Early Stage Money
The Business of Food
by Jennifer Barney
Early Stage Money
4-min read
If you’ve been thinking about investing in early stage CPG – perhaps someone you’ve been supplying – listen up.
Smart brands know they have to control their costs and tighten the supply chain, so partnering upstream with a supplier/supplier-manufacturer could help accomplish that. We see vertical integration happening at later stages, but what about early stage?
Let’s define early stage as brands with anywhere from $250K - $5M in revenues.
First Things First
Early stage is risky but accessible. As suppliers you may be witnessing brands getting acquired for exciting returns and saying to yourself, I supply them, maybe I should have invested as an equity investor back when they were small.
Brands have access to outside capital like they never have before, so if you wait too long you’ll have competition. So how do you get started?
The nature of your supplier/startup relationship has likely never entered these waters, so talking about investing will require some homework on both ends. I highly recommend speaking to professionals who work CPG deals specifically, and not just any kind of legal or investment advisor - see some recommendations at the end of this post.
Both parties need to have a basis of understanding beyond the investment vehicle being put in place.
Investors and startups should make this list:
How is the % equity ownership being determined?
How long will it last?
What will it be used for?
What are you each expecting from the relationship?
Amount of Ownership
Shark Tank climaxes when the deal/no deal is decided. What percent ownership the founder(s) are willing to give away for the ask (amount of raise) is the most important factor on the show. It is the first hurdle investors and founders need to cross. This all has to do with the concept of valuation. Even in an unpriced round where valuation is avoided, there can be pitfalls later on if the parties involved do not have the same understanding going in on how they are thinking about valuation.
In later rounds of financing, valuations are typically done based on some multiple of the latest twelve-month revenues or EBITDA. This doesn’t make a lot of sense for early stage because when you’re just starting out, revenues are tiny (albeit growing quickly), and there is no positive EBIDTA. Therefore, investors will need to look at a combination of things including addressable market size, trends, growth rate, margins, founder competency and comps.
Comps
But be careful with comps. You don’t want to make the mistake of looking at high-profile exits like Vitamin Water, RXBar or even Justin’s and think you can project forward revenues and apply those types of multiples. 4 – 6X multiples of revenue is unrealistic, and frankly anything over 3X is not normal. Of course, it depends on many factors, but normal is more like 1 – 2X forward revenues. Everyone should talk about comps because you want to avoid a situation where the founder presents bad supporting evidence which overvalues their company.
Valuation / Dilution
Startup founders tend to worry about dilution because they don’t want to own less of their company than they absolutely have to. But as Andy Whitman of 2X Partners says, valuation/dilution are two sides of the same coin. A lower valuation doesn’t have to be excessively dilutive (read Green Circle Capital’s Stu Strumwasser whitepaper, What’s my Valuation) and using a higher-than-normal valuation as an anti-dilutive measure is dangerous for everyone. It pressures the startup to put up an unrealistic pro-forma, and when it disappoints, they break trust with investors. This strains the relationship, risks any follow-on investment, and makes it difficult to find future investors.
Runway
Raising is a time suck. You want to make the money last as long as your next significant milestone.
What would that be?
Today’s investors are looking for capital efficiencies which means healthy margins and quicker paths to profitability. This is great news for supplier-investors whose inputs affect COGS and potentially other operating expenses (warehousing, freight). Projecting what is necessary to get to positive operating income should be your milestone.
Operating income is defined as:
Revenues – COGS – Operating Expenses = Operating Income
There is no better position by which to seek your next raise.
Use of Funds
The startup should know their business and the industry well enough to predict where funds need to be applied to reach positive operating income. Investors should be wary of these uses:
Significantly improve gross margins (like by more than a few points)
As a supplier you know the next pricing tier - and I’ve already talked about the perils of excess inventory due to larger-than-necessary runs
Increase sales by growing “brand equity”
This translates to oversized, short-term advertising
Insert Tortoise and the Hare fable here
Good uses are:
Grow team
Move into omnichannel
Working capital
Expectations
Think of this as a long-term relationship. It could be 18 months, several years, or even a decade before an exit happens (if it happens) where everyone gets paid out. You want this time to be positive and even exciting. How much support and resources from the investor the startup is expecting, and how much and how often the investor will get communication and see financials from the startup should be discussed upfront.
Advisors
Another great founder strength, and something investors will look for, is who the startup has on their side in some formal advisory capacity. (Startups: don’t BS this – just because you met Peter Rahal a few times and he was super nice doesn’t mean he’ll answer your emails so don’t put him down as your advisor). Look for CPG former founders or industry professionals that have a proven track record and that have the bandwidth to help you. Consummate the relationship with a legal agreement like a FAST (please seek professional advice- see below) or some other remuneration.
Recommended Professionals on CPG Investing:
Andy Whitman is the Founder/Managing Partner & Investment Committee Member at 2X Partners, and has been investing in emerging CPG brands for 20 years.
Stu Strumwasser is the Founder and Managing Director of Green Circle Capital, a leading boutique investment bank focused on the natural products space. He was previously the founder of a natural beverage company which he ran as CEO for six years.
Don Buder is a strategic legal advisor and corporate counsel to food and beverage, food-tech, and ag-tech innovators, entrepreneurs, and investors at Davis Wright Tremain LLP.
All my best,
Jennifer
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I'd love to hear from you - get in touch at jennifer@3rdandbroadway.com