Thinking About Outsourcing? Issues to Consider When Contemplating an Outsourcing Transaction

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1 Thinking About Outsourcing? Issues to Consider When Contemplating an Outsourcing Transaction Kevin C. Boyle and Allen J. Klein As a threshold matter, as you begin considering outsourcing it is critical to articulate your company's objectives for the transaction and obtain a broad management consensus in support of them. Are you outsourcing to cut costs? To facilitate organisational change? To free up resources? If there are multiple reasons, which are the real drivers and what are the relationships among them? The answers to these questions will help you identify the issues you will need to address and develop appropriate responses to them. No matter what your objectives, your issues list probably should include the following issues whether you are contemplating outsourcing information technology or business process, and whether your vendor is on-shore, near-shore or off-shore. Preparation and Process Count Perhaps the key advice we can provide prospective outsourcing clients is that the importance of preparation and process cannot be overstated. As to preparation, once you have defined and agreed upon your transaction objectives, before engaging prospective vendors in preliminary discussions, it is important to understand each of the following: (a) the scope of the services you are considering outsourcing (scope); (b) alternatives for measuring the performance of those services by a third party vendor (service levels); and (c) the costs you incur today and are likely to incur during the term of the contemplated agreement to provide those services yourself (costs). All too often companies that outsource start the process without first having gathered this critical information and inevitably they are disadvantaged as a result. Every industry lawyer and consultant has stories of a client doing a business process outsourcing that is unable to negotiate transaction pricing and forced to agree to resource-based pricing because it does not have reliable volume counts. Equally unfortunate are the stories about clients that contract without setting firm service levels agreeing instead to set them after the contract is executed because they do not have adequate data about their own performance of the in-scope services. Perhaps the most upsetting are the stories about companies that start the outsourcing procurement process without understanding their current costs. These companies are rolling the dice when they decide to outsource or retain the services in-house. This underscores the importance of articulating your objectives, outlining your scope, identifying the service level metrics and accumulating service level data (including, where necessary, starting to 1

2 measure your own performance against them), and determining your costs. If you take these steps up-front, and deploy a rigorous procurement process, you are likely to structure a transaction that will serve you well and withstand the test of time. As to process, consider the value of a competitive procurement. Many outsourcing customers are of the view that by engaging in such a process they are able to encourage the vendors to make proposals and reach agreements that better fit their needs than would be the case if the customer employed a sole source procurement process; other outsourcing customers are concerned about the time, resources and cost of such an effort. While we will of course pursue whatever approach the customer believes is in its best interests, our experience is that "sole sourcing" actually takes longer, costs more money and produces a less favorable result for the outsourcing customer than does a competitive process. In making this decision it is important to recognize that in an outsourcing transaction, price, scope, service levels, and risk are all integrally related and that for a competition to be successful it must address each of these aspects of the transaction. A cautionary note: A competition that addresses only price and results in the outsourcing customer's selection of its vendor before the negotiation of fairly detailed contract terms (including clear agreement on scope and service levels) is unlikely to produce a better structured transaction than is a sole source procurement. Limit Post-Contract Due Diligence Vendors typically seek to make their service level and pricing commitments subject to post-contract due diligence because, for example, the outsourcing customer has failed to gather the necessary data in advance of the outsourcing procurement process or the customer's timetable does not allow for adequate vendor due diligence. During contract negotiation, vendor interest in landing the deal typically provides the customer with considerable negotiating leverage. Post-contract due diligence allows the vendor to reopen negotiated terms after leverage has shifted from the customer to the vendor. Accordingly, post-contract adjustments to service levels and pricing should be discouraged and, if under the circumstances are unavoidable, should be constrained by well-defined parameters. However, the better course is to have the necessary data available as discussed above. Address Transition As a general matter two kinds of issues arise with respect to the transition of services from the outsourcing customer to the vendor. The first is the allocation of responsibility for the work that needs to be done to transition the services to the vendor. Consider these steps carefully and use the contract to clearly allocate responsibility for each such step. The second issue relates to responsibility for the services during transition. Vendors sometimes propose extended transition periods during which responsibility for various parts of the services is migrated over time. Based on our experience, it is very difficult to maintain accountability and a high level of service during any such period. Accordingly, such periods should be limited, or even avoided, wherever possible. To the extent reasonably possible, the vendor should do its transition planning simultaneously with the negotiation of the transaction and be in a position to take over the services on execution of the contract with little or no transition period. Anticipate Change Often a critical issue is how to allocate the risk from change to the outsourcing relationship over time, especially given that the nature, timing and magnitude of the change are unpredictable. Changes that have the potential to impact the outsourcing customer's needs and the vendor's costs include: changes in the customer's product lines or market focus; changes in the demand for the customer's product or service; changes in the technology or business process utilized by the customer; changes to the regulatory environment in which the customer operates; changes to the customer's operations resulting from "one-time" events such as the acquisition or sale by the customer of a line of business; and changes to the technology used by the vendor or the vendor's service delivery model. 2

3 We address this issue by structuring agreements to reflect the following principles: Non-Material Changes Should not Generate Re-Pricing: Given the administrative burden, time and effort required to re-negotiate pricing, outsourcing customers should consider taking the position that, whatever the cause of the change, non-material changes should not result in re-pricing. Price Changes Should be Determined on a Net Basis. Any additional vendor charges should reflect the additional costs incurred by vendor, net of any costs the vendor may reasonably be able to eliminate by virtue of the change. Pricing Algorithms Should Accommodate Changes in Customer Consumption. Over time the level of the outsourcing customer's consumption of the vendor's services will vary. Pricing algorithms that accommodate this without requiring a renegotiation are critical to the longterm success of the business. Consumption-based unit pricing (e.g., transaction pricing) accomplishes this objective and, at the same time, provides an important incentive for the vendor to perform efficiently. Plan for Significant One-Time Events. Following a significant, non-recurring event (e.g., the acquisition or disposition by the customer of a major line of business), the pricing model reflected in the agreement may no longer provide fair and equitable pricing. Moreover, while it is possible to anticipate that under such circumstances the pricing model may no longer work, it is impossible to predict which party will by be advantaged and which disadvantaged. Accordingly, it is useful to require that the pricing be "equitably adjusted' in such cases. This provision anticipates the parties will work in good faith to re-price and that if they cannot reach agreement, the pricing will be adjusted by arbitrating or litigating what is equitable. In practice the threat of third-party involvement in a re-pricing leads the parties to act reasonably and reach agreement without resort to formal dispute resolution. Employ a Flexible Definition of Scope It is very important that as part of the negotiating process the Parties clearly define the scope of the services the vendor is to perform and that such agreement provides for a flexible definition of scope. Without such agreement and definition, the outsourcing customer is at risk of paying additional charges for services omitted from scope, which may inflate the cost of the arrangement and defeat the business case for the transaction. We typically negotiate that the vendor assumes broad responsibility for entire functions, except for specific, enumerated tasks for which the customer retains responsibility. Specifically, we seek the vendor's agreement to perform: (a) the functions and tasks described in the agreement including a service description or statement of work; and (b) the functions and tasks omitted from the agreement but performed prior to the effective date by transitioning or displaced employees, or required for the proper performance of the functions tasks and responsibilities described in the agreement. Changes to services should not trigger re-pricing unless the changes, on a net basis, materially increase the vendor's cost of performance. Carefully Structure Service Levels Well-structured service levels are critically important contract and relationship management tools; major vendors are loathe to agree service levels they cannot meet and typically manage to service levels. Thus, it is critical to assure that the service levels and related remedial measures are calculated to drive desired conduct. When structuring and negotiating service level provisions keep in mind: As data is critical to effective performance management, the vendor should be obligated to monitor, measure and report on its performance of the services against the service levels. A 3

4 failure to do this in any month should be deemed to be a failure to meet the underlying service levels. Measure service levels and determine vendor compliance on a monthly basis. Measurement across a longer period may enable inconsistent service. Where possible, measure on transaction-by-transaction, or event-by-event basis, and avoid the use of averages. This will result in the vendor proposing and the parties agreeing to realistic service levels even if they appear to be lower than the levels the vendor offers using algorithms that provide for the averaging of its service. Measure only those components of the services that are susceptible to quantitative measurement and that have a meaningful business impact. Too many service levels can dilute management attention (and service credits discussed below). Generally service levels should rise over time. The contract should also contain mechanisms for reviewing and revising service levels periodically, as well as for replacing or adding service levels as the scope of services change or as custom and practice evolve. Service level credits should be set at a level that will incent the vendor to perform, but should not be punitive. The purpose of the credits is to ensure that the vendor's profit will be reduced sufficiently to get senior management attention if the vendor does not perform at the contracted service levels. Service level credits should be viewed as a management tool, and not as a substitute for damages. Service level credits should be limited to a subset of the service levels that are particularly important to the customer's business. Major vendors will insist on limiting their aggregate exposure to service level credits, and if that aggregate exposure is spread among too many service levels, service level credits become ineffective. Bonuses for services in excess of service levels are to be discouraged unless superior performance by the vendor will generate a significant economic benefit for the customer. "Banking" and broad earn-back rights for the vendor may dilute and undermine the effectiveness of service level credits. Limit Vendor's Termination Rights Although the outsourcing customer should have a broad right to terminate the outsourcing agreement upon a "material breach" (and perhaps other rights to terminate including for convenience), the vendor's rights to terminate should be limited to non-payment by the customer of significant undisputed amounts due the vendor (and, perhaps, material breaches of the provisions of the agreement protecting the vendor's intellectual property). The rationale is simple; other than failing to pay significant sums when due (and perhaps breaching its covenants regarding the vendor's intellectual property), there is little an outsourcing customer can do to warrant the potential jeopardy to its business that a vendor termination might cause. Vendor concerns that it not be liable for its failure to perform under circumstances outside its control can be accommodated through a force majeure provision and a "savings" clause providing that if the customer fails to perform a specific retained responsibility, the vendor will be relieved of liability for its non-performance to the extent the vendor's performance was dependent on the customer's performance. Termination Assistance It is very important that the parties plan for termination or expiration when structuring the contract and during the term of the agreement. In this regard the contract should require that the vendor provide such termination/expiration assistance as the customer may reasonably require to transition the 4

5 services back to the customer or to another third party vendor, and set forth in a schedule to the contract a non-exclusive list of the kinds of termination/expiration assistance services the customer may require. In addition, the contract should require that, prior to or shortly following the effective date vendor provide a procedures manual in form and substance reasonably acceptable to customer. Among other things, this manual should provide customer a "how to" guide for use by it or another third party vendor upon the transition of the services at termination or expiration (remember to make clear that the customer owns the manual and is free to use it in this fashion). To ensure knowledge transfer at expiration/termination, it is important to include in the contract rigorous requirements regarding other documentation that the vendor is required to create and maintain during the term. The customer should have unrestricted access to such documentation during the term and unrestricted rights to use it at expiration/termination. This can be extremely important in off-shore software maintenance and development transaction. Other Issues In addition to these critical, strategic issues, there are many critical legal issues including: the right of customer affiliates to receive services under the contract; the right of the customer to withdraw services; the need to protect the outsourcing customer's confidential information; the need to protect the privacy of third parties with whom the outsourcing customer does business (including customers); rules governing the submission of invoices; allocation of any foreign exchange risk; allocation of responsibility for taxes; cost of living adjustments, if any; rules governing the treatment of disputed charges; retention/removal of key personnel; approval of subcontractors; audit rights; indemnities (including for intellectual property infringement); representations and warranties; and limitations on liability. There are also a series of HR issues that need to be addressed including statutory labour laws and, if customer employees are becoming employees of the vendor as part of the transaction, the terms of transferring employees employment. Finally, offshore transactions raise a whole host of additional issues. Outsourcing complex operations is a complex process. However, careful planning from the start that includes consideration of the matters discussed in this white paper can keep the process manageable and efficient, and result in an agreement that will be the guidebook for a successful relationship. 5

6 This whitepaper is intended to introduce our current and prospective clients to some of the issues we typically deal with in outsourcing transactions; it is neither a comprehensive issues list nor a complete discussion of the listed issues, and it should not be treated as legal advice. CONTACT Justin Cornish Alice Marsden Brian Meenagh justin.cornish@lw.com alice.marsden@lw.com brian.meenagh@lw.com 6