Private Label Agreements Explained
A private label agreement is a contract between a company that promotes products under a brand name—known as the "private labeler"—and another company that manufactures the products under the brand name. In short, the purchase of products from the manufacturer and their sale by the private labeler under the brand name constitutes private label transactions. The brand name can be any name, and the products can vary from books to software to groceries. The products must conform to the specifications of the private labeler.
While not always, private labeling arrangements work best for established brands to gain access to more retailers, sell more products and bring in more revenue. They also work best when the private labeler has the expertise needed to promote the products. These conditions could apply to retailers, companies that have an online presence, or well-known businesses with a strong marketing reach.
Private labeling is common in many industries , including the grocery business. For example, grocery stores often offer canned foods that are offered under their own label but not made by them. Sometimes the label is different, but the product is identical to what is sold by other companies. In the technology sector, companies sometimes use private label software to drive income. Whether grocery or software, primary benefits of private label agreements include:
Convenient structure – Private label agreements are usually straightforward and easy to understand.
Low investment – Although the terms of the agreement vary, significant investments are typically not required of the private labeler at first to get started.
No special experience or technology needed – Because the private labeler does not make the product, no special training, education or equipment is required.
Brand building – Whether selling online or at a retail store, the private labeler can build brand awareness while expanding into new areas.
The Elements of a Private Label Contract
The structure of private label contracts will vary widely depending on the type of goods to be sold and the level of detail required, but there are a number of key elements one should typically expect to find in a private label agreement. The most basic components of a product supply agreement between a supplier and a retailer include: 1) parties specifying who will supply the product and who will sell it; 2) product specifications defining detailed physical and performance parameters for the product; 3) purchase specifications defining the obligations of each party to complete the transaction; and 4) terms of sale outlining the pricing, terms of payment, order and delivery schedules, warranties and indemnification requirements, etc. A supplier will also sometimes include specific language outlining the rights of the retailer to buy branded goods from the supplier, in preparation for expansion into a branded market and/or for back up inventory, as the case may be.
Benefits of a Private Label Agreement
In a consumer-centric retail environment, the advantages enjoyed by private label products are evident on store shelves across the country. For manufacturers (known as "own brand suppliers" in this context), the advantages of private labels speak for themselves in terms of sales numbers. The opportunity involves more than just increased shelf space for the brand, however. Factors such as supply chain efficacy and price control also factor into the equation.
Channel vendors who supply name brand products typically lack the supply chain flexibility of their own brand counterparts. Their distribution models assume national coverage rather than localized concentration, so they find it challenging to satisfy a store’s specific inventory needs, which are often structured to complement private label offerings.
The private label, meanwhile, eliminates channel vendor profitability analysis from the equation. A retailer can set mark-up and promotional strategy according to its own conception of brand value, with greater control over its cost of performance than it can exert over proprietary brands.
Common Issues in Private Label Agreements
Private label agreement contracts can present a unique set of potential challenges. Manufacturers and suppliers can run into obstacles such as quality control issues. Quality control problems can include defective or inferior product, late fulfillment of orders and the inability to fulfill all aspects of the product specifications. The issue could also be a failure to meet fulfillment schedules or the supplier misunderstanding the product specifications. Such problems may impact not only the relationship between the manufacturer or supplier and private labeler but also with retailers or others down the distribution chain.
Private label agreements can also present intellectual property and trademark risks. Registrations of trademarks are often a contract requirement. However in some cases, the trademarks or other intellectual property or trade secrets may be registered. Even if not registered, such items may still be protectable. A private label agreement or supplier agreement that fails to properly allocate the ownership of necessary registration rights and protections may present potential risks to the private labeler in terms of dissatisfied customers and loss of revenue.
The Process of Negotiating a Private Label Agreement
The key to understanding private label contract terms is identifying the terms that matter and how best to negotiate for those terms. Those terms that matter from a negotiation perspective comprise three basic categories:
A. Non price issues
There are a number of terms and conditions in private label contracts that are arguably more important than the price that a company pays to purchase a product. Importantly, these terms and conditions are also relevant under the private label laws. They include:
(i) Market Exclusivity
From a nutrition perspective, a company can only be overcharged for a product to the extent that the company will sell the product into a market where it otherwise could not have sold the product if it purchased the finished product from the private label contract manufacturer. Many private label contract manufacturers are large, diversified companies that manufacture other products. If those same private label products are on the shelf of the same retailers that sell the products through the private label agreement, the private label contract manufacturer might be able to sell its other products to the retailer using the same connection that was used to sell the finished product. Therefore, it is critical that the non-price terms of the private label contract ensure that the private label contract manufacturer is prohibited from using that connection to sell its own products through the retailer.
(ii) Manufacturing capacity
To the extent that a private label contract is awarded to the private label contract manufacturer based on its specific production capabilities (e.g., state-of-the-art manufacturing technology or unique quality attributes), it is important to determine whether the private label contract manufacturer is prohibited from selling the same or similar product to other customers, or in geographically relevant markets.
(iii) Ingredient/Finished Product Sourcing
In some private label contracts, a company requires that the private label contract manufacturer use ingredients or packaging materials from specified vendors . The private label contract manufacturer must agree to do so. In addition, the private label contract manufacturer must agree to obtain prior approval to substitute a different vendor or product, and must agree not to vertically integrate by supplying those ingredients or packaging materials to other companies.
B. Price Issues
Price-related terms include those issues that explicitly relate to the direct pricing for the product. They include:
(i) Manufacturer’s Margin
One of the most common forms of pricing deviation in private label contracts is the manufacturer’s margin. Although simple in concept, there are a couple of variants:
(1) Fixed Margin
The manufacturer’s margin is usually expressed as a percentage of the market price of the product and is added to that market price to obtain the price at which the retailer will purchase the product. The most common form of manufacturers margin is a fixed percentage of the product’s market price. For example, the private label contract manufacturer may agree to a 20% manufacturers margin, which will be applied against the market price of the finished product to arrive at the price the retailer pays the private label contract manufacturer. The fixed margin approach is simple in concept but will only work if the private label contract manufacturer has little to no negotiating leverage in the process. Otherwise, the retailer may have negotiating leverage with respect to the market price.
(2) Floating Margin
The floating margin approach is similar in concept to a net profit approach.
There is a significant risk, however, that the underlying numbers can be manipulated once they are out of the private label contract manufacturer’s hands. Some safeguards may minimize that risk, such as the requirement that the bookkeeper be independent and qualified, or that the bookkeeper be audited quarterly. However, both of these approaches have their own challenges. A balance must be struck that provides appropriate safeguards to minimize manipulation while avoiding unnecessary spending on an otherwise simple process.
Legal Implications of Private Labeling
It is important to note that when drafting a private label contract, it must comply with the trademark laws. This means that the private label should not infringe on any other party’s trademarks. The trademark may be searchable on the United States Patent and Trademark Office website among others. A private label agreement should note how the private label is "identifying" itself to the public. For example, is there "disclaimer" wording on the packaging so that the public knows what they’re getting? A critical aspect of the agreement must be to define how the company will guarantee the product adheres to very high quality standards (e.g., materials, specifications, etc.) can and will be met by the private label supplier. In this regard, frequency of quality audits and/or testing must be built into the private label agreement.
Dispute resolution is another area that must be addressed in the private label agreement. Will the parties agree that in the event of a dispute, they will go to mediation before arbitration or litigation? Will force majeure be a defense that terminates the contract? In addition, confidentiality should also be addressed in all private label agreements. Without accurate and effective confidential protection, the private label supplier may expose itself and its brand to theft. The need to maintain the value of the supplier’s brand requires that the supplier take steps to protect itself.
Case Studies in Successful Private Labeling
Sourced Sourcing, a company selling household goods, acquired its own level of SKUs by offering them as private label products. After purchasing branded products from distributors at wholesale prices, the company cleared up packaging, inserted its own labels and instructions, and sold them through various e-commerce and wholesale channels. The company has reported up to 20% higher margins on their private label items and increased customer loyalty into the double-digit range.
A New Zealand based home accessories company, Blunt Umbrellas, has been successful with a single product and distribution channel. Blunt Umbrellas’ superior wind-resistant, aerodynamic design has collected international awards since its launch in 2006. Entering the complex U.S. market in 2010, the company formed its private label strategy in two steps. First, it set up a private label manufacturing agreement between itself and its Singapore-based supplier. Under this relationship, the Singapore company has total control over the manufacturing process. By establishing a single supplier for its identified product, the company kept its costs low, and received and invoiced by Blunt. Second, the company started distributing by itself through earlier established online retailers and a limited number of physical retail outlets. The establishment of its private label manufacturing relationship assured the company that it had a steady supply of high-quality products already in-place when its distribution network began to grow.
The Future of Private Label Agreements
Over the past three decades, the private label retailing concept has evolved into a multibillion-dollar industry. While the majority of consumers associate private label goods with lower quality, the marketplace has changed in this regard, with store brands now competing head-to-head in terms of quality, packaging and price with manufacturer brands. Private label products established several decades ago are perceived by consumers as being of higher quality and value then their national-brand counterparts. Importantly, private label categories do not change from year to year but rather evolve over a long period of time driven by a variety of market factors, including channel proliferation, vendor consolidation, market maturity and consumer value-seeking behavior.
In the future, several developments will impact private label growth in local and global markets. These include: Private label products are likely to penetrate further into specialty and regional retailers , and supermarkets will continue to eat into the market share of competing formats, such as mass merchandisers, discounters and warehouse club chains. Private label segment also is expected to move beyond supermarket stores to other retail types, such as convenience stores, drugstores, discount retailers and wholesale clubs. In addition, retailers increasingly will invest heavily in store-level labor, store space and marketing to drive affinity with the retailer brand. Indeed, many private label programs are marketed to build customer loyalty and increase consumer trip frequency and market basket size. Further, with the increase in online shopping, online-only private label brands are growing in popularity and usage, including subscriptions for nutraceuticals, beauty/healthcare products and more general consumer items.
As can be imagined, changes in private label retailing may have significant implications for the negotiation of private label agreements.
