When the Great Depression of the 1930’s rocked the U.S. economy, many banks failed. Customers who had deposited their life savings in a bank watched their personal finances disappear overnight with no recourse. To prevent that horrific event from happening again, the U.S. Congress passed an act which insured bank deposits up to $100,000.
ASP buyers, however, have no such insurance. If their ASP goes under, they have to shoulder the financial burden as well as try to find another outsourcing provider with more staying power.
Outsourcing always involves risk. Today, the ASP world has become even more treacherous because the sector is in the midst of a shakeout. Ben Pring, a principal analyst for the Gartner Group in Mountain View, California and an ASP specialist, predicts that 60 percent of the ASP vendors that were operating at the end of 2000 will not be in the marketplace by 2004.
That said, the ASPs that do survive this shake up will do quite well, thank you. “The ASP value proposition is definitely here to stay,” says Pring.
Handing over important business functions to a third party in this uncertain business terrain requires more than deep due diligence and a leap of faith. There are concrete steps you can take to measure an ASP’s longevity and there are clauses you can write into your outsourcing contract to mitigate the losses if the worst actually comes about. “You can protect yourself from the vulnerability of an ASP,” says David Pace, partner and outsourcing specialist at Arter & Hadden, a Dallas, Texas law firm.
ASPs Pose New Legal Issues
Pace, an outsourcing expert, points out that the idea a buyer must protect its rights in an outsourcing contract is not new. Traditional IT outsourcing contracts always dealt with this issue, he reports. Outsourcing to an ASP provider, however, poses new challenges, because ASPs use a different method of delivery from traditional IT vendors. Receiving data via the Internet poses new legal issues, continues Pace.
Fortunately, the U.S. bankruptcy code clearly protects buyers who have contracts with American ASPs. The ASP business model has the vendor own the license to use the software which it then shares with its customers. If the ASP declares bankruptcy under the U.S. code, the law allows buyers to continue to use the software even though they don’t own the license. In other words, the right to use the software is irrevocable.
The right to the software becomes more problematic if the ASP is located in a different country from you. If the vendor goes out of business, all customers must seek recourse under the laws of that country. Litigation, by definition an expensive process, becomes even more costly. Buyers must pay to send their corporate attorneys to foreign soil and hire a local legal team, too.
Pace says outsourcing in foreign jurisdictions has become commonplace since the ASP model lent itself to a global market. “Globalization is great when everyone is doing well. But things change where there’s a shakeout. Clauses you included to protect yourself may not be much help,” points out the attorney.
Do Your Homework
Some of the best actions buyers can take to protect themselves occur at the due diligence stage. George Kadifa, president and CEO of Corio Inc., a San Carlos, California ASP, says the first thing a prospective ASP customer should do is find out if the ASP is a publicly traded company. In the United States, publicly traded companies like Corio must disclose their financial information quarterly. The information is easy to find on the Security and Exchange Commission’s EDGAR database.
Kadifa says if the company is not publicly traded, “alarm bells should go off.” He explains in today’s bear market it is difficult for private ASPs to continue to receive venture capital funding or go public themselves. With their cash source choked off, they are forced to live on earnings. Many can’t make the numbers; this problem with profitability is contributing to the ASP shake out. “I’d ask the ASP why they are not earning a month over month profit,” adds Pace.
Pace says his clients sleep better at night knowing their ASPs are publicly trading. The companies “who got started early are safer,” in his opinion.
Buyers must monitor the financial positions of their ASPs continuously. Kadifa says the number to watch is the cash position. If the ASP is living in negative spending territory and is burning cash, the CEO recommends doing the math to determine how long the company can survive without a cash infusion. “If the ASP has less than one year left, that would raise a major red flag,” he says.
Study the ASP’s Business Model
The Corio CEO also suggests studying an ASP’s business model carefully. Many ASPs offered their initial customers sweetheart deals so they could have big name references and grab market share. These three year contracts force the ASP to operate at a loss. The business plan assumed those names would be a magnet for a large number of new customers who would pay full price.
Some of these ASPs signed up their initial customers at a deep discount, but then were unable to find takers at full price. It’s unlikely this business model can generate the kind of profits a new company needs to survive without another round of venture capital funding in this “Rome burning” economy. “That business model scares me,” says Pace.
Kadifa says a good barometer for long term ASP health is to study vendor contracts to ensure the relationship “is a win/win situation for both parties.” Buyers should be wary of contracts that force the vendor into an unprofitable situation which does not augur well for corporate longevity.
Contracts with unlimited scope are another warning sign, points out the Corio CEO. “This kind of contract sets off an alarm because it shows the vendor doesn’t understand its pricing structure,” notes Kadifa.
Another red flag is a Texas-sized advertising budget. If the ASP is advertising during the U.S. Super Bowl, where a 60 second ad can cost over $2 million, buyers should think twice, continues the Corio executive.
A corollary is to track an ASP’s gifts to prospective and current customers, which uses scare capital without improving the offerings of the vendor. Kadifa relates the story of trying to win a new client’s business. The buyer had narrowed down the vendors to just two. Kadifa learned its competitor purchased fussball tables for the buyer’s decision makers.
If a company is privately held, it is under no obligation to reveal its financial position. Pace says buyers, however, can request this information in their Request for Proposal (RFP). He recommends requiring the ASP to provide an income statement, a balance sheet and a cash flow sheet for the past three and the next three years. And the contract should state the buyer has the ability to review an updated — even if unaudited — version of these documents every six months.
Create a Software Escrow Account
Buyers can also protect themselves by inserting certain clauses into their outsourcing contract. Pace says a wise CIO would demand the ASP develop a backup system and a source code escrow account. An independent agent should manage this account. Pace recommends this escrow account should be located in the country where you are domiciled. If your ASP closes shop, you can take the appropriate documentation to the escrow account agent who can release the source code software and the most recent backup to you.
Escrow accounts allows buyers to take the data home, load it on a computer in their office and launch their disaster recovery. That also buys time to investigate other outsourcing vendors and figure out what to do next.
The next step in lowering risk is write the right to terminate the outsourcing agreement into the contract. This allows buyers to bail out long before the landlord padlocks the doors for failure to pay rent.
Pace also suggests requiring every ASP to post a performance bond. If the ASP fails to perform according to agreed upon service level agreements, the bonding company pays the buyer for the amount of the bond. “Performance bonds give buyers a source of capital if they are left in the dark. Buyers should view the bond as an insurance policy to recover their costs,” says Pace.
What is an appropriate bond amount? The Dallas attorney suggests buyers calculate what it will cost them to complete a disaster recovery operation and bring the function back in house before outsourcing to another vendor. That number should be the bonded sum.
What are the signs an ASP is starting into a tail spin? Not posting an operating profit is one. Another is stringing out their vendors 60 to 90 days instead of paying them promptly. Pace says Dun and Bradstreet reports review the ASP’s payment history.
If the ASP does slide into bankruptcy, don’t hope for a quick resolution. Pace observes that bankruptcies unfold slowly.
The bottom line: buyers need to do their homework. “There are many ASPs who are making a profit by providing good service at a good price,” says Pace. Buyers just have to look a little harder to find them these days.
Lessons from the Outsourcing Primer:
- Buyers must do their homework when selecting an ASP. This is more important today because as many as 60 percent of today’s ASPs won’t be here in four years.
- If the company is publicly traded, check with the securities regulators for reports they must file to monitor the ASP’s cash position. Demand records in the contract if the company is privately held.
- Study the ASP’s business model carefully to make sure its contracts contribute to its profitability.
- Set up a source code and back up escrow account.
- Insist on a performance bond.
- Monitor the ASP’s supplier payment record in the Dunn & Bradstreet report.