I. Pros and Cons
What is outsourcing? In short, it involves a service previously provided internally, or in some cases not at all, being procured from a third party.
On hearing the word "outsourcing", the first thought that springs to mind is probably cost cutting; a way to enjoy the same services at a reduced price. For many organisations this is why they outsource, particularly in a depressed economy. But it is not the only reason. Outsourcing properly done gives an opportunity to access new resources and skills and to manage change. It can also give new strategic focus to an organisation.
On the other hand, if an outsourcing relationship does not work, it can cripple a company. A good contractual basis will help to avoid an outsourcing project becoming a disaster. Trust and cooperation between the parties involved is also crucial to success.
A. Reducing Costs
There can undoubtedly be financial benefits in outsourcing a service. Firstly, many service providers enjoy advantages of scale by offering the same or similar services to several clients: systems and personnel can be used more efficiently than is possible in-house. Service providers do not need to maintain the same level of unused capacity for times of peak demand because the peaks and troughs of their various clients level each other out. Depending on the pricing structure negotiated by the customer, it can obtain significant benefits from paying only for what it uses. Service providers operate against direct competition in the marketplace, which should work to keep costs down. Finally, outsourcing services enables transparency on costs. If the reporting and pricing structure is sufficiently transparent to show which users within a company represent the highest usage volumes, the customer will be able to further optimise IT provision across its organisation.
The share of any cost reductions passed on to the customer will depend on the customer's negotiating skills when price comes up for discussion. However, if the customer focuses on nothing more than driving down price, the service it receives may well fail to meet its expectations. The service provider should also receive a fair return for its efforts so that it has an incentive to do a good job.
B. Accessing Resources and Skills
Aside from financial considerations, outsourcing can bring significant benefits. IT service providers will generally have more sophisticated equipment and better technological capabilities than a customer can justify buying for its in-house operations. An obligation on the service provider to keep its technology up-to-date allows the customer to benefit from technological advances on an ongoing basis.
Where a company splits itself in two (i.e. in instances of de-merger), at least one of the de-merged companies will no longer have the IT-resources it needs. Outsourcing may be the only way, and in most cases the fastest way, to build up an adequate IT capability. Likewise, where two companies merge, outsourcing may provide a neat solution to the problem of whose IT system to use.
Outsourcing can also provide a quick route into new markets. A global service provider may already have operations in markets that the customer wishes to enter. This saves time for the customer and gives it access to a source of local knowledge and experience.
C. Pitfalls
Outsourcing represents a certain loss of control and this brings with it risks. Retaining control over the process may reduce the risks involved. However, keeping tight control also means losing some of the benefits of outsourcing. Handing over responsibility to the service provider will give it more freedom to innovate and to find ways of reducing costs. A fine balance is required.
Here we look briefly at a few particular types of risk and possible ways to minimise their impact.
a. Operations Risks
There is a risk that the outsourced service is not delivered as expected. This may be for any number of reasons. The risk can be minimised by a careful choice of service provider, but cannot be removed entirely. Contingency plans and an effective business resumption plan are necessary. Likewise, proper due diligence at the outset regarding the way the systems of service provider and customer will interact and adequate acceptance tests before the service "goes live" are essential. Often however, where services are not performed to the expected level, this is due to a failure to describe the services properly. The solution to this is simple: sufficient time and effort must be invested in the service description.
b. Strategic Risks
The use of a third party to perform certain business functions may distract a business from its strategic goals. For the party outsourcing its IT, setting up the outsourcing relationship will certainly require management time and divert resources from other tasks. If this is not properly managed, it can cause significant problems. The customer needs to be realistic about the commitment required from the very outset. A good organisational plan setting out the person to contact for each type of issue that may arise also helps to smooth interactions and minimise wasted time on redirecting enquiries.
c. Stakeholder Risks
Outsourcing may alienate employees and shareholders of a business if it is a concept with which they are not familiar or comfortable. Time needs to be spent on selling the reasons for outsourcing to these stakeholders in order to avoid internal conflicts or even blocking of the transaction.
d. Compliance Risks
For regulated businesses such as banks or insurers, there is a risk that the services are not performed in compliance with the applicable regulations. The service recipient remains responsible towards the authorities for regulatory compliance, but may lack the necessary control over the service provider to meet the regulatory burden. Regulated businesses cannot afford to assume that the service provider will automatically take on or even be aware of the full regulatory burden. Obligations arising from regulatory and compliance duties should therefore be dealt with in detail in the outsourcing agreement.
II. Structure of the Transaction
A. Sequence of Events
a. Internal Preparations
The better the customer prepares itself for the outsourcing process, the easier the discussions with potential service providers will be, in most cases producing a better end result for the customer. Preparations will most likely be focused on defining the scope of the services to be provided. However, time should also be spent on setting up the project team and reporting lines for the transaction, the internal business case and a communications strategy. Each of these topics deserves further consideration.
aa. Scoping the Services
The most important step in any outsourcing transaction is the definition of what is to be outsourced. The customer will need to identify its objectives and then decide which operations should be outsourced and which kept in-house in order to achieve those objectives. Once this is done, the operations to be outsourced need to be described in considerable detail. This description will form the basis for the pricing proposals from potential service providers. The more detail is given in the description, the easier it will be for the customer to compare the price proposals it receives. The service description is also critical to measure performance once the services have been outsourced. Therefore, although the description may develop over the course of the transaction, it is worth spending some time on it at the outset.
In describing the services, particular attention should be given to the interfaces between service provider and customer. There will certainly be discussions during the negotiations on liability at the interfaces. If the customer is clear about the boundaries of its responsibility and where exactly the interfaces occur, it will be in a stronger position when it comes to negotiate.
bb. The Project Team
Responsibility for defining the scope of the services will undoubtedly lie with a project team. The composition of that team also deserves some thought. The people involved should have a range of competences. They should not just be technical experts from the area to be outsourced; ideally at least some on the team will have experience of contract negotiation and management, if not of outsourcing. They will need proper and clear authority to make decisions. Without this, the outsourcing process can be very protracted and potential service providers are likely to become frustrated during negotiations. The project team must have the acceptance of the management of the customer and of those employees who will be impacted by the organisational change. Finally, the team must have the time to devote to the project. This component should not be underestimated. The implementation of a major outsourcing will take several months. During that time, the project team will need to be available on an almost constant basis.
cc. The Business Case
A clear business case will persuade the customer's senior executives to support the project. In the business case, the financial and organisational aspects of the outsourcing should be assessed, the benefits and possible downsides of the project set out and a forecast of the project time plan given. The business case will be part of the sales pitch internally, and it may also form part of the information package given to potential service providers. Therefore, it should present a realistic picture of finances and timing.
An accurate assessment of the current situation, particularly the current costs, of the services to be outsourced can be very difficult to come by. The financial data will not be stored in one place. It will be mixed in with figures that are irrelevant for the outsourcing transaction. Some aspects of the services will not appear in any existing costings or budgets. The business case will also need to assess future costs over the foreseen life of the outsourcing contract. The forecast must take account of future growth prospects and technological changes. Where cost is a driver for the outsourcing transaction, it is essential to produce accurate present and future cost estimates for the services on the premise that they continue to be provided in-house. The process of preparing cost estimates also creates a better understanding of what the service involves and what the customer's requirements are. Finally, it will give the customer a good idea of the costs that it will continue to incur once the outsourcing is complete.
dd. Communications Strategy
To retain full control over communications regarding the outsourcing project, the customer should develop a communications strategy at an early stage. This should not differ greatly from the way the customer already communicates with its employees, shareholders, clients and suppliers. If it introduces a completely new communications style, the customer is likely to raise suspicions and create uncertainty.
Keeping the project secret is difficult and can have a bad effect on morale. It will become apparent that something is afoot, either because of leaks from the customer's own personnel involved or via the potential service providers once the negotiation process starts, or just because employees observe unusual behaviour, for example, a colleague who is regularly away in confidential meetings. Once the secret is out, it becomes difficult for the customer to control the information flow itself.
b. Discussions with Potential Service Providers
aa. Request for Proposals ("RFP")
Generally, the next stage of the process – the negotiations with potential service providers – starts with a request for proposals ("RFP") sent to the various candidates. The request should present the customer's technical requirements, preferred pricing structure and rules for the bidding process. It should also ask for the candidates' positions on the important commercial terms of the deal and the allocation of risks. It needs to cover a lot of ground so that the customer can make a proper decision on which candidates to select for further negotiations but it must leave the candidates some flexibility to come up with innovative approaches to meeting the customer's requirements.
There are tactical decisions to be made when deciding how much information to disclose initially, particularly in relation to the customer's internal cost estimates. The customer will want to enable the candidates to produce a pricing proposal that is as realistic as possible, based on as clear a picture of what providing the services will involve as is possible, but without being influenced by the customer's existing or projected costs for the service.
To how many candidates should an RFP be sent? If the number of potential contractors is more than four, experience shows that the service providers no longer take the process seriously. Service providers will typically try to convince customers to negotiate with just one partner. Customers often agree to this, believing it will be quicker and more efficient. However, this is rarely the case. The service provider is only under pressure if it is in competition with other potential providers. This pressure will force it to react quickly when its input is needed and to take a much more reasonable position in negotiations. It will have an incentive to use its best people on the project and to give of its best in producing its proposal for providing the services. The customer's workload will not be increased much by having to deal with several partners at once. The work of preparing a service description and pricing proposal will remain the same. The increase in effort comes from having to review the feedback of two or three parties, rather than just one.
The customer will then use the responses to the RFP to narrow down the field of potential service providers. It is important not to close off too many alternatives at this stage. Customers sometimes want to, or have to, come back to a proposal that they had previously rejected. We have seen situations where the customer had almost completed its negotiations with one candidate but was not satisfied with the way the relationship had developed and so switched back to a service provider it had rejected (on the basis of price) much earlier in the process.
bb. Letter of Intent
Once the field of candidates has been narrowed down to two or possibly three, a letter of intent will be negotiated, setting out the points to be covered in the main contract and an outline of the parties' agreement on the material terms (financial, legal, technical and commercial).
Under Swiss law, certain types of preliminary agreement may be interpreted as a binding obligation to conclude a later agreement. The relevant provision is Article 22 of the Swiss Code of Obligations (CO), which concerns preliminary contracts. Art. 22 CO states "By contract, the parties may validly agree to conclude a contract in the future". This is in stark contrast to the position in common law countries, where an agreement to agree generally cannot be enforced.
There are differing opinions as to whether the parties can be forced by the courts to enter a subsequent agreement. On the one hand, the fact that they have entered into a pre-contract can be interpreted as an indication that they wished to be bound to a lesser extent than under a final contract, in which case damages should be the only remedy. On the other hand, if all of the essential elements of a contract have been agreed in the pre-contract, the courts may allow a direct claim for performance of the (unsigned) main contract, without any need to claim first for conclusion of the main contract. If damages are the remedy, they are awarded in an amount to put the injured party in the position it would have been in if a final contract had been concluded.
A letter of intent is not usually sufficient to constitute a binding agreement to agree. However, the situation is different if the pre-contract is sufficiently detailed and does not contain any reservation on its binding effect, so that it amounts to an offer which can be accepted simply by signature of the counterparty. A term sheet fixing the results of the parties negotiations will not be a preliminary contract provided it is clear that the parties are still free to take the basic decision of whether to conclude a contract at all. Particularly where negotiations are ongoing with several service providers at once, one could hardly assume that the parties intended to agree to enter into a later contract. But even here, it should be clearly stated in the letter of intent that there is no obligation to conclude a later contract.
Even where there is no pre-contract in terms of Art. 22 CO, there will be an obligation at least to conduct negotiations in good faith. If the negotiations are not conducted in good faith, the disappointed party then has a claim for damages (see in this regard III.E.d below).
cc. Choosing a Service Provider
The final choice of service provider should not be made too early. Ideally, each potential partner's views on all the main issues should be known before the decision is made. The customer may decide not to outsource all services to one provider. It may opt instead to enter into contracts with several providers for the services it requires. This can create complications when negotiating liability at the interface between services. However, it should then be simpler to switch away from a poorly performing service provider to one that is already delivering another service to the customer.
c. Finalising the Deal
The term sheet should be sufficiently developed so that the terms of the main contract can easily be translated into an agreement. There will be further negotiations at this stage as the parties' lawyers iron out the details of the deal. The parties may also agree to postpone discussion on some points to a later stage, once they have more information about each other's capabilities and requirements, or simply due to a lack of resources for parallel negotiations.
Even if, or perhaps especially if, certain discussions are to be postponed, the parties should agree on a clear dispute resolution procedure at the outset. They must also be clear on the consequences of failing to reach agreement. It should further be borne in mind that the distribution of bargaining power will change once the parties are bound to each other via the main contract, with the customer generally being in the weaker position once it is committed to the deal.
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