Performance targets and minimum purchase obligations: balancing obligations in distribution agreements.

Entering into a distribution agreement can give both suppliers and distributors access to significant commercial opportunities. For suppliers, a distributor (particularly an exclusive distributor) will usually expect the distributor to invest time and resources in developing sales and have already established customer relationships and market knowledge. However, the distributor may be reluctant to guarantee specific sales targets when the customer demand is not entirely within its control.

Performance targets and minimum purchase requirements provide a way of allocating responsibility. If carefully drafted, they can provide suppliers with meaningful protection against underperformance while giving distributors clear and achievable expectations. However, if the balance is wrong, they can become a source of commercial tension and contractual disputes.

What are performance targets and minimum purchase obligations?

There is an important distinction between a performance target and a binding minimum purchase obligation. Sales targets are usually measured by the volume of products sold within a specific area or territory; however, minimum purchase obligations require the distributor to purchase a specific number of products from the supplier.

What matters, is that the distribution agreement should clearly define what each of these terms mean, whether the obligation or target is legally binding and more importantly, what the consequences are if the distributor fails to meet these obligations.

Realistic targets

Inserting an unrealistic target does not do any favours for the supplier or the distributor, targets should reflect the commercial reality of the arrangement. When deciding what the targets should be, a supplier and distributor may want to consider:

• historic sales data;
• the size and maturity of the relevant market;
• anticipated customer demand;
• product pricing; and
• the distributor’s existing sales network.

A newly appointed distributor entering an unfamiliar market may need time to establish customers and develop its sales network. Gradually increasing targets over the first few years of the agreement may be more appropriate than imposing the supplier’s desired long-term sales volumes from day one.

Performance and exclusivity

Performance targets are particularly important where the distributor has been granted exclusive rights. Exclusivity can provide a distributor with confidence in developing a territory without facing competition from other distributors appointed by the supplier. This provides the distributor with a guaranteed source of income without the risk of losing business. However, from the supplier’s perspective, if its exclusive distributor is underperforming, the supplier may be prevented from appointing another distributor to increase its sales in a particular territory.

Rather than treating every missed target as grounds for immediate termination, distribution agreements can make exclusivity conditional on the distributor’s performance. For example, failure to meet a target might initially trigger discussions and a performance improvement plan. Continued underperformance might allow the supplier to convert the arrangement from exclusive to non-exclusive, appoint additional distributors or, ultimately, terminate the agreement.

This persuades distributor to invest in the territory, while the supplier is not indefinitely tied to an underperforming exclusive arrangement.

Flexibility

No matter how carefully targets are negotiated, market conditions can change. We have seen this recently where geo-political developments have been restricting supply chains globally. In these circumstances, a distributor may fail to achieve its target for reasons which are not entirely within its control. Product shortages, significant price increases, regulatory changes or disruption to the supplier’s own production could all affect the distributor’s ability to meet an agreed level of sales or purchases.

The parties should therefore consider whether the agreement needs a mechanism for reviewing or adjusting performance requirements in appropriate circumstances. For example, inserting an annual review provision could allow future targets to be adjusted against agreed criteria. The agreement could also identify specific circumstances in which a target will be reduced or suspended.

Consequences of underperformance

The most important drafting question is determining what happens when a specific performance target is not met. Common remedies for underperformance include things such as:

• implementing a performance improvement plan;
• revising the distributor’s exclusive territory;
• converting an exclusive appointment into a non-exclusive appointment;
• permitting the supplier to appoint additional distributors; or
• terminating the agreement in cases of substantial or persistent underperformance.

It is important to remember that any remedy should be clear and proportionate. Missing an annual purchase obligation by a small amount may not justify terminating the agreement or appointing an additional distributor, however these actions may be appropriate if only half the target has been achieved. The clearer these provisions are at the outset, the less scope there should be for disagreement when performance falls short.

Getting the balance right

There is no universal formula for setting the right performance target or minimum purchase obligations. The best approach will depend on the products, the relevant market, the maturity of the relationship and the commercial benefits being given to the distributor.

What matters is that performance requirements are clear, measurable and commercially realistic, with equally clear consequences if they are not achieved. When combined with appropriate review mechanisms and proportionate remedies, performance obligations can provide suppliers with meaningful protection against an underperforming distributor while giving distributors the flexibility needed to develop the market successfully.

If you require any assistance with a distribution agreement, the Geldards Commercial team are here to assist you with your requirements.