the company would have been under evaluated (post-money valuation) and they wshould have had to given up more equity for the funds. ABut as they were entering a new market, the risk for investors was pretty high and the value of the company was uncertain at the time. That is why Nalebuff came up with a new structure of financing which included warrants for the founders with exercise prices staged at multiples of the initial price at which family and friends bought in. Therefore, if the company performed well, the founders would exercise their warrants and own a bigger fraction of the company but if the company didn’t do so well, the original investors would own a larger piece of the company The product was so successful that the next round of financing was obtained from several loyal customers who offered to invest in the company because they were so impressed with the clean and refreshing taste of the tea. For the first round of financing from these angel investors Nalebuff managed to obtain commitments for $1.2 million with a pre-money valuation of $4 million. But in the year 2000 he realized that the company needs additional funds. In the second round of financing they managed to quickly get commitments for $1 million from existing investors at an $8.5 million pre-money valuation. The biggest advantage of gathering money from several smaller investors was that they were able to grow the company the way they wanted to and in the direction they wanted to without any external interference. But the disadvantage of this method was that it was a very timeconsuming process. Not only that the fundraising took a long time (approximately 8 months), but most of the investors were inexperienced and Goldman had to spend hours just explaining how to interpret the financial statements of the company to more than 50 people. 5. What sources of financing (investor types) should Goldman and Nalebuff explore for the current round?
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At this point, the company reached a level wheren it can’t rely solely on small individual investors anymore. Besides the fact that it takes considerable time to raise the funds and explain everything to the unsophisticated shareholders, this round they need more money and expertize. They clearly need some help with operating a company that grew faster than they expected and the current management team has becoame insufficient. Therefore, it is very important that for this round they will attract strategic investors who will become important assets of the company. On the other hand, an important success factor of the company was the concept of the product that was based on Goldman’s convictions. Hence, they should be careful not to make a deal with an investor that would push them in the wrong direction for the sake of a faster growth. The company has a short but very successful history and a large market potential. Therefore, a company that shows such promise is appealing to all sorts of investors. Considering all these things, they have two options for the next round of financing. The first option is to find some professional angel investors who have enough experience and knowledge that they could help bring the company to the next level. This would be a viable option if they could quickly find the right investors and establish a real board of directors. One of the biggest challenges of this source of financing is agreeing to the terms with multiple parties, but Goldman hoped to find a lead investor that would agree to terms and valuation and the other smaller ones would fall in line. If this were the case, this would be the best option of financing the company because they wouldn’t have to cede too much control of Honest Tea. Moreover, they would get valuable new members (who hopefully have the same convictions as the original founders) in the management team. On the other hand, if they can’t find the right investors in due time, another option for additional financing is a Venture Capitalist. This investor type also has its advantages. They have access to more funds and are able to provide support in running the daily operations of a start-up. This would ensure a faster growth of the company making HT a major player in the market. Furthermore, a VC wouldn’t require such a high maintenance as angel investors and that would save Goldman a lot of time and energy. But this option also presents a challenge. It would be hard to find a venture capital group whose mission and vision are in line with Honest Tea’s strategy. That is why it would be very hard to find a group that wouldn’t want a significant control over the board of directors and who would agree to all the decisions that the founders want to make. 6. Does the proposed financing and valuation make sense? How would you proceed to find out? The proposed financing structure (Exhibit 20-12) is similar to the one that the founders offered to the initial investors. They want to issue share-and-warrant packages that consist of two half warrants with different exercise prices (50k and 75k) and 1 share, issued on a first-come-firstserved basis. The purpose of these packages is to protect the shareholders against future dilution. If we look at the valuation from the beginning of the year 2000, which was $8.5 mil pre-money valuation, it makes sense that it increased to 13,113,000 (54% increase) since the revenue of the company increased in 2000 compared to 1999 by 75% (Exhibit 20-10). On the other hand, the valuation formula is oversimplified and not very clearly explained. The company is valuated solely on its sales, disregarding any other internal or external factors (e.g. brand value; knowhow; human resources etc.). Furthermore, it is not explained how the multipliers for tea bottle 3
sales and bag sales were obtained and the fixed value of the bottling plant is over estimated. They invested $300,000 to acquire the plant and get it up and running and now it is valuated at a fixed price of $750,000 without taking into consideration depreciation over time.
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