Monday, January 31, 2011

Net Present Value (NPV) and Discounted Cash Flow

To be a negotiator there are times when you need to understand certain financial concepts and Net Present Value and Discounted Cash Flow is one of those concepts negotiators should know.

Net Present Value looks at what a future cost is worth in today’s dollars. Discounted Cash Flow looks at how much of an investment would need to be made today to make a payment or investment in the future. Net Present Value takes into account the fact that the other party will have the benefit of using the money in the interim and getting the compounding effect on that, making it worth less to you (as you aren’t getting the compounding effect of the money). Discounted Cash Flow takes into account the fact that you will have the benefit of the investment and would be earning a return and get the benefit of compounding in the interim so the amount you need to invest today to make a payment in the future is less than the payment amount.

The NPV is calculated by dividing 1 by (1 plus the interest rate) N  where n equals the number of years. For example if you had a value of money of 12%, and the agreement was to pay you $1.00 three years from now, the NPV calculation would be:
                 1                         1                            1                         1
NPV  --------------  or   ----------------   or    ------------------      or    -----------   =  $.7117                     
            (1 + rate)n         (1 + .12)3             1.12 x 1.12 x 1.12       1.4049

This means that a commitment to pay you $1.00 three years in the future is equivalent to you having $.71 today. From a discounted cash flow perspective it would mean that for you to have that $1.00 three years in the future, you would need to invest $.71 today.

Net Present Value or Discounted Cash Flow deal with the concept of time value of money. That’s important to Procurement as throughout a contract there are promises to make payments, hold inventories, and pay damages, all which may have a time value impact. For example, if you were purchasing a major piece of equipment there can be a significant difference in the NPV based upon the payment schedule. Sometimes the issue of time value of money exists in the subtleties of the language used or the changes Suppliers try to negotiate. For example compare the same commitment, but with one word inserted:
            “Supplier will pay all damages awarded.” 

What’s the difference?  The difference is when you will get paid. In the first, once damages are awarded the Supplier must pay. In the second, payment will occur at some point in the distant future after the Supplier no longer has any possible appeals so the award is final. You will still get paid a dollar, but on a net present value basis you will get less.  Using a 12% value of money, here’s what they would be worth depending on timing:

Time to get paid
Current value of that payment commitment
1 year
2 years
3 years
4 years
5 years
6 years
8 years
10 years

So in the change of the language example, changing it from damages awarded to damages finally awarded would mean that the Supplier would not have to pay you until the award is final, meaning that they exhausted all means of appeal. If that took 8 years to happen, from a Net Present Value perspective it would mean that commitment to pay is really paying you the equivalent of 40% of what it would be worth if they paid you today. Sure if the award was $100,000 you would still be paid $100,000. The difference in value is because they are holding the money not you, so they would be getting the compounding effect of the investment on that money. 

Another way to look at it is from a discounted cash flow perspective, all they would need to invest today to pay you the $100,000 in 8 years if they had a 12% return on their money is $40,000.

Another way to look at it is if they paid you the $100,000 today and you were able to get a 12% simple return on your money here’s what it would be worth to you during the same period.
Day 1
End of 1st year
End of 2nd year
End of 3rd year
End of 4th year
End of 5th year
End of 6th year
End of 7th year
End of 8th year

So that one additional word in the commitment could cost you $147,598. That’s the  difference between being paid $100,000 at the end of the eighth year by the Supplier when the award was final versus having $247,596 because you were paid immediately and had the compounding effect on your money.

Non-Compete Provisions

In some Procurement situations there may be a need to make sure that the Supplier is not selling competing products. Most of the time it’s because the Buyer has committed to make significant investments in the creation of a new product or service. It could also involve the Buyer making certain volume commitments to the Supplier or the Buyer entering into a form of requirements contract where the Buyer is limited to only purchase from the Supplier. 

In the first case the Buyer wants the non-compete provision so they have a better assurance that they will get the return on the investment they made. In volume purchase situations the Buyer wants to be assured that the Supplier will not be taking actions that would prevent the Buyer from purchasing those committed volumes and winding up either having to purchase items they can’t sell, or pay termination charges on the items they don’t take delivery on. In a requirements situation the Buyer would not want to be limited to only being able to purchase from the Supplier while the Supplier is competing with them or creating other relationships that could impact the Buyer’s ability to make the sale. 

Agreements not to compete can be done by either a separate non-compete agreement between the parties or by the addition of a non-compete section where there is a “covenant not to compete”. A covenant is a formal commitment to do or not do something.

Most covenants to not compete will normally answer the following basic questions:
  • Who is agreeing?
  • What is the scope of the commitment?
  • The description of what is being restricted.
  • The term of the restriction.
  • The geographical scope of the restriction.

Here’s a simple example
Covenant Not To Compete.
Supplier hereby covenants and agrees that it shall not, directly or indirectly, either on its own or through an agent, joint venture, affiliate, or independent contractor, sell, lease or otherwise distribute the Ajax Product (Part number #______  or any product that contains the functionality and performance set forth below to parties other than Buyer. This covenant shall remain in effect for the term of this agreement and shall apply worldwide.
        Description of Product:
        Restricted functionality and performance

 In the example:
  • Who is agreeing: The Supplier
  • The scope of the commitment: The Supplier shall not, directly or indirectly, either on its own or through an agent, joint venture, affiliate, or independent contractor,  sell, lease or otherwise distribute the Ajax Product (Part number #______  or any product that contains the functionality and performance set forth below to parties other than Buyer
  • The description or scope of the restriction: It would exclude both the named product any other products that had the functionality and performance that was described
  • The term of the restriction.  For the term of the Agreement with Buyer
  • The geographical scope of the restriction: Worldwide

In the example I used functionality and performance as measures as a Supplier could easily come out with a slightly different product and by including both functionality and performance you could control the extent the Supplier may be able to use the technology. For example, you may not be concerned if substantial functionality wasn’t included or if the performance of the product was significantly less so that it didn’t compete on a price performance basis with the Product you are buying.

If you needed a covenant not to compete in an agreement, there are several additional changes that you would want to make to your agreement. The first is you would want the right of injunctive relief to enforce the covenant. Injunctive relief would allow you to seek a court ordered injunction to prevent the Supplier from further violating the covenant. The second thing is you would also want to modify your limitation of liability provision so the damages you could collect from the breach of the covenant would include lost revenue and profits as those would be the primary damages you would have from the breach of the covenant.

One last comment. Non-compete provisions are a form of a restraint of trade. If the circumstances would make sense for a non-compete provision, you should review it with your law department to ensure that the covenant would not be in violation of anti-trust laws and that it would be enforceable.

Opportunity Costs

In negotiations you mostly focus on direct and indirect costs associated with the Supplier relationship. In motivation behind the negotiation, you may also have opportunity costs that may drive the behavior of the Supplier or Buyer. For example, a common tactic in product development and sales is to be the first one out with a Product or Service so that you become designed into your customer’s product or solution so that it becomes difficult or costly to switch to another Supplier. In that situation the opportunity cost that drives their behavior is all the residual and annuity business they would get once they are selected.  If they don’t close the contract, they don’t just lose that sale, they also lose any residual or annuity sales that would flow from that.  It doesn’t hurt to remind a Supplier of that during the negotiation.

There can also be opportunity cost that you can use in negotiation of the renewal of service contracts. For example, I once negotiated a renewal bonus if we were to renew a major service agreement. The rationale that we used in negotiating the bonus was that if we walked away and went with a new supplier, the Supplier would have significant expense in bringing in new business to replace us, so if we saved them that cost we should get a benefit from that renewal.

Another form of opportunity cost to a Supplier can be in simply having your company as a customer.  There are two types of potential value involved. One is in what they can learn from you if they do business with you. The other is the value of your name or brand in the marketplace in their selling to other customers.  Being able to list certain companies as your customer can be like having the “Good Housekeeping Seal of Approval”.  Potential customers view Suppliers that have prestige customers different than ones that don’t, and that provides substantial marketing advantage to a Supplier.  If they don’t get your business or lose you as a Customer, that’s an opportunity cost to them.

In preparing for a negotiation one of the things you should always check is recent business news about the Supplier such as recent announcements, awards, cancellations, claims etc. That type of information can help identify their need for your business.

Buyer’s can have opportunity cost which also can motivate their behavior and it’s important in dealings and conversations with the Supplier to not disclose the facts behind such opportunity costs. For example a Buyer could need the Supplier’s product to do the same thing as the Supplier (such as try to be first to market with Buyer’s product so they can lock in their own customers in and get the same benefits of being designed in to a solution). Buyers can also have opportunity cost in terms of costs they accrue waiting for work to be done. I once had to negotiate a contract to fit out a Computer Store that we were locating on Wall Street. In that case the opportunity cost was the substantial rent that we had to pay each month until we could use the space.  The longer it took to negotiate the agreement the longer we would have to pay rent without using the space.

Buyers may also have opportunity cost tied the profit they can make once the work is complete. I once negotiated for the construction of a plant in Hong Kong and the Vice President who had control over the future plant made it very clear to me that he wanted the agreement closed as quickly as possible and he want the work done as fast as possible, but still pay a competitive price. It wasn’t until later that I found out the reason was that once completed, the operation would make enough profit in six months to pay for the entire building and all the equipment in it. That’s a real potential opportunity cost if there were delays.

Sunday, January 30, 2011

Order of Precedence

In the event of a conflict between terms of an agreement, the conflict will normally be resolved by determining the precedence that the parties gave to the various documents. If the parties fail to establish an order of precedence:
  • Unless otherwise stated or agreed the latest writing in time between the parties will have precedence over the prior writings. This means that documents like amendments or change orders need to be carefully written.
  • All documents that are incorporated by reference into a document will have the same precedence as the document.  For example, if you had a Statement of Work that incorporated the Supplier’s specifications into it, and the Statement of Work was silent on precedence, the Supplier’s Specifications would have the same priority as the Statement of Work.
  • Agreements are interpreted as a whole. The simple example of this is if Document 1 required items A through M to be done and Document 2 required N through Z to be done, The requirement would be A through Z.  If part of M conflicted with part of Z only then would you consider the precedence between the two documents that include the conflicting language. 

Order of Precedence only deals with conflicts between documents. In the same situation described above, if you incorporated the Suppliers specifications into the SOW and that contained contract terms,  those would be included in your contract. You need to read and make sure you understand and agree with any document you incorporate.

Precedence is established in several ways:
  1. As between multiple documents the precedence is normally established by an order of precedence provision.
  2. As between documents of the same priority, the precedence is given to the latest writing in time between the parties on the same subject matter.
  3. Precedence may also be established where there is a clear showing of intent shown within the agreement such as stating the requirements included in a specific section shall not apply or not have precedence over what is being agreed to in that section. (This is called a “Trumping” provision).

The more complex your agreement and the more documents you have incorporated by reference into the agreement, the more important it is to have the right order of precedence. For example, if multiple documents will be incorporated into an agreement you should establish the precedence between that agreement and those documents and if some are more important than others create a precedence between those individual documents. If your contract is made up of multiple documents such as Master Agreement. A Statement of Work, individual Work Statements, and Purchase Orders, you need to establish the precedence between those document or they will be considered to be complimentary and equal priority will be given to all.

There are two areas where additional caution should be used in establishing the order of precedence.
  1. When you incorporate Supplier generated documents into your agreement, those documents could contain terms that may restrict or limit the protection of your contract given the precedence that would be given to those Supplier documents. An Order of Precedence only protects against conflicting terms. It doesn’t protect against additional terms. So always read the Supplier documents and exclude any terms in them that you don’t want to be included in your agreement. 
  2. As amendments are a later writing in time between the parties on the same subject matter, the amendment will have priority over both prior amendments that have been written and the agreement that the amendment is written against. Amendments need to be written carefully so it’s very clear exactly what is being amend and for what purpose. For example you may have a single product that you want to have slightly different terms on, if you aren’t clear you could me making that change for all. Here’s a simple example.  A Commodity Manager had a Master Agreement and a Statement of Work with the Supplier.  The Master Agreement was evergreen with no fixed expiration date and the Statement of Work had a 2 year term. The Commodity Manager wrote an amendment that referenced both the Base Agreement and the SOW that extended the term to a specific date. That amendment changed the date of the SOW to the desired date, which is what they wanted to do. That amendment also changed  the Master Agreement from being an evergreen contract to a contract that now had a limited term.  

When purchasing something that involves both drawings and specifications to avoid potential conflicts you may want to add language that says that they are “complimentary and what is required for one is required by all. This is used to avoid potential conflicts between the documents and giving them equal priority so the requirements will be interpreted as a whole by reading both together.

The use of order of precedence language is not limited to documents incorporated into the contract. Documents that are made part of the contract may incorporate more documents, so it may make sense to establish the precedence between those individual documents. For example a specification may be consolidation of a number of different documents such as the Buyer’s RFP, the Suppliers response, clarifying Buyer letters and clarifying supplier letters all of which make up the agreed specification. As there could be conflicts between those documents you may need to establish the order of precedence as between those documents. As part of your final clarifying letter you would also exclude anything in the Supplier's proposal, Supplier clarifying letters that .

In many contracts every time a number is used, good legal writing would require that the number be expressed both alphabetically and numerically.  By including both if the two conflict are in conflict you could look at parol evidence to determine the correct amount. That is why you traditionally don’t see a precedence being established between the written number versus the numeric number. If you were to set a precedence between the two, you need to ensure that the one you established as having priority is accurate in all instances. If you set a precedence between the two the Courts won’t look beyong the four corners of your agreement as there would be no conflict since you established the precedence between the two.

Here’s an example of how order of precedence will work:

Contracts are read to be complimentary and what an order of precedence does is give priority in the event of a conflict. This means that if you had two documents (priority 1 (P1) and priority 2 (P2), if the P1 document required items A-M and the P2 document required N-Z there would be no conflict. It would be interpreted to require A-Z. However If P1 said Supplier will provide X and P2 said Owner will provide X, then you would have a conflict between the two documents and then the order of precedence would come into play. It would be interpreted that the Supplier must provide it because that was established in the higher priority document.


Parent / Company Guarantee

The terms in your agreement may have limited value if the entity that you are contracting with doesn’t have the assets or resources to stand behind their commitments. Sales Subsidiaries of Suppliers may be risky to contract with or purchase through if they do not have the appropriate assets or resources on their own. With the exception of tort liability, a Parent Company isn’t liable for sales by their Subsidiary unless they specifically agree to be liable.  Even if you had both the Supplier and their Subsidiary sign your agreement, the Supplier would not be liable for the actions of the Subsidiary or purchases made through the Subsidiary unless the agreement stated that they were jointly and severally liable. In that case either or both would be liable.

There are a number of reasons why a Parent Company may want to have Buyer's purchase from their Subsidiary:
  1. Avoidance if liability on those sales (except for potential product tort liability).
  2. The parent company may not want to conduct business directly in specific locations for tax reason. They may also want to avoid needing to be registered to do business in those locations or become subject to the laws of those locations.
  3. The parent may also want to protect their price and profit as purchases through a subsidiary have the price partially controlled by the Transfer Price (the Price the Parent sells the product or service to the subsidiary)

Parent companies may also not want to be liable for their Subsidiaries as not all subsidiaries are wholly owned, nor would they want to be responsible for what the Subsidiary promises in their agreement.

If the Supplier tries to push you into buying from their Subsidiary, you can qualify the Subsidiary to determine if the Subsidiary has the assets and resources to perform on its own. If they do, you can contract with them. If they don't have the necessary assets and resources, there are several ways to manage against that risk:
  • The Parent Company can become a party to the agreement where both the Parent and the Subsidiary agree to be jointly and severally liable.
  • You could have the agreement be with the Parent and have them designate the Subsidiary as an agent to transact business through. As long as the agent acts within the limits of their agency the Supplier would remain liable.
  • You can have the Parent execute what is called a company or parent guarantee.

There are several ways to create a company or parent guarantee.
  1. If you contract with the parent you could include the guarantee in that agreement.
  2. You could have the parent company sign a separate guarantee letter or as part of the contract. 
  3. You could add an additional signature block to the Subsidiary agreement with the parent company’s commitment such as:

What does a parent guarantee look like? Below is an example where “Supplier” would be the Subsidiary and XCorp the parent company.

“If Supplier defaults in performance of its obligations under the Agreement (as such Agreement may be modified by Supplier and Buyer) XCorp shall pay to Buyer all damages, costs and expenses that Buyer is entitled to recover from Supplier by reason of such default.  This obligation shall continue in force until all obligations of Supplier under the Agreement have been completely discharged or any claim by Buyer against Supplier remains outstanding, whichever is longer."

Suppliers, especially those that sell through Subsidiaries that aren't wholly owned, will be reluctant to assume potential liability for all of a Subsidiary's potential defaults. If you were to run into that problem my recommendation would be to work with you legal team to identify what liabilities the parent has control over and as a minimum look for parent guarantees for those.  For example a Subsidiary that is simply reselling the Parent Company's product has no control over the design of the product or how that product is manufactured. All contract terms that relate to that should be guaranteed by the Parent such as intellectual property infringement indemnities,  indemnities against personal injury or property damage claims caused by defective products and product warranties. 

The reason why this is important is many time a supplier subsidiary may be only a sales company with minimal assets and resources. If you look only to that subsidiary for protection in many cases they simply won't have the assets to resources to stand behind the commitment. Even if you had an agreement directly with the Supplier, you couldn't collect from the Supplier as those transactions were not made under that agreement, they would have been made under the agreement with the Subsidiary. If you can't collect from the subsidiary, and the parent isn't responsible, you would be assuming all of the cost of the problem.

Parent / Company guarantees are usually done in one of two manners. The parent can be added as a signatory to the agreement with the guarantee before their signature. If you use a separate guarantee 
letter for the parent company to sign, you should include a form of preamble paragraph that describes the relationship and the fact that they are providing the letter so their subsidiary will be awarded the
contract so it shows that they are getting consideration for making the guarantee. 

If you learned from this post, think about how much more you could learn from the book.
The book is only US$24.95 plus shipping. The hot-link to is above the date.

Saturday, January 29, 2011

Payment, Payment Schedules

For many purchases the negotiation of payment terms is very simple, you negotiate a certain number of days after some event in which you make payment. For example:
a commitment to pay net sixty days after the date of delivery.  The key factors in establishing the payment term for the Buyer are:
1.     Value of money for the use of the money during that term.
2.     Ability to perform inspection, test, and possibly rejection before you are obligated to make payment.

In major procurement activities the ability to pay after the work has been completed may not be possible and in those situations you may need to negotiate a payment schedule with the Supplier. In negotiating payment schedules Suppliers may want to do several things.
·      Front end load the payment so they are working off your money.
·      Use the payment schedule and the amount of payments so that it is difficult or costly for you to change suppliers. The more you have paid them up front the more difficult it may be to change as they have your money.

For Buyers one key in negotiating payment schedules is to make sure that you haven’t paid the Supplier more than the work is reasonably worth at the time the payment will be made.  This ensures that if the Supplier fails to perform, you still have the money to correct the performance. Having money owed to the Supplier is one of the best forms of leverage to get performance. For example, in some contracts payments will be structured based upon the percentage of the work that is completed less a certain amount of retainage to further ensure that all the work is completed.  It doesn’t matter whether you are having a building constructed, a major piece of capital equipment delivered, or a major piece of software development completed, in all instances you want to make sure that the Supplier has provided all they are supposed to provide before you want to release substantial amounts you may owe them.

In negotiating payment schedules it is also important to have any progress payments not be tied to time.  Time may pass and the Supplier may be running behind on the schedule so you don’t want to reward them for not performing.  Always tie payments to deliverables or actual progress. You can also use your payment schedule as leverage to try to drive the Supplier into making commitments to get you back on schedule simply by including a requirement that if they are late in meeting the milestone, percentage of performance or deliverable, you have the right to withhold those interim payments until they are back on schedule.  Delaying one payment may not be enough to have the Supplier invest in bringing the work back on schedule, but withholding all may drive the desired behavior.

Pen and Ink Changes

When a change is required to an Agreement sent for signature, sometimes a party will strike out or write in changed language and initial it. Assuming that you agree with the change, the cleanest way to manage these changes is to re-generate the Agreement with the changes included and have it re-signed. It is legal to make pen and ink changes. All pen and ink changes to the Agreement must be initialed by both of the individuals who are signing the Agreement at each point where a pen and ink change has been made. If only one party initials a change, the change has not been agreed upon.

A pen and ink change by one party would, under contract law, be considered a counter offer. If it is accepted by both parties initialing it, the agreement is formed with the change being part of the agreement. If its not initialed by both the parties, the counter offer has not been accepted and agreement has not been formed as there is not a meeting of the minds. 

Initialing all Pages

If there is any concern about the integrity of the Supplier, you may want to take the additional step of having both parties initial each page of the Agreement, Attachments, Exhibits and all other documents that make up the Agreement. This prevents the unscrupulous Supplier from removing a page and substituting another page with different content.  

Friday, January 28, 2011

Penalties versus Liquidated Damages

Penalty clauses are terms of contracts that seek to impose an obligation to pay a sum of money in the event that the contract has been breached. A traditional penalty clause amount would include an amount the far exceeds the amount of damages that would be sustained. In many jurisdictions penalty clauses are not enforceable as a matter of public policy. The rationale is that contract terms should not be used for party to profit from the breach of a contract by the other party. 

Penalty clauses are different than clauses for liquidated damages. Liquidated damages clauses also imposes an obligation to pay a sum in the event of a Breach, however with liquidated damages the intent is to only recover the amount of the damages you sustain. So the real difference between the two is whether you are trying to profit from the breach.

Calling a clause “liquidated damages” does not make it a true liquidated damages provision. In interpreting it a court would apply several tests to determine whether it is a penalty or a liquidated damage. It would be considered a penalty if:
1. The amount payable is excessive when compared to loss*.
2. The amount payable is greater than what should have been paid
3. The amount payable would apply to minor versus major breaches.

*Liquidated damages clauses must be a genuine estimate of the loss to be suffered by the party in the event of a breach. Whether the term is a penalty clause or not is determined as of the time the contract was formed. The amount only needs to be a genuine estimate of the loss at that time.  This means that irrespective of whether the loss would have been greater or smaller at the time of the actual breach does not apply as the parties agreed to establish that as the amount. Where a non-breaching party made a genuine effort to determine their loss and has acted in good faith, the clause will not be classified as a penalty.

To avoid having a liquidated damages term from being considered a penalty the amount needs to be a reasonable reflection of the non-breaching party’s expected loss for the breach. That means that a single liquidated damages amount should not be applied to all breaches. If the intent is to apply liquidated damages to multiple different types of breaches, you should tailor the amount of the liquidated damages for each different breach so each represents a reasonable reflection of the loss for that breach. Most of the time liquidated damages is applied only to the failure to deliver on time.
Amounts payable for performance are not penalty clauses if the performance is not met. For example if you included a bonus for early completion of work and the Supplier failed to complete the work early, the failure to pay the bonus would not be a penalty or liquidated damage as they are not connected with a breach.

The value of liquidated damages provisions is the parties agree on the amount in advance and it relieves the non-breaching party from having to prove their damage in court. The only thing that the breaching party can challenge is whether there was a breach. They could challenge that amount as representing a penalty, but if the amount was properly established as a reasonable reflection of the damage and was agreed by the parties, courts would most likely will not view it as a penalty.

Point in Time or Auto Updating Documents

Many times a contract will incorporate other agreements or documents into it.  For example, you may negotiate a Master Agreement and then incorporate that into Statements of Work negotiated for individual purchases. You may incorporate specifications and other documents into your contract.

When you incorporate a document or another agreement by reference into your Agreement, that document will be what I call a point in time document. Without expressing language to the contrary, the document you incorporate will be as it existed as of the date you incorporated it into your agreement, effectively being frozen at that point in time.  Sometimes that may work, other times it can require a huge number of contract amendments to constantly update your agreement.

When incorporating a document by reference into a contract you need to decide if a point in time incorporation works or if you want your agreement to change every time the incorporated document changes. If you want it to change, you also need to decide upon the extent it will be changed or updated.

If you wanted all the changes that were made to be included, at the point where you incorporate the document or agreement by reference you could, include  “as may be amended from time to time by the parties”. This shows the intent of the parties for it to automatically update within your agreement each time the referenced document changes.

You could also agree to limit the scope of the auto updating. For example if you had a strategy where Subsidiaries wrote their own agreements and incorporated their Parent Company’s agreement with the Supplier, there could be a number of reasons why they would want to separately review and agree what terms get incorporated into their agreement. They may want to take advantage of addition of new Products or Services that are added to the referenced document so they don’t have to amend their agreement every time a new product or service is added. They may also want to take advantage of any price changes that get negotiated. To do something like that you might say, “This agreement automatically incorporates any changes to the Products, Services and Prices included in the Referenced Agreement. All other changes to the Referenced Agreement shall require written agreement by the parties to this Agreement before incorporation into this agreement”.

Let me give you an example.

You have a Master Agreement. Over time you have written 20 statements of work that each incorporate the terms of the Master Agreement.  Each statement of work is still in effect. Over time the master agreement was amended 10 times.  You encounter a problem with the Supplier that could potentially affect all your statements of work. You want to determine what contract protection you have against this problem. To do that you would first look to see whether the incorporation was point in time or auto updating.  If all the incorporations were point in time, to understand your contract rights, you first need to review all amendments to the statement of work to see if any of them incorporated changes made to the Master Agreement. If they didn’t you then would need to understand what the Master Agreement terms were at the time it was incorporated into each statement of work.  To do that you would review the Master Agreement and any amendments executed prior to the date it was incorporated into the Statement of Work for to understand each statement of work's full terms. Depending on when they were written you could have up to 10 different versions of terms in effect for the SOW’s.

Auto updating works when the document being auto updated requires mutual agreement by the parties.  You would never use auto updating when the Supplier alone controls the document.

If you consider using auto updating, contact your legal support to see if Auto Updating provisions may be used in that jurisdiction and what they would recommend.

Thursday, January 27, 2011

Power - Assessing The Power In The Relationship

Part of preparation for any negotiation is assessing your and the Supplier’s power. Herb Cohen’s (“You Can Negotiate Anything”) list of Powers is a good starting point.

What power of competition do we have? Is it open, or do we want or need them? The more they think there is still competition (real or perceived), the better your chance for getting what you want. What is their power of position and do they know it? If we want or need them, do they know it? If they do, what is our strategy to overcome this? The fact that they know that you want or need what they have to sell makes it a little more difficult to negotiate, but you need to think of what other power can you use to get what you want. E.g. Is it the promise of future business or the threat of no future business, or commitment you will make to purchase more.

What power of authority will we both use? How will we overcome their authority? Suppliers use legitimacy such as published price lists, standard discounts, standard terms, anti-trust laws and everything else available to keep you from negotiating the best deal possible. The best way to overcome authority is to have competition and remind them of their competition. Cherry pick the best from each Supplier and try to get all the others to give you the same thing.

What power of precedent will be both parties use? How will we get what we want and explain away the rest as being different for this particular deal? In a long term relationship one of the things that you have to overcome is the stupid things that your predecessor or others may have agreed to. Explain why the circumstances are different. Remind them of what the competition will do to get them to change. Tell them “if you do things the way you’ve always done them you will get what you’ve always gotten”. Let them know that if they want a larger or closer relationship things need to change.

What power of commitment can I use? The greatest power of commitment is the promise of future business (either real or perceived).

What power of knowledge does each of us have? If they have done a good job at “back door selling” they will know what you need and where they and their competition stand. The time to start managing that is in the earliest stages of the relationship. Otherwise it is like trying to “close the gate after the horses have already left the corral”. Conversely, if you do a good job in pre-qualifying the Supplier, touring the facility, probing their people about what they do and who they do it for, and check references of people who are doing business with them, you can understand what their hot buttons are, what is negotiable, what they need, what their backlog is etc., etc.  

What power of risk taking can we offer? The greatest power of risk taking is to understand what the risks are, where they have built contingencies into their pricing to cover them and then decide which of those you may accept and manage and which they should continue to manage.

What power of time does each of us have? How much do they know about when you need something and why you need it then? The less they know the better. The more they know the more they may be able to determine exactly how much competition there really is.  The more you know about things which motivate them like the end of selling periods, end of fiscal years which may be motivation to close the deal the more you may ask for.

What power of investment does each of us have? This comes into play usually when there was a large up-front cost to get to this point in the relationship such as a very expensive response to your bid or request for proposal. It also comes into play when you want to close. Sales people make commitments to their management about the amount of business they will deliver and when. The more they have invested and the more they have told their management of the likelihood of a win, the more you can play on what the invested.

What power of size do we have? Make no mistake about it. Being big and offering the advantages of a big company can provide give you power. If you are with a big company you can always dangle the carrot of potential large amounts of business to get concessions. Smaller companies frequently are intoxicated with what the potential may be rather than what the real business is.

What power of money do we have? It also helps to understand their financial status. If they have cash flow problems, can you offer things to get greater concessions from them? E.g. shorter payment period or pay for certain investments. Conversely, if they have substantial funds, can you use them to have them be the banker in the relationship by financing / amortizing certain major investments.

What power of leadership or prestige do we have? If you are a leader in the industry and companies will follow your decisions you probably have both the power of expertise and identification as they will want to do business with you for the value it provides them with other customers

The power of precedent can by either what you have agreed with them in the past or what you have agreed with others. When you can show them that others have agreed it becomes the combined power of competition, precedence and legitimacy for your position.

The power of rewarding or punishing works best when there is competition and you can change the volumes you provide them based upon how they respond. If they give you what you need they are rewarded by keeping or growing the business, if they don’t they are punished by losing the business. One of the best ways to let a Supplier know you are serious is change the amount of business they get.

The Power of Investment doesn’t need to be financial, it can be something as simple as you investment of time and the impact that has on your options. If a Supplier has delayed coming to agreement to a point where you have no other option than to either use them or face a major schedule impact, you’ve probably given them a form of power of investment. Always have a walk away date to help you retain your competitive leverage.

While there are a number of types of Power, the most important factor to consider in determining Power is their motivation and motivation can change quickly. The simple fact is the more motivated they are because they need or want your business, the more of these powers you will have. If it makes no difference to them whether they get your business or not, you may have very limited power even if you’re a large purchaser. Motivation can shift rapidly, sometimes with the occurrence of a single event. A disaster at a major production facility can immediately change a market from excess capacity to allocation and their motivation and each party’s power will change immediately. A sales person making a large sale to another customer can change how they feel about your sale. You need to be aware of things that could change the Supplier’s motivation and the longer it takes to come to agreement the more changes there can be that impact their motivation. Someone once said that “the time to negotiate replacing a roof is not what its raining and the roof is leaking”. If you have the power you need, move to close your contract or purchase as quickly as possible before the power changes. Power can change easily and one of those shifts is what I call “the point of no return”.

For anyone that negotiates I would recommend reading Herb Cohen's book.

Power – Things that impact your power

Negotiating contract terms that represent a higher cost or risk for a Supplier provides a great example of power at work. Your probability of getting the Supplier to accept such terms will be impacted by a number of different factors that impact your power such as:

 Are there competitive products or alternatives available?
If the answer is no, you have little chance unless they really need or want to do business with you for some other reason.
 General Marketplace Requirements
The risks a Supplier will assume will be dependent upon what’s demanded by the marketplaces they sell into and Suppliers may sell the same products into multiple marketplaces which have entirely different issues and risks. The more markets they can sell into with less risk than what you’re asking, the less your leverage. Marketplace leverage is also impacted by the supply/demand position of the Supplier. If there is sufficient demand in other markets where there is less risk, your odds are even less. If they have excess capacity across all markets, your odds increase.
 Is Their Competition Providing It?
If they are, your chance is better as you have both competition and the potential for real loss of the business. If they aren’t, your probability is significantly reduced because they won’t feel threatened about losing the business.
 Supply / Demand Position
The risks a Supplier will assume in a buyer’s market of excess capacity are more than what they will assume in a market of excess demand. No one wants to accept additional risk or cost unless they have to. If there’s excess demand you probably won’t get what you want. If there’s excess demand plus other customers or markets don’t require it, your chance decreases. If there’s excess Supply other factors will come into play in the decision.
 Volume / Price Sensitivity  
If the Supplier can significantly increase market share by minor adjustments to price, they can cheaply offset the loss of your business and if they can do that cheaper than what it could cost them to assume the risk, you probably won’t get it.
 Customer Value
If it’s similar to what other customers require your odds are better. If there are limited customers for the product or service (so they can’t avoid the issue by selling to someone else) you have better leverage. The bigger and better the potential customer you will be for them in terms of other risks, reputation, advantages from the relationship, the more leverage you should have. If you aren’t dealing in significant volumes making your business worth pursuing or keeping, your odds are significantly reduced. Customer leverage only works well when you also have advantages in both marketplace and supply/demand leverage.
 Sales Channel
Sales channels can negate leverage. If the Supplier sell direct to all customers, your other leverage may work. If they sell only to major customers, and you don’t fit those requirements your chances are significantly reduced. If they only sell through 3rd party channels you have even less leverage. You may have leverage with the 3rd party Channel or between multiple Channels selling the product, but usually the 3rd party Channel doesn’t assume significant risks on their own and many times the sales channel can’t cover the risk on their own. For many issues, you really need the Supplier’s commitments and resources to manage the risk.
 Will The Supplier See An Immediate Benefit?
If they will, your odds get better. If they don’t your odds are further reduced. They only way they’ll give something is if they’re getting something they want or they’re forced to.
You’ll have less leverage if the Supplier is sole sourced or designed into your solution. The degree of the loss of that leverage will depend upon the ease of changing Suppliers. You can be locked in by nothing more than having passed the window of opportunity to change Suppliers without impacting your schedules.
 Ease Of Changing Suppliers
If the cost of replacing the Supplier  is high, or the ROI period or benefit of replacing the supplier is small, or it requires a significant commitment of limited resources (design or  engineering),  you’ll have limited leverage. When it’s fast, easy and cheap to change Suppliers, you’ll have more leverage. Where you stand versus the point of no return will further impact the ease of change.
 Magnitude, Precedent and Uniqueness
If what you are asking for is new, unique or represents a significant expansion of their risk, there are two factors a Supplier will consider even if you have significant leverage. One is whether they want to start the precedent, because of the impact it could have on other business. The other is whether it makes sense as an investment decision. If it becomes an investment decision, they will weigh the value of your business against the incremental cost and risk. The lower the incremental value your business provides them versus other customers, or the higher the potential magnitude or the risk of your business against others, the less likely you’ll get what you want. Suppliers will walk away from business that doesn’t make sense to them and if acquiring new customers can be done by simply cutting pricing to grab additional market share, they’ll weigh that cost against the cost and risk of what you want. If it’s cheaper for them to discount pricing your leverage is less.
 What’s Really At Risk
A small supplier who has few assets may be willing to sign up for all types of liability. It’s like the lyric from a Bob Dylan song “when you’ve got nothing, you’ve got nothing to lose”. The problem is that since they have little to lose, they don’t offer much protection against the risk to the Buyer. Major Suppliers with significant assets could provide the necessary protection, but they are more cautious and less willing to accept risk. Large suppliers will only make significant concessions on risk if they really need or want your business.
 Supplier’s Expectations
If the expectations about the need for the item weren’t set in advance, your odds of getting it will be less as they won’t have set internal expectations with their management that it was needed to win the business.
 Need or Want
How much the Supplier needs or wants of your business is really the overwhelming thing that determines how much all your other sources of potential leverage are really worth. If they don’t need your business, or it doesn’t matter much to them if they lose it, they’ll probably never even consider whether the investment required to get your business makes sense. They must really need or want your business to have leverage to get concessions.
 Following the above logic, you have the greatest ability to get what you want when:
  1. You have set the expectation of what’s needed from the beginning
  2. What you are asking for is demanded by the marketplace
  3. There is excess Supplier capacity
  4. The Supplier’s ability to replace your business by simply dropping price is limited
  5. You’re a customer they need or want
  6. You’re a direct customer
  7. You’re not locked into them and you have ease of changing Suppliers
  8. The amount and value of your business warrants the acceptance of the risk
Anything that impacts any one of the factors can dramatically reduce your leverage. For example once a market goes into allocation your leverage drops dramatically as the Supplier has enough demand from others to not be driven to accept less or give you more. They have less concern about losing your business because your demand can be easily replaced by another. In fact, they may even make more money selling to others. They don’t have to compete because everyone is getting more business than they can manage. The more short term their focus is, the greater the impact and the less they see an immediate benefit to them, the less willing they’ll be to provide you with what you want.

Just because all the factors may not be in your favor doesn’t mean you shouldn’t ask. You can never predict what Suppliers will or won’t agree upon. Things can happen, such a a major cancellation by another customer, that can potentially change the leverage. In preparing for a negotiation I would use these factors to establish realistic goals and expectations for negotiations so you don’t spend substantial time negotiating points which have a slight likelihood of success. I would also use them to set realistic expectations with your management and internal customers of what likely outcome will be. If you can do better they’ll be pleasantly surprised. If the leverage scale its heavily tilted in favor of the Supplier, you should consider shorter term agreements or other means by which you can escape from the agreement and avoid being locked in by Suppliers. You also need to on the watch for Suppliers that have significant point-in-time leverage who will try to lock customers into terms that will be more favorable to them when the market changes.

Power - The Point Of No Return

In aviation there’s a term called “the point of no return”. It’s the point in the flight beyond which the remaining fuel is insufficient for a return to the starting point. Once you pass the point of no return, you have no option but to continue on your current course. A similar point of no return also exists in many negotiations. It’s the point in the negotiation process where you must continue on your current course of action and try to close with that Supplier. It’s the point when starting the process over with another party may no longer be feasible. It could be driven by simply economics where you have too many sunk costs to walk away or it could occur when other alternatives become no longer available. More frequently it will occur when changing directions or Suppliers is simply not acceptable because of the impact that would have on activities that are dependent on that purchase such as project or development schedules, implementation plans, etc.  

When Herb Cohen talks about the Power of Investment its similar to the point of no return. The power of investment comes from the sunk costs or sunk effort that a party doesn’t want to walk away from. It could also mean the fact that you’ve invested so much in this Supplier that you have limited your options, and that’s significant leverage the other party can use against you.

Timing impacts the viability of other alternatives and also can create a form of point of no return. The point of no return places you in the position of having to choose from two less than desirable alternatives. One is to contine to try to resolve it with the Supplier which may mean to accept less or give more to the Supplier to close the agreement because you’ve lost leverage. The other is to walk away from that relationship, and have to deal with the impact is has. The more investments you’ve made in the relationship,  the more difficult it may be to walk away from those because a change in direction with cause other costs or problems and may require more investments on top of those already made.

As a Buyer its important to manage the point of no return in your negotiations as it can significantly impact your leverage. The more you have invested in creating the relationship with the Supplier, or the fewer acceptable alternatives you have if you don’t reach agreement, the less leverage you will have. The larger the impact to you of not reaching agreement, in comparison to the impact to the Supplier, the less leverage you will have. The point of no return can totally negate any competitive leverage you may have initially had and turn the negotiations into a quasi sole source negotation simply because you effectively have no other alternatives available without adding more cost or impacting schedules.

They key is to manage the closure of the negotitions in a manner where it maintains the most leverage for you. If a point of no return situations can occur, you need to manage the closure of the contract quickly where you still have maximum leverage and still have other options. If you won’t be impacted by the delay but the Supplier will be continuing to make investments of time and resources, don’t be in a rush to close as the more they have invested, the closer they are to being at the point of no return where it may be better for them to give you what you want than to wallk away from the business. When there are delays to the negotiation being caused by the Supplier, always consider the potential impact of those delays on your leverage and what their motivation may be. If they will put you at  leverage disadvantage, Don’t let them occur. If you can’t control them, consider starting a parallel activity to continue to keep your competitive leverage. Once time or circumstances has you locked into them, you’re at a disadvantage. I’d never threaten to walk away unless we were prepared to do it. If you are prepared to walk away and deal with the impact you no longer have a point of no return and simply telling them that you are prepared to walk away then shifts the leverage back to you and forces the Supplier into having to alternatives that are less desirable to them. They can simply walk away and loose all they’ve invested, or they can attempt to meet your needs to salvage the sale.  

Power - “You can’t always get what you want”

In Herb Cohen’s book on negotiating, he espouses that “You Can Negotiate Anything”, in fact that’s his book’s title. That’s the right attitude to have for negotiations, but the reality is sometimes more like the title of the Rolling Stones song: “You Can’t Always Get What You Want”.

I’ve seen negotiators become frustrated and fail by doing the equivalent of trying to put square pegs into round holes. Leverage is relative and there is an overriding factor in most leverage. Leverage helps you get what you want when giving it only impacts the Supplier’s relationship with you. The probability of getting what you want falls off dramatically when what you want will impact the Supplier’s larger interests. Suppliers will weigh the benefits your business provides against two things. The impact to providing it to you, and the impact it will have their other business. Here’s three common examples of this type of situation:

  1. In an outsourced environment you want the Supplier to extend your price and terms to that 3rd party. Your motivation may be simple, have the Outsourced Supplier get the price and terms directly so you don’t need to be involved in the transactions. The Supplier will consider the potential impact to them, not just on your business but for all the business they do with that 3rd party. Remember when we talked about the practice of tiers where Supplier’s have different terms and prices based on their volumes and how desirable a customer is?  Your request to have the Supplier extend the price and terms to the 3rd party may directly conflict with their tiering practices. If you had better pricing or terms, the 3rd pary will try to use them for all the other business they do with the Supplier and that’s difficult to stop. The net impact to the Supplier could be a loss of profit (because they are would selling at your lower prices to a much broader base and an increase in it risk (because they are selling at your terms preferred terms to a much broader base). If the Supplier says no to your demands, It may not be  because they don’t want to support you, it may be because your business may not be worth enough in comparison to the total impact to them.

  1. A second example is what’s referred to as channels conflict. I’ve seen a number of Buyer’s that wanted to buy direct from a local channel at their contracted price and weren’t able to. You may want to manage your purchase direct with the Supplier to avoid using a local channel or buy through the Channel at your price and terms. The Supplier must take into account the impact that could have with channel. They don’t want to expose special pricing or terms to the channel, as the channel would want those for all their business (which would once again decrease the Supplier’s margins or increase their risks).  Further as they are dependent on the channel for sales, they do not want to alienate the channel as that could impact the business they receive from the channel.  The channel may carry more weight from a sales perspective than the Buyer, so the Supplier may not want to do anything that would alienate them.

  1. A third example is sales location. Buyers may frequently want a Supplier to sell in a particular location so they can run VMI programs. For the Buyer a VMI program is win. To the Supplier, a VMI program can mean a change in the sales location which can create additional costs and risks.  A change in the location of sale can impact the income taxes they pay. It can subject them to duties or import expenses. It can subject them to other taxes such as transfer or inventory taxes. From a risk perspective, a change in the sales location would require that they be registered to operate there. It would make them subject to both local laws and local jurisdiction which may not be favorable to them. Any profits they make on those sales could also make them subject to other issues such as currency exchange or issues with repatriating the profits. A Supplier may refuse to agree to sell at a VMI Hub simply because of the many impacts that a different selling point could have on them financially or legally.

For agreement to be reached it must work for both parties. Trying to force a Supplier into doing something that’s against their broader interests is seldom successful. Think about the potential impact your request will have on their other business. Consider alternatives that can provide you with an equivalent to what you want, but structured in a way where it also works for the Supplier. For example, if the Supplier is concerned with giving a outsourced supplier with your price and terms, the parties could agree to a number of alternatives to provide something close. The Supplier could sells to the 3rd Party at the normal price and terms they would get at their tier, but agree to rebate you any price difference and allow you to enforce your terms directly on those outsourced supplier purchases so you continue to get the benefits you want while their relationship with the 3rd party won’t be impacted. They key is to not let the Supplier use these issues to keep the status quo or prevent it. Find out why the Supplier is not willing to agree to see if there is a workaround.

You know what the next portion of that Rolling Stones lyric is? “You can always get what you want, but if you try sometime you might find you get what you need.  Who knew the Stones were negotiation experts.