9 Critical Elements of Outsourcing Contracts

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Astute businesses recognize that outsourcing certain goods and services can save costs. However, recognizing the need to purchase externally is only half the battle. To optimize cost savings, the parties must craft key provisions of the outsourcing contract with particular care. While all terms of a contract are important, some merit special attention – those that outline how the parties will interact both in good times and bad.

Negotiating the Outsourcing Contract

Time spent upfront, at the time of negotiation and drafting, is time well spent. Doing so will ensure a good working relationship based on mutual benefit. In addition, thoughtful provisions help avoid conflict. If conflict becomes unavoidable, well-drafted provisions make for quicker, more acceptable resolutions to conflict.

When entering into an outsourcing agreement, such as a master services agreement, the parties should pay particular attention to the following nine areas. The first six relate to building a mutually beneficial relationship, while the last three ensure that, should problems arise, they are resolved quickly and amicably.

Outline the Relationship

No. 1 Provide measureable outcomes. Carefully defining the duties and expectations of each party is one of the most important components of any outsourcing agreement. Rather than focusing on processes and tactics, consider focusing on measureable outcomes and deadlines. As a result, the provider will have the requisite flexibility and both parties will more likely achieve their ultimate objectives.

No. 2 Incentivize the parties. While pricing is a critical component of any agreement, the direct cost is less important than ensuring that each party is properly motivated to make the relationship work. Both parties benefit when the contract appropriately incentivizes the provider to meet objectives and sufficiently penalizes the provider for not doing so. One method that works well is pegging compensation to specific yard markers as the relationship progresses. Designing a provision in this way allows more predictable budgets and, at the same time, provides flexibility to build on past successes (or problems).

No. 3 Address data security. We all know the importance of data security, so no surprise that security provisions are an important component of any contract. Make sure the contract requires compliance with industry best practices, such as ISO 27001 and ISO 27002, PCI Data Security Standard or the Control Objectives for Information and related Technology (COBIT). The parties should also cover breach reporting requirements, auditing and penetration testing and cybersecurity insurance. A provider may be a more secure option when compared to managing complex systems internally, but only if the requisite security provisions are properly drafted and in place.

No. 4 Clarify IP ownership. Sometimes a provider assists a customer in IP creation; at other times, the provider simply develops infrastructure to allow the customer to develop IP. In either case, IP ownership is ripe for dispute. Clearly lay out who owns what at the outset to avoid costly disagreements concerning IP ownership.

No. 5 Formulate service levels. Service level agreements (SLAs) identify objective measures of performance. Their effectiveness hinges on how well they outline definition, applicability and scope. Carefully draft SLAs so that the customer-provider relationship builds upon a foundation of trust and mutual benefit.

No. 6 Provide governance and audit provisions. During the contract term, both parties need transparency and oversight. Further, the processes to achieve both must be workable. Poorly drafted provisions that create tension between the parties defeat the purpose.

Cover the Undesirable Outcome

No. 7 Address dispute resolutions. Despite care in drafting contracts, disputes are part of doing business. Because disagreements are inevitable, make sure to provide for efficient resolution. Clumsy provisions can cause unnecessary complications and costs. Pay close attention to terms that often give rise to issues:

  •  Venue restrictions limiting disputes to certain states and types of courts (state or federal). • Forum restrictions requiring binding arbitration or informal dispute resolution.

If and when problems do arise, the parties will benefit from their front-end, predispute planning, which will prevent problems from spiraling out of control. Parties should consider informal dispute resolution options because these may be more accessible to business owners and encourage a faster, more efficient resolution of issues before they escalate.

No. 8 Detail bankruptcy contingencies. Given the highly competitive outsourcing market, businesses should consider the possibility that a provider may file for bankruptcy. No doubt, a bankruptcy complicates a sourcing relationship and can muddy clarity in data ownership and accessibility, thus accenting the need for forethought. The customer does not want to negotiate with creditors over data ownership.

No. 9 Provide an exit. The outsourcing contract should provide the parties a graceful exit. Take care in drafting provisions related to contract term, termination charges, data portability and transition assistance – all are critically important. Both parties need a path forward.

Conclusion

Outsourcing certain goods and services is the new normal. Ideally, a well-drafted outsourcing contract allows businesses to focus on what they do best, drive efficiency and control costs. Time spent at the outset focusing on the nine provisions outlined will benefit businesses and providers alike.

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