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An investor’s observation: The rainbows of managing a business during COVID-19
A focus on profitability, expense management and reasonable valuation expectations will benefit founders.
6 Min Read
We’ve all heard some iteration of the quote: “With every thunderstorm, there appears a rainbow.” There are a few rainbows from COVID-19 as it relates to investing in food companies. I believe these rainbows are also beneficial to entrepreneurs, which I’ll explain below.
But first, let’s put these rainbows into context. Investors invest in businesses to make money and there are two potential ways to do that.
One way, and the most common way for venture capitalists in the food industry, is when a company is acquired (the exit).
The other way, and unfortunately not discussed very often, is from the cash flow a company generates. Most emerging food companies don’t generate cash flow, usually due to low gross margins and the high cost of doing business with food retailers/distributors, or they are being influenced by their investors and media/industry hype to focus on revenue growth and go for “the big exit.”
I wrote an article last year titled Sorry, your company is too small to be acquired. In it, I pointed out the relatively small number of acquisitions in the food industry as well as how companies that do end up getting acquired are actually a lot bigger than everyone thinks. Most large food companies that buy smaller brands generally want to see a brand with at least $50 million in revenue, or preferably even $100 million, before they are willing to invest the time and effort to buy and integrate a small bolt-on. Think about it: Large food companies generally have billions of dollars in revenue. Buying a $25 million revenue company doesn’t move the needle for them. They need to see that a brand can become a meaningful size.
Who knows how these potential strategic buyers will change their acquisition criteria over the next couple of years, but I’d have to guess they won’t lower their revenue threshold.
So what does that mean for investors and emerging brands today? I believe all of this points to the growing importance of needing to be profitable and needing to generate cash flow. That is quickly becoming the new standard for many investors—not revenue growth.
That is where the rainbows come in.
The rainbows of managing a business during COVID-19
1. Expense management. This period has quickly forced companies to very quickly tighten down on expense management. When investor capital was readily available in past years, and when growth was more important than profitability, it was easy for CEOs to be less worried about expenses. They were investing in growth, right? Yes, they were, but when a business is focused on growth, and when cash is available from investors, it’s easy to get comfortable with an expense structure that isn’t conducive to profitability.
The rainbow here is that companies are now being more conscious about their spending decisions than they ever have been, which has brought forward their timeline for becoming profitable. I saw one company that was losing almost half a million dollars a month become profitable in just two months’ time!
2. Improvement in cost of goods. Similar to the need to tightly manage expenses, most companies during this time have put a huge focus on reducing cost of goods and improving gross margins. A company’s gross margin is usually the biggest lever a company has for achieving profitability, and as companies have been forced to get by without new investor capital, this focus has strengthened the financial profile of businesses. Have you found this rainbow and improved your cost of goods?
3. Valuation alignment. It’s no secret that in recent years, valuations of early stage brands have escalated well beyond the intrinsic values of the companies. Valuations in the food industry escalated for several reasons, three of which include the following:
Founders of early stage companies thought their relatively small business should be valued using the same multiple as the highest multiples paid by strategic acquirers for much larger businesses (Justin’s, Krave and Annie’s being common examples entrepreneurs would use). There was enough investor capital and interest which allowed early stage investments to get done at high valuation levels.
There has been so much capital available and many investment firms, for various reasons, have a sense of urgency with deploying capital. That has caused some investors to get comfortable with paying higher valuations so they don’t miss out on an opportunity to invest in what they believe is a high-profile brand.
Investors from other sectors such as tech, where multiples are much higher, have been making food investments and are used to paying higher prices.
Now, valuations are being brought back down to more realistic levels. With the increased focus by investors on profitability, the uncertainty around what the future exit potential looks like for smaller brands, and the uncertainty around the future state of the economy, valuations are dropping.
Why is that beneficial to emerging brands? Anytime a founder raises money at a high valuation, it sets a really high hurdle for how much they have to grow before raising money again. For a company that raised money at a really high valuation in recent years and has to go back out to the market to raise money again right now, they could be faced with having a flat round, down round or very little appreciation over the last round. That then creates a more challenging situation with a company’s current investors and it also leads to a lot more dilution for the founder.
On the contrary, for a company that hasn’t had to raise much money up until this point, the benefit of having more reasonable valuation levels right now is that it removes some of the pressure of crazy growth before having to raise money again, which is particularly helpful in a time of economic uncertainty. It also reduces the likelihood of a future down round or flat round so long as you continue to grow. Ultimately, it leads to more opportunity for a win-win for both the founder and the investors. And it generally makes a founder’s life a lot better if his/her investors are happy.
Implications
Even as an investor, the former operator in me remains a strong proponent of bootstrapping whenever possible. If you choose to take on investment, do it because you want to bring in some outside expertise to help you achieve your company’s objectives, not just because you need money. That means doing everything in your power to achieve profitability from the start.
The right investor can bring valuable strategic input and other knowledge that may be currently missing from a founder’s arsenal. The wrong investor will make a founder’s life really challenging.
So, in the end, do everything you can to not be forced to take on investor capital (focus on profitability!). Then, if you decide what a specific investor could bring would be valuable in helping you grow your business, you’ll have the opportunity to take the time and find the right strategically aligned partner.
Luke Vernon is a managing partner of Boulder-based Ridgeline Ventures, an investment firm in healthy living and active lifestyle companies. He’s a former executive- and entrepreneur-turned-investor and he also founded Luke's Circle which helps emerging companies find top talent.
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