It Takes Money to Make Coffee

Howard Schultz needed to raise $1.25 million. Rejected by 217 potential investors, he raised $600,000 so far. His former partners at Starbucks had invested $150,000 of that. Then, he raised $900,000 in June 1986. Obsessed with the Italian espresso bar experience, he left Starbucks. In 1986, he started Il Giornale. By August of that year, he signed the lease for a second location. For his business plan to pay off, he needed to launch eight espresso bars. Without capital, his plan wasn’t going to succeed.

Last week on Methods of Prosperity.

Howard Schultz experienced a pivotal moment. Determined to join Starbucks, the founders rejected his offer. They feared he would disrupt their culture. Howard refused to take no for an answer. He convinced Jerry, a Starbucks partner, to reconsider. Howard emphasized the potential destiny of Starbucks. He persuaded Jerry to hire him. Howard sacrificed his comfortable life in New York to join Starbucks in Seattle.

In 1983, Howard became inspired by Italian espresso bars. He believed in the potential for this concept in the US. His bosses resisted. Starbucks went into debt to buy out Peet’s Coffee & Tea. Starbucks tested Howard’s espresso bar idea in 1984. They opened a store offering espresso drinks which became popular. Jerry remained skeptical. This prompted Howard to leave and start his own company, Il Giornale, in 1985.

Howard struggled to raise the $1.7 million needed for Il Giornale. He faced significant rejection from potential investors. The first Il Giornale coffee bar opened in April 1986. It surpassed sales expectations but failed to make immediate profits. Howard continued to face funding challenges. He had only raised half of what he needed. By August, he signed the lease on the second Il Giornale and didn’t know how to pay for it.

Part 59. Howard Schultz (conclusion).

You can read this week’s TL;DR here.

Key Lessons:

• Don’t conflate stock price with actual value.

• Determine what need you’re fulfilling.

• Mix high standards with flexibility.

• Provide an affordable luxury.

• Take care of your people.

• Create a great culture.

• Build your brand.

Now there’s a collectible version of this newsletter! Methods of Prosperity newsletter number 22 is available to collect as of July 25, 2024. If you’re so inclined you can permanently own it!

In Seattle, there were three prominent business leaders. They were titans. A group of investors who developed some of the tallest buildings. Howard pitched them on his Italian-style espresso bar concept, Il Giornale. They agreed, but not without demands. They wanted a lower price, options and board seats. It took two weeks to work out all the details. The group invested $750,000. With their investment, Howard raised a total of $1.65 million from 30 partners. That included seed capital.

The previous year, Howard met Dave Olsen. Olsen was a prominent figure in Seattle’s coffee scene, running Café Allegro. That’s where he served a custom espresso roast developed with Starbucks’ founders. Café Allegro was the prototype for what Starbucks later became. It was a neighborhood gathering place with a bohemian style. Having Dave on his team would contribute to the success of Il Giornale. Recognizing the opportunity, Dave agreed to partner with Howard. Dave worked twenty hours per week for a salary of $12,000 per year. He would become senior vice president.

By mid-1987, revenue climbed to around $500,000 per year at each Il Giornale store. Still not making a profit they were on track to making their goal. Howard’s vision was becoming a reality. Then in March, Jerry and Gordon decided to sell Starbucks. Howard decided to buy it. At that time, Starbucks was much bigger than Howard’s Il Giornale, which hadn’t completed one year. Howard exhausted every resource to raise $1.25 million for his first company. Now he was going to raise $4 million to own Starbucks. He raised it all in a few weeks from existing investors.

By August 1987, Howard Schultz owned Starbucks Coffee Company. Il Giornale changed its name to Starbucks Corporation. Jerry and Gordon, the founders of Starbucks, still owned Peet’s until 2012 (they sold it for $1 billion). On August 18, 1987, the modern Starbucks was born.

Not only did Howard merge Il Giornale with Starbucks, but he expanded to 125 stores in five years. Howard needed to hire someone who could help deliver on this bold plan. Someone with experience as a corporate executive. Howard turned to Lawrence Maltz. He invested in Starbucks and joined as Executive Vice President in November 1987.

In the late 1980s, corporate generosity was out of fashion. Most employers cut back on employee benefits. Starbucks went the opposite direction. Instead of cutting healthcare benefits, Howard insisted on increasing them. It was a core strategy. It wasn’t as extreme as Henry Ford’s corporate welfare, but it did attract quality employees to Starbucks.

Board members fought Howard on his strategy. Starbucks wasn’t making a profit. In the short term, offering benefits to part time and full time employees would be costly. In the long term, it would reduce turnover. That would increase customer loyalty. When a customer knows their local barista, that gives an incentive to keep coming back. That facilitates relationships. If the customer’s favorite barista quits, that relationship ends. Howard argued that part time employees are important. They represent two thirds of the workforce. They deserve benefits. The board gave in. Starbucks granted full health benefits to all part timers in 1988. By 1990, Starbucks had their first profitable year.

Howard believes in pleasing customers, but you also have to know when to say yes and when to say no. For example, it was against tradition to use non-fat milk. When customers asked for it, Starbucks could be rigid and dogmatic about it, but would lose a customer. Baristas in the early days took pride in their work. That pride at times came off as rudeness or pretentiousness. Howard was intent on creating a culture with high standards that was also welcoming. Losing customers is the most powerful argument for flexibility.

While other brands offer franchises, Starbucks refuses to give up ownership. Jack Rodgers served as the first senior vice president of business development. He was an early franchisee for McDonalds. He advised that offering a franchise opportunity could help Starbucks grow. Howard refused on the grounds that franchising would jeopardize Starbucks on quality control.

Howard surrounded himself with the right people. He reached out to Jeff Brotman, the co-founder of Costco. In 1989 Brotman joined the board of directors. That year Howard hired Howard Behar. He started with Starbucks in 1989 as vice president of sales and operations. Behar later became the executive vice president.

In 1991, Starbucks opened in Los Angeles, California. The LA Times named Starbucks the best coffee in America. Word-of-mouth is powerful. Overnight, Starbucks was fashionable. During that time, an ad agency pitched Starbucks with an angle. This ad agency interviewed customers in Los Angeles. The common thread was that Starbucks is social. It’s the third place. That is, the place customers go for a social life between work and home. This is a phenomenon. There are very few “third places”. In the 1990s, coffee bars – not only Starbucks – but any local coffee shop, was the place to go to hang out.

In September 1991, Starbucks offered shares to employees, (referred to as “partners”). Howard presented the idea to the board in May. Bean Stock is Starbucks’ stock issuance program for employees. Partners who work for six months are eligible. It grants eligible employees Restricted Stock Units (RSUs). These RSUs convert into shares of Starbucks stock over a two-year vesting period. Partners must remain employed to receive their shares. Half of which vesting after one year and the remaining half after two years. Bean Stock allows partners to share in the financial success of the company. Giving stock options to your people gives them ownership. That changes the dynamic and aligns incentives. Starbucks gives generous benefits. That’s expensive, but not as costly as high turnover. The value of equity increased 22x from late 1991 to 1996. Starbucks went public on June 26, 1992.

In 1994, Starbucks invented the Frappucino and partnered with Pepsi to bring it to market. The company formed Starbucks International. A new roasting facility opened in Pennsylvania to supply east coast stores.

The biggest challenge that year was a 300 percent rise in coffee prices. There had been a massive shortfall of supply in Brazil. Starbucks was already paying more than competitors, buying premium quality beans. The easy solution would have been to raise prices for customers or buy lower quality beans. Howard new this would hurt the Starbucks brand. Downstream, their best baristas might leave. Second and third order consequences made the price too costly in the long run. It wasn’t a problem they needed to solve. Starbucks didn’t need to spend on marketing and advertising. They could afford to eat the cost of high quality coffee.

In June 1994, the board appointed Orin Smith as president and COO of Starbucks. He would later become CEO in 2000. Howard transitioned from holding both the president and CEO roles to CEO. Howard remained chairman of the board. Howard calls his role “leader”.

In December 1995, Starbucks stock reached a record high. When one store is successful, Starbucks opens another store nearby. That new store may cannibalize the first one. This can send a distorted signal to Wall Street. That’s why reported numbers don’t tell the whole story. You have to understand what’s happening with the business. So when the stock goes down, that doesn’t exactly correlate with the actual value of the business. That year, there was a $5 million shortfall in sales. That caused market value to decline by $300 million total. Starbucks was doing well, but the stock price suffered. Howard realized that he needed to detach his view of the company from the stock price. Three months later, the stock hit new highs.

That holiday season was below expectations. He reminded his team that success is not determined by the past. During that era, the economy slowed down in late 1995. It was not a recession. Starbucks did face a lot of competition. Business picked up in 1996. By that time they had 1000 stores. Revenue was around $700 million.

That same year, Scott Bedbury became the senior vice president of marketing. Before joining Starbucks, he was the head of advertising at Nike. This is the guy who launched the iconic “Just Do It” campaign. Most brands rely on extensive marketing and advertising. Starbucks spent less than $10 million between 1987 to 1998.

Schultz returned as CEO in January 2008 during the financial crisis. He replaced Jim Donald, who served as CEO from April 1, 2005 to 2008. Howard Schultz stepped down again as CEO in December 2016. Shultz assumed the role of executive chairman. Kevin Johnson became CEO. In June 2018, Schultz left his executive chairman role. He returned as interim CEO in March 2022, following Kevin Johnson’s departure. Schultz stepped down as interim CEO on March 20, 2023. The current CEO is Laxman Narasimhan.

Howard Schultz has a net worth of over $3 billion. Starbucks (Nasdaq: SBUX) has been one of the market’s top performing stocks. Since their IPO in 1992, SBUX is up over 240x. This equates to an average annual return of 18.6 percent, excluding dividends. This is relative to the S&P 500 return of 10.4 percent, even with dividends included. Today, Starbucks is a multinational brand. Starbucks is pioneer in the realm of coffee in America. It sits alongside major brands like McDonalds, Apple, Coca-Cola, Nike, and Amazon. Starbucks has over 16 thousand stores in the USA, and 38 thousand stores globally. In fiscal 2023, Starbucks revenue was $36 billion. That’s a 51x increase, 15.7 percent compounded annual growth rate over 27 years.

I like you,

– Sean Allen Fenn