Structuring Incentives in Fair Trade Outsourcing (Part 1 of 2)
I wasn’t always a good practitioner of fair trade. In fact, I only became engrossed in fair trade practices when I made an investment in coffee, which I love. That investment fell through, but my passion for fair trade continued to flourish. One of the first questions I asked myself back then was “can fair trade be applied to the outsourcing industry?” The thought excited me.
The possibility of doing that with my own company and making an impact on the lives of my employees never left me. That’s how I formed my business philosophy, which I call Fair Trade Entrepreneurship.
Keep in mind that I am not here preaching this philosophy without experience. If you’re an entrepreneur reading this, trust me — you’d make both more revenue and profit when you apply the golden rule liberally in your business dealings.
Do that while you make use of four tools of Fair Trade Entrepreneurship that I’m providing you through a series of articles. These simple tools are based on the principles of Fair Trade, which can be applied to your relationships with your vendors and employees. I promise they will return dividends to you — in the form of both higher revenue and profits.
It will take some time to read them, but know that at the end, you will save yourself from the mistakes that I made — to the benefit of your employees, vendors, and yourself.
In this post, I am going to describe to you a very specific process I go through when seeking a transaction with a counterparty — which is just a wonky finance term for the person or entity with whom your contracting, but legally appropriate when we’re talking about contracts.
Roughly, I follow four broad steps when evaluating whether to do a transaction, each I will describe in detail:
- Defining business terms
- Assessing incentives on both sides
- Assessing risk on both sides
- Final question — will your counterparty make a profit?
Defining Business Terms
I’m going to assume that you’ve already made the decision to work with this counterparty, but you’re not 100% sure. This is the final step and you’re figuring out how to do it in a sustainable way.
Strictly speaking where you are now is the penultimate step in the “Dating” process with this counterparty. You think you want to get hitched, and you’re thinking about your response with your friends if you receive a proposal, but there are some rational, real-world considerations first.
As much as possible, I try and draft business terms in bullets. This is a method I highly encourage you to follow for these key reasons:
- Bullets are more organized and easier for your counterparty to digest.
- Bullets force you to be succinct in your writing, which forces you to make your descriptions of the relationship action-verb laden (see below).
- Bullets can more easily be passed along and understood — more than likely your counterparty is your internal champion and will need approval from other decision makers.
- Bullets can be easily grouped with headers or nested together — making it easier for you to show relationships between the ideas in the bullets.
- Bullets reduce your tendency to get all legalese on your counterparty.
The last bullet is one to really remember — the goal in these bullets is to capture the real-world actions that each side will take. This post is written for the business people, not the lawyers. In this case, you and your counterparty/champion are approaching this from the same perspective. What you care about is defining what the hell this relationship is so you can move past the next contract phase, get this relationship done, and achieve whatever goal it’s meant to achieve (which hopefully is to make money!).
Action Verbs are key to well-defined business terms. Here are some examples of the start of bullets I like to use that cover some of the big basics:
- We/You will provide/do/complete… (“Provide” is a really big one that I use often — it keeps your descriptions high level but clear).
- We/You will pay/compensate for…
- On X date/X day of the month/quarter/year, we/you shall….
- We/you will report X…
- We/you will decide/notify/request…
For those of you working at the enterprise level — trust me — the lawyers will appreciate you negotiating and agreeing to the business terms before you come to them. It will save EVERYONE time, and legal fees, and lower the cost of your transaction and increase its speed to close.
For those of you working without lawyers, which can be appropriate depending on the monetary size of the transaction, I highly recommend nesting bullets to cover eventualities and their potential remedies, and simply extending your terms with “Should we/you do/fail to do X, then we/you shall notify/conduct/etc.”
I know you’ll find that well-constructed bullets will greatly enhance and accelerate your dating process. Your goal here should be to get good enough at the bullets such that you use them to document agreements with counterparties when maybe you otherwise wouldn’t. Getting in this habit will save you money in the long term.
Assessing the incentives on both sides
While you were writing your term bullets, you were probably intuitively assessing your incentives for doing this transaction as you were writing them. But now that they’re done, it’s time to go through and formally assessing both your and your counterparty’s incentives for participating in the transaction. There’s a number of ways to do this, but I like to simply do some quick modeling of the financials of the transaction. We are all in market economies at the end of the day (Sorry for those of you who may be reading from Pyongyang).
If I’m selling, first I want to have either exact or approximate margin numbers, including my COGS, gross profit and operating margin. With those in hand, I go ahead and model at least the first year of revenue from this transaction. For smaller transactions, this may seem like overkill (my definition of smaller is anything less than 5% of your company’s yearly gross revenue), but remember that a quick calculation on your phone will do. I apply COGS, gross profit and operating margin to my modeled year 1 gross revenue — and I’m either happy or sad at the result and the pricing of the deal as it stands now.
If I’m happy, I proceed to the next step. If I’m sad, I may consider halting the transaction or at a minimum, I will go back to my counterparty and be honest about what I’m facing from a margin perspective, and tell them that I can’t proceed under the current proposed terms. This may sound scary, especially if you need the transaction, but you will be MUCH better off in the long term.
If I’m buying, I want to model two key things: First, do I have the budget for this? Here, I model out my monthly costs of the proposed terms and then plug that into my monthly budget (if I’m keeping one) to make sure I’m okay with the spend.
Second, am I comfortable with the trade-off? Economics is largely the study of scarcity, so in any business (or personal budget, for that matter), do I feel like spending this money is the right decision for my business — from a strategic and progress standpoint?
Third, what is my ROI? After I know I have the money for this, and I think it’s a good use of my dollars if I make this investment, do I think I will get it back? This one is important. Here, you must calculate the total spend over the life of the contract, do your best to tie the spending to either a) increase in revenue or b) decrease in costs.
Once you have either the increase in revenue or the decrease in cost — you need to then calculate the expected increase in profit from this transaction. This is crucial — do not be lulled with the false sense of security of just an increase in revenue — you must understand how much extra profit you’ll get from the transaction — because that’s why you’re buying from this vendor. (BTW — evaluating extra revenue not profit from a transaction is a HUGE mistake I made at MODsolar — and certainly contributed to its near-bankruptcy.)
The final key thing you’ll need to prove is “When do I/we get this money back?” This is, of course, called the hurdle rate. But it’s a simple calculation — just take the year 1 expected profit, and divide it by the investment amount (contract amount). If you get greater than 1, you’re in great shape.
For example, Rethink Staffing just opened a new facility in General Santos City. That center will cost us about USD $100k to open, all in. We opened it for a specific customer. That customer’s contract runs through the middle of 2020. So we have about 28 months of revenue and profitability from this center. Our profit calculations show that we will make about $600k profit on this center in the next 28 months (all factors being constant). So, we will have a 500% ROI on our investment. Should we make that investment? You bet your ass we should (and we did).
I’ll stop there, for now, these are lengthy topics which must be taken in stages. In a few days, I’ll publish the second part of the business terms discussion: Assessing Risk and Will your counterparty make a profit?
If you have questions about fair trade entrepreneurship and how it applies to your company or you want to talk generally about outsourcing and setting up a business in the developing world, feel free to contact me at mike[at]mikedershowitz.com or leave your comments below.