Question: Revenue-share arrangement with a vendor

We are a 40 people IT service company, and rely heavily on our offshore vendors for service delivery. In fact, they employ more than twice the number of employees on our account.

Their billing so far has been on the basis of Full Time Employees (FTEs) they hire on our account. In the past, their billing has been out of sync with our revenues.... maybe due to hiring delays/ overhead costs etc. This leads to further unpredictability in our margins.

The vendor has now proposed to tie their billing to our revenues (average % of last few months).

Need your advice in considering this proposal.

Thank you.

5 Expert Insights

Sounds like this "vendor" wants to be your "partner."  Do you know you don't want to explore working with them more intimately? (In which case maybe the question's more about who to work with, rather than how to work with them.) Otherwise, how could that not be a good discussion to have, if done in a way focused on intentions and with an open mind about the best strategy to do it?  If nothing else, you might find a better way to align yourselves together than the initial idea.

Maybe start from what you're each looking for for the relationship to be a success.  Find overarching goals that integrates that.  Explore some means to align compensation to that goal--it might not be just revenues; maybe there are some quality indicators as well.  And/or maybe you want to put some constraints to protect you both (although I'd caution on overengineering that type of thing).

I'll confess a bias in this answer.  Part of it comes from 10 years doing incentive design 25 years ago in my career, so I'm always looking for ways that people can better align their interests.  The other is my own practice: I figure I have the capacity to work with about 100 clients a year, so each client represents 1% of my earnings potential.  For most clients, my fee structure is: I charge 1% of their earnings.  That's pretty unusual, so take my response with a grain of salt!

I agree with Mark Hurwich's main points - i won't comment on his own practices.

To add to his thoughts, you might also consider how many vendors you have. With a focused set of vendors you will be able to develop lower project management costs and better quality (measured in fewer bugs and better on time delivery).

In this process of exploring a deeper relationship you might also look at your strategic plan. Examine each of the vendors from the point of view of how well they support your present work, and, more significantly, since a deeper relationship implies a longer one, how well the vendor's strategic objectives and resources support your future needs.

With all of this in hand, the financial part will probably fall out pretty easily.

I would say Caveat Emptor - let the buyer beware - to this one!  What may be a great idea on the surface of the car may not be so good when you look on the hood.

I've seen a number of these arrangements work out very well, but the keys for that were clear expectations around metrics, responsibilities, and actions.  Without those, an arrangement like this is a recipe for a train wreck.

For example, I know of one nonprofit professional association who entered into an agreement to find new members with a telemarketing company.  Unfortunately, the contract was not well written, and at the end of the day the Association owed a telemarketing company far more money than it should have and forced it into a near bankruptcy.

My corporate attorney once said that a contract is the "rules of war drawn up in peacetime."  If you do decide to enter into an agreement like this, and I am not saying that you shouldn't, be sure that all the details are well spelled out and both sides have a clear understanding of them.

You are entering into a partnership, and a partnership is just like a marriage – are you ready to go the long haul, because that is what it takes for arrangements like this to be successful.  

The devil is in the detail thus a generic answer would not suffice. That said, and agreeing with Drumm, it sounds as if your vendor is adding insult to injury. He knows you apparently over depend on him thus, as stated above 'compensating you' for HIS delays by becoming a partner...doesn't make sense to me. I would suggest a deeper review of what is good for your company's long term health.

Good Luck!

Having written several vendor and partner agreements, here's how I would approach this.

How important is this vendor?  is it strategic?  Or are their FTE's duties easily replaced by another offshore partner?  If not strategic, I might take the opportunity to better align how you pay them with your revenue cycle to offset the unpredictability you mention in your note.  But on your terms, not theirs.

Tying to % of revenue is tricky - they'll ask for audit rights to your revenue which most folks don't want to share.

Perhaps you can negotiate the right percent (I would do it on profit, not revenue), then share with them the resulting fee.  For example, if you agree in principle on a number approximately equal to 3% of profits, then you can calculate the amount and offer that - $0.50 per unit sold (whatever business measure you have).

So, if it is a strategic vendor, they will feel good that you took their request seriously with an offer "tied to revenue" but you're reducing your risk by aligning to a cost / metric that fits your financial model .