Assessing Risk in the Supply Chain Weighs Heavily in M&A Transactions

We all have been amazed at the sight of shipping containers of equipment, merchandise, and food products from manufacturers and producers in Asia sitting off the West Coast.

As a backdrop to U.S. purchasing activity and record-setting sales are problems of delay, product and labor shortages, increased costs, and closed-down factories (especially those reliant on Vietnam). These issues and more are now crisscrossing the network of ports, trucks, railroads, and warehouses that are pushing to get goods to retailers, restaurant operators, hoteliers, and other service providers – many of which are part of franchise systems that, in turn, are pushing to get those goods to consumers across the U.S.

While Covid-19 was a prime actor in this disruption, supply chains have been ravaged by many factors, including China’s emission-reducing limits on metal products, disruptive storms and other weather, and natural gas shortages.

Retailers and operators have struggled to combat such supply disruptions. Solutions include replacing unavailable items with available substitutes; chartering their own container ships to alternative ports; canceling orders; increasing available factory capacity; localizing manufacturers and distributors; raising prices for goods to the consumer; and, where possible, renegotiating fixed price contracts to fight extra charges imposed by ports for containers of goods that linger at terminals.

With flights being added each day to increase air cargo space (notwithstanding the fits and starts suffered by airlines as they struggle to increase capacity), some retailers are choosing to move goods by air. In particular, accessibility to consumer electronics has been hit hard, but almost no goods – even down to the lids restaurants use to cover soda and coffee cups at drive- thru windows – are immune to becoming scarce commodities.

To address the extra costs, delays, and shortages of imported goods, as well as the shortage of labor to work in the business, retailers and franchise systems have their supply chains working 24/7 – all while reducing hours of operation at the store or restaurant level, increasing prices or assessing surcharges to the consumer, and increasing wages and benefits to attract labor that can take on the ever-increasing consumer demand for goods through drive-thru, delivery, and curb service options. Demand is high for digital freight platforms connecting farmers, distributors, wholesalers, retailers, and truckers that eliminate the intervening friction and provide needed transparency into data that can help supply chain managers anticipate delay and damage.

Supply chain’s effects on M&A

These are the problems and challenges of today’s supply chain, and they are never more open for investigation than in an M&A deal in which the buyer of a franchise system must assess the cost, viability, and risk of the existing supply chain on the overall reliability of the franchise model being purchased and the profitability of the business. Due diligence on the supply chain and the involvement of the target’s supply chain managers in the investigation is paramount. In today’s environment, important inquiry items include the following:

1) Identifying whether any material supplier, or any supplier under any other material contract has: terminated or threatened to terminate their relationship with the seller (or if the seller has terminated or threatened to terminate the supplier); materially decreased or limited (or threatened to do so) its services, supplies, or materials for use by the seller; or provided written notice that such supplier plans to increase the price to be charged by an amount not otherwise specified in the applicable contract.

2) Identifying whether the material contracts have been negotiated in the last 2 years and whether arrangements in place now for the manufacture and shipment of goods will be in place in the future, and to what extent concessions were made by the seller or supplier to effect sales and shipment of goods during the last 2 calendar years.

3) Identifying all material transportation contracts for shipping and delivery of those goods to the franchise system, including contracts with manufacturers, distributors, GPOs, and freight forwarders.

Get it in writing

To understand the impact of any positive responses to the foregoing inquiries on a buyer’s assessment of risk, it is important to obtain copies of material contracts with the following characteristics:

• requires the seller to make a material volume of purchases annually or make a significant annual spend;

• constitutes a sole source or exclusive supply contract;

• contains a fixed or flat price and terms for modification or updating;

• provides for the guarantee by the seller of the obligations of another individual or entity, or creates any material contingent liability;

• requires the seller to purchase its entire requirements or needs from the supplier or to sell its entire output of a product or service; and

• requires the seller to offer or obtain participation in the contract by all or substantially all of the franchisees system-wide or in any one or more geographic regions.

As further evidence of the reliability of the supply chain, buyers should obtain: 1) copies of the franchisor’s contract compliance methodologies or procedures for suppliers, including for tracking (a) exclusivity requirements, (b) minimum purchase obligations, and (c) renewal requirements; and 2) copies of any insurance policies covering the seller’s supply chain disruptions, including force majeure events, delivery failures, and closure of facilities.

Conclusion

Obtaining this information will assist a buyer in assessing the reliability and resilience of the supply chain and the cost of delivery of goods and services to franchisees and to the consumer. It is highly likely that such costs will vary significantly over the past few years, thus affecting the weight given to past profitability data and how future profitability of the business should be viewed.

Joyce Mazero, a shareholder with Polsinelli PC, a law firm with more than 900 attorneys in 21 offices, is Co-Chair of its Global Franchise and Supply Network Practice. Contact her at 214-661-5521 or jmazero@polsinelli.com.