Creating intelligent IT contracts
- 10 August, 2012 10:16
When a CIO wishes to spend money, a contract needs to be signed — at least, that’s the cost centre mindset. This mindset presents a fundamental challenge to CIOs today: How to position an IT contract to the board in a way that connects the contract with the realisation of tangible business benefits, as opposed to being just another expense cheque to sign?
A cost centre mindset stands in contrast to a benefits-oriented mindset, under which the contract is seen as a positive opportunity to incentivise the achievement of strategic business outcomes and facilitate the delivery of commercial solutions that will translate directly into corporate value.
While it is easy to sign the supplier’s standard terms and conditions, or to ask your lawyer to use a previous agreement or the company’s standard procurement template, this approach may result in a contract that is not aligned with nor appropriately customised for relevant commercial drivers. If business benefits are not demonstrable, the contract becomes completely functional and the old cost centre mindset is reinforced.
An intelligent contract manages the company’s key commercial risks effectively and also embeds incentives to achieve desired business outcomes. Here are some mechanisms and strategies to achieve this:
Well-defined and solution-orientated project outcomes
This will focus the minds of both the vendor and customer on the project outcomes that are ultimately desired. This mindset usefully defrays the typical preoccupation with service scope boundaries by reference to broader considerations of what is sought to be achieved (that is, not just the ‘what’, but importantly also the ‘why’ and ‘how’).
The outcomes should be realistic, but also flexible. This is particularly important for longer term arrangements and frameworks, or ‘master’ agreements which accommodate scope evolution over time. While a list of services and bill of materials may, depending on the nature of the arrangements, still be required, a prescriptive list will not of itself necessarily produce the desired end result for either party. For larger and longer term projects, there will inevitably be unknowns. Suppliers will undergo product transformations and customers will undergo changes in strategy.
Therefore, stringently predefining how exactly the outcomes will be achieved without regard to changing requirements may be unduly limiting, to both the supplier and customer.
When they are defined properly, service levels, KPIs and service rebates/credits will incentivise suppliers to meet expected outcomes. Rewards, such as service rebate earn-backs and gain-share/pain-share models, may also be appropriate to incentivise the supplier to deliver exceptional performance. For the incentives to be effective the performance drivers should be workable and verifiable; the service rebates and earn-backs should be carefully calculated so that they are meaningful; and the service levels should be tailored to suit the key outcomes expected from the specific project.
The contract should contemplate the parties actively working together to identify opportunities for new or improved services (and service levels). In identifying areas where improvement can be made, each party should take into account ongoing feedback on its performance of contractual obligations.
Appropriate allocation of responsibilities and risks
Calling out each party’s respective business risks upfront and addressing them in the contract will help ensure that mitigation strategies are adopted and implemented from the outset. Responsibilities should be clearly delineated, including any responsibilities that the parties are jointly responsible for. Once the necessary mitigation strategies are implemented, it will then leave the parties free to focus on ensuring the project’s success.
The management of the parties’ relationship and the management of the project go hand in hand. Including a workable decision-making framework will help ensure transparency of each other’s performance, information sharing and early problem identification and solving with minimum disruption. To be meaningful, the governance framework should contemplate the involvement of key decision makers on both sides. The representatives of each party engaged in the governance forums should be empowered with decision making powers and ideally have a high level of awareness of operational matters, so that their decisions are informed by practical reality.
Out of context negotiations and contracts
Negotiations should not be conducted in a vacuum, merely between lawyers, who are oblivious to the business strategy. While this may result in a contract that is acceptable to legal eyes, it will generate a superficial outcome. Often, a disproportionate amount of time during negotiations is spent on the necessary but ‘negative’ clauses, such as termination and liability. Often contracts will focus on strict legal remedies and neglect what is often most valuable to a customer: Good governance processes, remediation and problem management.
For instance, processes that identify the steps a vendor must take to restore service will be of more practical utility to a customer than a termination right. Negotiations should try to allocate (not eliminate) material risks that cannot be otherwise addressed, prescribe operational approaches that are acceptable to both parties and set out what workarounds, solutions and processes should apply in the event outcomes are not achieved.
If you are dealing with a sophisticated supplier, they will want to know your business drivers and the commercial pressures and challenges that you are facing. You should not assume that a supplier’s goal of generating sales and increasing revenue is always going to be inconsistent with your goal of realising value and increasing revenue for your company: There are many scenarios in which mutual success can be realised. Success stories are good news; however, project failure jeopardises a supplier’s track record, market reputation and prospects of repeat business. Therefore, the sophisticated supplier will want to stay closely aligned with your commercial goals and technology strategies. They should want to report to you on what the emerging trends are and the effect such emerging trends will have on your broader direction and commercial strategies.
You should also keep your lawyers informed of your business drivers, to prevent any disjuncture between legal negotiations and commercial priorities. Once your lawyers understand your commercial drivers, this will direct their attention to the critical parts of the contract during negotiations, resulting in a more efficient and fruitful negotiation.
Certainty is still key
This is not to say that the contract should be infused with vague terms. The specific outcomes and scope of the services and deliverables must be agreed, certain and capable of being enforced. Fundamental to a successful project is a common understanding of what needs to be delivered. For example, there may be little practical value in requiring the supplier to deliver the ‘best’ solution that achieves your ‘business outcomes’, when it is unclear how the ‘best’ solution and your ‘business outcomes’ can be defined or documented. Rather, the above strategies are a complement to, and not in substitution of, traditional legal approaches.
The project needs to be clearly scoped, tested, workshopped and documented. You should test the supplier before the contract is signed – what can they do and what can’t they do? If there appears to be a gap between your business outcomes and what the supplier can deliver, this gap should not be ignored. Exclusions, dependencies and assumptions need to be clearly understood and stated. If these are identified early on, the parties can work together to solve for (and cost in) any practical barriers, before project commencement.
Contracts that represent opportunity
The mechanisms described above are designed to ensure that during the life of the contract, there is continual transparency and information sharing between the parties and that any key commercial risks are identified and addressed early. The ideal contract should produce a positive outcome for both parties, by closely aligning your business outcomes with a vendor’s goals and by striking a balance between risk and reward that is realistically appropriate. Such a balance can only be obtained if negotiations are informed by your key business objectives and conducted in a sensible way.
When you are satisfied that the contract promotes the achievement of your desired outcomes, then you can confidently present the contract to internal stakeholders. Once the groundwork is done, the task of demonstrating a clear relationship between the requested expenditure and the corresponding business benefit will become more easily illustrated.
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