United States: Internet And E-Commerce Fulfilment Agreements

Fulfilment agreements are one of the cornerstones of the emerging "click and mortar" business partnership model. The typical fulfilment agreement involves a situation where an online business is seeking to enlist a "brick and mortar" manufacturer, distributor or large retailer to source and ship products or provide services to its customers. While simple in concept, fulfilment agreements can present a host of difficult and interrelated challenges. In this article, a number of strategic issues and negotiation concerns associated with fulfilment agreements are identified and discussed.

The first thing that any company should do before entering into a fulfilment agreement is to define fully the short-term and long-term business strategy that underlies the fulfilment relationship. Too often, businesses enter into fulfilment arrangements without analyzing the impact that these arrangements may have on their ability to achieve long term e-business objectives. The following issues should be carefully and thoroughly considered before entering into any fulfilment arrangement.

The online business should consider the following:

• Will the proposed fulfilment relationship integrate with existing fulfilment arrangements? For example, if a customer orders two products, will the products be shipped from separate fulfilment centers? Will customer service calls require routing to two (or more) different fulfilment centers?
• What relationship will the fulfilment partner have with customers of the online business? Will the fulfilment partner have any direct contact with customers? Whose brands will be permitted on the boxes and in inserts with the shipment? Who will handle customer service?

• Are any unique service or product capabilities offered by the fulfilment partner? For example, an existing broad product inventory? The ability to quickly ship product? The ability to provide proprietary products that are not available elsewhere?
• Are there plans to develop service or product capabilities that may overlap with those provided by the fulfilment partner? If so, will the proposed fulfilment partner be needed in the future, or is the partner’s role likely to change?
• If the fulfilment partner provides a product or service that is not available elsewhere, is it important (or feasible) to restrict the fulfilment partner from providing that product or service to other online businesses, or from offering the product or service directly to customers?
• How are customers going to be provided with accurate and up-to-date inventory and price information? Most customers today demand real time inventory and price information. Has a detailed technical assessment been undertaken to ensure that customer inventory and purchase applications can be easily integrated with the fulfilment partner’s back-end inventory management and purchase order systems?

The fulfilment partner should consider the following:

• Are there plans to be a business-to-business (B2B) provider of products or services to a number of different online businesses? Does the e-business strategy include selling directly to customers online (B2C)? How will the proposed fulfilment agreement mesh with that long term strategy, if at all?
• Will the fulfilment agreement create conflicts with other distribution channels? Are there any contractual, legal or other restrictions that may prevent the fulfilment partner from providing products or services to the online business? Will the online business cannibalize existing customer relationships? If so, are there plans to transition from the existing business model to an online model?
• Are the company’s information systems capable of handling real-time transactions? Have the information systems been tested with the volume of transactions anticipated under the proposed fulfilment agreement?
• Will the product sales under the proposed fulfilment agreement provide better or worse profit margins than existing distribution channels? If worse, what are the plans to recapture lost revenue? Do these plans rely on developing direct relationships with the customers of the online business, or transitioning away from the relationship with the online business? Do these plans rely on volume targets that the online business must meet?

After the underlying business objectives of the fulfilment relationship have been thought out and defined, the terms of the agreement that will govern the fulfilment relationship can be negotiated. Some of the areas that the parties often devote considerable time and attention to when negotiating fulfilment agreements are identified and discussed below.

Pricing. As would be expected, the issue of pricing the products and services is a subject to which much time is usually devoted during negotiations. Several models have emerged for pricing, and some of the more common models are described below:

(a) Wholesale pricing for the products, where the fulfilment partner charges a scheduled "wholesale price" to the online business. This type of pricing may be combined with a "most favored nations" clause to ensure that the online business is getting the best available price, and may also be combined with volume or other discounts.

(b) Percentage of revenue pricing requires the online business to pay a percentage of the net or gross revenue derived from each sale. When this model is chosen, the parties should carefully consider how to allocate revenue in cases where the product is at a negative net revenue (in other words, who should bear the loss of a below-cost sale).

(c) Cost of product plus management fee pricing requires the online business to pay the actual cost of products sold (or allocated), plus a management fee that is usually equal to a percentage of sales or revenues. The management fee reflects an agreed-upon profit margin for the fulfilment partner. It is essential in this type of arrangement to carefully define the "cost of product." If overhead is included in product cost, for example, the management fee should be reduced to reflect a net profit rather than a gross profit.

(d) Equity kickers (stock or options usually issued by the online business) can provide consideration for providing products on otherwise thin margins. If the fulfilment partner is relying on an equity kicker to make up for thin profit margins, the fulfilment partner should attempt to obtain timeframes to ensure liquidity. In addition, if the equity kicker represents a significant part of the online business’s outstanding stock, all of the issues normally associated with private equity stock purchases should be considered.

Whatever pricing model is agreed upon, the parties should further negotiate the allocation of shipping and handling revenues (which are often a significant profit center), service revenues and costs, revenues associated with advertising (including third party inserts that may be included with shipments) and allocation of costs and losses associated with product returns, fraud and credit card chargebacks.

Exclusivity. An exclusivity provision restricts the ability of a party to offer products or services to third parties. For example, an online business may request that they be the exclusive online seller of the fulfilment partner’s proprietary products. A fulfilment partner considering an exclusive relationship, even one limited to online sales, should consider whether exclusivity conflicts with commitments to other existing or future distribution channels.

Sole Source. A sole source provision is the flip-side of an exclusivity provision; it restricts the ability of the online business to purchase products or services from any source other than the fulfilment partner. A fulfilment partner that is relying on high volume to make up for thin profit margins may require some type of sole source relationship. The online business, faced with a request for a sole source relationship, should consider whether the products and services offered by the fulfilment partner have sufficient breadth and depth to satisfy its customers. In addition, the pricing model is critical in a sole source relationship because the sole source relationship essentially removes competition on price and creates the opportunity for the supplier to engage in price gouging. To avoid this, the online business should consider obtaining some form of price protection before agreeing to any sole source term. The online business should also consider requesting exclusivity, discounts and relief from any volume commitments in exchange for agreeing to a sole source relationship.

Technology. If changes to either party's information systems will be required under the proposed fulfilment agreement, make sure that detailed specifications for such changes are attached to the agreement, that the costs for making such changes are allocated, and that there is a defined timetable for completing the changes.

Risk of Loss/Title. Specify which party has the risk of product loss (shipping errors and damage, warehouse damage or destruction, etc.) at each point in the distribution chain. The party with the risk of loss should make sure to obtain insurance. If the online business is thinly capitalized, the fulfilment partner may insist on being named as an additional insured under the insurance policy covering the online business.

Volume Commitments/Forecasts. The fulfilment partner will usually request volume commitments, and at minimum, require product forecasts on a periodic basis. The failure of the online business to meet a volume commitment or a forecast may trigger such things as liquidated damages, termination, increased compensation, renegotiation rights, or may relieve the fulfilment partner of any exclusivity obligations.

Customer Data. Both the fulfilment partner and the online business typically fight hard for ownership of customer data. An obvious compromise is to permit data sharing. However, the parties must ensure that the online business’s privacy policy and any applicable privacy laws permit customer data to be provided to the fulfilment partner. If the fulfilment partner will be using the customer data for purposes other than shipping the product, or will obtain ownership of the customer data, the customer’s consent may be required.

Performance Criteria. The online business should consider requesting performance commitments tied to objective performance criteria. For example, average time from order to delivery, average call hold time (for customer service if provided by the fulfilment partner), and percentage of back-ordered/not-in-stock items.

Branding. The parties should consider such issues as whether to use the fulfilment partner’s trademarks or service marks in connection with the fulfilment services; whether the shipping containers will contain the trademarks or service marks of the online business; and which brand(s) will be presented to the consumer at any other customer touchpoints or interfaces (such as customer service).

No Conflict. Each party should obtain a representation that the other party’s obligations under the fulfilment agreement do not conflict with any obligation to a third party. The fulfilment partner should carefully examine existing contracts involving other distribution channels to ensure that this representation is true.

Term. A short initial term (6 months to 2 years) may be appropriate if the fulfilment agreement is intended to provide the online business with immediate fulfilment capabilities, but the online business has future plans to develop overlapping fulfilment capabilities of its own. Similarly, the fulfilment partner may desire a short term if the fulfilment partner has future plans to develop its own online business. A longer term (2 to 10 years) may be appropriate for the online business if the number of product suppliers is limited, or if the online business has no plans to develop parallel fulfilment capabilities. Additionally, investors in an online business (public or private) may prefer a long term fulfilment agreement because of the stability and predictability associated with such an agreement. A long term fulfilment agreement is generally advantageous to the fulfilment partner only when combined with a sole source or volume commitment, or in instances where the competition for providing similar fulfilment services is fierce and the profit margin under the proposed fulfilment agreement is relatively attractive.

Termination. In additional to termination for material breach, the parties may seek to reserve the right to terminate in the event of a failure to meet volume commitments, a failure to have agreed-upon products in stock, or a failure to make an initial public offering of stock within a certain number of years (usually used only if the consideration for the deal includes stock).

Post-Termination. After the term of the proposed fulfilment agreement expires, the relationship between the parties will likely continue for a period of time. Ordinarily, this is due to product supply that may have been ordered specially for the online business, special branding that may be placed on shipping containers, use of special customer service phone numbers, in-process orders, and the possibly time-consuming process of integrating a new fulfilment service provider with the online business’s information systems. In the fulfilment agreement, the parties agree on the appropriate period of time during which post-termination and transition services will be provided. Such services may be provided on different terms (regular price, non-exclusive, etc.) than were provided pre-termination. In addition, the parties should agree on whether to provide notices to customers about the transition, and on the wording of such notices.

The content of this article is intended to provide a general guide but specialist advice should be sought about your specific circumstances.