Expert: Warren D. Miller - 12/19/2008

Question
pls i saw a product i would love to market and i have done all the marketing research and sales forecast too. my problem is that i have no capital to order for the product i would like to know how i can write a joint venture letter to the manufacturer where i get a percentage share for the sales of his product. i have the customers but no capital outlay to buy the product upfront

Answer
Dear Samuel--

If you're going to write letters, you had better learn to use capital letters of the alphabet and learn to punctuate correctly. On the particular issue of a 'joint venture,' however, I think you're wasting your time. Let me explain why. I'll end with a possible solution for what you've described.

1. The money to be made from joint ventures comes off the bottom line (Net Income), not the top line (Sales).

2. If you had a track record of some kind in the industry about which you claim claim to 'have the customers,' that might make your idea attractive to the manufacturer. But, from your question and background above, I don't think you have such a track record.

3. From an economic standpoint, you have an even bigger problem: In order to prove you have the customers, you'd have to tell the manufacturer who they are. Once you did that, you'd lose your only real bargaining chip because then your secret wouldn't be a secret any more, assuming that your customers are not known to the manufacturer.

4. In short, Samuel, you're barking up the wrong tree about a joint venture. That's not going to happen. I don't mean to be negative, harsh, or discouraging, just realistic and honest.

5. Now the good news--and there IS some good news here--is that the kind of relationship you say you want is far better suited to commission-based selling than a 'joint venture.' That is, you would work as an independent sales representative for the manufacturer. Here's how that would work:

   a. You would have to hire a lawyer to represent you.

   b. You would need to form a company of some kind. Use the lawyer to help you with that. DON'T try to do it on your own. Saving money that way can turn it to be some of the most expensive 'saving' you ever did. I don't know what country you're in, but in the United States, you would have your choice of a corporation, a sole proprietorship, or a limited-liability company (LLC). In my country, for a one-person venture, the LLC often offers the greatest protection and more flexibility at a lower cost than the other two choices. But you and the lawyer need to decide.

   c. In the U.S., the kind of sales work you describe is called being a 'manufacturer's representative,' or just 'rep.' Most reps represent more than one manufacturer, but it's not required. However, repping for more than one manufacturer does reduce your risk because your economic well-being does not rest with only one company and one product or product line.

   d. You would then need to decide whether you would insist on having 'pricing discretion' where the product is concerned. That is, would you want to be able to adjust the price (usually downward) to make it more salable but without having to consult with the company first? That is a very important question. If you have pricing discretion, you will NOT be paid a commission based on a 'percentage share for the sales of the product'; if the manufacturer has any sense at all, then it will insist on paying your commission based on the 'gross profit' for each sale you make.

   e. Do the math. Let's assume the product sells for $100 and usually has a 40 gross profit. So for each unit of product sold, the manufacturer can expect to have $40 of gross profit left over to pay its operating expenses (rent, insurance, non-manufacturing overhead and fringe benefits, transportation, human resources, accounting, etc.). Let's say that you strike a deal to get paid a commission of 10. Let's look at how that would work in term of whether the 10 was paid on the sales number or the gross profit.

   f. If you sell a unit of product for $100 and get a 10commission, then, to help fund its non-manufacturing activities, the company will be left with $30--the $40 it would ordinarily have in gross profit less the $10 it paid you. But if you have pricing discretion and, due to local market conditions, you think that any price above $80 makes the product not salable, let's look at how those numbers work. If you are paid your 10commission on the sales line, you get $8, just $2 less than you would have gotten at the $100 price point. But what does the company have? Well, it still has to pay its $60 of manufacturing cost, doesn't it? And it has to pay you $8. That totals $68, leaving it a mere $12 to put towards those non-manufacturing expenses. You lost $2, and the company lost $28. I don't know about you, but that sounds like a pretty bad deal for the company to me.

   g. If I ran the company and you wanted pricing discretion, you'd have to take your commission based on the gross profit, not on sales. That way, when you cut the price, you'd be cutting your own income a lot more than the $2 you'd lose in the example above.

   h. The percentage of commission paid based on gross profit is larger than it is on sales. Let's assume you'd get 25 of gross profit. Now let's do the math again. If you sold the product for $100, you'd get a commission of $10 (25 x the $40 gross profit). If you cut the price to $80, your commission would be cut almost in half, to $5 (25 x the $20 gross profit [$80 sale minus $60 manufacturing cost]). The manufacturer would have $30 left over without the price cut and $15 with the price reduction. So it gets hurt by the price cut, but not as badly as when the commission is based on sales. More important, your commission would go down by 37.5, which is a big chunk.
 
   i. Let's carry it one step further. Some companies that pay commissions based on gross profit also pay a LOWER PERCENTAGE as the gross margin declines. Gross margin = gross profit / sales. In the case where you sell the product for $100, the company's gross margin is 40 ($40/$100). But when you sell it for $80, the company's gross margin falls to 25 ($20/$80). Because the 25 leaves the company a lot less money for its non-manufacturing expenses, it might pay you 20 or even 15 of gross profit. At 20, your $8 commission on a $100 sale would fall to $4 on an $80 sale. And at 15, your $8 commission on a $100 sale would fall to $3 at the lower price point. Obviously, this kind of arrangement is aimed at pain-sharing between company and rep. Just as obviously, you're going to do your dead-level best not to reduce the selling price because it really hurts your personal cash flow when you do.

   j. The lesson here is about incentives. Commissions are just one example of an incentive. The goal of well-designed incentives is to align the interests of the company's employees with those of its owners, the shareholders. Incentives are a central tenet of Austrian economics, which is a favorite subject of mine. Misaligned incentives account for a little of crazy and expensive behavior around the world. They were certainly at work big-time in the economic meltdown the U.S. economy is now experiencing. But that's another story for another time.

I hope I've been helpful here, Samuel. Let me know if the way I've explained this makes sense. I hope it does. If it doesn't, I'll try again.

But if it does, here's the deal I'll offer you: You draft a letter that you will eventually send to the manufacturing company proposing that they agree for you to represent them. I'll critique the letter and give you feedback on it, but I won't write it for you - if I did, you wouldn't learn anything. HOWEVER, I will do this for you ONLY if you complete the rate-the-expert email you'll receive right after you get this email reply from me. Do you see what I'm doing with the incentives between you and me? I'm offering to help you, but you have to help me, too.

Take care. Let me know how you want to proceed, please.

Warren