Preferred Vendor Agreements Defined
What is a preferred vendor agreement? The term "preferred vendor" is typically used to describe a relationship wherein one company (the "preferred vendor") has selected another company on the basis of performance history, with the intent of establishing a long-term, mutually-advantageous relationship. A "preferred vendor agreement" is a written agreement between a purchaser (the "client") and a provider (the "vendor") that establishes the terms under which a client may select the vendor as its preferred vendor for a defined period of time . Preferred vendor agreements are used in almost every business sector that encompasses more than one supplier and are often a critical element of a business’ supply chain. Preferred vendor agreements are often important because purchasers frequently have short-term needs that require immediate service, but often lack the capability and capacity to meet those needs internally. As such, a business may have a network of pre-selected vendors to whom it can turn to fulfill immediate needs.
Preferred Vendor Agreement Essentials
The fundamental goal of a preferred vendor agreement is to provide purchase terms which benefit the buyer and the seller. The main terms typically covered in a preferred vendor agreement include pricing, performance, exclusivity and termination.
Pricing Terms:
Pricing terms go to the heart of the deal. A preferred vendor agreement should outline specific pricing, discount and rebate terms. It should also address pricing increases, the conditions under which these increases can occur and how price increases allowed will be applied. The agreement should also clarify whether the vendor is entitled to charge a higher price if the buyer fails to meet a specific purchasing threshold, such as a guaranteed minimum purchase amount.
Performance Terms:
Performance terms are the cornerstone provisions of a preferred vendor agreement. They set forth the standards by which a vendor’s services will be measured. These terms should specifically describe the services to be provided, the timing and order of performance, including details of delivery by the seller and acceptance by the buyer. The parties may also want to include specific service levels that the vendor agrees to meet, as well as standards relating to packaging, warehousing and inventory management.
Exclusivity:
Exclusivity is a critical provision of a preferred vendor agreement because it forms the basis of the buyer’s business plan. The agreement must clearly set forth the extent to which the buyer is required to purchase a particular category of goods from the vendor. Exclusivity may apply to all of the seller’s products in a seller’s category, to a specific product line or to a limited group of specific seller products that are part of a buyer’s existing product lines or product lines that the buyer is developing. One of the critical components to a mutually beneficial exclusivity agreement is for the terms of exclusivity to be tied to the buyer’s forecast or commitment to purchase the seller’s products. In the absence of a required purchase commitment, exclusivity becomes meaningless and the term providing for exclusivity should be revised.
Termination:
Termination terms will vary based on the size of the agreement and the business sector involved. They usually include termination for convenience, breach, a change of control, or bankruptcy. One of the most important termination rights for a buyer to negotiate is a termination right that is exercisable upon payment of a fixed fee or formula that is not tied to the product’s increased market value at termination. When this type of termination right is included in the agreement, both parties can estimate the cost of early termination at the outset.
Advantages of Preferred Vendor Agreements
One primary reason is to improve efficiency. The requirements of preferred vendor relationships tend to focus on quality and price. In becoming a relationship partner, the supplier generally becomes less concerned with short term margins and more focused on the relationship and the expected long term margin enhancement. In become a preferred vendor the parties may well align their objectives to the point where they are each motivated to facilitate the others’ business objectives because they each recognize that they share in the overall financial success of the other.
Another reason businesses enter into preferred vendor relationships is to reduce costs. This is particularly true if the two parties share in future cost reductions because of a preference given by the other party. For example, in the case of a preferred supplier/commodity purchaser relationship, each party may share in the cost savings resulting from the supplier also being the chosen supplier for other, non-competing clients.
Lastly, by forming supplier development programs within the framework of a preferred vendor relationship, businesses frequently realize that the supplier is more than willing to provide tangible (and often expensive) assistance with supplier development. By providing this assistance, the preferred vendor reduces it costs to the commodity purchaser while simultaneously increasing its own profitability since the adjustments paid for by the supplier can be offset against the purchase price.
Common Hurdles and How to Tackle Them
Avoiding overreliance – A common pitfall for businesses and how to overcome it
It may be tempting for a business to negotiate an exclusive supply arrangement with a preferred vendor, sometimes at the expense of weakening relationships with other vendors or suppliers. You may feel that, with your purchasing power and clout, you’ll be able to force the vendor to provide all your needs. This "one-stop shop" strategy may seem like a good way to simplify processes, saving both time and money. However, overreliance on one vendor could cause problems in the future.
The pitfalls of exclusive supply deals include small or mid-size businesses being beholden to one national vendor for 100% of their raw materials or business supplies, or a large company with multiple locations locking into a longterm agreement with 80%+ yearly commitments to a third-party vendor. What happens when the vendor goes out of business, refuses to supply a critical item or service, or is dragged into legal problems that impacts your business? It can be extremely difficult, if not impossible, to recover from the fallout. If your company is faced with similar circumstances, you may be left trying to assess the damage and scramble to find another vendor to get you through the current time period. Depending on the nature of your business, you may face litigation with the current vendor as you try to figure out why they let you down.
Unfortunately, overcoming these issues may be difficult, as some contracts for exclusive supply arrangements may be sufficiently broad and others may include a term that is sufficiently long so that enforceability is not an issue. A business locked into an exclusive supply agreement for a raw material or essential input may not be able to simply replace it from an alternate provider without significantly higher production costs or longer manufacturing times. Even where exclusivity is limited to a certain class of products or services, the small size or scale of some businesses may still leave them at a disadvantage. The classic alternative is to buy from multiple vendors for those contracts that are not governed by an exclusivity commitment, but that may be impractical if your vendor terms don’t allow it or you consume the same raw materials from all your vendors.
To avoid overreliance on one vendor, your company’s purchasing team should take advantage of a competitive purchasing process. This process can help ensure that you’ve considered multiple offers before committing to an exclusive arrangement, and that your team is making a fully informed decision. Indeed, for large scale purchasing decisions, it may even be worth considering creating a formal request for proposals (RFP) document package. An RFP allows a company to clearly and concisely define its goals, key outcomes and general requirements for goods or services to be delivered. This creates an opportunity for a vendor to clarify ambiguities before providing a specific solution. Some issues that an RFP can help identify include:
As a general starting point, it’s recommended that an RFP outline the following information:
Some smaller businesses may still find themselves at a disadvantage because their competitors are larger and better-funded. If your company experiences issues when purchasing from vendors, you should consider consulting with an experienced attorney to explain your options and the potential next steps.
How to Write a Preferred Vendor Agreement
When drafting a preferred vendor agreement, a business should keep in mind several issues to ensure that the proposed agreement does not lead to unintended consequences. Aside from the obvious negotiation points (e.g., pricing, term, scope and nature of the relationship), the lawyer for a company should consider and draft to address the following:
- Whether the company is agreeing to maintain pricing levels, or its current pricing schedule, for the term of the agreement.
- Whether and when a company can hire the preferred vendor’s employees.
- Whether and when a company can terminate the relationship with the preferred vendor; e.g., will the preferred vendor have to be given the opportunity to cure under certain conditions.
- Whether the company is agreeing to use the preferred vendor as its exclusive vendor for the products and services described in the preferred vendor agreement , or whether certain purchases can be excluded from the preferred vendor agreement.
- Whether purchases made from the vendor should be designated to a particular store or an online mechanism for purchases from third parties, as well as whether the company is required to inform the preferred vendor of these designations.
- Whether a company can sell or trade inventory that it needs to replace, and other industries often allow "excessive" inventories to be sold or exchanged.
- The length of the preferred vendor relationship, and how the preferred vendor, or customers, terminate it, if necessary.
The best practice is for a company to consult with legal counsel who is knowledgeable in both corporate, commercial and intellectual property law (e.g., a Harrison & Held lawyer), especially in light of recent antitrust developments indicating that dealer networks are a serious threat to potential liability. A well-drafted preferred vendor agreement can help a company avoid a variety of liability from prying eyes of antitrust regulators trying to piece together what a preferred vendor agreement may mean.
The Role of Preferred Vendor Agreements in Risk Mitigation
Preferred vendor agreements function as a preventative medicine within risk management, addressing future threats to business continuity. They work to mitigate risk in their own right in the context of supply chain or vendor criticality, and they also help address future liabilities by providing a path for compensation if an error occurs in a process that affects the product delivered to the customer.
Smart businesses recognize the importance of preferred vendor agreements at all levels of their supply chains. Preferred vendor agreements help manage risk by identifying where the greatest potential for loss exists and where it will have the most serious impact on the business. The supply chain can then be mapped from the final product all the way back to the primary suppliers. This shows how the components could be modified, reengineered or increasingly diversified to ensure a greater customer base.
It also helps identify where imaginary vulnerabilities might exist in the case of lost power, flood, fire or another major disaster affecting a single preferred vendor. This requires periodic reviews of vendor criticality so that there is always a fallback source for critical components. If, for example, a major automobile manufacturer relies on egregiously overpriced pistons from a single manufacturer, it will be at the mercy of that company forever after. Even if independent design and manufacture is not critical, multiple companies should always be considered for every component.
Case Studies Illustrating the Use of Preferred Vendor Agreements
Preferred vendor arrangements have succeeded in a variety of businesses and industries. The following are some examples.
Domino’s Pizza has used the same pizza box vendor since 1984. As a result, the company has enjoyed steady pricing, consistent quality control, and some flexibility in customizing its packaging. These advantages have contributed to three decades of mutual savings and the ability to shift from paper to styrofoam boxes. Domino’s continues to encourage franchisees to use this vendor, even though they are not bound to do so.
Southwest Airlines uses a single source for the majority of its aircraft. Having a fleet made up primarily of Boeing 737’s allows Southwest to simplify training for pilots and maintenance personnel. This practice has also granted Southwest increased bargaining power in its negotiations with Boeing and has sped up the time that it takes Southwest to bring new planes online. The rail freight company Union Pacific has employed a similar strategy by purchasing only one type of locomotive. Today, the company’s fleet of nearly 7,000 locomotives is made up of a single model, which enables the company to reduce training costs by simplifying its maintenance and education programs.
Other companies have chosen to pursue more traditional preferred vendor agreements. The Coca-Cola bottling company sends a letter to new distributors, asking them to sign an agreement within 30 days that holds them to use only Coca-Cola products and states that they "shall not offer , promote or sell [or use their best efforts in offering, promoting or selling] any products competitive with bottled and canned beverages produced and sold by the Coca-Cola Company and named in the list at the end of this paragraph, or any product of the company, including but not limited to sparkling, noncarbonated and still waters, teas, juices, energy drinks, milk drinks, isotonic drinks, isotonic powders, coffee, cocktail mixers of any form, dairy based products, non-dairy based products, or milk based products of any form (collectively called the ‘Company Products’)." Coca-Cola subsequently sends out a list of its approved products with its list of restrictions under the agreement. The company has included the following categories on that list: soft drinks/mineral waters/sparkling waters/juices, fruit drinks/sports drinks/drinks (non alcoholic), cooler drinks (non alcoholic), water (non carbonated), pre-mixed cocktails, iced teas, iced coffees, and smoothies.
Manufacturers of medical supplies have been among the most aggressive users of preferred vendor agreements. To limit the liability resulting from claims such as questionable sterilization processes, device recalls, and defective products, vendors of medical products such as surgical sponges and heart valves have entered into preferred vendor agreements with hospitals stating that the company will be the exclusive source of the products covered by the agreement and that the company will assume all liability related to the products for the life of the device.