Acquisition: Outsourcing topics: Practical considerations: Disengagement

Disengagement

Disengagement from a supplier of packaged software is relatively simple. You can disengage yourself from Microsoft and switch to Lotus or Borland very easily. First, you buy the new product. Second, you convert the files that you created with the previous product. Most packages, especially in the area of office automation, allow "foreign" documents to be imported, so that your Word documents can be converted to WordPro or WordPerfect.

Disengagement from a software maintenance provider or a help desk provider may be more difficult, but there are alternative suppliers readily available, who will often help in the disengagement.

Disengagement from an provider or a facilities manager may be more difficult.

Causes

Let us consider some of the reasons for disengagement.

Normal Termination

When the period of the contract with an provider expires, the customer has three choices:

renew the contract;
bring the services back in-house; or
select an alternative provider.

In this paper we shall only be concerned with the second and third options, where the contract ends and the parties disengage.

Customer Choice

The customer may wish to end the agreement before its normal termination date, even though the provider is not at fault. Often, the customer may simply be “uncomfortable” with outsourcing and may wish to bring the services back in-house.

Provider Fault

If the provider is at fault, then there will usually be provisions in the contract for the form of disengagement known as “termination”, and these provisions may include the payment of damages or coverage of losses by the provider.

Effects

Some of the circumstances that occur are different, depending on whether the cause is the normal termination of the contract, or the provider's fault, or the customer's choice. It will be useful to look at each of these in turn, first.

Normal Termination

Today, most outsourcing agreements are reached on the basis that the customer and the provider will work together in future to help each other to attain their business objectives. The customer will often have a stake in ensuring that the provider's business flourishes, because it can bring returns in the form of:

lower pricing, driven by the reduction in unit costs to the provider of its administration and infrastructure overheads;
greater security, as the provider continues to grow and become financially stronger; and
better services, as the provider may be better able to improve services for a number of customers than for a single customer.

It is therefore usual to find that the continuing success of outsourcing agreements relies upon this vision of shared business goals.

In practice, this may not occur. It has been the practice of some providers to maintain that the building of a relationship with their customers is essential to their business. Unfortunately, the concept of working together with customers may have been introduced into provider through its marketing department. It may not be a basic objective to which everyone in the provider is committed; it may not have policies and procedures to which everyone in the provider adheres; and it may not be a central indicator for the performance of everyone in the provider.

In short, it may not actually exist within the provider's dealings with its customers except during a pitch for new business.

It is not cynical to suggest that the provider may not be aware of this situation. For a provider to develop good ongoing relationships with its customers, the commitment, practice and measurement aspects of customer relationships must be embedded in the provider's entire organization. Some providers only have a "vision" or "concept" of relationship building, although they may honestly believe that this is sufficient to ensure that good, ongoing relationships will ensue.

It may therefore come as a surprise to the provider to find that the customer does not feel that it has a good relationship with that provider.

At the end of the contract, if the customer does not renew, the provider may feel aggrieved. Its staff may have believed that they were forming a good relationship with the customer, and they may now be upset that the customer is prepared to walk away from that relationship.

It may therefore come as a surprise to the customer that, having announced disengagement, with no fault on either side, it is faced with a hostile and unhelpful provider. The customer knows that there was no sound, continuing relationship with the provider, and it cannot understand why the provider's staff are so upset.

During the agreement, the nature of the services provided may have changed considerably, and the provider is likely to know more about those services than the customer. This will be especially true of a medium to long term contract. When the customer decides not to renew the contract, it will need considerable assistance from the provider, whether the customer is moving to in-house services or to another service provider. A resentful and uncooperative provider can withhold this assistance, making the disengagement afflict the customer in terms of time, money and operational effectiveness.

The real solution to this problem is for a good relationship to develop, so that the customer does not withdraw from the provider. The secondary solution is to enforce co-operation during the disengagement. We shall look at this in more detail shortly.

Customer Choice

The same issues of hostility may apply if the customer chooses to disengage before normal termination, even if the customer stresses to the provider that the disengagement is not the provider's fault. The degree of hostility is likely to be less.

One new aspect of disengagement emerges, however. If the customer chooses to disengage, then the costs of the disengagement should be borne by the customer.

This is another issue to examine more closely shortly.

Provider Fault

When we consider a disengagement that is the provider's fault, a third issues emerges.

If the contract is terminated because the provider is in breach of it, it would be logical to assume that the provider should bear the costs of the disengagement. In practice, this will not happen.

Issues

We have identified three issues for disengagement:

The provider may be uncooperative.
The customer will pay if it chooses to disengage.
The provider will attempt to avoid payment if it causes the disengagement.

Co-operation

Whatever the circumstances under which the service contract is terminated, the co-operation of the provider during disengagement will be essential.

Consider the issues involved.

The customer will have mechanisms for receiving the outputs from the outputs services and for monitoring the delivery of those outputs, in terms of quality, volumes, cost and timeliness or through service level agreements. There are two serious impediments to brining all of the services back in-house from the provider.

The skills to provide the services on an in-house basis may no longer be available. When services are outsourced, the provider may take some of the customer's staff in the transition. These people are probably intended to provide services to the customer. Over time, however, the provider may be able to derive additional benefits or savings from having these people provide services to a number of customers. As a result, the provider may be reluctant to transfer these people back to the customer. In addition, the people may not want to return; they may have found greater fulfilment and opportunity with the service provider.
Even when there are people inside the customer who were involved in providing the services before the transition, these people may no longer be familiar with the services now being provided. The services may have increased in both scope and scale. This is one of the advantages of using an external service provider: over time, the services will expand to add increased benefit. It can stop being an advantage during disengagement.

So, regardless of the transfer of “hard” assets back to the customer, there will be a need for the provider to provide assistance to the customer to transfer the “soft” assets as well.

One of the best ways of ensuring someone's co-operation is to pay them. We shall look at this shortly.

Customer's Cost

There are certain occasions when the disengagement will be at the customer's cost.

The obvious example is when the customer decides to terminate the contract before normal termination without the provider being at fault.

The customer would then be expected to pay not only for its own disengagement but also for a proportion of the provider's costs, especially when these costs have been incurred at the customer's request.

A less obvious example is at normal termination. When the service contract ends and the customer decides not to renew it, the disengagement process should be covered by an “accession contract” that will outlive the service contract. Traditionally, the disengagement process has been included as clauses of the service contract that have been specified as outliving the remainder of the contract. Today, many customers rely on external service delivery to such an extent that it has become useful to manage disengagement through a separate accession contract.

The accession contract can state that the costs of disengagement at termination will be borne either by the customer or the provider or on a shared basis. In spite of this, it is useful to analyse who will actually pay.

If the service contract has been developed so that the provider will be expected to pay the costs of disengagement, then the provider will ensure that those costs will be retrieved from the customer over the duration of the service contract. So, if the service contract is for five years, the customer can expect that 20% of the costs of disengagement will be embedded in the price of the service each year.

We shall look shortly at the embedded costs of supplier's prices. For the moment, we shall just consider the cash-flow impacts of this pricing.

Each year, the customer will, in effect, be paying 20% of the disengagement costs to the provider. If the costs of disengagement had been excluded from the service contract or the accession contract, the customer would have been aware of having to bear these costs in five years and would have made provision for meeting these costs. There is an enormous difference between spending money and making provision for spending. Given that the customer will always pay in the end, it makes sense to agree that the customer will always pay at the start.

Supplier's Fault

The one major exception to this rule appears to be when the supplier is at fault and the contract is terminated as a result. It seems to make sense to develop an agreement that, in these circumstances, the provider will pay the costs of disengagement.

A prudent service provider will always ensure that the customer pays. It could be expected that the provider would embed the costs of disengagement into the service contract to allow for the contract being terminated at their fault. We have seen above that this might be expected to be 20% of the disengagement costs each year of a five-year contract.

This argument has a fault. The provider is more likely to default early in the life of the service contract rather than later. So, rather than add the disengagement costs at the rate of 20% per year, the provider may add 40% per year. This means that, if the contract is terminated half-way through its five-year duration, the provider will have taken at the costs of disengagement from the customer already. The provider may be willing to bear some of the exposure up to that point. As an alternative, it may increase the price still further, so that the customer may be paying up to 60% of the disengagement costs to the provider each year.

We shall now examine the true costs to the customer.

If the customer elects to pay all disengagement costs at termination, for whatever reason, the total paid by the customer will be 100% of the disengagement costs.
If the customer requires the supplier to pay all disengagement costs on breach and termination of the contract, then, if the supplier embeds an amount each year equivalent to:
- 20%, the customer will pay the supplier 100% of the disengagement costs over the duration of the contract;
- 40%, the customer will pay 200%;
- 60%, the customer will pay 300%.
If the contract runs to normal termination, the customer may then pay the costs of the actual disengagement. This means that, depending on the rate at which the provider charges back the costs of disengagement each year, the customer can pay 200%, 300% or even 400% of the actual disengagement costs over the duration of the service contract and the disengagement itself.

These costs do not include the finance costs or the costs of expenditure instead of provision of funds.

Solutions

There are two solutions to the three issues.

Co-operation

Whatever the cause of the disengagement, it is useful to include an agreement about co-operation in the original contract.

I am convinced that the terms and conditions for this co-operation are best determined by the customer and the provider when the agreement is being constructed. Guidance on some options may be useful, however.

It may be useful to initiate a set of disengagement procedures, so that assets can be transferred from the provider to the customer. These procedures will be similar to the “transition procedures” agreed for transferring assets from the customer to the provider for the service delivery to begin. They will cover the same assets, such as knowledge, information, data, procedures, documentation, buildings, plant, other equipment, and people.
Where there are disengagement procedures, they should be reviewed regularly during the operation of the service delivery contract. In particular, the fact that there is a service delivery contract in operation means that the circumstances of the disengagement may change and that the co-operation required from the provider may also change.
The work required of the provider during disengagement may be on a time-and-materials basis. This is because it may be difficult to establish a scope for the disengagement at the beginning of the contract. It may therefore be difficult to establish a price for the provider to complete the work which will remain reasonable.
Work to be done on a time-and-materials basis should be subject to an annual review, so that the rates remain reasonable.

Payment

In all cases, the customer is going to pay, regardless of the stated method of payment.

The issue is really whether the payment is direct and allocated to a specific purpose (which, in this case, is disengagement) or whether the payment is embedded in the prices of the supplier. We have seen above how a fully “unbundled” price can lead to over-charging.

The solution to embedding is:

to require the basis of all pricing to be shown in detail; and
to conduct a due diligence to determine the true costs to the service provider.

Other Considerations

In some circumstances, the provider may not be able to restore the original assets. A provider may have acquired a building from the customer, which was the customer's "data centre". This building may have been surplus to the requirements of the provider and may have been sold or leased. It would therefore be extremely difficult for the provider to restore full use of the building to the customer. The contract for outsourcing should therefore allow the provider to provide either an alternative building or a cash payment.

Less dramatically, the provider may have negotiated a special deal for software licences, and restoration of the original licensing arrangements may involve a charge to the customer.

It is important that the consequences of disengagement are considered carefully during the formulation of the agreement, and that appropriate safeguards of the interests of both the customer and the provider are included in the contract and reviewed throughout its duration.