The consumer landscape has changed markedly over the past five years, driven by changes in consumer demographics, an increased focus on health and wellness, and a desire for value and convenience. This evolution continues to solidify as Millennials become parents and likeminded Gen Z consumers gain more spending power.
This paradigm shift gave rise to the challenger brand phenomenon, where nimble competitors beat larger CPG companies to desirable product categories and channel positions, in turn creating substantial value for founders and investors. Many challenger brands rode the wave of shifting consumer preferences into the arms of trend-chasing, acquisitive conglomerates. But as we all know, the honeymoon can’t last forever. In many cases, big food failed to wring out the value in these deals. As a result, deal volume has slowed and valuation multiples have compressed.
With the ”growth at all costs” model falling out of favor, replaced by an emphasis on profitability, challenger brands are likely to remain independent longer. This enhances the focus on capital efficiency, which has implications for their relationships with retailers, co-manufacturers, and investors.
Looking for love in all the expensive places // Brands must pay-to-play
Every retail channel is seeking to monetize its slice of real estate. Brands are now competing in-store in natural food and grocery -stores, as well as online through Amazon, Instacart, and specialty e-commerce sites. The latter becoming increasingly more important post-COVID.
In the days of old, the natural channel thrived by providing a lower-cost venue for brands with a higher appeal to consumers who wanted “better-for-you” options. They offered tasty extras like prepared food and hot bars to get the incremental shopping business of the health-conscious consumer.
Fast forward to a world gone e-commerce and curbside grocery pick-up, the cost of doing business in every channel has risen. Competing on a price and convenience basis has fundamentally changed the nature of relationships between brands and retailers of all stripes.
In-store, brands used to be the destination. Now, that power pendulum has swung back to retailers. Shelf space has not grown at the same rate as challenger products have proliferated. As such, there is no more “free rent” at Trader Joe’s, Whole Foods, or Sprouts. Additionally, brands are sacrificing margin through temporary price reductions just to stand out among the sea of competitors. Every time you scan for your Amazon Prime discount at Whole Foods, a challenger brand founder winces, knowing they’re eating that cost and subsidizing your $0.99 avocados.
Brands must pay up online, too. Online channels that were traditionally more listing-oriented are now play-to-play arenas with complex search optimization and marketing requirements. Brands who want to see success on Amazon must navigate their ad products and platforms, such as AAP, Amazon’s programmatic ad buy platform. Consumers win on convenience—albeit we’re paying more, too—but brands are really left holding the Prime Now bag.
Will you be my co-man? // Finding the perfect co-packer
In light of these dynamics, brands need to become more capital efficient. Investors have become reluctant to fund owned manufacturing assets for a start-up brand, which is why they must find a manufacturing partner to make and distribute their products. This match is just as important as taste, packaging, or marketing.
Brands must trust that products are being produced uniformly in the safest possible way, because any failure from a food safety or quality standpoint is borne primarily by the brand, at least in the eyes of the consumer. But beyond food safety and brand integrity concerns, they must also consider how manufacturers will help deliver compelling product economics that will, in turn, drive their retail economics.
A particularly attractive brand may find co-manufacturers willing to participate in an equity exchange in lieu of favorable economics in the short-term. When brands find co-manufacturers that are eager to collaborate with them, compelling outcomes can be realized—true partnerships emerge when the value creation equation flows both ways.
Not every brand is as fortunate, though, and most have to deal with the inherent push-pull between what co-manufacturers want and what’s feasible for a brand below the scale threshold of negotiating power. Co-packers have a long list of requirements, some of which can become deal-breakers. They’re looking for minimum order quantities and advantageous payment terms. Additionally, line time optimization, overhead absorption, and yield loss allowances are central to their thinking. When brands achieve a modicum of scale, they can finally start to better negotiate co-manufacturer economics. Getting there is easier said than done, and the road to scale is generally paved with equity dollars.
Who’s picking up the tab? // Funding the future of challenger brands
Brands born in the last decade who thought they were going to grow at abnormal rates and exit are facing a new reality. Large CPG companies, many of whom have had their managerial agenda commandeered by activist investors and are engaged in divestitures and restructurings, have their sights set on driving share price through earnings. However, the sea of hopeful challenger brand acquisition candidates was designed and funded on the basis of growth, hoping that a strategic acquirer would eventually wield their leverage at retailers and supply chains to change the underlying profitability profile. This contradicting dynamic is widening the bid/ask spread of buyers and sellers.
The harsh reality is the market has contracted for the $20-$50m revenue growth-oriented food and beverage company lacking profitability. Brands need to either own their category and be meaningfully differentiated, or they must modify their valuation expectations and start thinking differently about a path to exit. Exit dynamics are now about scale and profitability, and it is not easy or cheap to stay independent for long enough to achieve both.
For brands who are really doing something special, Series C and D financings with both primary and secondary proceeds are an option. We are seeing this route proliferate, and pools of capital targeting these opportunities do exist. However, institutional investors of all varieties are rightfully picky because they are scarce.
In order to be competitive, brands need to be fine-tuned and have something meaningful to offer—be it innovation, enhanced distribution, international opportunities, or cost savings initiatives driven by supplier and co-manufacturer consolidation.
The strategics’ shift away from challenger brands has tipped the scales in favor of financial sponsors who are sitting on significant amounts of dry powder, and valuations have come along for the ride. Buyers now start by looking at gross profit, then back off direct selling costs (inclusive of what brands are paying in slotting, sampling, and promotion), and then buy businesses on this adjusted contribution at single-digit multiples.
Last year, financial sponsors did half of all domestic food and beverage M&A deals. This is up from just 21% in 2018. These sponsors are betting on the fact that people will have to eat, even in a potential recession, and capitalizing on the malaise of scorned strategics trying to get their houses in order. With an adjustment of valuation expectations, brands can find sponsors happy to benefit from this reality.
Always the brands-maid? // Considerations for co-manufacturers
In our next piece, we’ll focus on how co-manufacturers should be looking at the emerging growth brands with which they partner so they can protect themselves against the impact of acquisitions. And not to be left behind, the co-packers themselves are becoming more attractive acquisition targets for sponsors looking to bet not just on brands, but on the broader category.
Please consider our team as a resource as you explore how these market dynamics may impact your strategic alternatives. We look forward to speaking with you.