Who Should Make My Product?
At CircleUp I spend the majority of my time getting to know Founders and CEOs of early stage consumer brands in the food, beverage and personal care space. One of the more common questions I’m asked in those conversations is “do you think we should completely outsource the manufacturing of our product?” Truthfully I always say it depends, but here’s hoping this can shed some light on the question from an investor’s perspective.
The first thing to acknowledge about supply chain in early stage CPG is that most brands use a contract manufacturer (“co-man” or “co-packer”) to make their products. The reaction I get when describing this to people outside of the space is often surprise — we assume the core competency of a CPG brand would be making products, but in reality for most brands it’s product development, sales, and marketing. It’s for this reason that most CPG investors prefer that a brand outsource its manufacturing. Recently I caught up with Wayne Wu, Managing Director at VMG Partners, who nicely articulated the case for co-packing:
“All things being equal, we would prefer a brand co-pack their products at high quality contract manufacturers so they focus their limited resources in time, focus and capital towards building the brand versus the day-to-day challenges of running a plant and continued capex.”
It hasn’t always been this way; years ago, starting a food company meant buying a factory and equipment — there was no shortcut. The shift that occurred came in the form of specialized manufacturers emerging who could learn how to make your products to the quality you demand, with the safety standards you require and production minimums low enough to work with a startup. An evolution like this cannot be overstated — like Amazon Web Services in the technology world or Shopify in the online retailing world, shifting costs from fixed to variable fundamentally lowers the barriers to entry in any given industry. Rather than investing capital and time in your capacity to make products, small companies can invest in the creation and marketing of ideas, take greater risks, test and pivot quickly as they learn to evolve and focus on what truly makes them different and special.
Naturally there are exceptions to every rule, and a number of our favorite brands are those exceptions. I want to share a couple of frameworks for how we as investors evaluate those exceptions, starting again with Wayne:
“The situations that make sense for a startup to vertically integrate in its early days include a company who has developed a very novel product where there isn’t a viable contract manufacturing option, there isn’t a co packer who will pay sufficient attention to them as small brand, or IP is so unique (there should be a very high bar to this) that they want to keep all of the IP completely in-house.”
The key point here is just how high the bar is to make an exception. How do you know when your case is the exception rather than the rule?
No Viable Co-Packer Option
I call these binary hurdles. While the evolution and specialization of co-packers has continued to improve, there are times when it’s just not possible to move forward with a co-packer. They may not have the equipment, know-how or food-safety characteristics that you need. You will have given them the chance to reverse engineer your product and they just can’t quite do it. I see this often in products that are especially innovative from a food science perspective.
The Test: Would your business fail to move forward without manufacturing yourself?
The capital needed to buy equipment for something so specialized makes this a bet the company decision, so how sure are you that it’s the only way? We learn from The Lean Startup that a business’s success is how many times you can test, learn and pivot — buying a factory is putting your eggs in one basket, so you want to be sure there are no other possible baskets available to you first.
Unique IP
There are times where, despite a lack of scale relative to co-packers, your differentiated IP really could make you the best possible manufacturer of your product by such a meaningful degree that it’s worthwhile. These are situations where the product effectively will market itself because it’s so different from what your competitors are capable of doing. It will also have to market itself if you invest the marketing budget into building a factory! These are also situations where trusting a co-packer with your trade secrets might jeopardize the business. By investing in self-manufacturing, you’ve deemed that manufacturing will be your core competency.
The test: Pick the biggest company with a brand in your category — maybe it’s Coca-Cola or Unilever — if they were to acquire you, would they want your manufacturing facility?
Big CPG brands often love acquiring brands who use co-packers because the integration is plug-and-play once they know how to make the product. Often they do not get much value from the manufacturing facilities post-acquisition. More on this below.
Some of my favorite brands that I respect the most self-manufacture typically because of one (or both) of the above reasons. These reasons are related, and the tests have a similar philosophy: outsourcing should be the default option, and the decision to self-manufacture should be heavily scrutinized. This does not mean no exceptions, but when I see a company get it wrong it’s typically because of one of three underestimations they are making:
Underestimate Your Cost of Capital
One of the most important jobs of a CEO is to allocate scarce capital and resources, which requires both understanding the ROI of projects you invest in and understanding your own cost of capital (or in other words, the return that your investors expect). CEOs typically get the former right when they buy a factory: they know the cost of the factory, the fees you no longer have to pay to a co-packer, and the potentially increased capacity to reach higher volumes. What they might get wrong is how high that ROI needs to be to make investors happy. Most investors in early stage CPG want you to at least double sales every year, which is why they value your company sometimes upwards of 3x last 12 months revenue. If building a factory would not contribute to doubling sales, you likely won’t be returning your cost of capital.
Underestimate Your Eventual Acquirer’s Capabilities
Not every CPG founder wants to one day be acquired, so this may not be relevant to everyone, but considering whether your larger competitor would want to acquire you is a good self-reflection in the value you’re creating. At CircleUp, we’ve made it no secret which side we’re on in the battle of large vs small brands happening around us — but while we’re critical of the innovation from large CPG companies, they are actually quite good at manufacturing at scale. When PepsiCo acquires a small brand, they’re acquiring a set of core assets and capabilities that are different from what they’re good at: your branding, your formulation, your content, your knowledge of important channels or your digital marketing ability. With their scale, it is hard to be much better than they are at manufacturing products efficiently.
Underestimate The Value of Your Time
When we invest in a company with less than $25M of revenue, sure we’re investing in a product and a brand, but the most important asset we’re investing in is the CEO’s time. By that I mean the literal hours of the day that you direct your focus on one of many efforts you are juggling. That’s why every minute spent on things that don’t make the company different and special is really tough to get excited about for an investor. Focus is everything and distraction is dangerous — the distraction caused by managing a manufacturing plant has the potential to be enormous. It’s something that a spreadsheet could never calculate, but something the best CEOs have in common — the ability to say no to profitable opportunities because of the cost of their time.
So there really is no right answer…
…but hopefully whether you’re just starting out, or graduating from that first commercial kitchen, or even further along and considering taking manufacturing in-house, this framework of rules, exceptions and common mistakes can help make that decision a bit less ambiguous.
Who Should Make My Product?
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