Transactional attorneys spend almost all of their time working on business combinations and finance transactions. But they also need to understand the supply chain because supply chain transactions often form the foundation of the businesses they represent or negotiate against. Supply chain transactions include distribution and reseller agreements, manufacturing agreements, equipment leases, requirements and output contracts, franchise agreements, letter of credit transactions, transportation and storage agreements—basically any transaction involving the sale, lease, transportation or storage of goods.
This column discusses the basics of the compensation issues impacting “outside” sales representative agreements.1 Transactional attorneys should keep these issues in mind not only when they draft, negotiate or benchmark these agreements, but also when they review them during due diligence.
In a typical “outside” sales representative arrangement, the supplier engages an individual or firm to be its independent contractor sales representative to help the supplier sell the products to the specified customer base. These might include all customers in the specified geographic territory except excluded customers. Or the supplier might allow the sales rep to call on only customers in the specified market segment, whether defined by industry, type of player in the supply chain (e.g., distributors) or the customer’s intended use of the products. Excluded customers might include accounts that have been assigned to other sales reps, specified house accounts, or accounts excluded because central buying decisions for the customer are made in an office outside of the territory.
This article focuses on just the contractual issues; there will be no discussion of some of the other very important issues the supplier must consider when retaining sales reps (individuals or firms), including whether its sales reps (or the sales rep firm’s sales reps) might be legally deemed employees of the supplier rather than independent contractors. Therefore, for purposes of this article, assume that the sales rep controls the manner in which he or it conducts business, is not subject to periodic performance reviews, does not receive “merit” pay increases (other than pre-engineered accelerated commission or bonus incentives), invests in whatever he needs to conduct the business, and bears profit and loss risk. Also, assume that the sales rep is allowed to (and does) represent product lines of other manufacturers (even if the supplier might engage the sales rep to be its exclusive sales rep for the specified customer base).
The sales rep solicits purchase orders, and the supplier typically has either the sole discretion to reject or the reasonable discretion to reject based on the creditworthiness of the customer. The supplier enters into the purchase contract directly with the customer. Unlike a distributor (a true middleman), a sales rep does not take title, bear inventory risk, product warranty risk2 or the credit risk of the customer.
There are at least three areas that the parties should pay attention to. They should specify (i) the sales rep’s compensation structure, (ii) when the sales rep earns its commission, and (iii) the disposition of commissions upon termination.
Compensation structures vary depending on the type of business or product and negotiating leverage. The supplier needs to determine the best mechanism to achieve its goals without overcompensating (i.e., providing superfluous incentive to) the sales rep. Many of the issues overlap.
First, the supplier must determine how the market defines competitive compensation. Prospective sales reps in certain markets might judge compensation solely by comparing commission rates. But sales reps in other markets might judge compensation based on the sales rep’s expected dollar earnings. If competitive compensation is based on expected dollar earnings, the supplier needs to “work backwards” to create a compensation structure (including commission rates or bonuses) that meets the sales rep’s payout expectations, which the supplier pegs against specified sales targets or quotas.
The supplier must decide whether it will pay the sales rep some combination of fixed fee and contingent commission (as well as expense reimbursement), or just contingent commission (what sales reps sometimes refer to as “straight commission”). Generally, the higher the fixed component relative to the contingent component and the greater the sales rep’s right to expense reimbursement, the more likely the arrangement jeopardizes the independent contractor status of the sales rep.
When calculating the contingent component, the supplier must decide whether to structure a flat or variable rate of pay. If the supplier pays a flat rate of commission, it pays the sales rep a single rate that does not change regardless of the number of units sold, for example, X dollars for each unit sold or X percent of the net invoice amount (or gross margin) of each unit sold.
If the supplier pays a variable rate of commission, it pays the sales rep a commission rate that changes as sales increase. For example, the supplier might pay a higher rate for sales that exceed the specified annual sales target. Or it might pay “bonuses” calibrated to the achievement of sales quotas. On the other hand, while the supplier might be willing to pay a higher rate to secure a long-term sales contract, it does not want to pay an annuity as the contract winds down. In this case, the supplier might negotiate to pay progressively lower residual rates for sales made under a long-term sales agreement with the passage of time. Another possibility is that the supplier negotiates to pay no commission at all until the sales rep exceeds specified sales thresholds, upon which the supplier pays commission back to the first sale, or only for subsequent sales.
The supplier can tweak the compensation structure to push out new product lines or to invigorate sales of existing product lines. For example, the supplier might pay different rates for different product lines, or a higher rate for one product line only if the sales rep achieves sales targets for the other product line. It might pay the same rate for all products, but give more weight to sales of certain products, either by assigning points or a dollar multiplier to each product. The possibilities are endless.
The supplier typically pays sales compensation based on sales revenue of the products. It should define the parts of the invoiced amount for which it doesn’t want to pay sales compensation. These include items like logistics (e.g., shipping and handling and storage), sales and similar tax, and customs and similar duties. It should clarify the extent of its obligation to pay sales compensation for any service contract entered into in connection with the products. The supplier should clarify that it has no obligation to pay sales compensation for any products or value it provides for free to a customer as part of any advertising and marketing promotion (e.g., samples, free fills, etc.), or for products returned for any reason (e.g., warranty issues, etc.).
The supplier also needs to understand how the compensation provisions work together in the contract. For example, how will the supplier deal with a customer that falls off the face of the planet? Does this reduce the quota, which ultimately impacts the amount of sales compensation?
There are really two issues for when a sales representative earns its commission. First the parties should determine when commissions are deemed earned by the sales rep. The parties should also specify at what point in time the supplier is obligated to deliver commission that has been deemed earned under the agreement.
From the sales rep’s perspective, it wants its commission to be deemed earned sooner rather than later. An extreme example is commission deemed earned upon the sales rep’s dispatch of the corresponding purchase order. But this means that the supplier incurs the obligation to pay commission whether or not the supplier accepts the order.
Most suppliers negotiate the obligation to pay commission only when the customer has paid the purchase price under the corresponding purchase contract. This approach aligns the interests of the parties by giving the sales rep the incentive to solicit trustworthy customers, even though the supplier ultimately has the discretion to nix transactions with uncreditworthy customers.
In most cases, the supplier pays earned commissions periodically in batches rather than as the commissions are earned. For example, the supplier might agree to pay the commissions earned in the specified period (e.g., month or quarter) some specified number of days or weeks after the end of the specified period. This gives the supplier a chance to reconcile its books regarding incoming customer purchase price payments and outgoing commission payments. The time gap is also a form of financing for the supplier; it incurs the liability but may deliver the funds (interest free) many days or weeks later.
In almost all cases, the customer pays the purchase price directly to the supplier, and the supplier pays the sales rep its commission from the proceeds. However, in some cases, the sales rep is able to negotiate a kind of financing where the supplier allows the sales rep to receive payment from the customers and deduct its commission before forwarding the balance to the supplier. This approach raises many issues that are beyond the scope of this article, including how the supplier secures itself against the sales rep when the collateral is owned by a third party (the customer).
Payments After Termination
It’s also important to specify the sales rep’s right to commission after expiration or termination of the agreement. Let’s assume minimal risk that any post-termination compensation will be deemed “wages” under the labor and employment laws. The pro-supplier position is for the sales rep to be entitled only to commissions “earned” prior to expiration or termination (sales rep termination due to supplier default), which helps to deter undisciplined end-of-term selling.
Sales reps typically favor a structure that takes some control from the suppler and rewards compensation for purchase orders dispatched prior to expiration or termination. The parties often settle for middle ground, for example, rewarding compensation for purchase orders dispatched prior to expiration or termination, but accepted by the supplier according to objective criteria (even if during the term, the supplier had sole discretion) within the specified time frame after expiration or termination.
Lawrence Hsieh is an attorney editor at the Practical Law Company, and the author of the ‘Corporate Transactions Handbook’ (Data Trace Publishing Co. 2011).
1. For an annotated form of sales representative agreement (pro-supplier with corporate sales rep), with drafting notes discussing a wide range of issues, visit http://us.practicallaw.com/.
2. Note that in some cases, suppliers with strong bargaining power “squeeze” (by not providing contractual indemnities to) their distributors, reasoning that end users have recourse against the supplier via the “warranty” in the box.