Avoiding Construction Claims through Guaranteed Maximum Contracts

Guaranteed Maximum Contracts or G-Max are becoming more popular as a corporate vehicle to minimize risk, avoid claims and integrate the diverse interests of a complex project. Not to be confused with cost plus, the G-Max contract is bid exactly the same as lump sum. The contractor assumes the same risk, with a big stipulation: he's willing to share in the savings on the basis of the owner's guarantee of fee and prompt payment of net cost.

There's no difference in cost or risk between Lump Sum and Guaranteed Max, but a big difference in results, particularly on the owner's side of the fence. Don't let anyone tell you that G-Max cost more. They don't! In fact, Lump Sum contracts are sometimes converted to G-Max for the same price or less.

How do they work? In the following example, the best bid price received from a qualified general contractor for a major renovation is $2.5 million. The owner's budget is $2.2 million, but modifications and changes are anticipated for an additional $500,000 estimated construction costs. Time is of the essence. The project must start immediately. The owner wishes to cut $300,000 from the base contract without changing the scope of work and at the same time control cost of the additions without giving away the $500,000. The contractor already dropped his price on the first round of negotiations and won't budge off his $2.5 million. This project is an ideal candidate for G-Max conversion.

The Owner who awards the contract should ask the contractor: "How much fee (or profit) do you want in this project?" (Assume 6 percent). When the contractor states "$150,000," the owner says: "Then what you are saying is that this project's actual cost is $2.35 million. We'll guarantee your fee of $150,000, but we believe you can bring this project in for under $2 million by working with some of our people who know construction. Do you see that as a realistic possibility? " If the contractor answers "Yes," then the owner asks: "Would you then accept a Guaranteed Max contract with the understanding that all costs saved below the $2.35 million will be returned to the owner? " If the answer is "Yes," then you can establish the method of administration. If the answer is "No," then you negotiate a 75-25 or 50-50 split in the savings and ask: "If we guaranteed $500,000 of additional work to the base contract, will you agree to reduce your fee on extras for the first $250,000 of additional work?"

This is just the beginning, there are many possibilities. The yield at the end of the project often exceeds the original objective (in this case $300,000) because the atmosphere has changed from adversarial to partner. With proper controls, and by working with contractors as a team member, it is possible to obtain greater yields on the bottom line than by any other contracting method.

G-Max contracts best achieve the owner's objective because a partnership is formed between owner and contractor wherein the owner agrees to reimburse the contractor for actual cost as it occurs, not from a schedule of values. This eliminates the distrust between parties. It also eliminates the contractor's negligence to pay his suppliers and subcontractors because he gets audited monthly. In today's market, this one issue alone will solve a lot of problems and insure both savings and a smoothly running project.

The owner plays an active role throughout the entire process. The whole issue of cost is manageable when the savings are shared, rather than negotiated from an adversarial position. When the administration is properly set-up and organized, the benefits are truly amazing. Because every purchase order and invoice received from the contractor is submitted to the owner as backup, and because the owner agrees to cut the time for processing and pay promptly, a positive and successful relationship is assured. Front end loading disappears, so does the haggling with price.

There is another reason for using the G-Max contract system: It is the best vehicle for recovering cost when pricing on extras becomes unreasonable. The fact that owners have tremendous leverage on extras is not often mentioned among users, perhaps because it is a business advantage. Consider once again the outrageous cost for a new door. Assume that the contractor wants $1,500 to cut the hole and install a new door, plus another $50,000 to relocate the 4-inch gas pipe that nobody knew existed. Assume also that the true cost of the piping relocation is only $10,000, but the contractor will not back off his estimate. The work must start and he demands approval. Under lump sum contracts owner's haven't got much choice, but under the G Max system, even if you agree to the $50,000, all you've given away is the difference in fees, or $2,400 instead of $40,000. Once the work is complete and true cost is known, even this can be adjusted. There's a strong incentive here to be honest. Nothing like it exists with any other format. Cost plus contracts claim to be the same, but in reality they do not have any incentive for shared savings or efficiencies.

Still another advantage of G-Max occurs when work must start ahead of final drawings. There are often issues that delay completion of the drawings and therefore start of construction. The G-Max format allows owners to minimize risk when proceeding with work ahead of final drawings. It has been my experience to start work on 30 percent completed drawings while obtaining a G-Max price for the entire project based on preliminary drawings and outline specifications. That's an extreme example, but it does happen.

The downside also needs stating. G-Max contracts require more work on the owner's part to administer. The main effort involves defining what is cost. And if you are not interested in collecting discounts, obtaining credits for small tools, establishing realistic labor rates, monitoring rentals, and are not really prepared to act as a partner with your contractor in the project, then this program is not for you. Don't try this if you don't have a strong administrator experienced in general contracting. Contractors resent inexperienced owners questioning their decisions, and they certainly aren't eager to have their books audited by anyone they don't trust. Properly set-up and administered however, G-Max contracts are a win-win situation."

Building Protection into Representative Agreements

Relationships between manufacturers' representatives and suppliers are similar in many ways to a marriage. Before a contractual commitment, there is a courtship, a time during which both parties are able to examine their prospective partner during a variety of circumstances. If the attraction continues, both parties perform due diligence in order to ensure the absence of any nefarious dealings, both past and present. If a commitment is desired, both parties enter into a contractual relationship for the long-term. However, unlike a marriage, there is never a clause in a representative agreement that includes the words, "until death do us part." Representative relationships are expected to last only for a period during which both the rep and supplier reap benefit from the relationship. Once a partner can no longer foresee a benefit from the relationship, the partnership may be dissolved.

During the early years of a representative relationship, little fears on both sides can become irritants that grow, fester, and hold back both parties from achieving greater success. What can be done to reduce the impact of otherwise minor fears? Both parties can build into the representative agreement protection that shields them from some of their greatest fears. Manufacturers' representatives often fear unjust termination by a supplier for whom they work diligently for several months or years with relatively little compensation. Suppliers often fear inability to terminate a rep whose performance has deteriorated. Both fears are real and can be addressed in the representative agreement in an equitable manner.

If mutual success of the rep and the supplier is to be achieved, little fears on both sides must be dealt with in a manner that prohibits those fears from undermining performance. This paper addresses steps that can be taken to reduce fear on the part of both the manufacturers' representative and the supplier. By building protection into the representative agreement, two objectives can be accomplished: First, some natural fears can be either reduced or eliminated. By reducing the impact of some fears, performance of both the rep and the supplier can be enhanced. Second, when the time comes to dissolve the representative relationship, the same protections that were used to enhance performance can be used to unwind the relationship with less acrimony and legal action.

Well Written Agreements Reduce Fear
Suppliers have a natural fear of manufacturers' representatives. Simultaneously, manufacturers' representatives have a natural fear of suppliers. Any solution to this problem cannot be developed unless these natural fears are recognized. A solution, therefore, must identify some of the most obvious fears and work to minimize the impact of their realization. A manufacturers' representative might have a legitimate fear of being terminated if a small supplier becomes very successful and becomes acquired by a larger supplier. In most cases, the rep or the direct sales force of the surviving, (acquiring) supplier becomes the sales force of record and the rep of the smaller, (acquired) supplier is terminated. Termination is the result irrespective of performance.

Any manufacturer, large or small, may fear that the selected representative will not perform to expectations. If the gap between expectations and actual performance is too great, the manufacturer may need to change representation, but may feel trapped in a representative agreement that it feels cannot be changed easily or quickly. Well crafted representative agreements can relieve some of the fears of both reps and suppliers. We'll explore clauses that can be inserted to help protect both manufacturers' representatives and suppliers.

Protection for Manufacturers' Representatives
One common fear among manufacturers' representatives is that termination may come after months or years of hard work, but before significant commissions are generated. This a justifiable concern particularly where the supplier is relatively new and has no established customers. A rep must labor long and hard in order to create the first customers, designs and purchase orders. The world provides many examples whereby a small supplier signs up many reps that are required to provide several months of missionary work with customers before sales are realized. If the supplier provides a great product offering and executes well, its booming sales soon make it an attractive target of acquisition by a larger, more established competitor. During an acquisition, the sales organizations of the acquiring and acquired companies must be consolidated. Most often, the direct sales team or rep from the acquiring company survives, while the rep from the acquired supplier is terminated. Recognizing that history favors the reps of established suppliers, many reps are loath to adding start-up suppliers to their line card.

One solution that protects the manufacturers' representative for a small start-up supplier is the insertion of a clause that provides commissions beyond termination in the event of a change of ownership of the supplier. The rep may be offered six-to-twelve months of commissions after the effective date of termination if termination is the result of a change of ownership in the start-up supplier.

The mechanism calling for extended commissions is sometimes called a "double trigger." The term, "double trigger" is used in this case because two events must occur before the extra commissions are warranted: a) change of ownership, and b) termination of the representative agreement. If an acquisition occurs, but the rep is retained, there are no extended commissions. Similarly, if the rep is terminated, but there is no change of ownership, there are no extended commissions. When, however, termination occurs within weeks of a change of ownership, two conditions will have been "triggered" and the rep becomes entitled to extended commissions.

Inclusion of the "double trigger" clause removes the fear that reps might have when partnering with start-up suppliers. The expense of extended commissions become real to the start-up supplier only if it becomes very successful and simultaneously becomes acquired. The extended commissions can be easily justified and in addition, can be spread forward in time.

At first glance, extended commissions from a double trigger clause result to the benefit of the manufacturers' representative only. Upon deeper reflection, the start-up supplier benefits also. Without a double trigger clause, large and established rep organizations avoid start-up companies because of the risk that they represent. Without the clause, a start-up supplier might be forced to select a rep from among a group of smaller and less established rep organizations. Inclusion of a double trigger allows start-up suppliers to add powerful manufacturers' representatives to its sales team. Such an addition increases the suppliers' chances for success.

Protection for Suppliers
Suppliers seek the opportunity to exercise control over their own fate. Suppliers expect that control to extend over the sales organization. If that sales organization is composed of direct employees, hiring and firing is relatively straightforward. When the sales organization is a network of manufacturers' representatives, control may be muted. A supplier should be allowed, via the representative agreement, to add new reps and to terminate those reps that do not accomplish the objectives of the supplier. All representative agreements allow for termination under various scenarios. A supplier should ensure that it has the ability to terminate a rep both for cause and for convenience.

Most reps readily agree to termination for cause and the description of causes can be defined in the agreement. Some causes are obvious and may include gross malfeasance, change of ownership of the rep, and breach of the agreement. Very often, cause is disputed and leads to acrimony and legal action.

A representative agreement should include a clause allowing for "termination for convenience." In this case, the supplier may terminate the agreement without providing or proving cause. The supplier is provided the flexibility to change manufacturers' representatives if conditions warrant or change. A rep will not appreciate the opportunity to constantly fear termination for no reason at all. To encourage the rep to accept a "termination for convenience" clause, a provision is added to the agreement that adds extended commissions beyond termination, for a period of up to a full year after the effective date of termination. The period for extended commissions is often proportional to the length of service of the rep.

The Best Agreements Provide Balance
Inexperienced reps and suppliers sometimes attempt to insert clauses into representative agreements that favor one party at the expense of the other. Occasionally such too-clever attempts achieve their desired result. Unfortunately, most one-sided attempts fail to accomplish their objective. Too often, one-sided agreements achieve two undesirable characteristics. First, one-way clauses generally build mistrust into the relationship. Such mistrust acts as an anchor around the neck of both parties and prevents them from optimizing the results of the partnership. Second, agreements with one-sided clauses have a higher incidence of litigation when the relationship unwinds. Remember, representative relationships do not last forever. There is no "until death do us part" language. When a relationship unwinds, seasoned reps and suppliers agree that litigation should be avoided. Legal action is terribly expensive. It consumes vast amounts of human resources and management focus, and distracts both parties from their real agendas: growing sales, market share and profits.

Seasoned reps and suppliers agree that representative agreements should be written with attention given to balance. If a rep is allowed to operate in a certain manner, the supplier ought to be afforded the opportunity to operate in a similar manner. If a supplier may terminate the agreement without cause, the manufacturers' representative should be allowed to terminate for convenience as well. Balanced agreements help build trust between their partners. That trust adds to the productive energy applied by both partners. Greater trust and energy are two of many requisites for a successful representative relationship. Ensure that your agreements strive for a balance in the power between the representative and the supplier.

Conclusion
Entering into a new representative relationship can be a frightening experience. The consequences of entering into a representative agreement can be disastrous. By inserting protective clauses into the agreement, both parties can increase their chances of success and simultaneously reduce the likelihood of legal squabbling when the agreement comes to an end. Ensuring a theme of balance and fairness in the agreement further increases the opportunity for a satisfying representative relationship.

About the Author: Glen Balzer is a management and forensic consultant involved with domestic and international marketing and sales. He advises parties involved with contracts between suppliers, global customers, manufacturers' representatives and industrial distributors. He promotes conflict resolution between parties involved in representative and distribution agreements, serving as an expert witness. He has significant experience with integration and rationalization of merged and acquired companies. For 30 years, he has been involved in all aspects of creating and managing marketing and sales organizations throughout North America, Europe and Asia.