[co-author: John Hyman]

The food and beverage industry is booming and presents numerous attractive opportunities for acquisitions, investments and other strategic transactions. Whether a transaction involves the acquisition of a more mature brand owner, a younger brand owner, or a company that is purely a manufacturer or a distributor for a brand or multiple brands, it is critical for potential buyers and sellers to understand the unique attributes of the industry in order to negotiate and structure such transactions effectively. In this article, the first in a series on strategic transactions in the food and beverage sector, we will look at some of these key industry-specific considerations and the role that they play in the context of due diligence and in acquisition agreement negotiations. 

First, given how heavily regulated the food and beverage industry is in the U.S. and most other jurisdictions, thorough regulatory due diligence of a target company is of crucial importance. A buyer and its advisors should carefully review the target’s historical compliance with food safety, product labeling, advertising and other applicable laws and regulations, as well as evidence that the target has all necessary government licenses and permits to operate its business. Depending on the target’s business and geographic scope, this may require an understanding of multiple regulatory regimes to which the target may be subject. For example, buyers of alcoholic beverage businesses will need an understanding of both regulations applicable to food and beverages generally and regulations applicable to alcoholic beverages specifically. Informed buyers will also insist on information sufficient to understand the product quality standards applicable to products manufactured or sold by the target, product traceability for the target’s products, and any prior recalls, voluntary withdrawals from the marketplace or litigation involving the target’s products. 

The same regulatory and product quality considerations that impact the due diligence being performed will also be a factor in what provisions any buyer will want to see reflected in the acquisition agreement. Buyers should push for robust representations and warranties around product recalls, regulatory compliance, maintenance of required government licenses and permits, and product quality and safety. In the case of private M&A transactions, a buyer should also evaluate whether the results of its due diligence investigation warrant extended survival periods, higher caps and/or lower “deductibles” for breaches of these representations. Finally, if the diligence process raises material concerns in these areas, a buyer is likely to take those issues into account in determining the size and duration of any escrow or holdbacks, whether to request a specific indemnity with respect thereto (which would provide a buyer with post-closing protection even for known issues) and whether to adjust its overall valuation of the target’s business in light of that exposure.

Another key diligence area will be the target company’s contracts. As in almost any transaction involving consumer products, buyers will need to understand both the economic and noneconomic terms of the target’s key customer and vendor contracts, as well as the strength of the target’s relationships with those third parties. Equally important, however, are the arrangements governing the rights to the target’s key brands, including any agreements governing the manufacturing and distribution thereof. In the food and beverage industry, brand owners often rely on third parties to manufacture and/or distribute their products, and a thorough understanding of these relationships is critical not only for an accurate valuation of the target’s business, but also to ensure the target’s successful post-closing operation and, if applicable, its integration into the buyer’s broader business. At the most fundamental level, buyers need to understand all the parties involved in these relationships and the scope, duration and economics of the contractual agreements. 

Note that termination rights under manufacturing and distribution contracts can be particularly important in this context. For example, distribution and manufacturing agreements may grant brand owners the right to terminate without notice or compensation in connection with a change in ownership of a distributor/manufacturer, and some also grant reciprocal rights to the distributors or manufacturers following a change in ownership of a brand owner. In such cases, a buyer must consider appropriate closing conditions tied to the receipt of key third-party consents, and potentially request downward adjustments to the purchase price if such consents are not received. Similar rights are also often found in contracts between brand owners and suppliers of product ingredients, and sophisticated buyers will negotiate for similar termination or price adjustment rights if any of these contracts are critical to a target’s business. On the other hand, many distribution and manufacturing agreements are not terminable at will by brand owners. Instead, if they are terminable at all outside of a breach of the agreement by the distributor or manufacturer, they may be terminable only upon the payment of a termination fee by the brand owner to the manufacturer or distributor, and such a fee is often significant. If a strategic buyer wants to utilize its own distribution, production or supply chain for a newly acquired brand or to utilize a newly acquired distributor or manufacturer for its own brands, its focus (both in terms of diligence and negotiations) should be on contractual flexibility regarding how the target’s existing arrangements will be terminated and which party will bear the cost of any such termination.

A comprehensive understanding of how a target fits into a broader distribution, production and product supply system requires more than a superficial understanding of a few key contractual provisions, however. These relationships are often geographically allocated and involve multiple independent players and long-term, or even evergreen, agreements. A buyer of a brand owner needs to understand the full scope and extent of its distributor/manufacturer network and the target’s relationship with these third parties. A buyer of a manufacturer, supplier or distributor needs to understand how the target “fits in” relative to not only other players in the system, but also the owners of the brands it produces or distributes. In both cases, a buyer must obtain a clear picture of the relative allocation of rights among a brand owner and these independent partners. To provide just a few examples:

• How is responsibility for local marketing, and marketing expenses, allocated between the brand owner and its distributors, and who has control over the content of those marketing materials?
• Who is responsible for ensuring that products comply with agreed standards and applicable laws and regulations? Who is responsible for ordering and paying for product recalls if necessary?
• What rights does a manufacturer have to alter product recipes, and who owns the rights in any such alterations?
• What authority does a distributor have in price setting, and what are the economics of the relationship between the brand owner and its distributors?
• What are the limitations on a distributor’s geographic rights? Are these exclusive in all channels or only in certain channels? Are they exclusive in every geography?

Because many large and long-established distribution and production systems are governed in part by a series of unwritten understandings that have evolved over time, a buyer will need to understand these unwritten “rules of the road” specific to that system, as well as the written agreements to which the target is a party, in order to most effectively operate within – or evaluate its rights to exit from – that system following the closing of the transaction.

Depending on the nature of the target’s business, other areas of diligence and negotiation common across M&A transactions may also take on particular importance. For example, because the value of most businesses in the food and beverage industry derives in large part from their intellectual property and associated goodwill, buyers of brand owners will be extremely focused on the target’s IP portfolio and the rights the target has – and has granted to others – in that intellectual property, as well as any past or threatened events that could damage any associated goodwill. As with other key areas discussed above, a buyer will also push for robust representations, warranties and indemnification with respect to the target’s ownership of key intellectual property such as trademarks, recipes and other trade secrets, and the steps the target has taken to protect those rights. (For a discussion of trade secret protection in the U.S. food and beverage industry, please see this article from our August 2018 Gazette.) Further, if a target is involved in manufacturing or distribution operations, a buyer must also pay heed to environmental matters (especially given the wastewater that is often generated by beverage production), real estate and labor relations (particularly if any target employees are unionized). 

The foregoing examples are not an exhaustive list of all the unique considerations that inform due diligence and the acquisition agreements for food and beverage companies, but rather is intended to introduce the types of considerations that buyers and sellers should bear in mind as they evaluate and negotiate such transactions. In later articles, we will continue our study of M&A transactions in the food and beverage industry, including such topics as transaction structure and key ancillary agreements incident to such transactions.