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Outsourcing Law & Business Journal™ – April/May 2012

May 22, 2012 by Bierce & Kenerson, P.C.

OUTSOURCING LAW & BUSINESS JOURNAL™ : Strategies and rules for adding value and improving legal and regulation compliance through business process management techniques in strategic alliances, joint ventures, shared services and cost-effective, durable and flexible sourcing of services. www.outsourcing-law.com. Visit our blog at http://blog.outsourcing-law.com.

Insights by Bierce & Kenerson, P.C. Editor. www.biercekenerson.com.

Vol. 12,  No. 4,  April/May 2012

_____________________________________

Announcement:

Four “Hot” Deal Structures and Pricing Models in Sourcing of BPO and KPO Services

May 21, 2012 by Bierce & Kenerson, P.C.

CIO Magazine observes that outsourcing service providers are offering innovative pricing models to escape commodity-based pricing pressures: joint ventures, “business outcomes”-based pricing, revenue sharing and dedicated centers of excellence.  Here’s an outsourcing lawyer’s analysis of these pricing models. I have only two questions: is it valid, legal, binding and enforceable?  Does it cover the most significant risk-reward scenarios?

Classic Pricing Model: Inputs and Outputs. The traditional pricing model has been either an agreed fee per resource used (such as “dollars per full-time equivalent”) or, if demand and scope are stable, per-user per month.  These resource-based pricing models start with a “base case” of the customer’s current utilization rates for resources and projects future changes in volume.  The provider wants to ensure that demand will exceed a baseline, or that it can exit due to unrealized expectations.

In a resource-based pricing model, the customer wants scalability and predictability based on demand levels.  This traditional pricing model has resulted in mismatches of supply and demand, cost overruns due to the vendor’s adding resources to accommodate changed demand or scope, and a focus on input costs, not outputs or business results.   Further, this pricing model leaves the customer with little control over management of operations, which achieves the basic goals of delegation of operations but leaves the customer with only the contract to exercise governance and change management.

Innovative Alternatives:

1.         Joint Ventures. Any joint venture involves an ongoing relationship for a substantial time.  It can take the form of a contract or a new legal entity between the customer and service provider.

Contract Model: Scope, SLA’s, Pricing, Governance. The contract-based model is reflected in the classic outsourcing agreement.  The scope of service is defined, and related tasks and responsibilities are allocated, in an exhibit.  In early outsourcing contracts, the scope was defined by taking existing processes and re-defining them for sharing between the users and the provider.   Currently, it is a well-established best practice to take industry-standard definitions of process workflows (such as by using ITIL or ISO standards for operating a data center, or security management) as the baseline for defining scope.   By using industry standards, the parties improve transparency of interactions and workflows, as well as better governance, regulatory compliance and risk management.  The classic sourcing agreement also includes service level agreements (SLA’s) as key performance indicators, and pricing discounts for missing the targets.  Finally, governance by contract involves establishment of governance bodies, meeting schedules, informal dispute resolution, escalation of issues to “senior” executives and eventual arbitration.

Entity-Type Joint Ventures. The entity-type joint venture offer some advantages over classic sourcing contracts.  This assumes the entity’s structure contemplates the predictable relationship life cycle starting with transition and steady-state, then progressing to one of three future outcomes: renegotiation (such as restructuring of scope, SLA’s or pricing), rebid/or and post-termination insourcing.  Such advantages arise from the ownership structure: the entity, not the provider, is delivering the services to the corporate customer.

An entity-type joint venture can be structured to look just like a captive shared services “center of excellence.”   The JV entity, not the service provider, receives the customer’s proprietary process and the service provider’s personnel.  The resulting intellectual property, knowledge management procedures, workforce administration and deliverables are allocated under the entity’s internal corporate documents, such as an LLC operating agreement, and any licenses, services agreements and other transactional documents to define the roles of the parties.  This structure fits industry-specific BPO and KPO services, where knowledge management generates the most value to the customer.

Customers may like entity-type joint ventures for two reasons.  First, it can control operations by its ownership of equity interests.  Ownership can be shared during the term and transferred to either the service provider or the customer upon termination.  Second, the JV model has built-in governance models and requires the provider to disclose all cost and process information as co-managers.

• Call Option. Under a “call option,” the customer would have the right to require the service provider to transfer equity ownership to the customer.  The customer could convert the entity into a captive by merely taking ownership of all equity.  A transfer to the customer might occur if the customer wanted to take control of the people, process rights and internal knowledge base of the joint venture.

• Put Option. Under a “put option,” the customer would have the right to transfer equity ownership to the service provider.  This scenario might occur if the customer felt that the entity provided no value to the customer or a new supplier would provide better services, value or “seemless integration.”

• Impact of any Transfer of Ownership. Upon either transfer of ownership rights, there would be a transfer of shares, and no termination of employment or assignment of intellectual property, real estate (or leases) or equipment.  The entity has the full bundle of operating rights.  However, there could be tax consequences for each party.  The lesson of the 2012 Vodaphone decision (of India’s Supreme Court) and the Indian government’s General Anti-Abuse Rules suggests that third-country holding companies would be appropriate.  However, intercompany pricing between related parties would invite double taxation in the absence of a double-income tax treaty, and such treaties may limit benefits to local nationals.

Service providers may like this model for other reasons.  It can simplify governance management.  It is an alternative to insourcing.

In the end, though, joint-venture based arrangements require careful negotiation on:

• allocation of human resources and knowledge management,
• competitive offerings, and
• opportunity costs for the service provider and the economic incentives for the service provider to hire, train and then lose skilled personnel who could be lost not by attrition, but by a call option.

Also, joint ventures run the same legal gauntlet as any business.  Bankruptcy is possible.   See http://www.outsourcing-law.com/2009/10/case-study-farmland-industries-inc/

2.         “Business Outcomes”-Based Pricing. The resource-based pricing model fails to identify opportunities or opportunity cost of the enterprise customer.  An “outcomes-based” pricing structure will align the customer’s bottom-line goals with the service provider’s compensation.   In employment law, this kind of incentive compensation represents a bonus for achieving benefits for the employer.  As such, “incentive-based compensation” can work effectively.   However, just as senior executives get paid a base salary, so too would the service provider receive a base compensation relating to the customary “financial base case” starting point for resource-based pricing.

Sophisticated customers familiar with SLA management understand the negative impact of choosing unwisely.  If you target one outcome, you will optimize that outcome, potentially at the expense of all others.  But if you then add multiple SLA’s and multiple optimized metrics, you create conflicts of priorities, and each priority will have a “pecking order” based on the financial reward structure.

Thus, for the customer a broad business outcome could be used: shareholder value, cash flow, cost of goods sold, return on equity, return on investment, etc.

For the service provider, an outcome-based pricing exposes a raw nerve.  The service provider controls its service delivery environment, but not the customer’s core business operations.  The outcome-based pricing method forces the provider to become intimately familiar with the customer’s business and commercial environment and provide consulting services (in addition to IT-enabled BPO or KPO) without additional compensation.  And the customer might not accept any provider recommendations for achieving the relevant business outcome.   Hence, the service provider will adopt such an approach only if it understands the customer’s business gaps (to the extent disclosed or discovered in due diligence) up front, and it sees how its efficiencies can improve upon such gaps.  But after the provider “fixes” the customer’s “train wreck” processes, future “outcomes-based” pricing might not be able to achieve such goals.

This approach is just another way to address the problem of “continuous process improvement” vs. “specific short-term improvement projects.”

3.         Revenue Sharing. Revenue sharing focuses on defining revenue sources and increasing gross and/or net revenue.  This pricing method assumes the parties will be able to increase revenues by contributing to a quasi-joint venture that measures only revenue, not expenses.

Revenue-sharing models resemble traditional “build-own-operate-transfer” models of project finance.  An independent private company builds an infrastructure (such as a toll road, port, airport, bridge or other facility), operates it (and collects revenues), then transfers ownership to the local community (e.g., a government).  This model encourages BPO and KPO service providers to invest, collect a share of revenue for a while and then, if mutually agreeable, let go of the investment upon expiration.

Revenue sharing models are familiar in other industries, such as the distribution of Hollywood films in the after-market.   Success depends on the ability of the service provider to streamline the customer interface, build brand equity and manage collections in a transparent, audited manner.

Customers may like revenue sharing since it requires no payment without an increase in revenue.   The customer might be a non-profit membership organization that wishes to license its membership list and organizational meeting archives for a service provider to manage as a service for promotion and member loyalty.  What customers must balance, however, is whether the revenue gains are attributable to the service provider or to the customer’s own initiatives.

Service providers may like this model if they understand the customer’s business, the needs of its users and how to sell an improved service.

Pitfalls for both parties abound.  The enterprise customer cannot reasonably expect its service provider to depend on revenue growth if the enterprise customer does not perform its own, mutually agreed efforts for revenue growth.  This may involve new product development, patenting, branding, marketing, sales support and customer after-sales support.  And, most important, the customer needs to announce upfront that it wants a creative pricing model.

4.  Dedicated “Center of Excellence.”

A “center of excellence,” “shared service center,” “offshore development center” and “virtual outsourcing” all enable a global enterprise to develop, manage, update and retain knowledge processes.   A “dedicated” “center of excellence” offers outsourcing benefits of managed services, minimal startup capital investment and a managed workforce, without ownership.  It may just be an outsourcing with a call option (in the “build-own-operate-transfer” model).

Customer organizations might rely on this approach to build a center that would be transferred to a shared services captive over time.  The big questions for both parties in such arrangements relate to return on investment by each, as well as key assumptions on supply, demand, opportunity cost and exit costs.

HR Management: Having Practical Control without Legal Control. Pricing models rarely address the costs of human capital investment and workforce management.  The advent of these innovative pricing models invites a discussion beyond merely whether the “key employees” can be hired by the customer organization upon expiration or termination.  Key topics for agreement include:

• Workforce Planning as a Team Sport. The customer having its own project management office anticipate the expiration of particular project phases where key employees might be transitioned away from the customer to another account of the service provider.  By anticipating such transitions, and developing additional projects for such key employees to continue for the customer, both parties benefit through continuity, additional revenue and reduced training of replacement workers.  Of course, this strains the provider’s own workforce management and the key employee’s career path.  Unless the key employee is retained for increasingly challenging and complex work, he or she might leave the provider, to the detriment of both provider and customer.

• Planning for the Insourcing after the Outsourcing. In the 1990’s, outsourcing providers hired the customer’s production team, extracted and automated business processes, and then tranferrred work to lower cost venues.  To the amazement of experienced employment lawyers at the time, enterprise customers were too naïve, generous or stupid to demand a headhunter’s price: one third of the person’s first year gross compensation.  But when, now, enterprise customers want to re-hire persons who had been working on their business for years, service providers are reluctant to permit it, or seek to obtain a similar headhunter’s compensation.   The topic of investment in human capital now merits a frank exchange on planning, scenarios, costs and benefits.

Conclusion. Sourcing relationship have become more modular.  Every element of the relationship has an impact on pricing.  Pricing structure, capital investment, ROI, end-game scenarios, tectonic shifts in the service delivery model and human capital management are now part of the process of getting to viable, enforceable agreements.

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