Top Ten Strategic Recommendations For Negotiating an Outsourcing Transaction November 10th, 2011Sourcing & Procurement Global Sourcing and Procurement TOP TEN STRATEGIC RECOMMENDATIONS FOR NEGOTIATING AN OUTSOURCING TRANSACTION By: Alexander P. Woollcott, Esq. Despite the fact that it is often a hot potato in certain quarters at certain times (particularly in election years), outsourcing, or as the industry prefers to refer to it now “global sourcing,” is here to stay and will likely continue to grow exponentially. The economic imperatives of sourcing are undeniable: under the right circumstances, a business enterprise can engage an outside service provider to perform an internal business or technical function or process at a much higher quality level and at a lower cost. Global sourcing is expanding in multiple dimensions. Formerly, only “back office” or non-core functions were sourced out. Now, increasingly often, companies are turning to third parties to help them perform very strategic and core functions such as research and development and business transformation. Sourcing and procurement discipline are hot topics of the boardroom now and not merely among middle management. The C-level executive suite now often has a new resident – the chief sourcing officer or chief procurement officer. A much larger number of highly qualified service providers exist than in the past. Sourcing is spreading into new industries, such as health care and real estate. Many think that “outsourcing” necessarily involves “eliminating jobs” and “moving jobs to other countries.” While it is true that using offshore personnel can result in substantial cost savings and other strategic benefits, the situation isn’t as simplistic as the anti-sourcing rhetoric suggests. For one thing, many sourcing transactions involve movement of business and technical processes and functions to U.S. based service providers that will use U.S. based citizens to perform the functions. Sometimes the sourced functions are performed at the outsourcing business’ own facilities. There isn’t always a zero sum game when it comes to job loss at the company that is sourcing functions out. While some affected employees will probably be terminated, in many instances some of the employees will be re-deployed to other parts of the company’s business or in some cases “rebadged” or transferred to the service provider. The purpose of this article isn’t about the ethics or merits or demerits of sourcing. Rather, the focus of this article is on providing a high-level summary of ways that companies can negotiate and document stronger and more balanced sourcing relationships with their service providers. Service providers are generally very professional and can often provide exceptional value added service. At the same time, service providers’ form contracts are notoriously one-sided. This article offers businesses that have made a decision to outsource some suggestions (we’ve limited them to ten) for negotiating fairer, more balanced deals with their sourcing service providers. Because of space limitations, this article cannot cover everything. Plus, the relative importance of the ten suggestions in a given relationship will vary depending on the circumstances. Sourcing transactions are highly complex and should be carefully negotiated. It will take a good bit of hard work to negotiate the service provider’s form agreement into a document that appropriately balances the service provider’s interests with the buyer’s interests. Even though they may not admit this at the beginning of the negotiations, service providers will usually negotiate with you in good faith. 1. State Your Expectations Clearly Never lose sight of the fact that you are sourcing to accomplish two overriding objectives: (i) to have the sourced functions or processes performed at a higher level of quality by an experienced service provider that is in the business of performing those functions for many customers, and (ii) to have those functions performed more cost efficiently because the service provider has much more scale and leverage (e.g. buying power) than the company outsourcing the function. Every aspect of a sourcing transaction should use those two objectives as a touchstone for the service provider’s obligations. Begin every services Agreement with a very clear and objective statement of your company’s objectives as a buyer of sourced services. 2. Get Negotiating Leverage as Early as Possible As noted above, service providers and their form service agreements tend to be quite one-sided favoring the service provider. You should consider using your own form of services agreement, assuming that it has been prepared by an experienced sourcing lawyer. Get your lawyers involved sooner rather than later and use an experienced sourcing lawyer as opposed to a corporate generalist. Good sourcing lawyers are familiar with intricate risks and leverage points within a complex sourcing relationship and they can easily parlay this into real value, reduced risks and significant cost savings for you. If to save on legal fees you call your sourcing lawyer in at the last minute to “paper the deal” that you have negotiated without the sourcing lawyer, you have compromised much of his or her leverage to negotiate you a better deal. Besides, there aren’t simplistic distinctions between “business issues” and “legal issues” in sourcing transactions. If your company is soliciting competitive bids from service providers (something I recommend), you should attach your own form of services agreement to the solicitation document and require the bidding service provider to indicate any areas in the agreement that it will not accept. You should indicate clearly that your selection of the winning bidder will consider not only business terms such as price, but also the degree to which the service provider is willing to adhere to your service agreement form. 3. Nail Down Your Performance Metrics Clearly Up Front There are two broad categories of performance metrics that you should insist your service provider meet: first, broad, general performance quality standards and, second, specific, detailed specifications. Examples of the broader performance standards include commitments by the service provider to render the services in compliance with applicable laws and regulations, in accordance with prevailing or even “best practices” in the particular industry and in a manner that shows sustained improvement during the broader service term. Because sourcing relationships are often contracted to last for years, you might want to require the service provider to meet changing norms of performance standards. Advances in technology alone will make it easier for service providers to meet elevated performance standards in many cases. Performance criteria should not be static. An important, though often overlooked requirement of a buyer of sourced services is the requirement that the service provider commit to perform not only the specifically enumerated services but any additional services reasonably needed in order for service provider to meet the buyer’s requirements stated in the Agreement. That is why I recommend that buyers state clearly in the Agreement what their broadest objectives are. The following is an example of such an objective: In return for Company’s payment of the Service Fees set forth in this Agreement, service provider will (a) assume all facilities management functions outlined on Exhibit A, (b) will perform those services in a manner that meets or exceeds all Performance Metrics in this Agreement, including, without limitation, all SLAs set forth on Exhibit B, and (c) ensure that Company will achieve an overall reduction in facilities management expenditures of at least 20% during the First Contract Year, pursuant to the specific financial benchmarks set forth on Exhibit C. Do watch out for service providers that only want to commit only to using “commercially reasonable efforts” to meet your specified objectives and performance metrics. If they ask for this, perhaps your company should ask to use “commercially reasonable efforts” to pay their fees! 4. Understand What Service Level Agreements (SLAs) Really Are A buyer should always include in the sourcing agreement specific performance levels for the that are known as “service level agreements” or “SLAs.” SLAs, and their associated “credits/penalties,” are often the most heavily negotiated part of an sourcing deal. Most buyers of sourcing services, and often non-sourcing lawyers, do not really understand what SLAs are or what their function is in the sourcing relationship. SLAs are not performance warranties per se but rather are benchmarks that trigger certain rights or credits to the client if they are not met, or, increasingly, certain bonuses or service provider credits if they are materially surpassed. SLA credits are typically more of a “slap on the wrist” of the service provider than a severe remedy for poor performance. Their goal is to entice the service provider to do what is necessary to correct a flagging performance measure. Service providers will seek to limit SLAs to a few highly critical performance criteria and will (rightfully) insist that the SLAs be objective and easily verifiable. You will want to require that the parties review the service levels periodically throughout the term of the Agreement in order to make appropriate adjustments to them. If the service provider fails to meet a required SLA, the buyer should automatically receive monetary “service credits,” which typically would be remitted by service provider to you within a specified period of time (often 30 days) after the end of the month in which the failure occurred, or, at your option, sometimes the service provider will be required to deduct the service credits from the next invoice or other amounts due to service provider. Watch out for service providers that ask for SLA credits be your sole remedy for any failure to meet an SLA. SLA credits do not fully compensate clients for major performance breaches by a service provider. If service provider fails to meet a service level, it should be obligated contractually to: (i) promptly investigate the root cause(s) of the failure and deliver to you a written report identifying the root cause(s); (ii) use commercially diligent efforts to correct the problem and to begin meeting the service level as soon as practicable; and (iii) advise you of the status of the corrective efforts. 5. Often Ignored Transition services: Entrance and Exit of a service provider At the risk of stating the obvious, transitional issues arise at the inception of the sourcing relationship and at the end of the relationship. These issues, however, are ignored in service agreements far too often. The services agreement should contain a detailed description of how the services will be transitioned to the service provider at the outset of the relationship and the functions the service provider and the client are to perform. A detailed transition plan may be appropriate. You might want to ask that the timeframe for the transition schedule be extended for a certain period of time (e.g. 45 additional days) without incurring additional charges from service provider. The more challenging transitional issues arise at the end of the sourcing relationship. These issues are particularly delicate if the buyer terminates the relationship early “for cause” and the service provider disputes the basis for such a termination. Nevertheless, a well negotiated services agreement should contemplate this possible scenario and should carefully articulate the role and responsibilities of the parties in the event of an expected or unplanned termination of the relationship. Often the issues boil down to cost considerations. Are the transitional services provided by the service provider for free? Under all termination scenarios? For how long are the transitional services to be provided? What is the level of resources that the service provider has to commit? To what extent does the departing service provider have to interface or collaborate with a replacement service provider, which may be its direct competitor? 6. Defining Services Precisely to Avoid Loopholes The services should be defined in the agreement very carefully and very precisely. We estimate that over 75% of executed service agreements do not define the services with sufficient precision. As self-evident as this sounds, many sourcing relationships run into trouble because the scope of the services was defined too narrowly, broadly or ambiguously. Imprecision will cost you money one way or another. Too narrow a scope will require you to perform the uncovered services yourself, to obtain an additional service provider to perform the services or to negotiate with the primary service provider to add the uncovered services (for more money). Too broad a scope will lead to the service provider performing (and charging for) unnecessary services. Ambiguity leads, at a minimum, to additional legal fees and often to active disputes or litigation. Remember the saying about the whole sometimes being greater than a sum of the parts. That has great relevance in the sourcing industry. Service providers prefer to have a laundry list of specific, albeit minor, duties that they have to discharge. While there is no substitute for having such a list, that list should not be in lieu of a broad statement of objectives that must be met for the sourcing to be deemed successful by the buyer. To the extent that the service provider’s duties are in any way contingent on your company’s doing something, make sure the Service Agreement is crystal clear on what your company has to do. You want to avoid scenarios where a service provider can shift the blame of a service failure to the client for not doing something that was a pre-requisite to the service provider’s obligations. Watch out for “conditions” (which may sound reasonable) imposed by service providers such as conditions that the buyer’s personnel provide the service provider with “reasonable assistance” in performing the services. While this sounds fair, it creates a large loophole for poorly performing service providers to shift risk to buyers. The solution: state clearly and objectively what the buyer’s personnel have to do as a pre-requisite for the service provider’s performance of the services. And don’t forget – you are outsourcing the function or service and paying the service provider handsomely for this; you shouldn’t be retaining many responsibilities or much if any risk or it the function or process hasn’t really been outsourced. 7. Don’t Ignore the Importance of Service Provider Personnel Sourcing relationships sometimes involve the movement of employees from the client to the service provider. The Agreement should specify any of your employees to whom service provider shall offer employment, if any, and certain required terms and conditions of employment (e.g. credit for seniority purposes). You might want to designate certain “key employees” of the service provider that will be involved in providing the services and require that the service provider will not terminate any key employee other than upon a strong showing of cause and only after providing you with notice of the intended termination. You may also want to require that the service provider will not transfer the key employee away from your client account without your prior consent. Sometimes, service providers showcase their “A Team” when trying to win a sourcing bid and then after they are selected will move the “A Team” onto another bid and replace the A Team with the B Team. 8. Give Due Attention to Relationship Management Many sourcing relationships run into problems simply because the parties’ communications lines break down. The Agreement should set up a very well-defined communications and dispute resolution matrix. Typically, clients and service providers are usually each required under the services Agreement to appoint a project executive whose responsibility is to manage the sourcing relationship created by the Agreement. A management committee comprising an equal number of client and service provider employees is sometimes formed in order to handle certain administrative aspects of the relationship and certain disputes that may arise. 9. Fees and Expenses – Plug Up Back Door Expense Gouging Financial issues are one of the most treacherous aspects of sourcing relationships. Given that the sourcing relationship is premised on there being cost savings and efficiencies for the buyer, buyers should look closely for “back door” costs and other ways in which the service provider can drive up the cost of the sourcing relationships. This is not because service providers are somehow nefarious – they aren’t. But they are in the business of maximizing their profits just like your business so it is only natural that they will seek ways in which to maximize the fees that they are paid. Having said that, it is perfectly fair and appropriate for a buyer of sourced services to negotiate to eliminate as many back-door costs as possible. Typically, in return for the services, client will pay service provider the fees set forth in the Agreement. Unless specifically identified in the Agreement, you should not be required to reimburse service provider for any incidental expenses service provider incurs in performing the services (e.g. travel and lodging, document reproduction and shipping). Any pass-through expenses (a charge from a third party that is passed through service provider to you) are usually required to be approved in advance by clients, so insist on this. A buyer of sourced services might want to consider requesting “most favored customer” status – namely a commitment that charges payable by you under the Agreement will not exceed those then paid by other service provider customers to whom service provider provides similar services. If the prices charged to another service provider customer are, considering the foregoing, lower than the charges to you, then the charges to you should be equitably adjusted to provide you with the benefit of such lower charges, retroactive to the first date on which such lower charges to the other service provider customer first became effective. Because transactions often involve a multitude of considerations and varying value, and because “similarity” is not necessarily an ascertainable standard, service providers will be reluctant to agree to most favored customer pricing. 10. Termination of Relationship Sourcing relationships sometimes do not work out because of mere “bad chemistry” between the client and the service provider. Sometimes this happens without any true breach by the service provider. A client should not be forced into staying in a “bad marriage” with a service provider. Increasingly, clients with negotiating leverage are being able to successfully negotiate an early exit strategy, with relatively low early termination penalties (compared to earlier generations of long-term sourcing relationships which imposed severe penalties on clients for early termination of the relationship). You should not expect to get a “free walk” away from the relationship with a service provider if the service provider has performed up to par; however, the penalties should be reasonable. We have been occasionally successful in negotiating a “free walk” for some clients with high leverage, but this requires significant negotiation. To mitigate the risk of long-term soured relationships, many sourcing relationships simply have shorter terms than the first generation agreements of 15 or so years ago.