Sometimes Things Change
One of the most common analogies used by law school professors when explaining how parties to a contract, and particularly to long term contract, should approach defining rights and responsibilities is that of a marriage. Among other attributes, both constructs are best served by consideration, respect, fairness, and flexibility. It is this latter concept of flexibility that we dedicate this article to.
Both buyers and sellers tend to prefer flexibility when entering into long term agreements; although typically for different specific reasons. Buyers tend to value the flexibility to return a good or service for any number of reasons e.g. the good or service fails to meet their subjective expectations, they no longer need the good or service. Sellers tend to value flexibility in areas where their cost base may be vulnerable e.g. the flexibility to provide a buyer with an alternate product should their costs to make or obtain the originally sold product increase. Both may value the opportunity to modify pricing terms at increments pre-dating the termination date of the agreement.
Let’s use the following real world scenario to demonstrate where prioritizing flexibility can add value when unforeseen circumstances arise during performance of a contract:
Vendor Company A (VCA) provides high end technical engineering expertise to developers and operators of major manufacturing assets and infrastructure around the world. The pool of engineering labor available to VCA and its competitors has been, is, and is expected to remain, constrained. The demand for VCA’s services is in equilibrium with labor today but expected to exceed their engineering capacity in the not too distant future.
Each asset operated by VCA’s clients are technically unique or otherwise substantially customized. In addition, each operator has ‘their own way of doing things’ from both an operational and contracting perspective.
On a Sunday: Sr. Engineer for VCA plays frisbee golf with a former colleague turned personal friend who now works for a competitor to VCA. Mid way through the round, the friend says ‘sure could use you at our place. We could give you a 20% bump to come work for us.’
On Monday morning: The Sr. Engineer – who currently delivers approximately 70% of the services purchased by one of VCA’s top 3 clients – approaches his manager and transparently shares the details of the competing offer before requesting a 25% raise in exchange for remaining on staff with VCA. [For this example we assume there are no restrictions on the employees freedom to work elsewhere].
On Monday afternoon: Management for VCA meet to review this scenario and their options. They assess the following:
– That the client serviced by the Sr. Engineer represents ~30% of the company’s annual revenue.
– That their contract with this client currently delivers a 15% margin return and supplements total margin to such a degree that without this client, total operating margin for VCA would be substantially below budget forecast for the current year.
– That while there are technically enough other clients and projects to bid on across their market that they could theoretically replace the lost revenue should they lose the client, the costs involved to win and deliver that work would make replacing the margin lost very difficult if not impossible.
– That the service contract governing the relationship between VCA and the client has a duration of 6 years, was executed 2 years ago, and allows for changes to the pricing schedule on an annual basis unless otherwise mutually agreed.
– That the client is very fond of VCA’s Sr. Engineer due in large part to the trust they’ve built over the several years they have worked together.
– That if VCA were to give the Sr. Engineer a raise of even half what they were requesting, the updated economic model of the contract’s performance would no longer meet VCA’s internal commercial governance standards.
– That VCA does reliably give annual pay raises to the engineering team.
That’s a lot. But before we dismiss this scenario as too niche to yield useful insights, let’s consider the headlines: Tight labor. Long term service contract. Client relationship primarily held by member of service delivery team. Maybe this isn’t such a niche situation after all.
So what options would VCA have without flexibility in their client contract?
A) Tell Sr. Engineer ‘No’ > Sr. Engineer leaves to take the opportunity with VCB > VCA’s client chooses to ‘no schedule’ future work with VCA and shortly thereafter is a client of VCB *Let us assume there are no valid limitations on either the client VCB’s ability to work together.
B) VCA tells Sr. Engineer ‘No’ > Sr. Engineer leaves to take the opportunity with VCB > VCA continues to serve the client but sustains some performance issues as the Sr. Engineer’s replacement gets up to speed with the client’s assets > the relationship suffers.
C) VCA tells the Sr. Engineer ‘yes’ > VCA asks the client to renegotiate pricing to reflect the incremental increase to VCA’s service delivery costs > the client declines stating ‘this feels both unnecessary and untenable given we just agreed to updating pricing two months ago and our current contract does not provide a process mechanism for off cycle modifications’ > VCA absorbs the cost increase and resulting impact to project and portfolio margins > fails to meet this component of their annual budget targets.
How would including a mechanism that allowed for mutually agreed to modification off cycle impact VCA’s options?
D) VCA tells the Sr. Engineer ‘yes’ > VCA asks the client to renegotiate pricing to reflect the incremental increase to VCA’s service delivery costs > the client accepts the request and agrees to re-visit the current year pricing schedule because the contract provides clarity regarding how to execute this process efficiently and without undermining the enforceability of the contract.
There is no doubt that VCA, the Sr. Engineer and, one could argue, the client, are better served through option (D). The Sr. Engineer has the opportunity to maximize their income, the client while not taking on an absolute obligation has the opportunity to reinforce the stability of their supply chain, and VCA has the opportunity to further stabilize a major revenue source and reinforce their budget performance.
Of course having flexibility in terms only preserves options. Any proposed modification will be subject to bona fide analysis by counterparties and will have to be justifiable from their perspective(s). But if a proposed value add modification is the destination, then flexibility through clearly defined modification mechanisms is an excellent bridge contracting parties may use to get there.