noseFor those of you who are consistent followers of my blog, you might recall earlier this year I was rather sanguine (on a relative basis) with respect to the prospects for the pet industry in 2013. My thesis was based upon three factors. First, that a tepid recovery would result in slower pet population growth and the waning of the pet food upgrade cycle. Second, that slowing comp (same-store-sales) growth at PetSmart was in fact a proxy for the industry. Finally, that declining influence of the baby boomers, who have slowed pet replacement, would not be sufficiently supplanted by the necessarily levels of spending growth by Gen X/Y to propel the industry forward at projected levels.

As we round the final turn in the calendar year and head for home, things have not played out quite as I had expected.  The industry has proven itself to again be resilient and more adaptable than even I recognized. The economic recovery has been aided by strong equity returns and rising home prices that have exceeded most pundits expectations. Notably, this has resulted in solid growth in industry related personal consumption expenditures that indicate the industry should deliver projected 2013 results. While PetSmart comps are in fact slowing, management has found ways to adapt — prolonging the pet food upgrade cycle through expanding offerings and more square footage dedicated to the premium aisle, resetting key categories such as canine hardgoods, and evolving service offerings to be more compelling.  Management also reported their belief that the company’s online strategy is producing above market returns. Finally, pet adoption rates, a key driver of spend, have accelerated in 1H2013 adding additional reason for optimism. While there may be clouds on the horizon, rain does not appear imminent. As such, we expect the industry to hit its annual growth projections.

In addition to strong growth, we are also predicting that 2013 be a good year for industry related transactions, both M&A and private placements. One of the best predictors of future M&A volume is trailing private placement volume. Generally speaking, private and growth equity firms have three to five year hold periods. From 2010 – 2012 private placement volume met or exceeded M&A volume in the pet industry. Investments made in 2010 are now starting to come into season. Given the number of companies that will enter their exit window over the next two years we expect transaction velocity to continue to grow. Consumables, distribution, and hardgoods are expected to lead the way. Based on 2013 private placement volume we expect this to become a long-term trend.

The year has also produced a number of trends that we expect will have long term implications. Among these, we are seeing acquisition rationales of large strategic acquirers focus on the value of acquired brands in the pet specialty channel. As an example, when Del Monte Foods acquired Natural Balance Pet Foods, it was the latest in a long line of wellness oriented pet properties snapped up by a large strategic acquirer. Historically, these acquired brands have migrated out of pet specialty and into mass where the market opportunity is perceived to be greater. Our understanding is that Del Monte intends to keep Natural Balance in its current channel. Sure we have heard this before from other buyers, but if you consider that mass is losing sales to pet specialty and currently there is a lack of large brands in independent pet specialty with traffic pull, we may be reaching the tipping point where taking share in broader pet specialty is the more attractive opportunity. Increasingly, we see large strategics seeking ways to connect with a premium consumer in pet specialty and believe that acquisition rationales will increasingly rely on this inherent logic.

Additionally, we are seeing a proliferation of direct-to-consumer models in the pet industry. While ecommerce is the most well known business model for direct sales to consumers, a number of alternative models (flash sales, curated retail, marketplace) have emerged post-recession. During the past twenty-four months, companies promoting these models have begun targeting the pet space.  Notably, Bark & Co. (curated retail), Dog Vacay (marketplace), and A Place for Rover (marketplace), have all raised significant amounts of capital. What these companies, and their backers, are betting on is that as Gen X/Y, demographics that have grown up transacting online, ascend in purchasing power these models will see increasing adoption.

As always, a more complete exploration of these topics and the broader industry are available in my report (post here or email me to request a copy).

/bryan

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DVPYesterday, Del Monte Foods announced that they had entered into a merger agreement with Dick Van Patten’s Natural Balance Pet Foods.  The deal is expected to close in June, no financial information was disclosed. The fact that a transaction involving Natural Balance occurred is no surprise, the form of the transaction, well that is another story.

Some five years ago San Francisco consumer growth equity fund VMG Partners made an investment in Natural Balance, taking a minority position for an undisclosed amount at an undisclosed valuation (you might see a trend here).  The investment made a lot of sense for both sides at the time.  VMG had recently closed their first fund and was quickly able to get their brand associated with one of the leading independent players in the pet industry, a fact that would help them win the the Waggin’ Train deal later that same year.  Natural Balance was seeking to fuel growth and was able to attract the money at a valuation based on future financial performance. On paper, it was a win-win.

Generally speaking, minority investments from institutional equity funds come with a redemption right often set five years from the date of the investment (we see them range from five to seven years, but more heavily weighted towards the lower end of that range).  These rights require the company to repurchase the shares of the investor for the greater of a floor valuation (usually a multiple of invested capital) or fair market value. As a result, a minority investment often is the precursor to a larger financing or sale transaction.

With VMG’s mandatory redemption right looming, Natural Balance began to evaluate the potential for a transaction early in 2013.  While the company had grown nicely during VMG’s tenure as in investor, the San Francisco firm was a small player and had limited influence over strategy and operations.  Since 2007, revenue seemed to move up and to the right (exceeding $200 million), but profitability was elusive.  In contrast to Blue Buffalo, which is twice the size of Natural Balance, and boasts “high teens” operating income margins, Natural Balance was not thought to be highly profitable.  This would become a problem when the company went to market.   To raise sufficient capital to take out VMG (which generally invests +/- $20 million per deal) the company would need to raise a significant chunk of change. Assuming a redemption right at three times invested capital, Natural Balance would have had to raise in excess of $60 million, and likely much more. Equity funds do not write checks of that size in to companies with low levels of profitability at attractive valuations; enter Del Monte.

Del Monte was responsible for establishing the modern valuation paradigm for leading pet food and consumable companies through its acquisitions of Meow Mix and Milk Bone in 2006.  Today, when pet companies talk about being valued at 2.0x – 3.0x revenue, these are the transactions that set that precedent.  However, since that time Del Monte had undergone a transaction of its own, having been purchased by buyout giant KKR in 2010.  Notably, KKR would go on to purchase Pets-At-Home later that same year. While I have no insider knowledge of the purchase price, the acquisition of Natural Balance was unlikely to have taken place at those levels given the lack of profitability and limited competition for the transaction.  Natural Balance did not hire an agent or run an auction.  One of the driving factors for the deal was likely that Del Monte could rapidly expand Natural Balance’s distribution footprint through its Pets-At-Home franchise.

Net net, this appears to be a good pick-up for Del Monte making them an instant player in the natural category and in super premium.   It was able to achieve those objectives without shelling out the $1.5 billion Blue Buffalo has reportedly sought from strategic acquirors.  Opportunity knocked and Del Monte answered.  Expect them to keep the product in the pet specialty channel, as opposed to migrating it to mass a la Natura. VMG wins as well, likely making more than their mandatory redemption due to the valuation that would be associated with Natural Balance in a 100% sale transaction as opposed to another minority financing.

/bryan

Within the capital markets, ecommerce is of the hottest areas for growth and private equity investors.   The favorable bias from the investment community stems from the belief that online vendors can provide consumers a more compelling shopping experience than premises-based alternatives.  More compelling in terms of selection, price, and convenience.   Ecommerce retailers in shoes, books, groceries, diapers, electronics, furniture and a host of other categories are taking a bite out of the pocket book of bricks and mortar retailers.  Further, the first ecommerce generation is growing up and their comfort with the online consumer experience coupled with their growing purchasing power is driving category growth.

That all being said, the pet industry has not been a central participant in ecommerce revolution.  The overarching issue was that 50 pound bags of dog food are not cost effective to ship to consumers.  Therefore a dog owner, who had to seek out a premise-based retail concept for his best friend’s staples was much more likely to satisfy as much of his pet basket through a trusted retailer offering a one-stop-shop environment.  And now you know what Petsmart’s stock price has done so well over the past three years.

In fact, the only pet segment that seems to have benefited from the ecommerce revolution is pet health.  The ability to eschew a vet visit in order to get flea and tick and other remedies enabled 1800-Pet-Meds to go public in 2004.   A number of start-ups attempted to leap into the void.  Most memorably was pets.com, funded in part by Amazon.com, which launched in February 1999.  After considerable success the company jumped the shark with its 2000 Superbowl advertisement.  The company was out of business by the end of the year.   Pet based ecommerce has been rather dormant since then with the pet majors doing just enough to limit the potential for new market entrants — until now.

On July 6. 2011, Amazon.com, through its subsidiary Quidsi, Inc., better known as diapers.com, which was acquired nearly 10 years to the day after the demise of pets.com, launched wag.com, a comprehensive ecommerce portal for all things pet.   As an example, wag.com offers 44 brands of dry dog food, ranging from the mainstream to the obscure.   The site will have over 10,000 products for dogs, cats and a variety of other small companion animals.   Of greatest significance, the site leverages Amazon’s warehouse and distribution capabilities and shipping rates, enabling them to offer free shipping on all orders greater than $49, no exclusions.  Notably, the food I give my dogs is cheaper through wag.com after sales tax than through my pet specialty retailer.  However, I have no intention of switching.

Wag.com is not alone in petstuffonline.com 2.0, one day after wag.com launched, Lightspeed Ventures announced it had invested $10 million in Petflow, LLC, manager of the petflow.com website.  Petflow is in fact the old pets.com.  Petflow raised $5 million in 2010 from Westwood Ventures, and is reportedly moving over 500,000 pounds of petfood a month.  Further, on June 29, 2011 Pet360, an information and ecommerce site for pets raised $18 million from Updata Partners and LLR Partners.  Pet360 operates petfooddirect.com and nationalpetpharmacy.com two of the more established ecommerce players in the pet space.

The winner is this new movement is the consumer, who benefits from more choice and greater access to specialty brands in a high convenience format.  The ability to access all your pet needs online without be burdened by unreasonable shipping costs should give the pet majors some heartburn.   The opportunity to eschew the poor service of a big box retailer as well as save time and travel expenses is also compelling.

The biggest question is can these sites make money.  The vast majority of site traffic, and therefore potential customers, will be driven to these properties through search engine optimization — the buying traffic through Google and friends based on paying for placement of a site when specific key word searches are entered (“pet food delivery” as an example).  As competition increases, so too does the cost of the most attractive key word alternatives.  Major ecommerce sites generally run at EBITDA margins of between 3% – 6%, leaving little room for real profits (Amazon is the gold standard at long term average of 6%).  Notably, CSN Stores, which runs over 200 ecommerce micro-sites (luggage.com, furniture.com, etc.), recently raised $165 million from five equity investors to expand its footprin.  It’s margin profile does not approach that of Amazon’s despite over $350 million in sales.   In short search engine and offline marketing will eat up a healthy percentage of these sites’ margin profile.

Then one must consider the fact that price and loyalty competition is surely to ensue as site and online vs. offline formats compete for market share.    Ecommerce provides customers the ability to get their product of choice at the lowest cost if they choose.  Most sites offer significant concessions to win a customer’s first order, with the hopes of locking them in long term, ideally through an automatic food reordering program.  As an example, you literally cannot buy something off petfooddirect.com without be offered some form of discount.  As product providers begin to assert themselves with respect to minimum advertised price, which enables product vendors to ensure that no one channel has an advantage over the other, these discounts will take a bite directly out of the sites operating margin.

Finally, the shipping dilemma remains a major hurdle.  Surely Amazon has the best logistics infrastructure, but eating the cost on delivery for a 50 pound bag of dog food in a competitive category is not sustainable long term.  These vendors must believe that pet food has enough margin to absorb most of this expense, and that over time they will be able to provide consumers with an increasing percentage of their pet purchasing basket, enabling them to operate profitably.  I suspect it will work for some, but not all.

/bryan

I’ve been witnessing a disturbing trend, all in context, over the past 4 months in the consumer capital raise arena. I call it the “steak sauce” round. A stake sauce round occurs when a company tries to raise an interim round between its Series A and Series B. It’s grown up brother is called the “bomber” round, when a company raises an interim round between its Series B and Series C. These are often marketed as A-1 rounds (“steak sauce”) or B-1 rounds (“bombers”). Collectively we refer to them as “tweener rounds”. That said, I have seen more steak sauce offerings than bombers.

So why are we seeing so many interim rounds. Generally speaking, a majority of these offerings come to bare as a result of a company under performing it’s cash flow projections. Often times, in the interest of preserving value for the existing shareholders, a business is marketed under an aggressive set of projections so as to maximize valuation. It’s hard to ask for more money than your projections require, because it essentially invalidates them to a degree. However, projections are often made in a vacuum and fail to take into account the fluctuation’s that invariably occur when you are subject to economic cycles. All consumer businesses will experience some level of performance degradation in a deteriorating consumer environment. Given today’s economic climate it is not surprising that we are seeing so many steak rounds.

The second underlying cause of a steak round is that first time entrepreneurs underestimate the cost associated with market penetration. Invariably, in a start-up capital deployment is not fully efficient. Additionally, many consumer categories are either highly competitive or require work to educate the market on the value proposition. This takes more dollars than anyone ever anticipates.

Steak rounds are no fun for anyone. No surprise there. Existing management has to market the progress of the company in order to recruit more capital and existing investors must show support (hopefully with deep pockets) in order to incent new money to come into the equation if possible. Often times management must put on a brave face in light of performance that has not met. Further, this is a distraction for management at a critical time as tweener rounds can be protracted exercises, and the company is likely operating in challenging environment, hence the need for the additional capital ahead of plan.

So if you are faced with seeking fries for your steak round, how do you come up perfectly cooked (note I did not say well done)? A few ideas:

1) My first suggestion is to take mitigating action well in advance of tacking institutional capital. That is to focus your strategy on either profitability or defined market penetration. It is more marketable to show traction in one market that it is to show limited traction, but a broad distribution foot print. This is counter intuitive to many, but an ounce of prevention is worth a pound of cure. Of course this might not always be a viable strategy.

2) If you take anything away from my blog, ever, it is that you should not re-open your prior round. Not only is this a weak market signal, but it complicates things later down the road. It’s like getting a tattoo when you are 18; there is a high likelihood that you might regret that very demarcation later in life. Instead go for a convert. Convertible debt at a discount to the next rounds valuation offers the best opportunity to bring in new money due to the protections that it provides.

3) Be realistic, your convert should be at a discount to the next round and offer warrant coverage. Go heavy on the warrant coverage as opposed to the discount. Warrants will dilute everyone when exercised, discounts only dilute those who have invested to date when realized. I often hear from people who take my advice on a convert but do not offer a discount. More often than not those people end up less than enthused with the results of their tweener. Discounts of 10% – 33% are appropriate and warrants of 10% – 20% of the investment are within the acceptable parameters.

Of course, the way out of this mess is to be realistic about your capital plan in the first place. Easier said that done. However, the price of imperfection later is much greater than the value created by creating the price of perfection now. I know there I go again, robbing you of value on behalf of investors.

/bryan

In my previous post I alluded to the importance of keeping your valuation grounded. Let me be very clear, I am not advocating underselling yourself. When I say grounded, what I mean is connected to some rational equation, as opposed to some arbitrary heuristic. Easier said than done, I know, especially for companies that are early in their growth cycle and are experiencing accelerating market traction. Further, young consumer companies often lack known comparables to base a valuation off of.

Valuing a profitable and established operating business, is a more straight forward exercise, as one can rely on precedent transactions analysis, comparable public company analysis, discounted cash flow analysis and inputted IRR calculations. Performing a DCF for an emerging growth business where the terminal value comprises the majority of the valuation is not good fundamental finance. Alternatively, applying transaction or trading multiples to a small base of operating results is not much better. While there is no formula for overcoming these challenges, some heuristics can be helpful in guiding one through the thought process.

Before we get into the point of heuristics, let’s go the opposite direction and talk about some of the most eye popping pre-money valuations that have been reported recently:

– October 24, 2007: Facebook raises $240 million on a $15 billion pre-money valuation;

– January 18, 2008: Slide raises $50 million on a $500 million pre-money valuation;

– March 19, 2008: Federated Media raises $30 million on a $200 million pre-money valuation; and

– April 21, 2008: Ning raises $60 million on a $400 million pre-money valuation.

– May 5, 2008: Meebo raises $25 million on a $200 million pre-money valuation

So what are the common strings. First, several of these companies own dominate or near dominate market positions in the fast growing on-line world where growth rates dwarf those of traditional businesses. Second, a number of these companies were founded by and are run by folks who have created substantial investor wealth in the past. Ning was co-founded by Marc Andreessen of Netscape fame. Slide was founded by Max Levchin, of the PayPal lineage. Third, the Facebook deal was strategically motivated. Some say Microsoft was valuation agnostic, a fact I don’t believe. Finally, most of these companies did not need the money and therefore they could dictate the terms of the investment. The point I am trying to make is that even these absurd valuations could be rationalized given the market positions, growth rate or strategic importance of the transactions. While deals like the above, grab headlines they are far from the norm, but rather the exception.

With that out of the way, we turn to how to derive your own valuation. A good place to start is to understand how others will look at your business. Experience has told me that you can break up a company’s drivers into tangibles and intangibles. Tangibles are things are observable or can be estimated with some degree of accuracy like actual financial performance, addressable market, distribution footprint and profitability levels. For the most part, these factors are observed traits or have corollaries that can be observed based on historical experience. Intangibles relate to observations that are open to more interpretation — quality of management, first mover advantage and brand value. The value ascribed to these factors will vary between potential investors based on their perceptions; tangibles less so. I have summarized my own view of this hierarchy below.

Now that you know what investor will be looking for, you can sketch out a realistic expectation of your pre-money valuation. For a consumer business idea that is raising money on a business plan, I’ve generally seen valuation ranges of up to $5 million for first time CEOs, and up to $20 million for proven management teams on their second go around (think Clairisonic, which was founded by Sonicare (Optiva Corp.) vets David Giuliani and Jack Gallagher – ed note: I have no idea what their pre-money was on any financing) Where a company’s falls in the range between $0 – $5 million or $0 – $20 million should be based on an honest assessment of intangible factors.

For an operating business, one should add a tangible valuation component. Generally, I base this a multiple of historical revenues and forward 12 month revenues. In a capital raise you can sell based on forward run rates. The multiple I rely on is based on precedent transaction and trading multiples where the point in the range I select is based on the tangible business factors that do not show up in the financial results. For example, Sambazon, a producer and marketer of Acai, a so called “super fruit”, based beverages controls the supply of Acai from the Amazon rainforest. This is in marked contrast to its competitors and quality control in the Acai beverage market is very important. Bad Acai is commonplace and leads to a poor customer experience. Based on this thought process, much of which can be observed and verified, I would value Sambazon, if I was doing so, at the higher end of the range. I would tick down similar rationales for all the tangible valuation factors.

Once, you have completed your analysis sum of the parts gets you a good sense of where you should be aiming. All of the above notwithstanding, I encourage company owners to focus on finding the right partner first and valuation second. Communicating a sense of openness on valuation is important even if a healthy debt as to what if fair ensues thereafter.

Happy hunting.

/bryan

Over the past 18 months, I’ve been exposed to a number of emerging consumer brands. There are very interesting companies reinventing traditional consumer services, those putting a new twist on an established space and those that are pioneering new niches. For companies that have a product orientation, we are seeing a new paradigm emerge. Gone are the days where a product could lead and demand would follow. Today it takes real marketing and advertising spend to drive sell through and institutional capital wants hard data that the risk they are taking is distribution risk, not product risk.

Beverage comps are a great example of this. Companies like Tazo Tea, Sobe and Oregon Chai raised minimal institutional capital. Odwall was the exception back in the early days raising $8 million from Catterton Partners. Contrast that to Izze, which raise more than $11 million from the likes of Sherbrooke Capital and Greenmont Capital, FRS, which raised $25 million from Oak Investment Partners and Radar Partners, and Honest Tea, which raised $12 million from Inventages, the investment arm of Nestle S.A. The reason this came to be, is that the money necessary to differentiate yourself from the competition has accelerated exponentially. For example, FRS utilizes Lance Armstrong as a spokesperson. I suspect that’s not cheap.

The problem, as previously alluded to, is that institutional investment funds that focus on consumer products, have been loathe to take product risk. If you ask them their ideal company metrics for a private placement and many of the traditional players will tell you $10 million in capital requirement and $10 million in revenue run rate, if not trailing. Notably, this investment class has been buyout in terms of its orientation. However, few companies can achieve the required growth sans institutional capital given the competitive environment. We call this the Consumer Capital Conundrum.

While well heeled investors in this space are morphing to fill the capital void, Catterton, historically a buyout fund, closed a $300 million growth equity fund in March of 2008. Swander Pace has countered with its “brands of tomorrow” (or future?) program. A number of permutations have ensued, VMG Partners, Encore Consumer Capital, etc. Health and wellness funds have filled this void for appropriately situated companies, as their interest tends to be piqued at between $3 million and $5 million in trailing revenues. That all notwithstanding, if you are a consumer brand whose revenue base is beholden to a national Whole Foods contract, you’re facing an uphill battle on the capital front. On a regular basis my partners and I meet interesting consumer brands with $2 million in trailing revenues who are seeking an agent for their $10 million Series B financing. So how do these companies survive until they are ready for institutional capital?

If my partner Tom Newell were here he would tell you that a sound capital development program starts with a focus on profitability. Let’s assume that you don’t have the luxury of the slow growth plan that Tom would advocate. Survival begins with an emancipated view of capital recruitment. Yes, it would be wonderful to find a handful of deep pocketed angels to see you through, and some do, but in the consumer arena this is a rarity, especially in markets dominated by technology investment. My advice to companies is two fold — a) don’t be above using organized angle groups to recruit capital and b) do not let you valuation get ahead of itself.

When I talk about organized angel groups to entrepreneurs, often times they make a face that one might make if they had opened a skunked bottle of Chateau Margueax. In reality, organized angel groups are providing an effective funding avenue to consumer oriented companies. As an example, Adina World Beat Beverages raised $5 million through the Keiretsu Forum. That’s not pocket change. Consider that angel investors placed $26 billion into companies in 2007 vs. institutional investments of $30 billion. Some say that angels account for another $10 – $20 billion in angel investments outside the organized reporting environment. For example, my wife and I have invested in her business outside of any regulatory reporting environment other than the IRS. Net net there is no shame capitalize your company $50,000 at a time. Keiretsu Forum, Alliance of Angels and others are delivering real value for companies by connecting them to angel investors without forcing them into an endless string of one-on-ones.

The second piece of advice to consumer companies I can convey is keep your valuation reasonable. Let me be clear, I am not saying bend to the whim of investors or agents. What I am saying is keep your valuations grounded in tangible business results. A large pre-money valuation on a de minimis revenue base only constrains capital recruitment. It might make your early money feel good about your progress to have an every increasing valuation on their incremental capital contributions, but it is only going to create a headache later when valuation is leveled by an institutional investor. A rule of thumb is don’t let you valuation exceed 3.0x revenue plus intangible value (brand value). I haven’t seen a situation where intangible value had exceed $10 million prior to $5 million in revenues, that’s not to say it can’t happen (see FRS). Net net, I ask that you simply bring realism into the equation.

Long short the consumer capital continuum looks as follows:

> Product Risk > Sub $3 million in revenues > Angels and angel groups

> Early Distribution Risk > Sub $5 million in revenues > Local VCs/small consumer capital/local VCs

> Distribution risk > $10 million revenue run rate > Mainstream consumer capital

/bryan