Other Contractual Entry Modes

In addition to licensing, technical assistance, and franchising agreements, other contractual entry modes have become prominent in international business, particularly with the developing and Communist countries. We offer here some comments on the more important ones.

1. Contract Manufacturing

Contract manufacturing is a cross between licensing and investment entry. In contract manufacturing, an international firm sources a product from an independent manufacturer in a foreign target country, and subsequently markets that product in the target country or elsewhere. To obtain a prod­uct manufactured to its specifications, the international firm ordi­narily transfers technology and technical assistance to the local manufac­turer. These transfers may be formalized in a separate licensing/techni- cal-assistance agreement between the two parties.

Contract manufacturing can bring the international company several advantages. It requires only a comparatively small commitment of financial and management resources, allows for quick entry into the target country, avoids local ownership problems, and—unlike standard licensing—permits the international company to exercise control over marketing and after­sales services. Contract manufacturing is especially attractive when the tar­get market is too small to justify investment entry (assuming it is possible) and export entry is blocked by restrictions or is simply too costly.

The disadvantages of contract manufacturing resemble those of licens­ing. It may be difficult or impossible to find a suitable local manufacturer. Once a manufacturer is found, substantial technical assistance may be required to bring him up to the desired quality and volume levels, and to keep him at those levels. Finally, the international company runs the risk of creating a future competitor.

2. Turnkey Construction Contracts

A turnkey contract carries the standard construction contract a step further by obligating the contractor to bring a foreign project up to the point of operation before it is turned over to the owner. A further step is the contractor’s obligation to provide services, such as management and worker training, after construction is completed in order to prepare the owner to operate the project, an arrangement sometimes called “turnkey plus.”

It is impossible to use a standard turnkey contract, because each project is unique in one or more respects. Negotiations between the two parties are complex, involve large sums of money, take considerable time, and require sophisticated legal assistance. But whatever the details of a specific turnkey contract may be, experience demonstrates that the contractor should make certain that the contract clearly stipulates the project’s plant and equip­ment, the obligations and responsibilities of each party, the meaning of force majeure and contract violations and their legal consequences, and procedures for the resolution of disputes.

Many turnkey contracts are with host governments. As such, they are particularly exposed to political risks of contract revocation, compulsory renegotiation, and the arbitrary calling of bank guarantees. A brief discus­sion of the latter will indicate the political risks assumed by a company in construction contracts with host governments.

Middle Eastern and Communist governments commonly refuse to ac­cept surety bonds from surety or insurance companies. Instead, they de­mand bid, advance payment, maintenance, and performance bonds guaranteed by banks (standby letters of credit) that are callable at the discretion of the host government. This situation poses a formidable risk to the contractor, because he would experience an immediate loss of funds in the event of a calling: the guaranteeing bank would quickly exercise re­course on him. With on-demand guarantees, the host government can call a guarantee even if the contractor is not in default of the contract. And there is very little a company can do about it. It follows that this particular risk should be carefully assessed by the international company, along with other political risks such as general political instability.19

It is not sufficient to make certain that cash flow exposure is minimized with payments over the contract life. Expected cash flows should also be set against liabilities in the event of sudden contract termination by action of the host government or political upheaval. Even with favorable cash pay­ment terms, exposure to political risk can be a large fraction of the full contract value since it is the sum of bank guarantees, cancellation fees owing to subcontractors, and other termination expenses.20 International companies can get some protection against political risks through arbitra­tion and force majeure clauses in the contract, through spreading the risk by the formation of consortia, and through insurance with a government or private agency.21 In most instances, however, a contractor will need to assume some political risk, and his only protection will be his own assess­ment of political risk in deciding whether or not to enter the contract.

3. Management Contracts

An international management contract gives a company the right to man­age the day-to-day operations of an enterprise in a foreign target country. Ordinarily, such contracts do not give a company the authority to make new capital investments, assume long-term debt, decide on dividend policy, initiate basic management or policy changes, or alter ownership arrange­ments. Management control, therefore, is limited to ongoing operations.

Manufacturers seldom enter management contracts in isolation from other arrangements with a foreign enterprise. That is to say, they do not view themselves as primarily suppliers of management services. Rather, management contracts are used mainly to supplement an actual or intended joint-venture agreement or a turnkey project.22 In this way, an international company can obtain management control over a nonequity foreign venture. Fees from management services may contribute only modestly to income derived from a joint venture, but they may be an important fraction of the income derived from a turnkey-plus contract.

Viewed in isolation, a management contract can provide low-risk entry into a foreign target market, but income is limited to fees for a fixed duration of time. From an entry strategy perspective, management contracts are unsatisfactory because they do not allow a company to build a perma­nent market position for its products. Other disadvantages include time- consuming negotiations and the commitment of scarce management talent. But when combined with other arrangements, management contracts can sometimes help fashion a better “package” for both parties.

4. International Cooperation Agreements with Communist Countries

Industrial cooperation agreement (ICA) is a catchall term used to designate a contractual or equity relationship between a Western company and a government agency or enterprise in a Communist country that extends over a substantial period of time. ICAs include, therefore, all arrangements that run beyond simple trade transactions but fall short of subsidiaries con­trolled by Western companies, notably, licensing, turnkey projects, contract manufacturing, co-production agreements, and equity joint ventures.

By the mid-1970s more than 200 U.S. firms had entered into 434 industrial cooperation agreements with the Soviet Union and other Com­munist countries in East Europe (excluding Yugoslavia).23 The most com­mon of these ICAs were licensing/technical-assistance agreements and turnkey projects. Only six ICAs were equity joint ventures, a new form of cooperation available in only some of the Communist countries.

U.S. and other Western companies turn to industrial cooperation agree­ments because direct export sales and conventional investment entry are impossible or limited for one reason or another. The Communist countries insist that Western companies share their technology, accept payment in products (countertrade), and help provide a market for host country prod­ucts outside Communist East Europe.24 They push for long-range agree­ments to get up-to-date technology and full technical-service support.

One of the more interesting forms of cooperative agreement is co­production, a kind of nonequity joint venture. Ordinarily, the Western partner furnishes technology, components, and other inputs to a Commu­nist partner in return for a share of the resulting output, which the Western
partner then markets in the West—all under a long-term contract (five to ten years). Beyond this essential exchange, co-production agreements vary greatly in the degree of coordination in procurement, production, market­ing, and R&D.

A Western company can gain several advantages from a co-production agreement: the sale of equipment, components, and other products to the partner; a presence in the host country and an opportunity to build a reputation that can lead to new business; a source of products for sale in the West; licensing royalties; and (possibly) commissions on sales made for the Communist partner in Western markets. But co-production agreements can also have drawbacks: the possible creation of a competitor in Western markets, difficulties in protecting technology, and failure by the Communist partner to maintain quality standards or meet production/delivery commit­ments.

Two last comments on industrial cooperation agreements with Com­munist countries. First, ICAs require long negotiations with highly skilled and tough officials of Foreign Trade Organizations (FTOs) that monopolize all international economic transactions. Although hard bargainers, the Communist governments have a good reputation for meeting contractual obligations. Second, in doing business with Communist countries, U.S. firms are exposed to the political risk of shifting U.S. policy on East-West relations. The products and technology involved in most ICAs require vali­dated export licenses from the U.S. Department of Commerce, and the Export Administration Act allows the President to cancel export licenses at any time in the national interest. By participating in ICAs, therefore, U.S. firms become hostage not only to host governments (the usual political risk) but also to their own government. Somehow, American firms need to take account of this novel risk in making decisions on industrial cooperation agreements.

Source: Root Franklin R. (1998), Entry Strategies for International Markets, Jossey-Bass; 2nd edition.

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