This article attempts to set out in a straightforward fashion a number of key points relating to the main phases of an outsourcing transaction. The article is divided between the following sections, reflecting the three main transaction phases:
(i) getting into the relationship;
(ii) once in the relationship, managing it; and,
(iii) getting out of the relationship.
The article is intended to apply equally to the public and private sector, as well as insourcing or outsourcing models. The article principles are applicable to most deal sizes, but do assume a reasonably complex transaction, where most if not all elements are up for discussion and not precluded by a pre-packaged service, based on a set list price and with a set delivery model. However, even in such a pre-packaged service, the customer planning points below are relevant.
The article is based on the Irish experience, which generally follows international trends, with the exception of the reluctance to date of the public sector to embrace the business model, which is a key distinguishing feature of the Irish experience from international trends in other similar open economies and in particular the UK experience. Whether this reluctance is tempered by the euphemistically named ‘current economic climate’ remains to be seen, but to date the level of activity within the public sector in the area has been low, with less activity the closer one gets to central government. In line with international norms, a good number of Irish private sector outsourcing transactions are part of larger, typically pan-European, transactions.
Outsourcing is not a new concept. It is suggested (with weak author certainty admittedly) that outsourcing is as old as Eve being asked to harvest the apples. However, one certainty is that it is becoming ever more complex in its structuring and deal expression. The larger deals are more complex in their expression than the same type deal even a decade earlier. There is a danger of overly complicated structures causing the customer, in particular, difficulties in managing the deal over the term – and especially as the original deal delivery team moves on to pastures new. In one recent example, a complex multinational parent company developed outsourcing model was implemented in Ireland without implementing the developed objective delivery measurement model, essentially because both the local customer and supplier considered the model to be too complex and cumbersome to implement and manage. While there is some truth in their position, the downside is the absence of a very necessary delivery management model which has not assisted in resolving local project difficulties.
1. Getting into the Relationship
1.1 Scoping Requirements
It is of fundamental importance that any organisation contemplating outsourcing scopes its requirements prior to either, ideally, engaging with the supplier or, at least, before that engagement has moved along substantially. If the customer has not scoped requirements, it is unlikely to have a clear understanding of what it is expecting to achieve (the anticipated outcome) and how it is going to go about achieving it (the outsourcing process). This may seem an obvious a point to note, but it is quite frequently not done or not done to any great extent prior to engaging with suppliers. In fairness to the suppliers, they tend not to take outright advantage of customer weakness, being aware of the sense in not creating a wounded beast smarting from a prior injustice, given the likely long-term nature of the relationship. However, customer early cycle weakness does weaken the eventual customer outcome. Customer scoping and planning at an early stage is never wasted effort.
1.2 The Requirements Context
Customer requirements should be scoped across each of the areas that are likely to be impacted by the outsourcing process. These include the technical, commercial, people, and legal areas. In this article, you will see that there is a large overlap between the legal and commercial areas and, given the nature of outsourcing, the two are inextricably linked. The customer must keep the anticipated outcome to the forefront of its thinking as the process progresses. In addition, when the topic of scope is broached, the customer must have a clear understanding of the breadth and depth of activities it will require the outsourcing partner to take on. This will include among other considerations:
• the extent to which the customer is required to be engaged in the outsourced function going forward;
• how much control the customer is willing to relinquish or requires to retain;
• what governance processes will require to be put in place to ensure the effective management of the supplier andor the outsourced function across the agreement term; and
• how much internal resource will be required to manage the supplier relationship and interfaces back into the customer organisation over time.
It is one of the more common mistakes amongst customers new to outsourcing to believe that once a function or process is handed over to a supplier the customer has little in the way of further responsibilities. It is necessary that the customer allocates sufficient and sufficiently skilled resources to properly manage the supplier. Good project or contract managers, for both supplier and customer, are worth their weight in gold. Generally speaking, the more complex the outsourced function and the greater the size of the overall transaction, the greater the management overhead on the customer. This can be one of the most difficult points to get across to a customer not already thinking in these terms and especially where the outsourcing drivers are cost cutting andor headcount reduction. Service delivery may have commenced and be on a downward perception spiral before they accept that one must spend in order to save.
1.3 Engaging with the Supplier
In terms of engaging with the supplier, it is important that supplier expectations are set at the right level from the outset. All too often, the supplier commences the engagement with certain expectations and only when substantially into the negotiations does the customer begin to seek the kind of protection and leverage which are desirable and necessary to cover the perceived risks. A recurring problem is that the supplier has moved this far into the process on the basis of its initial expectations and, in particular, has priced its offering on the newly developed basis. This frequently causes relationship difficulties between the parties at an early stage and is often one of the first major difficulties in the customer engagement/supplier sales phase. It is important, therefore, that the supplier prices its offering inclusive of necessary risk. As part of the engagement stage, suitable business consultants and legal advisors should be engaged in order to address as many of the key risks and potential issues from the outset as possible. All too often the lawyers are left to the contract phase, which is generally too late to offer strategic advice, thereby restricting the lawyer to formalising the deal which has already, in essence, been arrived at. While this is part of the lawyer’s job, it minimises the benefit that the experienced lawyer brings to the transaction if engaged in an upstream way (ie from the earliest stage in the engagement or, ideally, before any engagement has actually occurred). Outsourcing is one area where skilled lawyers earn their keep and they should be engaged at the earliest stage in the transaction.
1.4 Sector-Specific Issues
Prior to engaging with the supplier, any sector-specific issues should be considered. For example, in the case of the pharmaceutical or financial services sectors, the extent to which governing law or regulatory authority requirements are necessarily part of the transaction should be considered. If, for example, it is necessary that a regulatory authority has oversight of the transaction, including, possible audit rights, then, this should be factored into the engagement early in the process. Where the use of offshore resources and capabilities are part of the proposed outsourcing model, areas such as export control, data security and data protection law will require to be addressed adequately.
1.5 Service Testing
Insofar as possible, the service should be tested prior to go-live. The extent to which this is possible will depend on the nature of the transaction and the outsourced function. It does tend to be the case that it is less advisable from the customer’s perspective to go for a big-bang commencement – this is typically followed by a bedding-in period within which service levels do not apply and it is only at the conclusion of that period that the full rigours of the service level and service management require apply. It can be a subtle difference, but it may be more advantageous for the customer to first test the service in a laboratory type atmosphere, as opposed to in a live environment. There are some obvious reasons for this, relating to adverse effect of poor service delivery on the organisation, but what is also relevant is the extent to which the customer thus gains leverage over the supplier. An initial test, following which a go/no-go decision is made by the customer, does tend to maximise customer leverage over the supplier, as well as providing customers with the necessary decision-making point as to whether the relationship will end or continue as anticipated. In practice, while it can be difficult to test a large scale outsourcing (success being subjectively decided by the customer in the context of its business, as opposed to any objective scale), service testing is one of the key elements of any outsourcing transaction and one of the key customer decision-making points. It is also, however, one of the most (if not the most) complex components of any transaction and requires significant advance customer consideration.
2. Once in the Relationship, Managing It
2.1 Service Levels and Service Credit Regime
Together with service management, discussed below, the service level and service credit regime, frequently called the service level agreement (SLA), is the engine room of the transaction. Often the change control procedure also becomes a significant part of the engine room, which may or may not be what the customer had originally intended, depending on the nature of the transaction. The SLA sets out the required service levels to be achieved by the supplier and deals with the consequences of failure to achieve those service levels, as discussed further below. One key area set out in the SLA is the supplier obligation to fix service deficiencies and make financial compensation to the customer for the deficiency. Of course, the customer has not entered into the transaction as a money-making exercise and service credits are, from the customer’s perspective, one of a number of necessary (if evil) levers over the supplier.
It is the nature of outsourcing that there tends to be no single armageddon or big bang relationship event, with the relationship managed by a series of levers of larger or smaller size, depending on the parties’ agreement. This concept of leverage is important and another way of looking at it is that the customer has options, which ultimately reflect a degree of control, at various points in the transaction. As well as service credits, the SLA may include a service bonus scheme or service credit earn-back option, for instances in which services exceed set levels. The SLA can also deal with service improvement, where this is within agreed scope.
2.2 Service Management and Governance
Service management and governance is a key sister of the SLA and sets out the parties’ agreement in relation to their inter-working during the course of the engagement, including matters such as the supplier’s regular and ad-hoc reporting to the customer, the parties’ interface at various levels, and escalation mechanisms. For example, it may be the case that the customer has set up a steering group, or other controlling mechanism, at which the supplier may either hold a fulltime seat, or be represented on an ad-hoc basis.
The service management regime is important both in terms of managing the parties’ relationship and in setting out procedural requirements which interface with the parties’ dispute resolution procedure. For example, supplier regular reports, once approved by the relevant representatives, board, or steering group, are then prima facie accepted by the parties and serve as reference documentation in circumstances of dispute.
The service management regime can include a formal dispute resolution procedure, which can be more or less complex depending on the nature of the transaction and the parties’ agreement. Dovetailing with the points above in relation to setting customer expectations, it is the case that a number of suppliers have a positive policy against what are known as alternative dispute resolution procedures – generally arbitration, expert resolution and mediation. There are a number of reasons for this, one of which is that they may provide the customer with a relatively quick and confidential forum in which to resolve disputes. The supplier may insist on the customer utilising the courts to resolve disputes; one reason for doing so is that it is generally unattractive to the customer to instigate formal litigation as it is a time consuming, lengthy, expensive and public process. Again, this area requires adequate early cycle consideration and creation of the type of project levers discussed in this article.
2.3 Personnel and Employment Law
The Transfer of Undertakings Regulations may be relevant to the transaction. The Regulations operate to entitle relevant staff (being those engaged in the relevant undertaking, the subject matter of the outsourcing) to transfer their employment with the undertaking. The Regulations require specific review.
2.4 Service and Contract Termination
While termination, whether of parts of the service or the overall agreement, is a rather blunt instrument, it is a necessary component of any well structured outsourcing transaction. Within this heading, there are a number of different categories, ranging from traditional contract termination for breach by the other party, being either capable of remedy (and not remedied within a set period) or incapable by its nature of remedy (which would include matters such as a breach of intellectual property rights or confidential information), to quite service-specific termination provisions. Service-specific termination would include, for example, the ability partially to terminate service components in the event that the supplier turns out to be less than adequate in a relevant area. It will very much depend on the nature and size of the transaction whether or not salami-slicing of the service is feasible. It will also depend on the parties’ commercial agreement, as it will obviously reduce the scope of the service and, therefore, the value of the service from the supplier’s perspective. It may, for example, not be cost efficient to allow service slicing, as it may render the remainder of the service inefficient or financially non-viable.
Termination provision should include service specific termination points, relating to a medley of recurring material service failures. This will mean that failure to achieve service levels, typically measured over a number of key service levels and over a recurring period, will lead to termination. In addition, one-off substantial service failure should be allowed for. Typically, suppliers have difficulty with the concept of a one-off substantial service failure allowing termination, as they do not have the opportunity to make good the service prior to termination. The major difficulty for the customer with having only a recurring termination measurement is that the service generally is required to be extremely poor over a lengthy recurring measured period before contract termination rights arise, which may be unlikely to occur. It is most important that customers have a clear route to contract termination throughout the relationship, and preferable that the route is of a technical nature, rather than allowing for arguing about the occurrence of material breach of contract and who is or is not responsible. Technical termination is intended to dovetail with the SLA and service management provisions and should insofar as possible be objectively based, typically being based upon supplier service reporting.
Generally speaking, from the customer’s perspective, termination should include termination for its convenience. This heading typically comes at a cost and exactly what it covers is a matter for negotiation. It is not unreasonable for the supplier to require that, if the customer has the ability to exit the relationship at a fixed point or points for its convenience, the customer pays for the pleasure of doing so. Typical supplier requirements range from payment of the total outstanding service charges for the outstanding term through the profit margin component of the charges to recovery of the investment cost and profit to the end of the reduced term or the service charge for a fixed component of the term, typically not being less than a year. This is very much a matter for commercial negotiation. The key point for the customer is to gain another contract lever, this one going to future proofing its room for substantial service decision making. There is little benefit in starting to negotiate termination provisions when a catastrophe has occurred or when a continuously failing service is affecting the customer’s business, these areas need to be considered from the outset and articulated as clearly as possible in the contract and related contract schedules. This is a key part of the next section.
3. Getting out of the Relationship
3.1 Exit Planning
Planning to exit the relationship, while hardly an attractive prospect, is a key part of any relationship planning. It tends to get downgraded in importance, generally because parties prefer to look to the positives at the point of initial engagement and because it can be quite difficult to assess requirements looking that far into the future. However, insofar as possible, it should be dealt with as part of the engagement process. Depending on the nature of the transaction, where exit detail is not fully scoped or understood, exit planning should be flexible. Typically, this is reflected in the inclusion within the contract schedules of a draft exit plan, which is to be reviewed and updated on a regular basis (typically annually) and, finally, at point of termination, the document should be further updated and finalised. The exit plan can be more or less detailed, again depending on the nature of the transaction. Typically, it requires to deal with the detail of the parties’ disengagement, including, in particular:
• supplier return of customer items in an orderly fashion
• interface with any one or more alternative/replacement customer suppliers
• potentially, supply of supplier-specific services (such as software licenses and support) for a period after the agreement has ended.
As suppliers tend not to be overly keen on interfacing with competitors, it is advisable that this area is mandated in the exit plan, within specific boundaries. Where necessary, supplier participation in any customer replacement supplier procurement process should be dealt with, although the need has to be recognised for what can be a tricky area to be tightly controlled by the customer.
3.2 What Next?
Assuming the relationship has either expired or been actively terminated, typically by the customer, the issue is what is the customer to do next? The options tend to range from in-sourcing the function previously outsourced to engaging a replacement outsourcing service supplier. A third option, which may be more or less attractive, depending on the size and complexity of the initially outsourced function, is to engage in multi-sourcing. This is where the function is divided up into a number of components, which are allocated to a range of suppliers. It tends to suit larger functions and larger customers, given that it does increase the customer’s management overhead and responsibility. There are issues to consider in relation to all of these options. The option generally seen in Ireland is for the supplier to re-outsource the function, generally known as second generation outsourcing (or perhaps a later generation). In particular, this brings up employment law issues, including the Transfer Regulations, where staff are entitled to transfer with the undertaking from the current supplier to the new replacement supplier. As the economy tightens we can expect to see suppliers increasingly keen to move staff to replacement suppliers, which has not been a general feature of the Irish outsourcing landscape for quite some years.
4. Summary
The intention of this article is to attempt to break down the overall outsourcing relationship between the parties into a number of distinct stages, each of which has its own particular issues and, ultimately, risks for each party. It is hoped that the article can assist customers in considering the key elements of the relationship as they apply across the relationship lifecycle and, insofar as possible, to plan for and address these elements of the relationship at an early stage.
It is, generally speaking, the case that all too often customers engage on the outsourcing path without having undergone this thought process, or at least not in adequate detail, and attempt to deal with issues as they arise. The difficulty with this reactive management is that very often leverage over the supplier has been lost, or at least much diminished. For example, if the supplier has bid for the business based on certain expectations and the customer then requires the type of comprehensive SLA mentioned above, the supplier will typically respond that this has not been priced into the bid and will require a re-pricing. In particular, it is important that the supplier’s bid addresses, insofar as possible, customer technical requirements, customer commercial requirements, and customer legal requirements. The more supplier expectations that can be set early in the process, the more the bid is risk inclusive and, generally speaking, the less difficulty there is in consummating the relationship thereafter in a manner satisfactory to both parties. Furthermore, the more planning that goes into a transaction the more likely parties are to have considered various scenarios and the better placed the parties and the supporting transaction documentation are to deal with scenarios as they arise. Insofar as possible, attempting to deal with ‘how’, ‘what’, and ‘what if’ in the preparation and negotiation stages of an outsourcing transaction is rarely wasted effort and contributes strongly to the possibility of the transaction succeeding over the medium to long term.
Pearse Ryan is a partner in the Technology & Life Sciences Group of Arthur Cox, Dublin. He would like to thank Ray Murphy, principal of Strategic Computing, for his valuable comments – he is available at ray.murphy@strategiccomputing.ie.
