Tuesday, December 10, 2013

Contract Retainage

In contracts that run over a long period in which payments are made based upon either milestones or the percentage of the work that is completed, it’s not uncommon to use retainage. Retainage is simply the concept of withholding a portion of the payment as financial security that the work will be completed and bills paid. Retainage is an alternative to or may be in addition to requiring the supplier or contractor to provide bonds.

The buyer or employer requires this type of protection for two reasons. The first reason is to financial protection to help ensure that the work gets done. If the supplier or contractor fails to complete the work, the buyer has those monies retained to complete it before needing to claim breach and pursue damages. The second reason is for some types of work (mainly construction)
laws provide subcontractors and material suppliers with protection in the event they do not get paid. That protection is called a mechanic’s or materialman’s lien that they can file against the property where their work was performed or their materials delivered. A lien against the property prevents the property from being sold and may prevent financing on the property until such time as the lien has been removed.

If you required bonds, a performance bond is to protect against the additional cost of completing the work if the supplier failed to. When you have a performance bond, the party that issued the bond has the option of completing the work or if it would cost more than the bond amount to complete the work, they may simply pay the recipient of the bond the amount of the bond. If you require a payment bond, the issuer of that bond would need to have any liens removed by paying the unpaid amounts up to the amount of the bond. If you don’t require bonds, your retainage may need to cover both risks.

Most of the time retainage is based upon a percentage of the amount to be paid. Over time as more payments are made the amount of the retainage grows. For large projects over extended periods of time the amount of retainage may be substantial. From my own perspective establishing the amount being withheld and any reductions or caps to the amount needs to weight the value of that protection against two things 1) the cost of that protection and 2) the financial impact the amount may have on the supplier’s performance. There is a value to the amount of money that is being retained that the supplier may include in their cost of performing the work. Similarly there is a significant value the supplier would get if you agree to release any amounts earlier than agreed. You also do not want to be holding so much that it is impacting the supplier’s cash that can in-turn impact their performance.

I’ve always preferred retainage over bonds as bonds cost more and if you have a problem and need to collect on the bond, what you want up with is a party whose sole goal is to minimize the costs they have to pay out under the bond. The other reason I prefer to use retainage is I don’t need to involve a third party. I can hire who I want to finish the work. I can manage the release of the liens. The cost of doing that becomes a receivable in which I can use the common law right of offset to set off my payables (the retainage) against my receivables. As the laws of locations can always be different, I would always investigate the laws concerning liens, and set off.

Another reason why I prefer retainage is I’ve always been of the opinion that from an owner’s perspective the last percentage of work is usually the hardest to get done. Individuals may have moved on to other work and the best way to retain the Supplier or Contractor’s attention is to be holding enough money so they provide you everything that’s due.

Tuesday, December 3, 2013

“Without prejudice to the contract”

I had a reader ask what “without prejudice to the contract” meant, so I thought I would share my response. It means that whatever action is being taken is being done where the language is being used will be without any loss or waiver of rights or privileges that you have under the contract.

For example if you agreed to accept a single lot of goods that didn't fully meet the specification, you might provide them with a letter or message accepting that lot without prejudice to the contract. You want that one act to not have any impact on the contract's requirement that the goods other than that lot must meet the contract requirements. You might do that because at times even thought its not perfect it may be usable and some product is better than no product and you might get other concessions to use the product.

In contracts I always include language to the effect that any waiver must be in writing and be signed by the parties to the agreement. Without that language, you can have a waiver of rights by your inaction in not enforcing your rights. You may be estopped (prevented) from asserting those rights. I'm not a big fan of using general statements. I prefer to be more specific about what I’m agreeing to. If I’m going to agree to waive something, in the separate waiver document, I make it clear exactly what that waiver applies to. If you do that right, you don't need to include the language reserving your rights. You would also not be concerned with having that waiver document introduced as evidence. It would already be clear what that waiver applied to. Any argument to expand that would, per the contract, require a separate waiver document signed by the parties.

In their example the individual had included the language in a section about getting notices of delay, as they wanted the notices of delay to not affect their rights. My opinion was that use didn’t provide them with anything. You use the language in trying to protect against a waiver of rights. Receiving a notice of a delay is not agreement consenting to the delay. If I received a notice of a delay I probably would acknowledge the notice and make it clear in that acknowledgement that unless the delay is excusable per the terms of the contract, their responsibility to complete the work on time still remains in effect. That makes it clear that I still retain all rights I have. The only way those rights may be modified is if there is an excusable delay where any changes to the rights would be modified as part of the change order or variation agreeing to the delay and any extension of time.

Saturday, November 30, 2013

Acceptance or sign-off

If you have ever seen this statement and wonder why it is used?

“Buyers acceptance or sign-off does not diminish or relieve the seller`s liability under the agreement.”

The problem is that the words “Acceptance” or “sign-off” may be used in a number of ways. In the worst case for a buyer it could be interpreted to constitute either a waiver or release of the buyer’s right to make future claims when your intent of signing may be far less. It might be to note that the product or services has been delivered and appears to be as described. It might function as a threshold, which triggers the responsibility for payment. Many times acceptance is the point at which a buyer is giving up their right to return a product as defective. After that type of acceptance any correction must be done under warranty obligations.

For products the language is used to make it clear that such acceptance is not functioning as either a waiver or release of potential future claims. The “acceptance” is functioning as a recognition that the work has been performed, not that there are no latent defects. Further, there could be future claims for negligence such as may occur from a defective product that causes injury in the future. It could be a contract claim, such as making a claim to have a defect corrected under warranty during the warranty period. There is frequently a potential for third party claims that may arise after completion and delivery of the work. For many services there are and should be warranty periods. In a service, even if there is no warranty, there may be performance commitments that were agreed must be met. For example, an engineering company designs something. They commit that when produced the product of the design will meet certain performance commitments. The employer who has no experience in the design “accepts” the design. That acceptance shouldn’t be waiving the responsibility of the designer that, if the item produced is accordance with that design, it must meet the performance commitment.

Many suppliers would love to have all their responsibilities end when there is either acceptance or upon completion of the warranty period. That doesn’t work for buyers as potential third party claims can still be made up to the applicable statute of limitations for that type of claim have been exhausted.
Is this an unknown risk at the time the contract was signed and as such placing an undue risk on the supplier or contractor? Those potential risks existed at the time the contract was signed.The only thing that isn’t known is the probability and magnitude. Making them responsible for those risks is not expanding their obligation under the contract.

Could an “acceptance” relieve supplier of potential future liability? For some liabilities it might be a reasonable to cut off of responsibility for things like correcting or making changes to work in the future. One example would be if the employer was an expert that was not relying upon the expertise of the service provider. In many situations that isn't the case and that's why when it comes to services I would still use that language just to make the legal impact of the acceptance or sign-off clear.

Wednesday, November 13, 2013

Applicable Law versus Governing Law

I had a major discussion about the use of “applicable law” and “governing law” and thought that I would share my thoughts with my readers.

Under “choice of laws” principals the parties to a contract can agree upon which law will be used for the interpretation of the contract in the event of a dispute. I refer to that as the “governing law”. It is the law that will govern the interpretation of the contract. The parties can also select the specific jurisdiction where they want the dispute to be heard. Further the parties may also specify the specific forum where they want the case to be heard within the specified jurisdiction. For example, the Governing Law could be the State of Delaware, the jurisdiction could be the State of New York, and the forum could be the Federal District Court in Lower Manhattan, New York, New York. Courts have the right to decide whether there is a nexus or connection between the case and the court to determine whether they “have standing” to hear the case. If they don’t find that connection, they may refuse to hear the case.

In most cases there will be a specific section within the contract that establishes the governing law, jurisdiction and sometimes forum. If no forum was specified, the case could potentially be filed either in a state court or Federal District Court within the agreed jurisdiction. The major difference between the two would are the court’s rules. In supporting the parties choice of governing law using the above example, the Federal District Court in Manhattan would interpret the contract using the Governing Law, which the parties agreed would be the State of Delaware.

When I refer to “Applicable Law” there are actually two basic types of applicable law. The first would be the laws of the jurisdiction where the work is being performed. In that the supplier is already legally obligated to comply with those laws. Still it is not uncommon for a Buyer's contract to have a statement of warranty that the work performed shall comply with applicable laws. This creates an obligation of conformance that runs to the buyer so if the supplier failed to comply with those laws, the buyer would have the right to claim breach and pursue damages they sustained as a result of the breach.

The second type of applicable law involves requirement that the product delivered or service performed complies with the laws of locations where it will be delivered or used. The ability to sell a product in another states will require compliance with the laws of that State. The ability to export or import products into other countries require compliance with the laws of those countries.

For example the European Economic Community enacted a law called RoHS, which was a Restriction on Hazardous Substances. This law set a time line after which products containing the specified substances were prevented from importation into the EEC and violators would be subject to significant fines and other sanctions. As a buyer of product that you intend to ship to other locations you need to ensure that not only do they meet the laws of where the product is produced, you also need a commitment that they will meet the laws of where they will be used.

As such its very clear to be specific when you use these words so it is clear what the intent is. For example in the example let's assume the following:
Governing Law was agreed to be Delaware
Jurisdiction was New York
Company A was headquartered in New York.
Company B was headquartered in California.
Company A manufactured the product in China
Company B wanted to buy the products for use in Texas and Colorado
Company A imported the products from China and stored them in a Warehouse in New Jersey

Company A has to comply with the Laws of New York State
Company B has to comply with the laws of the State of California
Company A, by manufacturing the product in China has to comply with the Laws of China
Company A, by exporting the product from China has to comply with the Chinese export laws.
Company A, be importing the product into the United States has to comply with the U.S. Import laws.
By selling the products for use in Texas and Colorado, company A has to comply with any U.S. Laws on the product and also for the individual sales must comply with the state laws.
As no transactions occurred in the State of Delaware there is no requirement to comply with Delaware state law, but Delaware state law would be used to interpret the contract.

If you used “Governing Law” that could limit the protection to only the governing law of the single jurisdiction you selected for interpreting the contract, Delaware, If you want compliance with the laws of more locations you would include a much broader statement. For example:
"Supplier is responsible for complying with all applicable laws that restrict, regulate or otherwise govern Buyer’s direct or indirect import, export, sale or other distribution of a product that is or contains Supplier’s Products or Deliverables."

Many supplier have concerns with "all applicable law" requirements as needing to potentially comply with laws of 180 plus countries. A common fall back solution I’ve used was to have a form of 80/20 compliance requirement listing the names of all the countries we wanted compliance with that also happened to be where we generated the majority of our sales. Most of the time the percentage was also the same countries where we had subsidiaries that needed to do import.

Thursday, November 7, 2013

Outsourcing Learnings

What is “Outsourcing” ?

Outsourcing was coined to describe the purchasing of products or services that a company previously had performed using their own resources. In the nineties, companies in search of competitiveness looked at outsourcing as a way of reducing personnel headcount along with pension and benefits liability, reducing their costs, and freeing up cash that would have been invested in plant, property or equipment and from investments in raw material inventories. Outsourcing can be a complete activity with the Supplier performing all of the activity or it can be used to supplement internal capability to provide increased capacity or to manage demand fluctuations.

When outsourcing is used to supplement a company’s internal capability it is just like any other purchase of a product or service and the same types of decision tools and agreements may be used. When outsourcing is done to replace the activity previously done by internal resources, the first problem that you encounter is what to do with the people who had been doing the work and the assets that have been used to perform the work and that adds significant complexity to the activity.

In its most complex form, Outsourcing is similar to the acquisition of a business with all the requirements of due diligence. The Service provider may be willing to assume the people and buy the equipment provided that there is a guaranteed return to them in doing so. In some instances they may see a potential for the use of the personnel in supporting other customer. In other instances they may not see the same potential use of the resources for other potential customers and to assume the people and purchase the equipment or facilities will usually require an extended commitment of business to the outsource supplier. In complex outsourcing activities there are numerous issues that must be resolved and a number of pitfalls.

Over the years every time I learned something about outsourcing I captured it as a learning. I thought I would share that list of learnings with my readers.

1. No one can fund all development or possess all knowledge. Some form of “outsourcing” will occur in all companies.
2. You can never truly outsource something completely. The need to manage the outsource relationship always remains.
3. There is a knowledge factor in outsourcing - either you gain or lose knowledge. When you send work out, the knowledge flows with the work. When you bring work in, the knowledge flows with the work. The risk is that once the basic knowledge to do the work is lost the competitive advantage from the work is lost.
4. Don't outsource core competencies.
5. Knowledge transference occurs over time. Be careful that your outsource supplier doesn't become your competitor.
6. To maintain control you may need to retain some level of capability internally. Without internal capability you run the risk of losing control of the transaction.
7. You need to be concerned about having the supplier backward integrate into your business. (move up the value chain).
8. You traditionally outsource for knowledge or capacity. If outsourcing is part of a divestment activity you may outsource for a variety of reasons:
Avoiding additional investments;
Get a short term capital infusion;
Belief that the outsource activity can be operated more competitively; or
Belief that demand is diminishing.
9. The best outsourcing involves minimal integration with internal work. Outsourcing that is integral to internal work is difficult to manage due to the complex relationships that exist.
10. Critical to outsourcing is ability to define exactly what is required of the outsource firm.
Review all assumptions critically
View all issues from both the company and outsource supplier perspectives.
12. Critical to success is finding a firm that can understand and meet your needs.
13. Critical to long term success is the ability to measure and manage the relationship over time.
14. Proximity of the outsource partner is important for management.
15. Success in outsourcing requires multi-level relationships between each company where they all operate under the same understanding of the relationship.
16. The more a supplier must integrate their actions with the Customer, the more the supplier must be perceived as an extension of the corporation and be included in or kept informed of actions and plans that will affect them.
17. Senior management must be committed to managing the relationship over time.
18. For each outsourcing activity there has to be advance agreement or understanding on the major goals of the outsourcing activity and the priorities in the event of conflict. Numerous groups or functions may be represented in or be affected by an outsourcing activity. In most cases they will have conflicting goals and priorities. Advance agreement will allow for affected groups to do contingency planning/actions to mitigate the affect it has on them. That agreement will allow presentation of a single position to the Outsource Supplier.
19. A high level review of strategy, direction, commitments proposed, financials, proposed strategy, and establishment of the negotiation team and negotiation plan should occur prior to any discussions with potential "supplier" candidates. Above all else these are negotiations. Initial discussions can and will set expectations that later become difficult to overcome. I also found that later reviews or bringing the team on mid-stream pose difficulty in changing the direction of the activity. As a negotiation, any mid-stream attempt to change position is viewed by the other party as either bargaining in bad faith and can kill a deal, or becomes a lever for the opposition to re-open items that had been previously agreed upon. The initial review should establish the parameters for the negotiation and agreement on the goals and priorities and mid-stream reviews should only be required if the negotiating team needs to go beyond those parameters.
20. A post negotiation review for the purpose of establishing the best way to manage the on-going relationship or to determine what went well and what could have been done better is appropriate. Negotiation is not a single point in time process, it is an on-going activity which occurs as long as the relationship exists. Planning how the relationship and risks will be managed is necessary, especially if you assume major risks or commitments. Anything learned should be captured and shared with future teams, will provide them valuable training.
21. The goal of the team has to be to not just complete the outsourcing activity but to establish a relationship that will meet everyone’s needs over time.
22. The more an outsourcing activity is incorporated into core business operations, the higher the risk.
23. The outsourcing activity must be staffed with individuals who are knowledgeable on what is required and how to best approach the activity. If that isn't done, each activity becomes a learning experience only for those individuals involved and their learning will cost the Company.
24. No two outsourcing activities are the same. Standard templates or checklists to use as a starting point and recommendations based on prior learning’s is the maximum that can be provided. Each outsourcing activity is driven by different motivations and goals and each activity encounters different Supplier motivations and goals.
25. The relationship must be managed to ensure all commitments made by both parties will in fact be delivered. It is also very important that a clear understanding of the relationship (if it is other than business as usual) be understood at all levels in both companies, otherwise while there may be agreement at the top, there may not be the same understandings at the point where the work and most interfaces occur.
26. It is extremely important that the business commit the business and technical resources necessary to properly manage the on-going activity. Many of these activities involve a major change for internal customers of the business and those customers need to be helped through the transition. Also many of these activities, because of their character and/or commitments made, require substantial on-going negotiation of work and changes etc. Any business left un-managed will cost more.
27. Use of comprehensive negotiating plans will provide the maximum return.
A. Establish a Negotiating Team - The appropriate business manager should assemble a negotiating team ("the Team") as soon as it becomes clear that a significant transaction will be negotiated.
B. The team should be kept small for efficiency and confidentiality but include representatives of business groups and support functions who will be impacted.
C. The team should manage all communications between the company and the other parties to the negotiations, keeping affected parties current with information.
D. Before negotiations the team should prepare a pre-negotiation plan. The plan should address our motivations, goals, and minimal acceptable positions and also address our expectations of the Outsource Supplier's motivations, goals and minimal acceptable positions
Plan contents:
1. Schedule, deliverables and responsibility. The schedule should provide adequate time for
A. Preparation of internal strategy.
B. Collection of information required for due diligence efforts.
C. Collection of forecast and other business sizing data
D. Financial evaluation,
E. Due diligence
F. Drafting of contract documents
G. Internal review and approval processes (for both parties)
H. Any regulatory approvals.
Every item the Buyer must provide needs a responsible party to manage and ensure the information is provided as scheduled.
28. It is important to have an excellent documented file in the event of later questions or disputes. From the beginning the team(s) should begin to build that file:
A. Track and document all contacts, correspondence, phone calls, meetings and negotiating sessions.
B. Document all information provided the Outsource Supplier.
C. Prepare formal minutes of each negotiating session to both document what was said but also what was agreed.
29. Negotiations require confidentiality. Parties should take precautions that are appropriate to the character of the activity to prevent any un-authorized disclosures. Information provided internally should be on a need to know basis until the activity is complete. If the activity requires the highest degree of confidentiality, it should be
managed as restricted distribution. Non-disclosure agreements with perspective suppliers will normally be required because of the sensitive nature of the business and technical information to be shared.
30. Due Diligence will be required and should take place prior to any commitment to the price and final structure of the deal. Rule #1 in negotiations is ALWAYS AGREE UPON THE SCOPE BEFORE YOU NEGOTIATE PRICE. Due diligence investigations should be tailored to the needs of the particular transaction and will occur on both sides. The Buyer’s due diligence or pre-qualification will include an assessment of the supplier's financial, technical and managerial capability to perform. The supplier's due diligence will be to the nature and character of the business - the financials, performance, forecasts, any assets and liabilities to be acquired (all the information they need to value the business and determine whether they can operate it with their desired profit).
31. The parties must have a clear understanding of what kind of business relationship they intend from the beginning. It is important to take the time to pre-determine the structure of relationship to ensure that it meets your goals and should meet the supplier's needs. Relationships should not "evolve", they should be planned. Negotiations will fail if you only consider your own goals and needs and do not consider the "Supplier" goals and needs. The parties must have a clear understanding of what business is being taken on or acquired by the "Supplier".
A) What are the performance responsibilities?
B) What capital equipment resources are being acquired? How valued? Book value? How depreciated?
C) What residual inventory/goods/materials are being acquired? How is it valued? Book value?
D) What contracts, in particular software licenses, are to be assigned?
E) What process(es) will be followed for disposal of residual or generated scrap or excess? Who owns it?
F) What other unique factors which could limit the Supplier's ability to perform should be listed by the seller/customer
Thorough analysis of the foregoing requires real "due diligence". Outsourcing should be looked upon as the sale/purchase of a portion of the business.
32. Outsourcing must provide wins for both parties. The parties must agree on short-term and long-term goals so that they understand what accomplishments constitute "wins". A reasonable, mutually agreed-to profit for the Supplier is one usual goal.
33. The roles and authority of designated middle-echelon contacts must be addressed functionally, or generically--in negotiations. "Who speaks for whom?" "Who can approve" etc.
34. The contract should contain a Statement of Work that addresses all issues of the relationship. This provides the baseline for the agreement, and for the provider's performance, and enables a clear definition of the roles of the parties: customer and supplier.
35. It is as important to define "how the work gets done" and "who is responsible to do the work" as it is to define "the work" itself.
36. The contract must provide a defined change-control process for both minor and major changes. This is an ongoing relationship which will evolve and change as your needs change. You need to insure that we have mechanisms to manage and control costs on minor changes and we need to have a mechanism to end the relationship with minimal pain and impact if the supplier is unable or unwilling to change with your changing needs. Changes to the "baseline" must be agreed to, written and recorded, and compensated.
37. The contract should clearly address the Supplier's ability to subcontract work to 3rd parties and the approval(s) for same, reserved by you. The relationship is with the supplier and anything that will substantial change that relationship must meet with your approval.
38. The contract should specify criteria for performance measurement. What constitutes success? What are the critical indicators? What are the frequency and methodology of measurement?
39. The contract should specify who is to handle common supplier management responsibilities if the relationship contemplates sub-contractor performance.
40. The contract should require that projects and rograms be "specified" in writing and that mutual acceptance of those specifications be documented.
41. Program Management responsibilities of the provider and customer with respect to projects and programs should be spelled out in the contract.
42. To minimize the administrative burden of managing changes in the scope of work and performance issues, the parties should assign specific contract administration responsibilities to designated personnel.
43. An outsourcing contract is first and foremost a purchase document. It should include in sufficient detail the rates of payment that reflect the provider's pricing and customer's financial obligations. UNDER NO CIRCUMSTANCES SHOULD THERE BE COMMITMENTS TO PERCENTAGES OF BUSINESS OR VOLUMES WITHOUT A
PRICE FORMULA. No surprises!
44. The contract should contain incentives (rewards) that motivate the right behavior for the provider to improve performance and/or lower costs and provisions to ensure that you have their complete attention (penalties, reduced rates, etc.) if they fail to perform or improve. A pass-through of savings to the customer that either does not affect or lowers the provider's profit (fee is calculated as a % of cost) is a disincentive to offer you improved performance. If the goal is to have them reduce cost, don’t penalize them when they do.
45. Cost Improvement should include avoidance as well as savings. There should be a benefit to the supplier for achieving either or both.
46. The contract must address in detail the possibility of termination or non-renewal of the agreement it embodies. This is a difficult discussion to have when you are just starting to create the relationship but it’s absolutely necessary. This can run from a simple termination to pre-agreeing to establish the outsourced activity as a separate company that you would have the option to re-purchase and re-sell or a number of other structures anywhere in between.
47. The Statement of Work and provider's performance responsibilities must address the rights and obligations of both parties.
48. The definition of the Buyer's responsibilities may involve a transfer of physical and human assets to the Supplier or to a third party or creating a transition agreement where the Buyer is obligated to provide assistance with the transition.
49. Due diligence is required in the determination of the value of assets to be transferred, and in understanding how those valuations were arrived at. It is EXTREMELY important that the information which you provide be accurate in every detail from the beginning. Accurate information builds trust in the information.
50. Avoid memorandums of understanding or letters of intent. If they must be given, they should only be given after completion of the appropriate internal analysis, review and approval processes as they may be held to be binding commitments.
51. Avoid any actions that could have the "Supplier" rely upon your information or representations or that will prevent or create estoppel from refuting claims. If memos of understanding or letters of intent must be given, they should include clear disclaimers on their non-binding nature prior to the execution of final agreements. This applies for everything but confidentiality provisions. All your personnel and agents must be counseled to avoid making any representations or demands that can create such problems such as:
A) Making assurances that agreement has been reached prior to necessary internal approvals;
B) Asking the "Supplier" to take actions, expend funds or make commitments to others in connection with it anticipated obligations;
C) Representing or stating that a certain condition such as board approval will be fulfilled;
D) Agreeing to significant terms, such as price lists or delivery schedules, without emphasizing that the deal will not be final until the definitive documents a signed.
E) Making commitments in anticipation of the agreement such as placement of purchase orders.
If placement of Purchase Orders is required for long lead materials or other reasonable business purposes, the purchase orders should include disclaimers as to their not committing an obligation with respect to the proposed agreement and should also contain language which either allows termination at no cost or assignment and novation of such orders to you at cost in the event the agreement is not consummated.
52. The Supplier must be able to sell products or services to the internal customers on terms at least as favorable as the best terms the customer can obtain outside the outsourcing contract. If they can't, their usage will erode as individuals seek lower cost alternatives.
53. Any non-competing provisions that you may desire to impose on the supplier need to be reviewed to weigh the risks to you if they were to compete versus the ability to benefit from the Supplier's opportunity to leverage profit through economies of scale.
54. The RISKS of failing to structure an outsourcing program properly, and to document that structure in a contract are great. They affect costs and profit, business relations between the parties, business relationships with 3rd parties, and may affect the position of the parties in the same or other markets.
55. If work statements and changes in scope are not documented and aggressively managed, cost/price relationships will be skewed and costs will increase.
56. If supply chain issues are not addressed in the contract, supplier relations will be unmanageable with adverse affects for both parties.
57. If economies of scale are not achieved, the provider may lose business and while the initial cost impact may rest solely on the supplier, you will be impacted through future price increases or the costs and service or product interruption required to move the outsourced activity to a third party.
58. If service does not meet requirements, you may suffer business loss for which you will look to the provider to compensate or will want "incentives" built into the agreement to improve service.
59. The rewards of success include planned profit margins for the provider, effective cost management for the customer, optimum service levels for the customer, and an opportunity for the provider to leverage other business in the same or related markets. Further benefits, calculable in real dollars when related to specific programs, accrue
from effective management of a common supply base and efficient disposition of capital assets and other goods at the outset, during, and at the end of an outsourcing program. When agreeing what to compensate the "Supplier" you need to consider all the rewards and benefits that will accrue.
60. Adherence to the terms of a well drafted contractual agreement will repay the effort taken to put such a contract in place. Clear understanding of all terms and conditions is as essential to successful outsourcing as to any contract for purchase. The rewards expected by an outsourcing Supplier will increase with the risks and complexity of the program.
61. You need to insure that what we offer is what they need to be successful. We should not try to force them to take more than they need. Any excess will have diminished value to them and they will price that accordingly in their offer. Use other alternatives to dispose of the excess which they do not require.
62. Make sure that your initial proposal or offering includes everything the supplier will need to be successful.
63. Understand the supplier's cash position as cash and cash flow may be the critical key to making the deal.
64. Establish a position on liabilities - at what date is buyer responsible and what date do they assume the liabilities.
65. Establish a position on timing of closure. It is very important to have structure that forces closure and not let discussions/negotiations drag on. The longer discussions / negotiations go on, the less you will get.
66. Document all discussions in detail to prevent misunderstandings. Misunderstandings cost money as you have the tendency to give in to make the sale of the business or assets.
67. Set values on everything that is included in the sale and seek agreement on those values.
68. Set minimum elements of the outsource purchase (below which you're not interested in the sale of assest and outsourcing.)
69. If you agree on the minimum, the values you can force agreement of a price. The whole should become the sum of the parts)
70. Be prepared to discuss the following:
A. Purchase Contracts. (are they included or not, if they are:)
A.1 Provide a summary of applicable open contracts ( Supplier, Parts covered , Contract $ Volume, expiration, and Assignability )
A.2 Will these contracts be assigned or terminated ? If they will be terminated, what is the estimated cost of termination ?
A.3 Summary of contracts with liability potential (Master Orders, Guaranteed volumes, bill-back Provisions, Extraordinary cancellation or termination Provisions). Will these contracts be assigned or terminated ? If they are to be terminated, what is the estimated cost of termination?
B. Equipment Leases.
B.1 Summary of open leases (Lessor, Items, Cost, expirations and Assignability.
B.2 Summary of Leases with liability potential (Extended lease terms, extraordinary cancellation or termination provisions).
Will these leases be assigned or terminated ? If they will be terminated, what is the estimated cost of termination ?
C. Open Purchase Orders.
C.1 Summary of open orders (Dollar Volume, dates)
C.2 Summary of Long Lead Orders (Open orders with over 90 days remaining)
How will these be treated ? Which are assumed, which are terminated ?
If terminated, what liability or cost will we assume ?
D. Non-disclosure agreements.
D.1 Copies of any Non-disclosure agreements the responsibility of which would have to be assumed by the Acquiring Entity (Supplier's Non-disclosures). Are there any which have to be transferred ?
D.2 List of Companies/contracts which have Non-disclosure agreements which we would need to continue.
Are there any which have to be transferred ?
E. License Commitments (rights acquired from third parties).
E.1 Summary of and copies of all third party licenses which would be transferred by the company. (License terms, Assignability)
What is included ? Will there be a cost to assign ?
F. Legal
F.1 Summarize all legally required programs.
F.2 Summarize license constraints on approval to operate (transfer of licenses, permits).
G. Taxes:
G.1 Summarize the nature and extent of any known Tax responsibility
How is this defined ?
H. Rental and Maintenance Agreements.
H.1 Summary of any major (in excess of $25K) rental or maintenance agreements. Period under agreement, amount, Assignability, unusual or extraordinary cancellation or termination costs. Are these to be assigned ? Are rights to pre-paid periods included ?
I.Tooling Agreements.
1.1 Summary of owned Tools which are at third party manufacturers.
Are these to be transferred ?
J. Consigned Equipment.
J.1 Summary of owned Equipment loaned to third party suppliers. Are these to be transferred ?
K. Consigned Material.
K.1 Amount and locations of consigned materials. Is this included in the sale ?
L. Loaned Equipment.
L.1 Amount and locations of equipment loaned to customers period of loan, disposition. Is this included in the sale ?
M. Hazardous Materials and Disposal.
M.1 Disclosure of any problems identified in this area through internal or environmental control organizations.
M.2 Summary of contracts for purchase of hazardous material (Supplier, Materials). Are these to be assigned or terminated ?
M.3 Summary of contracts for disposal of hazardous material. Are these to be assigned or terminated ?
N. Inventory:
N.1 History of Inventory Evaluation Changes
N.2 Date and status of last Physical Inventory
N.3 Inventory aging (Classifications, definitions)
What is transferred, when, AND HOW WILL ITS VALUE BE CALCULATED ?
O. Facilities:
O.1 Occupancy status
O.2 Description of any owned property (including all encumbrances) required insurance binders/policies etc.
What is to be transferred ? When ? For any pre-payments, deposits, bonds, made with respect to the facility, are these included or to be canceled ?
P. Equipment:
P.1 Provide a list of all equipment with a value in excess of $1,000
P.2 Provide a list of all equipment which has been fully depreciated but the sale is included.
What is included ?
Q. Systems and software used (Internal and third party)
Q.1 If external, supplier name, version, revision level and summary of internal enhancements. Are these to be included in the sale ?
Licenses are traditionally not assignable without the developers approval.
R. Determine detail allowed to remain for use after closing (as applicable):
List of all suppliers
List of Service Agents
List of Service Subcontractors
List of all authorized Purchasers and limits of authority
All part number detail
Detailed Purchase Specifications for all parts
Bills of Material, all products (Currently MFG or supported)
Illustrated Parts Breakdown, all products (Current or supported)
Property Disposal Procedures
Diagnostics (source code)
Existing Policies and Procedures in place in the groups
Key operation logs and reports
A description of filing system
Index of volume purchase agreements
S. If people are to be transferred, additional information will be required to be disclosed by both parties to insure compatibility of transfer offers, benefits etc. There is a high cost for personnel terminations in many locations. If the outsource activity involves the transfer of people, this risk will generate conditions from the acquiring company either of guarantees on the volume of business, the percentage of business or some recovery of costs if they must
Terminate transfered employees within an initial period. This risk has to be balanced against the cost if the company were to terminate the employees on their own. Sometimes it may be cheaper to terminate employees versus making long term commitments.
71. Sharing of information and communications. Unless otherwise instructed affected staff will "Open their Kimonos" and shared detailed information about all aspects of our business with the prospective buyer. The prospective buyer promptly will use the information provided against you in the negotiation of both the purchase of the business and the purchase agreement. Communication channels can form outside of the negotiation team, again with the result being that information can be disclosed and used against you. The learning here is:
1) you need to control the contacts.
2) all individuals who will have contacts with the potential buyer need to be counseled in advance as to what can or cannot be discussed and should probably be scripted in terms of what to say.
3) requests for information should be looked at from two perspectives
A) what does the prospective buyer need the information for and,
B) if disclosed, how would this information be used against you in
The negotiations of the purchase.
You need to give them enough to keep them interested but not so much
That they can use your information against you.
Every good negotiation has a detailed negotiation plan scripted out in advance with as many alternatives as possible considered and the team needs to stick to it. If you don't have one or people are allowed to freelance you run the serious risk that decisions or interim agreements will be reached without fully understanding the ramifications of what is being agreed upon.
72. NO IS AN ACCEPTABLE WORD. If the Supplier can sense tremendous internal motivation to sell the asset or outsource, they will continue to ask for concessions along the way. Until you say NO and hold firm to that NO, the supplier will continue to try to nibble away at different things to get the best deal they can get. We should learn to say NO to drive a behavioral change (If you agree they keep asking, several
NO’s will reduce or end the nibbling process). We need to be able to mask your motivation and learn to say no to insure you get the best deal.
73. The toughest job in sales in knowing how and when to close. In prior outsourcing deals we did not have a structure which forced closure. Discussions went on for months and there was nothing which forced closure. In one case, that coupled with a non-disclosure provision kept us from discussing the opportunity with other potential buyers was clearly used against us. In Real Estate they make it easy.If you want to
Lock something up you pay a deposit for that privilege and you have a date to close by or you may lose the deposit.
74. Minimum business obligations across multiple business units are difficult to enforce. "Forced marches" are strongly resisted and business unit profitability measurements drive business unit focused behavior.
75. Management of post-sale activities is almost as important as the pre-sale management and negotiation effort. Negotiation is an on-going process and it is important that we meet our obligations.
76. Avoid non-disclosure agreements that limit our rights to communicate the transaction with affected or other interested parties during negotiations. Until we have them locked in we should not be prevented from discussing with others.
77. The inability or failure to bring affected business unit managers into the conversation until later will result in a lack of buy-in as it relates to execution.
78. Limit future obligations and liabilities after closing. One should give as little as possible to ensure the sale. Don’t mortgage the future with commitments we may not be able to provide.
79. We should not indemnify the buyer on issues unless it is absolutely required to make the sale and the risk can be separated and managed.
80. Internal financial statements and performance measurements will not translate for a third party's evaluation of financials. There is a serious risk to provide a third party with internal financials. The entire accounting process/ procedures have to be restated in a “proforma” format to present it in a manner the the outside business would understand if they were reviewing a free-standing entity without the corporate or group overhead burdening the costs / performance.
81. The Supply Agreement should have specific, measurable performance metrics that preserve rights to terminate in the event performance is not at the committed level. When there are multiple teams with different goals the team charged with selling the assets have in the past made considerable efforts to soft-pedal this under the `we will partner with _______ and work the problem" theory or intent. This never works.
82. When quantitative measurements for cost, quality, performance and delivery were in the Contract we have been successful. When we have relied upon good faith of the parties it has been to our disadvantage. Protect rights by being very specific about performance metrics. The statement of work and provider's performance responsibilities must be addressed. You must have alternatives if they cannot perform.
83 For projects that are large enough to warrant it, having full-time representation gives you a window into what was going on, and provides the supplier with a focus for their issues and concerns. This is especially advisable when the activity is cross business.
84. You need defined process for making sure that pricing will be competitive for the length of any commitments and preferably longer in the future if transfer from the Supplier will be difficult, costly, or impractical. This may require refinement of a Pricing / Technology Matrix and considerable maintenance of the same.
85. Ensuring quality is also extremely important. There may be pressure to have some tolerance on the specifications, to use generally accepted specifications vs. internal criteria; or to use `form, fit or function' criteria. Insisting on the continuation of specifications blunts criticism and limits damage should poor quality occur.
86. Outsourcing is different and needs to be treated as such from a policies and procedures standpoint, both purchasing and financial. Trying to run outsourcing like any other business can be a mistake if it negatively impacts the relationship. Try to have the supplier run it as business as usual can also be a mistake if it impacts performance.
87. The buyer should expect and get "seamless" service. Seamless service means there should be either improvement or no change in service level and response between what internal customers were used to before and what they get through the outsource Supplier. This include responsiveness to requirements. Internal customers will expect seamless service and if there are any changes to the service they will receive or what they have to do to get that service that will be different, they need to be briefed in advance so they can take the appropriate steps to manage the difference (otherwise they will assume that it is business as usual).
88. Justification required by the Supplier's P & P's on customer directed requirements needs to be consistent with outsourcing.
89. As a part of the management due diligence we need to understand how the Supplier will staff up, where they draw people from, Which are temporary and which should be length of project. If people are critical to performance, you need to have control against movement of key personnel.
90. The Schedule and Agreement should plan for a "mobilization period" to allow a smooth start up and transfer of responsibilities.
91. If the deal is being sold on "we can save you money because of our buying power" concept, investigate if that is reasonably possible. Because of unique requirements, that may not be able to occur.
92. In people transfers there can be problems with the people on philosophy. When internal they may have delivered services on a cost plus basis. When they move to the Supplier they will operate under a more rigid set of price/cost constraints. Philosophical problems are harder to resolve if the transferred employees continue to work on the same site for the same clients.

93. As part of the management due diligence you need to ensure that defined processes are in place (Roadmaps, checklists of what to do, how to do it, etc.) Especially if they will staff with new personnel.
94. Another potential problem is the menu of services. What do they provide and what don't they provide? Can, should they, say no ? Can they discontinue providing products or services ?
95. Transfer of assets has problems but transfers that involve software create particular issues. Software is usually not assignable. Issues also exist with status of software maintenance/renewals.
96. Access to information and data needed to perform the work can cause problems. We need to understand all the information and systems the supplier will require access to and ensure that they have the required access in a secured mode.
97. Need to set expectations and be firm but fair from the beginning. This is what we need, this is the way it will be done unless you get us to agree otherwise..

Questions to consider in Outsourcing:
1. Why do we want to outsource or sell the business ?
A. Is the business (activity) unsuccessful ?
B. If it was unsuccessful what makes us think outsourcing it will improve the results?
2. What were the business' (activity) priorities?
2a. Would they change if the reporting structure or ownership changes?
3. What costs can be eliminated?
3a. What if they did business differently (e.g. License designs versus R&D,
Better forecasting, limit saleable menu, Contract work versus internal
Channels selling versus direct sell, Outsourced service versus direct.).
4. What overhead can be eliminated?
4a. Would they treat the overhead differently (Lease versus buy/ sublet unused space, sell unused capacity as contract services)
5. Are there any outstanding issues that can't be reversed? (E.g. Commitments, contracts)
6. Can the payroll be cut?
7. What assets are indispensable to the operation. Key Personnel, Assets, Intangible Assets
8. What assets can you do without?
9. Would they treat the assets differently (Lease versus own)
10. What, if any, business relationships would be threatened by this?
11. Are there issues with cash flow?
12. Will there be issues with receivables?
13. Are there political or labor risks involved ?


Monday, October 28, 2013

Consultants design / specification mistakes – Who should pay for them?

That was a question that someone asked on a LinkedIn website. Since I was surprised with the wide variety of responses (many of which were wrong) I decided to write a post as it involves a couple of key points.

First from a common sense perspective you need to ask the question if there was no error and the work cost more to construct, who would have paid the bill? The answer to that is the employer. While one never likes getting a large additional charge to complete the work correctly, you can't expect to get additional value added for free. If you wanted the consultants to pay the added costs required because of their mistake, you probably couldn't afford their services. It probably would also not be enforceable.

From a contracts perspective there is a concept under equity law where “unjust enrichment” is not allowed. Unjust enrichment is an equitable principle that no person should be allowed to profit at another's expense without making restitution for the reasonable value of any property, services, or other benefits that have been unfairly received and retained. In many jurisdictions that principal in equity has carried over to contract law. In those locations unjust enrichment in the form of penalties are not allowed. You can collect damages, but you cannot profit off the others breach and language that would create a penalty would not be enforceable in their jurisdictions.

If there is a mistake by the design consultant, you can't simply expect that you will get all of the cost to correct that mistake for free, especially if the correction of that mistake provides you with additional value. What you can expect is if the mistake causes you an additional cost over and above what it would have cost you if it had been done right, you might have a potential claim against the design consultant. The key in your success on that damages claim because of the mistake or error is what duty do they have to you? Are they obligated to produce an error free design? The answer to that is no. Are they expected to use ordinary and reasonable care for someone of that experience and skill level? The answer to that is yes. If you want to increase the standard of care they must provide you would want to have the designer represent that they are an “expert” and agree that in spite of any knowledge you may have, you are relying upon their expertise. That provides you with a highest standard of care.

If a design consultant is negligent and makes a mistake in locations that do not allow for penalties, the most you could collect are damages you sustained. Damages include the cost of work that needs to be removed, not the cost of what should have been there in the first place if not for the error. Here’s an example. A concrete floor was specified to be 5 inches deep by the design consultant. Based on the loading it is later determined that the floor depth needed to be 6 inches. If you could simply pour that additional inch without any other impact, should the consultant have to pay for that additional inch? In my thinking that would be a penalty and a form of unjust enrichment or penalty, as the owner would have paid for it in the first place if it was designed correctly. Using the same example but in this case the floor had to be demolished and re-poured. In that situation I think that the designer's potential liability could be for the cost of demolishing, the cost of the 5" floor that had been poured and demolished, but not the additional inch. To have the designer pay for that extra inch would constitute a penalty.

There are different standards of care between the designer and employer versus the standard of care that the designer has with respect to third parties. They have the responsibility to design safe buildings and if they don't not only may they be subject to employer claims for damages, they can also be subject to third party claims for personal injury (including death) and property damage sustained as a result of their negligence. As an employer to protect your company against third party claims you want general indemnifications and insurance from both the designer and the contractor. From the contractor you want "all perils" insurance, and from the designer you want errors and omissions coverage.

Have I every asked a design consultant to contribute a portion of the extra cost when their error cost me more than what it would have originally cost me if it had been done right (because work needed to be redone)? Sure, especially when I paid them for site supervision to prevent that. Have I ever had a contractor and designer get together and tell them that there is a problem, but it's not the employer’s problem. Both failed to identify an obvious error or were negligent. Do I look to them to determine how they will pay for the additional cost? Sure. In negligence there is a latin term “res ipsa loquitor”, which means "the thing speaks for itself".) One is presumed to be negligent if they had exclusive control of whatever caused the injury. There needs to no specific evidence of an act of negligence. However without negligence the accident would not have happened. If as the employer I had no involvement, I look to the companies that had control of the site to work to sort out responsibility.

Friday, October 11, 2013

Implied Warranties (Updated)

In the United States and in other jurisdiction, for transactions between businesses there may be implied warranties. For example under the Uniform Commercial Code enacted in the U.S. there are two implied warranties – merchantability, and fitness for a particular purpose. Below are the specific sections from the UCC that define these implied warranties:

(1) Unless excluded or modified (Section 2-316), a warranty that the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant with respect to goods of that kind. Under this section the serving for value of food or drink to be consumed either on the premises or elsewhere is a sale.
(2) Goods to be merchantable must be at least such as
• (a) pass without objection in the trade under the contract description; and
• (b) in the case of fungible goods, are of fair average quality within the description; and
• (c) are fit for the ordinary purposes for which such goods are used; and
• (d) run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and
• (e) are adequately contained, packaged, and labeled as the agreement may require; and
• (f) conform to the promise or affirmations of fact made on the container or label if any.
(3) Unless excluded or modified (Section 2-316) other implied warranties may arise from course of dealing or usage of trade.

Where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller's skill or judgment to select or furnish suitable goods, there is unless excluded or modified under the next section an implied warranty that the goods shall be fit for such purpose.

The first things to note is that these implied warranties apply to only goods. The sale must be from a merchant that sells those types of goods. If all a supplier wanted to not be responsible for quality, they could simply state that the product is being sold on an as-is basis. In doing that they are making no representations as to the quality of the product. Most suppliers are less concerned with the warranty of merchantability than they are with the warranty of fitness for a particular purpose. That’s usually the implied warranty they want to avoid. They may include a specific disclaimer against implied warranties or may disclaim only the warranty of fitness for a particular purpose.

As you can see from reading the section, for a supplier to be held to the warranty of fitness for a particular purpose the supplier must have reason to know the specific purpose, such as by having the buyer disclose the specific purpose to the supplier. If they did and the warranty of fitness for a particular purpose was not disclaimed, if the product was not fit for that purpose, the buyer would have a breach of that implied warranty. They could insist on the supplier correcting the problem at the supplier’s expense as an alternative to pursuing breach and damages. They could also keep the product and use the fact that it does not meet the implied warranty to collect damages for the diminished value. If the supplier fails to correct it the buyer could follow procedures to terminate the contract for breach of the warranty and pursue damages. Most suppliers simply want to sell products. They want buyers to determine what they need so that becomes buyer’s problem if the product doesn’t meet their needs. What they don’t want is their sales to result in claims, lawsuits or damages if it isn’t fit for the buyer’s specific purpose. That’s why most will want to include the disclaimer against the warranty of fitness for a particular purpose.

There can be a number of purchases where a buyer is definitely relying upon the supplier to provide them with a product or service that does meet a specific requirement or purpose. In those situations you would not want to rely upon an implied warranty. You would want to either make acceptance conditional upon proving that it does meet those requirement, make it an express warranty or both. In the acceptance and test requirement you would specify both the specific purpose it is required to meet and include acceptance terms that require proof that the item does in fact meet that specific purpose. Your obligation to make payment should be conditioned upon that acceptance. That way if it doesn’t meet those requirements you can return the product and not make payment or you can work with the supplier to correct the problem. Including it as a warranty would protect you against the potential that it did meet the requirements at acceptance but later failed to meet those needs.

Without acceptance to prove it works or an implied or express warranty of fitness for a particular the rule “caveat emptor” applies. If there is a problem it’s your problem. What you can do will depend upon what return or restocking rights you have in the agreement or what the supplier decides they will do.
In the end you need to decide whose problem do you want it to be if it isn’t fit for the specific purpose. Since I’m paying I always want it to be the supplier’s problem. Either make it work, give me my money back or let me decide whether I want to keep it at a reduced price.
Even if you get a warranty that the good is of merchantable quality, most sellers will protect themselves by publishing product specifications that have detailed operating parameters and environments for use. In doing that if you use the product outside the parameters you will have breached the agreement or have voided the warranty. Many suppliers will also include use restrictions to avoid the buyer using them high-risk uses. If the Buyer used it in a prohibited manner they would have breached the agreement and when you breach the agreement the supplier no longer needs to honor other commitments in the agreement such as indemnities against personal injury or property damage. For example, they may make a product that could be used in a life support system, but do not want their product used there because of potential liability should it fail.

Thursday, October 10, 2013

Responsibility to notify a supplier of a defect.

In linkedIN an individual asked the question whether language that waived responsibility for buyer to provide notice of a defect was common. In my opinion it isn’t and whether you would want to agree to that as a supplier would depend on a number of things. I personally wouldn’t recommend it for suppliers.

The first key issue in notification of a defect is at what point does a defect in the product change from being covered by the right to return the material for a full credit as being defective versus needing to process it as a warranty claim. For suppliers in U.S. that issue is important. The U.S. Securities and Exchange Commission (SEC) has revenue accounting rules to the effect that a company cannot claim a sale as revenue if the buyer has the right to return the product for credit. I think those accounting rules may have been put in place as a result of companies doing what I call phantom shipments at the end of a fiscal quarter to make their revenue look good only to get the materials returned in the next quarter for credit.

If you don’t have a notice period or leave the period open via including an exclusion from providing notice, my belief is the selling company couldn't claim that sale as revenue as the buyer could return it as defective at any time. As a result of the SEC’s revenue accounting rules most U.S, suppliers want to establish a specific time limit a buyer has to return the product for being defective so they can claim it as revenue. If you agree to that your sole recourse after that period has expired is under the product warranty provision.

As a buyer you want that time limit to notify the supplier of the product being defective to be long enough so it may be able to be put in use to discover the defect. That is because many companies no longer do incoming inspection on materials because of the added cost. As a buyer I always want the period to be at least as long as the payment period. That way if I discover that it’s defective I can stop payment rather than pay them and have to chase them for a refund. I also want the warranty obligation to provide me with repair, replacement or full refund in the event the supplier can't repair or replace it. Since my primary right is to get repair or replacement, the supplier can still classify it as a sale and classify it as take revenue. If they need to provide a refund because they couldn’t repair or replace it, that does not impact their claiming it as a sale from a revenue accounting perspective, it just becomes a later adjustment to their sales.

Another simple reason suppliers want to be notified of defects is so they can understand there are problems allowing them to identify the root cause of the defect. That way they can reduce or eliminate it the defect in the future reducing both their qualify and warranty costs. They also don’t want buyers to be collecting a stockpile of defective products for return at sometime in the future. They do that for a number of reasons. Some products have limited shelf lives where even if they could repair the defect no one would buy it because of the shelf life. Another reason is many products simply have a product life. If you were a supplier would you want to receive a large quantity of defective product where the buyer wants their money back because they are defective. Think about the financial impact it would have if they were returned at a point in time where even if they could be repaired there is no longer a demand for them, making them worthless.

Tuesday, October 8, 2013

Is Negotiation Only About Price and Discount?.

This was a question that someone asked in a LinkedIN forum. The ensuing exchange of posts brought forth an issue that I thought I would share.

My initial response was there are three stages to any major negotiation. The pre-negotiation stage involves qualification of the supplier and preparation for the negotiation. The better prepared you are, the better results you should achieve. The actual negotiation involves not just price but also contract terms. Contract term can either add to or reduce your cost and add to or reduce your risks. Risks that you assume under your contract that materialize add to your costs. You can have a great price and discount with lousy terms that will cost you more in the end. The third stage of negotiation is contract management. Contract management will determine how much of the deal that you negotiated you actually keep. Contracts that are left unmanaged will always cost you more. So my answer to the question was price and discount are never the only factors to negotiate.

Another responder took the approach to segment Suppliers into four categories using an IACCM segmentation:
1) Commodity
2) Developing
3) Legacy
4) Strategic
Their position was that with Commodity Suppliers, it was only about cost and discount but with other suppliers it involved more.

Based upon this I thought I would write about supplier segmentation and what affect that would have on what or how you would negotiate.

Different companies may segment suppliers differently I decided to first identify how I’ve managed this form of segmentation in the past. My view is based upon the computer industry where products, and the materials used in those products had a life cycle. Those life cycles for production can be as short as six months. You have suppliers that are industry technology leaders who are usually first to market with new products and new technology (“leaders”). You also have companies in those commodities that I call "followers". I define "Followers" as usually being late to market with their focus on low cost to capture market share. “Leaders” are usually classified as strategic and get managed as strategic suppliers. “Followers” are usually classified as commodity suppliers. The key is not how they are segmented, the key is the risks involved and the potential future opportunity they bring.

As there can be the same performance risks between strategic suppliers and commodity suppliers, price and discounts are never the entire focus of at least the initial negotiation. Once you have an existing agreement in place with a commodity supplier, future negotiations may be more focused on just price and discount but that is seldom the only thing that gets negotiated. As you move further out in the product’s life cycle the “followers” may become more important. The reason for this is leaders may end of life the current product you have been purchasing moving to their next leadership product and you may be dependent upon the “followers” for product until you end of life your product or can use the “leader’s” new product.

When you segment suppliers and have developing and legacy suppliers, what you negotiate in terms of your contract should be no different. Again the problems they can create and potential risks and costs they can cause really aren’t any different than commodity or strategic suppliers. The difference you have between those two categories is normally the amount of time you spend managing them or the frequency of the negotiations. A true legacy supplier has been working with you so you don’t need to invest the same amount of time in managing them as a developing supplier that may just be starting to learn what is needed to be successful to grow a long term relationship. You may also have less frequent negotiations with legacy suppliers as the opportunity to reduce cost may be less.

The reason less frequent negotiations with legacy suppliers is without outside influences such as increases in demand, most product pricing follows price curves.“Leaders” who are first to market will set the price high. As more competition enters the market the price will be drive down. When there is maximum competition (especially from “followers” joining the market) you reach the lowest price. Leaders may exit the market to introduce their next leading product and that may create a shortage of supply driving the price up. ( see http://knowledgetonegotiate.blogspot.com/2011/09/price-curves.html )

Segmentation of suppliers is more for determining the amount to time and effort you spend with a supplier and can be a tool to prioritize the frequency of negotiations. It’s not a tool to determine what gets negotiated. What gets negotiated should always depend upon the risk. How frequently things get negotiated depends upon the opportunity.

Thursday, September 26, 2013

Reverse Auctions

A reverse auction (sometimes referred to as a dutch auction) is a bidding process that operates differently that a regular auction where the highest bidder wins. In a reverse auction, the bidders may continue to re-bid at lower prices in an attempt to win the business. In the end the one with the lowest price wins. I’ve always felt that it is best to negotiate the final price after you have reached agreement on the contract terms as changes to the contract terms may add to or reduce your cost and may add to or reduce your risks. As such a concern that I’ve always had with reverse auctions is how to make them effective from a total cost perspective.

I suppose that if you purchased a commodity product with a simple set of terms such as a purchase order you might be able to get all parties to the auction to agree to that a standard agreement in advance. If you don’t get agreement in advance on what the terms of the contract will be, when it comes time to negotiate the contract you need to be prepared for “our price did not include that” in the contract. I personally like to negotiate the final price I will pay after I’ve agreed upon all terms in the contract. Throughout the negotiation I will document all the terms
That have added to or reduced my cost and risk based upon changes to my documents that have been agreed. I like to put a price on each change and argue that such change needs to be reflected in the final price I’m willing to pay. In doing that some negotiators will be willing to accept the original language to avoid having to provide a price reduction. One of the concerns that I have with using reverse auctions with more complex purchases is there is a disconnect between pricing and costs or risks. Your supplier with the lowest auction price may be higher from a total cost perspective when you take into account the terms they will agree upon.

I also suppose that you could require a red-line of the proposed changes to the agreement in advance of the reverse auction and could assign costs to each issue and somehow take that into account in determining the total cost of each bidder’s offer. The problem is that not all changes they propose will you be willing to accept. That complicates the negotiation and also puts you in the situation where they will say “our price was based upon our redline” and to provide you with that we need to adjust our price.

I think reverse auctions work well when you deal with standard commodities where there aren’t variables in what the supplier can provide so all are bidding on the same thing, and they work well when you have purchase orders or simple agreements that will be readily accepted.

Friday, September 20, 2013

Superimposed after the fact

In a linkedIN group someone asked what the meaning of this was as they were translating a contract. Since it was unusual I decided to post my response.

The language was included as part of the force majeure clause and one of the force majeure events described was "governmental regulations superimposed after the fact". "Superimposed" means layed on after the fact. Since the contract is effective on the date signed, the "after the fact” is referring to after the execution of the contract. The key in the clause is what does a force majeure event provide? Most force majeure events only provide for an excusable delay in performance. In that context, I would interpret the language to mean that the party proposing it wants an excusable delay in performance if there are any new governmental regulations that are enacted after the execution of the contract.

As governments are constantly publishing new regulations the language was extremely vague. It could be interpreted to give an excusable delay for any new regulations issued. For an item to be a force majeure event I want to see both a cause and effect creates a delay in performance. To do that I would first want it clarified to make sure that the regulations actually apply to the work being performed. I would also want to ensure that complying with those new applicable regulations actually causes a delay in performance.

If I agreed to allow for governmental regulations as a force majeure event, I would want to make it clear what I was agreeing to such as:
"Any governmental regulation enacted after the date of the execution of this Agreement shall be deemed a force majeure event if compliance with the regulation is required for the performance of work and compliance with the regulation causes a delay in performance.”

Saturday, September 7, 2013

From a cost perspective should you buy through an OEM versus a Distributor?

On LinkedIN someone asked the question about whether it would be cheaper to buy through an OEM versus a distributor and there were so many bad responses and misconceptions that I decided that I would write a post about it.

Every company will have a number of markets or what are called “sales channels” that they sell through. A company may have OEM sales. OEM stands for Original Equipment Manufacturer meaning the company that is purchasing the product will imbed that product within their product and as such will not be competing against either the company or its authorized distributors for sales. The company may also sell to VARS. A VAR or value added reseller is one that adds specific value to the product and sells that. Since they are adding value to the product they too are not directly competing against the company or its authorized distributors. The company may
direct customer account sales where they usually sell to large users of their product(s). They may also sell through Authorized Distributors. An authorized distributor is a company that has entered into an agreement with the manufacturer or producer to sell products. Normal authorized distributor agreements will have agreed geographical territories that they can sell within, they will have the obligations of the distributor and company defined such as responsibilities for marketing and conduct and they will have a a defined method of compensation.There are two primary models companies have for sales to distribution. One is a simple discount off list where the volume of the distributor's purchases will increase their discount off the company’s list price as their volume increases. The other is a form price protection where the discount they receive is tied to selling close to the targeted price. Distributors can provide a wide range of services from just being an order location to providing stocking and value added services.

Each of these "channels" will have different sales terms and different pricing or discount structures. Most companies will also have a tiering approach within a channel where terms and pricing or discounts you get will be based upon the volume of business and your importance as a customer. The highest tier in any channel will get both the best price and the best terms. Lower tiers will get higher prices or less discounts and less favorable terms. Normally the best pricing and best terms would be given to the highest tier OEM accounts. That is because they provide volume sales for the company, they don’t compete with the company or their authorized distributors for sales, and there is less sales and administrative expenses in dealing with that one OEM versus dealing with multiple companies that would provide the same volume of sales. If you fall below a certain level of business a company may not sell to you for whatever channel would be applicable to your business. You can also find companies that sell exclusively through distribution. In both those situations you would need to buy the product through one of their authorized distributors.

As to what what sales channel is best strictly from a cost perspective, if you have significant volume and can buy it directly as an OEM, that is usually the best way to go as OEM’s will normally get higher discounts than a distributor. Further out of their discount the distributor has to pay for there operating costs out of the discount they earn, so they have less of a margin to work with in selling to you. If you don't have significant volume you may be able to buy it for less from one of their high volume distributors but then the issue of distribution territories can impact that. I’ve had situations where I needed to have another subsidiary buy and resell me a product simply because they could buy it from a distributor in another location at a lower cost. Another thing that can impact your sourcing decision is if there is a problem with the product and it needs maintenance or repair, who will perform that? If the distributor performs service or maintenance they may be unwilling to do it on a product that they didn’t sell.

In addition to price there is another consideration you need to take into account. When you buy from a distributor, you do not have privity of contract with the original manufacturer. The manufacturer will provide a warranty to the Distributor that they assign to you. Most of the time that warranty cannot be further assigned. If there is any problem with the purchase other than what would be covered by their product warranty, since you bought from a distributor, your sole recourse is against the distributor. This means the smaller the distributor you deal with, the less the assets, the larger the potential risk. There are only two parties that could go directly against the original manufacturer; the distributor who purchased the product from them, and any third party is injured by the product who can claim product liability negligence.

The last thing to take into consideration in sourcing is your warranty on the product. You need to read the fine print in the warranty and especially read any warranty exclusion. Many times third party repair or use of third party materials will void a warranty. If you buy it in one country or location and your local distributor won’t service or repair it because you didn’t buy it from them, if you use another company to fix it that isn’t authorized by the company to perform such work, you may have voided your warranty.

OEM can also be used in describing the source for the parts. An OEM part is one that is sold by an Original Equipment Manufacturer. That part may also be available from the manufacturer the OEM purchased the product from. Parts that provide the same form, fit and function may also be available from other suppliers or from what is called "after market" suppliers. For example you purchase an IPad from apple and the earphones that came with it break. You could buy replacement earphones from Apple (the OEM) or from a variety of other sources.

Sunday, September 1, 2013

Negotiation Tactics

In the blog I've talked primarily about contract negotiation. Today I wanted to share a list of all the different negotiation tactics that I've used, seen used or read about in books or learned from training. I'd be interested in readers commenting about any other tactics they have used or encountered in a negotiation.

1. Take it or leave it.
2. You've got to do better.
3. Remind them of the competition.
4. Aim high.
5. Use funny money.
6. Exercise Patience
7. I can't go further.
8. Use your Power / Leverage.
9. Nibble away
10. Look at record, prior performance
11. Let's Split the difference.
12. When they offer less offer them something of lesser value
13. Use a team attack (outnumber the other party at the negotiating table).
14. Use time to your advantage.
15. Create an reverse auction between competitors.
16. Faking or share information to drive decisions such as planned price increases .
17. Intentional overload of requests for information.
18. Elevate to a higher authority.
19. Apparently withdraw from the negotiation.
20. Tell them what will happen if don't they don’t agree.
21. Dangle the carrot of more potential business.
22. Use limited authority or the need to get higher level approval above a certain amount
23. Use limited funding levels
24. Ask “What if"
25. Cherry pick only the items you get the most benefit from.
26. Tell them what you need and why.
27. Show legitimacy of your position.
28. Create intentional deadlock.
29. Establish deadlines.
30. Use past precedent.
31. Play to the Negotiator’s needs such as being risk averse.
32. Divide and conquer members of their team
33. Change (the pace, the team, etc.)
34. Use the Good Guy / Bad Guy tactic
35. Attempt to intimidate the negotiator.
36. Stonewall – just continue to say no.
37. Provide reasons to agree.
38. Ask for a new counterpart.
39. Leak information to help them decide.
40. Put them on the defensive.
41. Make them feel guilty about their position.
42. Be unpredictable.
43. Use silence to create uncertainty
44. Set expectations early about what is possible or needed
45. Create smokescreens
46. Use shills such as another team member making a comment that could impact the negotiation.
47. Be skeptical, demand proof
47. Catch them while they are weak, or wear them down.
48. Create power seating positions
49. Do things to distract them
50. Flinch at their proposals
51. Give non-verbal signals to show apparent feelings
52. Gasp in shock or surprise
53. Set aside issues (to either buy time to decide or use for greater effect)
54. Start easy and get them used to agreeing.
55. For every concession ask for something in return.
56. In conceding let then know you are conceding and what that is worth.
57. Withdraw an offer.
58. Tell them nothing is agreed until everything is agreed (revisit prior agreements because of impact)
59. Taper down concessions.
60. Ask them why they need it.
61. Learn to say no
62. Get the other side to commit first.
63. Act dumb, ask them to explain.
64. Summarize all agreements & and control the contract.
65. Assume there was agreement on an issue.
66. Talk about the need for win-win.
67. Introduce information at key times.
68. Work their emotions.
69. Let them save face with their management.
70. Show your knowledge
71. When what they say isn’t true, let them know that you know that and don’t agree.
72. Show them your commitment.
73. Use time such as end of month or end of quarter and readiness to buy in that period to get concessions.
74. Remind them of their investment either in money or time they will lose if they don’t agree.
75. Sell your position.
76. Give them good reasons to agree.
77. Use example and analogies to drive points
78. Use graphics to get their attention.
79. Use conditional proposals and language
80. Link items for agreement, To give you this, I need to get that.
81. Use contingent pricing.
82. Provide conditional acceptance.
83. Dilute the offer with exceptions.
84. Bait and switch.
85. Get something for the prestige of doing business with you.
86. Get something for being the first to act.
87. For ever extra they want to add, identify a deduct (e.g. If they want to change for “No problem found” returns ask them for a credit for quality performance problems.)
88. Tell them its not negotiable
89. Puff the significance of concessions
90. Make an intentional mistake.
91. Be ambiguous with the intent of later claiming or interpreting it to your interest.
92. Use blocking tactics - delay coming to agreement until they have no other choices to give them less.
93. Minimize the value of their concessions to you.
94. Give them what they want, but in a manner which is to your favor.
95. Ask leading questions to drive them to a specific conclusion you want.
96. Find their company or the negotiator’s hot button and use it.
97. Avoid direct comparison by providing something other than what they requested.
98. Offer to do things they would do.
100. Avoid the add on (e.g. plus shipping and handling)
101. Manage their expectations (early and often)
102. Offer to be a reference account.
103. Ask for return for your loyalty
104. Leverage all relations you have with them (both sales and buying)
105. Look for special concessions for giving a percent or all of your requirements.

Friday, August 30, 2013

Should Inflation be a Force Majeure Event?

In a recent LinkedIN forum someone asked the question of whether inflation could be a force majeure event. Under freedom of contract the parties could make anything a force majeure event. The real question is whether that would make sense. The underlying concept of force majeure is an event has occurred that is beyond that party’s control where performance is not possible because of that event, and as such performance is excused until the effected party is able to recover from the event. Inflation is not something that stops performance it just makes performance more expensive.

A fairly common force majeure clause may read something like this:
Neither party will be in default or liable for any delay or failure to comply with this Agreement due to any act beyond the control of the affected party, excluding labor disputes, provided such party immediately notifies the other.”

With such a clause the party that sustained the force majeure event is normally allowed to recover from that event. Neither party is excused from completely performing. The party that suffered the force majeure event simply won’t be in default or be liable for performance during the period. The party that did not suffer the force majeure event is not excused from performance so if a payment was due, they would need to make the payment.

Including inflation in a force majeure clause makes no sense. Delaying performance as a result of inflation only makes sense if you are sure that de-inflation will occur. If it that isn’t the case, delaying performance would only cost more, as performance is not excused. A force majeure does not excuse performance, it simply creates a situation where the party that suffers force majeure event isn’t in default of liable during the period performance cannot be provides as a result of the force majeure. Performance can only be excused by certain conditions: subsequently illegality; impossibility of performance; impracticability of performance; frustration; where the parties agree to rescind or stop the agreement; novation; and lapse of the contract term.

Since it makes no sense to have inflation be considered a force majeure event, how do you deal with inflation concerns? One way to deal with inflation is to allow price adjustment per a pre-agreed formula. As an employer you might what to include an upper limit where work could be stopped at a point where it makes it uneconomical for the employer to continue the work. Since performance can be excused by agreement of the parties to stop or rescind the agreement you could include that in advance in your agreement. I would probably write a separate clause where the parties agree in advance that if there is no pre-agreed formula to adjust the price for inflation, either party has the right to rescind or stop the agreement if inflation exceeds a specific rate. Since you would not want the party to use that simply to walk away from a bad deal, I would want advance notice of their intent to exercise that right and make that right conditioned upon the parties not being able to reasonably agree to a adjustment based upon actual inflation. That way if the buyer agrees to make a reasonable adjustment to the price to cover inflation the supplier or contractor can’t use inflation as a way to walk away from a bad deal they made.

Tuesday, August 13, 2013

As may be amended from time to time.

In a linkedIN group someone asked the meaning of what “from time to time” means. The most frequent use of the term is with a requirement that a party, their product or service complies with applicable laws. When you say “Supplier shall comply with all applicable laws as may be amended from time to time”, what you are doing is require the supplier to make changes each time an applicable law changes.

Complying with applicable laws as they are changed presents a huge potential risk. You can have labor laws, minimum wages or health care laws enacted. You can have environmental laws enacted. Imagine being a supplier to a company that sells products in well over 100 countries, each of which may have multiple political subdivisions that can each pass laws. A change or new environmental law can also force changes to materials and processes used to manufacture a product.

Should a supplier be forced to comply with all changes that may occur in these various locations? Is it even economically feasible? If a small country enacted an environmental law or other laws the cost to implement the changes may not be worth it for the volume of sales in that market. It may also not be worth it to manufacture a unique item for only that market, nor would a supplier want to burden their cost structure for markets that simply don’t require it.

Even if you require a supplier to make all changes that are necessary to comply with a new or changed law, there are several situations where they won’t be required to make changes. The first is if the change in the law would make performance of the contract illegal. In that case the contract would be voidable. The other situation would be where they would be excused from performance because the change in the law causes impossibility of performance, impracticability of performance, or in some locations results in an economic hardship.

One of the comments made in that discussion was “if the Supplier thinks he wants that deal, it is part of the risk they have to take which should be addressed in their quoted price”. If the contract is silent about compensation or other adjustments that may be required to comply with the law, the full responsibility and cost for compliance would need to be borne by the Supplier. Many times a change in the law may simply not be a cost issue, it can also impact the time for performance.

As I always say how you view of issues will always depend upon where you sit. As a buyer, transferring all the risk to meet any changes to the law is clean, but it can also be expensive. For a supplier to assume all risks associated with changes to laws the contractor will include a contingency in their price to cover that risk. The buyer will either win or lose when you force a supplier to carry contingencies. If a new law is passed the buyer may win or lose depending upon the amount of the contingency that was included in the price versus the supplier’s cost to implement the change. If the supplier’s cost is greater than what was included in the contingency, you win. If the cost is less than what was included in the contingency, you lose as you paid the supplier more in contingencies than they had to pay. If the law isn’t changed or a new law isn’t passed you lose as you paid the contingency and the supplier didn’t need to use it, so it becomes additional profit for the supplier.

My view is you should always consider the potential risks in the situation to determine which party should manage the risk. Some risks may be best for the supplier to manage if they can best manage and control the risk. Changes in government laws aren’t always something they can manage, especially on a long-term contract. Some risks may need to be assumed by the buyer. If you assume the risk the first thing you do is eliminate the contingency in your pricing. If the risk never materializes you save all of what you would have paid if there were a contingency. If the risk materializes later you will save. The only time you potentially lose is change occurs and the cost is greater you have to pay in the adjusted price is more than the total amount you would have paid with the contingency. In the interim you also had the use of your money.

If you know something is going to change but are not sure how much, there are a number of approaches you can take. You could agree to adjust the price. You could also set parameters to reduce the amount of the contingency where adjustment are made only if the cost falls outside of the range. If the cost falls below that range you agreed you get a price reduction. If the cost falls above that parameter, you adjust the price. That type of band approach is frequently used when dealing with the risk of fluctuations in currency exchange rates.

I would never agree with language about anything that is "as amended from time to time" unless I also had the right to an equitable adjustments to the cost, time for performance, etc. necessary to meet the changed requirement. A buyer cannot change a specification without compensating a supplier for the added cost of the change. Why should a government mandated change be any different? Even then I might not agree unless I knew that I would be able to recover all investments that were needed to comply. Making a change in a per-unit price or contract amount doesn’t work unless there is a corresponding volume across which one time investments can be amortized.

Many times a supplier that is not contractually required to make changes will make the changes anyway simply because it’s the right decision for their business. For example when the European Economic Union passed RoHS (Restriction of the Use of Certain Hazardous Substance), (which is an environmental law that banned the use of certain materials in products because of concerns over ground water contamination in the disposal of product after the end of their useful life), suppliers knew that if they didn’t meet those requirement, their products would not be used in their customers products that were being sold in that huge market.

If you do push for a supplier to be fully responsible to comply with all applicable laws, don’t be surprised when they seek to limit the scope of that to a limited number of countries that represent the highest volume of your sales, as that will also equate to the highest consumption of their products.