Understanding your value in an IT outsourcing deal

Andy Treder, Managing Consultant, Alsbridge Europe

If you are reading this article then this probably means you have a relationship with an outsourcing supplier, or you could be about to enter some process to create or redefine such a relationship.  You may well have read all about the benefits of outsourcing, the pitfalls, and the disaster stories.  You know it’s a tough process.  You’re going to end up negotiating or renegotiating a contract so you’ll need lawyers, the HR issues associated with staff transfer and offshoring options create their own special considerations. Your technical architects are entrenching around their favoured products, the users continue to rely on your service, your Chief Executives are looking for further contribution.  And you’ve by now come across the thorny questions around supplier relationships.

One basic fact often gets mislaid in the midst of all this causing fatal consequences.  IT outsourcing is a two way transaction: you are selling (some) of your capabilities and assets to the supplier, the supplier is selling their expertise and future services back to you.  It is a marriage of divestiture and services contract.  Too many transactions end up focused solely on the services contract.  The consequence is that as the process unfolds towards the final negotiations you, as the customer, sense unwillingness by the supplier to behave like a company who is trying to sell you what they’re bidding for!  In turn, this can develop into adversarial negotiations with the truly catastrophic possibility that the deal will be signed against an uncooperative, mistrustful backdrop which may take years to remove, if ever.

Now consider best practice in negotiation.  The common wisdom is to avoid an adversarial, position based negotiation and to aim for a more collaborative, win-win approach.  The key principle which underpins win-win negotiation is to understand the other party’s drivers.  So it comes as some surprise that many customers barely consider what motivates an outsourcer and so fail to appreciate their own value in an outsourcing deal.

So what motivates an outsourcing supplier?

Above all, the supplier is in business, and their business is to make money from providing IT or Business Process Services.  It’s not about technical beauty, a desire to create sophisticated, integrated solutions, or even efficiency for efficiency’s sake.  Sophistication, elegance, integration, and efficiency fulfil a purpose: that is to drive the cost of service delivery down.  This is Commerce, not Art or Science.  Even if the deal starts with technical discussions, it will end with very commercially oriented solutions, based on this fact.  As advisors, interpreting these factors is a key element of domain expertise that we bring to the table, but below is a sample of the factors you need to consider to value your deal with the Supplier.

Factors that determine how a supplier will value your deal

• Growth:  Suppliers have to grow, they cannot afford to stand still.  Every deal which a Supplier signs represents growth: of revenue certainly, probably headcount too.  And a failed renegotiation is a double loss.  Your signature on a deal provides your supplier with the basic life force they require: growth.  Remember, you are selling this growth to the supplier, you don’t have to give it to them, this is your key contribution in the deal.  A corollary to this is the bigger the supplier, the bigger the deal they desire to sustain their growth, e.g. the largest suppliers need annual growth on a scale equivalent to the entire revenue stream of a small supplier.
• Revenue / Backlog:  As mentioned, the primary growth which you are providing to your supplier is through the service charges, revenue for them.  This can be interpreted in two slightly different dimensions:  the annualised “run rate”, and the backlog, or total contract value (TCV), the sum of the annual run rates for the defined period of the contract.  TCV, clearly, is a consequence of the average annual run rate and the period of the contract.  So, whilst the general advice is to avoid long, say 10 year, deals do not undervalue the negotiating strength that offering a longer term may give (as opposed to an increased scope,) maybe to win that one concession you require.
• Profitability / Margin:  Outsourcing contracts tend to be high value, low margin deals.  It is unlikely that your single deal can grow the supplier’s overall margin.  But a single, risk-laden, deal can create significant overall margin dilution.  Therefore this parameter is more likely to be present in the form of a hurdle rate which must be met or surpassed.  One of the most crucial internal calculations the supplier will make, and one of their most carefully guarded figures, will be the forecast margin for your deal.  An overly strong focus by the customer on the commodity aspects of the deal, failing to include value-add projects (where higher value resources are utilized) significantly restricts the perceived value of the deal which you are selling to the supplier.
• Cashflow:  A low margin, high turnover business will be cashflow sensitive.  Therefore any contractual discussions around withheld payments, service credits, or liquidated damages (with their parallel impact on margin) will be treated with a greater fear than you may initially consider.  This doesn’t imply that these terms are unreasonable, just understand and expect the objections you will encounter.
• Market share:  Suppliers, clearly, have a growth strategy, based on geography and / or vertical segment.  You may consider a supplier weak where they do not have credentials in your geography or vertical, but for them, your deal, the market presence which you bring to the table, may be a springboard for their growth.  The exact alternative may also be true, you may actually be in a market where they genuinely have little interest!
• Assets (Hardware):  In early deals hardware assets tended to be well received by suppliers, valued at Net Book Value (NBV) or Fair Market Value (FMV), the intent being to introduce automated systems management, consolidation, and leveraging of the assets across multiple deals, disposing (at no loss) of those which became surplus.  The cash injection into the customer was also well received.  Generally this approach failed (with the exception of systems management) and hardware assets if transferred are generally treated on a lease basis, which makes the financial case for transfer somewhat less interesting than before.  (Outsourcing suppliers do not make the best finance houses, although some have Financing arms.)
• HR Assets (People):  Fundamentally treated to the same analysis as hardware, with similar results: those who could be were replaced through systems automation, others offshored (basically any form of price arbitrage.)  Scarce resources were leveraged, especially by suppliers in their early stages of growth who acquire their skilled staffed from you, their Customer.  With the advent of a more commoditised approach and widespread offshoring this too has decreased in impact.
• Assets (Facilities):  The one dimension of assets which potentially still retains some interest to a supplier is facilities, e.g. data- or call- centres, especially if they are offshore.
• Assets (Software):  Licensed software assets may be a source of cost consolidation for a supplier (where they may be allowed to aggregate licences by the Software owner) but have little value otherwise.  In-house developed software (typically incorporating reusable IP) will only be of interest where a joint go-to-market (e.g. a Joint Venture) is an option.  These ventures have often yielded poorer results than forecast.
• Other interests (Systems Integration, Transformation, Hardware, Software):  Scope of the deal creates a strong interest with the supplier, especially where development or project work (which typically carry a higher margin) is included.  Equally, suppliers who are also hardware manufacturers like to assure sales of their product, as do software suppliers.  Indeed, it is interesting to see how suppliers who also provide hardware and / or software are moving into outsourcing, despite the lower margins, in order to protect their base.
• Financial Year:  Considering at a more personal dimension, different suppliers account for target  revenues (the numbers which drive a teams sales bonuses) in different ways, some measure a win by TCV, some by first year revenue, some by the portion of first year revenue within the current financial year.  Clearly if you are negotiating a deal in month 11 of the supplier’s financial year then teams from the first two categories are likely to be keen to sign before the year end (unless they already hit their targets) while teams from the third category may well wish to delay until the first day of a new financial year.
• Sales Bandwidth:  Suppliers typically maintain an outsourcing sales pursuit team, with fixed headcount, expense budget, and revenue targets.  This implies that they will qualify your deal as meeting their interests.  Even if your deal is qualified in, the level of interest may determine the quality of team that they assign to the pursuit, and not all teams are equally effective.  And that will affect your negotiations.

What do outsourcing suppliers perceive as the “risk”

Risk is the view which counterbalances the potential positives above.  And there is one aspect of risk which does not necessarily have a positive counterbalance: operational delivery.  The Business As Usual operation which the supplier takes over is full of unknown risks.  Experience will allow the supplier to reasonably assess such risks, but risk, by definition, is always an unknown.  And with operational risk (or rather, operational failure) come the realisation of all the other major commercial risks, withheld payments and margin erosion by virtue of cost of remediation.  The most hardnosed suppliers have to view signing a new deal as signing up for a new risk, and the process of managing service delivery includes a substantial portion (and maybe cost) of risk management.  Associated with forecasting cost and offering a price (which form the positive basis of forecasting profitability as described above) comes risk assessment, with its associated cost of failure.  This generates the most complex dimension of the transaction:  the bigger the deal, the bigger the transformation required, the bigger the geographic scope etc. then the bigger the risk.

As a customer you need to be aware that the sales cycle, as perceived by the supplier, moves from a positive, sales opportunity oriented to a more cautious, commercially risk oriented discussion which often hits its nadir as contract negotiations are fully engaged.  Each term negotiated exposes another risk element, and strong negotiation by customers pushes a keen supplier into deeper risk territory.  Pushing more and more risk onto a supplier as a one sided transaction is seldom a good strategy, although it can be done.  It is not an exaggeration to say that there have been internal supplier announcements which start “the bad news is that we won the deal…”

However, we started this discussion with the view that suppliers are first and foremost commercial animals, risk is an inherent part of commerce.  We should see it as positive that the supplier actively manages their risk, because your success will become linked with theirs.  Indeed, a supplier who appears cavalier with risk should be viewed with caution, your contract may look fine, but what about the next one they sign, which may break their company, and damage you in the process?

The final ingredient

To summarise, the “out” of outsourcing denotes a fairly unique transaction, a sale and transfer of assets, processes, and service delivery capability linked to a reciprocal agreement to purchase similar services over a committed period.  You are selling a revenue stream alongside the means to deliver it, and you are committing to buy services.  The supplier is committing their expertise to deliver improved services at better value, and is purchasing capabilities and a risk.  You and the supplier have differing aims and capabilities but you are not a transactional, product, customer.  You are an equal partner in the transaction.  A win-win results from an open understanding and acceptance of respective positions, along with the confidence, and respect, to behave like a partner.  A lose-lose scenario develops when negotiations become position based, adversarial due to lack of understanding, or the significance of risk is under-valued, typically by the customer.  Striking the balance remains the final ingredient.

For more information about Alsbridge plc, the independent advisors on outsourcing, shared services and offshoring, please contact Helen Ricardo on +44(0)20 7242 0666 or email Helen.ricardo@alsbridge.eu.

 

Subscribe to our newsletters

Subscribe

email

Contact

How can Alsbridge plc help you?

Please get in touch to discuss your business needs. 

Europe Head Office:
+44 (0)20 7242 0666
Email: enquiryEUR@alsbridge.eu

US Head Office:
 +1 (214) 696 6410
Email: enquiryUSA@alsbridge.com