Supplier funding for capital investments in catering is a tricky affair

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By: Sujit Kumar -- Senior Research Analyst, Facilities Management

18 November, 2016

Supplier funding for capital investments in catering is a tricky affair
WHITEPAPER

Abstract

The concept of suppliers funding buyers’ capital investments has been in practice for a while now. This is because of the growing understanding of the benefits of such symbiotic relationships. However, such a practice has been very rare and niche in the catering industry.

This white paper addresses various critical aspects related to supplier funding for a capital investment model such as:

  • The various opportunities and risks involved in such a model
  • The general payment terms
  • Asset ownership and what happens in case of exit from the contract by either side?
  • How to work out the payback period for the investments made?

Since this is a highly niche segment in the catering industry, there are primary concerns of quality and control over the engagement. Understanding the finer details of the engagement and the factors that need to be considered before entering into such arrangement is essential to avoid failures.

Introduction

Category managers of global companies are constantly looking at opportunities to cut down on cost and the need to invest heavily on activities that are not a part of their core business. Supplier funding for capital investments in non-core areas therefore become highly lucrative as they present an opportunity to free working capital without affecting the operations and hurting the line of credit with the bank.

However, entering into such an agreement based on this perception of free money can be disastrous for buyers. Since the suppliers are putting in the necessary capital, buyers have little control over the quality of services provided unless explicitly agreed upon during the contract formulation phase. This exposes the buyers to the risk of poor service quality unless they decide to break the contract and pay back the unamortized amount to the suppliers. However, this defeats the entire purpose of getting into the contract in the first place.

Why do buyers look for suppliers funding for capital investments in catering?

                                                                                          

How is the market with respect to supplier funding for capital investments in catering?

Among the various segments of the total catering buyer market, the largest users of caterer’s investments are educational institutions such as colleges and universities. Often educational institutions accept several million dollars in investments in exchange for a long-term contract with the supplier and are also preferred by the suppliers.

  • Businesses and Industries: Businesses and Industries segment has slowly started to adopt the concept of supplier funding for capital investments to save on deployment of own working capital which could be used elsewhere. The primary area of concern hampering this segment’s increased adoption remains to be the quality of service delivered and the lack of control, due to which large deals are very rare
  • Education: Educational business segment has been one of the early adopters of this model for catering and some of the largest deals are seen in this segment. Educational institutions are usually not very demanding compared to others regarding quality of service and do not want to involve themselves into the catering aspects. Hence they are comfortable enough to handover the control to the suppliers who manage the whole function on their own
  • Healthcare: Catering for healthcare segment is highly specialized and the institutions prefer to have a strong control over the quality as well as the functional delivery of the service. Further, volumes of onsite business is not large enough to motivate the suppliers to make large investments
  • Government: Government sector often sees the supplier funding as a way to generate free capital. The major deciding factor for investment decisions and changing supplier landscape of physical security services market is the attractiveness of the business proposal forwarded to the supplier in terms of value of returns and the period of tenure
  • Military and welfare: Military and welfare are well funded by the government and do not employ supplier funding owing to reasons such as external risks due to which there are no such known models in operation for catering

As noted above, suppliers prefer investing primarily in educational segments and business segments. The major drivers for the suppliers to invest in these segments are:

Education

Business and Industries

Drivers

Explanation

Drivers

Explanation

Large Revenue Opportunities

 

Large number of resident students who would potentially eat on campus three meals a day for seven days a week over the academic year

Business opportunity

 

Suppliers use investment offers as means to secure business in cases where there is potential for good on site sales

Opportunities to earn revenue from the large number of fests and special functions organized on campus annually, which require catering services, as well as sources other than just catering such as vending commissions

Freedom to operate freely

Educational institutions are not very demanding in terms of the quality of the services as well as the control on suppliers function

Defensive tactics in competitive scenario

Suppliers usually use investment offers as a defensive tool in cases of competitive scenarios involving other major suppliers and prospects wherein other services such as facilities services can be bundled together with the catering contract

While the major driver for the buyers to accept supplier funding is the availability of working capital without affecting the core business functions, greater opportunities presented by colleges and universities to recover the investments faster than any other corporate engagement scenario definitely do make them attractive for the suppliers. But the supplier may or may not invest in the buyer’s project depending on various factors that influence the investment decisions.

What are the various factors influencing the supplier’s investment decision?

Suppliers use investment offers as means to secure business and critical decisions such as to invest or not to invest and the quantum of investment are dependent on the following major factors:

                                                                 

What are the pros and cons of the model that needs to be considered by the buyer before making a decision?

PROS

  • Lower impact on the working capital for the buyer
  • Gives the buyer access to funds without having to use the company’s own capital or credit
  • Investment and associated risks are borne by the supplier
  • The caterer’s expertise can be leveraged by the buyer in planning and advising on development of a new, or renovation/reorganization of an existing food service facility

CONS

  • The supplier does not make upfront payment for the buyer and instead makes commitment to spend certain amount for specific purposes
  • Rebates for the purchase are usually not passed onto the buyer
  • Only a certain portion of the funding is used for investment in facilities and equipment
  • The other portion would be typically used for purposes such as merchandising and small wares, marketing initiatives and pre-opening expenses (labor and travel expenses for the caterer’s management team involved in starting up the new account), of which only a small part would be used while the whole amount is billed. This can be viewed as capital being spent towards mobilization of the contract and the buyer is paying for the perishable materials and services over a long period of time

 What are the factors that need to be considered by the buyer before the model can be adopted?

                                                       

In case of large critical requirements where the buyer feels that substantial investments would be required and is hesitant to put in own capital, supplier investments can be looked into. In such cases, the best option is to identify the purpose for the investment and include an invitation to fund the project in its Request for Proposals (RFP) so that, the competing caterers will make their best offers as they strive to win the contract. Suitable projects for such an engagement include construction of a new food service facility or renovation of an existing facility.

What should be the buyers’ strategy for a best-in-class contract formulation?

To have a best-in-class contract, it is important for buyers to look into the following:

  • Identify the purpose for the investment and prepare the terms and conditions to negotiate in advance rather than negotiating based on the caterer’s terms and proposals
  • Obtain independent estimates of the costs involved to use as leverage in the negotiations
  • Describe the project in detail within the RFP and ask for offers based on it. In this scenario, if the buyer has already obtained an estimate of costs, they can identify which caterer’s offer is most realistic and thereby simplify the process considerably
  • Prepare to negotiate for a signing bonus as it is relatively hard to get due to the supplier’s motive to keep his spend to a bare minimum
  • The buyer’s contract draft should definitely include terms describing the purpose of the project to be funded; a timetable for implementation; provision for accountability (detailed report of costs including copies of supplier invoices), and terms for repayment – number of years of amortization/depreciation; ownership of equipment during the payback period; no interest or service charges, and repayment terms in case of early termination of contract
  • A competent attorney in service contracts to review the draft in advance and be available during negotiations, especially when caterers bring their own attorneys
  • Setting up of clear deadlines for various stages of contract negotiations. Caterers often drag negotiations with delaying tactics to wear down the buyers’ patience and gain acceptance of its preferred terms

How are the payment terms defined in a supplier-funded model?

In a supplier-funded capital investment model, the payment terms are usually defined as:

                                                

Signing bonus: Usually the signing bonus is not charged directly to the buyer, but is amortized over the prospective contract duration. If the contract is terminated for any reason by either of the party, before the end of the contract period, then the buyer must repay the unamortized balance to the supplier.

Charges for facilities improvements: Investment is charged to the food service department as a cost of operation, also amortized or depreciated over the contract duration on the same terms as the signing bonus. If the contract is terminated for any reason by either of the party before the end of the contract period, then the buyer must repay the unamortized balance to the supplier.

Commission on sales: Depending on the annual projected catering sales from the site, the catering supplier usually pays a commission of about 5 percent of the total annual sales to the buyer upfront. If the sales from the site is more than the projected amount during the contract period, then the buyer can negotiate for a share in it.

Generally, a large corporation with around 2,000 employees at one site can expect:

·         To be offered up to $500,000 as an investment for a 5- to 10-year contract

·         The repayment terms would be the same as described above

·         The amount and whether some portion will be a signing bonus depends on the circumstances of each individual deal, including the competition among caterers trying to win the contract

How is the payback period for the investment calculated?

The investment payback is commonly calculated on a straight-line basis, with equal payments per month for an agreed number of years. The size of the investment in relation to the size of the food service operation dictates the length of the payback period.  The annual payback should not exceed 5 percent of total revenue or, in a subsidized operation 5 percent of total costs. (When a food service operation is subsidized, only the management fee or other direct income is considered revenue to the caterer).

Scenario 1: For Investments backed by large scale operations

 

Size of Investment

$2.5 million

$5 million

$10 million

Size of operation

$10,000,000

$20,000,000

$40,000,000

Years of Payback

5

5

5

Annual Payback

$500,000

$1,000,000

$2,000,000

Percent of Annual Sales/Task

5%

5%

5%

Alternative

Annual Payback, 10 years

$250,000

$500,000

$1,000,000

Percent of Annual Sales/Task

2.5%

2.5%

2.5%

Most medium to large-size educational institutions such as colleges and universities have food service sales of $10 million or more and large investments are common. But very few companies have services of such size and operational volume at a single location. Companies such as Boeing and IBM may have volumes close to $30 million - $50 million in total, but for them too, very few locations would have as much as $10 million in sales at one location. 

Scenario 2: For investments not backed by large scale operations

                                

Size of Investment

$2.5 million

$5 million

$10 million

Size of operation

$7,000,000

$12,000,000

$15,000,000

Percent of Annual Sales/Task

5%

5%

5%

Years of Payback        

7.1

8.3

13.3

Annual Payback

$350,000

$600,000

$750.000

Alternative

Term/Annual Payback

15 yrs. $166,667

15 yrs. $333,333

20 yrs. $500,000

Percent of Annual Sales/Task

2.4%

2.8%

3.3%

Note: All the above calculations are based on the assumption that the caterer will earn at least a 20 percent ROI (Return on Investments)

A company desiring a $2.5 million or more investment, but whose food service is not of the sizes indicated above, would have to agree to a longer payback period. The caterer will require some concessions and assurances to reduce the risks.

Ownership of assets

Caterers differ on ownership of the equipment purchased with the investment during the amortization/depreciation period, primarily because of their tax considerations. Primarily in all situations, the buyer is the owner only upon the completion of the amortization/ depreciation period. In case the contract is terminated early and the buyer makes payment to the caterer of the unamortized/undepreciated balance, the buyer is deemed as the owner of the assets which are part of the contract.

The buyer should be flexible about the investment being amortized or depreciated and the caterer or buyer owning the equipment provided during the payback period. In any arrangement, improvements to facilities will always belong to the buyer and title to equipment always passes to the buyer upon repayment of the investment.

What are the opportunities and threats to buyers in this model?

The various opportunities for the buyers are:

  • Access to working capital without any interest component being involved thereby not affecting the buyer’s accounting books
  • Risks associated with the investment is borne by the supplier so that the buyer can be free from hassles
  • Utilization of the previously unutilized space and revenue through commission from the sales
  • Buyer can bundle some other services at the site/location such as a few FM services along with the catering contract to make the offering more tempting for the supplier to pump in capital thereby improving the buyer’s cash flows

There are potential threats in the engagement that needs buyers’ attention as:

  • The buyers have little control over the quality of services provided
  • The financed project might not achieve the anticipated results such as increase in sales, reduction in costs and gain in efficiencies for which the buyers needs to be prepared
  • The investment committed to the project by suppliers might exceed its actual cost. The caterers may not report this to buyers and may retain the difference as profit. Hence buyers should audit caterers’ actual costs to understand the actual expenditure.  
  • The investment committed for the project by the suppliers might turn out to be insufficient. The caterers may deliberately or by mistake underestimate the cost and make the buyers either pay the excess cost directly or increase the repayment obligation to cover their increased investment
  • The caterers may use inferior materials and equipment that may not last more than a few years; sometimes not even the length of the amortization/ depreciation period

What are the risk mitigation strategies that help in minimizing the risk exposure of buyers in this engagement?

To minimize the risks associated with the engagement, the buyers may adopt the following strategies:

  • Conducting audit for estimating the required investment

The buyer should ensure that proper audits are conducted to ascertain the exact amount that would be required for investment so that there is no excess or shortfall in the investment made by the supplier

  • Ensure strong negotiations

The suppliers may try to maximize their benefit from the deal. Therefore, the buyer needs to be well prepared and negotiate hard for more accountability for quality and more control

  • Fix on the standards and equipments

The make and quality of the equipment to be purchased as well as other depreciating assets should be discussed before hand. The average life time of kitchen equipment is about 15 years and this needs to be considered before making a purchase

  • Ensure provision to audit the final accounts of the supplier

Provision should be made to enable audits of the final account books so that it can be verified if the supplier has spent the money on appropriate items as claimed in the bills

Conclusion

While the opportunities might be tempting to go for a supplier-funded investment model, the buyer needs to look into preparedness in terms of handling the contract and mitigating the risks/ threats associated with the engagement. This being a highly niche engagement strategy, the buyer needs to have a clear understanding of why they want to go for it and accordingly formulate strategies that would govern the engagement with the supplier. Since the investments vary significantly depending on the scenarios and negotiation, it is advisable for the buyer to engage an external consultant proficient in the supplier investment processes as a normal catering manager might be under-equipped to handle such scenarios.