Outsourcing Gotchas

Hidden traps lurk in every outsourcing contract. Here are 12 big ones -- and how you can avoid them.

To a CIO, outsourcing contracts may look like other procurement and service agreements, but they're much riskier. "You're writing a contract for a service that's impossible to describe, that will change over time and need to be renegotiated, that will make you dependent on the service provider and for which termination is not an option," says Paul Roy, a partner at Mayer, Brown, Rowe & Maw LLP in Chicago, who has put together some of the largest outsourcing deals in history. "That's not an ideal negotiating position," he adds.

Roy and other attorneys who specialize in outsourcing have seen the challenges CIOs face when they sit down to negotiate outsourcing deals. Here's some advice on gotchas that can undo the unwary:

Problem: Unresolved issues. Amid the pressure to get the deal done, the outsourcer may push you to sign before pricing or service levels are nailed down, promising only minor adjustments later. "The supplier may say, 'This is standard; we do this all the time,' " says Bob Zahler, a partner in the outsourcing practice at Shaw Pittman LLP in Washington. "But in our experience, in every case that has produced a bad result."

Solution: "It's much better to resolve those things beforehand, even if it means delaying the signing," Zahler says. It takes many months to put together an outsourcing deal, he adds, so if you know you don't have sufficient data to establish service levels or pricing, start measuring immediately.

Problem: Fixed service levels and incentives can become antiquated over time.

Solution: Design the agreement to be flexible so you can add and remove service levels and set incentives so you can move from one service level to another, says Roy. Include a mechanism that allows you to ratchet up service levels to keep pace with the market, focus on things that create business value and adapt over time.

Problem: Fuzzy scope. The standard contract has voluminous descriptions of scope of service - often in excess of 100 pages, Zahler says -- but they're written by technical people who aren't as precise and detailed as they should be. "And clients don't read them," he adds.

Solution: Zahler's firm breaks IT into 77 detailed processes based on industry standards and creates a matrix with processes down the left side and the client's description of his IT group across the top. Then they color-code supplier and customer responsibilities. "It's easier to do a contract that way and it gets clients to focus on scope of service," he says.

Problem: Tasks missing from scope. No matter how careful you are with the scope of work, you'll miss something, and that can cost you more, Roy says.

Solution: Build in a "dragnet" clause that states the following:

-- The outsourcer will do everything your staff did over the preceding 12 months, even if you neglect to list it.

-- The outsourcer commits to perform the function as it's performed in the market, recognizing that things will change over time.

Problem: Exclusivity. In order to get economies of scale, critical mass and broad integration, the outsourcer will want the exclusive right to perform the functions in the contract. "But think very carefully about this," Roy says. "Not all suppliers have equal capability in all functions. This is one of the biggest problems we see."

Solution: Retain the right to perform the function in-house or send it to a third party, Roy says. This right allows you to maintain competitive pressure on the outsourcer and test service levels in categories where there may be problems. If the outsourcer is weak in one function or region, you can take back that piece or give it to someone else. "Where you have multiple outsourcing agreements, over time you may find that what you've outsourced to one supplier really fits better with another," Roy says. "This enables you to reorganize the matrix of outsourcing functions."

Problem: Damages waivers. The outsourcer wants to cap reimbursements for direct damages -- out-of-pocket expenses you pay because of its failures - and completely waive indirect or consequential damages, such as lost profits or a decline in stock price, as a result of such failures. "That means if you outsource the call center and the vendor messes up and you lose $10 million in profits, if it didn't 'cost' you anything, you would have essentially no recourse," says Brad Peterson, a partner in the outsourcing practice at Mayer Brown. "It is one of the most dangerous provisions."

Solution: This is difficult to work around, Peterson says, but three tactics may help:

-- Try to negotiate the cap on direct damages as high as possible. The outsourcer will want to limit it to one to three months' revenue; try for 12 to 24 months. "Get the number high enough to provide a meaningful remedy," Peterson says.

-- If you must waive indirect damages, demand as many exclusions as you can. For example, retain the right to indirect damages if the outsourcer fails to provide termination assistance or if your company is sued for intellectual property infringement based on software the outsourcer is using.

-- Make sure the contract defines specific amounts the outsourcer will pay if it fails to perform.

Problem: Decreasing costs. Technology costs -- especially in areas like telecommunications -- can decline dramatically over time, but an outsourcing contract can span five to 10 years. How do you avoid overpaying?

Solution: Write short-term contracts for the most volatile pieces, or allow the outsourcer to provide the service on the condition that it passes through to you any cost reductions from its supplier on a dollar-for-dollar basis. (You can require the outsourcer to disclose its costs or certify when it has renegotiated.) "The supplier keeps the margin, but they don't get a windfall, and this allows you to get into a longer-term contract," Roy says.

Problem: Benchmarking can be ineffective in complex outsourcing deals because it's very difficult to find comparable situations at other companies.

Solution: Benchmark the prices of individual components and regions, Roy suggests. For example: How much are you paying for application programmers in India compared with the competition? Keep in mind that this type of benchmarking requires the outsourcer to charge a straightforward amount for each component. That means no cross-subsidizing (subsidizing an expensive element in the contract - say, mainframe maintenance -- by raising profits on another element, such as applications development).

Problem: Lock-in. For business reasons, you may need to terminate the outsourcing contract for convenience -- that is, without a failure or breach from the outsourcer. But the fee can be prohibitive.

Solution: Outsourcers try to set a termination-for-convenience fee as high as possible to lock you in, says Peterson, but be sure it's low enough that termination remains an option.

Problem: Ownership of intellectual property developed in the course of outsourcing is always in contention. You want to own what you've paid for. The outsourcer wants to own what it has developed.

Solution: Focus on whether the application is strategic to your business, says Gregg Kirchhoefer, a partner at Kirkland & Ellis LLP in Chicago. If an application isn't strategic, let it go, but you may want to negotiate some return on that investment in terms of royalties or other compensation.

Problem: The outsourcer's people are critical because of the close interaction between supplier and customer, but you have to cede control of personnel.

Solution:Retain the right to approve six to 12 people in certain key positions who solve problems and interface with management, such as project executives, help desk managers, systems architects and software troubleshooters, Roy says. Get commitments that those people will stay on for a reasonable minimum time and, when they do leave, that you'll interview and approve their replacements. Retain the right to request reassignment of people who don't work out and to hire the outsourcer's staff at the end of the deal.

Problem: Ignoring termination issues. In the eagerness to get the deal done, people often pay insufficient attention to termination, causing trouble later.

Solution: Focus on what should happen under various circumstances: termination at the end of the contract, termination for cause or termination for convenience. Carefully consider the rights and responsibilities of each party in each circumstance, and be sure the contract reflects that, says Kirchhoefer.

"When [termination] happens, the parties won't be talking as much and won't be as interested in helping each other out," he notes, "so you want to have clear-cut rules."

Copyright © 2004 IDG Communications, Inc.

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