Starbucks, Kraft and the $2.7 Billion Divorce

Last week’s LIMA Bottom Line featured an article I wrote about the recent resolution of a long-running dispute between Starbucks and its licensee, Kraft.   It explains how our approach to treating licensees as partners might have led to a different result in this case, and features some legal recommendations for for structuring long-term agreements.  You can read the full article below or you can read it and the rest of the LIMA Bottom Line here.  

By now most licensing professionals know that the long-running arbitration between Kraft and Starbucks ended with a ruling in Kraft’s favor: Starbucks must pay Kraft $2.7 billion for the supermarket coffee business that Kraft built from 1998-2011.

What Happened?

In the late 1990, while Starbucks was focused on building out its own network of stores, it relied on partners to create and deliver Starbucks-branded products to supermarkets. Those partners included the biggest food and beverage companies in the world: Pepsi (beverages), Nestle/Dreyer’s (ice cream), and Kraft (packaged coffee).

With sales flat for its own Maxwell House brand, Kraft bet on the right brand for growth at retail, and Starbucks gained a partner with the capacity to make its re­tail coffee business a big one. Between 1998-2010 Kraft grew the Starbucks retail business from $50 million to $500 million in sales.

As with others, Starbucks used the mar­ket power of its brand to gain compensation terms from Kraft far better than the average food-licensing agreements. Kraft appears to have paid Starbucks either half of its an­nual profits or a royalty rate in the 15-20% range.

But Kraft’s market power – and the large-scale investment it would be making in the Starbucks business – gave it leverage, too. Kraft negotiated both a long-term contract and the right to renew it in perpetuity, un­less it committed an incurable breach or Starbucks decided to buy the business back, in which case the agreement speci­fied a valuation process that included a 35% sale premium. As early as 1998, both sides recognized the serious loss that Kraft would suffer if Starbucks ever took back the business, and agreed on a way to reward Kraft for the value it had built.

By 2009, Howard Schultz concluded that one of Starbucks’ best opportunities for growth was to take its packaged-goods business away from licensees and do that work itself.

In mid-2010, Starbucks offered Kraft $750 million to give up the Starbucks busi­ness. Kraft declined, and almost immedi­ately afterwards, Starbucks began contend­ing (apparently for the first time) that Kraft had in fact breached the agreement.

After the U.S. District Court and 1st Cir­cuit Court of Appeals denied it an injunc­tion, Kraft took its case to arbitration. The arbitrator found that Kraft had not commit­ted a material breach of the agreement but that Starbucks had effectively exercised its rights to terminate the agreement and needed to pay Kraft under the agreement’s valuation provisions. The total price was almost 3 times the offer Starbucks made in 2010: $2.2 billion, plus interest, penalties and attorneys fees.

What’s the Lesson?

It may sound strange coming from an at­torney, but Starbucks should have paid less attention to small print in its license agree­ment and more attention to the reality of a large-scale partnership.

What if cooler heads had prevailed on Howard Schultz to manage this process as the agreement laid out? What if Howard Schultz had called Irene Rosenfeld at Kraft and said, “Irene, we’ve had a very good run, but as our agreement provides I am going to exercise our right to take back the pack­aged coffee business. Our lawyers will work with yours to calculate the appropri­ate valuation under our agreement. Thank you for our long partnership and for having done so much for our brand.”

Sometimes lawyers (and CEOs) get stuck over-managing the terms of their license agreements and forgetting the realities of the marketplace, the complicated nature of partnerships, and how your behavior may affect other relationships. Ron Johnson and his attorneys at JC Penney apparently fell into the same trap earlier this year, per­suading themselves that Martha Stewart’s agreement with Macy’s allowed them to build a broad Martha-branded business at Penney’s.

Licensing – especially at the scale of the Kraft-Starbucks deal – is really about partnership, and the more time you spend studying your agreement and looking for loopholes in its language, the farther you may be getting from what made it (or could make it) a success.

Should the agreement have been structured differently?

Many have criticized Starbucks’ attor­neys for having given Kraft so much lever­age. I don’t agree. If you want one of the biggest players in an industry to commit its own capital and resources to supporting your brand, you need to offer something in return. I cannot imagine Kraft signing this agreement if it had left more control in the hands of Starbucks.

I might, however, have applied a declin­ing rate to the valuation formula and/or the premium applied to the valuation based on the number of years and the overall re­turns Kraft had generated under the deal (returns which may have reached $1 billion by 2010.) Under this scenario, Starbucks would have treated Kraft like an important partner, but one whose upside should have some reasonable limits based on its returns over time.

Licensors sometimes think licensees are lucky to make anything off their brands. But partners value and reward each other for mutual investments. Starbucks might have saved itself a billion dollars if it had done so in this case.