Contract Complexity



As the markets adjust to the new economic reality, what has the impact been on outsourcing contracts? In the first part of a two part series, SSON speaks with Richard Cumbley, Partner, Technology, Media and Telecoms, Linklaters LLP, London

SSON: Richard, over the past year it seems that outsourcing contracts have become longer and more complex. Is this really necessary?

Richard Cumbley
: A great question. And no, we don’t need complex agreements at all! Certainly as far as Common Law jurisdictions go — the US, Canada, Australia, UK, Ireland — we constantly see contracts being signed, which don’t entail three- or four-hundred page agreements. But you need to think about why they can do this: It’s because throughout the process of implementation of these agreements, no one has a leverage advantage over the other. The moment you construct a deal where one side does have such an advantage, the other will demand protection — and reams of paperwork to support this protection. Put differently: if a provider has spent millions on a pitch process, and is funding some of the initial operation up front, they are vulnerable and will require protection via a contract.

Big outsourcing deals can mean 10 million dollars for the pitch and another 40-50 million dollars spent on the transition, never mind what a supplier has to spend on buying assets from the customer. At that point, the supplier is completely in the customer’s pocket and needs to protect himself. Similarly, if a customer sells all his assets to the suppliers, say in an IT or accounts payable (AP) outsourcing deal, he’ll want to know that at the end of the arrangement he has the right to buy them back. If he can’t buy them back he potentially has no AP function!
If one party does have an economic advantage at any point, then the contract snowballs. Customer says, in the above example, "I need to be able to buy assets back from you at the end." Supplier says, "OK, but how do I know I will get a fair price?" Customer can’t say "we’ll agree" because what happens if the supplier doesn’t agree, and the customer has no assets? So instead he says, "my advisors have prepared a short asset valuation schedule which I know you’re going to just love . . ."

So the balance of economic position between both parties is key — the extent to which one party is exposed to the other. If you can build a deal where no party is ever disadvantaged significantly, even during transition and exit, then your contract can be pretty short. Where that’s not possible, and contracts do snowball, that’s not the supplier’s fault, or the customer’s fault, or the adviser’s fault.

SSON: Doesn’t that imply that it’s always the commercial models that drive deal complexity?

RC:
OK! OK! I take the rap for my profession. Every deal is different and every commercial model is different – which ought to mean the way each agreement is structured ought to be different, too. But you’re right, one of the biggest problem areas for deals gone wrong is where advisors (not just lawyers) have squeezed perfectly sensible commercial arrangements to fit the kind of model they are used to. Too often, that means a fixed price model for a fixed price service, because that’s the approach most advisers know best; which can lead to all sorts of trouble. And advisers, by and large, are turning to those long fixed price/scope deal documents they have used before for their next deal, for the best of reasons – drafting a document for a client is much cheaper if you simply change the names on a deal document you have used before, rather than spend five or six weeks really working out how the client’s commercial model might work best. And the adviser can say to their client, "look how little money you have spent drafting this agreement, but look how long it is and how quickly I have produced it for you!" In an ideal world, a client would say "I don’t want your precedent deal document you have used 50 times before Mr. Advisor, because my deal is unique, and I’m going to invest in creating the right deal document up front because it will save me $millions more over the life of the contract."

SSON: So, should we be pushing for simpler contracts? How do we get there?

RC:
There’s a mind set that needs shifting – cost vs. value. Drafting a short agreement, unique to a deal’s commercial model, requires an investment by clients up front. That costs more in the short term, but delivers massively on value over deal life cycle. So invest time and money in working through your commercial model with your advisers and helping them draft an agreement that really works for you. In particular, clients and advisers need to work through the economic drivers of deals: what behaviors am I motivating in both sides and are they the right ones? Having said that many customers, especially right now, start a discussion with suppliers with the absolute idea of reducing cost. And advisers understand that goal – it’s easy to write down, and a lot of deals have been structured that way before, so they can just "crank the handle" on their documents. The trouble is, if you start a discussion on reducing cost, you inevitably force yourself down a route based on a fixed price or fixed saving contract ("because I want my cost saving, I’ve put it in a powerpoint presentation to my boss" says customer) and a fixed scope ("because it’s the only way I can deliver that crazy saving you want" says supplier). So every time you, the customer, want to make changes to the service — and you will — more costs are incurred — above the number you committed to your boss. So as a customer, if your mindset is on reducing price, incurring extra costs does not bode well for the health of the relationship. You risk setting yourself up to fail with this approach.

SSON: So, what’s the solution?

RC:
Well, you need to reassess the initial discussion. In terms of getting to simpler contracts, a first step is to try to get beyond the idea of "I just want to save money," because that will lead only to fixed process/fixed scope contracts which are recipes for conflicts. So you need more meaningful metrics, to get at the real economic drivers of a deal and the behaviors you want to promote.

An interesting question for a supplier to ask a customer in the first meeting would be: "Tell me what success looks like to you." If the answer is "cheaper price," then the next question should be: "How will that happen?" Suppliers often shy away from that question because it suggests they don’t know something about how to do a deal, but there’s no harm in asking! On a BPO deal, the customer often translates cost savings into generating efficiencies out of your FTEs. So, rather than having 50 FTEs processing 500 invoices a week, you’ll have 25 FTEs processing the same. So make that a definition of part of the service, a generator of revenue benefits. In other words: Scratching away at the surface to find out what saving money really means can get to much more meaningful metrics than just "price."

If you do fall into the fixed price/fixed scope arrangements, recognize that you will want to change and buy yourself some "free change" as part of the contract. In other words: give yourself a margin of error – say x number of changes worth say 5% of the revenue as "free change." Change is inevitable, so don’t pretend your service scope will be the same for five years.

Something else we are doing a lot more of now, than four or five years ago, and which has really helped improve supplier relationships is multi-sourcing. Customers are setting themselves up with two or three suppliers, which creates a constant competitive force and puts less pressure on signing really long, complex contracts. It creates good economic drivers and behaviors. Relationships are fresher as a result of this approach, and tend to be more flexible. The downside is it tends to cost more to set up these multi-sourcing contracts, but the costs are made up over the life of the agreement. A good example was Vodafone’s applications development deal, last year, for global applications support with both EDF and IBM. It gave the company more flexibility to pick and choose.

SSON: what about length of agreement? 10-year deals used to be the norm, especially given the significant costs involved with pitching and transitioning. Is this changing?

RC
: Yes, we are definitely seeing fewer long deals now; five years tends to be the norm. Given so many changes in the industry, neither side is keen to pin themselves down for longer anymore, so five years seems to hit the sweet spot. I haven’t seen a deal past 10 years for a long time in the private sector.

Click here to read Part II of this series