Not all brands are destined to be unicorns: those that achieve hockey stick growth and exit on a bombastic note. More likely than not, you’re going to have more success being a tardigrade brand which, like its slow, bottom-feeding namesake, is a master of resilience and efficiency. Tardigrades are wildly successful organisms while unicorns basically exist only in the imagination, and there is a good reason for that. Tardigrade businesses focus on resilience, capital efficiency and nimbleness instead of constantly chasing around for big game. They focus on building a business with solid fundamentals, unit economics, and a path to profitability that creates a positive EBITDA and positive cashflow. They may not be as fast as the unicorns, but their path to growth is pretty much carved out for them. Elliot Begoun brings in two data experts to put substance to support this thesis: Nick McCoy from Whipstitch Capital and Chris Fenster from Propeller Industries.

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Tardigrades Versus Unicorns: The Less Celebrated Path To Brand Success With Chris Fenster And Nick McCoy

For those who are readers of the content that I put out regularly, you all know that I want to make founders aware that there’s more than one path to success in this industry. That while the industry as a whole celebrates the unicorn, that quick, meteoric brand that hits the hockey stick trajectory and sells for some crazy multiple of revenue, that is not the only path. Those outcomes are rare. They’re not the norm. There is another way to build a business and that starts with being focused on being nimble, capital-efficient, resilient. It’s building a business with solid fundamentals, unit economics, and a path to profitability that creates a positive EBITDA and positive cashflow. What I wanted to do is I brought two people here with me who are much smarter than I am, which doesn’t take much, but I am better looking. I wanted to take this away from opinion and start using facts and some data to support this thesis. Without going on further, I’m going to introduce my two guests. First, Nick McCoy from Whipstitch Capital, and then Chris Fenster with Propeller Industries. Nick, why don’t you introduce yourself and share a bit about your background?

I’m Nick McCoy, Cofounder of Whipstitch Capital. What we do is we work with companies in raising capital, usually $10 million or more, or selling. We also do some work on the buy-side for strategics looking to invest in or buy companies as well. The reason why I’m here talking to this is obvious that we do help companies exit. We know a lot about what gets them there and the format that Elliot is talking about. Also, we spend a tremendous amount of time looking into a company’s data and figuring out what makes a brand work so that we can figure out how to illustrate to the buyer or investor where the value is and the company getting the most interest that way, and also getting the most value. We only succeed in our business when our clients succeed. We spend a lot of time making sure that we do that as best we can.

Thanks, Nick. I’m going to then pass it over to Chris.

Thanks, Elliot. I’m happy to be here. I’m Chris Fenster, the Founder of Propeller Industries. We’re a finance and accounting partner for venture stage companies. What that means is we start working with them around the time they raised their first outside institutional capital and we support them through all their finance and accounting needs 3 to 5 years until they can start to bring roles in-house. We’re working with about 300 companies who have raised nearly $2 billion in outside capital. Within the CPG space, we’re working with about 100 and we’ve got some alumni that have gone from single-digit millions in revenue to $100 million exits or more, including firms like Krave, Sir Kensington’s, and Chameleon Cold-Brew. We’ve also worked with a bunch of direct to consumer brands, companies like Casper and Away and Hims starting at a similar threshold when they were below $20 million in revenue.

All three of those firms that I mentioned are now or at least were at one point $1 billion valuations. I’m here because we have a behind the scenes purview into everything about these brands. How they’re capitalized, how they’re hiring, what’s happening in their customer acquisition costs and their spending? We see the impact of the capital that they raise on the decisions that the founders are making over time. There’s a narrative that you hear about in the media and then there’s what’s going on behind the scenes. Hopefully, we can talk about some of that.

Let me start with this question. In broad generalities, I mentioned that narrative which is the unicorn, but I’ll start with you, Nick. Give a sense of what has changed not since the outbreak of COVID, but in general. What has changed in the M&A space in this industry and any insights that you would want to share with the readers?

If I think back, I first started going to expos. I think about the size of the industry then. The industry was much smaller and better for your brands, even the ones that were getting bought by large strategics were also much smaller. As the industry has grown, the number of larger brands available for purchase has gone up and the relevance to the brands in our industry to being mainstream and mainstream customers, because they’ve gotten so much bigger, has also gone up. Larger strategics, the big CPGs that buy the unicorns, as Elliot elegantly puts it, they’re set up for multi $100 million brands. They’ve got brand managers that want to manage bigger brands because they get more resources and more ways that they can advertise them.

That’s how their machine is oiled and they’re good at it. They’re good at finding every pocket of demand that you can find for a brand to get market share. There are only many of those big strategics and there are lots and lots of other companies. That creates an opportunity when the bigger strategics are waiting to buy bigger companies for new exits and some things that have felt that private equity. It was probably one of the first in the last 3 or 4 years. We’ve seen private equity firms that historically were precluded from buying in this industry because we didn’t have a lot of EBITDA and brands before they got bought. Now, suddenly brands are getting big enough that they can get profitable and they’re getting the attention of these buyers.

Some of these buyers are also recognizing that the industry offers more growth than the more stable industries that they focus on manufacturing and things like that. They’re modifying their criteria. They don’t just buy off an EBITDA multiple, they’re also considering the growth in addition to the fact that the company is profitable. Between all that, that’s great, quickly increased the size of the buyer base by offering options for up to 100% purchase there. We’ve also had specs and this is something that’s new in the last year for our industry. It’s been big in tech and healthcare, it’s SPAC, short for Special Purpose Acquisition Company.

What it is it’s a shell company that somebody who sponsors that, who has usually got a playbook in the industry, they put some of their money in and they do an IPO and they have a pool of cash that’s sitting in a company for one transaction. They do that transaction and that’s usually a $100 million revenue company or higher that’s usually more mature with a higher EBITDA margin. They look for add-on deals because SPACs need add-ons. They need to be able to buy more EBITDA to make that model work. There have been probably 5 or 10 that have gone out in the last year and they’re all hungry right now in the M&A market and being aggressive. That’s another leg on the stool of buyers and I’ll stop there and let Chris chime in a bit.

Chris, same question for you. First, a broad brush on what you’re seeing that’s changing or evolving in this space.

COVID as an accelerant is a narrative that is coming up almost every day. The challenges that we’ve seen probably unprecedented historically, but I think a lot of brands have been forced to grow faster, not necessarily through revenue, but to learn faster or adapt faster. We’re seeing a lot of changes in the way that founders are thinking about scale. In addition to COVID, we’ve seen several companies either exit or IPO. I’m thinking about Casper here, which IPO did a valuation. Their market cap now is about a third of what their last private valuation was years ago. Anybody that funded their direct to consumer brand, making similar assumptions that Casper did is probably looking at that and saying, “Now, what do we do?”

There’s an increasing awareness that valuations might make sense for a venture stage. Direct to consumer business might not make sense for a more mature multichannel business that is maybe 50% direct to consumer and probably not getting that much bigger. Where most of their growth starts coming from conventional bricks and mortar retail. Your valuation should start to look like a conventional brick and mortar retailer. The COVID element certainly created a tailwind around eCommerce and we saw a ton of CPG companies step up and accelerate their progress from traditional bricks and mortar to direct to consumer. That’s been fantastic for a bunch of them. There are a bunch of firms that had big pops in March and April and saw huge gains in their eCommerce businesses.

Some of those have sustained. Some of those have pulled back a bit, but in every case, the companies are healthier now in most cases than they were pre-COVID. In some cases, they’ll raise a bit of extra money, maybe go back to an old valuation to be safe, see if you can get a little more cash from your current investors, but pull back expenses to try to link their runways where they’ve gotten traction from the direct consumer business. The companies are fundamentally healthier. They’ve got a longer runway and a lot of founders are rethinking their reliance on outside capital now. COVID as an accelerant, some awareness that markets were not validating some of the valuations that we’d seen in a later-stage venture.

Lately, we saw Hershey divest themselves of Krave and we see Coke essentially shutting down ZICO. I don’t know what the appetite is there for big strategies. They’re gun-shy. They’re going to be careful. Founders should be thinking differently about creating fundamentally healthier businesses earlier in the growth cycle. Totally get that you’ve got to burn a bunch of cash for the first couple of years to get something out of the gate. That still makes sense for a lot of venture stage companies, but this idea that you can do that for the long-term, that you can take a company public with a massive burn rate. You shouldn’t be assuming that anymore.

I don’t know that we should have ever been assuming that because the reality is, we’ve all seen this, and we can point to countless examples. We can think of many that have had those big exits, but for every one of those big exits, there have been hundreds that have been caught out in that Valley of Death where they’ve raised a bunch of capital that have propelled them so far, but then that burn and that reality confronted them. They weren’t able then to secure that next big raise of capital or they were suffering a down round. They found themselves languishing out there with no prospects to either go forward or retreat. One of the things that I’ve been talking a lot about and somewhat tongue-in-cheek, but at some, it’s taken on a bit of a life of its own was, I wanted the antithesis. A mascot that represented the other path.

We found the tardigrade, which is this incredibly resilient pioneer of new ecosystems. It can live in the depths of the ocean. There was an article, an Israeli scientific probe crashed on the moon and spilled a bunch of them there and they’ll be able to survive. They’re resilient and efficient and so forth. I’m calling them the tardigrade brands. These are brands that are building businesses to what you said. Chris was on good fundamentals, fundamentally good businesses with maybe they’re not profitable now. Maybe they’re not profitable for the first couple of years, but they have a clear path to profitability. They know where that’s going to come from. They know when it’s going to happen. Nick, I’m going to start here with you. Let’s talk about data. You guys are both lovingly data geeks. Nick, what is the data telling you about what’s transpiring in the business in terms of those companies that are focused on what we’re talking about, that resilience and capital efficiency and nimbleness?

On the M&A side, we are seeing more and more of the transactions be almost what I call EBITDA-based or selling off of a profit stream. Whereas I think the classic unicorn purchase was more of a revenue-based deal. The EBITDA multiples are outsized compared to traditional multiples that you would see in manufacturing and other slow-growth industries, reflecting the growth and the potential of the brands. Another thing that we see here too is if you’re building your business as a fundamentally good business and you’re growing profitably over time, it might be a bit slower, you’re also raising less capital. When we see these M&A things happen, the owners own a much larger chunk of the business than they would in the unicorn scenario.

In many cases, that means that at the end of the day you end up in about the same place. The other thing too is if you have that stream of EBITDA, specifically if you have $10 million or more of EBITDA, your chances of getting a successful exit at that point in time, if you’re willing to accept private equity is north of 80%. I would never tell anybody they have a chance above 80% as it will, but I would say it shows you can get in today’s market. Whereas, even the best unicorn business with $150 million or $200 million in revenue isn’t necessarily going to find a buyer because there are not that many buyers.

Chris, let’s talk about fundamentals. In looking at the data, looking at the brands that have success, survive or have an exit or maybe even don’t, maybe continue to operate as profitable wealth-building engines for their founders, what do you see as the key fundamentals to that?

Capital efficiency has probably been the one that jumps out at me most for the last couple of years. That was partly a function of what we saw. I’m thinking specifically about the CPG space here where the highest-performing companies in terms of revenue growth were the most highly-capitalized companies. We did a whole analysis on our client base and have continued to update that over the last couple of years. One of those things that we found is that within this CPG category, companies fell into a couple of different buckets. When we looked at performance to get to $20 million in revenue and analyze that data, what we found on average was not indicative of what was happening in the client base. We went into the data and we looked at how companies were performing at $2 million, $6 million, $12 million, and $20 million in revenue. How much capital it took them to get there, what their margins were, how much they were spending on trade spending.

When we looked at the averages across the whole client base, the numbers didn’t make sense. They didn’t correlate to specific companies. When we took a deeper dive into the data, we discovered that our brands shook out into two distinct cohorts. There was a group of highly capitalized brands that burned $1 in equity for $1 in revenue. You want to get to $20 million, it’s going to take $20 million to get the $20 million revenue run rate. At the other end of the spectrum, there was another cluster of companies that raised about $5 million to get to $20 million. It turned out that there were few companies that were average companies either raised a lot or they raised a little.

The interesting thing was that the bigger exits came from companies that raised a lot, that was the playbook for a while. The efficient companies were much less well known, but to Nick’s point, all things being equal, raising $5 million to get to $20 million versus raising $20 million to get the $20 million has different meanings in terms of your dilution and the percentage of the company that you own. You’re in a lot more the company. Even if you don’t get the same number of exit or the same multiple exits, you could well wind up making more money. Part of what we learned there is that I feel we fetishize the founders that raise all the money and have the big brands.

It draws a lot of tension and new founders will aspire to do what the founders that we perceive as being successful have done. There’s an alternative playbook here. There’s a capital efficiency playbook in here. It’s not rocket science. It’s obvious. You can build the business the way that people have been building businesses for 100 years. Don’t overspend, you’re going to grow more slowly. You’re not going to be able to move as quickly, but you can certainly be a lot healthier. That’s been the biggest takeaway from the data.

It’s counterintuitive to what a lot of founders are told. A lot of founders are told that first of all, they have to build distribution and prove traction quickly and be able to demonstrate that hockey stick growth to get venture capital money. The other thing that is somewhat true in this industry, there’s some incestuousness in this industry. One of the ways that materialize is on who’s on the cap table. When you win investment from certain funds or certain super Angels or so forth, that’s a validator and starts putting you on that hamster wheel of raising. That’s the question that’s asked here is that money begets money. If you’re not chasing what is prototypical, how do you make sure that you still fund your business? I’ll throw that to you first, Nick.

There are funds that have a DNA where the investors are good at throwing $10 million a year behind a brand and getting the most economically possible velocity growth and doing that year after year, building a unicorn. There are other investors that have a DNA that is much more what Elliot is saying. It’s investing more, one check, spending it over 2 or 3 years. There may not be a need for another check, holding price point up, getting a higher gross margin, being a bit more methodical timewise about expansion into other subcategories. Not rushing to keep that first-mover advantage if there is one. Whichever path you choose and any path you choose, you always want to line up your vision with your investor’s DNA. You want somebody with a playbook that’s going to be serving your company perfectly the way that you envision it.

Not everything goes smoothly and things are going to change. Whoever is closest to your vision is going to be able to morph with you but if somebody is here and you’re there and things get a bit bumpy, it’s difficult to come together sometimes. That’s where we see the company relationships get frayed. I do think with lower check sizes, then that also means that you’re probably not going to be doing the $10 million-plus check in many cases. There are a lot of people who have now exited entrepreneurs or professional board members, super Angels in the industry who do have a lot of knowledge and have a lot of connections and make great board members and can write checks of $500,000 or $1 million or $1.5 million. Through them and other connections, sometimes it’s the general partners themselves at a private equity firm or their friends that might command and these things built. That validation of a certain person is great, but it’s not necessarily great to get the big check. It’s also rarely good to fill around that Series A too.

The other thing too is that as a founder, you need to understand fund economics and you need to understand what you’re signing up for. Depending on who you’re asking for money from, they have a thesis and they have economics that they need to achieve. You need to make sure those economics are aligned with what your economics are and what your wants are. If they’re not, you need to have that discussion before there’s money wired. Chris, a question here from Dan. It’s all given to you both. One is you look at that data across those two subsets of brands, those that raised little or those raised a lot. Is there a gross profit percentage and a trade spend percentage that is normalized or is seen between the two or different between the two?

We expected to see differences in both of those numbers. Product gross margin is product revenue minus the product costs. This is before trade spending. The product gross margins were identical in both cohorts. Trade spending was a lot different and it changed a bit over time. Even trade spending, we can break down between slotting and trade spending and everything else. The product gross profit margins at $20 million for both cohorts were around 43%. The trade spending for the highly capitalized cohort was closer to, all in, it was 16%, maybe 15%. The slotting in that highly capitalized cohort was 9% or 10%. All in, they were buying revenue. That is what they were doing. Slotting in a smaller cohort was 2%. Right there, there’s a 7% difference between the highly capitalized companies and the less capitalized businesses. The highly efficient companies were closer to 11% in trade spending, maybe 5% lower there. It’s a huge difference.

That’s one of the things I talk about all the time is understanding what your contribution margin is. There are many brands, especially in your first few years where if you look at your contribution margin on a transaction by transaction or account by account or even channel by channel, you’re at a negative contribution margin. It means that every product that you sell is an investment. If you thought of it that way, instead of growth, instead of revenue and said, “I’m investing in this region of whole foods, or I’m investing in this conventional grocer.” The question that you would ask yourself then in return is, “Am I going to get that return? Am I going to show an ROI for that investment and what is it?” Otherwise, you say no. Nick, a question from Matt Perry was about the EBITDA multiples that you see out there. What do those look like?

To frame it, I would say if you are a private label company with a concentrated customer base, and you had $10 million of EBITDA, to set a baseline probably around 6x. What we’re seeing is brands that are fairly mature and not growing, they are truly mature and they’re larger and they’re flat. Those are probably more 10x to 12x for a similar size range. Once you layer growth in there, then it can go up. I’ve seen things 16x, 18x as well. One thing you have to remember is when a brand gets larger, particularly brands that have a lot of headroom in them and brands that have been around for a few years and have done a good job marketing is that they build brand equity.

When you think about the value of a brand, even if it’s starting to get toward that slowly mature stage, there’s a fundamental value, which is X times EBITDA. I would refer to it as a real estate premium that comes on top of that because there is only one of the brands that you have. If you’re a leader in a sector, which is a new emerging sector, or in a white space that is growing a sector, you’re the only brand doing it. It’s not easy for another brand to come in and copy what you’re doing because they don’t have your brand and that’s worth a premium. In some cases, it could be small, but in other cases, we’ve seen things where I would argue that the brand premium could be as much as 50% or 60%.

What I want founders to understand is that when you build a business with good, strong fundamentals, and you have a clear path to profitability, or you are profitable, and you can be discerning about the capital that you take in or use that capital for growth. What you create for yourself as choices. There’s nothing more powerful as a founder than to have choices in what direction you take your business. In many cases, what founders wind up doing is signing up for somebody else to make those choices for them there. They hitch behind the horse that’s going in a certain direction and that’s the direction they’re going to go whether that’s what they want or not. It’s important to me for founders to understand that. Good fundamentals, good businesses, the path to profitability, provide choices and choices are more powerful than when you don’t have them. Chris, another question that came into was what are you seeing in the data around team size or percentage of spend on SG&A?

There were big differences too there, in the data. It’s hard, especially for smaller companies to break that information out. A lot of times they combine all their payroll into one bucket so you can look at the total spend, but it’s harder to break out the sales and marketing spend. One thing that was interesting in the data is that the more efficient companies were spending a lot less on trade spending. Above the line, deductions, customer controllable expenses, they’re spending more on sales teams. It was consistent across the dataset. It was the one area where the more efficient companies were spending more as a percentage of revenue than the less capital efficient businesses. Big variances, in general, for total spending, this is hard to break out the payroll specific data, but I can tell you that at $20 million, total SG&A expenses were 35% in the efficient businesses and 61% in the inefficient businesses. A lot of that was in payroll.

Elliot, you brought this up and I think it’s critical. Much of this comes back to the founder’s selection of partners in their investors. Are you picking venture investors? Are you picking PE investors? Are you picking a large fund that has an incentive to write big checks? They almost can’t afford to write small checks and they’re going to follow a certain playbook that tends to be more capital intensive. Are you finding an investor who’s going to be thrilled to give you a check for $1 million and then never write another check? Is that okay? With the $1 million, do they need to put more money into the business in order to make their fund economics work? You’ve got to remember that the founder is not the customer of the investor.

The LP is the customer, founders are inventory to investors. We’re close with a lot of investors. That’s not disparaging, it’s how it is. Those of us who have raised capital, buy low, sell high. That is how it works. Good funds know that they have to do right by the founders that were critical stakeholders for them. You work hard to raise that money that when somebody offers you a term sheet, most founders especially if they haven’t done it before, are not thinking qualitatively about whether the investors’ interests are aligned with their interests. It’s one thing for an investor that’s been doing this for a long time and has a huge balance sheet. It’s something else for an early-stage founder that hasn’t had an exit yet. It’s easy to see those incentives become misaligned over time and it happens all the time.

This is a cool question. I’m going to double down on you, Chris, before we go back to Nick. This is about looking at the differences between those two cohorts. Is there a difference in channel focus or channel blend between the two?

That was the first place that we went when we saw the difference. The highly efficient businesses had 2 to 3 times as much revenue coming from online. That explains the lower percentage of trade spending that you see and you would expect it to show relatively higher margins. It doesn’t seem it was doing that at least in the cohort that we were looking at across the life cycle. That was a bigger part of the capital efficiency and probably a somewhat higher part of the sales spending.

This one’s mine. What about alternative channels? Foodservice, corporate campuses, unique locations. Do you see a blend of that too between one cohort or the other?

We couldn’t find anything that was statistically significant in the data for that. Our founders would tell you that food service tends to be good for trial. You’re not spending a bunch on trade spending, you might have slightly lower margins to create some incremental incentive, but knowing that a customer is going to try your product at a restaurant somewhere else, and then, hopefully, buy it, it’s an efficient way to acquire customers. We saw that in a couple of clients, Sir Kensington’s did a great job of that. They had a great foodservice channel. They made efficient use of it. They learned a lot by serving that business.

One distinction is that branded food service is much better if you can do it. For some companies that might mean branding on a menu, if your product is an ingredient in something they use as well.

You’ll probably have some thoughts on this too, Elliot, but let’s differentiate that from white labeling product for Trader Joe’s. The only thing you’re getting there, you’re going to get squeezed for margin. The only thing you might get there is some supply chain efficiency. If you’re doubling the size of all your orders, maybe you’re paying a couple of points less for products that you’re selling into other channels. We’ve seen a lot of brands jump at that because it drives the revenue numbers, but the margins are lower and there are some risks selling into channels like that.

On channels like that, whatever that first price is, is the best price you’ll ever see in that relationship because there’s nowhere to go but down. To Nick’s point, you mentioned program or building brand in food services, something that can be done even if you’re a back of the house item. We talk about this a lot that a key to all of this and the key to being able to be capital efficient where most brands spend the most money. The data that Chris was referring to around trade spend and the difference between the two is trying to drive discovery and trial. One of the reasons for that is that oftentimes depending on the product or the category that you’re in, and this is going to be a question as well that I’m looking at here for you, Nick. Retail is the worst place to drive discovery or trial.

It’s not where the problem that you’re solving is pronounced. It’s not where the unmet need is acute. If you can find outlets and places for that to drive trial like foodservice, corporate campuses, travel when the world opens back up, colleges and universities. Places that may be closer to both that problem or that need state. You can do it much more efficiently and then use retail what it’s best for which is replenishment. Nick, there’s a question here from Sarah. Are there category differences in both exit multiples and what you’re seeing in terms of businesses that reach that point of exit or acquisition? I think you could speak to both and that is, does it also matter about where you fall in that category? Are you a challenger? Are you the category creator? Are you a 3rd or 4th tier or a member of that category?

There is. The largest factor that determines multiple and category is the frequency of consumption. If you think about snacks and beverages, they’re always tagged with high multiples. Those are things that you can eat before you get home from the convenience store. They also lend themselves to incrementality in a convenience store or other purchases. It’s not the replenishment in grocery, there’s the other usage engagement of single-serve. You can have a single-serve pancake mix. You’re not going to sit there with a spoon driving your car and eating that, for example. I think that’s probably the number one. The multiples in categories are honestly moving around by the amount of white space there.

Frozen meals, for instance, it’s gotten a big COVID bump, but years ago, frozen was something that everybody avoided. You’re “crazy” if you’re going to start a company in frozen. Now it’s more and more attractive. We’re starting to see multiples rise there. To your question, are you growing the category? That is what I think is the most interesting, if you can show that your white space within a category is incremental in the category and back that will not only sell-through data but panel data as well, which is showing where people are switching from to buy you. If you’re growing a category, that opens up a lot of doors for you with big companies. Categories are fixed and not growing, it is a market share war, but once you start incrementally growing it, then that brand management machine can go to work.

That also means your direct to consumer business is not fighting against the retail business. Your direct to consumer business becomes incremental to the category. In itself gets that much more valuable and we see more interest in big CPGs and DTC because of that. They’re viewing those niches now as things that are growing a category that they’re already in and so that channel is more and more interesting and it’s not what some have you classically as the channel, which is fragile and founder-dependent because the founder is a type of social media and if something ever happened, then all of a sudden the sales vaporize. It’s more and more a necessary channel.

Products and brands that are our category of creative, day part of creative or use case of creative, it’s super important to ask that because you’re delivering growth to not only your consumer but to your customer potentially. That’s ultimately what they want and so forth. Chris, a question here for you is to talk about the brands that have made it to $20 million, those that are highly capitalized, and those less. What does the data show about the brands that have failed? Is there any commonality, the brands that don’t get there or find themselves out in that Valley of Death and have to wave the white flag?

We have a lot of data on what’s working and what’s not working. It’s harder to find patterns in the failures, at least that we’ve seen from a client base so far. There are many different things that can go wrong. Everything from founder drama, over-funding, underfunding. We always talk about underfunding as a source of company mortality. I think over-funding is a source of mortality as well. We saw a couple of well-known direct to consumer brands get completely sideways over the summer and too much capital too soon, it’s like over-watering a plant or something. It can kill it, it sets you up to become dependent on it and you don’t develop healthy habits.

It’s not that complicated, too much can be bad. Margin structure is another one, the supply chain is challenging especially for smaller companies. You see all these pitch decks that are based on hopes and dreams and you can see gross profit margin assumptions going up by 3 to 5 points every year for five years. It doesn’t happen that way, but I think the biggest piece of it is going into your plan with unreasonable expectations. In particular, under hiring, waiting too long to find the key roles and people are such a critical element of this, you can find companies that get sideways and realize that they haven’t made a good decision and act quickly and decisively to address it. There are other companies that wait or it’s a hard conversation and people don’t want to have hard conversations, they don’t, and they wait too long. By the time they do have the hard conversation, it’s too late. It’s too close to the edge and if you don’t have a deep-pocketed investor that’s got some skin in the game through probably not somebody that’s going to step up and write you a check to give you one more shot.

One of the points you made, I want to go further on it because that concept of many times founders are heads down. They’re so heads down in their business, focusing on the moment. What they don’t see are the cliffs and what they find, they realize them after their toes are dangling over the edge. That’s usually too late to make a good decision for your business. You’re making an urgent decision for your business, which rarely is the best decision for your business. Anecdotally, when I look at it, brands that don’t grow for the sake of growth but grow only after they’ve proven that they have a model that they can repeat and grow and consistently separate consumers from their cash. They are always taking enough time to look up and look forward to trying to identify when those walls or cliffs are coming so that they can be proactive about planning instead of reactive.

I don’t have data other than 30 years of amassed experience in doing this shit, but the data would probably support that hypothesis. Nick, a question for you, I’ll let either of you jump in on this, but I’m going to direct it to you first. Often in order to win any investment especially for earlier stage brands, this founder says, “We have to prove consistent ACV growth, philosophy growth. They’re rarely asking us about profitability or EBITDA. They’re asking us about our velocity and our distribution growth. What do we do? How do I change that conversation?”

The ACV and distribution and velocity is important. If you’re proving out natural as a channel, you need to show that you’ve got a certain velocity and that you’re able to get to a certain ACV and you can validate that with your own data and also what other brands have achieved in that channel. You can say, “I’m in salty snacks and I’m in conventional and I look at whatever late July or something that’s big and better for you, they’ve got 8.2 SKUs and they’re at 60 ACV. It’s reasonable that I can get six SKUs and 50. You can focus the future conversation on those validators. That is important. The profitability one though comes back to gross margin at the end of the day because no matter what, no matter which path you take, your gross margin is your potential profitability.

If you’re in the growth unicorn path, then the more gross margin you have, the more that you have internally to spend on marketing and other things that are going to grow revenue. It also means, if you’re running a 43 margin, what Chris was saying before and your SG&A is at scale 20% to 25%. You know that you can get to something close to a 20% EBITDA margin. Directing to that gross margin number, and then to Elliot’s point, your gross margin will go up over time, but it’s important to look deep in your model and what the assumptions are behind that. You can’t say, “I’m going to double my revenue so I’m going to get ten points.” First look at freight. Freight is usually the first thing that people save with scale.

Warehousing and inventory, that’s also a good place, although they’re smaller numbers and these are things that by the way are outside of gross margin but incremental. I throw them in there. Packaging is usually another one. I’ve seen a lot of version one packages, the ten colors and customs caps and things like that. All of a sudden version two is third the price. When you get some of that stuff out of there and then usually totaling is next and that, by the way from self-manufacturer there is going to be your overhead. How much is your overhead on it? If you’re self-manufacturing and you’re not seasonal, 80% to 85% capacity utilization is usually about as good as your margin gets. Above that, you start running into production bumps and overtime and things like that. Below that, you’re not spreading your overhead efficiently. If you’re seasonal, it could be as low as 60%, depending on how you hold inventory and what business you’re in and ingredients is usually last. Especially if you have one ingredient that dominates your stack and it tends to be more commodity and that’s when it’s tough to save without something that compromises on quality.

The other thing I will tell you is that one of the mistakes and one of the things that I see so often in pro formas and I prefer everyone to call them growth hypotheses because that’s what they are. They’re your best hypothesis of where that growth can come is that margin improvement with scale because there is another competing force that happens with scale. As you begin to expand into conventional and other outlets and that’s price compression, as you build ubiquity, as you become not the new person and not the end brand, but something that’s more common, there’s usually priced depression. Consistently I see the end of the day margin staying the same, maybe COGS have gone down, but so has wholesale price and retail. It’s at a similar rate sometimes more so it’s a nebulous, narrow way to forecast profitability simply on economies of scale because you have to build in at least some belief that there’s going to be price compression over time. This is a cool question from Justin and that is, how can you guys use this data to educate investors that there is a different path? I’ll add whoever wants to jump in on that one, go for it.

There is another way to build companies. We founders come to look at venture as the end-all, be-all, if I need money, it’s either crowdfunding or friends and family or venture. If you’re below $10 million in revenue, it might be a PE fund but it’s essentially a venture investment. It’s a super high-risk investment. It’s going to fall into venture economics. I don’t know that educating a venture investor who has venture LPs and a venture fund helps solve the problem. I think venture LPs know most of this. The challenge is that if you expect 75% of your portfolio to return something less than 1x what you put into it, the 25% has got to pay for the rest.

It creates this incentive to take risks. You’ve got to find the firms that you think can generate a 10x or a 20x or a 50x outcome and you’ve got to shovel capital into those businesses to essentially try to get them to make up for the dogs in the portfolio, if we’re being brutal about it. I don’t know that it’s necessarily an education issue. The question is, what are the other sources of capital? How can we change the narrative or empower founders to understand what the trade-offs are, the risk-reward trade-offs are? When you get a company, let’s say it should take $1 million to get to $3 million and it should take $2 million to get the $10 million if we’re looking at the track record of the capital-efficient brands. You’ve got to have some amount of permanent capital in a manufacturing business. In a working capital-intensive business, you have to have some amount of permanent capital.

Permanent capital means equity. Maybe you need more than that. Maybe we can start using debt earlier or revenue-based financing earlier. There is probably a cohort of investors that can be optimized for investing in brands like that. Particularly if brands are taking advantage of direct to consumer channels to get from 0 to 2 or 0 to 3, that is a more efficient way to get to $3 million, way more capital efficient to get to $3 million in revenue than selling through wholesale and trade spending and we see more and more companies do that for sure.

Nick, I’m going to pass this to you too, to get some feedback. One thing to add to that is when I mentioned before about creating founder choice, that’s another reason for it because if you can create choice if you build a business, then one of the choices you can make is where you source capital and the type of capital that you source. If you build a business that is healthy then you have better access to debt. Over the long-term debt is going to be a lot less expensive from a capital perspective than equity. Oftentimes, founders don’t see that, don’t know that, don’t know that they can build towards that and then begin to have access to it. I’m going to ask you both, but I want to give Nick first the opportunity to respond to this question about educating investors. As a whole, I want to come back and ask if either of you, any data points on those companies have been successful with those two different cohorts as to their use of debt. First, Nick, a bit about what you would advise on educating investors.

It’s hard to override DNA. Investors have a playbook and they have for years and years develop the expertise behind that. The knowledge base is a lot more in-depth than you might think so if there’s an investor that’s good at building velocity and growing a brand that is going to be a $100 million-plus brand and that’s how they’ve made their money and that’s their playbook. It’s difficult for them to change their business model, to morph it to grow profitably model. It’s not they can’t do it. It’s some people are good at some things, and some people are good at others. I do know one of those investors who had a portfolio company that didn’t grow as fast as they wanted and it had about a 20% negative EBITDA margin. They turned it around and made it profitable to the tune of about plus 10% EBITDA and successfully sold it earlier in 2020.

That was through a number of things like SKU rationalization and making sure the SKUs that were selling through the most were the ones that were in stores and doing trade spend in a more efficient manner, less depth of trade and more frequent trade. All those things that you might do to grow more profitably. The skillsets are there. It’s a question of what if they sold their LPs? What is their objective? What are they good at?

The last question is, I’ll give it to you first, Nick, so you can hop off if need be, any parting thoughts to leave with the founders reading?

I love asset-backed debt, receivables and inventory, because by the nature of it, the fact that you have those assets and they’re going to get liquid, you can pay it back. Debt for companies that have a big burn and are using debt when equity should be used frequently leads to trouble because you end up blowing covenants on the debt and getting into an adverse relationship with your lenders, because they have a short-term relationship mindset and you have a long-term. When you get in trouble, those two things can conflict with each other and it can ruin companies. I like debt when you know you can pay it back and asset back, you always know that. If you’ve got good EBITDA, if you’re $5 million or more on EBITDA, you can weather some bumps. A turn or two of EBITDA and cashflow debt is conservative too.

Nick, any last thoughts in general before you jump off? Is that your parting thinking?

I’ll make that my parting thinking. Thank you, Elliot. This is great.

Thank you. Chris, any last feedback for those reading?

Losses should be funded with equity and working capital growth can be funded with debt and that’s how we do it. You’re going to lose money for two years, almost all that money is going to have to come from equity or convertible notes. As your receivables grow, as your inventory grows, you should be able to funnel a lot of that fund. In some cases, all of it. With debt, asset-based lending, receivables financing, there are a lot more options now than there were years ago. Almost all of our companies with high working capital needs are taking advantage of it.

Bringing us home, all the data that you see, everything there. If you were going to leave the founders reading with any thought or any parting advice, what would that be?

Stay lean. It’s this whole notion that we’re glamorizing fundraising, is glamorizing dilution and you’re giving up your flexibility to build a great business and hold it for a long time. For some founders, they choose that path and it’s the right path for them. I think there are a lot of people that choose that path without realizing that they have chosen it.

Thanks for joining, Chris, and thanks to Nick who had to jump off and a shout out to Lauryn from Mother-in-Law’s Kimchi. I appreciate everyone joining and hopefully this information and this conversation makes you rethink or at least consider that there is more than one way to build a successful CPG brand in the natural product space. Thanks for joining and we’ll see you next time.

Important Links

• Whipstitch Capital

• Propeller Industries

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