Innocent Smoothies Case PDF

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Summary

Case of Venture and Capital Structure,When it comes to weight, weighing WACC by market value is preferable to book value.
The rationale is that utilising book value, such as the amount on financial statements, is
regarded backward looking, but WACC is typically employed in a future looki...

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9- 8 0 5 - 031 NO VEMBER 24, 2004

W IL L IAM A. SAHLMAN

Innocent Drinks Richard Reed was walking across the green AstroTurf floors of Innocent Drinks toward the Acorn Room, the office conference room. It was 10 am on a Wednesday (September 29, 2004), which meant that it was time for the weekly meeting between Reed and the other two founders of Innocent. The three of them were old friends from college, so the atmosphere of the meetings was usually light. Today, though, there was a bit more anxiety in the air than usual. The problem on the table was success. In 1998, the three founders—Reed, Jon Wright, and Adam Balon—started Innocent, a Londonbased company selling prepackaged smoothies and juices to customers via channels such as grocers and convenience stores. (See Exhibit 1 for background on the founders.) In 2004, they were expected to hit £16 million in revenue. (Exhibit 2 shows Innocent's revenue growth.) The founders had raised £235,000 to get started and not another dime since. They had managed to exceed the projections in their initial business plan, which, in the entrepreneurial world, was a rarity on par with sighting a bald eagle. With a winning Lotto ticket in its beak. Things had gone well so far for Innocent. And now, with expectations raised by success, they had to figure out what to do next. Having grown at a compounded rate of 63% over the preceding four years, Innocent had earned a 30% share of the UK smoothie market, eclipsing the former leader, PJ. But the UK smoothie market was small—estimated at £50 million annually. For Innocent to continue its spectacular growth, they needed a market with more headroom. One option for Innocent was to extend its brand, which had gained a devoted following in the UK, to other product lines such as ice cream or yogurt. Another option was to expand internationally, either to continental Europe or to the United States. Richard Reed, vice-president of marketing, started the meeting: “We all know that for the last year, we’ve been trying to do everything—develop ice cream, open markets in Europe, expand the market here. I don’t think it’s working. I don’t think we’re making progress fast enough. I think we need to choose one option for growth and focus on it.” Over the next two hours of discussion, the other founders’ positions became clear. Jon Wright was in favor of pursuing expansion in Europe. Adam Balon thought they should be patient and continue to do both. He said, "Once we start generating revenues in both markets, we'll know more about which option to pursue." There were other viable options that didn’t involve growth. Innocent had ________________________________________________________________________________________________________________ Professor William A. Sahlman and Research Associate Dan Heath prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2004 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

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attracted acquisition interest from other beverage companies. Was it time to sell? In addition, Innocent was capable of generating strong cash flow. The founders knew that, if they chose, they could put the brakes on growth and start harvesting some of the value they had created. Reed was torn. He wanted to do everything. He hated closing off options but knew it was the right thing to do. The question was: Which options should be closed off?

Company background Reed, Balon, and Wright met at Cambridge during their first week of school. The three became instant friends. Reed and Balon were roommates during school, and it apparently worked out, because the two would spend ten years as roommates. After graduating from Cambridge, the three of them moved to London and started their careers. Reed spent four years at the advertising agency BMP DDB Needham. Balon spent two years at McKinsey and two years at Virgin Cola. Wright, who had earned a masters in manufacturing engineering, spent three years at Bain. Despite the diverging career paths, the three friends stayed in touch and constantly bantered about starting a company together. In a sense, they had already worked together: They had organized events, both in college and afterward. In 1997 and 1998, for instance, Reed and Balon had organized a music festival in West London called Jazz on the Green, which drew over 20,000 attendees. In March 1998, the three of them planned a weekend trip to France for skiing and snowboarding. As they drove through the Chunnel, the topic came up again: Wouldn’t it be great to work on something together? Jon Wright said, “We’d had this conversation so many times. Finally, on the way to France, we said to ourselves: ‘We’re going in circles here. Let’s either figure out something to do or forget about it and be happy with our jobs.’ Everyone said, ‘Great.’ Then, we realized the problem: We weren’t sure what we were qualified to do.” Their first idea was to start a “strategic marketing consultancy,” which built directly on the experience of the three. The idea was scrapped, according to Wright, after they concluded that they lacked the necessary experience, desire, and clients. This seemed conclusive. On to the next idea. They began to discuss the things in life that frustrated them. Wright said, “We thought that people were prepared to pay for things that make life a little bit better and a little bit easier.” They had almost unconsciously made the leap to consumer products. The first brainstorm involved bathing. Wasn’t it a pain, the founders thought, to get a bath to the right level and the right temperature? What if you could just press a button and have your bath drawn exactly the way you preferred? This idea, too, was nixed. Balon did not want to be a bath salesman, and Wright preferred not to work on a product that mixed electricity and water. A second brainstorm that didn’t make the cut involved keyless door entry systems—applying security card technology to home users. No one seemed passionate about the concept. The third brainstorm paid off. They talked about their lifestyles in London—working hard and playing hard. They had a desire to be healthier but didn't have much time to act on it. What about healthier food or drinks? They talked about their habit of buying juice on the way to work in the

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morning—a little thing that made them feel a bit healthier. They were shocked that none of them could remember the names of the brands they were buying. The pitch, as it evolved, was simple. According to Wright, “We thought that if we could come up with a more memorable brand, and with juice that tasted a bit better, that it could be a good business opportunity. No one could think of a reason that it couldn’t work. We put it to the Snowboarding Test – we said if we’re still excited about this idea on the way home, let’s do something about it.” The strategic marketing consultancy had transmogrified into a juice company.

The juice and smoothie market The market for smoothies was considered to be a subset of the much larger market for juices. Smoothies were blends of fruit that included the fruit's pulp and sometimes included dairy products such as yogurt. (For instance, the ingredients in one of Innocent's best-selling smoothies were: 1 ½ freshly squeezed oranges, 1 crushed banana, and ¼ pressed pineapple.) Smoothies tended to be thicker and fresher than regular juice. (See Exhibit 3 for a list of Innocent’s product line in fall 2004.) Some smoothies were made on demand at a juice bar, such as Smoothie King or Jamba Juice in the U.S. Innocent did not compete in this market, but rather in the market for prepackaged smoothies. The UK prepackaged smoothie market was divided into two segments: premium and standard. Premium smoothies contained no water or added sugar and commanded a higher price point. Standard smoothies were made with water and added sugar and were closer in price to ordinary juice. Most prepackaged smoothies were sold through three channels: •

grocery stores

•

cafes and sandwich shops

•

impulse retail (e.g., convenience stores and gas station minimarts)

In all three channels, smoothies were packaged in individual serving sizes ranging from 250mL to 330mL. Juice and smoothie buying patterns were distinct. A customer shopping at a grocer might buy a liter of orange juice to take home for the family and, while in the store, pick up a 250mL smoothie to drink on the way home. (In 2004, Innocent introduced a larger-volume take-home product, but the great majority of sales still came from individual servings.)

Competition Adam Balon estimated the size of the UK smoothie market in 2004 to be £50 million. The pie was carved into four pieces, with rough market share figures as follows: •

Innocent: 30% market share

•

PJ Smoothies: 25% market share

•

Store own-brands: 25% market share

•

All others: 20% market share

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PJ had essentially created the smoothie market in the UK. When Innocent entered the market in 1999, PJ was the only branded premium smoothie player in the market. Only in 2004 did Innocent begin to eclipse PJ's market share. Innocent benefited from a higher-qualiity product and the customer perception of a hipper brand. Store own-brands were tougher to compete against. Chains such as Prêt a Manger, a popular sandwich shop, formulated their own smoothies and were able to lock out the competition. In the U.S., the smoothie market was more mature and the competition was fiercer. The size of the U.S. smoothie market was estimated to be $300 million. Odwalla, the largest competitor, was bought by Coca-Cola in late 2001 for $180 million. Juice buying patterns across different countries, even countries similar demographically, were surprisingly idiosyncratic. (See Exhibit 4 for a comparison of juice buying patterns.) Germans, for instance, bought large amounts of juice per capita but had no true market for smoothies. Italians, on the other hand, bought very little juice, period.

Market sizing The smoothie market was small compared to the overall juice market in the UK, which was an estimated £1.3 billion in 2004. However, the smoothie market had been growing rapidly – 30-40% annually for the three-year period from 2002 to 2004. There were internal debates within Innocent about the "ceiling" of the UK smoothie market. How big was the market? How big could it get? It depended on how you defined the market. There was no question that Innocent could encroach on the traditional juice market, for instance by introducing larger-volume take-home products. Yet smoothies were, perhaps fundamentally, a niche product. The price per milliliter of a smoothie could be five times the price per milliliter of Tropicana orange juice. Switching from juice to smoothies was simply not an affordable option for many families.

Early developments and decisions at Innocent Having agreed on a company concept in March 1998, the three founders spent the next five months investigating the idea and developing the business plan. Early on, they divided up roles. Reed, with his ad agency experience, took charge of marketing. Balon, with recent experience marketing Virgin Cola, wanted to take over sales. Wright, the manufacturing engineer, handled operations. They agreed that, rather than select one of them to serve as CEO, the three of them would jointly serve as leaders of the company.

Conducting a pilot test Their homework on the smoothie concept led up to a crucial test run in August 1998. It took place at the Jazz on the Green Festival, which had been organized by Reed and Balon. The three founders set up a smoothie booth at the festival in order to gauge demand for the product. They squeezed the fruit themselves, borrowed bottles from a guy who made carrot juice, printed up 2000 labels, and set up a stand on some bales of hay. They thought up a gimmick that doubled as market research. Next to their smoothie stand, they set up two trash bins, one labeled “Yes” and one labeled “No.” Above the bins was a question:

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“Should we quit our day jobs and start a smoothie company?” The “Yes” bin overflowed. This would become the oft-told founding story of Innocent.

Pricing the smoothies In the four months following the jazz festival, the founders made three key decisions that, in retrospect, proved pivotal. First, the company had a challenge with pricing. The founders were emphatic that Innocent smoothies would not be made from concentrate, unlike the other alternatives on the market at that point. They believed freshness and quality would be a critical differentiator in the marketplace and the key to Innocent’s positioning against its competitor, PJ. In 1998, PJ was the only important competitor in the smoothie market. PJ sold a line of 330mL smoothies made from concentrate. PJ smoothies were priced at £1.99, which was a premium price. Innocent planned to beat PJ on quality and taste by making a fresher, more natural product. Freshness came at a price, however. After talking to potential suppliers, Wright learned some disturbing news about ingredient costs. For Innocent to make a reasonable margin on a 330mL product, they would have to charge over £2.50. This was considered a non-starter. There was simply no evidence that such a high price point could exist in the beverage market. Wright said, “We were depressed. We thought, ‘This is it, isn’t it? The model just doesn’t make sense.” The three founders agreed that £2.00—matching PJ’s price—was the highest they could go. They also agreed that they couldn’t give on the freshness issue. There was only one variable left to adjust: volume. A London design shop came up with an idea for a 250mL bottle that impressed the Innocent team. They decided to run with it. It was a risky move: Innocent planned to match PJ’s retail price while offering a third less juice. Balon said, “We were wavering. We didn’t know if we could get such a premium price. But our financial model told us we HAD to get that amount, so we stuck to our decision. At the time, we were scared. In retrospect, the price may have actually helped our growth by sending a signal that our drinks were something different.”

Finding a manufacturer The second key decision made in late 1998 involved manufacturing. At the time, there were no British manufacturers set up to create the fresh smoothies that Innocent wanted. The manufacturers were certainly willing to adapt to earn a large account, but Innocent wasn't a large account. What manufacturer was going to make a big investment in new technology for a risky startup offering puny product volumes? Wright said, “Nothing was coming together. Out of frustration, we started talking about building our own factory. We just felt like we needed to bring this issue under our control.” In November 1998, Wright met with a small supplier in a rural area. The supplier was relatively dependent on a few key supermarket customers, so he liked the idea of diversifying his client base. More importantly, perhaps, he got along well with the Innocent team. He agreed to take a risk on them.

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Wright said, “If we’d made it to Christmas without a supplier, I am sure we would have started building a factory. And I think it would have been a disaster. All the energy we put into the brand might have gone into reinventing ways to squeeze fruit.”

Raising investment capital The final important decision was whether to raise money and, if so, how much to raise. Initially the founders had thought they could grow the business organically. When they began to run projections, they quickly realized that it would be impossible. They considered small business loans, but found the paperwork terrifying. Also, banks were reluctant to lend to them due to a lack of assets. They pursued venture capital firms. They met with perhaps 12 investors and never got a second meeting. Said Wright, “They had no interest whatsoever. They’d say, ‘You're selling a drink?! Isn’t that one of the world's most competitive marketplaces? And, on top of that, it’s a chilled drink. Isn’t that a nasty distribution problem?’” With no leads and mounting personal debt, they threw a Hail Mary. They sent an email to all their friends and acquaintances, asking if they knew anyone who was rich. A few responses trickled back. Wright had a friend at Bain who had worked with a man named Maurice Pinto, who had been an angel investor in other deals. The team met with Pinto in October 1998. Wright remembers being surprised by Pinto’s approach to the meeting. “He didn’t ask detailed questions about our plan. He asked about our lifestyle, about how we’d make decisions, about where we were headed as people and as a team.” They learned later that Pinto had made search fund investments in the past and felt it important to evaluate individuals rather than products. After more discussions, Pinto sicced two business students on Innocent, who grilled the founders about their assumptions and forecasts. In the end, an investment offer was extended: £235,000 for 20% of the company. The team accepted, and the investment was closed in January 1999. Three months later, the company received its first pallet of smoothies from the manufacturer. (See Exhibit 5 for a timeline of selected events.)

The Innocent brand In the summer of 1999, Dan Germain was back in London after a stint teaching English in Thailand and Indonesia. He called up the Innocent founders, whom he had known since he was 18. He thought their juice business sounded fun, so he deferred a masters program he had been planning to start in the fall. He started by delivering juice to retailers in Innocent’s vans. Germain and the founders were checking out the packaging of other beverages and someone commented on how boring labels were. The labels were dominated by minutiae. Why not make labels fun to read, like cereal boxes for kids? They came up with the idea to print offbeat messages on the smoothie labels. One of the earliest messages, written by Richard Reed, was: “We’re not saying that there’s anything wrong with having a gym workout, it’s just, you know, all bit of an effort really, isn’t it? If I were you, I’d just have an Innocent smoothie instead. They’re 100% pure fruit, they’re made with fresh rather than concentrated juice and they contain no additives whatsoever. As a result they taste good and do you good. And you don’t need to take a communal ...