When middlemen discredit your goods

Jon Jordan, in Baton Rouge with the car speakers he makes, is being hurt by cut-rate online retailers.

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FSB checks back in with three businesses that suffered from patent infringement and IP theft.

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(FORTUNE Small Business) -- It seems counterintuitive, but Jon Jordan, CEO of Southern Audio Services (SAS) in Baton Rouge, wants to curb the number of dealers who are selling his car speakers.

Jordan understands that he can't handpick all his vendors, but he never expected the rise in unauthorized dealers that came with the e-commerce boom.

"A few years ago I decided to look for the SAS name on eBay (EBAY, Fortune 500), and it came up thousands of times," he says. "I thought, Holy smokes - who doesn't have my speakers for sale?"

Dealers who sell products without a manufacturer's consent are part of the gray market, a growing group of unauthorized, mainly Internet-based vendors who circumvent channels to offer rock-bottom prices. They're not stealing the products they sell, but they are taking market share from authorized dealers, who often provide guidance and service crucial to the reputation of high-end products.

"Ultimately, they're devaluing my speakers in the marketplace - most sell them at 30% discounts or more," says Jordan. "Legitimate dealers can't afford to sell them at those low prices and provide customer service."

Customers who buy gray-market goods often blame the manufacturer when a warranty isn't honored or when they can't get support, all of which hurts a company's brand value. (Like most electronics companies, SAS honors warranties only when products are purchased through contracted dealers.)

Another victim is the authorized retailer. Lombards Auto Sounds, a high-end audio vendor, sells SAS speakers at its four California locations. David Joy, manager of the shop in Santa Maria, estimates that his industry loses as much as 40% in revenues to gray-market dealers. He says that some customers come into the store to scope out the products before buying them online: "You almost want to start charging people just to show them things."

The gray market isn't new. For years certain electronics retailers have sold cheap cameras and TVs acquired wholesale in overseas markets or bought from U.S. wholesalers trying to unload excess inventory at cost. Proponents of the gray market argue that retailers should be able to sell at any price they want. Manufacturers, they say, should adjust to this reality by offering a two-tiered pricing system, charging more for products with warranties and white-glove service and less for bare-bones products.

Gray-market sales are growing with the popularity of the Internet.

"Years ago a guy in San Diego could sell our speakers from his house, but it didn't affect business in New York," says Jordan. "The Web has exposed him to the entire world."

Jordan attributes much of his gray-market dilemma to wholesalers that violate his sales policies and sell to unauthorized vendors. John Ferreira, a global manufacturing expert at Archstone Consulting in Stamford, Conn., says, "Between the manufacturer and the end customer, there are huge networks of intermediate distributors. It's easy for products to trickle outward." He advises companies to monitor exactly what happens to their inventory - who's buying it and how much they're selling it for.

Ferreira says the explosion of unauthorized e-commerce has hit many sectors, including pharmaceuticals, electronics, and software. While many businesses complain that the government is doing little to stop the problem, last June the Supreme Court overruled a 1911 decision that had prevented manufacturers from setting price floors for their dealers.

The new ruling gives manufacturers the right to hold inventory back from unauthorized vendors who refuse to follow pricing guidelines. It doesn't, however, give them grounds to sue retailers who find back-door ways to get their hands on products. Reselling on the gray market remains legal. For now, manufacturers can sue only if they can prove a vendor has stolen intellectual property - the manufacturers' brand images, text, and photography - to peddle the product.

To cut back on unauthorized selling, Jordan turned to Net Enforcers, a Phoenix-based startup. The firm's 55 employees scour the Internet using its custom software, which spiders into the web's nooks and crannies - RSS feeds, chat rooms, forums - to ferret out transgressors. For $1,500 a month, this online detective agency regularly informs Jordan when his subwoofers make unexpected appearances online and also refers him to lawyers who can send cease-and-desist letters to offending parties. The company, which had sales of $4.5 million in 2007, has a list of 110 corporate clients - including JVC, Samsung, and LG (LPL).

Net Enforcers isn't alone. Cyveillance, a ten-year-old business in Arlington, Va., sells comparable services.

"We call it distribution control," says Todd Bransford, the company's VP of marketing. While Net Enforcers' clients come largely from the electronics industry, Cyveillance tends to work with businesses in financial services and tourism.

Ever resourceful, some gray-market resellers are finding ways to evade these intellectual-property watchdogs. Tony Macrini, VP of sales at Soundstream, a Montebello, Calif., business that sells entertainment systems, is a Net Enforcers customer who is worried that his success with the service-Internet search hits for his products have declined from several thousand to about 200 a month-may be short-lived.

"A lot of guys know they can't use our images, so they're making their own, and it's going to get harder to take them down," he says.

The results could be dire.

"When a manufacturer's goods sell for cheaper prices or through disreputable channels," says Ferreira, "the company will eventually have to bring its prices down, or suffer lost revenues."