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The Dynamics of Beer Distribution
The Three-Tier System, Franchise Laws, and the Sometimes Bumpy Route to Market
If there’s one lesson we can all take away from Prohibition, it’s this: with great power comes great irresponsibility. At the beginning of the twentieth century, the US alcohol industry was like one big party. The beer business in particular was at the top of its game, with thousands of breweries nationwide cranking out millions of barrels of the stuff. And it wasn’t too hard to sell what they produced because they had ownership stakes in—or outright ownership of—the taverns that put their products the hands of consumers. This “tied-house” system is one of the elements that precipitated the industry’s downfall. The landscape was so competitively cutthroat that the brewers would push their beers through by any means necessary, with little regard for the public’s well-being or common decency. And the bars were beholden to them, so the proprietors of those establishments had no choice but to carry out the brewers’ will.
These abuses only emboldened the dry movement, which, by the end of the century’s second decade, finally got its way.
Flash forward fourteen years. The long national nightmare has ended and America is ready for legal alcohol once more. But wet advocates who fought long and hard to leave Prohibition in the rearview mirror were determined to ensure that it wouldn’t happen again. That meant the now-legitimate industry needed to learn how to behave itself. One of the safeguards against the shenanigans of the past was a ban on tied houses.
The Twenty-first Amendment repealing “The Noble Experiment” gave the states the authority to regulate the sale and distribution of alcoholic beverages within their borders. It laid the groundwork for the modern three-tier system of alcohol distribution—the three tiers being (1) brewers/importers, (2) distributors, and (3) retailers/bars/restaurants. The structure has maintained the balance of power through a set of checks and balances ever since. In theory.
No regulatory framework is perfect, and the three-tier system definitely has its share of detractors. Not a day goes by when a small brewer isn’t griping about the system. But some of their more seasoned peers grudgingly acknowledge it’s a necessary, though considerably flawed, evil.
There’s barely ever been a time when the system wasn’t lopsided in favor of one of the tiers. In the years immediately following the repeal of the law, the main consideration was keeping the brewers at bay. It was their virtual omnipotence in the decades prior to the ratification of the Eighteenth Amendment (the one that established Prohibition) that got the nation into that nearly decade-and-a-half-long mess in the first place, and America certainly wasn’t going to allow them to hold most of the cards.
Six decades later, the brewers really weren’t the ones to be concerned about anymore. In the waning years of the twentieth century, retail became the dominant tier in the three-level equation—obviously not small mom-and-pop establishments, of which there were fewer and fewer, but the big box/club stores (Costco and its ilk) and the mega mass-merchandisers (Walmart, Target, and others—well, mostly Walmart). Their market hegemony afforded them unprecedented resources and lobbying muscle that essentially has enabled them to mold the marketplace to their liking.
As the bottom tier consolidated its power, another dynamic was playing out in tandem: top-tier consolidation. Medium-size breweries got scooped up by large ones or simply went out of business. By the 1990s, three companies dominated the US market, with one of them lording over the other two. Anheuser-Busch seized nearly half of the market by that point. Miller Brewing Company, then an operating unit of Phillip Morris (which acquired the Milwaukee-based brewer in 1969) was a distance second. Coors was the able-bodied No. 3. In 2002, Miller ceased to be an American-owned company when South African Breweries purchased it and formed SABMiller. Coors followed suit three years later when it merged with Canada’s Molson Brewing Co., and two years after that SABMiller and Molson Coors combined their US businesses in a joint venture. For the next three years, Anheuser-Busch tried to exploit its competitors’ foreign ownership as their Achilles’ heels—that is, until it joined their ranks in 2008. InBev, the already massive conglomerate that emerged from the combination of Belgium’s Interbrew and Brazil’s AmBev, completed what was arguably the most significant transaction of the modern beer age when it bought Budweiser’s St. Louis parent for a cool $46 billion.
Retail beer aisles showcase much more diversity than ever before.
As this was happening, craft brewers were regaining their moment after a leveling off in the mid-’90s (when they were still, for the most part, called microbrewers). By 2003, craft volume was growing in the low to mid single digits and accounted for about 2 percent of the overall US beer market. By the end of that decade, that volume was in the double digits. By 2015, craft had achieved more than 12 percent beer share (and about 20 percent of the industry’s total revenue). Craft brewers hope to reach 20 percent share by 2020 (provided that the AB InBevs of the world don’t keep acquiring them, but that’s another story entirely).
The small brewers and the big megas rarely have been on the same page about anything, and that includes distribution. The three-tier system prevents brewers and importers from owning distributors and retailers, but that doesn’t mean they haven’t found other ways to navigate around it. In the mid-’90s—not-so-coincidentally at the same moment the initial craft/microbrewing movement was plateauing—Anheuser-Busch launched its notorious “100 percent share of mind” initiative, through which it demanded that distributors carrying its products carry ONLY its products. A-B was the only macro to impose such a mandate. It was actually fairly common for Miller and Coors products to be in the same distribution houses, which made it that much easier when they ultimately formed the MillerCoors JV in 2007.
Craft brewers whose brands were in A-B wholesale houses in the ’90s were unceremoniously dumped thanks to August Busch IV’s mandate. So, even though A-B technically didn’t own its distributors, it proved that the word “ownership” can have many other shades of meaning.
Small brewers who struggled to gain or regain distribution had very little recourse beyond going out of business or self-distribution, and the latter was only a possibility in states that permitted self-distribution. As of this writing, thirty-four states allow small producers to distribute their own products. There’s usually a cap on the volume eligible for self-distribution, otherwise it risks running afoul of the Twenty-first Amendment. That ceiling varies from state to state; in some states a brewer can distribute up to 25,000 barrels per year, while in others the number is 60,000, etc. For some perspective, Anheuser-Busch produces in the neighborhood of 100 million-plus barrels annually.
Some craft brewers have found considerable success launching separate distribution subsidiaries. Escondido, California’s Stone Brewing, best known among mainstream consumers for its Arrogant Bastard brand, is a textbook case on how to run a craft distributorship. Not only does it distribute its own portfolio in its local market, but it’s also a wholesaler for some thirty-five brands produced by other brewers. Like most craft operators that have self-distributed, it wasn’t by design but by necessity that Stone Distributing Company came into being.
Stone Brewing launched in what was probably the worst year for the burgeoning craft segment: 1996, the year that A-B announced its share-of-mind scheme and Consumer Reports ran a pretty damning exposé of microbrewed beer (many say at the behest of A-B). Over the next couple of years more brewers were going out of business than were going into it. (But in a lot of ways, this was a blessing in disguise because the ones that folded, by and large, were those motivated by a misguided get-rich-quick mentality, making product of highly questionable quality.)
At that time it was next to impossible for a small brand to gain distribution at a house dominated by the large brewers. So Stone and many others took matters into their own hands.
On the opposite coast, Boston’s Harpoon Brewery launched Harpoon Distributing Co. to move its own products in its home market. And, in 2015, it announced it was taking on brands from other producers, primarily those that were new to the greater Boston market.
The idea behind self-distribution is to build a presence in one’s home market that is robust enough to attract the attention of distributors there and in other metro areas and states when it comes time to expand. But that doesn’t mean a brewer’s problems are over when it signs on the dotted line with a major wholesaler. If it happens to be in a state with ironclad franchise laws, its problems might just be beginning.
In states with strong franchise laws, it’s extremely difficult—often impossible—for a brewer to end its relationship with a distributor. Let’s say a brewer feels the distributor is not putting enough support behind its brand in the market and the brand is suffering for it. Meanwhile, here’s another wholesaler down the road willing to more closely align its efforts with the brewer’s expectations. If it’s a franchise state, the brewer and its prospective new distribution partner are out of luck. The distributor currently carrying the brands pretty much owns them in its region until the end of time and doesn’t have to let them go. Those brands could be doing little more than collecting dust in the distributor’s warehouse, but the wholesaler still refuses to let them go. If it sounds fairly draconian, that’s because it is.
Franchise laws are not a product of the repeal of Prohibition. Their existence in various states dates back only to the early ’70s—a full four decades after ratification of the Twenty-first Amendment. At the time, distributors were on pretty shaky ground. There were only forty-odd breweries in the country at the time and around 5,000 distributors. These largely family-owned wholesale operations often depended on the brands of a single brewery for 100 percent of their business. To avoid the risk of overnight bankruptcy, distributors sought legal safeguards within their states to prevent brewers from suddenly pulling their products and moving them to another distribution house.
The landscape has changed considerably in the forty years since. There are now close to 5,000 breweries in the US—99 percent of those are defined as “craft brewers”—and the distribution tier has consolidated down to include barely one-fifth as many wholesalers as had been operating at the dawn of the franchise law era. Consolidation begets consolidation. As brewers on the top tier and retailers on the bottom tier M&A’d their way to greater power, so did the wholesalers on the middle tier. It was their only means of survival when they were being squeezed by their trading partners on either end.
One of the byproducts of consolidation has been an influx of an unprecedented number of new SKUs—“stock keeping units,” which is distribution-speak for “individual brands or packaging formats that take up space in a warehouse and need to be delivered”—into a wholesaler’s operation. (SKU is such an ugly acronym, one to be used sparingly.) Add that to the tidal wave of new products coming from those thousands (and counting) of new breweries. And those breweries’ brands aren’t finding it as hard to get distributors interested in their brands as they had in the late ’90s/early 2000s. Between 2005 and 2007, distributors en masse started to find religion about craft. That’s around the time macro beer volume started to flatten and decline and it became harder and harder for distributors to make a profit. And that contrasted immensely with the “good old days.” Selling such iconic, large-scale brands during the first four or five decades after Prohibition had been a license to print money for distributors. Then it became an incredible struggle to squeeze a couple pennies’ worth of margin out of a case of Budweiser or Miller Lite. It was all about pushing as much volume as possible and that meant massive capital investments in larger delivery fleets, warehouse expansion, and automation to move cases as quickly and efficiently as possible. Though craft brands account for significantly smaller volume than their mass-marketed counterparts, they’re sold at a considerably higher price point, meaning greater profit potential for the distributors. They can make more money from products that take up a lot less space on their trucks, delivering to retailers to sell to consumers drinking less but drinking better (and willing to pay a couple of extra bucks on a six-pack).
During that period in the mid-aughts, the dynamic shifted to one where distributors were actively courting craft brewers. Larger wholesalers even launched specialty divisions to deal with the artisanal segment, as maintaining and selling craft beer requires a certain degree of TLC and a specially trained sales team.
For every distributor crossing every ‘t’ and dotting every ‘i’ with its craft portfolio, there were a handful of “brand collectors”—those who wanted to see what “this craft thing is all about” and gain bragging rights that were more about the quantity than the quality of their craft brands. That created a scenario where there were more SKUs (there’s that acronym again) than the distributor could credibly manage, setting such brands up for failure. The trouble is that if this situation happens in one of those franchise states, there’s not a whole lot the brewer can do about it.
The Brewers Association has been confronting the franchise reform issue head on in its push for franchise law reform. Distributors who favor maintaining strong franchise laws have understandably pushed back, arguing that weakening such laws could be one step on a path back to Prohibition.
The Brewers Association has asserted that it has no interest in torpedoing the three-tier system. The fact that its most successful members got to be so successful, in part, thanks to its distribution partnerships is not lost on those breweries. In a one-two media punch in 2014, craft brewers made their case for franchise reform, shooting down distributors’ assertion that such changes would destroy the three-level framework put in place by the Twenty-first Amendment. Steve Hindy—cofounder and president of the Brooklyn Brewery, Brewers Association executive board member, and a former skilled journalist who worked as a foreign correspondent in the Middle East before getting into the beer business—authored a March 30, 2014 New York Times op-ed piece titled “Free Craft Beer.” Hindy was on the Brewers Association’s board of directors at the time and wrote it on behalf of that organization (and took some heat from distributors for doing so).
Meanwhile, Brewers Association president and godfather of American homebrewing Charlie Papazian published a piece a few months later in the organization’s trade publication, The New Brewer, that sought to poke holes in the case distributors were making for business as usual.
With regard to the notion that reforming franchise laws in some states will compromise the three-tier system, Papazian contends that in states where such legislations are “more reasonable” (Papazian singles out Delaware, New York, and Washington as being among the reasonable ones) or non-existent (Alaska, California, and the District of Columbia), the three-tier system remains “vibrant and effective.”
New York’s wasn’t always quite so “reasonable,” as Hindy points out. He recalls the time he once tried to terminate a contract with an underperforming distributor in the state for selling products outside of his territory, as well as selling out-of-date beer. “I thought it would be straightforward,” Hindy wrote, since my contract said I could leave ‘with or without cause.’” However, the distributor took Brooklyn Brewery to court, and Hindy said that New York’s franchise law, “which sets a high standard for showing cause, trumped whatever my contract said.” Two New York State Supreme Courts upheld Brooklyn’s position, but, fearing yet another costly, protracted appeal, Hindy settled out of court. Brooklyn was able to terminate the relationship, but only after paying more than $300,000 on legal fees for both appeals and the settlement—a huge burden for a small brewery.
It wasn’t until 2012 that the state’s franchise laws got a tad less insurmountable for brewers. That year, New York governor Andrew Cuomo and the state legislature agreed on a special dispensation for breweries that individually represent less than 3 percent of a distributor’s business and produce under 300,000 barrels a year. Brewers of that size—which includes most craft breweries, save for the six or seven largest—may now change distributors by paying a “fair market value” of the distribution rights, as negotiated by brewer and the wholesaler. “Still an expensive proposition,” Hindy wrote, “but easier than going to court.”
Needless to say, many brewers have learned to tread extremely lightly as they approach new distributor contracts, but many of those same brewers are still dealing with the headaches of existing contracts in strong franchise states.
The National Beer Wholesalers Association (NBWA), the trade group that represents the nation’s distributors, has been an advocate for preserving states’ franchise laws as they are. NBWA’s argument has been that such laws promote consumer choice and product diversity because they encourage distributors to make investments in small brands without fear of abrupt contract termination. When distributors are able to do that, they can stay independent, which, NBWA asserts, ultimately fosters greater consumer choice. NBWA also argues that there’s a safety element. In a position piece on its website, the organization claims that franchise laws prohibit a brewer or importer from terminating a relationship “because the distributor refuses to violate federal or state alcohol regulations, such as selling to unlicensed retailers.”
By and large, that last point is a rare occurrence and is very unlikely to apply to a small brewer. Craft brewers tend to have very limited resources, and they’re not likely to risk what little they have by trying to force their distributors to do something illegal. That safeguard applies more to the macro brewers, but even they aren’t willing to risk the bad PR and likely subsequent drop in share price that would result from anything so shady. (Mega brewers’ shadiness usually manifests itself within the confines of the law.)
Efforts to keep every line of a franchise agreement intact in the name of public safety often come off as disingenuous and merely protectionist. It’s hard to blame the distributors because they’ve got a good thing going, so why would they want to mess with it. But their critics accuse them of not fully recognizing how much market dynamics have changed. It really is an industry of small brewers and brands now, despite the fact that the macros—including domestics and mass-market imports—still account for nearly 90 percent of volume. But that share number is falling rapidly, and the macros can’t acquire them fast enough to stem the tide (not for lack of trying—they’ve already absorbed plenty of once-fiercely independent breweries into their operations).
It’s a tricky issue for the parties on either end of the debate. Craft brewers need distributors and they certainly don’t want to alienate their route to market. Though many do self-distribute in their home markets, most don’t want the headache of actually running a distributorship. Conversely, distributors have grown quite fond of the handsome margins their small suppliers’ brands bring to the table, and they won’t be giving up craft any time soon, especially since mega brand volume has flattened. And many distributors love working with craft brewers and all of their entrepreneurial (and often offbeat) personalities. A number have said selling craft has been the most fun they’ve had in the beer business in a very long time.
Though most of small brewers’ criticism of the distribution tier targets franchise laws, many of their acolytes tend to be a bit knee-jerk and call for the complete dissolution of the three-tier system. As is the case with any form of fandom—be it sports, comic books, Star Wars, or The Walking Dead—passions flare and folks often make some impulsive comments (thanks, Facebook) based more on emotion than on actual facts. It’s usually the less-informed consumers—or at least those who don’t actually work in the industry—who make such blanket statements.
A number of other countries—many of which still have tied-house systems where it’s immensely difficult for small brands to gain a footing—envy America’s system. A disproportionate number of European countries are trying to curtail out-of-control binge drinking, a task that would be substantially less daunting with the checks and balances the US system affords, as flawed as it is.
On the business side, the industry that’s been fairly vocal in its distaste for three-tier has been wine—small, independent wineries, to be precise. Much of that opposition stems from the issue of direct shipping. A significant number of states don’t allow alcohol beverage marketers to sell their products on the Internet, and a lot of wine makers are pretty miffed about that. Rightly so, because they depend a great deal more on consumers outside their immediate area than brewers do.
Although the number of wineries in the country is about twice that of breweries, they’re not as geographically dispersed as breweries. One of the Brewers Association’s big talking points has been that 75 percent of Americans live within ten miles of a brewery. Wine producers can’t really make the same claim about themselves, as their products, compared to beer, are more dependent on climate conditions. Obviously, there are exceptions; New York’s Finger Lakes region isn’t exactly known for its mild winters, but it does have a disproportionate number of wineries. Still, they depend on more temperate regions for a large percentage of their grapes, as their growing season is limited.
Most consumers can brag about their local breweries; most Californians, Washingtonians, and Oregonians can brag about their local wineries, but beyond those regions, things get pretty sparse (though urban wine making is a growing trend). Sure, there are burgeoning wine scenes in states like Virginia, Texas, and the aforementioned New York, but one hardly could argue that most of those states’ residents live within ten miles of a winery. If someone visits a winery, there’s a good chance they’re visiting from someplace else. If they want to buy a bottle of that Cabernet they tasted at that small mom-and-pop operation they visited outside of Sonoma, they’d better hope it’s distributed in their state. If not, they’d better hope they live in a state that allows direct shipping.
The number of states that do permit direct shipping is growing, but legalizing the practice hasn’t been without a fair amount of political and judicial maneuvering.
Perhaps the most frequently cited case related to in-state shipping was Granholm v. Heald, which went all the way to the US Supreme Court in 2005. The decision actually represented the convergence of separate lawsuits filed in the states of New York and Michigan. In the latter state, wine collector Eleanor Heald led a group of plaintiffs in challenging Michigan’s Liquor Control Code, which allowed in-state wineries to ship directly to consumers but forbade out-of-state producers from doing so. The plaintiffs argued that preferential treatment to in-state winemakers violated the Dormant Commerce Clause of the US Constitution in that it discriminated against interstate commerce. The plaintiffs in the New York case, led by Virginia wine producer Juanita Swedenburg, argued a similar point.
After many rounds of appeals, the Supreme Court ultimately decided, in a 5-4 decision, that the Michigan and New York laws did, in fact, violate the Dormant Commerce Cause and were, therefore, unconstitutional. The states had two options: Either ban in-state direct shipping, as well as out-of-state direct shipping—forbidding it for both eliminates the possibility of discriminating against one in favor of the other—or legalize interstate shipping. Both states chose the latter.
The cases may have been specific to wine, but they applied to beer as well. And, as these cases played out in their respective states, the distributor lobby advocated against direct shipping every step of the way. Once again, distributors cited public safety concerns and their desire to prevent the three-tier system from being dismantled. Wholesalers argued that such commerce lacks gatekeepers; what would stop a minor from receiving alcohol through the mail and consuming it illegally? (In most states, however, a carrier won’t deliver alcohol unless someone twenty-one or older signs for it.) The practice does, on a minute level, circumvent distributors and thus condenses the three tiers into two, but direct-shipping laws permit very small volumes to be sold that way. Distributors wouldn’t be going out of business any time soon.
So, what is it that distributors actually do, besides getting beer from A to B, that is? First of all, beer (and all alcohol for that matter) is a highly taxed industry, and the distributors are the ones collecting the taxes.
Increasingly they’re doing a fair amount of marketing as well. The brewers used to handle pretty much everything on that end, but now those suppliers from the top tier are focused primarily on national advertising. Anything local tends to fall on the distributors. It’s not uncommon to walk into a distributor’s warehouse and find a full-service print shop. That’s because the distributor is tasked with producing items such as point-of-sale materials for local bars and retailers, as well as signs banners for community events.
Distributor in-house printing applies, for the most part, to the products supplied by the large macro breweries. Crafts tend to be regional operations and aren’t really engaged in national marketing campaigns. Most of the time when a craft brewer’s products enter a particular market, it hires local reps who work in tandem with their distributors to build their brands across the wholesaler’s geographic footprint. When the relationship is solid, the brewery rep and the distributor rep co-host events like tap takeovers, beer dinners, and other promotional shindigs to boost the brand’s profile in a particular region and make everyone—retailer/bar, brewer, and distributor—more money.
Additionally, the distribution tier has become a major source for market intelligence, something to which the companies have been able to adapt in the age of Big Data. Many have moved to virtually paperless operations with real-time information on product velocity, pricing fluctuations, retailer order history, inventory, and out-of-stocks at their fingertips. And they’re able to share that data with their trading partners on either end of the supply chain to make the relationships (again, in theory) more profitable.
Still, there’s no denying that distributors and brewers increasingly have been on divergent paths for the better part of a decade. And it’s not just between the craft producers that have changed the dynamics of the beer industry and the distributors that aren’t fans of change. The NBWA has been at odds with the large brewers on particular issues—namely, the question of whether breweries should be allowed to own distributorships.
Anheuser-Busch InBev has made no secret of its desire to control the middle tier any way it legally can. There was that aforementioned “share of mind” scheme, of course, but in some cases it has tried, and succeeded outright, in actually owning distributorships in some states (some states are bit more loosey goosey about the whole three-tier thing).
Back in 1978, thirty years before its acquisition by InBev, Anheuser-Busch successfully sued the state of Kentucky for the right to purchase a distributorship. After that, state regulators banned brewers from owning distributors, primarily to appease the latter. However, in 2014, AB InBev attempted to buy a second distributor in the Bluegrass State, suing the state once again to circumvent the regulation. And, yet again, the brewing behemoth was successful. However, state legislators stepped in to change the law, and, in the spring of 2015, the state senate voted to do so, requiring AB InBev to sell its distribution interests in Kentucky.
The divide between brewers of all sizes and the middle tier has played out on Capitol Hill, as well—or at least in the conference center of the Hyatt Regency at Capitol Hill. Each spring the Beer Institute, NBWA, and Brewers Association would convene there for a joint legislative conference. In addition to educating their respective memberships on the critical issues that affect all of them, they’d all get the chance to meet with their members of Congress. However, it ceased to be the NBWA/Brewers Joint Legislative Conference and became, simply, the NBWA Legislative Conference in 2010. Each tier had its own fish to fry and more and more those fish were at odds.
Perfection is never going to be in the cards for the three-tier system. If anyone expects that, they should probably consider getting into another business. On the continuum between “complete, unmitigated failure” and “perfect,” the only place the three-tier system needs to reside is “functional/adequate”—somewhere close to the middle. For it to remain there depends on how willing to be flexible each of the stakeholders on the value chain is.
A group of legal experts at the 2015 Craft Brewers Conference in Portland, Oregon, wrestled with such issues in a panel discussion titled “Strength Through Flexibility: The Three-Tier System of the Future.” It was a bit of a tug of war between small brewer interests (represented by a lawyer for equity funds that play in the space) and distributor interests (represented by a similar professional who advocates for the wholesaler tier). Though they predictably couldn’t agree on much, they did find common ground on two fundamental realities.
Reality No. 1: With a new brewery essentially opening every twelve hours, there’s unprecedented stress on the system of distribution as it exists today. Something’s got to give. Business models will have to evolve in order to sustain the deluge of new players and products on the market.
Reality No. 2: Regardless of tier or financial interest, every business on the beer value chain works for the consumer. Brands aren’t making TV ads for distributors or retailers, and they’re certainly not fashioning their tweets to reach those trading partners. They’re trying to reach the consumer. And ultimately, whether through introducing ballot initiatives, holding public demonstrations, calling legislators, or voting with one’s wallet, it’s ultimately the consumer who’s going to decide what shape the future takes.