Distribution Disasters

It’s a Jungle Out There!

Anyone in the business knows that product distribution in Canada has recently undergone tumultuous changes. More fundamental changes are on the way. The pace of change is relentless and the competition is brutal. Not all of the changes are either efficient or permanent, but a firm must be able to deal with these gyrations. Only the smart and the agile will survive. Marginal players will be toast.

It’s not just one widget against another: it’s an internecine battle among manufacturers, importers, distributors, retailers and agents who were once happy allies in the supply chain. As margins are squeezed, especially by the big-box retailers, the down-chain participants are left to fight each other over the scraps.

Most of my clients are manufacturers, distributors, sales agents, and dealers. I observe several recurring, yet largely avoidable pitfalls. Before a business can even hope to address the new paradigms of distribution, it must understand and master the basics of the distribution industry.

This article describes a few of the most commonly encountered problems of distribution, and offers some tips on how to avoid those problems. I try to deal with traditional concepts, as well as those which might help a company to adjust to evolving forces. Yeah, it’s pretty presumptuous stuff for a lawyer to do!

I will primarily deal with manufacturers of a new product and a distributor for that new product. What is viewed as advantageous for one party is considered to be disadvantageous for the other. So says the conventional wisdom of contractual warfare. I will make the case that this concept (if I lose, he wins, and vice versa) is the single most frequent and serious cause of problems in this area.

“Sure, But Does Anyone Want To Buy It?”

Experts say that the most common cause of failure of new small businesses is insufficient working capital. In the case of new makers or distributors of new products, I would speculate that the real cause of failure is inadequate market research.

Put bluntly, firms sometimes forge ahead with a massive marketing and distribution plan before they have proven that there is demand for the product at a price and for quantities which will create both adequate cash flow and longer term profits.

I know this sounds so basic as to be insulting, but hey, it happens a lot. The entrepreneur, either inventor or re-seller, gets so enthused with the product that time and money which is spent on pure demand research is regarded as a waste! It cuts into the budget for rolling out the product!! It holds up the business!! “We know it will sell, we just have to get it out there!”

Which is true, of course, if there is a business to be had. Now, I’m most certainly not a marketing expert, but I suggest that this is one area you should not skimp on at the outset. Sure, your spouse/best friend/uncle/lawyer/neighbour/ told you it’s a great product that will make millions. You must resist the temptation to rely solely on your own gut instincts and the gratuitous flattery of people close to you. The buyer from Wal-Mart won’t be so kind!!

The early marketing research must involve professional, experienced, independent and objective resources. By all means, seek the opinions of those close to you, but understand their inherent limitations of expertise and bias. Be wary of those who have a conflict of interest: they give you encouragement so you will hire them on an efforts-based compensation (not contingent on success).

The Exclusivity Folly

This is a tough one to deal with in a few words. Let me start by giving my opinion as to the only situations in which there should be an exclusive distribution agreement:

  1. if the business is essentially a well-established franchise with strong trade marks, patents or trade marks; or
  2. if the distributor is well capitalized, very experienced and successful in that product area: or
  3. if the distributor plunks down a big chunk of cash to buy the territory or purchase initial stock,and is subject to strict milestone/performance objectives, and no other situations!

Newcomers to distribution (either makers or sellers) have a strong tendency to “overreach” in their initial distribution agreements. Both new manufacturers and distributors of a single new product are often very unrealistic in their contract demands.

Live By the Sword, Die By the Sword

Their distribution agreements are frequently much negotiated, legalistic document stretching to 30 pages of detailed covenants, restrictions, default clauses and boiler plate which only vaguely resembles the business deal originally discussed. It attempts to address every conceivable negative eventuality, while blissfully ignoring the business realities.

On the one hand, a rookie distributor tries to extract exclusivity for a huge territory for an inappropriately long term, without a workable mechanism for adjustment without killing the deal. Bigger is better, right? Well, no, not actually.

For the treasured exclusivity, this distributor proposes to give the manufacturer nothing, no upfront payment, and a minimal, if any, initial stocking order. The distributor likely doesn’t realize that it has no hope whatsoever of servicing a huge territory, but events will quickly prove that out.

On the other hand, the manufacturer will require the ambitious distributor to meet stringent performance milestones, failing which the agreement is terminated or special rights, like exclusivity (see more about this topic below) or favourable pricing, is lost.

The introduction of any new product in Canada is incredibly expensive, slow and difficult. A new manufacturer, especially a single product company, is typically undercapitalized and lacking in marketing expertise (people). Hence, it is unable or unwilling to give the distributor the technical support, marketing, advertising, samples, credit terms, trade show assistance and so on which are absolutely essesntial to the rollout of a new product.

The new distributor is also typically undercapitalized and short on experience, so it too can’t do the things that must be done to rollout the product. And thus, it is like the proverbial “blind leading the blind”, with a neophyte manufacturer directing a rookie distributor how to sell a brand new widget. The manufacturer is legally tied to the distributor until the milestones are not met, or other material default occurs.

The manufacturer likely doesn’t yet know its true costs, its price points, the size of its market or the make-up of the competition. And, neither does the new distributor.

Too Many Fingers in the Pie

Just to make the process more interesting, another counterproductive element is commonly encountered: an additonal party in the distribution chain, perhaps the “master distributor” or some kind of intermediary which has snagged the “world wide marketing rights” for this new product.

Often, this is someone close to the manufacturer/inventor, and this party usually isn’t a professional distributor/marketer (they just happened to be the first person who gushed enthusiasm over the product). The superfluous participant inevitably takes a high percentage of the overall margin for doing little if anything of value for anybody.

My advice is: any party in the supply chain which doesn’t add value equivalent to their reward will either ruin the business or be edged out eventually. There is no room in today’s distributing for parasites.

Marriages of virgin maker and/or virgin seller are destined for distribution purgatory, if not destinations below. A bad exclusive agreement stymies early market development, poisons some sales and can lead to nasty litigation. If either party has good business instincts, then the actual behaviour and actions will tend to gravitate to business realities. That is, one or both parties will increasingly ignore the contract, and operate in the most economically efficient manner. It’s that market thing.

For example, the distributor will work to avoid/destroy/eliminate an up-chain party which is stealing precious margin points without delivering commensurate value. Manufacturers will soon realize their new exclusive distributor doesn’t have a clue (and can’t buy one either), and will commence dealings with other sellers. The distributor will discount to reach sales milestones, and try to negotiate pricing concessions. Meanwhile, the competition passes by.

Pearls of Wisdom(?)

The solution? Here are some suggestions:

1. Bite off only what you can chew! Manufacturers should grant any one distributor a modest initial territory, non-exclusively. More territory, and perhaps exclusivity, can be earned if sales are achieved. Both maker and sellee can use the initial small territory to experiment, to make their mistakes, and then to make essential adjustments to price, marketing and the product itself, without blowing their brains out with a national rollout.

2. Hire an expert. Even though your new widget is “the best thing since sliced bread” and will “virtually sell itself”, resist the temptation to hire your pal, brother, in-laws or neighbour to be the distributor. After you have proven the market, then reward that person with a dealership or something, but hire a veteran distributor in your sector first.

3. Don’t give exclusivity! Exclusivity is a reward, in the form of a monopoly, for a sure thing, like a franchise. Unless the first distributor pays you a large upfront, non-refundable fee, guarantees a major marketing expenditure in the first two years, or takes a gigantic initial stocking order (which it can afford!), do not grant exclusivity. Hire two or more experienced distributors to compete in a territory. Even try using a sales agent (not a stocking distributor) for the home office territory or house accounts.

4. Use short agreements: By and large, seasoned distributors aren’t appointed and micro-managed under lengthy legal tomes running for long terms. A good distributor is quite happy to have a short agreement (2 -5 pages should do it) for renewable one year terms, terminable on 90 days notice.

5. Experiment: Don’t plunge headlong in one direction with a new product. Try different things in small, controllable experiments. Sell off a website, give some to a store on consignment, give a sales agent a territory and compare to a distributor’s performance. Try direct sales. Similarly, a distributor must experiment with a new product introduction. Make your mistakes on a small scale. Remember the “New Coke”?

There are, of course, lots of other issues which crop up in distribution arrangements, such as regulatory compliance, protecting trade marks and patents, and non-competition clauses, each of which should be addressed at the outset of the deal. However, if you move forward a short, pragmatic agreement, you can work out the other details with relative ease.

Your success will be gauged by the amount of business you do and the absence of reference to either the written agreement or the courts to resolve ongoing questions.