Outsourcing
“Y2K is a crisis without precedent in human history.” – Edmund DeJesus, Byte magazine, 1998
If you search online you will find as many videos, talks, books, and articles that are pro- outsourcing as you will ones that are anti-outsourcing. Let me be clear what I mean by the word outsourcing for the non-employer business.
As a non-employer business you have no choice but to outsource. That does not mean, however, that you base your customer service function in Siberia.
The clip I attached to this activity actually says everything I want to say about it. The point of outsourcing is to relieve you of the need to manage people, systems and tasks in order to focus on growing the company. The fee-for-service contract model also allows you to better manage cash-flow at the start.
For a small business there are usually plenty of outsourcing options available locally. Perhaps one day you will be so large that saving a few cents on a widget matters, and at that time you can consider Siberia or even building your own widget plant. In the meantime, you are totally focused on growth and cash-flow and outsourcing is the mechanism for that.
I think outsourcing makes common sense at the outset and than at some point vertical integration makes sense. You’ll decide when. Unless you are the next Elon Musk, vertical integration at the start is madness. Even with Elon it almost bankrupted him a half dozen times before his PayPal pals rode to his rescue. (see Elon Musk biography by Walter Isaacson)
Let’s start with a fun case-study:
Mattel
Ruth Mosko grew up as a tomboy who shunned dolls. Elliot handler grew up an artist. Two most unlikely entrepreneurs in the making.
Ruth was a secretary for Paramount Pictures in Los Angeles when she married Elliot Handler in 1938. While attending design school, Elliot got a job designing light fixtures. Elliot was fascinated with new materials, especially an acrylic plastic called Lucite that had been used up to that point only in the defense industry. His sketches and mock ups of plastic furniture impressed Ruth.
Their first apartment came with half a shared garage. They did not have much money so Elliot made their furniture in the garage out of the lucite. In their half they made coffee tables, end tables, and lamps for their apartment, then used the leftover material to make hand mirrors, candle holders, cigarette boxes, and bookends to sell to friends. Ruth asked Elliot to make her samples so she could try selling the designs at work. Orders came thick and fast and the garage became a factory.
When those who shared the garage complained to the landlord, the Handlers were evicted.
Elliot quit his job and dropped out of school. They moved into another apartment, and they rented a disused Chinese laundry for their workshop. Ruth, still working at Paramount, made sales calls with the samples during her lunch hour. “I found that I loved the challenge of selling,” Ruth recalls in her autobiography. “Adrenaline surged through me whenever I walked into a store with samples and walked out with an order.”
The plastic business in the Chinese laundry attracted four partners and quickly rose to become a $2 million enterprise making gift-ware and costume jewelry. That would be $24 million in today’s money, and probably most entrepreneurs would be satisfied at that point. There is, however, something quite addictive about building companies.
In 1945, Elliot Handler had a dispute with his partners and he sold his interest in the company at a loss. Meanwhile, Ruth hooked up with an old friend, Harold “Matt” Matson, and they started Mattel Creations, with Elliot designing products. (Combining Matson’s last name with Handler’s first name formed the name Mattel.) Ill health soon forced Matson to sell out.
Mattel started by making picture frames using scrap plastic and wood. With the leftovers, Elliot Handler designed dollhouse furniture, which soon proved to be a far more lucrative business than picture frames.
Ruth Handler formed a simple sales organization, and the company bounced along, barely breaking even for two years, but they realized that a bigger market existed for children’s toys than picture frames. Given the impact of the war years on the United States economy and infrastructure, not many companies still existed that made toys.
The “Uke-A-Doodle,” a miniature plastic ukulele, was an immediate success and drew large orders.
Mattel incorporated in 1948. At the same time, the Handlers and an outside inventor began developing a music box employing a unique mechanism. A shortage of capital and the refusal of banks to gamble on the struggling young firm put the project on hold. With a $20,000 loan from Ruth Handler’s brother-in-law, (equivalent to $200,000 today) however, Mattel completed the project and produced another winner.
By 1955, sales climbed to $5 million but profits were still low; the company introduced another hit, Burp Guns; and the Handlers decided to take a gamble that would change the toy business forever. In what seemed a risky venture, they agreed to sponsor a 15-minute segment of Walt Disney’s Mickey Mouse Club on the ABC television network for 52 weeks at a cost of $500,000, equal to Mattel’s net worth at the time. Mattel’s sales reached $9 million, and the following year hit $14 million. Then in 1959, Mattel introduced the Barbie doll, the best-selling toy of all time with close to a billion units produced. Ironically Barbie was tomboy Ruth’s brainchild.
In 1960, Mattel went public, and by 1963 its common stock was listed on the New York Stock Exchange. Mattel began a decade of expansion by acquiring other toy manufacturers. The history books call this time in Mattel’s history one of stretching themselves too thin, but the simple lessons of cash flow management apply to the largest global corporations in exactly the same way as they do a simple home-based business.
In 1970, Mattel’s manufacturing plant in Mexico was destroyed by fire, and the following year a shipyard strike in the Far East cut off its toy supplies. Mattel had no back-up plan and insufficient cash and inventory on hand to see them through such a crisis.
To maintain the appearance of corporate growth, Seymour Rosenberg, executive vice-president and chief financial officer, cooked the books by reporting orders as sales, although many of the orders had been canceled and shipments had not been made. For two years Mattel issued false and misleading financial reports, until 1973, when the company reported a $32 million loss just three weeks after stockholders had been assured that the company was in sound financial condition. Mattel’s stock plummeted and the Security and Exchange Commission (SEC) stepped in to investigate.
In 1974, Rosenberg was fired, the banks pressured the Handlers to resign, and the court ordered Mattel to restructure its board so that its majority would be company outsiders. In addition, the court fined Ruth Handler and Rosenberg each $57,000 and gave them 41-year sentences, which were suspended on the condition that they both performed 500 hours of charitable work annually for five years. Finally, in 1980, the Handlers cashed in most of their Mattel stock, ending their involvement in the company they had founded. Comprising approximately 12 percent of the company, the stock was worth about $18.5 million ($52 million in 2011 money).
Mattel is currently valued at a market capitalization of $10.5 billion.
There are enough business lessons in this one case study to keep MBA students occupied for a week. The Handlers were certainly able to adapt to changing markets and better opportunities, and were prepared to dilute their ownership in exchange for cash. It was, however, the lack of a back up plan for their virtual manufacturing strategy that triggered a cash flow crisis that almost brought this company to its knees. It is that aspect of their fascinating story that we need to focus on here.
Outsourcing Preserves Cash-flow
The most obvious way to preserve cash is to not have to spend it in advance of revenue showing up. This simple premise known to every homemaker is often overlooked by even the most sophisticated businesses. Most companies believe their own BS and in anticipation of a launch or a product line extension will invest in anticipation of demand, build up manufacturing capability, inventory, distribution and retail positioning.
To bridge the time between investment and receipt of revenue requires patient investors and bankers, the sort that stood with Amazon.com Inc. for all those years before it finally turned a profit. That patience is rare, and it could be said in the case of Amazon that so much money had been invested that the creditors had no choice but to complete the ride. Small businesses are less fortunate and investors usually want to see a return on investment sooner.
The virtual company has an immediate advantage with its business model. The outsource aspect of the business model works differently to the “build it and they will come” mentality. It is based on a fee-for-service contract with built-in volume discounts. This permits starting small and ratcheting up or down as needed. The upfront investment is minimal and contracts can be customized to delay payments in order to allow revenue to catch up.
Outsourcing contracts can be put together rapidly because perfectly qualified vendors who specialize in specific aspects of a business already exist. Typically they make their money by providing add-on services to larger companies that are expanding too quickly for their own resources. For the small business they are a ready-made solution.
Vendors are easy to find with a little online searching. Dealing with them is never more complicated than picking up the phone and chatting to their business development representative. Oftentimes if the vendor thinks my business too small for them they can recommend good alternatives that may or may not have shown up in my search.
Due diligence
Once a general verbal agreement is reached then all that remains to do is to get references and perhaps do an in-person visit to their facilities. I highly recommend using common sense for the due diligence process. In all likelihood the vendor already has a lot of successful clients. One can assume that they have done all the due diligence that can be imagined. If you try to mimic the big boys the vendor can quite easily grow weary and decide the volume of your business is not worth the inconvenience. I have seen this happen, especially where the entrepreneur is doing due diligence in the same function that was considered their area of expertise in a regular career. You have to get the balance right between showing business caution and not being a pain in the derriere.
Attorneys?
Once an entrepreneur selects a preferred vendor, checks references to their satisfaction, and perhaps visits the facility to do an in-person audit, the process of negotiating the terms of the outsource contract starts. Negotiating is an easy practice made difficult by people who let their egos rule over their brains. Then attorneys can get involved and what should have been a simple, quick matter gets bogged down in endless rounds of wordsmith games that drive everyone mad.
If you have a friendly, inexpensive, attorney that you can use to check contracts quickly and pragmatically then by all means use him or her. Unfortunately, my experience with attorneys has been a painful one.
Again, I find that a little common sense goes a long way here. Because you are new, small, and not worth a lot of profit to the vendor right now, burdening them with complicated contracts, and attorney wordsmith games can result in them deciding that your business is not worth the legal cost or effort. They have bigger fish to fry, and your real challenge at the outset is getting them to pay you any attention at all.
Most vendors will have gone through exhaustive negotiations with larger clients involving an army of highly-paid attorneys, and you can use that to your advantage. If the template contract that they supply was agreed with a large company and its small legal army, there is a high likelihood that it is strong enough and fair enough for your new company. There is a risk/benefit decision to be made. Can you risk avoiding the high cost and time of attorney review by assuming that the contract template is largely acceptable? Attorney fees creep up on a small business like a rising tide. Some, like patent maintenance work, are unavoidable, but some are totally unnecessary.
Attorneys everywhere will be in incandescent with rage by my stance, but I managed fine without attorneys until it came time to sell my businesses. By then the numbers justified hiring expert deal attorneys. That said, I was still shocked by the cost involved. Selling one company cost over a million dollars in legal fees. It is another form of corporate insanity.
Attorneys everywhere will be in incandescent with rage by my stance, but I managed fine without attorneys until it came time to sell my businesses. By then the numbers justified hiring expert deal attorneys.
That said, I was still shocked by the cost involved. Selling one company cost over a million dollars in legal fees. It is another form of corporate insanity.
When it came to vendor contracting, I did little more than redact the contract of a larger company. The vendors appreciated the inherent trust I had in them. The fact we did not need to haggle over very much meant the contracts could be turned around quickly, which saved everyone time and money and started the relationship off in a positive spirit. In a regular company, any contract has to be reviewed by several layers of people and even the simplest of matters can take months of back and forth discussions to resolve. Time is your enemy, because people change jobs and companies change their strategic directions all the time. As an entrepreneur you have to decide what is more important. Is it getting the vendor you want as a long-term partner or is winning an argument about the wording of a term or clause?
Common sense Contracts
This is where ego usually trips up people. Entrepreneurs often believe that winning a negotiation is the goal. It is not. The goal is simply getting started with the vendor you want. So what if you look back later and think you could have held out for better terms? Contracts can always be changed and re-negotiated in the future when you will have the resources and power position to handle it. Right now you need to be focusing on attracting customers, not spending hours at your desk fighting with company attorneys over which state’s legal jurisdiction is to be used.
You must also be aware of the very natural human reaction to negotiating. Rarely will one person propose something without the opposing person countering. It is our nature. In fact most negotiating skills classes teach that behavior. They say never agree to a proposal without attaching a concession. In other words the skill goes like this, “We can agree to the 10 percent discount on condition that you agree to (fill the blank).” That is all well and good in the regular corporate world, but it can be death for the small business.
I have seen two $100million deals, in which everyone was in agreement on the big things like deal value and terms, collapse over a concession that would have cost $3000 or so to either party. Egos got in the way of common sense.
I have also seen start-ups collapse because the founders fell into the trap of negotiating every aspect of a proposal. By the time everyone was about to reach agreement, the source of financing simply changed his mind. There are millions of start-ups lining up to take your place, so common sense and speed are the keys.
Typical Elements of an Outsourcing Contract:
Scope of Service clearly laid out in detail.
Their management fee. This is typically a nominal amount that covers the person-hours of the account manager on the vendor side. You can usually add a fee-free period of, say, six months.
A one-time set up fee that covers the vendor’s administration costs.
A fee-for-service arrangement for the scope of services provided in which the vendor bills monthly or quarterly. In this part you can consider volume discounts or volume incentives that lower unit costs over time.
The length of contract depends on how you feel about the vendor. Starting out it is better to go for a short-term (1-2 years), automatically renewable. It is important to agree a lengthy period for notice of cancellation, because you need time to find an alternative vendor if either side does not want to continue the relationship. When you feel the relationship is working well you can go back to the vendor and extend for a longer term like 5 years.
Add language that calls for formal review periods quarterly for the first year and annually thereafter.
Termination clause that allows you time to find alternative vendors.
Responsibilities of each party.
An ideal contract would include terms with a small monthly management fee that covers administration costs at the vendor’s end with everything else thereafter based on volume pricing. That gives your company the flexibility it needs to manage cash flow by spending only based on activity. The vendors should also be sympathetic to your need to manage cash flow with a 60 to 90 days payment terms. That means you have 60 to 90 days to pay their invoices before overdue interest payments apply. If they have strict repayment terms, ask them for a 12-month exception so you can have time to build up revenue and allow start-up costs to flow through. They are businesses too so they should understand your need.
Whether it is accounting, manufacturing, or commercialization, I have found all vendors willing to work out a deal. They exist in competitive fields and work on small margins, and are usually keen for the business. They also know that your company might be a great success and the long-term benefit is what everyone should focus on. There is no greater advertisement for a vendor than to be able to boast “We were their first vendor at the beginning and we are their billion-dollar vendor today. Look how we helped them succeed.”
Resources
TED talk on startup success.
