Since January 2018, distributors have played an interesting role in California cannabis. From a regulation perspective, dealing with a distributor is not optional. However, from the business decision vantage point, they’re not all that necessary. Still, some manufacturing and cultivation licensees opt to utilize distributors for sales and retail relationships with the distributor attempting to act like a brand house (more akin to the liquor model). Whether you have a short or long term supply and distribution agreement with a distribution licensees, your basic key terms have to be covered in order to avoid disaster on production and sales (see here for more on that). Lately though in California, I’m seeing more and more terribly written, one-sided distribution agreements that leave me scratching my head when it comes to manufacturers and distributors actually signing on. In turn, this post is dedicated to identifying red flags in distribution agreements in California.
But first, a little history.
As of summer 2017, because of a technical fix to the (now repealed) Medical Cannabis Regulation and Safety Act and Prop. 64, distributors do not have to take title to cannabis products. This of course stripped distributors of what would have been a massive amount of power between cultivators, manufacturers and retailers. And this move by California distinctly pivots the cannabis regulatory model away from the liquor distribution model. Still, all licensees have to use distributors for product transport, mandatory quality assurance testing, quality assurance review (i.e., reviewing packaging and labeling of finished products), and for the collection and remittance of cultivation and excise taxes to the California Department of Tax and Fee Administration.
Whether cultivators and manufacturers utilize distributors to gain greater market share through a distributor’s retail network is completely optional. Some distributors are holding themselves out as having long term sales relationships with retailers that enable the distributor to develop increased brand power across products that an individual manufacturer or retailer wouldn’t otherwise have. Whether that’s actually true or not remains to be seen, but it hasn’t stopped certain distributors from locking manufacturers and cultivators (collectively, “wholesalers”) into truly bad supply and distribution agreements.
If you’re contemplating entering into a more traditional distribution relationship, here’s what should get your Spidey senses tingling:
1. Supply and Timing. A true distribution agreement is really defined by the amount of supply wholesalers make that the distributor is buying (to sell to retail) and the timing around that production and those sales. Typically, a distributor is going to buy up all or a minimum set amount of wholesaler product on a set schedule or, if the parties so agree, according to specific notice terms that give the wholesaler enough to time to sufficiently perform. The worst distribution agreements in cannabis either don’t clearly identify the amount of product the distributor is supposed to buy, have no minimum purchase standard, or they do identify the amount of product to be bought but give way too short of a notice period to the wholesaler to adequately perform. A good distributor will know the industry and will provide sufficient lead times on certain kinds of production that don’t automatically set up the wholesaler for breach.
2. Exclusivity. Bad distribution agreements will obfuscate whether the relationship is exclusive or non-exclusive and especially in regard to certain or various product lines. This is a huge mistake really for both sides. And especially if a distributor is obligated to buy up “all of the product produced by a wholesaler.” One great example is if the wholesaler creates a new product line that isn’t mentioned specifically in the distribution agreement. Without being super specific on exclusivity, disputes are bound to occur.
3. Relationship with Retail. The relationship with retailers is probably the most valuable asset coming out of the distribution agreement. Routinely, distributors will bar wholesalers from making contacting with or selling direct to retailers that are sourced through the distribution agreement. It’s incredibly important then in the agreement (especially in California where distributors don’t have to buy products from wholesalers if wholesalers want to be on retail shelves) to define what retail relationships are included as “off limits” in the contract. For example, if a wholesaler already sold direct to a given retailer in the past and the wholesaler is also within the distributor’s network, ask this question: Is that direct sale relationship locked into the new distribution agreement or not?
4. Sales, Marketing, Advertising, and Sales Data and Information Rights. Wholesalers can still afford to be picky with distributors in California. As a result, as a wholesaler, if you have specific conditions around the sales of your product (e.g. price, placement, prominence, store selection), you need to negotiate these with the distributor and not necessarily let the distributor take the helm. In addition, wholesalers should not be hesitant to put the onus on distributors to participate in the marketing and advertising of their products (especially in an exclusive relationship) or to at least force the distributor to assist the wholesaler with its marketing and advertising efforts. The alternative is jockeying for attention amongst all the other wholesalers selling to the distributor and leaving any product promotion or pushing solely up to the distributor at its discretion. In addition, I’ve now seen multiple distributors take away or winnow down the audit and information rights of wholesalers relative to sales performance on wholesaler product. This is a pretty big red flag for wholesalers as that data will tell you how your products are performing in the marketplace compared to your competition and also how hard your distributor is working to support your interests.
5. Pricing. The parties cannot leave product pricing to chance and expect to have a harmonious or successful relationship. The parties have to obviously negotiate the price (typically per product type) the distributor will pay for the products, and that agreement should be memorialized in the distribution contract (usually in a distributor pricing schedule that’s discounted to account for distributor margins). Distributor pricing strategy is hugely important because too high can drive away the distributor and too low means little to no potential for raising prices in the future. Do yourself a favor though and do not let the distributor completely dictate distributor pricing in the distribution agreement–the parties should actually analyze and be transparent about what makes sense for both keeping retailers happy and maintaining their own bottom lines, which requires a significant amount of look back at past market performance and really knowing the products and market trends.
6. Payment Terms. Getting paid from licensee to licensee in California can be a massive challenge because it’s expensive to run a licensed cannabis business and margins are typically not great at any volume. A solid distribution agreement will have a very clear payment schedule (and even protocol for disputes specifically related to getting paid). And there’s a big difference between getting paid when the distributor picks up the product versus getting paid when the product actually sells at the retail level. What’s worse is that some distributors may extend credit to retailers thereby delaying the ultimate pay date for the wholesaler, and if that’s the case the wholesaler should expect to wait a good long time to get paid out. In turn, wholesalers need to really drill down on payment terms in distribution agreements and also research how and when the distributor is usually getting paid by retailers within its retail network.
7. Territory. Seemingly innocuous at first glance, how the parties define the distribution territory is very important. This is more of a business decision, but wholesalers really need to do diligence on any distributor to see how strong they are throughout California. You otherwise could end up locked down with a distributor that while having immense power and influence in Los Angeles county is a relative unknown with no retail prospects in San Diego county.
8. Termination and Effect. This, to me, is one of the biggest areas of screw-up in these agreements. Way too often, the distributor has a unilateral, “without cause” right to terminate with however many days notice to the wholesaler. If you’re a wholesaler, this makes you a sitting duck in that a line of sales could vanish with limited notice and you’d be powerless to stop it. Plus, the impact unilateral termination can have on existing orders (if not properly determined) can be devastating to a wholesaler that may have changed its entire business and labor force to accommodate the distribution relationship. And return of product in California is incredibly strict–one you buy cannabis, only infused products can come back down the chain for a return (of a substantially similar or identical product (not for cash)), and only if those products are “defective.” Lastly, when the relationship is over, the question will stand as to whether the wholesaler can still pursue relationship with those retail entities, and if there’s a non-circumvent that’s instituted by the distributor for a matter of years, the wholesaler is SOL. This all goes to highlight how important it is for a wholesaler to take a really detailed look at any termination provisions.
9. Product Reps and Warranties. Usually, a distributor isn’t going to have robust product representation and warranties. However, in California, where a distributor can store products, has to have them tested, and can package, label, re-package, and re-label flower products, there’s a lot of product handling and interaction going on at a distribution facility. In turn, wholesalers should seek to get at least some reps and warranties around product fitness when in the hands of the distributor (depending on what the distributor will actually do with the product), and indemnification for the same. And of course, any good California cannabis distribution agreement is going to contain succinct protocol for any recall (i.e., who gets to make that call and who’s responsible for the logistics and resulting costs of a recall).
10. Distributor Bill of Business Health. This goes without saying, but it would surprise you how often wholesalers do zero diligence into the operational history and successes of a distributor. At the outset of the relationship, questions to ask are: does the distributor have a history of honoring its contractual obligations? Does it have a history of damaging material breaches? Does it have a history of litigation? Does it really have that expansive retail network it claims to have? Is it operating in compliance with the law (or, instead, is it allowing an unaccountable, unlicensed third party to do its contractual bidding)? If the distributor can’t or won’t answer these questions, you’re in red flag territory.
Distributors could end up being as important to cannabis as they are in alcohol, despite their lack of power under current regulations. A lot of that hinges though on the actual value add they can provide through their distribution relationships and agreements. It’s a rough market out there right now because California is still emerging, and wholesalers need to be very careful when evaluating whether to ink a distribution agreement (or not).
Back in March, former Food and Drug Administration (“FDA”) Commission, Scott Gottlieb, 