WHITE PAPERS:
Insights of a Remote CEO
Pre-Sale Strategy -- Successful Preparations
What is a Virtual CFO?
Going Global: Opportunity or Quagmire?
Seven Biggest Challenges Small Businesses Face
Contract Negotiations: Do You Understand the Math?
Bridging the Information Gap
The Point of No Return
Beware of the Working Capital Adjustment
Benefits of Outsourcing the CFO Role
Does Your Company's Finance Department Earn a Passing Grade?
Pre-Sale Strategy -- Positioning Your Company For Maximum Value
Managing Your Bank Relationship in Times of Financial Covenant Violations
Effective Due Diligence - Do Not Miss These Two Key Steps
When a Company Needs a Business Consultant
Contract Negotiations: Do you Understand the Math?
A client asked me to review a revenue and profit
share calculation related to one of its technology
licensing deals. I will refer to my client as
“TechCo”. In the past TechCo had sold their
technology via direct channels to business users.
Recently, it had the opportunity through a third
party, “PayMeCo”, to widen its market share. The two
companies subsequently entered into a revenue/profit
share agreement. PayMeCo’s responsibility was to
obtain new distribution channels. TechCo would
provide the technology and manage implementation and
ongoing support. The two companies entered into an
agreement to split the revenues 60% to TechCo and
40% to PayMeCo. But the agreement also provided that
TechCo would be entitled to recoup its
implementation and support costs.
After the
first quarter of the relationship, TechCo was
obligated to pay PayMeCo for their share of the
revenues to date. The CEO of TechCo presented me
with the following calculation of the profit share
for PayMeCo prepared by the head of TechCo’s product
division.
Total new distribution channel
revenues
Less TechCo implementation
and support costs
Net amount for
revenue share
PayMeCo share
percentage
Amount due to PayMeCo
$ 6.0 million
$ 1.1
$ 4.9
x 40%
$
2.0
After looking at the calculation I asked to see the contract between the parties. I looked at the licensing agreement language relative to the share calculation. The agreement read as follows: “PayMeCo shall be entitled to a 40% share of the revenue derived from distribution channels directly attributable to PayMeCo activities. TechCo shall be entitled to offset amounts owed to PayMeCo for 100% of the implementation and support costs incurred by TechCo directly associated with revenues generated from PayMeCo distribution channels.” The rest of the revenue share language just added clarification of what costs could be included and how they could be calculated. Unfortunately it was somewhat vague and didn’t include any calculations or examples of the contemplated share methodology.
I then went back to the CEO and presented the following alternate calculation:
Total new distribution channel revenues
PayMeCo share percentage
PayMeCo share
Less TechCo implementation
and support costs
Amount due to PayMeCo
$ 6.0 million
x 40%
$ 2.4
$ 1.1
$
1.3
The company prepared calculation deducted the implementation and support costs off the top before applying the 40%. My alternate calculation deducted TechCo’s costs after applying the 40% share of revenue. This alternate calculation resulted in a reduction of the amount due to PayMeCo of $700,000, 35% less than was owed under TechCo’s calculation.
The CEO reviewed the calculation, scratched his head, and then looked up at me and said “ Wow there is a big difference between the results of the two calculations. But I am not sure which one is correct. They both make sense; neither looks wrong. We will have to take a long look at this and figure out what to do.”
I then asked the CEO who was responsible for crafting the language regarding these financial terms of the agreement. He told me that the head of the product division and their in-house counsel drafted the language, which was edited by both parties during negotiations. I asked if there was any involvement with someone from the finance side of the company? He said, “no.”
I wasn’t suggesting that my
calculation was correct and that the
other one was incorrect. I was just
showing the CEO that the contract
language was sufficiently vague so
that alternate calculations were
possible. I don’t know which method
is right. The true intent can only
be determined by those involved in
the negotiation of terms; although
it is very possible that both sides
put insufficient thought to these
terms. I do know that there should
have been someone with a finance
focus involved in the creation of
the arrangement to make sure that
the math made sense and was
appropriately constructed and
described in the agreement to
reflect the true intentions of both
parties.
Ultimately TechCo
will have to have some serious
discussions about the original
intent of the arrangement and may
have to have a difficult discussion
with PayMeCo. That matter is yet
still unresolved. But it just shows
how important it is for a finance
person to be involved in every facet
of a company’s operations. There is
substantial benefit to be derived
with finance leader involvement in
sales negotiations, pricing
strategies, contract negotiations,
vendor contracts, and many other
areas. Make sure you have a capable
finance leader that is involved in
all significant aspects of the your
company’s operations so that you
don’t find yourself in TechCo’s
position.
This white paper was written by Steven Bell