What I learned at RVC LOHAS Natural Food and Beverage Conference

LOHAS (Lifestyles of Health and Sustainability) Food and Beverage is a unique market segment and it has its own set of rules and metrics.  I’ve been looking forward to RVC’s LOHAS Natural Food and Beverage Conference for over a year now because we’ve seen a number of natural food and beverage companies coming across our sights and it has been difficult to gauge whether they are a good opportunity or not.

Natural Food and Beverage companies are not like SaaS (Software as a service) companies.

The first thing to know is that the reason investors like SaaS companies so much is that once they start to get traction, they can grow really fast.  The marginal cost to add a customer is sometimes zero or close to it.  This means that SaaS companies can grow fast and can become remarkably profitable at scale.  Although most SaaS entrepreneurs are WAY too optimistic about the ability of the market to accept their products and thus they neglect go-to-market strategy and have anemic marketing budgets, we know that and can easily make adjustments and coach the entrepreneurs.  With LOHAS companies, the ratios are all different – and I learned a lot about what to look for this week.

It costs a lot to move into distribution

Yes, we knew that with a physical product you have to actually produce it and keep enough in inventory to keep your customers supplied in a timely fashion.  But it’s far worse than that!  Retailers expect Free Fills, where the manufacturer supplies the first order to fill the shelves with product for free.  If the product is expensive and/or the retailer is large with multiple stores, this can be extremely expensive.  Some retailers go beyond free fills and require that companies pay $35,000 for shelf space.  The logic is that every new product takes the place of another product that must be removed.  The retailer has a lot of work to add the new product to the shelves, to their computer systems, etc.  Clearly with all these expenses, it can be tough to grow fast.

Free in-store Product Samples and Tasting is Critical for New Products

If you have a new brand, it’s going to sit unrecognized on the shelves, lost among many other products if people don’t know about it.  There’s a reason why there are all those people offering free product samples in the grocery stores – it works!  People tend to buy what they know and if they’ve had a free sample, buying a new product is de-risked for them.  Conversions for  product samples are big and it’s a good way, although expensive, to get consumers to recognize your product and get it moving off the shelves.

Margins for Food Products Companies are LOW

One of the companies who pitched at the RVC LOHAS event showed a 25% Net profit after all costs on their proforma.  This seemed high to me and this was confirmed by natural foods industry experts at the conference.  After a company pays their co-packer for production, and a big cut to distribution and another cut for profit for the retailer, there’s not much left for the manufacturer.  In fact, most companies will end up with a single digit net margin by the time everyone else gets paid.

Growth is Slower

Natural food and beverage companies take longer to build a following and get big enough to get acquired.  Because of the time it takes to build a brand, get into distribution and get people consistently buying your product, it’s a long haul to get to the exit.  In addition, the expenses of growing that following are extraordinary, so there is a lot of time taken to build a market that you wouldn’t have with a tech company.

Building Brand is Critical

Brands are what drive consumer behavior in the retail store.  Companies that successfully build solid brands will have repeat customers and ultimately build value for their companies.  Acquisitions like Annies’ (by General Mills) have huge multiples because of the brand and the following that a brand brings with it.

Exits Happen at Lower Dollar Amounts

There are big exits like Annie’s that bring in $820 million, but many of the acquisitions in the natural food and beverage industry are much smaller, starting at $10-$15 million.  Many companies will continue to grow beyond that revenue level in order to build more value for shareholders, and this makes sense especially if the company is on a steep growth curve.

Valuations for Startups are Lower

The companies pitching at the RVC LOHAS event had an average valuation of about $1 million.  At first it seemed strange in comparison to the $2-3 million valuations we see for tech companies.  After learning about the economics of getting a new product to market and crafting a path to an exit, these valuations made more sense.  At lower valuations, investors can come in to an early stage company and make an impact, and still get a good return at the end of the day.

The Good News – Natural Food and Beverage Companies are Rarely a Total Loss

While tech companies can grow fast, they can also fail fast.  Investors who jump in on unproven tech companies can end up losing all of their investment and that’s why they need to target 10X returns – so they can pay for the losers.  The good news in Natural Food and Beverage is that if a company can build a market of just a few million dollars a year, the company is still worth something and investors may get out with 2X or better on their investment.  Venture capital investors at the conference described the strategy as focusing on singles and doubles consistently over time rather than swinging for home runs on each investment.  They have done very well with this strategy.

I was left thinking that there is a lot of opportunity in this area for entrepreneurs and investors alike.  Those who will be successful will do a lot more digging into what works and what doesn’t and they will develop a deep understanding of the norms and key ratios that make sense for this industry.  If these companies fail at a lower rate than high growth tech companies, then investors don’t need to push for big 10X exits.  Since the total portfolio return for a tech investor is more like 3X, I can see how natural food and beverage investors can match those returns by buying on lower initial valuations, then exiting lower, but more consistently over time and with far fewer total losses.  That seems like a good thing to me.

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