Distribution & Wholesale
A small brewer is usually at a disadvantage when negotiating a distribution contract. Knowing what provisions are critical and the risks are key. Here’s what to know when negotiating a distribution agreement for the first time.
It’s a familiar story. Two families invest all their cash (and then some) and start a small brewery. First, there is just a taproom, then a few bars and more accounts, some notoriety and favorable publicity. Pretty soon, the founders simply don’t have enough time to make great beer, market it, and deliver it to the growing list of customers. Eventually, with extra capacity comes the potential for geographic expansion and a realization that self-distribution is neither a legal nor a practical option. It’s time for a big step—to independent distribution. Here, we discuss what you need to know about negotiating a distribution agreement for the first time.
The three-tier distribution system for alcoholic beverages (suppliers, distributors, and retailers) was first enshrined in state law following the end of Prohibition. In many states (and particularly with beer), the distribution of alcoholic beverages was required to be through independent distributors. “Tied house” laws in nearly every state prohibited ownership at multiple levels of the distribution system. Thus, a brewer couldn’t own an interest in a distributor or a retail outlet, and a distributor couldn’t own an interest in a brewer or a retailer.
Later, state legislatures responded to complaints from distributors about mistreatment by large brewers by enacting sweeping distributor-protection laws, which trumped provisions in distribution contracts. State distributor-protection laws typically render distribution rights perpetual, despite what a contract might say. Under these laws, the distribution contract runs forever unless the brewer can show that
- (S)he has good cause to terminate or non-renew, meaning a breach of the distribution agreement or inability of the distributor to carry out its obligations;
- The distributor is given a lengthy period to correct the problems and fails to do so;
- The brewer acts in “good faith.”
Distributors are guaranteed exclusive territories by law. Moreover, brewers are severely limited as to the grounds for objecting to a distributor’s sale of distribution rights to another distributor. And to put the state’s finger further on the scale, if distributors win a legal dispute with a brewer, the brewer pays the distributor’s attorney fees and costs. Most often, even if the brewer wins the litigation, s(he) pays his/her own attorney fees and costs.
Enter Craft Breweries
But applied to the relationship between a craft brewer and a distributor, the economic world is turned upside down. With years of consolidation, most markets are served by two or three distributors that are usually huge businesses covering many markets. No longer is the distributor the “little guy” who needs protection against the big bad national brewer. Yet, with only a few exceptions, state law irrationally continues to favor the distributor in its relationship with brewers of all sizes. It is the craft brewer who is at a disadvantage in the negotiations for a distribution contract. Because state law most often requires that all beer sold at retail go through an independent distributor, the distributor controls a state-sanctioned bottleneck in the distribution system. So while the oft-stated justification for the three-tier distribution system and distributor-protection laws is to promote temperance and protect local distributors from being abused by national and international brewers, the real effect has been to vest power in distributors over the much smaller craft brewers.
Many states allow small brewers to self-distribute, but typically there are barrel limits, and interstate distribution is prohibited. Moreover, we started this discussion with the observation that sooner or later, a successful small brewer will want to concentrate on making and marketing great beer, not being in the distribution business.
Recently, there has been an increasing trend toward exempting small brewers from the full coverage of state distributor-protection laws. With the explosion of home-grown micro and craft brewers, politicians are starting to realize that these local businesses deserve the right to negotiate on a more even playing field with larger distributors, without the onerous application of the distributor-protection statutes. Currently about 20 percent of the states either have or are contemplating some type of exemption from the distributor-protection laws for small brewers or in-state brewers. For example, in Washington, brewers producing fewer than 200,000 barrels annually are exempted from the state’s distributor-protection law. In Colorado, it is 300,000 barrels, while in Arkansas, it is 30,000 barrels. Some states, such as Pennsylvania and Rhode Island, exempt in-state brewers from the operation of the distributor-protection statutes. Other states, such as Illinois and New Jersey, exempt brewers if the brewer’s products constitute a small share of the distributor’s sales.
Even if a small brewer is fortunate enough to approach independent distribution in a state with a small-brewer or in-state brewer exemption, the fact remains that the distributor starts out with substantially greater bargaining power. Yes, if your brand is the next hot thing in a market, you might be able to play one distributor against another, but that doesn’t happen very often. Instead, an emerging craft brewer is lucky to get the attention and interest of one of the few distributors in the market. As a result, the brewer is almost always in the down position in negotiations. What that means for negotiations is different in every case. One of the largest distributors in the country offers to craft brewers a distribution agreement that is surprisingly balanced. But most distributors are likely to start out with a contract that avoids promises of performance and protects the distributor against termination for all but the most egregious of causes, while at the same time allowing the distributor to terminate for any reason or no reason, at any time.
Nevertheless, you will never have a better chance to get what you can than at the outset of the negotiations for your first distribution contract. Once you sign on the dotted line, the state dealer-protection law will descend on the relationship. You’re in a marriage that, as a practical matter, is destined to last for as long as the distributor wants it to. And even if you have a small-brewer exemption in your state, the distributor’s proposed contract terms will likely only permit termination for a continuing violation of the contract. Fighting a termination battle can be a financial impossibility for a small brewer without a large capital base of support.
Like most marriages, both parties to the distribution contract enter the relationship with the best of intentions. If the distributor didn’t see a true upside to representing your products, you wouldn’t be having the conversation. There is a sound economic reason why craft beers occupy the premium eye-level shelf space in the bottle shop or grocery aisle. Craft brews generally yield substantially greater margins per case than non-craft beers, both for the distributor and for the retailer.
The Brewers Association has reported that in 2016 craft-beer sales grew to 12.3 percent of the U.S. market. Retailers follow consumer demand, and distributors supply what retailers demand.
We also can’t forget that beer distributors are generally very good at what they do, in exchange for the roughly 20 percent of the retail price attributable to the distributor’s markup. They provide high levels of service to retailers and almost always call on every potential account. Once you’re onboard, the fierce competition between consolidated distributors means that your brand will have the best representation possible, provided the distributor is motivated (and obliged) to aggressively grow your brand.
Imagine we are approaching the negotiations for your first distribution contract. What are your most important points? Clearly, promised effort, points of distribution, and agreed promotions are the three most important promises you want from the distributor. The distributor is your exclusive window to the consumer and thus controls your destiny in the market. If you had the hammer in the negotiations, you could demand sales and distribution objectives with contractual teeth and per-case expenditures toward the brands. As a small brewer just entering distribution, you will be extremely lucky to get iron-clad performance promises.
So, in reality, you try to get language in the contract obliging the distributor to use “best efforts” or “commercially reasonable efforts” or “efforts consistent with that of other similar craft brands.” The point here is that you simply need some contractual assurance that there is a standard, however vague or undefined, that requires a distributor to devote continuing efforts to the brands. As has been so often noted in the popular craft-brewing literature, craft-beer consumers are all about the “new,” following each new brand for a moment with sustained allegiance to only a few brands. The danger is that your new distributor taps the excitement of the brand hitting the market, but efforts might decrease if the bloom threatens to leave the rose. You need a promise of sustained efforts to build your brand.
It might be useful to pause and discuss briefly the “tone” of the negotiations. The distributor is going to be your partner in this enterprise, which means that nothing you do in the negotiations should risk creating ill will at the outset. You must find a way to make your points eminently reasonable and fair to both parties. Some distributors might be inclined to offer a “take it or leave it” agreement and be unwilling to change a thing, but most often the distributor and its counsel will at least be willing to listen to your concerns.
Again, remember this is your maximum point of negotiation. As you proceed with the discussion, at some point the distributor will at least tell you what he or she thinks “might” be possible. You then have the start of a “marketing plan.” Most modern distribution contracts create an obligation for the brewer and the distributor to meet at least annually to develop a mutually agreed upon marketing plan for the coming year. So think about this pre-contract discussion as the outline of the marketing plan for the first year (or, at least, the first six months). Think in terms of:
- What kind of commitment of effort is the distributor willing to make toward your products coming out of the gate and in the first year?
- What accounts?
- Points of distribution?
- What kind of promotion is the distributor willing to fund, and how much will you contribute in shared funds?
- Who will be the brand manager with responsibility for the launch and success of the brand?
You don’t absolutely need (and probably can’t get) a provision in the contract binding the distributor to specific targets. But if the agreement requires the parties to agree on a marketing plan and you can get the first one done as part of the initial negotiations, you likely have what you need. It may not be all you want or as specific as you would like, but it will at least be something that you can point to if efforts lag.
You also need a provision in the contract discussing quality obligations covering such points as:
- Do you require a temperature-controlled warehouse and trucks?
- What is the sell-by date?
- Who is responsible for replacing out-of-code product and will costs be shared or born by the distributor entirely?
- What kind of inventory levels will the distributor agree to?
- Will the distributor agree to rotate inventory at retailers?
- Will you indemnify the distributor for product found to be unsaleable at delivery?
Most distribution contracts also require the distributor to provide order forecasting, so the brewer can plan production and delivery. The when and how will vary with the distributor and the market. Most distributors can easily provide the same removal data and retail pricing information that they provide for the major brewers. The agreement should also state the notice required for the brewer to change wholesale prices.
Assuming the agreement will be terminable only for cause, either because of the distributor-protection law of the state or because the distributor insists on it as a contract provision (which is 100 percent likely), you need to set out the breaches of contract or conditions that justify termination. Some of these are likely contained in the distributor-protection statute, such as, loss of distributor’s license or permits, insolvency, sales outside of the designated territory, uncured breach of a material provision of the distribution agreement. Others you will want to attempt to include in your contract include:
- Failure to pay for beer
- Fraud in dealings with you or with the public concerning the brands
- Intentional violation of quality-control standards
- Unpermitted ownership change or sale of distribution rights
At the same time, the distributor is likely to demand a provision that allows the distributor to terminate the agreement for any reason, at any time. While you may have to accede to a demand to include the distributor’s right to terminate without cause, it is entirely reasonable to require that the distributor give you at least 90-days (six months is even better) notice of such a termination so that you can attempt to find a replacement. An immediate termination by the distributor would leave the market dark and devastate brand value.
Finally, someday, you may decide that the relationship is simply not working. So at the beginning, you should attempt to agree on brand value, usually expressed as a multiple of trailing 12-month gross profits for the brand sales by the distributor. If you lack good cause to terminate or the road to termination with cause looks too long or expensive, it may be that the distributor will release the brands to another distributor if the current distributor gets three or four times the trailing 12-month gross profits from the replacement distributor. These negotiations are frequently difficult because distributors often resist the concept entirely or press for “fair market value (FMV)” of the brand distribution rights. While understandable, FMV often just leads to an expensive and time-consuming fight about how FMV is calculated.
The reality is that a small craft brewer is usually at a disadvantage when negotiating a distribution contract. However, knowing what provisions are critical and the risks being undertaken by agreeing to the distributor’s form of contract are the first steps in a successful negotiation. To paraphrase the Rolling Stones song, you can’t always get what you want, but if you try really, really hard, you might get what you need.