A Business Model for Partnerships in Consuming Markets
INTRODUCTION & BACKGROUND
In a word, the goal of this post (an except from my thesis) is disintermediation, or in a bigger sense, the empowerment that comes to small businesses by removing intermediaries that are unnecessary to them.
Coffee commodity markets are notoriously complex and undifferentiated, not to mention volatile. For coffee, it is a labyrinth of stakeholders spread across the world, making communication unreliable and inconsistent from one end of the chain to the other. This lack of information fosters a significant misunderstanding of coffee’s true value, leaving the end consumer grossly under-informed. This is not the ideal system for smallholder farms, most of whom lack the time and resources to play on this level.
The majority of coffee farmers in the world are smallholder farmers, meaning they cultivate on small tracts of land. (United Nations FAO) In Colombia, for example, despite its contribution as the third largest coffee-producing country, the average plantation is just 5 acres. (Café de Colombia) A coffee farmer of that size is just a drop in the bucket, and is forced to be a “price-taker”. Their produce is valued by the speculative commodity market, not by the end consumer, so they have to take whatever they can get. This unpredictability to the farmer’s finances makes year-to-year forecasting and investments very difficult to manage, in addition to a lack of available business loans.
Furthermore, smallholder coffee farmers are struggling to keep pace with the global challenges. There are increasing demands and costs put on coffee producers. Climate Change for example, has had devastating effects on coffee farms in places like South America and Africa, and may threaten the majority of suitable land on these continents over the next several decades. In the meantime, worldwide consumption is increasing, putting more and more pressure on farmers to simultaneously increase quantity and quality, all-the-while only receiving a fraction of what the customer pays per cup. In a later section I’ll discuss how the numbers below compare to my own findings, and how it would be helped by my proposal.
Likewise, small business roasters in consuming countries face challenges when competing with the big players in the industry. Although growing in popularity, third wave coffee shops and specialty coffee roasters represent a small portion of the US market for coffee, limiting their influence on the global market. It’s similar to the emergence of the craft beer industry – in both cases, a traditional industry is challenged by the emergence of an artisan elite, crafting a new level of appreciation. Roasters equally face the challenges of market volatility though, and opportunities for expansion are limited. Furthermore, like any small business, there is a mediocre probability of economic success. According to the Small Business Association (SBA), one third of all small businesses fail within the first 2 years, and 50% within in 5 years.
WHAT’S WORKING SO FAR
The traditional commodity supply chain is composed of multiple independent actors, each contributing a value addition. The many actors in this arrangement make for a very specialized and effective chain. A conceptually-abridged version is illustrated below.
The market is increasingly demanding traceability though, and many coffee-producing countries are incorporating this attribute into their national coffee programs and regulations. Traceability means knowing exactly where the coffee originated, and is useful when building regional or farm reputations that reward consistent quality. It’s also very useful in tracking down the precise source, or ground zero, of defects and diseases.
Independent Roasters however, don’t just opt for traceable sourcing because it may still require several intermediaries, resulting in some of the communication and cost challenges I mentioned before. Instead, ambitious roasters reach out directly to farmers in coffee-producing countries. This often involves research trips to origin countries where the roaster visits farms and interviews farmers in search of sourcing partners. The communication channel that is established is very useful in collaboratively improving the quality of the product, and quality of the business. When a deal is made, a third-party freight entity is usually used for the physical movement of goods and customs clearance.
It is the Direct Trade model on which I will base my proposed international partnership. It already accomplishes a lot in terms of the issues I laid out in the introduction, but there’s still more to be gained from expanded collaboration. First I’ll show you how, and then I’ll touch on why.
An international partnership between smallholder farms and small business roasters can help serve as a stabilizing force to both businesses, as well as enabling them for improved growth. I’ve devised two equity-earning mechanisms that will drive the partnership, and integrated them into the normal financial dealings of both entities. The first mechanism addresses the initial start-up of a new roaster. The second describes a model for continued partnership through the on-going supply of raw materials (e.g. green coffee). The direct trade format is utilized in order to minimize the presence, and profit-share, of intermediary entities while maximizing the influence and control of the business owners.
The Bulk Investment Mechanism
Opening a roaster is a costly endeavor – perhaps even riskier as a small business entrepreneur. And so in simplest term, this first mechanism is intended to pool the resources of both parties to alleviate the financial burden of opening a roaster, while offering the farmer a valuable intangible benefit in return, stability. The farmer will provide the raw materials (e.g. green coffee) to the roaster in exchange for equity in the business. The material provision will decrease the initial cash outlay for the roaster since he will not have to front the cash to purchase the raw materials.
Continuous Equity Dispersal Mechanism
The obvious flaw in this mechanism is that a farmer cannot possibly forgo all that revenue for the year without going-under him/herself. Instead, it makes sense to pair the bulk investment mechanism with a long-term one. For example, let’s say the initial investment was set to a maximum of a 4 months’ supply of coffee. After this initial supply of raw materials is used up, a standardized equity-payment plan will take over.
The foundation of this mechanism is what’s called the price differential. Typically, in the commodity coffee market, coffee pricing is based on two factors, the market price, and a price differential. The commodity price is what fluctuates erratically with the stock market, but the “differential is determined by the coffee broker, the farm, or the country of origin, and is based on the quantity and quality available, in the long and short term.” (Graham, S.)
The imprecise nature of this pricing feature is generally not favorable for the farmer, but here I’ve re-envisioned it as an opportunity. In terms of cash-flow, this mechanism will help the roaster by allowing him/her to pay for a portion of the raw materials in equity shares instead of cash, reducing the Cost-of-Goods-Sold (COGS). This mechanism also ensures that the premium will be paid in a value equivalent to or better than what a certification such as Fair Trade would offer. In plainer terms, it guarantees that the farmer pockets a minimum amount of cash, while paying out equity as reward for high quality.
Over time, the equity of the farmer will increase due to both mechanisms, slowly earning the farmer a permanent share in the business. This has ample benefits to the farmer in terms of increasing credit ratings and business expansions.
Now, for sake of time and space, I’m going to make a quantum leap over all of my data, research parameters, and calculations to skip right to the conclusion.
Under a direct trade relationship, particularly one in which an international partnership is employed, the farmer is bound to receive a higher percentage of the profit. My findings were that it would double.
There are a lot of other benefits from this partnership, as well as disadvantages, but you’ll have to read the thesis in its entirety to get that far into the weeds. Profit share was my first and foremost objective with the model, because more money in the pockets of the farmer will solve far more problems than any other single benefit. And my goal here, with you my reader, is to simply gloss over a basic situational analysis and to share a brief, but stable, skeleton of my plan. After all, you may start to see some of this model put into action at JWC Coffee Merchants.
Today’s coffee market is the proving ground for small businesses – a time to capitalize on a market that craves them. They only need the tools to enter the game. Collaboration is that tool, and partnerships are the most direct manifestation of it. In the long-run, smallholder farmers can benefit tremendously from setting up an international partnership, and in-turn, help a small roaster survive a start-up period that’s known to be rife with difficulties. Collaborative partnerships offer a harmonious balance of stability and enabling to keep the companies simultaneously steady, yet forward-moving.
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