DLA Piper UK LLP

Servitization: the legal challenges

Question

What is servitization and what are the legal challenges associated with it?

Answer

Servitization is the process whereby manufacturers provide services to customers alongside or in place of a product offering; it can provide a potential major new source of revenue for manufacturers beyond the production and sale of products. Some basic examples include product finance, helplines and consultancy services, but there is an increasing trend toward servitization in more complicated services such as automated air-conditioning monitoring and ‘pay as you go’ use of assets.

Servitizing can help to forge closer relationships and deeper integration with customers, as well as annuitise revenue and encourage product improvement.

Who is doing it

Many industry sectors have the potential to engage with this model, with examples including pharmaceutical manufacturers providing 'healthcare solutions' and technology firms offering integrated 'business solutions'. Examples of manufacturers that have embraced aspects of this model include:

  • Rolls Royce, which now reports a 50:50 split between service and product revenues – its "power by the hour" is the flagship example of successful servitization; and
  • Xerox, which derives 54% of its revenue from services including its "pay-per-print" model.

Legal issues

The change from a pure product offering toward providing accompanying services is one with a number of commercial challenges. It requires a significant shift in terms of the legal approach in a number of areas and across a broad range of practices, including corporate and commercial, insurance, real estate, employment and banking. Specific examples include the following:

Due diligence

While not necessary when a manufacturer is simply providing a product, it is vital for service providers to undertake appropriate due diligence to ensure that they can accurately scope and satisfy their ongoing obligations under a service contract and to include appropriate mechanisms to adjust the price if new information arises after signature.

Title to products

In a traditional sale-of-goods model, title in goods will pass to the customer under the contract. Under a servitized solution, title may remain with the provider/manufacturer. Accordingly, issues such as potential insolvency of the customer will need to be considered at the drafting stage of the contract to ensure that the manufacturer is able to recover its assets.

Governance

While in a sale-of-goods model there is often some form of account management, ongoing relationship governance becomes a critical consideration in the servitization model. Consequently it is vital for the contract to contain detailed governance provisions which reflect the long-term nature of the relationship and possibility of disputes throughout the life of the contract. With this is mind, duration and termination provisions should also be included which protect each party and provide an opportunity to terminate the relationship if required. Moreover, parties should also provide for changes to the services during the term. This allows the manufacturer to provide an agile and customer-sensitive service and ensure that any techniques and technology used in providing the services are up-to-date.

Performance measurement

With sale of goods, this is usually covered by product warranties which tend to have a finite term. Servitization requires the parties to accurately agree ongoing service levels with appropriate contractual remedies for poor performance and suitable carve-outs/reliefs where poor performance is caused by the customer.

Insurance

While product liability will be the most relevant insurance in relation to the sale of goods, professional indemnity insurance will also be required where services are offered.

Intellectual property

Whereas ownership of intellectual property would usually be retained by a manufacturer in a sale-of-goods scenario, servitization may require the use of a number of licences. In addition, the collaborative approach inherent to successful operation of the servitization model means that intellectual property may be developed during the life of the contract - ownership of this should be considered at the outset.

Premises

In sale-of-goods situations, it is rare that a manufacturer will require access to a customer's premises beyond delivery of the product. Conversely, with a servitization offering the service provision element may require regular onsite support. With this in mind, the rights of access and any restrictions thereto need to be considered at the contractual stage and providers/manufacturers should ensure that any restriction does not impact upon their ability to offer the contracted services.

Funding

While the switch from front-loaded revenue streams (ie, cash on delivery) to longer-term revenue streams can be a potential benefit of servitization, it is important to consider how this will be funded. Specifically, in the absence of immediate satisfaction of capital costs of producing the product, charges will need to be amortised over a long-term service charge and appropriate mechanisms should be included in the contract to ensure payment. External funding may also be needed to balance this.

Employment

Transfer-of-undertakings (TUPE) issues are very unlikely to arise in sale-of-goods scenarios, but there may be a risk of a transfer of employees under the servitization model. This should be understood and mitigated at the outset.

Final thoughts

Servitization is an increasingly popular method by which manufacturers can diversify their businesses and engage customers over the longer term. Legal services providers who act for such manufacturers should be aware of the legal issues and challenges that arise and encourage their clients to engage with them at the outset of a matter.

Pete Fletcher and Tom Prince are trainee solicitors at DLA Piper’s Liverpool office.

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