How to Achieve Innovation through Outsourcing: Shifting the Paradigm
Posted March 19, 2010 by Bierce & Kenerson, P.C. · 
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Can an enterprise customer get real innovation through outsourcing? It depends. After looking at a case study in contract manufacturing and finance and accounting outsourcing, we can draw some lessons on the squeaky wheel that will need lubrication beyond effective governance.
New Product Development. Recently, Bierce & Kenerson, P.C. was engaged by a global enterprise to assist in a two-phase deal with a supplier. In phase one, the parties entered into an agreement for the joint development of a new type of product to retrofit an old product using new energy-efficient technology. In phase two, the enterprise customer agreed to either buy the new product from the supplier or to pay a royalty for the value of the supplier’s intellectual property and development efforts. The risk of failure was essentially nil, since the enterprise customer could have developed the product alone. Yet it chose to work in tandem with the supplier to achieve a speedier path to market for a hot product with a big potential demand in order to avoid loss of market share to well-financed agile competitors.
The contract development process took much longer than the product development process for several reasons.
o Market Positioning. First, the customer and supplier had not really reached agreement on issues of exclusivity, market positioning and branding. Having already committed resources for joint development of a new innovative product offering to the enterprise’s customers, the enterprise customer lost some of its bargaining power (and actually lost some goodwill in the marketplace) until these issues were resolved in the master supply agreement.
o Financial Viability and Contingency Planning. Second, the supplier was a new entrant into the market, with venture funding but no strong ongoing revenue stream. Financial viability issues challenged the paradigm, requiring careful scenario analysis and negotiation of step-in rights using various sources of goods, services and intellectual property rights. Both parties had different compliance issues arising from separate provisions of securities disclosure laws, including the Sarbanes-Oxley Act of 2002.
o Publicity. Third, the supplier was a publicly traded company for which the new deal would require public disclosure under investor protection laws. The enterprise customer had not focused on managing the public message that might be presented by the supplier. Initially, the supplier was considering issuing messages – through its Marketing Department – that suggested that the enterprise customer could not develop the new product through its own skill, ingenuity, foresight and initiative. The supplier wanted to build its own goodwill on the back of its customer, while the customer wanted an OEM relationship. Modifications of the supply agreement were negotiated so that it would not constitute a “material” relationship for disclosure to investors. This delayed disclosure and thus enabled the enterprise customer to pursue the OEM strategy until after its entry into the new market under its own name.
o Teamwork and Leadership. Fourth, initially, the enterprise customer’s internal teams lacked a management leader to pull together all the participants in a pre-deal analysis of the entire impact. The Sales Department wanted new product to compete with new customers. The R&D Department responded to the Sales Department’s push by offering innovation through joint development with a potential competitor. The Finance Department did not kill the deal even though it lacked a strong business continuity plan. The Legal Department was told that it did not need to bind the parties in one master relationship agreement because deal terms were still being worked out for phase two (production and delivery). As the relationship evolved, the team coalesced and aligned their common interests for achieving, selling and supporting the innovative new product.
New Service Development. Use of third parties to assist in development of new lines of service face similar issues.
o Continuous Process Improvement. It is a best practice in outsourcing deals for service providers to deliver “continuous process improvement.” In designing the outsourcing relationship, the parties need to distinguish between incremental process improvements that come from learning how to be more efficient at a given process, on one hand, and major shifts in business process design that can yield dramatic cost savings. To overcome the hurdle, some dealmakers simply accept that, if there is no measurable “process improvement,” the service provider will drop the price over time in lieu of real process improvement. This is no substitute for true innovation through joint design.
o Intellectual Property. It is a best practice in outsourcing deals to allocate rights in existing and future intellectual property. In advance of a master services agreement, the parties must therefore distinguish between ordinary intellectual property that comes from continuous process improvement and that which flows from some form of capital investment by either party or both parties. Neither party wants to be foreclosed from using improvements or new breakthroughs. The challenge is to agree in advance on scenarios for each case and to provide rewards and governance criteria to minimize disputes on governance as the “innovation” unfolds during the course of the relationship.
o Competition by Service Providers. It is also a best practice for service providers to use “state of the art” service delivery platform – people, process, technology and business processes — to deliver competitive services. In designing their business relationship, the parties to an outsourcing need to distinguish between the service provider’s competitive service delivery platform and the enterprise customer’s unique brand and goodwill in the marketplace. Management of the business reputation and goodwill of each party to a joint innovation project thus becomes a critical contract and business element for negotiation. It requires careful scenario analysis involving business opportunities in new markets and existing markets, capital investment and ROI hurdle rates as well as contractual provisions consistent with applicable antitrust and competition laws.
o Joint Venture. It is a best practice in outsourcing for the parties to expressly disclaim they are in a joint venture. In effect, this eliminates a fiduciary duty to account for profits from the joint efforts. This clause could defeat joint efforts in innovation, since it segregates benefits and promotes potential competition.
Designing Relationships for Innovation. These examples underscore that outsourcing and OEM contract manufacturing cannot be relied upon to achieve “innovation” without a clear business plan. That plan must include the key factors that are considered in any joint venture. Each party needs to focus on its investment, the proprietary nature of its investment and the ultimate uses of those innovations. Ultimately these impact innovation’s on marketing, branding, sales, customer relationships, goodwill, competitive positioning and new product development. The parties need effective communication on evolution of the innovation and how to share future benefits and ongoing investment, if any, in maintenance.
In short, without an innovation strategy, outsourcing is unlikely to yield much other than some cost savings and some gain sharing. In any event, even such a narrow goal risks an inability to reach agreement. The parties must first reach agreement on allocating ownership of any resulting intellectual property rights and understanding the impact on each party’s competitive positioning.
Most importantly, implementing an innovation strategy will require a governance plan for managing collaboration and competition. A governance plan will identify conflicts of interest and principles for collaboratively resolving conflicts.