infoTECH Feature

October 30, 2015

Financial Models for Engaging a Product Development Partner

There are many different financial models under which clients of product development consulting firms choose to engage. Start-up and early stage companies are often looking for flexibility in how they engage with a PD partner, and they often seek alternate ways to help stretch their dollars further. Even in the case of larger companies, our firm has recently started seeing non-traditional approaches to funding development. Here are some examples:

  • Direct fee for service

This is the most common means for engaging a PD partner. It is very simple. 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 needs. Generally speaking, the more well defined the scope of the engagement, the more likely it is that the PD partner can bound the project tightly enough to offer a fixed price proposal. This is the simplest and cleanest of the engagements.

  • Engagement for Equity or Royalty Stake

In this method, the client engages the PD firm without direct payments for non-recurring expenses. The model offers the PD partner future benefit based on the success of the company or 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 and other) which may be required for successful execution.

There are a few other considerations for such an engagement. First, the client must realize that the PD partner is joining them in the risk of product or company success. The PD partner will want to have an understanding of the nature of the risk. They may want a clear understanding of the market opportunity and how the client plans to realize the opportunity to recover benefit through product or service sales. In the case of equity exchange, the client may also be expected to provide the PD partner information similar to that which would be provided to investors. That is, they will want a clear understanding of the business plan.

For the PD partner engaging in a project with funding of this type, a higher level of risk is being assumed. For the client, they must realize that the PD partner is entitled to a higher potential economic benefit in that they are willing to share in the risk. In simple terms, the risk/reward assessment has to be favorable enough to warrant undertake the risks. This may be a good means for tightly-funded startup or new business to stretch their limited dollars further. They should, however, realize that if there is success, they will in the end be paying more for the services than if they had engaged in a much less risky (to the PD partner) direct fee-for-service program.

  • Engagement for Manufacturing Rights (ODM)

This is a model whereby a firm is willing to productize a design or develop a product for a client in return for the exclusive manufacturing rights. An arrangement like this is often used in relationships between Asian manufacturers (who 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 engagements, a manufacturer will want to have a clear understanding of product requirements and definition as well as volume projections over some period of performance. In such scenarios, 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 return for generating returns through selling finished product 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 on the part of the client 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 commitment of cash and will have a partner with substantial “skin in the game.” This is a very tight partnership.

There are cautions here. The client needs to map the right ODM partner to the opportunity. It would be nice to think your startup is using the ODM making the next iPhone (News - Alert). Certainly, the quality processes and capabilities of such a firm will have been well vetted. However, realize that if the scale of the client’s business is radically below that of Apple (News - Alert), they will have little chance of getting the “A team” assigned to their program. Clients in this situation should not be surprised if their product production needs play “second fiddle” to the demands of Apple. It is crucial to get an ODM partner matched to the client where the client’s opportunity is inherently of high value to the ODM partner. There are ODM partners out there scaled to serve large clients and those to serve small-to-mid sized clients.

Another caution here, for the client: clients need to be very careful in who they pick as an ODM partner. It can be very difficult to extricate from an exclusive manufacturing agreement. This is more than a legal permission to terminate. Clients who have to change manufacturing partners have to be concerned with who owns the intellectual property and who owns the drawings or other manufacturing data. Who owns any specialized equipment or tooling for the product? Even if one can extract all the fixtures, equipment and tooling, will this equipment be portable enough 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 bidding. While the initial pricing may have been agreed to by the client and ODM partner, as a client, do you 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 they pay for part of the non-recurring expenses as accrued (either at cost, a steep discount or a below market rate). A PD partner and the client might both 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 they 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 relates to funding of product development using partners. While the old models are still prevalent, new models are being used offering potential benefits to both clients and their PD partners.

Mitch Maiman is the President and Co-Founder of Intelligent Product Solutions (IPS), a company that delivers a new model for software and hardware product development, integrating the full spectrum of design and engineering disciplines as a single source solution.  Always espousing a hands-on approach to design, he holds a portfolio of United States and international patents and has more than 30 years of  product design experience. Mitch can be reached at [email protected].




Edited by Kyle Piscioniere
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