The Keurig Machine inventor gets 50k for stake in multi billion dollar business, read it and weep.
The inside story of Keurig’s rise — a tale unlikely, ultra-caffeinated, and sometimes explosive.
August 07, 2011|By Daniel McGinn
One day in the spring of 1995, John Sylvan was parked outside a BayBank ATM in Coolidge Corner when he started feeling woozy. His heart palpitated. His head throbbed. He began to experience tunnel vision. Sylvan called his father-in-law, a physician, who insisted he drive directly to the emergency room.
At Beth Israel, doctors determined Sylvan, then 37 years old, wasn’t having a heart attack. They did a CAT scan to rule out a brain injury. And so, as doctors typically do, they began to ask questions. Did he get enough sleep? Did he exercise? Most of Sylvan’s answers were medically uninteresting, until a doctor asked if he drank coffee.
Well, yes, he did.
“How much coffee do you drink?” the doctor asked.
Sylvan paused before answering: “Around 30 or 40 cups a day.”
Sylvan was quickly diagnosed with caffeine poisoning, something of an occupational hazard for a guy in his line of work. For the past three years, he and his business partner, Peter Dragone, had been trying to perfect a new kind of coffee maker – one they believed would revolutionize the way America started its morning. They named their invention “Keurig,” a word meaning excellence that Sylvan pulled from a Danish-English dictionary.
On doctor’s orders, Sylvan cut back on his coffee intake, but only slightly. It was the least of the deprivations he suffered while creating a device that could make traditional coffeepots obsolete. Unlike the drip models already on the market, Sylvan’s machine would brew single cups using sealed capsules of ground coffee. From Keurig’s founding in 1992 until their departure in 1997, Sylvan and Dragone hacked together prototype after prototype, working in small offices in Waltham and doing most of the taste-testing themselves. For the first few years, they drew no salary and were turned down for funding by scores of venture capitalists.
But today, 16 years after that trip to the hospital, the company Sylvan dreamed up is a billion-dollar juggernaut. Keurig’s commercial models are now in 13 percent of American workplaces (and more than 25 percent of those in Boston). Last Christmas, one out of every four home coffee makers sold in the United States was a Keurig. Lately the brand has taken on a viral quality: If someone gets a machine and shows it off to friends, soon everyone else in the neighborhood wants one, too.
During its 2010 fiscal year, Keurig sold more than $330 million worth of brewers, which go for anywhere from $79.95 to $249.95 each. The company’s real money, though, comes from its “K-Cup” coffee capsules – it sold well over $800 million worth of those last year. And Keurig, now wholly owned by Vermont-based Green Mountain Coffee Roasters, only continues to soar. In May, the parent company told investment analysts it expected total revenue to increase more than 80 percent in 2011, to approximately $2.5 billion.
Keurig executives admit they’re surprised by their success. “We felt it would be more of a niche product,” says John Whoriskey, general manager of the company’s At Home division. “We never really expected it to be as widely accepted as it is today.” In fact, Keurig’s biggest challenge these days is figuring out how to keep up with demand, which everyone agrees isn’t really a bad problem to have.
There are other challenges coming, however. For one, kitchen gadgets are a notoriously faddish product category. (Raise your hand if you own a bread maker. Now raise your other hand if you’ve actually used it to make bread in the last five years.) The key patents that protect Keurig from competition expire next year, and that could allow imitators to begin selling low-priced knockoffs. And as Green Mountain’s share price has rocketed up – from $27 a year ago to $90 in mid-July – short-sellers have grown louder in predicting it must be heading for a fall.
For now, though, during an agonizing one-step-forward-two-steps-back economic recovery, Keurig – which has added 100 jobs since last October – is a rare Massachusetts company that’s charging ahead. But it wasn’t always that way, says longtime Keurig executive Chris Stevens. To sum up the extraordinary journey, he conjures up that old showbiz aphorism. “We’re an overnight success story,” he says, “that was 20 years in the making.”
When you walk into the lobby of Keurig headquarters, in a six-story glass building just off Route 128 in Reading, the first thing you see is a wall unit containing K-Cups –? 56 different kinds of them, from flavored coffees to chais to energy drinks (the company offers more than 200 varieties in all). Beside them is a counter lined with various Keurig brewers. When workers meet in the nearby conference rooms, they’re likely to offer one another breath mints. If ever there was a workforce prone to coffee breath, it’s this one.
Sitting in one such conference room on a recent morning, Keurig’s third cofounder, Dick Sweeney, carefully cuts a K-Cup in two with a pair of scissors. There’s a small pop when he punctures the plastic capsule, releasing the shot of nitrogen that keeps the coffee from oxidizing. Inside the container, there’s a conical filter filled with grounds. The amount ranges from 9 to 15 grams, Sweeney explains, depending on flavor and variety. When the plastic capsule is closed into the Keurig brewer, wide needles pierce its foil top and plastic bottom. The brewer then pumps in hot water, turning the capsule into a miniaturized version of the filter basket in a traditional coffeepot. The process takes just 45 seconds, and if you like French vanilla while your co-worker wants a hazelnut decaf, that’s no problem. Freed from the tyranny of brewing by the pot, to each his own.
The idea for the Keurig machine came to John Sylvan in the mid-1980s. At the time, the Colby College graduate was working as a low-level marketing manager at Analog Devices, the Norwood semiconductor company. Among his unofficial responsibilities was periodically shaking down his colleagues to pay the coffee vendor. “It was like the Mafia – you had to go around and extract money to pay the coffee guy,” Sylvan recalls. “It was like my full-time job some days.”
Beyond the headaches created by the communal chip-in system, the coffee itself was generally terrible – even if a co-worker somehow managed to measure out the right quantity of coffee and water to make a decent pot, which rarely happened, the half-full carafe would then sit on the burner for hours, getting stale and bitter. Sylvan knew he could do better.
In theory, single-serve brewing sounds simple, but it took years of painstaking trial and error to make the K-Cups actually work – and to find a way to cost-effectively produce billions of them. When Dick Sweeney joined the nascent company in 1993, the original founders were cutting filter paper into cones and inserting them into plastic cups by hand. (The cups themselves came from a company that made containers for Jell-O shots.) They then sealed each assemblage shut with a converted clothing iron. “It was all arts and crafts,” says Sweeney, who was named a cofounder and tasked with designing machines to automate the process.
At one particularly busy point, Keurig hired temp workers to hand-make 40,000 K-Cups. When a potential investor sampled the brew and asked how much it cost to make per cup, Sweeney replied fifty dollars each. He was joking, but if you accounted for all the bespoke elements in the prototype brewer and the handcrafted K-Cups, he probably wasn’t far off.
The brewer, too, still had problems. A few years into the project, the Keurig prototypes were still so unreliable that whenever the founders did a demonstration for potential backers, they never knew what would happen. Early models leaked puddles of coffee onto expensive wooden conference tables. The K-Cup filters would often split, leading to drinks so laced with grounds that they were alarmingly crunchy. During one trip to meet potential financiers in Minnesota, the founders made the mistake of checking the luggage containing their trove of homemade K-Cups. Once aloft, the lack of pressurization in the cargo hold caused them to burst. Sylvan and Dragone stayed up all night creating several dozen more by hand.
One thing made these travails worthwhile: the promise of capturing even a small fraction of America’s $40 billion coffee industry. Roughly one in two US adults consumes coffee, and the average drinker quaffs two cups a day. In many workplaces, free coffee is an expected perk – and in the Starbucks era, if the company-provided brew isn’t decent, employees will simply abandon their desks for the nearest coffee shop. According to Keurig research, those excursions can cost a company an average of 40 hours of lost productivity per worker per year.
These office workers were Keurig’s original target market. The company planned to sell the brewers to local coffee distributors, which in turn would place them for free in offices. The money would then roll in from the K-Cups, which the distributors could sell for around 50 cents apiece. If half a 500-person company drinks two cups daily, that’s $250 in coffee sales for the distributor each day. This cheap razor/expensive razor-blade model is at the core of how Keurig does business today. (It’s worth noting that president Michelle Stacy was a longtime Gillette executive.) Even though Keurig actually loses money on some machines, it hopes each sale will funnel a steady stream of K-Cup profits to its bottom line for years to come.
With limited resources, however, that dream was proving hard for Keurig to fulfill. For several years, the founders’ meetings with venture capitalists went nowhere. “People really don’t realize how often we were kicked out of various places – I mean literally kicked out,” Dragone says. Often what started as a pitch devolved into potential investors, such as those at Mr. Coffee, patiently explaining why the device would never catch on.
As their own money dried up, Sylvan and Dragone began to think they might have to close up shop. By 1994, however, just as Dragone was about to pull out of the venture in frustration, the Minneapolis-based investor Food Fund agreed to kick in $50,000. Then the Cambridge-based fund MDT Advisers raised $1,000,000 for the company.
But even as Keurig was thrown these financial lifelines, Sylvan began to chafe against the investors who now wanted a say in the company’s direction. “After the money came in, it went downhill for me personally,” he says now. “I didn’t get along with them. I don’t take orders well, and I didn’t agree with any of their strategies.” Larry Kernan, principal at MDT Advisers who became Keurig’s chairman, says: “John did not play well in the sandbox. He held everything inside, and it was harder and harder to know where the company was standing.” In 1997, Sylvan was forced out and demanded the company buy his stake; he received just over $50,000. Dragone left under better terms a few months later and retained his investment in the company.
The new investors’ money allowed Keurig to hire outside companies to build improved brewers and create a K-Cup manufacturing line. In early 1998, sales executive Chris Stevens began visiting offices to deliver the new machines. They were still unreliable, but in a way that provided Keurig with valuable confirmation of their burgeoning appeal. Whenever one broke, employees would beg for a replacement. Convenience, like caffeine, was proving downright addictive.
Around 2002, a year that Keurig sold 10,000 commercial brewers, the company began laying serious plans to go after what its executives had long considered the Holy Grail: getting machines into homes, where roughly 75 percent of coffee is consumed. There was money to be had, but it was hardly a slam-dunk proposition. Early Keurig models cost $900 each and were too big to fit under kitchen cabinets. They needed to be hooked up directly to a water line, so buyers would need a plumber to install them. On top of that, the K-Cups weren’t available in stores, so customers would have to order them directly from the company. It wasn’t exactly a user-friendly experience.
It took Keurig nearly two years to develop a home model for retail stores that worked, as well as find a manufacturer that could produce it for a sticker price under $150. Suddenly, however, it had plenty of company on store shelves. Salton, Sara Lee, Procter & Gamble, and other competitors had all been developing their own single-serve coffee systems, and they all hit the market at about the same time. Unlike Keurig, which had a shoestring marketing budget, these deep-pocketed competitors had more than $100 million to spend on advertising their new products. But Keurig was able to turn the competition to its advantage. “We piggybacked on all the marketing investments our competitors made developing [awareness of the idea] and doing TV ads,” says Nick Lazaris, who led Keurig between 1997 and 2008. Keurig let the competition spend freely on airtime, then sent reps into stores to do live demonstrations.
On the day after Thanksgiving in 2004, John Whoriskey recalls standing in Filene’s in Braintree, showing off a Keurig brewer and giving out samples. His machine was the priciest one on display, but it was handily outselling competitors. Within days, actual sales data began confirming Whoriskey’s anecdotal evidence. “It became blatantly obvious when you saw the retail sales trends – Keurig was the winner. It wasn’t in question,” says Scott Van Winkle, a managing director at the investment firm Canaccord Genuity, who’s tracked Keurig for more than a decade.
The acquisition seemed a little off-message for Green Mountain, which prides itself on being eco-friendly. Keurig’s K-Cups are famously neither recyclable nor biodegradable, and the companies’ efforts to fix the problem have met with little success. The machines “generate a ton of plastic waste,” says Eric Anderson, a Northwestern University marketing professor who has written two case studies on Keurig and owns several of its brewers himself. “There could be a consumer backlash that would limit the growth of the company.”
Nevertheless, Green Mountain’s $160 million investment now looks like a ridiculous bargain. In the 2010 fiscal year, Keurig brewers and K-Cups delivered $1.2 billion to Green Mountain, 88 percent of the parent company’s revenues. By the end of this year, that number is expected to top $2 billion.
If you think about Keurig’s success for more than a few minutes, you might begin to wonder what it says about life in 21st-century America. Coffee is an exceedingly easy beverage to produce: Measure out some grounds, pour in water, press a button. If that’s too much early morning labor, buy a programmable coffee maker. Mr. Coffee sells a four-cup version for $15.95. Load it up the night before, and voila – the best part of waking up. Yes, it’s true you and your spouse will need to agree on a single flavor, but if you can’t compromise on something this basic, should you really be married in the first place?
Keurig doesn’t boast of saving marriages, but its machine does eliminate the complexities, such as they are, of old-fashioned coffee making. And yet it does so at incredible cost. Even the least expensive Keurig brewer can cost five times the price of its drip counterparts. And at roughly 50 cents apiece, K-Cups cost 10 times as much as generic supermarket coffee. The label on a $3.99 tin of Stop & Shop’s breakfast blend says it can brew up to 90 cups; that’s less than a nickel apiece.
In 2008, when Michelle Stacy was named Keurig’s new president, she was worried about exactly that kind of shopping-list calculus. Yet Stacy was surprised to see that people kept buying K-Cups, even in the worst of the recession. “That was the ‘aha’ moment,” she says.
While a few manufacturers still market single-serve coffee systems, their sales are dwindling, and Keurig is increasingly recognized as the industry’s champ. A few months ago, the website Coffeereview.com held a taste test with a Keurig and four rivals, Nespresso, Tassimo, Bunn, and Senseo. “Keurig produces a style of coffee arguably closer in sensory terms to classic American filter coffee than anything produced by competing systems,” the website’s editors wrote, praising the variety and quality of K-Cup coffees. While Euro-philes who like teeny cups of espresso will prefer the Nespresso system, they added, it’s clear that Keurig’s dominance of single-cup brewing for regular American coffee is only going to grow.
For its part, Keurig has been eyeing the big retail coffee companies. In last year’s annual report, the company expressed a bit of concern over what it called its “primary competitors,” Dunkin’ Donuts, Peet’s Coffee, and Starbucks. But that worry largely dissipated this spring when Keurig locked up exclusive licensing deals with the two biggest brands, Dunkin’ and Starbucks. Bullish analysts like Van Winkle now figure that Keurigs could someday be sitting on the counters of 36 million American homes.
Yet even as the mood inside Keurig seems rightly celebratory – no surprise, given that many workers hold shares of Green Mountain stock – there’s still a hint of jitteriness. It’s not easy finding ways to crank out ever more brewers and billions of new K-Cups each year. Investors seem to believe that Keurig’s recent success will continue unabated, but any number of things could in fact go wrong: supply shortages, environmental alarms, new competition.
The company’s skittishness comes through when officials are asked specific questions about their machines. How hot is the water in the brewer? “That’s somewhat proprietary.” What components in the brewer are in shortest supply? “I don’t know if I want to give names.” What exactly do the expiring patents cover? “Responses to those questions are best held at the enterprise level.” What can you tell me about your research and development operation? “There’s nothing we would share with anyone.”
Under this veil of secrecy, though, Keurig is clearly working intensely to keep its edge. The parent company’s legal team, for one, has been vigorously taking on imitators. Last year, quasi K-Cups, filled with instant coffee, not fresh, began showing up at Wal-Mart. But the maker, Sturm Foods, wasn’t paying the licensing fee that every other coffee brand that uses K-Cup packaging is required to – the company made nearly $40 million on such fees in 2009 – and Green Mountain filed a lawsuit. (Sturm denied wrongdoing, and the case is ongoing.)
Roughly one-third of Keurig’s 340 employees are degreed engineers, a substantial number of them focused on research and development. The company does confirm it’s working on a new-generation brewer, but declines to say what it will look like. Last year, Green Mountain announced it was partnering with Lavazza, Italy’s largest coffee company, to develop a single-serve espresso machine – but the company won’t discuss the status of that project.
Regarding their secretiveness, Keurig executives are mildly apologetic. “You have to understand, we’re a one-trick pony,” says Dick Sweeney, who now oversees quality control. “We have a brewer and a K-Cup. We don’t have a cellphone or a flat-screen TV or a microwave to fall back on if the brewer doesn’t make it.”
Sipping a mild-roast venti at a Starbucks near his Needham home, John Sylvan seems amused by all the machinations over his invention. These days, Sylvan uses a drip machine at home, drinks a cup or two a day, and buys whatever brand happens to be on sale at the grocery store.
You’d think he’d be bitter about the way this story has turned out: His invention now fuels a billion-dollar empire that’s swimming in profits, while he earned little more than $50,000 for a half decade of toil. Indeed, if Keurig were Facebook, he could have played the role of an eternally suing Winklevoss twin. But he doesn’t, even as he admits to sometimes wondering whether he should have cut a better deal when he exited. “In hindsight,” he says, “I wish I’d put a royalty on each one of those [K-Cups].”
Mostly, though, Sylvan’s just happy to have played a role in creating America’s hottest consumer appliance. And although he no longer has any incentive to root for Keurig’s success – he hasn’t talked to Dragone or anyone from the company in years – he does keep tabs on its progress. A few years ago, he bought a Keurig brewer and took it apart, just to see what innovations its engineers had made since he’d left. “My first prototype is still what they sell; it hasn’t really changed,” he says. When he hears all the speculation about the new functions a next-generation machine might perform, he scoffs. “It’s a coffee maker,” he says. “How do you improve it?” Of course, people once asked him that same question.
Even when Sylvan’s original patents expire next year, he doubts a rival will emerge to steal Keurig’s franchise. The parent company has developed too much expertise in manufacturing K-Cups at low prices and high volume. “Green Mountain is way down the learning curve,” he says. “You’d have to work for years to catch up.” (Suzanne Delong, Keurig’s director of investor relations, concurs. There are only two companies in the world making K-Cup packaging equipment, she says, and they’re both under contract.)
Sylvan downs the last of this morning’s coffee and then heads off to his Needham workshop, where he’s plugging away on a solar-powered heating and cooling device. “I’m trying to see if lightning can strike twice,” he says. Whether it does or doesn’t, at least his new project has this benefit: It carries no risk of caffeine poisoning.
