Avoid Costly Risks With Well-drafted Distribution Agreements

When expanding into new markets, companies often rely on business partners through various distribution arrangements. In this blog, we present important practical aspects concerning reseller and agency agreements we have encountered over the years.

Agency agreement or reseller agreement?

In recent years, and depending somewhat on the industry, there has been a shift away from direct sales towards either adopting an agency model or expanding reseller networks. These models have fundamental differences that affect sales and business operations in different ways, and which are worth bearing in mind when weighing up the options. Both of these distribution agreement alternatives come with their own pros and cons.

In a reseller agreement, the reseller assumes the risk of purchasing and reselling goods independently. This improves the manufacturer's cash flow and reduces the need for sales resources. On the other hand, the challenges include a more distant relationship with customers and less control over product sales and marketing.

In an agency model, the agent acts on behalf of the manufacturer as a ‘hired salesperson' without the products becoming the property of the agent. The manufacturer retains control over pricing, sales processes and customer relationships. However, it is important to keep in mind that in Finland and in many other countries, agents enjoy legal protection which may, for example, oblige the manufacturer to pay compensation at the termination of the agreement. In other words, agency relationships involve mandatory employment-like protection mechanisms that do not exist in reseller relationships.

In a reseller agreement, the commission model is clear: the reseller purchases products from the principal at agreed prices and decides its own end customer pricing and margins. In an agency model, the commission structure must be agreed separately. It is important to carefully consider and agree in sufficient detail how commissions are calculated, accounted for and paid. Consider also including a trial sales period, during which the parties can jointly assess the success of the trial period and the future potential of the partnership.

The same party can act simultaneously as both an agent and a reseller. For example, a reseller can purchase the main product for its own account, but act as an agent with respect to maintenance services or spare parts related to the main product. In such situations, the overall model and roles must be clearly defined, specifying when the partner will assume which role and which contractual terms apply to each situation.

A reseller agreement is suitable in situations where the aim is to transfer inventory risk to the partner and target a broad market area. An agency model, on the other hand, works best when the manufacturer seeks to retain tighter control over pricing and customer relationships or when the products are complex and sales cycles are long.

Consider the essential aspects of your specific goals

Distribution agreements are case-specific and their content varies according to the type of goods or services. It is downright dangerous to think that, for example, a distribution agreement relating to movable goods would work in SaaS or software business, or that it could be used to sell large industrial machinery. Some sectors also have special regulations, and the related agreements must be tailored accordingly.

It is also essential to organise the aftermarket. It is easy to send movable goods to the manufacturer for warranty repairs whereas software can be repaired remotely. The same model does not apply to tractors in production use on the other side of the world, let alone machinery installed in a factory.

Various payment and financial instruments are an integral part of international trade. Smaller goods can be sold against an invoice, but larger deliveries may require better security.

It is important to understand and set the price for the terms of delivery and the related liabilities and costs. In today's unpredictable world, it is essential to provide for the allocation of responsibility concerning export restrictions as well as customs duties and tariffs.

Exclusivity

In general, there are three approaches to exclusivity: non-exclusive agreements, exclusive agreements, and sole distributorship agreements, where the distributor is the sole external party, but the manufacturer retains the right to direct sales.

Exclusive distribution rights are valuable for the distributor, as they protect investments and enable long-term marketing. Non-exclusive distribution agreements too often merely result in the product being added to the distributor's product catalogue without effective measures to promote sales.

It is in the manufacturer's interest to always limit any exclusivity to a specific geographical area or segment and to tie it to the achievement of sales targets – if the distributor does not achieve the agreed targets, the exclusivity may be terminated or the manufacturer may gain the right to appoint parallel distributors. In the worst-case scenario, an agreement may enable the manufacturer to be excluded from the market while allowing the distributor to offer products from the manufacturer's competitor.

A non-exclusive worldwide distribution right without any restrictions makes it virtually impossible to grant exclusive rights to certain markets at a later stage, which may change the negotiating position with future partners.

Competition law

Distribution agreements are, as a contract type, exceptionally sensitive to terms that are prohibited or problematic under competition law. Breaching competition legislation can lead to fines, invalid contracts, and liability for damages.

Competition law issues regularly arise in due diligence reviews, and, in some situations where severe breaches of competition law have been identified, IPOs and M&A deals have been cancelled.

The EU's Vertical Block Exemption Regulation, supplemented by the Commission's Guidelines, applies specifically to distribution agreements. It outlines so-called black and grey provisions; black provisions are categorically prohibited, while grey ones allow for case-by-case assessment.

Common pitfalls are that the manufacturer is not allowed to set minimum resale prices for the reseller nor restrict its passive sales outside a certain territory or segment and that a non-compete obligation may not exceed five years during the term of the agreement. In addition, competition law risks are greater if the manufacturer has a significant market share.

Identifying risks in advance is significantly more cost-effective, which is why it is advisable to review distribution agreements from a competition law perspective before signing the agreement.

Intellectual property rights

Although the distributor sells products as a separate entity, the manufacturer's brand is often strongly present. It is important to agree on the limits within which the distributor may represent the manufacturer and use its brand.

While it is in the interest of both parties to protect the brand properly in the target market, the manufacturer should remember to retain control of its IPRs in all markets. If the distributor registers the trademark in its own name, the manufacturer may lose the possibility to use its own brand in that market after the agreement terminates.

In a so-called white label partnership, the distributor sells and markets the product under its own brand. In such cases, it is essential to agree clearly on who owns which IPRs, whether the manufacturer's name appears on the product, and in whose name the CE marking is. It is also often in the manufacturer's interest to ensure that the trademarks are sufficiently different so that the white label distributor's trademarks cannot be confused with the manufacturer's corresponding trademarks. Situations where the distributor develops its own additional products or services around the manufacturer's products also require careful agreement on the ownership of the resulting IPRs.

International surprises

Reseller and agency agreements often cover several jurisdictions, each with its own legal obligations. In the EU, legislation concerning agency agreements has been harmonised by a directive, but significant surprises may arise outside the EU that can change the commercial balance of the agreement.

Particularly challenging are certain US states, which have surprisingly strict mandatory legislation in place to protect distributors. Insolvency issues, the validity of retention of title clauses, and the rights of consumers, who are often the end customers, are also surprisingly national issues.

Simply choosing the law of the manufacturer's own country as the applicable law is not enough if the target country's mandatory legislation overrides the agreement terms. Generally, to manage these risks, it would be advisable to investigate in advance the specific features of each target country and ensure that the agreement has been drafted taking into account local mandatory legislation. In practice, however, there is often no budget for this, and the matter remains a risk.

Last, but certainly not least: term and termination

Perhaps the most significant provision of a distribution agreement relates to its term: how long is the term of the agreement and under what conditions can it be terminated.

From the manufacturer's perspective, it is essential that an inadequately performing distributor can be replaced. This setup keeps the distributor in a constant competitive situation in order to achieve sales targets. From the distributor's perspective, on the other hand, an unexpected termination can be disastrous if it results in substantial investments becoming worthless and, at worst, benefiting the new distributor. A similar scenario may befall the manufacturer if the distributor switches to a competitor's product.

A sufficiently flexible termination provision compensates for contractual flaws and maintains the commercial balance of the agreement.

A good distribution agreement supports growth – a poor one can prevent it

Reseller and agency agreements are a key part of international business, but their successful implementation requires careful planning and legal expertise. In order to be functional, a distribution agreement needs to be tailored to the nature of the business, the type of products or services, and the target markets.

A well-drafted agreement lays the foundations fora long-term and mutually beneficial partnership. A poorly drafted agreement, on the other hand, may lead to costly disputes, regulatory investigations, lost market areas, and even prevent the business from growing and going international.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.