Wednesday, December 5, 2012

When Should a Professional Service Provider Consider Exclusive Service Contracts

This morning a friend of mine who runs a small electromechanical design and development service company asked me for my advice on customers who demand exclusivity in their contracts.  In his case he was asked by a prospective customer whether he would grant the customer exclusivity, i.e. to not work for other customers in this particular product area.  My friend asked me whether I had run into this type of request before, either at my current firm, MIE Labs, or previously at ICD, and if I had ever considered accepting this type of restriction.  

I told him yes, and yes.  While in general you should do your best to avoid this type of restriction, there are cases where this is a truly a valid concern of the customer and should be addressed with understanding.  In most cases the concern is in relation to the possibility of a customer’s IP ‘leaking’ to a competitor.  Sometimes the customer believes that they are ‘investing’ in you and therefore want to insure that you will be working for them when they need you and not a direct competitor.  Others are simply concerned about losing your bandwidth.  These are all common concerns among those outsourcing product development tasks.  The first step is always to try to understand the customer’s concerns and see if they can be alleviated short of a contractual agreement (in my experience, the vast majority of my customers over the past 17 years did not in the end need this type of restriction).  If that is not possible, the next step is to limit the scope of the restriction to the greatest extent; if one particular competitor is a concern and they are not currently a customer or seen to be one in the near future, perhaps that specific restriction would be acceptable.  Or if the specific product area can be narrowed to the point that it is unlikely you will see a similar opportunity - that might work.  In either case there should be some valuable consideration in return.

In my case, there were two main instances I can recall where we ended up accepting this type of limitation.  On one occasion, a Master Services Agreement was negotiated with a large semiconductor manufacturer who wanted us to do power management products exclusively for them.  In that instance, the mutual intention was that there would be a steady stream of business that would consume the majority of our staff doing power management designs.  We limited this restriction in our agreement by a) noting a short list of specific competitors the customer was concerned with and b) stipulating that if a certain level of business was not maintained, the restriction would be relaxed.  As it turned out, due to the downturn in 2001 the customer was not able to maintain the prescribed level of business we ended up removing this restriction, although it was a bit of a hassle getting them to first admit that the level of business was below the threshold and not coming back and then get the lawyers to implement modifications to the contract.  The lesson here is to be VERY SPECIFIC and as in all contracts consider well l the situation that you don’t want or expect.

In another case, the customer became a significant investor in our firm in order to secure a certain significant level of our bandwidth for their product developments.  There was not a specific contractual restriction involved however the investor was a Japanese company and made it clear that they would want to vet and approve any potential Japanese competitor that we might want to do business with.  In this case it was not a big problem to accept the restriction as they owned a significant portion of our company and their interests were therefore well aligned with ours.   Also the restriction was in practice not very limiting (they were our only Japanese customer) and they did provide us with a significant stream of work.  As our key investor of course I preferred not to antagonize them.

So in conclusion, do your best to try to understand your customer’s concerns and hopefully avoid this type of restriction in the first place, but if that is not practical, consider exclusivity restrictions, along with all other contract provisions that favor the customer, as a benefit you are providing and should be well compensated for in return.

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