What Wins Over Investors – Growth or CapEx?

0:00How are smart brands approaching raising capital? What's the impact of rising interest rates on CPG brands? And how to bring joy back to your fundraising process? Find out this week on The Nosh Podcast.

0:24Hi, everyone. I'm your host, Carol Ortenberg. On The Nosh Podcast, we go inside the business of natural, organic, sustainable, and healthy food. Today, we chat with Charles Korstein, the owner, president, and CEO of Lesser Evil, learning how he and the company approach their most recent capital raise, and what his advice is to brands when undertaking their own fundraising efforts. Over the past few years, Charles has reshaped the brand's identity, added a number of new product types to its lineup, and set up a manufacturing facility. Charles, thank you so much for joining us today. Thanks for having me.

1:00In the last month, you've had some news surrounding a capital raise. Tell me a little bit more about that. Yeah, we've actually raised money twice in the last couple of years. We've been busy. Most of it has been secondary transaction, but we raised a little bit of money for lesser evil in two different transactions. The last one, we wanted to kind of fortify our balance sheet and add some money to work on some CapEx in terms of opening up a new manufacturing facility. We've raised about $32 million. The last raise was about$19.5 million. Of that$32 million, about$11 million was primary. So a lot of it was taking out early investors, mainly friends and family that we're in from the very beginning.

1:49And then the rest was obviously money that we're going to use to grow. It's interesting as you have different stages of your company's life cycle, we focused at the beginning was all about efficient capital allocation because we really didn't have a lot of capital and we had to be really scrappy. A lot of it was at the beginning was my money and then some family money and some friends money. And lesser evil had a kind of a speckled past. And when I first got into it, because it had failed a couple of times, private equity or VC really didn't have an appetite to invest in this company because usually companies aren't successful and they're restarted.

2:28Because of need, we really had to be really smart in terms of how we spent money because we just didn't have a lot. And then as we found our groove in terms of products and we got a little more successful, we obviously continued to focus on capital efficiency, but we moved into building an amazing team and focusing really, really hard on culture and finding the right people to get on the bus. And then in this last phase, we're really focused on operational excellence. And as we go through our life cycle and different investors come on, these investors, you know, kind of force some new fresh blood in and they have different focuses and they basically help us along, you know, kind of how, you know, how we're meant to look at, at the business and how we're going to meant to grow it efficiently.

3:16efficiently. So now it's all about working on quality control, working on the efficiency of our production lines, making sure we get them up early and they're running efficiently all day long. We're worried about labor, overtime, how efficient we are being in terms of allocating labor towards unit costs. We're worried about purchasing and purchasing commodities efficiently and not filling up the warehouse with too much because that's a huge burn of cash for us. And then obviously freight is we've taken on freight recently and we've, you know, we've become somewhat efficient in terms of getting our product to our consumers, not having not having distributors pick up at our warehouse.

4:01Charles, you mentioned primary and secondary capital. When you're raising capital for these different purposes and you're going out to investors, do you have to approach the process differently? Typically, we've been lucky because there has been an appetite for equity from private equity guys. So typically, they want to invest more money than we typically have. So in order to – obviously, we don't want to sell too much of lesser evil because we don't need all that capital. So what typically happens is I'll go out to shareholders, to existing shareholders, and say, listen, there's a need by investors for this amount of shares.

4:41Would you be interested in selling them? And this is what they're willing to pay. And some investors, based on what they need their money for, will say, you know what? Yeah, I've made some money on this. I'd like to de-risk the situation. I'd like to sell a third of my shares or a half of my shares. Not many. I think there's a couple of investors that have taken all their chips off the table on this last one. But most of the people are kind of staggering out of lesser evil in terms of they sell a little piece. Maybe they sell as much as they first invested, so they feel like they've got their nest egg back and the rest is free to gamble.

5:15For whatever reasons, it's nice to offer liquidity for investors because it doesn't happen very often. Now, you also touched on raising capital for CapEx versus funding. I think this nebulous term of growth that we hear thrown around a lot. How do investors respond to that? But what's the interest from investors when it comes to funding CapEx projects? Because it is so nebulous, the entrepreneur has a kind of a lot of leverage in terms of how that's spent. And that typically can make investors nervous, right? Because you really have to trust the entrepreneur that they're going to spend money the right way.

5:52VC funds are typically more focused on growth. So they want to see revenue growth. You know, private equity is a little more focused on, you know, on financials and financial returns. So typically, when we talk about improving gross margin by investing in CapEx and investing in the capability of making more products, that's a good thing because it really means that demand is high and we're anticipating growing pretty quickly if we're investing in that kind of stuff. when you talk about expansion and you have a very determined plan and you talk about this is how we're going to produce more and that this CapEx is going to have this effect on our balance sheet and our income statement because we've seen the demand and we need to get out in front of it.

6:37That's a really different situation. And I think investors get really excited about that. Has that changed over time? You know, when you were first raising capital, was there hesitation about building out a manufacturing facility? The first time we built out a manufacturing facility was because we had really terrible margins and there was no way we were going to survive. So the first one was a bit of a hail Mary. I'm sure that went over well, like to begin with. We had terrible margins. We've got terrible margins. We've got terrible margins. We probably had negative margins, fully loaded margins.

7:12And unless we actually created a manufacturing facility, we probably weren't going to last more than a year because we were going to run out of cash. So I had to figure out a way to basically pad my margins. And the only way that I could figure it out was taking the manufacturing in-house. So yeah, it was a huge leap. I had no idea what I was doing. Luckily, my partner was an engineer by background and actually could figure out how these machines worked. So the first line, actually production line we bought was new. And I, you know, I had worked at TD Bank or whatever, and I had a contact there.

7:46And I think I used my house as collateral or whatever. And they were willing to lend me the money to buy the first production. But anyways, long and short of it is, after we bought the first line, and we kind of figured out what we were doing, then we started adding and we added pretty slow, we bought a lot of used equipment, because we couldn't afford new equipment. And we would we would buy broken, broken stuff on in auction, and we would, you know, jerry rig it and figure out how to put it into production. And, you know, we slowly grew, you know, basically by how fast we could, you know, pop popcorn with our shitty equipment.

8:24Charles, well, thinking back over the history of the company, you know, how have rising interest rates impacted fundraising, you know, in general, and then this most recent round that you undertook? It's been a really interesting couple of years. So COVID hits, nobody really knows what's going to happen, right? So the Fed pumps a lot of liquidity into the market, right? Because they really cared that businesses were going to survive. And on top of that, you had interest rates at zero, right? So it was kind of like the perfect money multiplier. And it's not surprising to me that we've seen a lot of inflation.

9:01It was really just a matter of time. But there was a lot of free cash flowing around and a lot of VCs put money into work, basically focused on future cash flows. And then as we saw inflation, the Fed realized they had put too much liquidity into the system and had to basically pump the brakes and take a lot of money out of the system. And it wasn't the fact that the Fed raised rates. It was the fact that the Fed raised rates so quickly. And what ended up happening was, you know, a lot of business models that were focused on revenue, you know, had to rejigger really quickly. And unfortunately for businesses, it takes businesses a long time to change their business models.

9:44And you can't change a company's business model in six months to a year. Sometimes it can take two, three, four years, right? Because there's a whole bunch of different things you need to change in order to focus on margin and profitability versus growth. And I think you've seen that. I think you've seen it. Even banks had a really tough time because they were invested in long-term mortgages. All of a sudden, their deposit rates went – they had to pay 5 % of their money and they were only earning 3 % of their money. Then tech companies and all direct-to-consumer companies, everything had to change really, really quickly.

10:18Unfortunately, it doesn't happen that fast, but it is happening. I hope that some of these companies that are working as fast as they can can survive this. But I think it's a necessary evil. And I'm hoping that the economy and basically a lot of these CPG companies that we see will be a lot healthier as a result. How has this impacted lesser evil? I hate to say, because of where we came from and because of our background and because we had a lot of identity and being super scrappy, we didn't invest in a lot of these kind of softer activities, spending a lot of money on awareness and doing this and doing that.

10:57And we were hyper-focused on, you know, our 10 or 15 retailers that we're really focused on. And we grow only as fast as we can. You know, obviously, we've got to pump money in, as I told you, into some capex. And we've got to pump, you know, we can talk about accounts payables versus receivables and all those things. I mean, we have capital needs. But for the most part, we make money, which is very different than some companies. Making money is always good. I'm not an entrepreneur, but I hear that's the thing to do. Yeah. If you're making money now, it's a lot better than making money in the future.

11:34Well, you mentioned kind of where you've come from and being scrappy. You know, one of the tactics you've used is iterating on the brand itself and really evolving it over the years. How have you approached that, you know, internally, as well as when you're talking to your investors, making sure they understand, you know, this is a good thing. It's not necessarily that we screwed up. Yeah. And it's funny, as we focus on operational excellence, the nature of the brand is changing. And a lot of what made us super successful at the beginning aren't necessarily what investors want us to focus on, you know?

12:11So I made it kind of like failing really quickly and throwing a lot of stuff at the wall and seeing what would work. I probably came up with, I don't know, five or six different product lines, before I came up with our flagship product line. And I remember one year where I was just constantly getting lesser evil press releases about new products or rebrands back to back. And I was constantly tweaking because nothing was working exactly like I wanted it to work. And for me, getting out of a trade quickly is kind of how I grew up in that I always had the confidence that I could learn from each mistake and get better with the new launch.

12:49and I still continue to do that. Like you'll see with our popcorn, we're gonna launch some new packaging, you know, brand refreshing. I think it's really good to keep pivoting. But so getting back to the point of investors and focusing on, you know, on your money skews or your hero skews, I still want to be innovative and I still want to, I mean, Spaceballs was an innovation that came after Power Girls and Paleo Puffs and all those things. I realized that maybe I was too focused on niche categories, you know, like paleo is pretty niche and power curls were cassava made with egg white powder. And, you know, they sell really well in some retailers, but they're not, you know, appropriate for, you know, kind of bigger retailers.

13:33I don't mean to interrupt, but wait, what's a space ball? So a space ball is a cheese ball, basically. OK, I'm with you. I see how this could be a popular thing. I won't interrupt any further. there. No, no, no, no. So one thing, you know, so one thing I've really focused on now is like, okay, so we got to play in bigger categories with higher velocities. And we can kind of, I think we can kind of bring our magic to what we did to popcorn to, to kind of more American favorites rather than, you know, more niche products. So this is an attempt to kind of like clean up the, you know, kind of the, the, the traditional cheese ball and make it, you know, a little more healthy.

14:11Charles, we're going into these larger categories, means you're competing against larger incumbents who have been doing this a lot longer and have a lot more power behind them on manufacturing, margin, sales, and marketing. How are you tackling that? You know, some of these guys are not vertically integrated. Some of the bigger CPG companies, some of them use go-packers. So I think we can compete against them. Some of them do have their own manufacturing. I think we compete on value. I think we compete really well. We bring kind of, and I think that this is the ethos of lesser evil is like, can we produce organic items with functional ingredients like better for ULs and sell them at the same price as conventional guys are selling them?

14:54And we can, and we've proven that we can have 50 plus gross margin points or, you know, let's say high 40s, you know, across the board and have lower prices than our competitors. So I think we're doing a good job. Are you having to sacrifice certain things financially in order to achieve that value, so to speak? I wonder. I mean, I don't know what these guys are spending on marketing. I know what our marketing budget is. It's obviously not huge, and we're pretty scrappy with trade spend. We did away with our whole off-invoice kind of thing with distributors, and we only promote using MCBs. I don't know how they're doing it.

15:31I know that our competitors have raised price probably three times during COVID. it. We've only raised price once. And now it seems like our products are priced below some of our competitors, which is kind of surprising to me. When you're going after these big categories, there's a huge opportunity there. How has that influenced your valuation and how you're thinking about the company and the opportunity out there when you're talking to investors? We've always raised money at the exact same valuation. There's no secret. It's a little over three times trailing 12-month revenue. We probably are more valuable than we were in the first two rounds, but we raised at the same valuation just because there were similar parties involved in the third one as we're in the second one.

16:21And the times were a little more uncertain. And we just didn't want to get into a whole new valuation discussion. We just were like, okay, this round needs to happen within 30 days. We want to find the right partner. We need to get it done quickly. We've got a lot to focus on. So it was really more about speed than about the money and the final valuation. What's your advice around valuation then for companies when they're thinking about this? I know you advise Biscuit brand, O 'Leara, and they just closed around using that as an example or just emerging brands in general. What's your thoughts on that?

16:57How should brands be attacking this? Yeah, I think giving your investors a very reasonable valuation is a good thing. And I think making money for your investors makes them want to kind of carry on with the company. We've had a lot of investors or institutional investors invest in multiple rounds, right? And they've come to us even before we do a round and say, hey, in your next round, we'd be interested. So it makes it a much more fluid situation in terms of raising. So I think that's a big thing. That being said, I would tell, you know, smaller companies don't raise too much, right? Because you don't want to give up too much too early.

17:32Because if you if you give up too much, you kind of lose the enthusiasm because you feel like even in a successful life, like it may not be the result that you want. So I say, don't take only what you need. I would say that you need to have a long term plan, you know, gone are the days of getting in and exiting in three to five years. I think it's now like I'm in, I'm in year 10 now. And I think that that's healthy. I think that, you know, you know, you're probably looking at a seven to 10 year horizon, maybe even longer. I would focus on the partner, you know, make sure that that partner is bringing something really substantial to the table.

18:09And then you're going to be able to have, you know, kind of tough conversations with that person. So that, that, that's key. I think they've learned a little bit because I'm all about having a pipeline of innovation. And I think Olyra has done a really nice job. I mean, I think those new cookies are pretty addictive. I'm not going to lie. The guy launches new products every three months. So I'm pretty excited about that because he's learning from his mistakes. And I think he's just going to continue to do whatever works. So he's scrappy. And then he's super smart with cash. And I think that the investors see that, right?

18:41They know that he's going to hold onto it pretty tightly. And they know he's going to spend it smartly. So I think he's doing all the things right. He reminds me a little bit of me. He's so passionate about what he does. And he's, you know, it takes himself, it takes the business extremely seriously, and he's willing to pivot and figure things out. He's not stubborn. And I think that stubborn entrepreneurs are typically are in for a tough time. I think you've got to just take what the market tells you and do what the market tells you to do. What are you seeing play out when brands are seeking a very specific valuation?

19:19And is this something, you know, how hard should they hold on to this number they have in their head? What's the risk? The risk is that, you know, these private equity guys, VC guys are really smart and they need a certain return. You know, typically if they're looking at a five-year window, they need an internal rate of return of, you know, it works out to about 25%. So this money is going to be expensive that you're taking, right? And they're going to figure out a way to get it. And what they'll typically do is if the valuation is too high, they figure out a way to put an embedded return into the term sheet.

19:56And typically, you'll see that in a liquidity preference of some kind. Typically, it's more than a 1x preferred. You're looking at 1.5 or 2x. And what that does is it kind of screws up the economics of the deal, especially if you don't perform like you're going to perform. And it can really misalign all the investors. So I've always fought for a super clean term sheet and rather take a lower valuation because it's really about the joy of the experience. And when you feel like your investors have an upper hand on you, it takes away from the joy. And to me, if we can all make money on this together, on this journey together, it makes for a really fun process.

20:40Okay, we got to talk about the joy of experience in raising capital. Because when I talk to founders, they're like, the worst hardest thing I have to do is raise capital. It is the worst. It's by far, it's the thing that I hate the most, you know, I mean, and where's the joy? Well, the joy is afterwards. Okay, you know, once once the dust settles, the process is really ugly, right? I mean, you're, you're both trying to get the best possible deal for yourselves. And you're not missed, you're not aligned. But once the deal, the ink is signed, then you're aligned, right? And you got to make sure that once that happens, that there is joy.

21:15If you get the wrong person in the boardroom, you know, it can make for a really kind of jolting experience. And you're seeing that, right? I've seen, you see, you just did a, you just did a story on a, on a company that has a chief operating officer and a CEO, a woman CEO that had a kind of an ugly experience, right? Yeah. And that was something we talked about in another podcast with Jane Miller and Seth Goldman, which is, you know, how do you avoid finding yourself in these adversarial board sort of situations? By having, you know, A, a clean term sheet and B, having realistic valuation and realistic financials and fully baked gross margins and understanding what the metrics the investors are looking for and talking about them and looking at them and being realistic.

22:05Like, you know, I see it. I see the dreamers. But unfortunately, this is as much as I love to dream. This is this is a world baked on, you know, on on realities. And it's a tough, tough market right now. And you've got to be focused on what investors want. I mean, I think sometimes in our industry, it's very easy to get caught up in the glitz and the glam and the dreamers. And it's hard for those realists day in, day out. Oh, I know. And I used to see like I'd be like we were in Danbury, right? So we don't get a lot of attention. And you would, you know, you see these, you know, they get a ton of media attention.

22:39They're spending money on, you know, a lot of impressions and they're really out there. And you're like, wow, I wish that was me. But, you know, sometimes it's nice. I've grown to appreciate being under the radar because it takes a lot, you know, it takes a lot of pressure off the table. So as much as I get jealous, sometimes I'm like, oh, it's much better than this. Now, you said, you know, don't raise too much. I think a lot of investors I speak to are like, hey, if you can get more than you wanted, take more because you don't know when you're going to be able to raise capital again. How do brands kind of balance those two opposing forces and suggestions?

23:17I think having a very conservative budget, which is not built on wishes, that is built on certainty. I mean, we only put stuff that we have an 80 % certainty into our budget in terms of growth. So in terms of new distribution or whatever. So we really focus on our own cash forecast, like how much money. And because we believe in our model so vehemently that we've been lucky, we see like, okay, we raise typically once every year, once every 18 months. We know we're going to need$2.8 million of working capital. We know we're going to spend a million and a half dollars on CapEx. So I'm going to go out and I'm going to probably go out and maybe raise an extra million dollars over top of what we need.

24:07But that's all I need to raise. And as long as you're being realistic and moving forward, you've got to just believe in your own estimations. On a podcast about two episodes ago, we talked about working capital and the feedback was that not enough brands are really thinking through their working capital needs and really planning that out. What's been your experience in the industry with some of the brands you're advising or just talking to? I think I talked to, we had someone come visit here and I'm not going to tell you what the brand is, but he was telling me that he had free cashflow this year.

24:40And I was like, you have free cashflow? That's just amazing. I mean, companies that have free cashflow, you know, that are growing at 40, 50 % are, you know, are unicorns to me. So I am always, you know, I mean, I haven't seen it. We're a profitable company and we're still, I'm hoping this is the year, Carol, that we have some free cash flow, but I think that you always want to have excess money in the bank. I mean, we always have a couple million dollars just to make sure that things don't go sideways. And here's a great time to talk about something that I'm seeing that I think that other investors should be wary about, that we usually, over the years, we used our accounts payable as a source of funding for us, right?

25:26We would probably pay them in 45, 60 days, whatever we could get away with, you know, because that was credit for us. And now, because, you know, obviously a lot of our suppliers want to make 5 % on their money in the bank, and they don't want us to be stretching our terms to 45 and 60 days, they're coming to us and clamping down on our credit. And on the other side of the equation, our accounts receivable, you know, a lot of the bigger retailers that we're dealing with are slowing down their payments. So all of a sudden, we've gone from a kind of a, let's say a 5 million, 5 million or an 8 million, 8 million in terms of payables and receivables.