CPG Funding Realities: CFO Insights on Surprises, Vision, and Milestones

Welcome to Propeller Perspectives, a monthly newsletter focused on sharing expert industry knowledge from the top strategic finance and accounting partner for venture-stage companies. In this month's newsletter, Propeller CFO and CPG Practice Area Lead, Matt Turner delves into the financing challenges faced by CPG founders. As an experienced CFO, he uncovers frequent surprises that founders face such as underestimating costs and navigating deductions. Matt also emphasizes the importance of clarifying long-term visions and setting milestones when it comes to fundraising.

February 2024 Newsletter with Matt Turner - Propeller CFO

Are there CPG balance sheet challenges that are unique to the industry?

MT: The biggest balance sheet risk for CPG companies, especially in relation to tech companies, is inventory. It's very different moving 1s and 0s across the country than moving a can of water. Understanding the heavy lift of what moving things across the country requires is a big balance sheet challenge.

What we try to bring, from a balance sheet perspective, is finding out your cash conversion cycle. What does it look like? That cash conversion cycle for a tech company, especially a direct to consumer over the counter software company that's just charging people monthly, is very fast. For a CPG company, the cash conversion cycle is typically very long. We work with our clients to try to shorten that as much as possible. Where can you renegotiate with suppliers? Supplier payment terms are effectively free debt. I think that's the way you want to think about negotiating with them, if you can get terms. A lot of early-stage companies are pre-paying for their inventory, like raw materials, to go to a copacker to then convert it and charge a tolling fee, convert that into their product, then move it to a warehouse where it sits, and then finally sell to their customer - whether that's direct to consumer or through retail. If it's through a retail channel, then it goes to their customer, and they've got 30-to-60-day terms with their customer before they get paid. So, if you think about all the time that goes into that, from their first outlay of prepaid raw material to getting paid from their customer, it's a very long cycle. And I think that's one of the things that first-time founders, especially, have trouble grasping, is just how long that conversion cycle is and what their options are for bringing that down.

I would say from a balance sheet perspective, there's other things you can do. You can put debt in place, like working capital debt, to offset some of the inventory and some of the AR, but that's not a bridge to financing, which some people think it is. I think the reason they think that is because in ‘20 and ‘21, that was more available to do. With interest rates rising, the early-stage debt also took a big hit. And so, optionality around working capital funding became a lot harder to get than it was before, and the dynamic of using working capital to bridge cash outlays went away. So, debt became much harder to get. It was a tough environment in 2023. Debt was harder to get, investment was harder to get, and people expected to be profitable faster. It was a bunch of macroeconomics effects having a downside on CPG founders.

How do you lead founders through a conversation about how much to raise? What criteria are you considering?

MT: It's tough to give advice because it's different for everybody. If you can raise less, great. But the classic ethos around fundraising is that you raise for 12 to 24 months, ideally 18. The reality is it's mostly 12. And you're meant to have a change in valuation that justifies the previous valuation, at a minimum. When you think about fundraising, you want to get to a changing business dynamic, from a fundraising perspective. And usually that's top-line revenue. How long does it take you to get to a point where you are significantly better off from a revenue perspective than you are today? That changes the dynamic of your valuation because if you just raised for 12 months and your revenue is 20% more, that's not going to be super enticing to investors. What gets us to double revenue? And how long does that take us? That’s how you want to think about fundraising.

You want to get to those milestones of valuation change that will support raising another round and not dilute you. Every time you take money, you're giving away a piece of the company. You're changing the dynamics of what you need to have a good exit. You're reducing your odds and increasing the amount that needs to come in for you to make the same amount of money. There's a funny quote that says when we celebrate fundraising rounds, we're celebrating dilution, which is a way you should be thinking about fundraising - you're diluting yourself. And not everyone always does. This is also changing in the current environment, but I think before, people were looking for certain valuations as a measure of success. We've got to this valuation, that means we are successful. That's not a good way to look at fundraising. You should look at fundraising as a tool to get you to a dynamic change, to get you closer to an exit that you want. And it's a slightly different view, but chasing a valuation is not where you should be, other than to get you to a milestone to reduce your dilution for the next round.

How do you guide founders and CEOs around marketing expenses?

MT: Managing marketing spend is tough, especially when you get into omnichannel. As you think about a lot of the marketing spend in a retail environment – it’s mostly around price promotion. Getting your product into people's hands through a reduced price is most of the cost. Basically, half of your spend in retail is above the line, which is trade spend. That's sitting in revenue, it's negative revenue. The other half is below the line, which is how you're getting exposure to your brand outside of price promotion. So, in a retail environment, that's advertising in a store, and then you have the omnichannel DTC component, which is true customer acquisition. I think the dynamics of that have also changed greatly from a digital advertising perspective over the last two years.

2022 saw a digital advertising fall-off. It was companies that had been very successful with digital advertising and D2C, especially through COVID, and who saw real traction and good customer acquisition costs that fell off a cliff - and then it became expensive. And it just wasn't successful, it was this thing where no one knew if it was iOS 14 or the privacy stuff that Apple was doing that was keeping it from being effective. That was the thought, but there's been this weird resurgence of it in ‘23, where a lot of that has come back to being a viable opportunity for people in the digital advertising space. That's been heartening to see for a lot of our clients that were unsure how to get through. A lot of them had gone off digital into other opportunities. Whether it's classic advertising methods, catalog, outdoor, radio, etc. They were looking at different areas and they've found some success with those, but I think they're still now finding more success back in the digital space. It may be a thing where the cure for high prices is high prices. Digital advertising got so expensive that it just wasn't feasible for anybody, so everybody stopped doing it, and then it became affordable again. And people were able to find their customers.

But I feel like with digital advertising, there's always a thing where no matter what gets thrown at digital advertisers, there's always a lag. Whether it's a change in the algorithm for how search works or whatever it happens to be, they always figure it out eventually. Then there'll be some blockers put onto it, and then they'll figure it out again. It just never goes away, and every time it happens, everyone thinks, ‘this is the end of digital advertising,’ and then it makes a comeback. So, I think right now we saw a comeback of it in ‘23, which is good to see. But something may change, so it's always fighting an uphill battle with digital.

What shifting challenges are you seeing founders face as you have been in the CPG space over the years?

MT: I think the biggest challenge and the biggest change over the last two years is the whole focus of what a company should be doing from an investor perspective. There's an argument that a lot of this had to do with tech money coming into CPG. It was kind of a growth at all costs, and that works for some companies but doesn't work for most CPG companies. CPG is expensive, it’s capital intensive, especially trying to grow fast in retail and wholesale settings. For a few years that was the mandate, and now in the last two years that mandate from investors and acquirers as well is that they want to see a path to profitability. The real macroeconomic effects of the environment have changed, and I think that's been hard for some people to manage. One of the side effects of this is that you have a bunch of break-even or slightly profitable companies with no or negative growth that no one wants to buy.

Also, the valuations have changed significantly in the last two years. They were blown up coming out of COVID for a lot of these companies because people were still shopping and still going to the store, so they proved to be durable during that environment. Because of that, they got pumped up. It happened across the board. It happened in technology. It happened in CPG. It happened in D2C. That kind of come down has been hard for everyone to deal with historically, which has led to a lack of funding, which then led to people tightening their belts - and there’s a bunch of knock-on effects from that.

Most people don't want to see growth at all costs. They want to see sustainable growth and that you have a business that can have potential for positive EBITDA coming eventually, but companies need to be growing if they want to look good for a potential acquisition.

What are the two biggest challenges that surprise a CPG founder that you see as a fractional CFO?

MT: The two biggest surprises in CPG are the true cost of getting something into a store and the true cost of their inventory. That's where we get pulled in a lot - when people know they need to professionalize their accounting and finance but are dealing with ballooning costs and not understanding them. Either their margins are all over the place because their inventories are not being managed well, or the true cost of managing deductions from wholesalers and retailers has become too much and they can't manage it. The costs are spinning out of control, and they just don't know how to deal with it. So, we bring rigor around making sure you're reconciling inventory every month and understanding what's happening with it.

Many people, founders especially, that have never worked with inventory before have an assumption around their cost of goods sold and their unit economics based on when they put everything together. The reality of the situation is that almost 100% of the time it’s more expensive than they think it is. Whether it’s inbound freight, outbound freight, or the true cost they're paying for those goods - they have a conversation that it’s going to cost X and the reality is its costing Y when they're buying. Understanding those costs is something we try to bring control to in chaotic and early-stage companies, while providing guidance, because things are just all over the place.

The second challenge is trade spend, and really, it's all deductions from retailers and wholesalers. We help understand how that's working and give input on what's happening. Sometimes their sales team will go out and close deals, and what they sold can be painful from a deduction standpoint, but also from a delivery and shortage standpoint. Can they fulfill the orders? There's a bunch of additional consequences to some deals that are signed with retailers that founders are unaware of. We come in and show them what's happening, and this is why it's happening. We can tell them someone on their team potentially signed this deal - maybe they didn't. Maybe it's just their bad deductions coming through, maybe you're not on program. But we give them the ability to have that conversation with their customers to make sure that they're turning this business into something that can be successful.

When you first sit down with a founder, do you have a series of items that you dive into first?

MT: When you're sitting down with a founder for the first time, it's important to kick things off by digging into what they're really aiming for with their company. You'd be surprised how many founders haven't really thought about it deeply. They're just caught up in the day-to-day hustle. But it's crucial to ask: What's your big picture? Do you see yourself running this ship for years to come, or are you eyeing an exit in a few years? Knowing their end game sets the stage for giving them the right kind of advice and support. After all, without a clear destination in mind, it's tough to map out the journey ahead.

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