After a 1998 trip to India, where he drank vats of tea, Nalebuff came up with the idea for a lightly sweetened tea that he believed could wedge itself into the ultracompetitive beverage market. Around the same time, Seth Goldman, who had studied with Nalebuff as an MBA student and who was working for a socially responsible mutual fund, returned thirsty from a run in Central Park one day and found himself frustrated that there was nothing to drink that wasn’t sickly sweet. Soon afterward, the professor and student happened to talk; this led to a classic why not? moment, and with $500,000 collected from friends and family, the company was born.
The formula with which Nalebuff and Goldman capitalized the company was pure game theory. Normally, startups have to gin up a valuation for a company that doesn’t yet exist. “Rather than try to defend something that we pulled out of thin air, we created a valuation that was based on our subsequent performance,” Nalebuff says. The early investors came in with a zero pre-money valuation, but the founders got warrants at two times, three times, and five times valuations. Once the stock price doubled, the initial investors would be diluted. Once they had tripled their money, they would get diluted again. They would be diluted one more time when they had received five times their money. Nalebuff had created a contingent valuation. The effective initial valuation ultimately depended on how well Honest Tea did. “The game theory lesson here is that when two sides disagree about something, rather than try to convince the other side that you are right, agree to a bet,” Nalebuff says. “If we did as well as we hoped or expected, then our initial valuation would prove to be high. But if not, then we would not dilute the initial investors.”
To survive as an independent in a fiercely competitive market, Barry Nalebuff has time and again turned to tactics grounded in game theory. For example, whereas most commercial tea producers use crushed leaves and dust to make their products, Honest Tea figured out how to brew its product from whole leaves. When a larger rival came up with its own whole-leaf brewing technology, Nalebuff saw a real threat: That rival, with its superior marketing and sales muscle, was going to grow the pie without cutting Honest Tea in on the growth. By sharing its technology with yet another rival in the form of a private-label arrangement, Honest Tea was able to help grow the pie and enjoy a bigger slice of it. “It allowed us to position the private-label products against a rival’s lineup,” he says. “And prevented them from doing it to us.”
Of course, game theory cannot yield answers to all the challenges that Honest Tea faces. It cannot help in the cutthroat competition for shelf space, for example. As Seth Goldman, the CEO and natural sales and marketing chief, describes it, Nalebuff hit a brick wall when he went to argue with a retailer for more display space for his product. “He has a very rational approach,” Goldman says. “He’ll go to a store and find out we have a product that is selling well for them, and just expect that they’ll understand that they need to carry more of that product.”
That retailers behave irrationally in the face of such logic baffles Nalebuff. “Sometimes people don’t see what is in their best interest,” he says. “You have to work hard to make your business idiotproof — and you’ll still be amazed at what you see in the market. For example, we’ve had stores that don’t put our tea in the cooler because, they say, ‘Your product sells so fast that we’d have to restock the cooler before lunch and we don’t have the staff to do it.’”