What's Wrong With A Transactional Relationship With Your Contractor?
By Kenton Shultis
It seems that “transactional” has become a pejorative description of business relationships. This is odd because all business relationships are transactional. This perception of business relationships in outsourcing is due to the poor alignment of interests between buyer and seller. Better alignment of interests in outsourcing relationships can be very powerful under the right circumstances.
If you have ever attended a conference on outsourcing pharmaceutical production services, there were, undoubtedly, presentations on the contractor-client relationship and panel discussions on the subject. And no wonder; it’s an important topic that deserves attention. Within 5 minutes, the transactional nature of many relationships will be decried. It is unlikely the speaker or panelist means that transactions are bad or somehow trivial. After all, a transaction is the reason for the relationship in the first place. What they mean is that a relationship that is “merely” transactional is not as valuable as a collaborative relationship, and they go on to discuss the additional aspects of the relationship they think are important.
Perhaps the collaborative aspects of business relationships need to be talked about a lot because, while we correctly sense that they provide value, the value can be hard to evaluate. There is a body of literature dedicated to showing how collaborative aspects create value. In a recent article accessible to non-experts (“Different recipes for success in business relationships,” Industrial Marketing Management), the authors consider the spectrum of collaborative forms two firms may need to explore when seeking an alignment of interests. Their evaluation of added value considers the characteristics of a relationship: trust, commitment, communication, cooperation, and relationship-specific investment. These characteristics, apart from an investment, are also aspects of a merely transactional relationship. The difference between merely transactional relationships and collaborative relationships is a matter of degree rather than kind. An example of excellent business-to-business relationship management presented at an Outsourced Pharma conference in 2016 is Shire’s “Golden Rule” in outsourcing partnerships. As presented, the Shire program was well designed and executed. Shire’s contractors were continually evaluated according to several metrics. The results and conclusions were shared with the contractor in a spirit of constructive criticism in nearly real time. Shire spent considerable effort helping its network of contractors improve their performance with advice and ideas, benefiting themselves and the contractors’ businesses. However, this outstanding program is exceptional.
Partnership relationships between firms, especially with nonpartners, are ephemeral. Once the effort of collaboration exceeds the benefits for either of the parties, the partnership will fail. Unfortunately, many programs of rigorous contractor evaluation use the metrics as a club to extract concessions from a contractor. A program starts in the spirit of mutual benefit, but as the program achieves less (often and, ironically, because it was successful and there is little more to gain), one of the partners no longer realizes benefits and the partnership breaks.
NO FRIENDS, ONLY INTERESTS
“Countries have no friends, only interests” is a maxim that can be extended to companies. A deal between firms is necessarily an alignment of interests, at least over the term of the deal. There should be no expectation that the interests of two firms will be constant over time or that they will always be able to make a deal or collaborate. The market changes, the people who make up the firms change, business models change, and the interests will inevitably shift. Two companies can have common interests over an extended period, but the relative value in which those interests is held by the respective firms is unlikely to be constant over a long time period.
Therefore, in the long run, all business-to-business relationships are merely transactional. Even true partnerships that involve extensive coordination of activities and the sharing of assets, risks, and profits are temporary. The wise and kindly CEO of a firm with which my former employer was establishing a partnership told us that a joint venture was “twice the work and half the fun.” We all knew from the start that the venture was a means to a common goal, with no expectation of permanence. Relationships regress to the underlying base relationship type, the merely transactional.
A reason for the search for something better in outsourcing business relationships is the long-standing issue of poor alignment of interests between the buyer and seller. For manufacturing or process development contracts, it is in the interest of the seller to spend as little time and as few resources on executing the deliverable as possible. It is in the interest of the buyer to extract as much know-how and effort from the seller as possible without going far out of scope for the project. The seller wants more work from the buyer in the future and so will bend a little on expending more effort but may ask for additional compensation for some tasks (opening the seller up to the accusation of “nickel and diming”).
Both parties get most of what they want out of a transaction … most of the time. However, even if the project goes well, there is often a residue of feeling by both parties that they had been taken advantage of. This is a common reason for frustration between buyers and sellers in outsourcing.
If the seller was interested financially in the success of the buyer’s project, there would be a reason to provide all necessary resources to execute the project as well as can be done. A financial interest in the project can be granted by the buyer in return for a financial benefit from the contractor. Now both parties have skin in the game. Within living memory, contractors built facilities on their own dime in return for a promise of a lucrative manufacturing contract from a buyer. In this same era, it was not uncommon for contractors to do the process development work and produce the clinical trial material in exchange for a future contract. A spate of late-stage failures of drug candidates that left contractors holding the bag made risk-sharing deals less attractive. Buyers also became less interested. Contractors in low-cost countries offered such attractive commercial prices that an offer of reduced up-front costs was more than offset by much lower commercial rates.
The promise of a future contract, while still a strong incentive, is not always worthy of significant risk-sharing by the contractor. It is hard for either party to consider such an arrangement for an early-stage project.
A share of the profits on a project would be a very strong incentive for a contractor. However, a royalty would be viewed by the client as a serious hurdle to making a deal with a future sales and marketing partner or to a buyout. Unless the contractor is providing enabling technology that the buyer wants to lock in, the contractor does not deserve a royalty on future sales.
Risk-sharing and royalty incentives require the future success of the project. No one can guarantee that, and so the incentive must be discounted by the contractor, which therefore loses at least some of the alignment. It would be better if the incentive were based on the success of the client, not just the project.
Drug development companies offer options (or, in some circumstances, warrants) to important advisors to engage their services over long periods. Development companies could offer options in exchange for reduced prices of services from contractors, which has an immediate benefit for the client and makes the contractor strongly interested in making the client successful.
This approach to alignment will not be sensible in all relationships. For example, Shire’s approach to a value-added relationship makes good sense to managing a supply network. Shire has the expertise to offer its contractors and brings value to a collaboration.
For clients who are experts in finding cures but not manufacturing, a high degree of collaboration with their manufacturing contractors is not valuable. However, if successful in developing a cure, these companies generate tremendous value and their contractors can play a major role in making their clients successful. Drug developers could offer options to their contractors in exchange for a reduced rate for clinical trial material (CTM), process and analytical development, and process validation. This could save the drug developer significant cash at a critical point in its financial history. The contractor gains an asset potentially worth many times the reduction of revenue for the services provided.
ALIGNING CLIENT SUCCESS
The contractor must be aligned with the success of the client, not the project. Projects are stopped because they prove not to be cures, not because the contractor did a poor job. If the incentives are tied to the project, the contractor may get nothing for its risk, despite a valiant effort. But killing a bad project in a timely fashion because the drug developer had all the CTM it needed may be the best contribution a contractor can make to the success of the client. The client preserves resources and can move on to finding a cure. The interests of the two firms remain aligned, even if the buyer decides not to place the next project with the contractor. Skin in the game gains endurance for the alignment of interests.
Contractors could accumulate a portfolio of options in their clients. Over time and through the power of diversification, the portfolio could become very valuable. That value could be realized far earlier than the ultimate success of the underlying project. Clients will want to control value realization through vesting and limitations on the rights of the contractor to sell the options, but it could provide an interesting way for a drug developer to preserve cash and keep its contractor’s interests aligned. If the client is purchased, the options can be monetized, and the contractor benefits directly from the buyout instead of fighting with the new owner over the terms of a services agreement.
Contractors will want to be careful when accepting such an arrangement. Due diligence into the client’s corporate structure and other obligations will be critical. A portfolio of options in hot companies is an attractive prospect, but it comes from reduced profits in the current period. A pharmaceutical manufacturer is not a hedge fund, and the contractor cannot always afford the reduced cash flow. If a deal can be struck, this is a way for large contractors to be attractive partners to start-up biotechs and for startup biotechs to be attractive customers to large contractors. It is also a way for small contractors to become large contractors more quickly. Pharmaceutical manufacturers can deliver a lot of value beyond the contracted services to their clients. This is a way to directly realize that value.
Finally, to answer the question, “What is wrong with a transactional relationship with your contractor?” — nothing. While this is a rhetorical question, it is one that underlies a frustration in pharmaceutical outsourcing. “How can you align the interests of your contractor with your company’s?” is a more useful question. A common answer is to enhance the collaboration between client and contractor. While beneficial, however, this solution is fleeting. Making the contractor a direct beneficiary of the success of your company gives the alignment of interests an endurance that is hard to achieve simply by improving the collaborative aspects of the relationship.
KENTON SHULTIS began working with Rondaxe Pharma in 2006 and became managing partner in 2007. He has more than 35 years’ experience in pharmaceutical process development and manufacturing.