Are you getting ready to negotiate an outsourcing contract? If so, place “flexibility” high on the list of negotiation goals. Many customers involved in long-term outsourcing contracts in the past have learned the hard way that the restrictive and static nature of normal contract terms can tie their hands in the rapidly changing outsourced IT environment. Lawyers, consultants and business people involved in negotiating outsourcing contracts must continue both to become more comfortable with the concept of flexibility and continue finding better ways to design flexible terms into contracts.
One could naturally assume that both the customer and the outsourcing vendor would want maximum flexibility in the contractual relationship, so that the party affected by the changed circumstances or new information could react in a way most beneficial to themselves. Indeed, this is the way many outsourcing negotiations are approached — and the result can be a battle royal. A productive contract negotiation will take into consideration the flexibility needs of the vendor to a degree, and most vendors are quite adept at letting the customer know where it must have such flexibility.
However, the concept of flexibility integral to a mutually satisfactory long-term outsourcing contract is flexibility that accommodates the changing business and technology needs of the customer, as the purchaser and recipient of the vendor’s services, while treating the vendor fairly. The goal is to have a “living document” that allows both parties to enjoy a continuous and satisfactory relationship. The best outsourcing vendors today recognize that the quid pro quo of a long-term outsourcing contract is built-in flexibility for the customer. One of the reasons we are seeing so many outsourcing contracts renegotiated mid-term today is that these contracts were not designed by the parties with flexibility as a goal.
Why is it that so few outsourcing deals actually accomplish true flexibility of this nature? One of the more common reasons is that the customer doesn’t realize that flexibility is important. The customer may never have outsourced a significant IT function before, or it may not be getting good advice from experienced outsourcing lawyers or consultants.
Now let’s assume the customer is aware of the importance of flexibility. For various reasons, flexibility still may not be achieved in a particular contract. Designing flexibility terms is time consuming because solutions must be, in large part, tailored to the customer’s environment. In many cases, the urgency to sign the deal doesn’t allow sufficient time. Moreover, accomplishing flexibility requires the cooperation of the vendor’s negotiating team, and sometimes — for selfish reasons — the vendor won’t cooperate in identifying flexibility opportunities for the customer’s benefit. Finally, in given cases, the customer and the vendor may have a vague notion of the flexibility concept, but not know how to go about designing these terms for the contract. When that happens, both sides mutually fail to address flexibility in any meaningful sense.
What are some specific examples of ways to address flexibility in outsourcing contracts? Let’s address the obvious first. There is a definite trend in IT outsourcing to shorter term contracts. In the past several years, the 10-year contract term has become less prevalent, not only for network and desktop outsourcing but also for data center outsourcing as well. The ultimate flexibility for the customer is a short-term contract. However, everyone knows that a short-term contract is likely to cost more, generally in terms of price, service or technology benefits that would be offered with a long-term contract. If that has you reaching for the longer term, remember: the longer the term of the contract, the more important flexibility is to that contract. Assuming the outsourcing contract will be a long- term contract (which could be anywhere from three to 10 years), several areas offer the potential for flexibility.
The outsourcing contract may provide the customer the right to terminate the contract for the customer’s “convenience.” This means the customer can terminate the contract without demonstrating a breach of contract by the outsourcer. A termination fee probably will be associated with the customer’s right to terminate for convenience, but the amount can be negotiated. It normally will approximate some discounted return of the profits the outsourcer would have received if the contract had not been terminated. However, in competitive bid situations, customers may very well be able to negotiate a termination for convenience provision that requires the customer to pay the vendor only the unamortized portion of certain initial investments by the vendor without any “unrealized profits” fee.
On the subject of money, be aware that pricing is an area into which a great deal of flexibility can be designed. For example, if the contract provides for a fixed base price with variable pricing for excess volumes, the parties may negotiate a “band” for increased and decreased volumes above or below the baseline. A documented, sustained trend above or below this volume band would result in either a re-negotiation or an equitable adjustment to the base pricing for the remaining term of the contract. The parties can negotiate whether the increase or decrease in volumes must be attributable to some unexpected significant event in the customer’s business or attributable to any event, including normal business growth or shrinkage.
New on the horizon are pricing models that some people are experimenting with to spread business risks between the customer and vendor. These “gain-sharing” or “risk-reward” models are intended to ensure that the vendor has significant financial interest in the customer’s business performance. They can be difficult to structure and negotiate, but the pricing models provide significant flexibility to the outsourcing customer.
In the area of service level agreements, a customer should negotiate continuous improvement requirements. In some cases, the parties will be able to negotiate specific improvements in the service levels if there are known technology or process improvements to be implemented by the outsourcer in the early stage of an outsourcing relationship. In other cases, the contract can provide for periodic meetings and studies by the joint project team to identify opportunities for improvement in service levels. In general, the outsourcer should agree that it will work with the customer to design and implement appropriate service levels for any new or substitute services during the term of the contract.
One of the most important ways to ensure flexibility is to provide for periodic “benchmarking” by the customer, the vendor and an independent benchmarker. Most outsourcing vendors today are agreeing to include benchmarking provisions in contracts. However, the process has not been reduced to a science, by any means, and successful implementation will require good faith cooperation between customers and vendors.
Benchmarking can be applied to pricing, service level agreements or both. Generally, the process will permit the customer to initiate a benchmark study periodically by the independent benchmarker which will provide a current peer group comparison of the pricing and service level agreements the customer is experiencing under its outsourcing contract. The benchmarking procedure will set forth the process by which the parties adjust services, service levels and pricing based on the results of the benchmarking.
The customer should also look for flexibility in the area of future acquisitions, divestures and joint ventures in which the customer may engage. For example, if the customer entity is acquired, does the acquirer have the right to continue receiving the benefit of the customer’s outsourcing contract? If the customer acquires other operations, does the contract permit the customer to bring those operations in under the customer’s contract terms? If the customer divests certain of its operations, does the contract provide for a transition period during which the divested entity can continue receiving the benefits of the customer’s outsourcing contract? Finally, if the customer operates through joint ventures frequently, the contract should address under what circumstances the benefits of the outsourcing contract will extend to the joint venture itself.
Any discussion of flexibility in outsourcing contracts should address the common problem of “agreements to agree.” These occur in outsourcing negotiations when the parties are unable to finalize contract terms at the initiation of the contract, due either to lack of research or documentation of the information they need to negotiate or because the information will not become available until later. The parties simply “agree to agree” when the information can be fully researched or when it becomes available. Many parties to outsourcing contracts are lulled into a false sense of security with such agreements to agree, thinking they have accomplished significant flexibility in their contract. The problem is that in most cases the consequences of the parties’ failure to agree are simply not addressed in the contract. This can have devastating consequences to the relationship if the parties are ultimately unable to reach agreement. So “agreements to agree,” if used selectively and drafted properly, can be an effective flexibility tool for outsourcing contracts. While they are often necessary under the circumstances, generally the parties are better off avoiding these clauses if possible.
Flexibility can be substantively addressed in a number of ways in an outsourcing contract, but a customer considering outsourcing should also keep in mind that flexibility must be maintained even in the process leading up to signing of the contract. Customers should be wary of signing binding “letters of intent” or “agreements in principle” that legally commit the customer pending signing of the final contract. These types of arrangements are notorious for severely limiting a customer’s flexibility from the beginning of an outsourcing relationship for what usually is only short- term benefit.