Making network-services deals: Structuring the transaction

In our companion article, “Making network-services deals: Sourcing and service-delivery strategies that work,” we examine how enterprises should approach sourcing and designing managed network service arrangements under current outsourcing market conditions by applying certain  best practices to help identy the optimal providers and service delivery approaches.

This article explores the key commercial terms and contract practices that are crucial for negotiating flexible and resilient managed network services arrangements in view of the outsourcing industry challenges currently facing enterprises.

Commercial Structures

The dynamic and rapidly changing nature of the technology and provider landscape has led to shorter and more flexible contracts. The amount or lack of flexibility provided to a customer in a managed-network-services contract can manifest in various commercial structures, for example:

• Term - Contract durations of three years are now common, and terms longer than five years should be avoided.
• Spend commitments – Some service providers – particularly carriers – will expect a customer to commit to spending a certain minimum amount on the managed network services or commit to minimum revenue commitments for individual services, such as maintenance. The spend commitment should be measured over the term of the contract. The spend commitment is typically set at a level that is considerably below the expected spend to provide the customer with contract flexibility, and shortfall charges apply if the spend is below the agreed minimum.
• Minimum volume commitments – Rather than a spend commitment, the commitment may also be defined in terms of a minimum volume of services to be consumed (which would ultimately correspond to a minimum spend), where the volume may be measured in various ways such as the number of devices being managed, number of ports, number of sites, etc. This is less preferable than committing to a spend over a specific term. 
• “ARC/RRC” models – Additional Resource Charge (ARC) and Reduced Resource Charge (RRC) pricing provide a fixed total monthly fee that corresponds to a certain volume of infrastructure being managed and services being provided. A menu of ARC and RRC unit prices is then used to adjust the monthly fee when there are additions and reductions to the scope of the infrastructure being managed. For instance, a unit ARC/RRC might be agreed to for each type of network device. If an additional network device is added to the service provider’s scope, then the fixed monthly fee would be increased by the applicable ARC. The unit ARC/RRC charges are less than the total fixed monthly fee divided by the total units such that even if 100% of the infrastructure was removed from scope, the aggregate RRCs would be less than the fixed monthly fee. That means there is always a latent fixed monthly fee, even if the scope of support is reduced to zero. This is another form of commitment or lock-in to the contract.
• Base fixed fees – Not dissimilar to the ARC/RRC model, this alternative pricing construct establishes a material monthly fixed fee, plus incremental unit charges for the infrastructure included in-scope of the managed network services (e.g. unit charges per managed device/port/site). Whereas there may be no commitment to a minimum volume of unit charges, the fixed monthly fee always applies, and so the customer is essentially committing to that amount as a minimum spend.
• Early termination fees – Most deal constructs present early termination fees (ETFs) that apply when the entire contract is terminated before the end of its contract term – often linked to the minimum charges/commitments described in the preceding bullets. But you should avoid ETFs that apply for ceasing individual services such as those that would apply if you simply close a site. Termination of any services in whole or in part by the customer for cause should never trigger ETFs. 

There are pros and cons for all the above models, with no single model necessarily being significantly better or worse than another. The most important point is to make sure that you understand the commercial construct that each service provider’s proposal is based on so that you can evaluate and negotiate it when you are still in discussions with multiple potential providers. Providers may not proactively present their commercial structure, which means you may need to draw it out of them. Not all commercial negotiations are zero-sum, but providers typically try to lock in revenue, which in turn defeats customer flexibility. Nailing down the commercial deal points early in the sourcing process – ideally as part of your RFP document – is a best practice.  It is also a good practice to work through different scenarios of increasing/decreasing managed service volumes with each of your potential providers, to make sure the flexibility being offered, and any associated costs/termination fees, are clear.

Contracting for Flexibility

To preserve and enhance the business deal, and hold suppliers accountable for delivering the benefits enterprises bargain for during the RFP process, there must be a well-designed master services agreement.  Contract documents that adequately capture the commercial terms, establish performance commitments backed by remedies, and allocate liabilities for foreseeable risks fairly and consistent with industry norms is an essential output of the competitive procurement process. 

Each deal uniquely reflects the parties’ negotiated understandings and the nature of the in-scope services. When done correctly, structuring the executable transaction documents is a disciplined process that remains in sync with the rest of the RFP effort.  There are no shortcuts to putting in place the right agreements and aligning both sides on the terms and conditions.  But there are certain practices and fundamental terms and conditions enterprise buyers should incorporate in contracting for managed network services.

• When and how to use contract templates – Although it is unrealistic to assume any specific standard form will map to a given deal, you should start with an agreement framework and key terms that appropriately cover all the areas of concern for the enterprise. In an RFP process, enterprises can achieve this by including in the RFP requirements a set of key contract-term requirements written in plain English rather than as contract clauses. The set of issues should be limited to flesh out the more difficult and likely controversial legal terms and conditions. Bidder responses to this limited set of contract terms must then be evaluated, weighted and treated as part of the overall proposal scores. Ignoring the response to the legal requirements is more harmful than not including any terms.  For this reason, demanding that every bidder accept or mark-up the contract template at the early stages of the RFP process rarely yields the intended result.  A better practice that actually works is to deliver the full contract set to bidders that have passed the first round of screening.  At that stage, they will put in the right effort, and the enterprise’s RFP team can concentrate on developing a contract negotiating strategy with the suppliers most likely to be selected.
• Termination triggers – Establishing termination-for-cause triggers and incorporating termination-for-convenience mechanisms (allowing the customer to walk away for no reason by paying a pre-set termination fee or ETF) are both basic best practices. For a best-in-class deal that allows the customer to exit (in part or whole) poor-performing service arrangements, the agreement should include these additional triggers that allow the customer to terminate services or the agreement for cause:
  • Chronic or sufficiently severe service-level failures that fall below a preset and contractually documented critical-performance failure level. The critical-performance-failure threshold can be based on repeat service-level failures over a defined period or a small number of very severe service-level misses.
  • The supplier fails to maintain the regulatory and legal authority to provide the in-scope services in and throughout the countries covered by the base scope of work.
  • The supplier ceases providing in-scope services generally or in any country that is within the geographic scope of the deal.
  • A major milestone is missed during the initial implementation of the services.
  • The services’ or provider’s repeated failures to meet the contract requirements materially with adverse effects on the customer.
  • As the result of an excused force majeure condition such as a natural disaster, war or acts of state, the supplier is unable to provide services for an extended period of time (e.g., 60 or more days).
• Accounting for M&A activity – Buying, selling, and spinning out entities is a common corporate strategy for many large enterprises. In M&A deals, service arrangements for inbound IT and network services agreements of the impacted entities is never a material deal driver. However, identifying the processes and underlying technical support resources (internal and external) that will be used after the M&A deal closes is a core part of M&A-deal due diligence.  Following from due diligence, the transacting parties must develop and execute an integration or, as applicable, separation plan to ensure the parties have continuity and effective IT and network support.  The contracts with the underlying providers play a major role in each of these phases.  In anticipation of M&A activity during the life of your managed network services deal, the service agreement should incorporate clauses that:
  • Obligate your providers to continue providing services to affiliates or business units that are divested (independent of the form of divestiture) for a preset period (typically, a minimum of 12 months but often as long as 24 months) under the same terms and conditions in effect before the divestiture.
  • Proportionally reduce any site, resource usage, revenue or other forms of commitment to account for the reduced service consumption by the surviving entity after a divestiture without adversely affecting unit rates or otherwise weakening the deal. Customers should be prepared for providers to push for an ultimate deal-value floor that allows them to renegotiate price or serves as a cap on the M&A reductions and negotiate any such floor aggressively to preserve the necessary flexibility.
  • Allow an acquiring entity to terminate (without liability) a redundant deal with the provider if an acquired entity has a similar services agreement, provided that the acquiring and acquired entities’ services are combined under the surviving service agreement with the provider.
• Benchmarking – Negotiating competitive rates during the RFP process and then establishing contract terms (3 years with optional annual renewals) helps reduce the chances that deal pricing across all in-scope services will fall significantly out of market. But as services are added, terms extended and technology changes, setting a short initial contract-term period alone isn’t enough. Annual price and performance benchmarking is an important mechanism to regularly check rates against the market and apply mid-term price pressure on providers whose rates have failed to keep pace. Benchmarking clauses can take several forms. The most common are the negotiated benchmark and third-party benchmark studies. 

Negotiated benchmarks are triggered (ideally, annually) at the customer’s request.  For each benchmarking exercise, the parties gather evidence of market pricing for the in-scope services, report their results to each other, and then negotiate rate reductions if the customer demonstrates that the rates it’s paying are too high.  Without some consequence for being unreasonable in the benchmarking negotiation, providers will not agree to voluntarily reduce their rates. The art of a well-crafted negotiated benchmarking clause is establishing a remedy for the customer to invoke when the provider behaves unreasonably. Examples include partial termination without liability and commitment reductions, but others are available depending on the commercial elements of the transaction.

Third-party benchmark clauses involve commissioning a third party to assess and prepare a written report on the performance and price of the services when compared to comparable deals in the market.  If the benchmarker’s report shows the rates are too high, the provider should be compelled contractually to decrease its rates to meet the market rates in the report. The third-party benchmark seems simplest but in fact it is far more challenging than the negotiated benchmark. Parties struggle to (a) select qualified independent benchmarkers that both parties will accept, and (b) agree on the criteria to be used to objectively identify comparable deals in the market without unduly limiting the sample set to make the exercise non-viable. The negotiated benchmark approach is the more effective method.