Agreements with third parties and the ensuing relationships have been critical to the growth of companies into the global marketplace, but this growth comes with complexities. While these complexities have benefits which can increase value of a company, they also hold risks, which can decrease the value added by the relationship and/or create unintended problems.
The good news? Risks associated with third-party agreements can be identified, monitored and managed with an effective management program of internal and external controls.
Third-party agreements are common practice in the franchise, entertainment, sports, life science, manufacturing, energy and technology industries. Typically, when a company enters an agreement with a vendor, supplier, distributor, contractor, agent or manufacturer (often referred to as a licensee) they license the usage rights or access to business know-how for a wide variety of products and services.
The licensee would be granted certain rights from the company (often referred to as a licensor) with an established brand, copyright, intellectual property or business model. Examples include a franchise service brand or restaurant, property managers, sub-contractor, food vendor and manufacturer. These agreements can increase brand recognition, market share and global market presence without investment costs and experience in an additional industry.
Before entering into a third-party agreement, do your due diligence of their industry and financial standing. Other examples of mitigating risks include:
- Continue monitoring and discussing irregularities or concerns.
- Maintain an open dialogue with your third party and the difficulties they face and how it impacts you.
- Implement a strong program with effective internal controls, policies and procedures, which are monitored and evolve as your business grows.
Understanding third-party relationships and agreements helps to maintain control over your program. Various software tools can be used to streamline agreements, reporting and approvals, but they are only an aid to your program. Most third-party agreements have an audit clause, allowing for an audit, internal or external, and these should be used periodically in conjunction with a third-party management program.
One of the more common risks occurs when a third-party agreement provides for self-reporting, which creates a concern for completeness and accuracy of revenue, and royalty or expenses sharing. Additionally, if a third party uses a software system that the licensor owns or has access to, there could be ways to circumvent these systems, creating a potential opportunity for fraud. Other risks, such as a competing business, marketing and advertising expenditures, brand integrity and product quality, have a financial impact, but can also impact the brand image you have created.
It is important to understand whether self-reporting amounts are based on the third-party’s internal accounting procedures, policies and generally accepted accounting principles (GAAP), or in accordance with the agreement. These risks can have a significant impact on brand image and profitability.
In our experience, these agreements are often complex with specifically defined terms and conditions for revenue and expenses, which can be difficult and misstated in self-reporting. This does not mean it is intentional – it may be a case where the third party is not fully aware of the agreement’s terms and conditions, or key personnel responsible for reporting are not aware of the terms and conditions. A third party may have other businesses, which compete with and have negative impact on the rights granted under the agreement. In manufacturing, a third-party could use your trademark or intellectual property on unapproved or unauthorized products and create unfavorable images of your brand.
The best approach to mitigating these risks is be proactive and identify areas where red flags could arise, from the beginning, including understanding agreement terms and conditions, ensuring timely reporting and payments, requiring detailed reporting, reviewing reports periodically and cross-checking reporting with written approvals.
The more you understand about your third party’s business practice and industry, the better equipped you are to identify areas of risk and market expectation. Establish internal controls that identify key terms, conditions and reporting requirements of your third-party agreements within your accounting departments. Include your legal team in the discussion of these internal controls and share these reporting requirements with your third party.
A proactive approach can benefit a company in the short-term financially, but it can also improve or create long-term relationships between companies. Start small and refine your controls, policies and procedures. Next, see which third-party agreements have the highest material financial effect on your company, request supporting documents from the third parties and consult a professional on ways to improve your management and relationships with third parties.
By taking the time to understand your third-party agreements and the relationships, you can identify, monitor and manage the risks of your company’s revenue, royalty share and expenses.
This article was originally posted on the Houston Business Journal website.