Communication - Manage Your Team’s Communications

Since so much of negotiation is communication if you will have other members of your team meeting with the Supplier you need to spend time coaching them on communication. Many times a negotiation can be severely damaged by one of your own team’s actions or comments before it ever starts and all the tactics in the world may not help after that.

They should understand that:

Ø  Negotiations are a process and not a single point in time activity.

o   You need to effectively manage communications with the Supplier throughout the process.

Ø  What is said to a Supplier from the prospecting stage onward may be used against you during the actual negotiation.

Ø  What you can learn about the Supplier from those early discussions and from your detailed pre-qualification may be extremely useful in your negotiating with the Supplier.

Ø  Suppliers will frequently give away substantial amounts of information about them and their products to attract your interest. Learn all you can.

Ø  Once the actual negotiations commence they will manage their communications tighter and your ability to discover information that will help you is reduced.

Ø  In discussions you need to avoid language, topics and behavior that provides them with any type of negative reaction. If they get a negative reaction that may turn them off to the discussion and thereby limit the amount of information you can discover or their willingness to deal with you.

Ø  The goal should be to get as much information as possible about them and their products.

Ø  Start out with broad questions, and then focus on specific issues.

Ø  Probe with open-ended questions just like they may have tried to probe to try to find out about your needs.

Ø  Ask them for their advice or recommendations. Many times the Supplier will know far more about a specific subject and their advice may cause you to change directions or strategies.

Ø  Get them to talk about themselves, the company, the work, and their customers by seeming interested or needing to be educated.

Ø  Probe to understand potential alternatives.

Ø  Probe to understand the organizational values so you will understand whether you have a conflict and, if you don’t, so you can speak to them later in the negotiation, showing that you have viewed the issue from their perspective.

Ø  Probe to understand their motivations and what they may consider as important, as threats, as benefits etc.

Ø  The key in your communications with them is the need to either set or continue to manage their expectations that it will be competitive in nature

Ø  Provide them with enough to peak their interest and be willing to share information, but not enough so that it will affect you later.

For any team members that will actually participate in the negotiation I’ve frequently called a team meeting in advance to establish a set of rules I expect them to follow. Having learned the hard way, I found that I could avoid “being shot in the foot” by my own team member if I set ground rules in advance. Some of these may seem like common sense, but I learned each of them the hard way:

1.     Negotiations and meetings with a Supplier are not forums for discussing internal disagreements. Negotiations are not the place to challenge what another team member has said. If something is said that you disagree with, make a note of it and discuss or resolve it off line. If the item is critical to the discussion at hand, pass a note to the lead negotiator asking that you break to caucus.

2.     References to the way you do business should be mentioned when necessary and in a positive manner. If you have nothing positive to say, don't comment on it.

3.     References to the way the Supplier does business should be positive so as to not turn them off, but not so positive for them to believe that they have any edge over the competition. If others do something better, let them know it.

4.     Never disclose an area where you can't measure the Supplier's performance. If you can't measure their performance you may be able to do so in the future or, you may wish to make a concession. If they know you can't measure them they will also know that it is really no concession.

5.     Never agree to anything immediately. At first look a proposal may seem very enticing. All ramifications need to be considered and it may not be a deal or you may be able to do better.

6.     Don't accept the Supplier’s "standards or policies" as final. Companies publish standards and quote policies for customers who are not wise enough to negotiate them.

7.     Never re-enforce a Supplier’s objection. If you are part of the discussions with the Supplier and you agree with them, keep it to yourself. Re-enforcing a Supplier’s objection takes power from the negotiator.

8.     Don't agree to make any concessions until you know all the demands. A normal negotiating tactic is nibbling, a little here, a little there, each of which seems harmless, but the total effect will surprise you.

9.     Keep track of all the concessions which they are asking for and weigh them from both your and the Supplier's perspective. What may appear to be nothing for you to give away may be a substantial gain for the Supplier and as such you should use it to get a concession of equal or greater value.

10.  If you are unsure of what you heard the Supplier say, seek to clarify it by re-phrasing it. A number of times your impression will not equal their impression and it's best to clarify it before you may be locked in.

11.  When the team breaks into sub-groups and in subsequent meetings or phone calls remember that the rules still apply. Suppliers will probe at individual team members to get information that will assist them in their negotiations. Volunteer only information that is necessary. Use that time to do probing about the Supplier’s operation.

12.  Take good notes of your meetings. Use them when the Supplier says something contradictory in the negotiation.

Easy ways to lose in a negotiation is to allow the Supplier to divide and conquer your team and ask someone who would be sympathetic to their position what their opinion is. If there is a high risk of that, control who attends.

Compatability - Managing Compatibility In Agreements

I’ve worked for a number of companies where their contracting strategy was to use multiple documents to create an agreement. For example you could have a master agreement that established all the legal terms that apply to all purchases and then have other agreements that incorporate those master agreement terms for a specific purchase. Any time there are a number of documents that make up your purchase agreement you need to ensure that there is compatibility. There are a number of compatibility checks to make.

The first is basic compatibility between template versions. If you are using a master agreement that is older, you need to ensure that it works with the version of the other document(s) you are using. For example it the master agreement looks to other documents to establish a term, you need to ensure that the documents you use establish that term or there are placeholders included to establish the term.

The second check is compatibility and consistent use of defined terms. For example, if the master agreement pointed to a statement of work to establish an Epidemic Defect Rate (a defined term). The statement of work should refer to it as the Epidemic Defect Rate.

 

If your Agreement is dependent upon an Attachment or Exhibit to establish the requirements of a term, those Attachments must be reviewed to ensure compatibility with the Agreement and you also need to make them part of your agreement by incorporating them by reference. For example, If your Epidemic Defects Rate is established as a multiple of a Failure in Time (FIT) rate measurement a quality document made part of the agreement, you need to identify which rate (as there may be multiple quality rates), and what it is called so that the correct rate is pointed to.

 

When you have any term that looks to another document to establish the complete term, always follow it through to ensure that the commitment is in fact established. When an agreement uses a cross-reference to another section in the same document or another document, always check that the cross reference is correct.

Here’s an example of the need to check for compatibility and the completion of commitments. I ran into a situation where a master agreement pointed to the statement of work to establish an Epidemic Defect Rate. The statement of work template did not establish an Epidemic Defect Rate, but pointed to a Quality Addendum. The Quality Addendum did not include an Epidemic Defect Rate. Every one of the Supplier’s product failed in the field. Since there was never an epidemic defect rate established, there was no contract right to collect all the incidental and consequential costs that resulted from the failure of all the products. This one failure to fully establish the term cost many millions of dollars.

Competition

The internet has a huge wealth of information if you can find it. In doing research I came across a web site entitled Valuebasedmanagement.net.  The site contains a number of papers on management methods, management models and management theories by experts in their field. In searching about power I came across a few papers that were written by Michael Porter and decided that there is much procurement can learn from his writings on business strategic planning. Professor Porter is a Professor at Harvard Business School and a leading authority on company strategy and competitiveness.

One of the things he created is called the five forces of competitive position. Many companies use his five forces of competitive positioning in strategically determining whether to enter into certain markets. Much of what he describes for companies to understand before entering into a market can be applied to understanding the leverage or power in the relationship between the Buyer and Supplier.

Professor Porter’s five forces are:

• Supplier power (How a company’s Suppliers can affect a company).
• Buyer power (How a company’s  customers can affect a company)
• Product and technology development (alternatives, price and quality)
• New Market Entrants and barriers
• Competitive rivalry within the marketplace

In procurement you deal with the same five forces but from a slightly different perspective.

Competitive Position	Negotiation competitive position
Supplier power	Supplier power
Buyer power	Buyer power includes the potential power of the Buyer and their customers
Product and technology development as a differentiator	Alternatives from the perspective of their features and cost and quality and their use in applying competitive pressure
New Market Entrants	Ease of movement to another Supplier (for the threat of switching suppliers)
Competitive rivalry in the market	Competition between suppliers and demand from competitors and other industries

In negotiation the last three forces impact either the Buyer’s or Supplier’s power.  If there are substantial alternatives that meet the Buyer’s needs, the Buyer will have more power because of the power of competition.  If it’s difficult or costly to change Suppliers, that can provide the Supplier more power in follow on negotiations. If it’s easy for new companies to enter the market, Buyers will seldom want to make long term commitments as the competitive position of the market will most likely change.

In the past many times you derived power by your place in your industry. Now you need to be concerned with competition from all industries. For example, for years tantalum capacitors were almost exclusively used by the computer industry.  Leader in the industry would get the best deals from the Suppliers. Along came cell phones that also used them and the demand from the Cell phone industry was higher than the computer industry. This change not only increased demand, but the dynamics and requirements between the industries were different.  When that happens, the Buyer’s position and leverage is no longer measured against the one market, they are measured against the total market. Suppliers will also look at the costs and risks of each industry and that can impact what they are willing to agree upon. When it was only the computer market a leader could ask for and get extremely favorable terms. Once the market broadened, Suppliers could compare the costs and risks in both markets and respond accordingly.

In a separate article Professor Porter also created a simple classification of industries:

1.     Fragmented

2.     Emerging

3.     Mature

4.     Declining

5.     Global

Once again the same terms can be used in procurement to describe commodities, but more frequently we may think of them not from the perspective of the market or industry as much as we think about product life cycle.

·       Instead of thinking of things as fragmented, we think of products or services being niche market products or having volumes so small they aren’t leveraged.

·       Instead of thinking about emerging markets, we think of new products or new versions of a product being at the beginning of a new product life cycle.

·       Our concept of a mature market is one that has maximum amount of competition where the Buyer may have the most leverage.

·       Instead of thinking about declining markets, we think about when companies begin to exit that individual product’s market to move on to the next product reducing the competition.

·       Instead of thinking about global markets, we think about landed costs and whether a product can legally be imported, used, services and supported and whether that is financially practical.

Irrespective of how the industry would be classified on its own, while that can have some impact on the procurement strategy or leverage, we are usually more concerned about individual product life cycles and where you are in the product life cycle as that can impact a number of things such as the costs and risks of doing business with a supplier and relying upon that supplier to meet your needs.

In another article Professor Porter also published a competitive advantage model and describes three different focus or approaches to competitive advantage.

1.     Cost leadership

2.     Differentiation

3.     Focus

Once again we see these focuses in procurement. Many times a market will be made up of all three types of Suppliers.

You can have technology leaders whose goal is to come out with leading products that differentiate themselves in the market where their goal is either to get designed into the Buyer’s product, or to win most of the business until there are other entrants in the market. They want to make high profit margins until competition drive the price of the product down. You can have suppliers whose focus is trying to differentiate them from the competition by offering unique product features and services. Both of these are differentiators as Professor Porter would describe them.

Many markets also have technology followers and they are usually focused on cost leadership. They will enter the market at some point and usually drive the price of the product or service down through price competition.  At some point the technology leader may exit the market to move to a new market, so the cost leader may get the benefit of their exit from the market by the supply / demand imbalance created by the exit of the technology leader(s).

The third type of approach that Professor Porter describes is focus. Focus companies want to be the best in a segment either based on cost or differentiation. In procurement in addition to having companies that focus on a segment (what we would call niche suppliers), there are also suppliers that I refer to as bottom fishers. Bottom fishers are one that will buy into or enter a market after the technology leaders have left and after the cost leaders have decided that the reduced volume of the market doesn’t warrant being there. They are Suppliers that can be profitable because there will be on-going demand because customers for whatever reason have not migrated to the new technology and because at the volume the cost leaders aren’t interested.

A typical product price curve reflects the different entry point and effect that each has on the market.

• The Technology leaders will set the initial price of the product high.
• As cost leadership suppliers enter the market, the price will be drive down (unless there is excess demand against capacity)
• The price will bottom out when the market reaches saturation and that will usually drive out technology leaders.
• As volumes fall with companies migrating to newer product, the cost leaders may exit the market and drive the price up for bottom feeders
• Companies with a market segment focus (niche players) will usually not be impacted by other suppliers wanting to enter the market, unless the volumes become significant enough, Where niche players will get impacted is when customers do a form of value equivalence evaluation and determine that the differentiation isn’t worth the price premium.

Competition - How to you get and maintain competition.

The most important factors in ensuring that you get the best price and terms in a negotiation is the ability to maintain the competitive process or the illusion of competition. If the supplier believes that there is really no true competition, they will see little need to make further concessions. Even the most skilled negotiator with all the tactics may not be successful if the competitive process of the illusion of competition is lost. Here are some thought on getting and maintaining competition.

From the earliest stages of selling the salesperson will be looking for information which will help them assess what, if any, competition they have. They may simply ask whom else you are considering. They may try to understand your problems and needs to see if they will be the only supplier who can meet your exact needs or solve your problem. They may ask for information about your budget to see who would be eliminated based on cost. They may ask for information about your schedule to see who would be eliminated based on availability. They will want to understand the quantity required to see who would be eliminated. They will want to talk with managers and operators to understand their preferences, not just on the product but all associated issues with the product such as installation, service, repairs, etc. They may ask them about how they feel about the other suppliers, their performance, and their reputation. They will want to understand what the motivating factors are for the decision and who the key decision makers will be. Their main goal in asking all these questions is to determine who the real competition is, if any, who to focus their sales efforts on, and what selling approach to take.

They will look at your history to see if there are any trends in your selection process. While you can't change the past, you can make a point of explaining why the future will be different (e.g. different management, different focus, different needs, different philosophy). For example, your current cost challenges is forcing you to make different sourcing decision, seek lower cost alternatives, etc.

The plain and simple fact is the more they know about you and your preferences, the more they will know whether there is really competition. Once competition or the appearance of competition is lost, it is extremely difficult to get back, and it will always cost you more in the end.

Everyone who talks with the salesperson from the secretary and operator up need to be coached about what they should or shouldn't say. You may even use them as a shill to plant seeds of doubt with the salesperson, just to enhance the appearance of competition. For example, you could point out all the areas where their product is less than the competition (even though you may not need or want that functionality) or where it doesn't fully meet your needs or where it will require you to do things or make investments that others won't. You might agree to disclose who the completion is, if that can be used to your advantage. For example, having some low priced suppliers in the mix may cause some suppliers to want to withdraw from the process unless you explain to them that you will select based upon total value. The higher priced supplier will still be aware that value has to include a competitive price. The more competitive the marketplace and the more doubt they have about their standing, the more they are forced to consider discounting as the means to try to win the business.

Sometimes maintaining competition may require you to "bring in a ringer" or outsider. Many businesses are traditionally locally based and become non-competitive because of informal arrangements, or sometimes-illegal arrangements such as collusion or price fixing. An outsider who is not part of the group may be required to keep them honest.

The team should guard against providing the supplier preferences unless you want to use them as a shill to note that they have preferences for the competitor's machine (even if they don't) so the supplier has to overcome those preferences with a better price.

Discussion on features should be neutral unless you want to use them to be a shill to note that they see value in features that the competition has that they don't so the supplier has to overcome those feature preferences with a better price.

Discussion on schedule or volume should be avoided if you feel that it will give one supplier a clear advantage. Once you have the price where you want it, you can usually leverage them for schedule and volume improvements as the final factor to close the deal.

Discussion on budget amounts should be avoided unless it can be used to your advantage. The budget amount may eliminate some potential competition. You may, however, want to use a budget to establish a target for negotiation (this is all I have to spend).

The one caution I have maintaining competition or the illusion of competition is if you plan to have suppliers know who else is in the running, because of activities like pre-bid conferences, you need to make sure that all the suppliers will be acceptable to you. The reason is different suppliers have different characteristics and ways they prefer to consider themselves. The appearance of a supplier who has a significantly lesser reputation, skill or quality, may cause the better suppliers to not bid or only submit a courtesy bid. When you need to include suppliers of different profiles and want to keep them in the process, the best way is to let them know that the selection will be based upon value. It will still force them to aggressively consider their pricing.    

Ninety percent of the time when competition or the illusion of competition has been lost, it was the result of well meaning people making the wrong comment at the wrong time. To get the best pricing they all need to be part of the negotiating team and be educated on what they should or shouldn't say.

Competitive Price Benchmarks

There can be some situations where you may be locked into using a Supplier where you need to establish a benchmark for competitive pricing in the future. Who you use to set the benchmark and the approach you use to benchmark is important.  I want to share with you an example of how not to do it that I ran into. As part of a divestiture of a business there was a commitment to purchase products and services back from the purchaser of the Business.  The business person that structured the deal understood the need to have competitive pricing in the future.  What they didn’t do was to think through what they were agreeing to. They included a process where they would take bids from the Supplier and three other competitors and future pricing would then be based upon the average of the four.  To them it made perfect sense. To me it was a recipe for a disaster. 

The problem was that since the Supplier could not lose the business during the term of the commitment they would always bid very high. In doing so they were able to drive the average price up.  They knew that for every dollar they increased their bid, it would increase the average that would be used in establishing the new price by twenty five cents.  What they had done was to allow the Supplier to significantly impact the future price and in doing so what they thought would provide them with competitive pricing really didn’t.

There are other approaches they could have used with more effective results. For example:

1.     Have the benchmark be based upon a number of suppliers other than the Supplier, so the Supplier can’t influence the benchmark average.

2.     Include a formula that allows the Supplier to quote, but throws out the high quote or both the high and low quotes to create the average of the remaining quotes (negating their ability to drive the average up).

3.     Include a formula where if Supplier’s price is X percent over the current price it won’t be included in the average (to limit how much they can effect it)

4.     Agree to use another form of external benchmark such as well respected industry cost sources

Whenever you use any type of formula in a contract, always check it using real numbers in a number of different scenarios to understand what the real impact of the words are.

Confidentiality Agreements

There are four basic ways a company protects their proprietary rights:

• Patents protects an idea and provide a right to exclude others from making/using/selling items that include the patent for 20 years from filing date
• Copyright protects a particular expression of an idea from copying.
• Trademark identifies the source of a good or service to eliminate consumer confusion.
• The last way is managing information as a Trade Secret to protect the information.

.Most of the time “trade secret” information is information or technology that has been kept secret and that provides commercial value or advantage to that company.  A trade secret can be any type of information that meets three conditions:

1. The information is not generally known or readily ascertainable.
2. The information is valuable to its owner (or would be valuable to a competitor),
3. The company must demonstrate that it intended to keep the information secret.

One of the ways a company demonstrates the intent to keep their Trade Secret information secret, is by requiring Confidentiality or Non-Disclosure Agreements to protect the information.

Suppliers will want to protect are things such a specifications on unannounced products, business plans, product road maps, cost information, technical information about their products or processes, etc.  Buyers want to protect many of the same types of things.

Most Confidential or Non-disclosure agreements will contain the same basic requirements:

• The description of what is confidential and what is required for it to be managed as confidential. For example, the parties may require a non-confidential description of what each plans to transmit.
• The process which must be followed for submission and receipt, This would include things like who to submit it to and how it must be marked.
• Restrictions on disclosing the information to other individuals or companies. This would identify whether subsequently disclosure under a CDA to another party would be allowed.
• Restrictions on the use of the information. This could be restrictive such as using it solely in connection with business with the discloser. It could also provide broad use, such as being able to use it for any purpose subject to maintaining the confidentiality obligations.
• The period during which those obligations remain in effect. This is the term you need to hold it as confidential. The term should never be left open ended, as you would be obligated to maintain it as confidential forever when most information has a useful life.
• The standard by which the information will be protected. Frequently this is the standard to which you manage your own confidential information, but for highly sensitive data extreme restrictions may be imposed such as limited the number of copies, prohibiting copying, requiring access control etc,
• Rights the recipient may have in the disclosed materials subject to the confidentiality and underlying intellectual property rights of the Discloser.
• Exceptions to the obligations.  Examples of this are when there is a court order that requires disclosure or the information becomes public knowledge

Receiving technical confidential information is a serious problem for many companies as there is always the potential for the breach of the agreement and the damages associated with that. Many times confidentiality agreements do not include a limitation of liability. There is also the risk that such receipt could be used to limit the ability to develop, manufacture or market future products. There is further the risk the information may inadvertently wind up being used in a future product that would subject the recipient to:

• Potential injunctions on the sale, manufacture or use of such products or services for infringement of the Discloser’s intellectual property rights, or
• Claims for misappropriation of trade secret information (unlawfully taking the property of the discloser).

That’s why many CDA's will either include a right to use the information as long as the confidentiality obligations are met or provide a right to use retained information so individuals that were exposed to the information would be able to use what they mentally retained.

The best was to manage the risk associated with the receipt of confidential information is to manage and limit its receipt. You want to ensure you do not get unsolicited information and all receipts should be justified on a “need to know” basis.

If you need to share confidential information, you need to put an appropriate agreement in place before you receive it or before you disclose it. If a Supplier submits something that is market as confidential and there is no agreement in place, return it. If you are seeking bids or proposals put the Supplier on notice in your document that all materials submitted should be non-confidential and if they require something be treated as confidential, that it be submitted only after an appropriate agreement is in place.

One of the issues that frequently may be an issue in negotiating confidentiality agreements is the term you must maintain the information as confidential. The simple fact is most things that a Supplier would want to protect have a limited life where it meets the three conditions of a trade secret. Un-announced products get announced. Product designs that needed to be protected lose their value once the product is available for sale where anyone can buy one and see how it’s made. Business plans and strategies seldom remain fixed for an extended period. The period you agree to for confidentiality obligation should depend upon what’s being disclosed and the dynamics of the market. There are few things that would be disclosed that need protection for more than two or three years.

Continuity of Supply - Period of Availability / End of Life

With the period of availability or end of life rights the thing the Buyer needs to be concerned about is continuity of Supply, especially if you have something that is sole source with the Supplier. The second issue with end of life is it can force the Buyer to purchase significant quantities of materials to meet their on-going needs for both production and service. If the Buyer guesses wrong, you have a problem either way - not enough materials to meet the needs or too many materials that become obsolete.

What is a reasonable period of availability?  In most cases the Buyer will want availability as long as they have the need to purchase the product or service. From a Supplier’s perspective, they need to consider both the volumes and costs of the current product or service and whether it makes sense financially to continue to offer it for sale. In most cases they will have a replacement product that they want customers to migrate to.  If the follow on product meets all the Buyer’s needs and the price is right, most Buyers will migrate to the new product.  In situations where the new Product may not work for the Buyer, they will want the old one provided as long as they can. 

Any commitment to a term of availability is basically useless if the prices for those future periods are not established. The Supplier could price the product at levels making it financially unfeasible for the Buyer to purchase and effectively eliminate the commitment.  Periods of availability need to be tied to the commodity and product, as that will determine the frequency of change. If the entire market changes every three years with a new generation, expecting a long period of availability on the product probably isn’t likely unless you have huge leverage and huge volumes that would allow you to have production dedicated to your needs.

The biggest thing you want protection against is surprises that can affect availability. Normally the length of time required for an End of Life notice should address either:

1. How long would it take to qualify another source and once qualified what is the lead time to purchase from the new source as that determines when alternative items will be available, or
2. If you can't qualify another source, how long will it take to determine what the last time buy amounts would be for both any on-going production or service needs.

In negotiating end of life one of the important things to understand is what is causing the end of life. End of life can be caused by a Suppliers new product introduction, it could also be caused by a supplier or material Supplier to them doing an end of life on items the Supplier needs to make the product or perform the service. It could also result from the Supplier doing an end of life on specific processes that is used. The reason why you want to understand the reason is different actions may provide you with different end of life alternatives.  Its always best to hold any material at the lowest possible level in inventory without adding all the costs to it especially if you are unsure of the end of life volumes you need.  For example in semiconductor manufacturing a Supplier could be end of life their wafer fabrication process, but all the other steps after that required to produce the product could remain the same. Wouldn’t it be better to have the Supplier build and hold completed wafer die, for completing and use if and when you need them. If you guess wrong, you only pay for the cost of the die, not the fully assembled and packaged chip. 

Continuity of Supply - Manufacturing Rights

The term “manufacturing rights” in most cases is really a misnomer as what you are really looking for is a license from the owner of those rights to make or have made the product. A license to manufacture may be sought in a variety of situations ranging from where the Supplier may not have the resources or capability to produce the product in the volumes required to having rights as a form of protection in the event the Supplier’s long term financial stability is of question. In the former situation you would frequently pay a royalty payment for the right to manufacture the product as the means by which the Supplier recovers payment for the partial transfer of their knowledge and rights.  In the latter situation whether you will agree to pay the Supplier a royalty or not would depend on the circumstances surrounding the license.

Manufacturing rights provisions traditionally consist of the following:

1. A description of the “package of information” the Supplier must provide the Buyer that would enable the Buyer to manufacture or have the product manufactured.
2. A description of Buyer’s rights to use the information to produce the product which would include any limitations on the production
3. A description of when the Buyer is able to exercise its rights and when those rights may be terminated.
4. Requirements for delivery of the Information package either directly to the Buyer for use or for placement into Escrow similar to a SW escrow situation.
5. The Compensation or royalties for the use of the Manufacturing package. These could be expressed as lump sum payment, or per unit royalty.
6. Any limitations or offsets against such royalty payments, For example one approach could be to use the Purchase Price as the Base, and then deduct all of buyer’s costs, investments and cost of management on a per unit basis and if there is anything left, that’s the royalty
7. An escrow agreement if the materials are to be placed into escrow.
8. Requirements on the part of the Supplier, if any, to keep the information provided or escrowed current.

The decision to seek manufacturing rights needs to be well thought through before pursuing these rights by asking the following questions:

a)    Are the Business prepared to manage the royalty payment process on their own (as hardware royalties cannot be managed under the SW warranty process)

b)    What can the Supplier license, and is it going to be enough to manufacture the product?  What will need to be licensed from a 3^rd party? At what cost?

c)    What skills and technology are required to build and test the product? Where will you get them if you plan to make it or have it made?

d)    What investments will be required to be able to manufacture the product in terms of things like capital equipment, testers etc.?

e)    If the product involves semiconductor chips, will you be able to purchase those chips and at what cost?

f)     If you need to have them made, what investment is involved in replicating all the Masks that are used and what FAB has the right technology level and equipment to be able to use copies of the existing masks and not need to convert them?  How much will it cost to convert them if they cannot be used as is?

g)    Where and how will all tests be performed and what is required to replicate the Supplier’s test capabilities?

h)    What subcontractors and material suppliers does the Supplier use and how will purchases from all those suppliers be managed? Are their any restrictions imposed by them that may restrict your ability to make or have them made or that would force you to use them?

Going through all the effort of negotiating Manufacturing rights will only be a significant waste of time unless you know that you can clearly make or have the product made at a cost that’s.  For some situations, such are where the Supplier is mostly outsourced and has most, if not all of the work performed by others, it may be easy as long as those subcontractors and material suppliers are allowed by the Supplier to sell to you directly and there is nothing that prevents them from making those sales.  They may have been willing to sell their product or license their technology to the Supplier but there could be situations were they may be reluctant or unwilling to sell it to Buyer. 

Let’s look at a sample and explain they type of rights sought and the terms:

Manufacturing Rights.

For the purpose of this Section the term Product shall mean the ________ and variations thereof and successors thereto sold to Buyer by Supplier under this SOW. For the purpose of this Section the term Semiconductor Vendor shall mean the supplier (or suppliers) with which Supplier has contracted for the management, production and creation of the complete, fully tested Product for Supplier. Any change to the Semiconductor Vendor or the ownership of anything necessary to produce the Product shall require notice to Buyer pursuant to Section ______hereof, and shall be subject to the provisions thereof. As of the date of execution of this SOW the Semiconductor Vendor is ______________________   “Manufacturing Package” shall mean all technology, documents, materials, authorizations, agreements, rights, licenses and information (including, but not limited to, the  Device Specification, Overview, Design Database, ASIC design specifications, RTL source files, structural netlist, simulation test-benches, simulation vectors, synthesis scripts, timing constraints and scripts, Microcode source files, and Microcode assembler any other documentation owned or controlled by Supplier, any test routines owned by Supplier, Semiconductor Vendor contacts, and contracts, authorizations, rights and/or licenses that may be needed to purchase the assembled and tested Product from the Semiconductor Vendor, as well as all information necessary to help Buyer have the Product manufactured by the Semiconductor Vendor) that are required to allow Buyer to develop, manufacture, produce, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product.

In this situation there was a Semiconductor Supplier that owned the primary technology required to produce the product and the Supplier’s Product was the equivalent of a derivative work building off that underlying technology. So one of the keys was if the Supplier was unable to perform, we would need to still have the chip made by the Semiconductor Supplier. To ensure that the Semiconductor Supplier and we had everything necessary to make the chip we identified what was required for the manufacturing package to both build and test the product.

(a)       Upon the occurrence of one of the trigger events (“Trigger Events”) listed below in section (c), Supplier shall provide Buyer with the Manufacturing Package as well as all information necessary to help Buyer have the Product manufactured by the Semiconductor Vendor. Upon execution of this SOW, Supplier shall obtain consent from the Semiconductor Vendor for Buyer to purchase the Product under such Semiconductor under and Adoption Agreement as set forth as Attachment A. Supplier shall further obtain consent from the Semiconductor Vendor allowing Buyer to assume and/or replace any open purchase orders placed on the Semiconductor Vendor on behalf of Buyer immediately upon a Trigger Event.

In this case the license and the delivery of the manufacturing package was tied to a triggering event which would allow Buyer to both receive the materials and commence production

(b)       Thirty (30) days after execution of this SOW, Supplier shall place the Manufacturing Package in Escrow under an escrow account (the “Manufacturing Escrow”) with XXXX Group, Inc. and Buyer shall become a third party beneficiary of such Manufacturing Escrow pursuant to the terms of the Escrow Agreement set forth as Attachment A to the Base Agreement.  (“Custodial Agreement”). 

As the rights were tied to a triggering event in the future, we required the materials be placed in Escrow so we could access them immediately on occurrence of the triggering event

(c)       Buyer shall have the right to demand from Supplier or the escrow agent, and Supplier agrees to immediately provide (either directly or through rights granted in the Escrow Agreement), the Manufacturing Package upon the occurrence of a Material Breach (as that term is defined in Section 15.4 of the Base Agreement).

In this relationship a number of items were defined as Material Breaches including the supplier’s failure to consistently delivery product.  The key is you want the right to manufacture to transfer before a Supplier enters into Bankruptcy as once they enter into Bankruptcy the trustee in Bankruptcy does not have to honor the agreement and would not be bound to provide Buyer with those rights.  

(d)       In the event of a material breach that is solely attributable to the breach of the Components SOW wherein Buyer elects to terminate for Cause only the Components SOW, Supplier grants to Buyer a limited,  non-transferable, non-exclusive, perpetual, royalty bearing (as set forth below) license under all intellectual property rights in the Manufacturing Package, to develop, manufacture, produce, modify, create derivative works of, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product as part of Buyer’s product.

1. Buyer shall pay to Supplier a royalty for each Product sold by Buyer, after exercise by Buyer of the license set forth in this subsection (d).  The royalty will be calculated as 80% of the Price of the Product as last agreed at the time of such termination less Buyer’s cost of purchase of the Product from the Semiconductor Vendor.

2. Once per year the parties the parties will review the competitive position of Buyer’s product in the market place and negotiate in good faith reasonable adjustments to royalty to allow Buyer’s product incorporating the Product to remain competitive.  If there is a subsequent Material Breach by Supplier and Buyer elects to terminate any of the other Agreements, the license shall be royalty free. 

In that case if they breached the hardware SOW and we elected to terminate for cause we agree to pay them a royalty.  The royalty first backed out 20% off the price to account for costs and warranty risks being assumed. We then deducted our cost of purchasing the completed Product from the Semiconductor Vendor and if there was any amount remaining, that was their royalty payment.  We also allowed for the formula to be further adjusted downward based on the product’s competitive position in the market as pricing will normally erode over time and as such the royalty formula needed to take that into account

(e)       In the event of a material breach as provided for in section 15.2 of the Base Agreement, wherein Buyer elects to terminate the Base Agreement, Object Code Licensed Works SOW and the Components SOW, Supplier grants to Buyer a limited,, non-transferable, non-exclusive, perpetual, royalty free license under all intellectual property rights in the Manufacturing Package, to develop, manufacture, produce, modify, create derivative works of, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product .

As the breach of other portions of the relationship would have cause the Buyer to assume substantial additional costs to do things like complete the SW, if the entire agreement was breached, the obligation was that it would be royalty free if we used it.

(f)        For paragraphs (d) and (e) above, If Supplier is not authorized to license or transfer rights granted to it by a third party that are necessary to develop, manufacture, produce, modify, create derivative works of, test (or have manufactured, produced and tested), use, sell or otherwise distribute the Product, then Supplier will use its best efforts to acquire such rights from any such third party.]

We included a very high standard of performance for them to get any third party rights that were needed.

(g)       Buyer shall have all remedies available at law or in equity for enforcement of this section including the right to seek Specific Performance.

In this, because the supplier was financially questionable where money damages would not have provided and adequate remedy, we made it clear that for the Manufacturing Rights we had equitable rights including specific performance were we could go to court to order their compliance.