Out with the Old, In with the New: Commercial Flexibility & Revenue Expectation in IT Outsourcing Agreements (Part 1 of 2)

The advent of the new year provides an opportunity to contemplate a fresh start — and that’s just what is needed when it comes to structuring the fundamentals of an IT outsourcing transaction.

Early IT outsourcing transactions typically involved significant capital investments by suppliers, who would often purchase the customer’s existing assets and promise to deliver services inclusive of refreshed assets at defined refresh cycles. These “asset-heavy” transactions often included mechanisms to either prevent the customer from exiting early, or to compensate the supplier for significant unamortized capital investment where the customer terminated services early. Examples of these “exit-restricting” mechanisms are:

• Whole or partial exclusivity;
• Termination for convenience and/or wind-down fees;
• Limitations on the customer’s withdrawal of services (calculated in a variety of different ways);
• Variable resource category “banding”, whereby fluctuations in chargeable volume metrics force renegotiation of pricing; and
• Mandatory asset buyout mechanisms.

Very few transactions today contemplate the same level of capital investment by the supplier. This is due in part to the evolution of technology (e.g., cloud-based computing leveraging different degrees of shared resources), and in part to the shareholders of maturing supplier organizations demanding a greater return on their capital investments. Unfortunately for the customer, however, the “exit-restricting” mechanisms have tended to linger, even though the capital investments that they were once designed to protect have largely disappeared.

Suppliers seek to defend the continued use of these mechanisms for a variety of reasons, most of which are not very compelling. Justifying the continued use of the mechanisms as being “industry standard” is misleading; this might be true for asset-heavy deals that were once common, but is questionable for the deals that are more common today. Similarly, justifying their use as being necessary to compensate the supplier for costs associated with the transaction is often an exaggerated claim, as in many cases there are little or no stranded costs associated with losing a customer (e.g., where resources can be easily redeployed for use by other customers). Even if such costs do exist, the basis for compensation is questionable for things like pursuit costs or overhead, which should arguably not be directly allocable to the customer.

Suppliers do, however, have a legitimate expectation of revenue in an outsourcing deal. Consider where a customer offers high volumes of services for an extended term, and seeks discounts based on the aggregate, anticipated revenue. If the supplier did not employ some mechanism to assure revenue, the customer could simply take the discounted pricing and provide only marginal volumes for a modest term, taking the benefit of the pricing but not actually providing the revenue that justified the discounts in the first place.

While the old mechanisms can be deployed to assure this expectation, doing so tends to come at a heavy cost for the customer, who are forced to sacrifice their legitimate objectives of price certainty and commercial flexibility. The new year brings an opportunity to contemplate a fresh approach to balance both the supplier’s and the customer’s objectives.

In our next post, we’ll explore why these old mechanisms really ought to be left to history, and offer an example of a better solution more attuned to the fundamentals of today’s transactions.