October 2008 will be remembered for years to come as the U.S. economic crisis redefines the commercial landscape. While many companies are facing pressure directly from their financial woes, many more are struggling to deal with the broader challenge presented to the credit markets. Potential home buyers with reasonably good credit are struggling to find mortgages, offsetting the opportunity created by falling real estate prices. Retail automobile sales have dropped to all-time lows as consumers await more fuel efficient vehicles and struggle to find credit.
For entrepreneurs and small business owners who provide non-luxury goods and services, the combination of tight credit and economic anxiety have made doing business as normal a thing of the past. In the absence of affordable credit, however, companies which provide counter-cyclical products should ride out the economic storm if they plan ahead.
The alternative to a fluid credit market harkens back to a commercial barter system. A good barter economy allows those who have excess products to trade those products with other producers that have excesses of other products. In the same way, for businesses struggling to grow, coordination of excess productivity may create new opportunities.
Through joint venture agreements, profit participation agreements or installment contracts, companies can pull together to reduce part of their cash-flow burden and reduce the impact of poor credit markets.
Joint Venture Agreements. For companies that have many interests in common, one potential model is the joint venture. In a joint venture, an agreement is reached between two companies to pool particular resources for a common goal. For example, a manufacturer and distributor may seek to create a joint venture for sale of a product to retailers. In this way, the manufacturer selling those products to the distributor does not need to wait thirty — or sixty — or ninety — days for revenue to come from the distributor. Instead, the manufacturer and distributor together sell the products to the retailer or the consumer. This same model may work for parts manufacturers, which prefer to accept a business portion of the revenue stream from their parts than risk their buyers being unable to make their payments.
The terms of such a joint venture must clearly be spelled out. Because they are agreements of necessity, they should be relatively short-term contracts. The scope of the venture should also be clearly defined. It may be defined by the number and type of units manufactured, the length of the agreement or the stated dollar value of the products contributed to the joint venture. Similarly, the scope of the agreement should clearly be specified so that neither joint venturer can claim it is entitled to more than the specified return under the agreement.
The joint venture is not a partnership, and the contract should state that clearly. To further avoid being perceived as a partnership, the contract must clearly state the responsibilities and range of authority granted to each member of the joint venture. Moreover, it is likely that the joint venture will not be the only arrangement made by the parties, so the agreement should specify that both parties have the right to conduct business outside the joint venture and waive any conflict of interest that such competing activities might create.
At the same time, such competition must be handled with good faith. Take, for example, the situation where a parts supplier entered into a joint venture with a customer to create and sell a finished product. Prior to the agreement, the part’s cost reflected 35% of the sales price and the part supplier provided 75% of that part to the manufacturer. The agreement would likely provide that the parts supplier was to receive 35% of the receipts on the sale of all products which incorporated the part. The agreement should further stipulate that the manufacturer would utilize at least 75% of the part from the parts supplier. Depending on the relationship and other factors, the agreement might provide that all parts of that type were to come from the parts supplier. The important aspect of the illustration is that it demonstrates that the numbers need to be specified in the agreement.
Revenue Sharing. If a joint venture is too detailed an arrangement, another alternative is to use a revenue sharing model for the parties. Rather than pay for goods or service directly, a distributor may wish to switch to a royalty model, paying a higher amount based on goods or services actually sold. Like the publishing industry, which pays most authors a royalty on books sold — and not returned — the risk of sale is shifted to the author from the publisher. Authors who receive large advances are protected from the risk of poor sales. In the same fashion, a royalty model with a negotiated advance can allow the parties to craft an appropriate shift in the risk of poor sales or non-payment, while reducing the importance of credit to the transactions.
Installment Contracts. The economic arrangement most in vogue during the Great Depression was the installment contract. An installment contract is really nothing more than a form of self-financing whereby the seller of an expensive item — such as a farm tractor or supercomputer — can reduce the upfront cost of the sale by selling the item on an installment plan. The cost of the monthly or annual payments includes both the purchase price and an interest rate. If the payments are not made, the contract terminates and the property is again owned by the seller.
Installment contracts are more heavily regulated than other forms of risk redistribution because they were sometimes the source of economic abuse during the Depression. Nonetheless, these agreements provide both sellers and purchasers of large equipment with an opportunity to circumvent the difficult credit business and make arrangements to work carefully together. In the case of supercomputers, the installment contract was accompanied by a service agreement to assure that the complex equipment was adequately maintained. In high-tech fields, companies never really expected to purchase equipment through to the end of the contract. Instead, provisions in the agreements created economic benefits to stay with the same vendor when switching to an updated machine.
Installment contracts with service agreements and upgrade provisions have great potential to solve some of the difficult problems sellers and buyers of complex equipment face today. Whether used by hospitals or alternative energy companies, these arrangements provide realistic alternatives to difficult financing challenges.
Conclusion. When joint ventures, profit participation agreements or installment contracts work effectively, then can result in extremely strong ties between the economic collaborators. If properly drafted, the parties can also extricate themselves if the arrangement turns out to be less complementary than hoped. Through diligence and planning, these tools can help keep the wheels of industry turning even when credit’s important ability to grease the gears is lost.
About the author. Professor of Law, Hamline University School of Law, and Of Counsel, Gallagher, Callahan & Gartrell, Jon Garon is author of OWN IT, The Law & Business Guide(tm) to Launching a New Business through Innovation, Exclusivity and Relevance, which provides a step-by-step guide to developing successful start-up companies using concepts of intellectual property in all aspects of business planning and financing.
*Jon Garon is admitted in New Hampshire, California and Minnesota. He can be reached at 800-528-1181.