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Preventing the Top 10 Mistakes with Distribution Agreements

by Glen Balzer

Many factors go into the creation of a great distributor agreement. Mistakes in a distributor agreement are almost invisible during the courtship between a distributor and a manufacturer. Unfortunately, those same mistakes grow into glaring errors at the end of a distribution partnership. In order to avoid problems at the time of termination, the creator of a distribution agreement must not insert unsound clauses. Equally important, the author must not omit important clauses. Here is a checklist of ten common mistakes to avoid when drafting your next distributor agreement.

1

Annual Termination and Semiautomatic Renewal

Parties that are inexperienced with distributor agreements sometimes attempt to minimize the opportunity for termination. They falsely assume that, without addressing termination, the relationship can last forever. Annual termination and semiautomatic renewal is a routine procedure among experienced players. In these cases, there is a provision in the agreement calling for termination of the agreement and semiautomatic renewal at the end of the first full calendar year of the agreement, and each year thereafter. Terms and conditions allow either party to submit a Notice of Intention to Not Renew 30 days prior to the end of the calendar year.

When the agreement contains annual termination and semiautomatic renewal, both parties have the opportunity to exit the agreement, without proving cause, once per year. Performance, not a collection of words in the agreement, binds the two parties together. Experienced partners usually prefer to have performance as the binding force in the partnership.

2

Too Much — Too Fast

Every new partnership between a distributor and a supplier is born in a period of bright optimism. Like marriage, there is a limit on the number of partnerships in which a supplier or distributor may engage. A new distribution relationship prohibits a supplier from seeking an additional distributor immediately. That same new distribution relationship prohibits the distributor from immediately initiating a relationship with a new supplier. When partnering with a new distributor, it is important to assign a territory that is not too large initially. If a distributor has a history in only small territory, it is not prudent to assign a large territory and hope for the best. A better policy would be to open a new distributor relationship in that distributor’s proven territory and expand the territory gradually, after results in the smaller territory suggest that an expanded geography is a wise decision.

3

Termination for Cause Only

Most distributor agreements involving seasoned distributors and manufacturers allow for termination for cause and termination for convenience, (or no cause at all). Less experienced partners sometimes attempt to allow for termination for a limited set of specific causes. Termination for cause is sometimes straightforward and without controversy, as when one partner declares bankruptcy. However, partners sometimes disagree over the presence of cause. Partners often disagree over responsibility for cause.

The best distributor agreements allow for termination for cause and for termination for convenience. When an agreement allows termination for convenience, a partner wishing to disengage from the agreement serves Notice of Termination to the other partner with 30 days notice. When either party invokes the convenience clause, neither party needs to argue cause or responsibility for cause. More important, the distributor agreement does not end in a legal skirmish. Without a legal confrontation, the distributor and manufacturer are able to focus on their respective customers and businesses without consuming management time, corporate focus and financial resources on attorneys, courts and arbitration.

4

Exclusive or Nonexclusive

Distributor franchises may be either exclusive, where there will be no other distributor franchised in the territory; or nonexclusive, where the new distributor might be one of several distributors franchised in the territory. Distributors sometimes make an appeal for an exclusive territory, arguing that without an exclusive territory, the distributor has no incentive to allocate adequate resources toward development of sales for the manufacturer.

Once a supplier agrees to an exclusive territory, it forfeits the opportunity, for a period, to franchise an additional distributor. Assignment of an exclusive distributor in a territory represents an unnecessary leap of faith on the part of the supplier. An alternative to assigning an exclusive territory is to draft the distribution agreement in such a way that the distributor is nonexclusive, and simultaneously explain verbally that only one distributor would operate in the territory. A verbal understanding would suggest that if the distributor meets the supplier’s objectives, the distributor would operate without competition in the nonexclusive territory. Such an arrangement provides encouragement for the distributor to perform without restricting options of the manufacturer. Suppliers lacking experience negotiating distributor agreements often feel awkward writing about non-exclusivity while speaking about de facto exclusivity. However, most distributors agree to the technique. Suppliers are often surprised to witness how smoothly this style works. Suppliers learn that verbally offering exclusivity predicated upon a distributor meeting mutually agreed goals leads to increased trust between the parties when the supplier continues with a single distribution relationship.

5

Frequency of Price Changes

Distributors sometimes believe that they would have a competitive advantage if their manufacturers are restricted to adjusting prices only once per year. This may serve the distributor well, but at the expense of the supplier. An arbitrary advantage of one party over the other party does not bode well for the partnership.

During periods of inflation or other rising costs, the manufacturer must have the opportunity to pass along increases in cost. The marketplace disallows aggressive price increases. Allowing a manufacturer to increase prices upon 30-day notice eliminates one opportunity for conflict and reinforces the principle of fairness in the partnership.

6

Termination by Only One Party — Not Both

Distributor agreements that allow termination by only one partner are biased. Experience teaches that such lopsided agreements more frequently end in a legal dispute. By allowing both parties to terminate the agreement, power of the supplier is in balance with that of the distributor. Balance in distribution agreements leads to less litigation upon termination. The best distributor agreements allow either party to terminate the agreement.

7

Frequency of Amendments

Relationships between manufacturers and distributors are organic. They are born. They develop. They grow. They mature. They decay. Ultimately, they expire. External factors periodically apply pressure to the distributor and the manufacturer. Those pressures sometimes call for a change in the distributor agreement. If the agreement allows changes to be made throughout the year, there is little problem. However, if the agreement allows for changes only once per year, one or both partners must survive undue pressure until the agreement can accommodate such an annual change. In the best distribution agreements, either party may suggest changes to the agreement throughout the year. When both parties agree, they can easily approve and amend the existing agreement.

8

What Happens after Termination?

The distributor agreement must spell out responsibilities of both parties during and after the life of the agreement. All distributors and manufacturers understand that the agreement must define responsibilities of both parties during the period that the agreement is in effect. However, fewer truly understand that the agreement must spell out responsibilities for the period after termination. Distributors and manufacturers must be specific about which products are eligible for return for credit, and the timetable for such returns. A reliable distribution agreement must clearly state the rights, responsibilities and obligations of both parties during the life of the agreement, upon notice of termination, and after termination is effective.

9

Comparison with Proven Industry Agreements

Most mistakes written into distribution agreements occur when one or both parties lack experience with creation and negotiation of those agreements. Most large companies with years of experience with agreements rarely write mistakes into those agreements. Many mistakes are the result of one partner attempting to gain advantage over the other partner by inserting a bias into the agreement favoring the party with greater experience.

How does an inexperienced party to distribution agreements level the playing field during negotiation? There are several methods: First, solicit a model agreement from your industry’s distributor association. Many distribution associations provide a model agreement free or at modest cost to their membership, (National Electronic Distributors Association, Material Handling Equipment Distributors Association, etc.). The model is a good baseline from which to compare a new agreement.

Second, use your network of friends in the industry. Although it is unlikely that your direct competitor would lend a copy of its distributor agreement, friends at indirect competitors rarely fear sharing an agreement that has proven over time to be problem free.

Third, if you are attempting to sign a distributor agreement in a foreign land, use the foreign network. American Chambers of Commerce exist in most countries around the world, (American Chamber of Commerce in Argentina, American Chamber of Commerce in Poland, American Chamber of Commerce in Korea, etc.). If your foreign subsidiary does not yet have a connection with the local chamber of commerce, initiate one immediately. The cost of membership in these organizations is miniscule and the benefits extend far beyond learning how to negotiate a balanced distribution agreement.

Fourth, ask the distributor or supplier with which you are negotiating an agreement for a blind copy of two or three agreements that are currently in effect. You need not know the name of the parties in the agreement; you are just looking to establish a feel for what is normal in a particular market.

10

Leaving the Negotiation Process Strictly to Attorneys

Problems with distribution agreements sometimes become visible only after the agreements become effective. It might be disappointing to discover that corporate counsel or outside attorneys did not discover or correct some of the most frequent mistakes found in distribution agreements. How does this happen? Too often, attorneys eliminate onerous clauses, but are simply not aware of industry norms. They lack an understanding of the problems with agreements that arise most frequently. It is a good practice to have the agreement reviewed by both a legal professional and an industry professional. If your company lacks an industry professional experienced with distributor agreements, seek outside professional assistance. Having a legal professional review a distributor agreement is necessary, but never sufficient, for the creation of a great distributor agreement.

Conclusion

Distribution agreements are an integral tool in the construction of a relationship between a distributor and a supplier. A well-written agreement can assist in developing that relationship. The agreement cannot extend the life of a relationship once the relationship expires. A poorly written agreement often leads to a legal quarrel that in turn consumes management time, financial resources and the involvement of attorneys, courts and arbitration. A well-written agreement can eliminate expenditure of resources on these unproductive activities and encourage the distributor and manufacturer to go about their respective businesses upon expiration of the relationship.