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Understanding Legal and Structural Issues In Establishing Sales and Distribution Channels

Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP

Many growing entrepreneurial companies choose to offer their products and services to the marketplace through independent third-party distributors and dealerships. Manufacturers of electronic and stereo equipment, computer hardware and software, sporting goods, medical equipment, and automobile parts and accessories commonly use this type of arrangement.

In developing distributor and dealership agreements, growing companies must be careful to avoid being included within the broad definition of a franchise under FTC Rule 436, which would require the preparation of a disclosure document. To avoid such a classification, the agreement should impose minimal controls over the dealer, and the sale of products must be at bona fide wholesale prices. In addition, the manufacturer must offer no more than minimal assistance in the marketing or management of the dealer’s business

Distributors Versus Sales Representatives

Distributors are often confused with sales representatives, but there are critical differences. Typically, a distributor buys the product from the manufacturer, at wholesale prices, with title passing to the distributor when payment is received. There is usually no actual fee paid by the distributor for the grant of the distributorship, and the distributor will typically be permitted to carry competitive products. The distributor is expected to maintain some retail location or showroom where the manufacturer’s products are displayed. The distributor must maintain its own inventory storage and warehousing capabilities.

The distributor looks to the manufacturer for technical support, advertising contributions, supportive repair, maintenance, service policies, new product training, volume discounts, favorable payment and return policies, and brand name recognition. The manufacturer looks to the distributor for in-store and local promotion, adequate inventory controls, financial stability, preferred display and stocking, prompt payment, and qualified sales personnel. Although the distributorship network offers a viable alternative to franchising, it is not a panacea. The management and control of the distributorship may be even more difficult than that involved in franchising (especially without the benefit of a comprehensive franchise agreement), and many state anti-termination statutes regulate the termination of these relationships.

By contrast, the sales representative or sales agent is an independent marketing resource for the manufacturer. The sales representative, unlike the distributor, does not typically take title to the merchandise, maintain inventories or retail locations, or engage in any special price promotions unless instigated by the manufacturer. A well-drafted distributorship agreement should address the following issues:

  • What is the scope of the appointment? Which products is the dealer authorized to distribute and under what conditions? What is the scope, if any, of the exclusive territory to be granted to the distributor? To what extent are product, vendor, customer, or geographic restrictions applicable?
  • What activities will the distributor be expected to perform in terms of manufacturing, sales, marketing, display, billing, market research, maintenance of books and records, storage, training, installations, support, and servicing?
  • What obligations will the distributor have to preserve and protect the intellectual property of the manufacturer?
  • What right, if any, will the distributor have to modify or enhance the manufacturer’s warranties, terms of sale, credit policies, or refund procedures?
  • What advertising literature, technical and marketing support, training, seminars, or special promotions will the manufacturer provide to enhance the performance of the distributor?
  • What sales or performance quotas will be imposed on the dealer as a condition to its right to continue to distribute the manufacturer’s products or services? What are the rights and remedies of the manufacturer if the dealer fails to meet these performance standards?

Cooperatives: An Alternative

An alternative to a distributorship is to establish a sales or marketing cooperative. Companies in the same industry, or similar industries, form Cooperatives (“Co-Op”) to achieve operating, advertising, and purchasing efficiencies and economies of scale. Typically, the Co-Op is owned and controlled by its members. Commonly known retail Co-Ops (which are often confused with franchises) include ACE Hardware and NAPA Auto Parts. Co-Ops have been especially effective in certain inventory-intensive industries, such as hardware, automobile parts and accessories, pharmacies, and grocery stores.

Co-Ops typically provide a common trade identity that each independent business may use in its advertising and promotion. However, ownership of the actual trademarks rests with the Co-Op itself. Retail Co-Ops, if properly structured, are exempt from FTC Rule 436 and from some state franchise laws. An attorney should periodically review the organization and ongoing operation of the Co-Op.

A Co-Op is a business owned and controlled by the people who use its services, and finance and operate the business for their mutual benefit. By working together, they can reach an objective unattainable by acting alone. These mutually beneficial services can include obtaining production supplies, processing and marketing member products, or providing functions related to purchasing, marketing or providing a service. The Co-Op may be the vehicle to obtain services that are otherwise unavailable or more beneficial to members. The underlying function of the Co-Op is to increase member income or in other ways enhance their way of living. A Co-Op may or may not be incorporated and may or may not have its own staff or operate independently from its constituent members. Operating characteristics of a Co-Op include the following:

  • Service At-Cost. The purpose of a Co-Op is to provide a service to its user-owners at the lowest possible cost, rather than generate a profit for investors. However, the Co-Op must generate income sufficient to cover all administrative costs and meet continuing capital needs. Because many costs cannot be absolutely determined before year-end, it is important for a Co-Op to charge competitive market prices, or fees for services, and then determine its at-cost basis at year-end.
  • Financial Obligation and Benefits Proportional to Use. Benefits are tied to use rather than to the amount of investment. Likewise, members are obligated to provide financing in proportion to the use that produces those benefits. Most Co-Ops' bylaws provide a system of returning capital contributions to maintain proportionality on a current basis. The bylaws should also include a provision that establishes the Co-Op's obligation to return net margins--total income from all sources minus expenses--to patrons. When the net margin is returned to members based on their use of the Co-Op, it is called a patronage refund.
  • Democratic Control. Voting control is vested with the membership, either on an equal basis or according to use, rather than based on the amount of stock each member holds. Democratic control is usually expressed as one member, one vote. A few cooperatives have limited proportional voting based on use.
  • Limited Return on Equity Capital. This feature means that payments for use of members' equity capital, primarily in the form of stock dividends, are limited. It does not mean that benefits realized from the Co-Op, monetary or otherwise, are limited. The overriding value of the Co-Op to its owners is in the range of services or economies of scale that it provides. Limiting the return on equity capital is a mechanism to support distribution of benefits according to use. It helps to keep management decisions focused on providing services attuned to members' need. Both federal and state laws recognize limiting the payment for the use of equity capital. Some state laws require that Co-Ops either limit the dividends on stock or member capital to 8 percent a year or follow one-member, one-vote control.

Co-Ops usually perform any one or a combination of four kinds of service functions, but with varying strategic emphasis. These include the following:

  • Purchasing. Co-Ops provide members with consumer goods, products for resale through their members or equipment, and supplies for their business operation. Individual Co-Ops may form federations of cooperatives to obtain further benefits of group purchasing.
  • Marketing. Co-Ops market the products their members produce, such as crafts or agricultural products. Marketing includes assembling, processing, and selling products or services in retail or wholesale markets for members.
  • Service. Co-Ops provide services related to the production of a product or service for business or the home. These services may include credit, electricity, telephones, insurance, research, telecommunications, common management, or other shared services.
  • Production. Co-Ops pool production and distribution resources in large-scale industries such as agricultural products or electrical utilities.

Distributors, sales representatives, and cooperatives are all different venues for enabling entrepreneurial companies to sell their products and services. Understand the similarities and differences, and chose the alternative that is right for your business.

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