As an investment banking firm, we regularly dialogue with the top executives in the beverage industry. We have to chuckle when we reach a decision maker with a large beverage company and he says, "We have a corporate policy that we organically develop all of our own beverage concepts." Does this guy read the industry publications? Did he miss the surge in beverage start-ups caused by the success of Red Bull, Hansens, Vitamin Water, and others? It seems like the major source of innovation in the beverage industry is coming from these new rule makers that defy the odds and launch successful new brands and even new categories.
This surge of innovative activity is fun. What energy. It reminds us of the old Internet days - lots of money, talent, ideas, hope, energy, and potential successful businesses. This is the innovation environment in the beverage industry and any large company that feels it can keep pace with this force through internal development efforts alone is headed down the path of extinction.
Almost everyone will agree that the new drivers of innovation in the beverage industry are entrepreneurial small companies that launch their products on a shoe string and defy the odds to reach a critical mass with very little outside funding. There is, however, a huge barrier in this market. The institutional buyers often make the cost of entry on to the shelves of their stores prohibitively expensive. This often prevents the expected innovation and commercial success that should naturally follow the effort and passion of these innovators.
These entrepreneurs respond to a market need and achieve encouraging initial success from the early adopters. They soon hit the wall and are not able to "cross the chasm" from a small group of early adaptors to general market distribution within the large retailers. There is little economic value created when promising concepts are in the control of an under funded start-up company and the brand never reaches broad acceptance.
Most of the blockbuster new products are the result of an entrepreneurial effort from an early stage company bootstrapping its growth in a very cost conscious lean environment. Think of some of the new developments from companies mentioned above. The big companies, with all their seeming advantages have a very high internal cost structure for new product introductions and the losses resulting from those failures are substantial. Don't get me wrong, there were hundreds of failures from the start-ups as well. However, the failure for the edgy little start-up resulted in losses in the $1 - $5 million range. The same result from an industry giant was often in the $100 million to $250 million range.
For every Red Bull and Vitamin Water there are literally hundreds of companies that either flame out or never reach a critical mass beyond a loyal early adapter market. It seems like the mentality of these smaller business owners is, using the example of the popular TV show, Deal or No Deal, to hold out for the $1 million briefcase. What about that logical contestant that objectively weighs the facts and the odds and cashes out for $280,000?
As we contemplated the dynamics of this market, we were drawn to a merger and acquisition model that is used in the networking technology market by Cisco Systems. We believe that model could also be applied to great advantage in the new era beverage industry. The giant networking company, is a serial acquirer of companies. They do a tremendous amount of R&D and organic product development. They recognize, however, that they cannot possibly capture all the new developments in this rapidly changing field through internal development alone.
Cisco seeks out investments in promising, small, technology companies and this approach has been a key element in their market dominance. They bring what we refer to as smart equity to the high tech entrepreneur. They purchase a minority stake in the early stage company with a call option on acquiring the remainder at a later date with an agreed-upon valuation multiple. This structure is a brilliantly elegant method to dramatically enhance the risk reward profile of new product introduction. Here is why:
For the Entrepreneur:
1. The involvement of the large beverage industry investor - resources, market presence, brand, distribution capability is a self fulfilling prophecy to your product's success. The halo of the big secure company helps you cross the chasm to the conservative majority institutional customer.
2. For the same level of dilution that an entrepreneur would get from a VC, angel investor or private equity group, the entrepreneur gets the performance leverage of "smart equity." See #1.
3. The entrepreneur gets to grow his business with Large Beverage Company Investor's support at a far more rapid pace than he could alone. He is more likely to establish the critical mass needed for market leadership within his industry's brief window of opportunity.
4. He gets an exit strategy with an established valuation metric while the buyer/investor helps him make his exit much more lucrative.
5. As an old Wharton professor used to ask, "What would you rather have, all of a grape or part of a watermelon?" That sums it up pretty well. The involvement of Large Beverage Industry Investor gives the product a much better probability of growing significantly. The entrepreneur will own a meaningful portion of a far bigger asset.
For the Large Beverage Industry Investor:
1. Create access to a large funnel of developing technology and products.
2. Creates a very nimble, market sensitive, product development or R&D arm.
3. Minor resource allocation to the autonomous operator during his "skunk works" market proving development stage.
4. Diversify their product development portfolio - because this approach provides for a relatively small investment in a greater number of opportunities fueled by the entrepreneurial spirit, they greatly improve the probability of creating a winner.
5. By investing early and getting an equity position in a small company and favorable valuation metrics on the call option, they pay a fraction of the market price to what they would have to pay if they acquired the company once the product had proven successful.
This hybrid merger and acquisition model is a collaborative effort drawing on both Investment Banking experience combined with 25 years of beverage industry experience. Both the small entrepreneurial firm looking for the "smart equity" investment with the appropriate growth partner or the large industry player looking to enhance their new product strategy can benefit from this creative approach. This model has successfully served the technology industry through periods of outstanding growth and market value creation. Many of the same dynamics are present in the beverage industry and these same transaction structures can be similarly employed to create value.
Dave Kauppi is an investment banker and President of MidMarket Capital. We help business owners with all aspects of Mergers and Acquisitions.