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The Court of Justice of the European Union (CJEU) has been very busy in recent weeks re-shaping EU privacy laws. In addition to the much-anticipated decision in “Schrems” (Case C-362/14), which essentially rules the US-EU Safe Harbor invalid, the CJEU has also considered the key issue of “establishment” in another landmark case, namely “Weltimmo” (Case C-230/14).

In particular, it has ruled that businesses with only very minimal operations in an EU Member State can nevertheless be subject to the data protection laws of that Member State, where they process personal data in the context of activities directed towards that Member State. This effectively widens the scope of “establishment” and creates additional headaches for those with European operations.

The action point for companies with a European footprint is therefore to review their European processing activities, re-think where they might be established and look to comply with local laws in those jurisdictions. Status quo is not an option for those who wish to avoid enforcement action in “foreign” jurisdictions they previously thought they could ignore.

Background

The Weltimmo case was referred to the CJEU by the Kúria, Hungary’s Supreme Court, and the facts of the case can be summarized as follows.

Weltimmo operated a property advertising service in Hungary, but was headquartered in Slovakia. It allowed people to advertise a property free of charge for one month, but then would subsequently charge a fee. When Weltimmo failed to delete adverts and personal data at its customers’ request upon the expiry of the free offer period, and passed such data on to debt collection agencies seeking payment for an on-going subscription, it was fined by the Hungarian Data Protection Authority (DPA).  The DPA considered it had jurisdiction to impose a fine on the Slovakian company for breaches of Hungarian data protection laws because Weltimmo was “established” in Hungary.

Weltimmo had one representative on the ground in Hungary, a Hungarian bank account and a post office box in the country, and so it appealed the DPA’s decision to the Hungarian court on the basis this was not sufficient to amount to an establishment, nor confer jurisdiction on the Hungarian DPA. Although the DPA’s decision was annulled for lack of clarity over some of the facts, the first instance court did not accept Weltimmo’s defence.

The dispute was then escalated up to the Kúria, at which point Weltimmo continued to argue that the Hungarian DPA had no jurisdiction to apply Hungarian law to it, as (i) it was registered in Slovakia, and (ii) the DPA had failed in its view to follow the procedure set out in the Data Protection Directive (95/46/EC) dealing with “supervisory authorities”, namely that the Hungarian DPA should have shared its findings with the Slovakian DPA and requested the Slovakian DPA to exercise its authority.

The KĂşria was unclear as to the correct interpretation and decided to make a reference to the CJEU.

The CJEU’s Ruling

The CJEU’s judgment concerned the interpretation of the words “in the context of the activities of an establishment” as they are used in the Directive and, significantly, ruled that this extends to “any real and effective activity – even a minimal one – exercised through stable arrangements”.

Given the nature of Weltimmo’s operations, the CJEU considered that Weltimmo did have an establishment in Hungary and was, therefore, subject to Hungary’s data protection regime.

Comment

This ruling has changed the landscape of data protection for companies operating in more than one EU Member State, eroding the idea of a “one-stop-shop” in terms of one supervising DPA and making many companies subject to multiple DPAs in Europe.

Previously, companies could arguably “forum shop” from a data protection perspective, choosing to headquarter in a Member State perceived to be more business friendly, such as the UK or Ireland for example, whilst seeking to avoid the long arms of some of the traditionally more conservative (and often aggressive) DPAs.

However, following this ruling, if a company operates a website in the native language of a particular Member State, or has representatives in that Member State (amongst other things), then this could well be enough to constitute an “establishment” such that the company would be accountable under that Member State’s laws and be subject to enforcement action in that Member State, regardless of where it is headquartered.

Whilst this ruling means Weltimmo is likely to be liable for a fairly hefty fine levied by the Hungarian DPA, the ramifications of this judgment are much further reaching and are likely to significantly increase compliance costs for companies with pan-European operations.

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These days it seems every supplier’s infrastructure pitch book is full of the virtues and potential benefits of their drive toward automation, the objective being to get the same work done for less. What’s not clear is whether the supplier will actually be able to achieve what they promise or how to allocate the benefits between buyer and seller.

The same for less is a well-travelled road; the same goal drove moving work to less expensive delivery locations over the last couple of decades. Along the way some algorithmic alchemy created an acceptable balance among costs, margins, prices and benefit to the buyer. While the arithmetic to ensure the benefits were reasonably distributed amongst buyers and sellers could be complex, the factors of production to drive economic verification models were pretty well known, or at least could be with a bit of research. Underlying it all was a basic assumption, that an FTE was an FTE, and many buyers used the number of proposed FTEs to validate a suppliers’ ability to actually perform the work.

Automation changes all that. Is an FTE still an FTE, or is an automation assisted FTE a 125% of an historical FTE or maybe it is 150%, or maybe even more? What if there is no FTE at all just some robotics doing what an FTE used to do? Since an automaton is likely to make fewer mistakes than a human FTE, and will do those error-reduced tasks faster than the human FTE, the promise of better and faster and cheaper seems attainable.

Nothing wrong with any of that — it all sounds pretty terrific…

Yet the road to automation nirvana features unexpected curves and potholes. Overcoming these obstacles requires answering the challenge of accurately projecting the financial impact of automation. Putting aside for a moment how to allocate the benefits of automation between the buyer and seller, what will a supplier expect costs do over the typical five-year term of an ITO? What is the probability of the supplier under and over estimating progress?

Suppliers projecting year-over-year pricing improvements is nothing new. ITOs have, for many years, included cyclical pricing improvements in the 4% to 10% range, linked to known learning curve improvements and the introduction of management tooling. But automation presents two new problems, the automation technology is just now being deployed into supplier delivery engines and processes and the potential range of productivity increases is far larger. Assuming, sans automation, a provider server administrator can oversee about 75 virtual server images, resulting in a gap of at least one and half orders of magnitude with the productivity ratios achieved by Internet scale operators like Google and Amazon. Drawing a pricing curve between those two productivity points is very different problem than computing the incremental adjustments suppliers have accommodated in their past pricing and will be, at the outset, far more difficult to model.

The inclination of buyers is to press suppliers to maximize improvements in year over year pricing over the term. Consider the consequences if a supplier makes an extremely aggressive pricing choice to win the business and later fails to be able to meet their automation goals – resulting in higher supplier costs. That leaves the supplier with several unpleasant choices, take a margin haircut, negotiate with the buyer for a price increase or reduce the manpower to the levels projected as if the automation objectives were achieved and run the risk of failing to meet service levels. Historical behavior would suggest a higher probability of the supplier reducing the amount of labor and taking the risk of reduced performance.

So how does a buyer cope with the situation of entering into a new or renewed ITO arrangement over the next two years or so before the automation track record is established? What kind of pricing improvements should be demanded? How does the buyer avoid unintended consequences and resultant issues in performance or price uncertainty?

Recently we have seen situations where suppliers, in order to maintain or expand margins, have reduced staffing across their entire delivery engine, resulting in individual buyers seeing resources simply vanish from their engagements, without suitable replacements in either numbers or skills.

Automation offers suppliers a sexy cover story for these moves. One can imagine hearing something along the lines of “of course we reduced staffing, that is the result of our automation efforts and that is how we were able to offer you the low pricing levels that you enjoy.” Skepticism would suggest that buyers would be hearing that refrain whether or not the supplier has actually achieved the automation objectives supporting that position.

The dilemma is that it is still early days and neither buyers nor sellers have the ability to accurately predict the automation benefits that will be achieved over a five-year term. What is needed is some sort of commercial mousetrap that can be adjusted over time; adjusted as more is known about the benefits of automation and the supplier’s ability to actually harvest them.

One way to build that adjustable mousetrap…

An appropriate approach would be to set several trigger points for discussion of adjustments, these triggers should include: (i) annual periodic reviews of the suppliers overall progress in respect to achieving the productivity changes to support the scheduled contract year pricing reductions, (ii) any supplier action to materially change the amount or quality of staffing on the engagement, and (iii) any sustained deterioration in service delivery. The first two of these of these triggered discussions should be conducted well in advance of any action to allow the buyer and supplier ample opportunity to resolve any differences of opinion prior to the supplier implementing their proposed or scheduled action.

These discussions should be formalized and should include buyer and seller leadership above the managers running the day-to-day relationship. Our experience is that improperly planned resource reductions are a cause for serious operational concern and have the potential to be escalated to the COO/CEO even in very large enterprises.

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This blog is the second part of a two-part series on key contracting issues with technology service providers, and the focus is specifically geared toward companies doing business in the real estate industry.

As noted in Part 1, technology has infused every sector of society, and the real estate business is no different. Firms running large, complex real estate projects typically do not have the core competency to design, develop, implement, host, and/or maintain the technology applications and systems to run these innovative ideas, which is why these firms typically partner with third party technology service providers to design, develop, and implement their technology needs.

Entering into these partnerships with third party technology providers can come with risk and requires a contracting strategy. In Part 1, I discussed the issues of pricing and service performance. In this Part 2 below, I discuss data protection, infringement, and insurance.

Data Protection

A wave of data security breaches has arrived – from Target to the United States Office of Personnel Management. For a real estate company to protect itself, should it terminate all the contracts with its technology providers and crawl into a cave? Of course not. Or maybe it can just hope that the hackers will not be interested in the company’s data? Given the amount of personal information real estate management companies typically collect about current and prospective tenants, that is not an option either.

First, it is important to have a clear understanding of which of the company’s current and proposed third-party suppliers have access to sensitive data and systems. Second, with respect to those suppliers that have access to such data and systems, there are measures that the company can implement in the contract to mitigate the risks and costs of a supplier data breach. This is especially important when the average cost of a data breach can run into the millions. One key area in the supplier contract on which to focus is the limitation of liability provision, which should be carefully tailored to ensure that the company’s ability to recover from a supplier responsible for the breach is commensurate with the company’s overall risk of exposure.

An additional – and maybe more important – consideration with respect to the supplier contract is that of prevention. Does the contract require the supplier to design, implement and maintain a comprehensive safeguard of security controls? What kind of firewall and encryption technology is the supplier using? Will the supplier commit to meeting industry standard security controls (e.g., ISO standards)? If the supplier collects credit card data, is it PCI compliant? What technical and operational commitments will the supplier make if a security breach occurs?

Planning for a data breach has become the new normal, and those companies operating in the real estate industry are not immune. When partnering with a technology supplier, these companies must be mindful of how to protect their data, especially in relation to their supplier contracts.

Infringement

As an in-house counsel at a real estate firm, imagine one day receiving notice of an infringement lawsuit being brought against the company alleging infringement of a third-party’s software code or technical patent. How in the world could the firm be involved in such a claim? As you keep reading, you realize that the claim involves your company’s use of your technology supplier’s services or products. Did you negotiate an infringement indemnity in your technology supplier’s contract? Let’s hope so.

Discussions around indemnities can be painful during business negotiations, indemnities really do matter. Dealing with a lawsuit can be extremely costly, and a properly negotiated indemnity provision can be used as an important shield if and/or when third-party claims arise in connection with a supplier’s performance of technology services. For example, claims of IP infringement can be a risk, even with respect to cloud transactions. These provisions are complicated, which is why having properly engaged internal or outside counsel is important when negotiating contracts with technology service providers.

Insurance

Real estate firms are quite sophisticated when it comes to maintaining insurance coverage and requiring insurance coverage from contractors. This sophistication is not surprising, given the dangerous nature of conducting complex real estate projects and/or managing buildings with many individual or commercial tenants.

However, does the company have appropriate cyber liability insurance to cover a potential network or data security breach? If so, has the company properly negotiated its policy to account for its risk of exposure? Every cyber insurance policy is different, but thankfully Sourcing Speak has covered how to negotiate those policies.

Insurance can also be a negotiated issue in a supplier contract. Real estate firms will often include required levels of coverage in form contracts with suppliers. Sophisticated technology suppliers are used to seeing these provisions in a contract, and negotiations in this area are usually not a big sticking point.

Conclusion

The real estate industry is embracing the technology revolution – innovative software and systems are becoming an integral part of the design and development of commercial and residential buildings. Furthermore, data collection and analysis is making it easier for property managers to market and manage their portfolios.

All of this innovation means real estate firms are engaging with third-party technology suppliers to execute this strategic vision. Each engagement requires a sophisticated contracting strategy to ensure that the real estate firm properly protects itself from financial and operational risk.

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Technology continues to infuse our homes, businesses, and places of employment. For example, the “Internet of Things” – as it is sometimes called – brings a lot of promise to a wide variety of industries and sectors, including farming, government, natural resources, and manufacturing. The list goes on.

Even though it often gets the (unwarranted) reputation as being slow to innovate, the real estate industry has joined the technological trend. Real estate developers, property managers, and construction firms are constantly on the lookout for new ways to incorporate the promises of new technology into the design, development, and maintenance of their projects and properties.

For example, automated parking garages have become an efficient way to maximize parking in markets where automobile space is at a premium. Some hotel chains are doing away with keys and permitting guests to access their rooms with smartphone apps. Homes and apartments are following suit. Construction firms are starting to gain FAA approval for drone use in connection with their projects. And finally, there is a smartphone app for just about every sector of the real estate industry.

Firms running large, complex real estate projects typically do not have the core competency to design, develop, implement, host, and/or maintain the technology applications and systems to run these innovative ideas, which is why these firms typically partner with third-party technology service providers to design, develop, and implement their technology needs.

Entering into these partnerships with third-party technology providers can come with risk and requires a contracting strategy. Has the company developed its own contractual forms governing technology services? Is the company content with negotiating on supplier paper every time? Companies operating in the real estate space that buy, license, or otherwise incorporate technology into their projects should be thoughtful regarding their contracting strategy and their approach to key risk and financial issues. Some of these key issues include:

  • Pricing and commercial terms
  • Service performance
  • Data protection
  • Infringement
  • Insurance

In this Part 1 of this blog, I will discuss issues of pricing and service performance. In Part 2 of this blog, I will discuss data protection, infringement, and insurance.

Price and Commercial Terms

Typically, the pricing gets all the attention. As it should! If an innovative technology idea cannot be supported by the company’s budget, then the deal will be dead in the water before it even starts.

Whether a supplier’s solution fits into a company’s budget, however, is only one consideration. Just because the company can pay does not mean the company should pay. For example, some suppliers like to include cost of living inflationary adjustments in their proposed pricing. Given the nature of the particular transaction, is it reasonable to have an inflationary adjustment at all? If the service is highly automated, then likely not. Even if having an adjustment is reasonable, sometimes a supplier will propose an upward adjustment with no ceiling. In our view, uncapped inflationary adjustment is certainly unreasonable.

There are numerous other pricing issues to consider. When will the company receive its invoices – when it signs the contract or when the service actually goes live? Does the contract permit the company to dispute fees that are incorrectly invoiced? How long does the company have to remit payment on an invoice? Will the company be required to pay in advance or in arrears? Are there any “hidden” costs like travel expenses, per diem amounts, or late payment fees? Is there a minimum revenue or volume commitment? Companies negotiating technology transactions should be on the lookout for hidden expenses that can impact its base case.

Service Performance

A typical real estate company is unaware that a technology supplier’s level of performance can be subject to negotiation. The company should ask itself: does the contract with our technology partner contain sufficient performance standards or service levels? For that matter, what is a service level anyway? A service level is a contractual commitment by the service provider to perform its functions in accordance with a certain level of performance.

Sophisticated IT service providers will offer their customers a service level agreement, and these terms are usually subject to negotiation. One particular software-as-a-service provider (with whom I have negotiated several transactions) that operates exclusively in the real estate space never proactively offers service levels unless the customer specifically asks for them.

Having service levels can help drive better performance from the supplier, but only if the company has focused on the right service levels. For example, a service provider may contractually commit that its cloud offering be available for use and working normally 99.9% of the time each month (i.e., allowing approximately 43 minutes of system downtime per month). Given the critical nature of the particular system and service, is that metric acceptable?

Another service level might measure the responsiveness by the service provider to correct errors and bugs in a software or system. For example, if the software operating a sophisticated automated parking garage contains a bug that impedes the operation of the system, how fast will the software developer respond to and resolve the issue? Does that response or resolution commitment meet the building manager’s business needs?

Finally, are the service levels being enforced? Sure, a breach of the service level could be considered a material breach of the contract, but typical contract breach remedies (e.g., termination, suit for damages) are usually not commensurate with the nature of the performance failure. The parties may instead negotiate a predetermined amount of money – known as a service level credit – that the service provider will pay to the customer for the service provider’s failure to meet a particular service level. These credits drive the supplier’s incentive to meet the service levels and serve as a powerful self-enforcement mechanism. In other words, service levels are typically only as good as the associated service level credits.

Next Time

As mentioned above, in Part 2 of this blog I will discuss issues concerning data protection, infringement, and insurance as illustrative topics for real estate companies to consider when formulating a contracting strategy with technology service providers.

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Managed security services are often a natural “add-on” when outsourcing IT services given that data protection is integral to application development, software as a service, and cloud storage, among other services. More recently, managed security services has become a “niche” sourcing alternative that many companies are considering as they seek to leverage supplier’s expertise in cyber threat assessment, detection and response. One critical consideration to keep in mind prior to outsourcing your cybersecurity is that you cannot outsource your regulatory responsibilities. In a sense, you may hire a supplier to protect your and your clients’ data and cyber infrastructure to the degree required of your organization under the law, but if those legal standards are not met by the supplier, your organization remains liable.

Under U.S. laws such as the Health Insurance Portability and Accountability Act (HIPAA), the Gramm-Leach-Bliley Act, the Federal Information Security Management Act (FISMA), executive orders and state-specific regulations, or the UK Data Protection Act, you may outsource day-to-day information management; you may not outsource your regulatory liability. If a breach occurs, your organization must notify your own clients, state Attorneys General and federal agencies, as applicable. Enforcement actions may be taken against your organization based on violation by a supplier, regardless of your organization’s knowledge, involvement, or lack thereof. For example, the Consumer Financial Protection Bureau (CFPB), a relatively new federal agency formed in 2011 under The Dodd-Frank Act, explicitly targets its enforcement powers at the conduct of both financial institutions and their service providers.

As of 2012, the CFPB announced that it expects “supervised banks and nonbanks to oversee their business relationships with service providers in a manner that ensures compliance with federal consumer financial law” and avoids harm to consumers. And what is one of the biggest risks of harm facing consumers in 2015? Loss or improper disclosure of consumers’ personal and financial data, which may occur over the Internet, via smart-devices and related applications, at merchant points of sale when making card payments, or even at the hands of a rogue employee within your organization or that of your supplier. If the CFPB investigates your organization, as a matter of course they will likely investigate your service provider(s), if any, and focus on areas of consumer data security and risk of identity fraud.

But remaining under the thumb of various regulatory regimes doesn’t mean that you shouldn’t take advantage of managed security outsourcing. So what does it mean?

  • Know before you select a managed security services provider. Complete due diligence on the suppliers’ then-current regulatory compliance status pre down-selection. Particularly emphasize the systems and experience needed to comply with agencies that have authority over your organization.
  • Shift the risk of breach to the party best able to avoid such risk at the lowest cost. Negotiate contractual obligations requiring the supplier to comply with relevant cybersecurity law and indemnify your organization for supplier-caused breaches of data security and confidentiality obligations. Bear the risks that your organization can more easily defray than a supplier.
  • Keep up with the law. Institute a rigorous process in-house or via outside counsel to regularly update your supplier(s) on regulatory changes that are applicable to your organization’s business. You know (or should know!) better than a supplier what your obligations are and what actions you’re capable of undertaking in the event of information loss or disclosure.
  • Document your vendor management processes and actions, particularly any security incidents, related communications with the supplier, corrective measures and resolutions.
  • Check in periodically. Include audit rights provisions in your outsourcing agreement and exercise those rights regularly. Pleading ignorance won’t absolve your organization of a compliance violation, but timely awareness of a problem may allow you to fix it and/or the supplier relationship before a violation occurs.

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Nearly every website, app or online service posts a set of Terms of Use outlining company policies for users (sometimes called Terms of Service) (“Terms”), but many companies do not know if their Terms are enforceable in court. Do you? Online platform use has increased quickly, and companies have tried a variety of methods to present these Terms to users. Not every method works—some companies have been dragged into unfavorable litigation when courts hold their Terms unenforceable, a situation which can result in a tremendous drain on time and resources. Today, appropriate website design and Terms content are crucial for addressing the enforceability of your company’s policies, reducing uncertainty, and minimizing future costs.

I. Importance of Terms of Service

Clearly communicating Terms of Use to users is critical to reducing liability and demonstrating transparency to customers. Terms of Use outline a company’s expectations and the types of penalties that can be imposed for violations. If a third party brings a claim against your company based on their or another’s use of your service, Terms can serve to protect your interests and reduce litigation costs by designating on the front end which state’s laws will apply or possibly requiring arbitration. When properly coordinated with a Privacy Policy, your company can also minimize liability involving use by children, copyright or intellectual property infringement, and the performance or security of your service.

II. Types of Online Contracts

Online contracts developed from shrink-wrap agreements – the paper license agreements found inside tight plastic packaging of a product box. Today, these online contracts tend to come in two major forms: click-wrap and browse-wrap. Click-wrap agreements require a user’s assent to Terms through an affirmative action, such as clicking an “I Agree” button or similar. In contrast, a browse-wrap agreement does not require a click – a user passively consents simply by using the website or app. Generally, we see the Terms for online contracts are posted via hyperlink at the bottom of the webpage.

    a. Click-Wrap Enforceability

In terms of enforceability, click-wrap agreements are the safest bet. A user is presented either with a link to the Terms or the Terms are displayed directly to users on a screen. Only by affirmatively “clicking” are users permitted to proceed to using the service being offered (e.g., paying for an item, downloading software, or even just using your company’s website). These agreements align with traditional contract principles – it is easy to see whether a user (i) had reasonable notice of, and (ii) manifested assent to the Terms because of the affirmative clicking action. Keep in mind that a user’s click of an “I Agree” button will show these elements only when the design of a webpage or app makes it clear that clicking signifies assent to the Terms.

    b. Browse-Wrap Enforceability

Browse-wrap agreements are upheld less often. Showing a user (i) had reasonable notice of, and (ii) manifested assent to the Terms can be more difficult without an affirmative action such as a click. An oft-cited case involves Barnes & Noble’s browse-wrap agreement where the website’s Terms were located in a hyperlink at the bottom left-hand corner of every webpage. The court held the Terms unenforceable because a reasonable user would not have had notice. Proximity or conspicuousness of the hyperlink alone, such as underlined, color-contrasting text, was not enough to infer notice and enforce the arbitration provision without more effort to give customers notice of the Terms.

III. Making Your Online Agreements Enforceable

    a. Design

Where possible use a click-wrap model for your Terms of Use which allows users to have the opportunity to both review the Terms and affirmatively consent to them. One model includes requiring a user to scroll through the Terms in their entirety and presenting the option to click a clear “I Agree to the Terms of Use” button before moving onto the next step. This button should be close enough to the Terms that it is obvious what it references. If for some reason a browse-wrap model must be used, the Terms’ hyperlink should be conspicuous – for instance, constantly visible on every webpage, color-contrasted, and underlined. Importantly, there should be explicit text referencing the Terms that tell users they are giving assent to agreements by navigating the website.

    b. Content

Even if you are able to demonstrate a valid contract with users through the design of your webpage or app, enforcement of every provision is not guaranteed. Particularly sensitive terms might be more difficult for a company to enforce without additional action. These terms might include forum selection clauses, arbitration provisions, class action waivers, or statements about data collection and use. Depending on the state, most forum selection and arbitration clauses are upheld, however, companies should strive to give as full and clear a disclosure about these types of provisions. Strategies include:

  • requiring specific consent to these provisions through multiple clicks,
  • using headers,
  • avoiding boilerplate language or legalese,
  • using highly readable font,
  • adding spaces between paragraphs and sections,
  • allowing printing or saving, and
  • using easy or limited scrolling.

Lastly, it is critical to maintain a digital record of each individual user’s click-wrap acceptance to provide evidence necessary to enforce the contract in its entirety.

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On 24 June, the UK’s National Outsourcing Association hosted its annual symposium in London.  This is one of the best attended and most prestigious sourcing industry events in the UK, and is well attended by suppliers, customers and advisors.

Pillsbury sponsored this year’s event, and hosted a breakout session on transition and change in outsourcing, chaired by Aaron Oser, and Tim Wright.  Guest speaker was Andrew Cubitt, Senior Commercial Lead at Transport for London.  The session focused on how customers’ and suppliers’ priorities during a transition programme can often conflict in respect of the key matters of scope, pricing and performance, and the challenges that arise from such conflict.  Working in break-outs with the attendees, the Pillsbury team identified several key recurring themes such as relationship breakdowns exacerbated by poor governance and challenges in balancing incentivisation with punishment.

More information about the event, including the slides prepared by the Pillsbury team for the transition session and the materials prepared by the other symposium speakers on topics such as robotics and digitalisation, can be found via this link: http://www.noa.co.uk/event/noa-symposium-2015/.

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There is no doubt cloud computing has delivered multiple benefits to the IT organization. However, without proper management and controls, these benefits could become a non-trivial expense to the organization. In a Wall Street Journal article earlier this year The Hidden Waste and Expense of Cloud Computing, Clint Boulton outlines the pitfalls of buying too much and not tightly controlling what is bought. ISG just released a Cloud Comparison Index which is described in Stanton Jones’ blog posting and makes many of the same points.

As Boulton rightly points out, after the cloud purchase is made, another big cost management opportunity remains: managing demand and shutting down compute resources when they’re not being used. Paying for unused resources can turn a good financial decision into a bad one.

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This is the second of two postings that discuss SaaS pricing. In the earlier posting, we discussed the underlying economics of SaaS solutions and their implications for how SaaS services are priced. This posting identifies some key considerations in negotiating pricing for SaaS services that can help lower total subscription costs.

Committed Growth vs. Incremental Purchases

As a general matter, the higher the volume you commit upfront to a SaaS provider over the contract term, the higher the discount you can negotiate. However, this carries a risk that your projected growth may not materialize and you’ll wind up paying for a higher volume of service than you need. As a result, it is important to use the negotiation process to assess the level of upfront commitment to future growth that achieves the optimal balance between high discount levels and the risk of paying for more than you need.

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Software as a Service (SaaS) is growing rapidly as an alternative to licensing on-premises software for corporate customers. As reported by Forbes earlier this year, analysts are forecasting that global SaaS revenues will reach $10.6B in 2016, representing a 21% increase over projected 2015 spending levels. By 2018, 27.8% of the worldwide enterprise applications market is projected to be SaaS based.

SaaS solutions are attractive to customers because they substantially reduce the upfront investment and risk associated with licensing and implementing on-premises software and avoid the ongoing costs of maintaining the infrastructure and implementing upgrades for the licensed software. In a SaaS solution, those costs and risks are transferred to the supplier.

SaaS combines elements of software licensing, outsourcing and hosting into an integrated solution. The pricing models for SaaS solutions have certain distinct characteristics that are driven by the economics of those solutions and differentiate SaaS pricing from pricing models for software licensing, outsourcing and hosting services.

This is the first of two postings that addresses some of the key considerations relating to SaaS pricing. This posting discusses the underlying supplier-side economics of SaaS services and their implications for how SaaS services are priced. The second posting will identify some key considerations in negotiating pricing for SaaS services that can help lower subscription costs.

SaaS Economics

From a supplier standpoint, the economics of SaaS solutions are very different than software licensing. In a typical software license, the supplier receives a large upfront payment in the form of one-time license fees that help offset investments in sales, marketing and product development. In contrast, under a SaaS model those fees are spread over the contract term (typically 1 – 5 years for SaaS offerings to corporate customers).

This explains why established software licensors are taking significant hits to earnings as their on-premises software revenue is being replaced by SaaS subscription fees. For example, the Wall Street Journal reported recently that SAP’s first quarter net profit in 2015 fell 23% even though overall revenue increased by 22% and cloud subscriptions and support jumped by more than 100%.

From a supplier standpoint, the economics of SaaS solutions are also very different than outsourcing and hosting services. Outsourcing or hosting is typically a “one-to-one” service that is customized to meet the specific needs of a customer and in which the direct cost of delivering service represents a substantial portion of, and is directly correlated with, the supplier’s charges for the service. In contrast, SaaS is a “one-to-many” service that is not customized for individual clients and in which the direct cost of service delivery represents only a modest portion of the supplier’s fees.

To understand the economics of SaaS solutions, it’s helpful to look at the income statements of some of the leading SaaS providers. The lion’s share of costs is for sales and marketing to acquire new customers. As reflected in their 10-Ks, sales and marketing as a percentage of revenue for salesforce.com, Workday and Netsuite ranged from 40 to 53%. Combined costs for product development (R&D) and general and administrative (G&A) expenses accounted for somewhere between 30 to 53% of revenue for these companies. The direct cost of delivering the SaaS service is relatively low in relation to revenues, ranging from 17 to 19% of subscription revenue.

Each of these companies had gross profit margins of over 80% on subscription revenue, but had substantial net operating losses due to sales and marketing, R&D and G&A costs. This is a reflection of the high growth trajectory of these companies and the time it takes to recover their investments in customer acquisition, R&D and the assets required to deliver the service. The road to profitability depends on high customer retention rates and expansion of business with existing customers.

Pricing Implications

These economics have several implications for how SaaS services are priced:

  • Size Matters (a lot) – while large customers can always expect to receive higher discounts for IT services than small customers, this dynamic is magnified for SaaS services. The lifetime value (LTV) of a customer in relation to the cost to acquire a customer (CAC) is much higher for large customers than small customers. At 80%+ gross profit margins on subscription revenue, the revenue stream from a large customer has a much greater impact on the supplier’s earnings than, say, a large outsourcing or hosting customer (where gross profit margins are lower due to higher direct costs of service delivery in relation to revenue). Even though it typically costs more to acquire a large customer, these are one-time costs that are more than offset over time by the revenue stream of a large customer. Large customers also have longer retention rates for SaaS services. Therefore, large customers should expect to receive substantially higher discounts on subscription fees and considerably more flexibility on other pricing and non-pricing related terms. In this respect, SaaS pricing is analogous to pricing on software licenses where a large client may pay half of what a small client pays on a per unit basis.
  • Minimum Revenue Commitment – the payback on the supplier’s investment in acquiring a SaaS customer can take many months (in some cases over a year) of subscription fees to break even. Therefore, minimum revenue commitments are particularly important for SaaS providers. A typical SaaS agreement will obligate the customer to purchase a specified volume of SaaS services for a committed single or multi-year term. Suppliers normally attempt to avoid or limit termination for convenience rights and the ability of customers to reduce volumes below baseline levels. Since the cost of service delivery is relatively low in relation to subscription fee revenue (e.g., only 17 to 19% for salesforce.com, Workday and NetSuite), there is very little opportunity for the supplier to shed costs when a customer terminates or reduces volumes. As a result, the traditional outsourcing or hosting services model – which generally provides a high degree of flexibility for customers with respect to termination and volume reductions – does not translate well to SaaS service offerings.
  • Payments Start When the Service is Made Available (not at “Go Live”) – SaaS providers normally insist that the full subscription fee commence on the date that the service is turned on for a customer (i.e. made available to a customer to begin the configuration and implementation work to be able to use the service). Customers often argue that they should not have to pay the full subscription fee prior to their “go live” date in production since the customer will be consuming fewer resources of the supplier prior to that date. This is a legitimate point. However, given the relatively low cost of service delivery in relation to the subscription fee (e.g., typically under 20%) with a substantial portion of those service delivery costs being fixed infrastructure investments, there is likely only a modest amount of savings to be achieved in pursuing this line of argument.
  • Payments in Advance (not arrears) – many SaaS providers insist on payment in advance, either annually or quarterly. This is to help the supplier with cash flow issues associated with the upfront investments in customer acquisition, R&D and service delivery infrastructure – which can be particularly important for suppliers with rapid growth trajectories. In addition, payment in advance tends to make customers more invested in actually using the SaaS products they purchased and working to overcome initial transition challenges.

Although SaaS pricing can be inflexible in some respects, one benefit to customers of the economics of the SaaS model is that suppliers have a particularly strong incentive to maintain competitiveness in pricing their products even after the customer has subscribed to the service. Retention and expansion of business with existing customers is critical to SaaS providers in generating returns on their upfront investments. Since it is generally easier for customers to change SaaS solutions than on-premises software (in which the customer may have made substantial capital investments) or even outsourcing or hosting solutions, SaaS providers cannot necessarily count on their customers becoming “captive” to them in the same way that customers become captive to their major software licensors or outsourcing providers. This can provide leverage to customers in negotiating favorable pricing for expanded business and renewals.