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.

• Termination assistance – Managed service providers are often intertwined with internal processes and workflows, and integrated with the enterprise customer’s other critical service providers. Consequently, it can take considerable time, planning and coordination with many parties to extricate a provider from your environment.  In many managed service deals, service term, volume or revenue commitments may also limit the pace at which the customer can migrate services away from an incumbent provider.  To allow you to plan an effective exit, the managed-services agreement should include clear guidance and impose requirements on the provider to provide transition assistance for a period that extends beyond the expiration or termination of the agreement.  As part of the transition, the provider should continue to provide the base services at the same prices, terms and conditions, subject to a ramp-down established by the customer’s transition plan. As an input to the transition plan, the provider should also be obligated to provide information (e.g., inventory service elements, in-flight projects, incident and problem historical data), and provide other support to implement the transition to the successor provider.  Experienced providers will not proactively offer transition assistance, but will readily agree to provide it. The burden is, however, on the customer to set the transition period, transition service parameters, and differentiate which transition activities are within the base scope of work (i.e., no additional fees apply), from those that are separately chargeable.
• Required personnel transfers – Companies continue to strike traditional outsourcing deals that include the transfer of employees to their providers. Direct transfers from customer to outsourcing provider present many legal and financial issues to contemplate, but it is an understood discipline with mature checklist processes designed to identify transfer candidates, set minimum post-transfer compensation, benefits and employment terms, and calculate the specific financial impact of the transfers.  Outside of the United States, particularly in EU countries, worker protection laws can give rise to mandatory transfers without regard to you or your new providers’ preferences. In EU member states, the Acquired Rights Directive (ARD), also known as the Transfer of Undertaking (Protection of Employees) regulations (TUPE) in the UK, establishes rights for employees to transfer their employment contracts from an existing employer to a new employer when the work they perform for their old employer moves to a new employer. 

ARD transfers can occur when the enterprise shifts an internal process to a managed network services provider.  In such cases, the customer must honor its employees’ right to transfer to the new provider following the particular processes in the regulation. ARD transfers can also arise when an enterprise customer terminates one managed network services provider and shifts services to a new provider.  Under this scenario, the customer is not directly subject to ARD regulations. The enterprise nevertheless has a stake in the process. A poorly executed transfer from incumbent provider to successor provider will adversely affect service continuity and could give rise to considerable unexpected costs.  And the new provider may attempt to pass on to the customer incremental liability or costs that the new provider incurs by taking on the legacy provider’s employees.  Although the statutory transfer obligations attach to the providers in this case, one or both of them may try to make the customer contractually accountable for facilitating the transfers between competing providers.  Some cooperation and assistance by the customer are reasonable, but the customer should avoid accepting liability for its new or old providers’ violations of ARD regulations.

Whether a direct transfer from customer to new provider or a secondary transfer between the incumbent provider and new provider is contemplated, customers with sites and operations in any EU country should add ARD transfer due diligence to its RFP planning process.  Shaped by the results of that due diligence, your managed services contract should establish clear outbound and inbound transfer rights and responsibilities for both you and your supplier. Inbound transfer provisions address the responsibilities and liabilities attributable to employee transfers to the new provider at the outset of the deal, and the outbound transfers cover employee transfers from the new provider at the expiration or termination of the agreement, or a material portion of work.

Outsourcing is a journey, not a destination

Outsourcing is rarely a completely smooth ride, and most managed network services contracts experience difficulties from time to time. Common challenges include contract interpretation disputes, service/pricing gaps (e.g. pricing for new network technologies that the customer starts to adopt partway through a contract) and service delivery shortcomings.  Customers typically have very high expectations for their managed service providers (not least based on all the promises they made during the sales process) and are rarely willing to tolerate teething troubles for more than the first few months of a new contract.  But in reality, it can take twelve months or so of service delivery for the managed services to “bed in”, which can be far longer than most customers expect. 

To help overcome the initial gap between customer expectation and actual provider performance, customers must anticipate and plan for problems that may arise. Strong governance processes and contract terms are crucial, as is a willingness from both the customer and the service provider to work collaboratively to mitigate the impact of issues and find mutually acceptable solutions to problems.  It also helps enormously if key resources from the sales and contract teams are retained through to the service delivery phase; when there is no continuity, issues and confusion arise far more frequently.

Managed network services will continue to evolve, and customers will continue to become increasingly sophisticated in their selection and use of managed services and managed services providers.  Sourcing strategies, RFP processes and contracts must adapt to keep up.

Ben Fox is a managing director at TC2, a global IT and networking consultancy. He can be reached at bfox@techcaliber.com.

Marc Lindsey is a partner at Levine, Blaszak, Block & Boothby, LLP (“LB3”), an IT and telecommunications law firm dedicated to advising enterprises clients on technology transactions and telecom regulations. He can be reached at mlindsey@lb3law.com.