The Hidden Dangers of Short-Term Outsourcing Deals

Think it's easy to get out of a short deal when you want to switch outsourcing providers? Think again. Exits from short deals can be costly, time-consuming and disruptive.

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In today's dynamic business and technology environment, companies have embraced the flexibility that comes with shorter term IT outsourcing deals. And at a time when niche specialty providers continue to proliferate, outsourcing customers may assume that it's relatively easy to get into — and out of — these smaller IT services deals.

However, exits from short-term IT outsourcing contracts can be costly, time-consuming and disruptive to the business, warns Paul Roy, business and technology sourcing partner at law firm Mayer Brown.

"Customers may assume they can move the service to a different provider or back in-house, which gives them ample leverage to negotiate extensions if needed," says Roy. "They may also assume that they do not need longer-term protections since they can update their agreements on renegotiation."

While either of those might be true in some instances, that shouldn't be a chance companies are willing to take with potentially complex or mission-critical technology service. "In those instances, the customer is more likely to be dependent on its ability to negotiate extension terms," Roy says. "As lawyers well know, necessity seldom makes a good bargain."

Identifying and qualifying replacement providers (or creating an in-house alternative), negotiating new terms, and transitioning the services will require a significant amount of time and money. And the more customized or complex the service being replaced, the greater the risk during switchover. And the more critical the service being provided, the lower a company's tolerance for potential disruption.

"The risk comes from potential for error at the time a replacement provider takes over the service," says Roy. "This cost and risk have less to do with the size of the deal and more with the complexity or customization of the services and whether they are mission critical." It could be cost and risk-prohibitive, for example, to jump from short-term deal to short-term deal in supporting a treasury system that integrated with a company's customers and serves as an end-to-end solution.

All IT Outsourcing Deals Require Careful Planning

Even with shorter contracts, outsourcing deals require careful negotiation and preparation. Companies should consider spelling out options and rights in their short-term contracts to help them keep pace and create leverage in the event of moving the work from one provider to another. A few of the more important provisions, says Roy, include market-based price protections, technology currency and refresh, and updating of service and security standards:

Market-based price protections allow outsourcing customers to benchmark their prices to current costs in the market for substantially similar services. "This is an issue with long-term agreements because prices for technology typically drop and cost of labor varies by location and the extent to which labor is required to the evolving technology," says Roy, but can be an effective lever in short-term deals as well.
Technology currency and refresh clauses obligate the service provider to update its technology solutions (i.e., hardware and software features) to keep pace with competitors in the marketplace. "Technology is evolving rapidly and failure to require the service provider to keep pace with technology may make the customer less competitive in its industry or obligated to pay for updates that should be factored into each customer's business plans and budgets," says Roy. Such a provision could also lay out a schedule for service provider technology refreshes.
Obligations for updating service and security standards. Standards and requirements for compliance or cybersecurity are evolving and can change substantially over even a short contract term. "The customer should expect and require the service provider to keep pace at least with established best practices in the industry as a normal part of the provider's cost of doing business," says Roy. Absent this requirement, the customer could be required to pay more for updates.

"Looking at it from the customer's standpoint, the IT departments of companies have been faced with declining budgets and expectations that they will keep the company competitive in the long-term," says Roy. "The above requirements translate these same expectations onto the service provider. Customers who do not get these protections could find themselves with unexpected additional costs over time to the likely dismay of the CFO."

Service providers will resist putting such protections — normally associated with longer-term deals — in a shorter-term contract. But customers should be diligent in pursuing them, says Roy. "The vendor will argue those are unnecessary since the parties can negotiate changes when they negotiate contract extensions. This ignores the frequent reality that the customer is putting itself in a position of being dependent on the vendor and has to have these protections as a condition of getting into the deal."

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