Product Development Outsourcing Agreements: What You Must Know

There are many financial models under which clients of product development consulting firms choose to engage. Start-up and early-stage companies often look for flexibility in how they engage with PD partners and might -- and often do -- seek alternate ways to stretch their dollars. Our firm has recently started seeing non-traditional approaches to funding development even with larger companies. Here are several funding scenarios.

Direct Fee for Service

This is a very simple and therefore most common means for engaging a product development partner. The client outlines a project definition as explicitly as possible. The PD partner then provides a fixed price or time-and-materials proposal in response to the client's needs. In general, the more well defined the scope of the engagement, the more likely the PD partner can bound the project tightly to offer a fixed-price proposal. This is the cleanest of client-vendor engagements.

Engagement for Equity or Royalty Stake

In this method, the client engages the PD firm without direct payments for non-recurring expenses. This model offers the PD partner a future benefit based on the success of the client or the product offering. As with a direct fee-for-service model, getting this down to the right equity proposition or royalty level on product sales is predicated on the PD partner having a clear understanding of the project scope and resources (labor, materials, etc).

There are a few other considerations for such an engagement. First, the client must realize that the PD partner is taking on risk for the product or the company. The PD partner will want to know the nature of the risk, plus a clear understanding of the market opportunity and how the client plans to realize that opportunity, in order to recover a benefit either through product or service sales.

With equity exchange, the client may also be expected to provide information similar to that provided to investors. That is, investors will want a clear understanding of the business plan.

For the PD partner, engaging in a project with funding of this type assumes a higher level of risk. The client must realize that the PD partner is entitled to a higher potential economic benefit because it is willing to take on greater risk. In simple terms, the risk/reward assessment has to be favorable enough to warrant the risk.

This may be a good means for a tightly-funded startup or new business to stretch limited dollars. The client should, however, realize that if it attains success, it will pay more for the services from the PD partner than if it engages in a much less risky (to the PD partner) direct fee-for-service program. Besides the near-term economic benefit, an engagement of this type tends to create an enhanced partner relationship between the PD service provider and its client. Both parties will have meaningful "skin in the game," and this helps ensure that true product success in the marketplace (not just meeting the original stated product requirements) is the ultimate goal of the engagement.

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Engagement for Manufacturing Rights

This is a model whereby a firm is willing to productize a design or develop a product for a client in return for exclusive manufacturing rights. This type of arrangement is often used between Asian manufacturers (which have PD capabilities) and businesses large and small.

The name of the game here is about product volume and selling price from the manufacturer to the client. In such an engagement, a manufacturer will want to have a clear understanding of product requirements and definition, as well as volume projections over some period of performance. The manufacturing and engineering partner (often called an ODM - outside design and manufacturer) will often absorb all (or substantially all) of the product realization costs in exchange for generating returns through selling finished products to the client.

In order for this model to work, and to attract interested ODM partners, the client will need to be prepared to make substantial commitments around volume. There will likely be contractual assurances required around volume, along with financial commitments.

This kind of arrangement becomes viable when a client has a high-volume projection with a rapid ramp-up -- all backed by a solid business plan for execution and a willingness to make volume commitments. All of this by the client must be backed with a substantial financial commitment. The benefit here is that the client may be able to avoid early cash commitment and will have a partner with substantial "skin in the game." This is a very tight partnership.

There are precautions here. The client needs to map the right ODM partner to the opportunity. It would be nice to think that a startup is using the ODM to make the next iPhone. Certainly, the quality processes and capabilities of an ODM will have been well vetted. However, realize that if the scale of the client's business is radically below that of, say, Apple, it will have little chance of getting the "A team" at the ODM assigned to the program.

Clients in this type of situation should not be surprised if their product production needs play "second fiddle" to the demands of bigger ODM clients. It is crucial to get the right ODM where the client's opportunity is inherently of high value to the partner. There are ODM partners out there that are scaled to serve large clients, and then there are those that serve small to midsize clients.

Another caution here for the client is it can be very difficult to extricate from an exclusive manufacturing agreement. This is more than a legal permission to terminate. Clients that have to change manufacturing partners have to be concerned with who owns the intellectual property, the product drawings, or other manufacturing data. Who owns any specialized equipment or tooling to make the product? Even if one can extract all the fixtures, equipment, and tooling, will this equipment be portable enough so that it can easily be utilized by a new partner?

Lastly, engaging in an exclusive arrangement with an ODM partner limits the client's ability to secure competitive bids. While the initial pricing may have been agreed to, do you, as a client, know if you are getting the best or reasonable product cost structure? Trying to extricate from a contract or move manufacturers can be a risky, expensive, and time-consuming activity - especially if the client is already committed to a manufacturing flow rate.

Hybrid Approaches

None of the prior approaches are absolutes. In the case of royalty or equity arrangements, the client can also consider options whereby it pays for part of the non-recurring expenses as accrued (either at cost, a steep discount, or a below-market rate). Both the PD partner and client might prefer such an arrangement, as it reduces the risk for the PD partner (with commensurate reduction in upside reward potential). A client may prefer this in that it gets the early out-of-pocket costs into a range it can swallow without giving away too much of the downstream potential benefit. Likewise, it is also common for an ODM partner with an inherently lower cost of PD labor to charge a greatly reduced fee for product realization in exchange for reduced financial and contractual commitments on the back end. Again, this is all about managing the risk/reward scenarios for the client and the ODM partner.

The world is definitely changing as it relates to funding of product development. While the old models are still prevalent, new models are being used to offer potential benefits to both clients and their PD partners.

Mitch Maiman is the president and co-founder of Intelligent Product Solutions (IPS), building on a vision of delivering a new model for software and hardware product development that integrates the full spectrum of design and engineering disciplines as a single-source solution.