Third party logistics companies manage any type of vital outsourced process related to the operations of businesses including delivering finished supplies or products and storing and maintaining intermediate and end-of-the-line inventory. Third party logistics companies are born when entrepreneurs identify and decide to fill such procedural holes. As a result of this nexus and the nature of third party logistics, certain general characteristics of prototypical third party logistics companies can be identified. The third party logistics market is generally fragmented with a great number of companies in the growth stage of their life cycle. Additionally, since the purpose of third party logistics is procedural efficiency, such companies offer premiums on increased efficiency and economies of scale to private equity investors relative to asset based businesses. Furthermore, unlike assetbased businesses, the most important assets of third party logistics companies are relationships with their vendors and customers.
These characteristics make third party logistics companies attractive to private equity investors, who have recently been very active in the third party logistics market. Many of these investments have flourished as a result of infusions of capital and private equity managerial expertise providing a great deal of value to growing companies in a fragmented market within an industry emphasizing efficiency and economies of scale.
Independent Contractor Classification
Perhaps the most marked characteristic of third party logistics companies is the utilization of the independent contractor/owner-operator model to satisfy workforce needs while minimizing expenses. Utilizing independent contractors can allow third party logistics companies more flexibility in quickly adjusting the size of the workforce, reducing the amount of energy such companies have to spend on human resources and decreasing certain employee-related costs. Many federal and state laws protect employees, however. Therefore, despite the many benefits, claims that independent contractors are actually employees who have been misclassified can expose such companies to onerous liabilities of which private equity investors should be mindful.
Common law defines an employer-employee relationship as one in which the employer has the right to direct and control the employee. To aid in determining whether an individual is an employee under the common law standard, the Internal Revenue Service has historically used a 20-factor analysis. These factors provide guidance with respect to various elements of the relationship, such as working premises, hours, investment, and realization of profits and loss. Courts have addressed independent contractor classifications within numerous industries, spanning from ground delivery to exotic dancing. One line of guiding litigation involves one of the most prominent logistics companies, FedEx. Courts have had conflicting views regarding FedEx’s classification of independent contractors in recent years, with differing results in the U.S. Courts of Appeals for the District of Columbia Circuit and the Eighth Circuit and the U.S. District Court for the Northern District of Indiana, depending on what law has been applied. For example, in multi-district litigation covering numerous state class action suits brought by FedEx drivers, the Northern District of Indiana ruled in a 2010 decision that FedEx drivers were correctly classified as independent contractors in a vast majority of states involved. The Court distinguished between apparent control of the workers’ performance and control of the results of such performance. The Court ruled that FedEx had misclassified its drivers as independent contractors in several of the remaining states because control over results of performance was sufficient to establish employee status in such states.
“[when] investing in third party logistics companies, [a buyer must] carefully analyze the classification of such workers and consider potential liabilities and penalties for misclassification”
In addition to the threat of class action lawsuits from independent contractors, third party logistics companies are also subject to enforcement actions by government agencies, which have been on the rise in recent years. Significant funding has been allotted in the budgets of the Internal Revenue Service, Department of Labor, and the Treasury Department, as well as many state agencies, for increased enforcement. Such enforcement actions resulting from alleged misclassification of independent contractors are based on claims of improper tax withholdings and payments as well as violations of the federal Fair Labor Standards Act which regulates minimum wage and overtime pay for employees. As a result of this climate, private equity investors considering investing in third party logistics companies employing an independent contractor model should carefully analyze the classification of such workers and consider potential liabilities and penalties for misclassification.
Ongoing Relationships with Founders
The relative youth of many third party logistics companies and the importance of customer and vendor arrangements emphasize a need to ensure solid ongoing relationships with founders who continue to operate such companies as employees. Generally, fledgling third party logistics companies are operated by one or more founders who are integral to the maintenance of relationships with vendors and customers. Certain aspects of a transaction can be utilized to maintain and strengthen these relationships such as requiring rollover equity investments and/or instituting earn-out arrangements as part of such founders’ consideration. This approach aligns the interests of founders with private equity investors by providing economic upside based on company performance. Economic incentives can also be put in place through negotiated employment agreements with founders, and properly negotiated bonus and severance structures within employment agreements can be utilized to ensure peak performance.
The importance of founders in maintaining customer and vendor relationships further necessitates certain protections for private equity investors. Noncompetition and non-solicitation agreements are essential to protect private equity investors from founders’ poaching of certain material relationships. Such provisions should generally be included in both purchase agreements and employment agreements since many states (particularly California) are more stringent in their enforcement of non-competition and non-solicitation limitations on selling stockholders than on employees. Additionally, employment agreements should include provisions providing for assignment of inventions and protection of confidential information. Proper termination provisions in employment agreements are also necessary to protect private equity investors from the malfeasance of founders. Severance should only be available if termination of founders’ employment is other than for “cause” which should be defined broadly and include criminal activity, negligence, and intentional offenses.
The importance of customer and vendor relationships to third party logistics companies also dominates the focus of due diligence of a target company. Since many service contracts are terminable at will upon a short period’s notice, customer and vendor calls prior to a transaction are especially important in order to ensure that such relationships will continue after the investment is consummated. Third party logistics companies frequently use specialized software platforms in order to provide services more efficiently. As a result, software and intellectual property due diligence is often critical. Real estate may also be a key area of due diligence, particularly for those companies involved in the transportation of physical goods that own or lease numerous warehousing facilities in various locations. Other important due diligence concerns with respect to third party logistics companies involve applicable regulatory concerns (including transportation of certain substances, import/export regulations, Department of Transportation licensing, e.g.). Finally, the importance of founders’ roles in maintaining customer and vendor relationships amplifies the importance of background checks on such founders as part of the due diligence process.
Recent deals indicate that private equity investment in third party logistics companies is a growing trend. By considering independent contractor issues and the role of founders, mindfully drafting purchase and employment agreements, and properly focusing due diligence, private equity investors can successfully partner with third party logistics companies, increasing efficiencies while earning a handsome return for all parties involved.
A version of this article has been published in Private Equity Law360 Newsletter.