Contract exclusivity clauses are interesting. Suppliers almost always like them, but some companies use them and some don’t. Today let’s talk about what they are, when they are used, ways to structure them, how to negotiate using them, and enforceability.
Note: This article is about the buyer/supplier relationship where an exclusivity clause refers to the goods or services purchased by a company/buyer from a supplier. It does not refer to employment exclusivity where an employment relationship or intellectual property is governed by a contract.
What is a Contract Exclusivity Clause?
So what is a contract exclusivity clause? Basically it’s a clause in a contract where a company commits to purchasing all or part of the volume for a good or service exclusively from a particular supplier. It’s a two-way commitment that the supplier will provide the company with the needed material or service and the company will purchase a certain amount or percentage of their need from that supplier. One of the central tenants of a supply chain is that risk always carries cost, so a contract exclusivity clause spreads the risk between buyer and supplier.
An example contract exclusivity clause use would be a manufacturing company who welds a lot of steel negotiating that they will purchase 80% of their expected weld gas volume per year from Airgas. In this case, they would provide their previous year’s volume, perhaps some expected increase or decrease in that volume, and then commit to at least 80% of their volume purchased from Airgas. In return, Airgas would guarantee to provide the manufacturing company with their required volume (similar to a Most Favored Nation arrangement) and might provide an additional discount in exchange for the commitment.
Note that previously, Airgas would have simply received orders as they came in and provided the company with weld gas at current or negotiated lead times. With an exclusivity clause, Airgas gains predictability for their year and can better secure inventory, financing, and otherwise lower their risk. They can “put the order on the books” sooner with a commitment from their customer.
When to Use a Contract Exclusivity Clause?
There are multiple factors that lead to companies agreeing to a contract exclusivity clause.
- The supplier requires it. This is one of the more common reasons a company will agree to an exclusivity clause with a supplier. Some suppliers simply require a commitment from their customers in order to do business. Suppliers can do this when they have leverage, perhaps as the only supplier for a good or service, supply is scarce, or their reputation and history with their customer(s) is strong.
- The company wants Most Favored Nation status. This means the company wants to be favored above the supplier’s other customers for best pricing, availability, or even quality factors. In exchange for this favored status, the buyer is likely to need to “give something up,” in this case a competition between the exclusive supplier and other sources for the same product.
- Supply is scarce. When supply of a resource is scarce in a market, committing to purchase from a supplier can ensure the scarce supply is allocated to a certain company first as part of that commitment. This typically happens for materials when they become scarce as part of a catastrophic event, but it may also apply to services such as labor due to tight labor markets. In the utility infrastructure and large construction industries in the US, a labor shortage happens every time there are large wildfires somewhere because most of the available labor goes to help with the fires (and make more money in hazard pay). Ironically, utility businesses are usually so risk averse they will not sign exclusivity clauses, even in this predictable situation.
- The buyer is seeking better pricing or lead times. Signing an exclusivity clause can become a leverage point for better pricing or lead times. A supplier who knows their customer volumes can then negotiate better pricing and terms with their own suppliers and can even stockpile material to meet their commitments. Suppliers then pass that certainty on to their customer.
- Prevent competitors from gaining access to the supplier. If a company signs an exclusivity clause for 80-90% of a supplier’s capacity, it prevents that company’s competitor from gaining access to high volumes of that supply. It is possible an exclusivity clause will also contain explicit commitments from a supplier not to sell to the company’s competitors. Sometimes an exclusivity clause is the first step to a partnership between businesses as they use it to tie their fates together.
- The company wants to lower overall risk. While an exclusivity clause moves some risk back to the buyer/company, it also lowers risk overall. The company knows what they will purchase and who they will purchase it from. The supplier knows who will purchase their offering and how much of it they will sell. Adding certainty lowers risk without necessarily “moving” it, so an exclusivity clause can accomplish that goal.
Exclusivity Clause Structures
There are multiple ways to structure an exclusivity clause, but only one major decision: quantity or percentage. The other question is: for how long? Here is an example exclusivity clause where the company is purchasing 1000 widgets a year from a supplier:
During the Term of this Agreement, the Company agrees to purchase exclusively from the Supplier a total of 1000 widgets annually, to be delivered in accordance with the schedule set forth in Exhibit A. The Company shall not procure, directly or indirectly, the same or substantially similar widgets from any other supplier, nor shall it engage any third party to manufacture or supply such widgets.
In consideration of this exclusivity, the Supplier agrees to prioritize the Company’s orders and ensure timely delivery of the widgets in accordance with the agreed terms, quality standards, and pricing as set forth in this Agreement. The Supplier further warrants that it will not offer more favorable terms, pricing, or supply conditions for the same or substantially similar widgets to any other buyer without extending the same terms to the Company.
This exclusivity obligation shall remain in effect for the duration of the Agreement, unless terminated earlier in accordance with the provisions herein. In the event of a material breach of this clause by either party, the non-breaching party shall have the right to seek appropriate remedies, including but not limited to termination of the Agreement and recovery of damages.
In this case, we had a set quantity to purchase, but we could also use a percentage of the total volume (such as 60-90%). Typically an exclusivity clause would only be employed for a majority of the volume, and in that case you might take out some of the language about not procuring from other suppliers for the remainder of the supply. While this still allows a secondary supplier, that also means the Supplier with the exclusivity clause might not offer as many incentives for less than 100% of the volume. The process would be similar for services, but might use different terms (i.e. Contractor or Consultant and Work or Hours instead of widgets).
As for duration of the exclusivity, the default would be for the length of the Agreement or Contract, as in the example. This would be one reason not to enter into an automatically renewing or evergreen contract with an exclusivity clause – it might simply be too binding on both parties. If you have a set of master terms and conditions with a supplier, you might also create an amendment to simply apply to certain goods or services, incorporate the exclusivity clause, and impose a time limit on that exclusivity separate from the main terms and conditions. An example of this would be a ten-year contract with a large manufacturing supplier but an annual or three-year exclusivity agreement for a certain strategic widget.
Negotiating Exclusivity Clauses
As a procurement or supply chain professional, be sure you get the appropriate amount of value for an exclusivity clause. Bringing in the exclusivity clause option is part of rule-changing negotiation strategies, specifically part of the long-term commitment approach. Levers to pull when an exclusivity clause is on the negotiating table:
- Price – price is the most obvious negotiation point, of course. In exchange for certainty and volumes, suppliers should be able to offer the best possible price. Consider also a performance-based pricing option where you can help the supplier increase efficiency or decrease costs and share that value with you as the buyer. Your fates are tied together, so you may as well make a rising tide to float all boats.
- Lead time – because of the predictability offered with an exclusivity clause, suppliers can stockpile, staff up, and otherwise make plans for your volume. Use this to shorten lead times (possibly dramatically) in exchange for the certainty you’re offering.
- Supply certainty – at this point it goes without saying, but make sure you get certainty of supply for the business in your contract. Make sure force majeure clauses are tight and well-defined and that it is difficult for the supplier to cancel the contract unilaterally. This is an “ask me how I know” moment with the supplier I happened to give an example for at the beginning of this article. There was a point where they were a tough negotiation partner, insisting on an exclusivity clause, but then offering a force majeure clause where they could drop supply if there was the slightest disruption in their own supply chain. I didn’t let them have their exclusivity clause.
- Other value-add items – putting an exclusivity clause on the table might open up some other value-add (but non-monetary) negotiation points. Consider requiring a single point of contact, certain reporting requirements that are beyond the standard offering, additional warranty, storage or cross-docking, planning or continuous improvement assistance, or additional meetings and touchpoints with the supplier.
Enforceability
The ability to enforce an exclusivity clause is tricky. Especially when the clause is for less than 100% of the business (and is a percentage instead of a set volume), the supplier puts a lot of faith in the buyer to manage that volume split. For an example where the exclusivity clause covers 80% of the volume (and there is a backup supplier providing 20% of the volume), here are some options for the purchasing company to manage the enforcement of that contract:
- ERP system – Some of the larger and more sophisticated ERP systems do have options to allocate spend to certain suppliers or make buying suggestions to keep a mix of suppliers in play. Unfortunately I cannot get any deeper into this option as each system is different and configured differently, so investigate your options with your IT and supplier software team.
- Blanket POs – A blanket purchase order written for the expected volumes can help manage the split between suppliers. Use estimated volumes for the blanket quantities, and make it difficult to increase the blanket amount for the secondary supplier.
- Training – Simply communicating contract commitments to internal stakeholders is important for success in honoring those commitments. Be clear about what suppliers offered in exchange for their percentage of business and how it benefits those stakeholders. If the stakeholders do not see the benefit, it means you either need to change your negotiation approach (go chase things they do value!) or communicate differently.
- Audits – Audits are a reactive instead of proactive solution, so be careful how you use them. If you’re left only with audits as a compliance tracking tool, try to do them as frequently and proactively as possible. This might mean pulling spend for multiple suppliers monthly to measure the business spread between primary and secondary suppliers and adjust accordingly.
Exclusivity clauses are an interesting and useful lever to pull in negotiations and supplier relationships, and they can have great benefits for both parties. Be thoughtful about how you implement and enforce them, and ensure your business is willing to take on the risk they represent. If you’d like to talk to me about your company’s specific exclusivity clause uses, let’s chat.
