For the many companies that chose to pursue outsourcing strategies in the late 1990s and early 2000s, new challenges are arising these days as their outsourcing agreements are reaching the end of term. While bringing the services back in-house, or insourcing, is becoming more common, most outsourcing customers are more likely to either renew their existing outsourcing arrangements or pursue options with a new provider. For those companies, there are lessons to be learned from an initial, or “first generation,” outsourcing experience that may create advantages for the second time around. Some of these lessons also apply to first time outsourcing transactions as advice on best practices from the seasoned veterans.
ADVANTAGES FOR THE SECOND TIME AROUND
The Scope of the Services is No Longer a Black Box. There is no way, even under the best of circumstances, that most outsourcing customers could have fully understood exactly what was being outsourced at the time the first outsourcing agreement was signed. Typically, there are disagreements and compromises with the provider as to what is considered “in-scope” (i.e., included in the services for no extra charge) and what is “out of scope” (i.e., services for which the provider expects to be paid extra amounts). In a second generation outsourcing, the package of in-scope services is no longer a black box. During the term of the first generation agreement, both parties had to come up with some functional way of discovering, discussing and resolving scope issues and other disputes. That experience can be used to guide the future change management and dispute resolution processes.
Lessons Learned: Customers have a much better understanding of what exactly is being outsourced and can use that experience to more clearly define what is in scope the next time around.
Practical Steps: Customers should seriously revisit the work descriptions for each of the outsourced functions to fill in gaps, take out confusing language, and clearly incorporate into the work description those services that had been in a gray area. The documented baselines developed by the first provider can provide clarity regarding the services desired from the new provider. This clarity, combined with the knowledge that a competitor has already successfully provided these services, should aid substantially in developing a new statement of work. In addition, customers should revisit the dispute resolution and scope change procedures to cull out the things that did not work for their organization, and incorporate processes and methods that have proven effective for them with the first generation provider.
Dynamics of Termination Charges are Changed. First generation comprehensive IT outsourcing agreements that are thoroughly negotiated will typically include a large termination charge to be paid by the customer in the event of a termination for convenience. There are several reasons that a provider may give for this termination charge, some stated (e.g., recovery of capital investment, compensation for re-deployment of personnel and resources) and some unstated (e.g., recovery of lost profit, hedge against unforeseen risk in the deal, hedge against the customer changing its mind). Some of those reasons are mitigated in a second generation outsourcing agreement.
Lessons Learned: Repeat outsourcing customers now have a demonstrated institutional commitment to outsourcing and may be past initial capital investment in modernized facilities. A provider attuned to these factors may recognize the reduced risks of a termination for convenience in a second generation outsourcing and may try to distinguish itself from its competition by significantly reducing, or even eliminating, termination charges from its proposal.
Practical Steps: Customers should feel comfortable taking aggressive positions with respect to termination charges in connection with second generation outsourcing agreements.
BEST PRACTICES FOR THE SECOND (AND FIRST) TIME AROUND
Align Incentives Around Transition. In first generation outsourcing agreements, it is critical that the transition of the outsourced services from the customer to the outsourcing provider happen smoothly and without serious incident. If employees or other resources have been transferred to the provider, it could be very difficult, but perhaps not impossible, for the customer to regain control of the services and continue to perform them as it did right before the transition attempt. Transitioning from a first generation provider to a second generation provider is even more risky in that it is impossible for the customer to take direct control of the services. Instead, the customer is wholly dependent on at least one, if not both, of the providers to perform.
Best Practices: Here are two practical steps to create meaningful incentives for quality and timely transitions:
(1) Customers could seek to carve out breaches in transition obligations from the liability cap and disclaimer of consequential damages provisions in their new outsourcing agreements, or subject breaches by the new provider of its transition obligations to a substantially higher liability cap. The most common type of damages that customers will suffer in a botched transition will be the costs to perform the services itself or to pay (often at a premium) the first generation provider to continue to perform while the transition problems are fixed. These “cost of cover” damages are frequently identified by savvy outsourcing vendors as a type of damage for which they will not be responsible. Customers should also consider including language expressly allowing the customer to recover such damages and incorporating the cost of internal efforts to perform the services in the definition of such damages.
(2) Another option is to price the transition separately, on a milestone basis, with a holdback of a portion of the transition fees until the new provider successfully completes all of the transition milestones. Customers could require the new provider to separately price the transition services, break up the transition price, and link pieces of the transition price to completion of key milestones. A milestone payment structure is nothing new, but is a valuable tool to make sure that incentives are aligned. The last facet of this milestone payment method is to require a holdback (i.e., a short pay of the various transition milestones by 10% to 30%), which will remain unpaid until the whole transition is successfully completed.
Planning for Disentanglement. As important as it is to ensure that a new outsourcing provider is transitioning the services into its organization as desired, it is equally important to make sure that an exiting provider stays appropriately engaged when transitioning away at the end of a relationship. An outsourcing agreement can be compared to a celebrity marriage. No matter how well-intentioned the parties are at the beginning about spending a lifetime together, the marriage frequently ends, and each party’s success and happiness upon exiting the marriage will depend on the terms of the pre-nuptial agreement. Any experienced outsourcing customer will confirm that any limitations in the contract provisions around disentangling with the existing provider (i.e., the pre-nup) will come into sharp focus when preparing for a subsequent generation outsourcing.
Best Practices: Customers should include appropriate language dealing with disentanglement in their first outsourcing agreement and in all subsequent agreements. Issues to consider include:
(1) Access to Information. Many of the benefits earned in a first generation outsourcing will be squandered if the customer cannot access the information developed and held by the first generation provider as part of its performance of the services. The first generation provider will have detailed information as to volumes of consumption of certain services, network diagrams, IT standards, brands and versions of software deployed and other very useful information. The customer should have easy access to this information (at little or no cost), not only as part of disentanglement, but also throughout the life of the outsourcing agreement, in order to be able to present a clear picture of the customer’s current environment to a successor provider.
(2) Access to Intellectual Property. A change in service provider should not necessarily change all the tools and products used by the customer to support and execute its outsourced infrastructure. Customers should have the opportunity to keep using the software and other intellectual property provided by the exiting outsourcing provider that are needed in order to survive after transition to a successor provider. Customers should seek to include broad licenses in the contract to cover the use of tools and products throughout the term and following the termination of the agreement. This would take the form of licenses for not only the customer, but also the customer’s third party service providers (e.g., successor outsourcing providers) for the conduct of customer’s business and operations.
Planning and executing outsourcings, of any generation, is a service provided by the McGuireWoods Outsourcing & Technology Transactions Practice Group. This practice group is part of the firm’s integrated Technology & Business Department, which provides legal services for business transactions driven by technology. These service areas are led by Department Co-Chair Steve Gold. For further information about this or any related topics, please contact us.