Financial Analysis of Honest Tea

Analysis, Pages 11 (2616 words)

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Through Honest Tea’s three years of business, their business shows some positive signs of a promising company. Since Honest Tea is a start-up company, it is understandable that their net income is in the negatives since their expenses will outweigh their sales, but as the three years have gone on, their net income has improved, and even increased by 74% from 1999 to 2000 from -$882,359 to -$228,879, which shows a positive sign of growth. Honest Tea is also very capable to pay back their short term liabilities since their current ratio is a high 5.

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92. Their profit margin has also increased over the three year period from -71.7% to -36.3% showing positive signs of profit and ability to grow. Honest Tea is able to generate $0.50 for every dollar of assets they have, which isn’t a huge amount, but being in the positive for a start-up company is important.

Unfortunately, Honest Tea isn’t very efficient in turning over its inventory since this turnover ratio is less than one, but, for a start up, they are doing well.

Revenues increased tremendously from 1998 to 1999, but fell by almost 50% in 2000, so that is worrisome. The debt to equity ratio in 1999 was .241 and it decreased in 2000 to .142. A lower debt to equity ratio usually implies a more financially stable business, so it’s great that the debt to equity decreased from 1999 to 2000.

Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender and requires debt servicing or regular interest payments.

In other words, debt can be a far more expensive form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments. Creditors view a higher debt to equity ratio as risky because it shows that the investors haven't funded the operations as much as creditors have, so it’s good to see that Honest Tea has been getting more money from investors so they don’t have a large amount of debt.

Compared to some other companies in their industry (Triarc Cos Inc, Saratoga Beverage, National Beverage Corp., Clearly Canadian Beverage, etc.), Honest Tea is far behind. Most of this is due to the fact that Honest Tea is a start-up company and all of these other companies are well established, but these competitors are turning out positive profit margins and positive net incomes which makes it very hard for Honest Tea to compete in the market.

1.) Honest Tea’s sales dropped in 2000, so they are trying to find more capital to keep the company running. The success of the company, before the cold spell in 2000, had drawn a lot of media attention which caused Honest Tea to be featured in Fortune, Entrepreneur, and Beverage World, which definitely helps the company’s reputation, but Honest Tea really needs to get their sales back going in order to stay relevant in the market.

2.) First of all, in the future, Honest Tea need to raise more financing to be successful. They need to find more venture capitalists or angel group in order to support the continuation of the company. Honest Tea also needs to start expanding distribution of their product, but that can only happen if they get the financing to pay for the distribution. They need more distribution so they can pick up more customers that will demand their product, in hopes that either they can grow Honest Tea as its own company, or that it will get picked up as part of another big brand such as Pepsi or Coca Cola.

3.) In order to continue its distribution and growing the company, Honest Tea believes a $2 million round of financing would carry Honest Tea to profitability.

4.) Honest Tea has received financing from many different places. The first financing had come from Goldman and Nalebuff, they would be decent investors but they only have so much money to give to the company. Next, they approached family and friends, they raised around $200,000 for Honest Tea but they wouldn’t be considered the ideal investor because they don’t have enough money to support Honest Tea past their seed stage.

Customers of their product have also contributed capital to the company, but these investors have not been the right investors because they are not as sophisticated as venture capitalists and angels, and don’t necessarily have the experience with interpreting financial statements which means they require a lot of extra time and attention and that takes away from Goldman and Nalebuff’s ability to focus on growing Honest Tea. They also received financing from venture capital groups, which would be a better fit for Honest Tea since the venture groups don’t need as much attention as Honest Tea’s other unexperienced investors but they also demand more control of the company than Honest Tea’s other investors.

5.) Right away with the financing from the family and friends, there wasn’t really a specific structure, but in 1998 Honest Tea established a financing structure. The financings have been structured so that when an investor purchased common stock, the founders were given warrants for creating the company. Honest Tea structured them in this way because Nalebuff though that by including warrants for the founders with exercise prices staged at multiples of the initial price at which family and friends brought in would avoid such disagreements. If the company did well, then they would be able to exercise their warrants and they would own a greater fraction of the company, but if they didn’t, then the original investors would own a larger piece of the firm.

6.) Honest Tea should look for angel investors or venture capitalists, this is because the investors that Honest Tea currently has are very inexperienced when it comes to financial statements, so to have financiers that have experience and knowledge when it comes to investing and finance. Angel investors and venture capitalists also have more access to large amounts of capital and have connections that the current investors do not.

7.) The proposed financing and valuation do make sense because it gives Honest Tea the best chance of the founders maintaining 50% of the equity of the company. Honest Tea is using a warrant based structure, which seems complex, but really it’s a smart way to structure their financing. This type of financing allows Honest Tea to keep founder equity, as long as they meet their goals and targets. If they don’t, more of the equity goes to their investors because they will be issued more shares of the company.

This is a good set-up because it gives Honest Tea’s owners a reason to work hard to meet their goals, and if they don’t the founders will lose their 50% share of the company. The valuation of the company makes sense because it’s based on Honest Tea’s sales of their two products and the value of their bottling plant. If they sell a lot of their products, the valuation of their company goes up. However, if they don’t sell enough of their product, the valuation of the company goes down. If the valuation goes below $15.1 million, then shareholders will be issued more shares and they would get more control over the company.

8.) The ready to drink tea market is looking very promising for Honest Tea. In 1999, the ready to drink tea market totaled $2.67 billion, which was an increase by 9% from 1998. Although this doesn’t seem like a huge market, because the wholesale and retail sales have increased by 9% in just one year, I believe that the market will grow. Experts even projected that the read to drink tea market would more than double in size over the next 10 years, meaning the $2.67 billion market will be an over $5 billion market in a short 10 years.

Distribution channels have also been growing, ready to drink tea sales and loose tea bag sales have been growing in other channels such as drug stores, and growing by 21.2% growth in volume sales in mass merchandise, which is outgrowing other forms of drinks such as coffee and bottled juice. Honest Tea’s competitors are national brands; Snapple controls 14.6% of the market, Arizona Iced Tea holds 10.6% of the market, and Lipton represents 9.5% of the market.

Honest Tea’s competition/ brand loyalty would be considered one of the barriers to entry; all of Honest Tea’s competition is well established national companies, which means that it would be very hard to compete with them since they have already mastered their distribution around the country and they all have significant control of the ready to drink tea market. Economies of scale is another barrier to entry for Honest Tea, since other companies in the market has a lot of production their average costs fall, but since Honest Tea is a small company their average costs are still large, so they need to work to increase their production to get their average costs down.

9.) Rapid growth is not that important, especially if it causes Honest Tea to compromise some of their convictions. It would be more beneficial for the company to grow slowly and organically to keep the mission of their company. If a venture capitalist pushes Honest Tea to grow too fast, this may cause Honest Tea to take shortcuts when it comes to being organic and environmentally and economically responsible, which could cause customers to not value the Honest Tea brand as they did when they were growing slowly.

So I would say that rapid growth is not important to Honest Tea. However, going national is very important for Honest Tea. Honest Tea needs to go national in order to get brand loyalty, so grocery stores, gas stations, dining establishments, etc., would demand to have Honest Tea in their establishment. Going national would also mean that Honest Tea would have better access to investments or a chance to be acquired by a strategic partner, which is part of Honest Tea’s exit strategy. So going national is a huge part of what Honest Tea wants to accomplish with its company, which means it’s very important to go national.

10.) Honest Tea needs the money for investing in new distribution channels, hiring a nation sales force, purchasing marketing and merchandising materials, gaining capital to support the launch of Honest Tea in new super market chains, and gaining capital to get the Three Rivers Bottling plant to profitability. They need the money as soon as possible because it need to cover operating losses for the next several quarters to keep Honest Tea functioning.

11.) The pro forma projections of Honest Tea do make sense. The pro forma projections take into account the months that ready to drink tea sales may decline due to seasonal preferences, for example since January and February aren’t a time where the market would demand a cold, refreshing drink, Honest Tea has projected those months to have the smallest amount of cases sold. Conversely, the projections also show that the tea bag sales will increase when ready to drink tea decreases.

Honest Tea’s projections make sense in the aspect that they take into account the coolers, marketing, travel expenses, etc., that will come with expanding their business. The projections also show how the expenses per month decrease showing that the company is taking economies of scale into consideration, meaning that the more production they have the average cost will decrease. One aspect of the projections that don’t make sense is how the end of 2001 the company’s net income is in the positive, but once January of 2002 begins, Honest Tea is projecting a huge drop in net income to -$286.1, but besides that, Honest Tea’s projections make sense.

12.) Honest Tea’s financing strategies thus far have not been ideal. They have depended on family, friends, and customers to provide them with capital, and this has caused Seth and Barry to spend much of their time explaining financial statements, searching for more capital, and holding the hands of their inexperienced investors. The current financing has caused Seth and Barry to spend too much time worrying about investments, and not enough time to figure out how to grow the business. Seth and Barry really need to start looking for more professional sources of financing such as angels and venture capitalists.The valuation and financing structure that Seth and Barry have set up for the offering of their shares have provided Honest Tea with a much more organized and reliable financial structure that allows them to not have to spend so much time explaining themselves, which gives them more time to grow their business.

13.) This deal is very attractive to venture capitalists. Honest Tea has a huge market opportunity since they have created a new beverage category that has been on the rise the past couple of years, which would be very attractive to an investor. Honest Tea has also proved that customers are willing to buy their product and even invest in it, which shows they have a following. Another reason this deal is very attractive, is that Honest Tea has received much media attention and received different awards for sustainable practices and packaging, so the product is well known and has the potential to have brand loyalty in the future.

Honest Tea also has great management teams that have expertise in the tea industry, and have even worked for companies, such as Sobe, who have rapidly expanded in the past. A great management team is very appealing for a venture capitalist because it means that the VC has to spend less time watching over the company since they already have the expertise that they need to grow. Lastly, Honest Tea is a great venture capital investment because it already has access to its own bottling plant, so they have no barriers when it comes to mass production. Their bottling plant has the opportunity to provide Honest Tea with approximately $30 million in sales, which is very attractive for an investor.

14.) The deal with the venture capitalist is not attractive for Seth and Barry. First of all, the deal wanted the pre-money valuation of the company to be $5-$7 million, which means that the founders have to give up their proposed 50% control of the company. Secondly, the rapid growth that the venture capitalist is pushing may require Honest Tea to compromise on some of its more socially conscious principles. Currently, Honest Tea is structured so that the founders have the control of the company, so they can do what they like, but giving up half of their control would most likely mean compromising their principles.

Even though the $5 million investment would help Honest Tea tremendously, it isn’t worth sacrificing their principles to grow quickly. Honest Tea should consider the Investors’ Circle investment over the venture capitalists. Even though Investors’ Circle isn’t offering as much money as the VC, their principles match Honest Tea’s principles. Investors’ Circle invests in socially responsible start-ups, so they won’t push Honest Tea to compromise their principles, instead, they would support their principles. Investors’ Circle is even willing to invest up to $6.5 million depending on the company’s needs, so Honest Tea should really consider getting an investment from Investors’ Circle over the venture capitalist.

15.) The deal structure and valuation make sense, but it’s hard to know what they based the pre money valuation on since it’s very low compared to Honest Tea’s valuation. The deal structure does make sense, since the venture capitalist is giving Honest Tea so much in financing it makes sense that they would require significant control over the company.