CHAPTER 10
A Hundred-Story Building First Needs a Strong Foundation

The builders of visionary companies . . .
concentrate primarily on building an organization—
building a ticking clock—rather than on hitting a
market just right with a visionary product idea.

—JAMES C. COLLINS AND JERRY I. PORRAS ,

BUILT TO LAST

Sometimes losing money is healthy.

Now there’s a novel thought.

Losing money is scary—that I know from experience. It’s a danger sign for most businesses, especially mature, established ones. But for a young entrepreneurial company, full of promise, losing money could be a healthy sign that it’s investing ahead of the growth curve.

If you aspire to fast growth, you need to create an infrastructure for the larger enterprise you are planning to create.

You can’t build a hundred-story skyscraper on a foundation designed for a two-story house.

THE IMPORTANCE OF INVESTORS WITH STRONG STOMACHS

Starbucks was profitable until I took over. It didn’t take long for me to realize that we couldn’t both sustain that level of earnings and build the foundation we needed for fast growth. I predicted that we would lose money for three years.

In fact, that’s precisely what we did. In 1987, we lost $330,000. The next year losses more than doubled, to $764,000. The third year we lost $1.2 million. It wasn’t until 1990 that we finally turned a profit.

That was a nerve-wracking period for all of us, filled with many white-knuckle days. Although we knew we were investing in the future and had accepted the fact that we wouldn’t be profitable, I was often filled with doubts.

One night in 1988, Ron Lawrence, then Starbucks’ controller, knocked at the door of my house at 11 P.M. Sheri and our son were already asleep upstairs, and when I led Ron into the kitchen, I saw that his face was ashen. He had just calculated our monthly numbers, and we had lost four times more than we had budgeted for. A board meeting was scheduled for the following week, and as we sat at the table with the figures spread before us, I was appalled.

“I can’t go to the board with these numbers,” I said. “This is unbelievable. How did this happen?”

Ron explained that it was an unusual circumstance, in which everything hit the P&L at once. It was unlikely to happen again. Still, I didn’t sleep well that night, trying to plan how I would explain the huge shortfall to the directors.

The board meeting was as tense as I had expected it would be. “Things aren’t working,” one of the directors said after hearing my report. “We will have to change strategy.” We had only about 20 stores at the time, and some directors thought my plans were far too ambitious. I began to imagine conversations among board members, before and after those meetings, in which directors complained: We’ve got to get this guy out of here. Howard doesn’t know what he’s doing. How much of our money are we going to let him lose before we pull the plug?

The pressure was on, and I had to justify those losses. I had to prove that they were necessary for my investment strategy and not just money poured down the drain. Although I was quaking inside, I had to summon every ounce of my conviction to convince them.

“Look,” I told the board, keeping my voice as steady as possible, “we’re going to keep losing money until we can do three things. We have to attract a management team well beyond our expansion needs. We have to build a world-class roasting facility. And we need a computer information system sophisticated enough to keep track of sales in hundreds and hundreds of stores.”

Although it took various forms in the years to come, that message became like a mantra, repeated every quarter: “We have to invest ahead of the growth curve.”

Fortunately, the board and investor group showed remarkable patience in supporting me and my plans. If Starbucks hadn’t turned a profit in 1990, they would have had good reason to kick me out.

Looking back now, I realize how sound our strategy proved to be. In those early years, 1987–1989, we laid a solid base for rapid national expansion by hiring key managers and by investing early in facilities we would soon need—far sooner than we realized. It was expensive, but without it, we would never have been able to accelerate our growth, year after year, without stopping to catch our breath.

When you’re starting a business, whatever the size, it’s critically important to recognize that things are going to take longer and cost more money than you expect. If your plan is ambitious, you have to count on temporarily investing more than you earn, even if sales are increasing rapidly. If you recruit experienced executives, build manufacturing facilities far beyond your current needs, and formulate a clear strategy for managing through the lean years, you’ll be ready as the company shifts into ever higher gears.

What we did was try to figure out how big we wanted to be in two years and hire experienced executives who had already built and managed companies of that size. Their background enabled them to anticipate the pitfalls of growth and plan and react accordingly. Hiring ahead of the growth curve may seem costly at the time, but it’s a lot wiser to bring in experts before you need them than to stumble ahead with green, untested people who are prone to making avoidable mistakes.

Of course, building an infrastructure takes money. Ideally, capital should be in place even before you need it, not only to fund the expansion itself but to respond quickly to problems and opportunities as they arise. Convincing shareholders to increase their investment is probably the hardest part of an entrepreneur’s work. It’s a humbling experience to stand before these financially savvy individuals, who are already full of doubts, and tell them, “We’re losing money. Can you invest more?”

In our case, just a year after we raised $3.8 million to acquire Starbucks, we had to raise an additional $3.9 million to finance our growth plans. By 1990, we needed even more money, and we brought in $13.5 million from venture capital funds. The following year, we completed a second round of venture capital, for $15 million. That added up to four rounds of private placements before Starbucks went public in 1992. If Starbucks had failed to perform, if investors had lost faith in us, obtaining those levels of funding would never have been possible.

Luckily, Starbucks’ revenues were rising at more than 80 percent a year, and we were nearly doubling the number of stores annually. We pushed into markets outside our home base, including Chicago, to prove the idea could work in other cities. We were able to show attractive “unit economics” at each store, and investors could see that the overall specialty coffee business, both in supermarkets and in stand-alone stores, was catching on all over the country.

To supply our accelerating number of stores, we needed a much larger roasting facility than we had acquired with the purchase of Starbucks. With the help of Jack Benaroya, we built a new office and plant in Seattle in 1989, large enough, we thought, to last ten years. We installed a high-speed roaster and packaging equipment and moved across Airport Way to a building that seemed huge at the time. Now it houses only our mail-order business.

Securing good sites for new stores also became increasingly expensive as we expanded. For the first five years after 1987, I approved every site personally—for more than a hundred stores. We aimed for highly visible locations, either in downtown office buildings or in densely populated urban or suburban neighborhoods, near supermarkets. We worked with outside brokers in each region, and in 1989, we hired one of our best brokers, Yves Mizrahi, to be our vice president for real estate. Working closely with me, he pre-screened each site and closed each deal. Our process of site selection was enormously time-consuming, but we couldn’t afford a single mistake. One real-estate error in judgment would mean a $350,000 write-down for leasehold improvements, plus the cost of getting out of the lease. That represented a minimum of a half million dollars at stake, not counting the opportunity cost of money we could have been using elsewhere.

Eventually I came to the conclusion that store development was too big a task to run out of the CEO’s office, so I did something controversial: I hired an old friend from New York to be senior vice president for real estate. Arthur Rubinfeld, whom I had gotten to know during my single days in Greenwich Village, was a practicing architect and developer who had moved to San Francisco around the same time I moved to Seattle. Arthur started a firm that specialized in retail real estate brokerage in northern California, and we turned to him to represent us in our entry strategy into the San Francisco market. I realized I needed not only his expertise and professional judgment but also someone I could trust. Choosing the right sites is such a critical part of success for a retailer that it should be done by someone with a passionate commitment to the future of the company.

But Arthur didn’t want to do just site selection. He convinced me that we needed real estate, design, and construction to speak with one voice, under the direction of one person, to avoid the conflicts that sometimes arise between those disciplines. He coordinated the departments and built a complete store-development organization that ultimately enabled Starbucks to plan for and open one store every business day. Of the first 1,000 stores we opened, we opted to close only two locations because of site misjudgments. Few other retailers could boast such a record.

Although we leased rather than owned our sites, we bore the entire cost of design and construction. Why? Because every store was company-owned. We refused to franchise. Although it would have been tempting to share costs with franchisees, I didn’t want to risk losing control of the all-important link to the customer.

Behind the scenes, we also kept investing in new systems and processes for a far larger operation than we had at the time. In late 1991, when we had just over 100 stores, we hired Carol Eastin, a computer expert from McDonald’s, gave her a blank slate, and asked her to design a point-of-sale system that would link all our outlets and would be able to accommodate the 300 stores we planned to have within three years.

When companies fail, or fail to grow, it’s almost always because they don’t invest in the people, the systems, and the processes they need. Most people underestimate how much money it will take to do that. They also tend to underestimate how they are going to feel about reporting large losses. Unfortunately, that’s a given in the early stages of retail development, unless you raise money by franchising. Huge investments upfront mean not only potential annual losses but also a dilution of the founder’s shareholding.

If you want to know what Starbucks did right, you have to look at our competition and find out what they did wrong. Clearly, Starbucks isn’t perfect. But among our competitors in the specialty coffee business, you’ll see examples of all the mistakes we didn’t make: companies that didn’t raise enough money to finance growth; companies that franchised too early and too widely; companies that lost control of quality; companies that didn’t invest in systems and processes; companies that hired inexperienced people, or the wrong people; companies that were so eager to grow that they picked the wrong real estate locations; companies that didn’t have the discipline to walk away from a site if they couldn’t make the economics work. All of them lost money, too; some are still doing so. But they didn’t use their years of losses to build a strong foundation for growth.

You can’t create a world-class enterprise without investing in it. In a growth company, you can’t play catch-up. But you also can’t just excuse losses in the early stage of the business without examining each expenditure. Growth covers up a lot of mistakes, and you have to be honest about what’s right and what’s wrong about your operations.

Fortunately, we realized this in the early years. And our investors had strong stomachs.

IF NO MENTOR FINDS YOU, SEEK ONE OUT

Sometimes, in life as in business, you know exactly what you need to accomplish your goals and you have to go out to look for it.

During those tense years when we were losing money, I realized I was badly in need of a mentor. I had a faithful board of wealthy investors who believed in me and trusted me (for the most part!) to make the right decisions. They questioned me diligently, but because most of them had no experience building a retail company into a national brand, they could offer only limited guidance for future planning.

I had also never anticipated how isolating running a company would be. You can never let your guard down and admit what you don’t know. Few people can share your frustrations and anxieties when you’re losing money, when you have to deal with investors who have high expectations, when you suddenly find yourself responsible for hundreds of employees, when you face difficult hiring decisions. Trying to balance the intricacies of rallying people and forging complex strategies can feel like running a political campaign—with the same sense of accountability to many different constituencies.

Although they can hire executives with many talents and skills, many CEOs discover that what they lack most is a reliable sounding board. They don’t want to show vulnerability to those who report to them. If they feel uncertain or fearful, or if they just want to think out loud, they need to have friends they can call up and complain: “Oh, shit! You wouldn’t believe what happened today!”

In the Il Giornale years, the only person with whom I could talk openly was Sheri. I’d come home so tired, so beaten down, so out of sorts that I’m sure I wasn’t easy to live with. But she listened, and she gave me much-needed support. She anticipated what I was going to need and made sure she off-loaded the pressure I would have on other things so I could concentrate on my work. So much of that period is a testimonial to Sheri’s forbearance and wisdom, but still I felt acutely the lack of a professional confidant.

Not long after taking over Starbucks, I strengthened a friendship with one of my investors, Steve Ritt, a relaxed and genial guy who runs a leather-cleaning company in Seattle. For almost two years, until my daughter was born, we ran together, three mornings a week, starting at 5:30 A.M. During these runs, I was able to get Steve’s reading on any number of problems I was facing. It was great therapy for me. Steve proved a valued adviser because he had no vested interest other than to be supportive of me. I could share my doubts with him as comfortably as I could my triumphs. He had great confidence in me and became a close friend. But even he didn’t have experience in building a retail company.

I knew that what I needed was advice from a person who had been there before, someone who understood what I was trying to accomplish. I wanted someone who had built a fast-growing company, who lived and breathed the retail business, who could guide me and direct me whenever I reached an unfamiliar fork in the road.

I did a mental audit of the Seattle business community, thinking about the many individuals who had built successful retail companies. One in particular had both the experience I lacked and a willingness to help: Jeff Brotman.

Jeff is a seasoned veteran of retailing, eleven years older than I. As the son of a retailer, he understands the operations instinctively. He ran a family-owned chain of twenty clothing stores and founded several other companies. In 1983, he made his biggest, boldest move when he founded Costco Wholesale, a company of membership-only wholesale club stores. In ten years, he and Jim Sinegal built Costco into a national operator of more than a hundred outlets with annual sales of $6.5 billion. In 1993, they merged with Price Club, and now Jeff is chairman of the combined company, which has $19 billion in revenues and more than 250 warehouse stores. Starbucks is a dwarf by comparison.

I first met Jeff Brotman when I was trying to raise money for Il Giornale. Later, after I bought Starbucks, I called on him several times, asking his advice. He offered his time and counsel unselfishly, well before he had any connection to Starbucks. He had a sixth sense for good opportunities and an understanding for the range of issues entrepreneurs face. I confided in him, and I realized I could trust him. Listening to his counsel, I appreciated how talented he was. He became, de facto, my mentor.

After several meetings, I asked him to join Starbucks’ board of directors. It took a while to court him. Jeff is careful about his investments, of both time and money, but once he makes a commitment, he takes it seriously.

Jeff eventually joined the board in 1989, a rough time in Starbucks’ history. We were losing money for the third year in a row, and it was by no means clear we would make it in Chicago. Although I had assured the board that we would turn profitable in fiscal 1990, it took Jeff Brotman to give my arguments credibility in the face of escalating losses. His was the voice of authority and experience, and much easier to believe than my promises based on sheer faith.

Jeff also understood what a fast-growing retail company just emerging on the national scene would need to do to raise capital. By late 1989, it was clear that Starbucks had to reach outside Seattle for institutional investors, which meant approaching the venture capital community. As the chairman of a company that had recently gone public, Jeff had the connections and the credibility to make contacts for us.

At first, I was wary of taking this step, for I had heard that some venture capitalists intrude on entrepreneurial ventures and ultimately ruin them with short-term thinking. At best, venture capital can energize a company with both dollars and expertise and help it grow and mature. But the wrong partners can pursue their short-term self-interest at the expense of the long-term future of the company.

Once we decided to go ahead, though, we had more difficulty than we expected. In the early 1980s, retail start-ups had become highly popular with institutional investors. Then, the market collapsed, and several venture-backed retailers collapsed. The funds that had invested in them performed so poorly that some were unable to continue to raise money. Many venture funds refused to invest in retail after that, sticking to companies in technology and health care. Many turned us down.

Craig Foley, who then headed Citibank’s Chancellor Capital Management Inc., was one investor who decided to take a chance on us. Unlike other fund managers, who quickly dismissed us as a coffee-shop chain, Craig was a coffee lover who missed the quality of coffee he had tasted in Europe. He did have a long-term commitment to retail investments and had heard of Starbucks through a colleague. But after visiting a poor-performing store in Chicago, he had decided not to invest. He had, though, supported Costco, so when Jeff Brotman asked him to take another look at Starbucks, he did.

Craig’s biggest concern was that our idea was not “portable,” that it wouldn’t appeal to customers outside the cool, rainy Northwest. I rose to the challenge and went to great lengths to convince him he was wrong. He closely examined all our Chicago stores and decided that not only was gourmet coffee potentially a big growth opportunity but it could also be a “lifestyle phenomenon.” To compensate for the weakness he saw in Chicago, he negotiated a somewhat lower valuation in the company, $3.75 a share, only slightly above the $3 share price of the previous round, in 1988. Still, because of Chancellor’s high profile, his decision to invest $4.5 million, a rather risky leap of faith in Starbucks, attracted several other institutional investors. In all, we were able to raise $13.5 million in March 1990, by far our biggest financing at that time.

Our Chicago stores proved critical, too, in attracting another investor in that round, Jamie Shennan, a general partner of Trinity Ventures. He first saw Starbucks by happenstance, while walking down a street, and he later heard from a colleague that we were looking for venture capital. An experienced marketer, he was attracted by the power of the Starbucks brand and the buzz he heard from our customers. So was Ken Purcell, of T. Rowe Price.

My initial fears about venture capitalists proved unfounded; what I found, in fact, was the opposite. Instead of interference, I gained another set of trusted advisers with long-term horizons. We were fortunate that our venture capital partners genuinely understood and appreciated the culture of Starbucks.

Craig Foley and Jamie Shennan joined the Starbucks board when their funds invested, in March 1990. They pushed me to conduct market research and to begin strategic planning, and also gave invaluable guidance on how to make the transition from an entrepreneurial, private company to a professionally managed public one. Jamie, who spent many years as a brand manager at Procter & Gamble and later as a consumer marketing consultant, provided astute insights into the building of the brand, establishing joint ventures, improving the catalogue, and introducing new products.

Craig contributed financial know-how, guided us in our strategic planning, and helped evaluate new business opportunities. It speaks volumes about their contributions and their commitment to Starbucks that Jamie and Craig both remained on the board long after their funds sold their Starbucks stock, as planned. (Venture capital funds, by nature, usually distribute profits to their investors after a company goes public.)

Craig and Jamie’s joining the board meant that several of my earliest, staunchest supporters had to step down. Of the original Il Giornale board and investor group, only Arnie Prentice remains a director. Just as every business has a memory, every board should have one, too, and it’s been critical for me to have the presence of someone who understands me and where Starbucks came from, to have someone from the past who is linked to the future.

My relationship with the board took an unusual turn when I came to view them more as trusted advisers rather than as supervisors. Unlike many CEOs, I was direct with them, confiding in them my problems in running the business. They always challenged me to defend my ideas, and we had open and frank discussions at board meetings. They continually pushed me to sharpen my focus and set clear priorities, fearing that my entrepreneurial zeal would send the company in too many directions. The board also strongly encouraged me to strengthen my management team ahead of the curve, hiring people with bigger company experience. Debates were at times intense and sometimes difficult but also healthy and constructive. We never needed to take a vote. When one person disagreed strongly, we took the time to work it out and come up with an acceptable solution.

With time, the board’s culture and values evolved into a mirror image of those of Starbucks. The outside directors gradually developed more trust in me than they had in the early period, when they thought perhaps I was just another raw young entrepreneur who would have to be replaced, at some point, by a professional manager and CEO. They, too, have poured their hearts into the company.

Starbucks’ board remained stable for six years, adding only two inside directors. Then, in 1996, as we faced the reality of becoming a $1 billion company, we once again looked for someone who had the expertise that comes with experience. That person was Barbara Bass, who had risen at Macy’s and Bloomingdale’s before becoming CEO of I. Magnin and later of Carter Hawley Hales’ Emporium Weinstock, which had annual sales of nearly $1 billion. Barbara brought not only a rich store of knowledge and insights about national retailing but also a fresh perspective to what had too long been an all-male board.

To any entrepreneur, I would offer this advice: Once you’ve figured out what you want to do, find someone who has done it before. Find not just talented executives but even more experienced entrepreneurs and businesspeople who can guide you. They know where to look for the mines in the minefield. If they have thought and acted boldly in their own careers, and proven successful, they can help you do the same. If they share your values and aspirations, and if they freely share their counsel, they can help you through rough patches and celebrate your victories as their own.

That’s the kind of mentor I never had as a kid or as a young adult. If one doesn’t find you, beat the bushes till you find one who will take you on. And with the right mentor, don’t be afraid to expose your vulnerabilities. Admit you don’t know what you don’t know. When you acknowledge your weaknesses and ask for advice, you’ll be surprised how much others will help.