A Clear Understanding of Outcome-Based Contracts?

Posted: 01/20/2018 - 01:27

It’s easy to hear a buzz word in the industry and make assumptions. However, what happens when those assumptions prove incorrect? And what happens when those assumptions are the bedrock under which a sourcing contract is being shaped, priced and a customer/service provider relationship is developed? 

I’ve heard it many times; “I don’t care how you do it – but we need the job done.” This can be a dangerous mindset if seeking to embark on an outcome-based project. If the customer is stating this, they have missed the point of an outcome-based agreement and should re-think their approach. If a service provider is on the other side of the table hearing that statement, they should challenge the customer’s approach and determine whether the customer has fully comprehended the level of work and commitment associated with the outcome-based approach. 

Outcome-based contracting is not a tool by which customers can shift responsibility to their service providers and seek to avoid the effort and time associated with good governance and performance delivery. It is an operational model that requires a strong customer and service provider relationship, trust and a genuine sharing of risk and reward. If a customer misunderstands what outcome-based contracting is (and perhaps confuses it with output-based contracting as this statement suggests), the customer’s expectations are already misaligned with the service provider’s and what each party should be committing to. 

Outcome-based models are by no means new to the sourcing world but now with a greater understanding and implementation of Artificial Intelligence (AI) at the customer side, they have grown again in popularity as we see a resurgence in customers demanding greater innovation and more cost-effective service, particularly in process-driven services such as finance and accounting. 

But with potential for misunderstanding and customers confusing output for outcome, will we start to see an increase in issues arising from outcome-based contracts? 

A true outcome-based model requires a considerable amount of strategic planning from the customer before engaging with service providers. A customer needs to be capable of introspective analysis to understand, develop and communicate its business values and strategic agenda. However, this flow of information will need to go both ways as the parties will need to determine whether they share the same business values and approach on which to base the relationship. While trust will be of utmost importance, this flow of communication should be subject to early contractual commitments of confidentiality. Both parties may want to share, at a high level, their business strategies and potentially confidential information about business projections and future aspirations. This should be done in a controlled and respectful manner, sharing only the information that will benefit the relationship, with the requisite protections in place. 

Ultimately both parties need “buy in” from senior stakeholders and will need commitment from every level of the organisation before a strong working relationship can be established. All levels of the customer organisation have to want to work with a service provider as a strategic partner and see the benefit in the service provider helping them achieve their organisational goals. This is more than just the parties outlining and agreeing to certain contract outcomes. A strong and well developed business case should be circulated to ensure that internal alignment. In turn, the service provider has to want to align its business with the customer and trust that the customer will commit to a true risk and reward model. 

Each party will need to invest in the process at an early stage. The customer will need to have the right resources available for its internal analysis and baseline of existing services. Both parties will need their project teams to invest time and effort in deal structuring and seeking to exclude external factors that may impact the measurable outcomes that the service provider is remunerated upon. Early investment of this type (on both sides) will be key to demonstrating commitment to the process and a successful, working contract. The time spent in the early stages of development of core principles, agreed measures and conducting due diligence means that there is a significant level of work done before the parties reach contractual negotiation. If customers are not capable or cannot spare the resource to take on these tasks, they would do well to consider using a consultant who understands the complexities of an outcome-based approach and who can assist with baselining the relevant existing services and create a true risk and reward program. 

Although not yet at contracting phase, the work effort involved in this early stage of development should be documented and agreed to by the parties. In addition, the baselines from which the outcomes can be measured, the outcomes themselves and any risk factors that may adversely impact the service provider’s efforts should also be agreed on and clearly documented. Outcome measurements will involve negotiation and discussion between the parties. Each measurement should be capable of being objectively monitored rather than an internal metric understood by only one of the parties. 

Strong governance is key in most (if not all) sourcing relationships, but it is even more important when working on an outcome-based model. Governance structures should be developed early in the relationship and be robust with the ability to flex over time in line with the relationship needs and both customer’s and service provider’s businesses. It is of paramount importance that the parties – at all levels of the relationship – adhere to the agreed structure. Like with all sourcing models, if one party deviates from the model, the relationship is strained and trust is lost. 

The parties will need to trust each other sufficiently to afford a greater level of transparency than is customary with other contractual models. If a party experiences changes in its interests, business strategies or demands, it is important that this information be shared in sufficient detail to allow the parties to address what changes may need to be made, whether that should cause a re-baselining or a change in measurable business outcome. These will be difficult to legislate for at the outset but the contract should afford the parties sufficient flexibility to ensure the ongoing success of the contract for both parties. 

Some may feel an outcome-based contract implies a greater level of understanding and more sophisticated level of contracting between customer and service provider. However, more simplistically it involves good planning, a clear demand from the customer for increased innovation and cost savings and a genuine alignment of the service provider'sI lov and customer’s interests. Outcome-based contracting is not suitable for all services but for business processes the model is a joint endeavour that rests on the strength of the relationship and an honest and open sharing of information and risk and reward.

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About The Author

Megan Paul's picture

Megan is a partner in the Commercial team with Charles Russell Speechlys LLP in London. She has in-depth experience in technology, communications and large-scale complex outsourcing transactions, both locally and internationally. Megan also advises on the commercial aspects of private equity and M&A transactions. Megan was previously at Mayer Brown International LLP where she spent ten years, with secondments to Nomura International plc, Unilever plc and Airbus SAS as well as an international secondment to Mayer Brown's head office in Chicago working for the firm's US client base. 

Megan is admitted to practice in England and Wales.