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Pros and Cons of Complex Outsourcing

10/24/2013 Articles

For many brands, there are often tangible benefits in identifying and contracting to outside companies noncore functions, such as affinity marketing programs (i.e., user “rewards”) or complex logistics. These functions are often crucial to customer experience, but are not necessarily within a brand owner’s expertise. Brand owners need to maintain control, but still allow an outside partner to bring its own skills to bear. Outsourcing of this type goes well beyond typical “business process outsourcing” because of the customer impact and the potential risks and rewards to the brand.

 

Rather than outsourcing a business function, brand owners are engineering a complex relationship between two companies that will last for many years, with mutual benefits and proper incentives built in. Partnering with effective legal counsel is critical, as contractual relationships with third-parties operating under a company’s corporate banner and with access to its proprietary customer data need to be extremely carefully crafted and routinely reviewed so as to not inflict damage on the company and its brand. Done properly, this type of complex outsourcing can result in better customer experiences and increased value to the brand. Done poorly, however, it can erode goodwill quickly and also be a huge drain on management’s time and focus.

 

Planning for complex outsourcing projects usually begins in a business unit, and often involves support from a company’s sourcing or vendor relations groups. Typically, the impetus is finding a way to enhance and broaden consumer interaction with a brand through “sticky” services or enhancements that are outside of the core competency of the brand. This can include organizing a customer loyalty program, developing a mobile strategy or improving customer experience through enhanced logistics, call center operations or other services. However, it often becomes apparent that the success of the program will depend on a deep integration with the brand owner’s overall brand strategies and operations, as well as deep knowledge of some complicated technology or highly specialized markets. The resulting complexity is often difficult for sourcing groups to manage, and the time commitment needed to fully understand and document the arrangement can be more than in-house counsel can provide.

 

Example: Loyalty Program. Loyalty programs can bring many benefits to a brand. Done well, they can increase customer retention and brand profitability. However, the dangers from a poorly run program are equally potent — frustrated and angry consumers who may seek to avoid the brand in the future. Few brands have the expertise themselves to create a compelling loyalty program from scratch. The IT demands alone are daunting. Systems have to be put in place to capture transactions, calculate points and facilitate redemptions. The design of the website is crucial for ensuring a positive customer experience. And the rewards catalog has to be attractive, with goods, services or experiences that appeal. But on top of the basics of the program itself, a truly successful loyalty program has to be integrated throughout a brand’s customer experience — its advertising, its website, its in-store sales and increasingly through mobile channels.

 

Example: Logistics. Regardless of whether a brand sells through retail channels or direct to consumer, logistics has taken on increased importance. Retailers demand “just in time” deliveries. Consumers expect to be able to track their purchases through the entire delivery process. Warehousing strategies can mean the difference between profitability and loss. However, brands typically come to prominence through mastery of their products and their marketing, not their warehousing and delivery systems. Many brands need to bring in third parties with specialized expertise to make sure that their logistics operations are efficient and reliable. Partnering with a logistics firm, though, can require the brand to provide an outside company with access to the brand’s ERP and other systems containing highly confidential information, as well as access to sensitive information about sales projections.

 

These types of arrangements share some common risks. Each involves allowing some degree of access to a brand’s systems, including to potentially sensitive information such as transaction data and merchandise flows. Also, in each case a critical interface with the brand’s customers is controlled by a third party. In order to have a mutually beneficial partnership, each party will need to be privy to some of the other’s confidential information, particularly with respect to future technological and business developments.

 

How should counsel approach these difficult situations? The most important thing to do is to listen. None of these situations is susceptible to “cookie cutter” documentation. A deal lawyer needs to find out as much as possible about his client’s business goals for the arrangement, both short- and long-term. He also needs to understand the technical and operational constraints on both sides of the transaction. Based on these inputs, the documentation has to be crafted to best achieve the client’s goals, but it also needs to be fair, because complex outsourcing transactions are more like a marriage than a vendor relationship. Like a marriage, the arrangement has to be beneficial to both parties, and neither party will be able to easily leave the relationship. The brand will not be able to change partners quickly because the time and effort needed to replicate the arrangement will be prohibitive and the changes will expose its customers to disruptions. The service provider will not be able to leave because it will have exposure if it fails to live up to its commitments — not only legal exposure, but also reputational risk.

 

Documentation for complex outsourcing can get complicated. At a minimum, there will be some type of services agreement that spells out in detail how the services will be provided. However, licensing and development documentation, hosting and maintenance agreements, a source code escrow and other technology-related contracts are also common. The use of trademarks also has to be addressed. Because the brand needs to feel comfortable that it will be able to control the experience of its customers, the documentation will often go into a great deal of detail about operational matters. Areas such as how customer service inquiries are handled or how customer-facing websites are designed and maintained can be particularly sensitive. It can take some extended conversations to determine how the brand and the service provider can work best together, with each leveraging its unique capabilities.

 

One of the most contentious but important parts of the services agreement is the section that sets out performance standards and how those standards are enforced. The performance standards are often called SLAs, for “service level agreements,” or KPIs, for “key performance indicators.” Regardless of what they are called, the performance standards set out the expectations of the parties about the quality of the services that will be provided. For example, if the service provider will operate a website for the brand, there may be SLAs about website availability or Web services response times. If a call center will be provided, there may be SLAs about the maximum amount of time before an incoming call is answered or the number of calls that do not get through. Logistics-related measurements can include accuracy of shipping, time to unload shipments into a warehouse or handling of returns. The more complex the program, the more areas where SLAs may be needed.

 

SLAs are often paired with pricing adjustments. These provide that failure by the service provider to meet an SLA in a given month will result in a pricing discount to the brand. Although many people refer to pricing adjustments as “SLA penalties,” in fact they should not be thought of as punitive. Rather, pricing adjustments are intended to compensate the brand for the service provider’s failure to deliver the contracted services. The brand’s damages are cumulative, and result from the damage to goodwill caused by poor customer experiences. These kinds of damages are difficult to prove, and it is not practical for the brand to bring a detailed damage claim every time a performance default occurs. Agreeing to pricing adjustments in advance is an efficient mechanism for dealing with these issues. Most importantly, though, no brand ever wants to have to collect pricing adjustments. They would much prefer that the service provider avoid having any performance defaults. Pricing adjustments are a none too subtle encouragement to service providers to meet the service levels that they have agreed to.

 

Negotiation of the pricing adjustments can be quite contentious. The service provider is often operating on thin margins, and repeated pricing adjustments could take up so much of its revenue that it is no longer profitable for the service provider to provide the services. That is a dangerous situation for the brand as well as the service provider. If the service provider is not making a reasonable profit, it will not have much incentive to provide the best service. At the same time, if the adjustments are not meaningful in the overall economics of the outsourcing arrangement the service provider may not take its performance obligations seriously.

 

Because SLAs are tied to pricing adjustments, it is important that the performance standards be realistic. This does not mean that they should be “easy.” SLAs are usually quite stringent. For example, it is typical for system availability SLAs to be set at 99.5 percent or even higher. It does mean, though, that SLAs should not be viewed by the brand as a wish list. The service provider’s true capabilities must be assessed, and operational processes that might have an impact on the ability to achieve performance standards should be carefully evaluated. The brand also needs to think critically about the standards that really matter in ensuring a satisfying customer experience. It is surprisingly easy to put together a long list of SLAs, but the longer the list the harder it will be to manage ongoing compliance. Depending on circumstances, it can be more beneficial to a brand to have four or five key SLAs that are thoughtfully implemented than to have ongoing battles with a supplier over its compliance with 30 SLA that have only a marginal effect on its customer’s satisfaction. While there are programs where 30 SLAs may all be mission critical, they are not very common.

 

Finally, SLAs have to be measurable. This means that monitoring tools and reporting protocols should be specified. If appropriate tools cannot be identified, think about whether there are other approaches to achieve the desired customer service goals.

 

Although constructing a complex outsourcing arrangement can be demanding, if done well it can be very rewarding for all parties involved. By working closely with business owners to think through issues like SLAs, confidentiality and data protection, and how operations of both partners will be integrated, the parties can form a lasting relationship with the flexibility to promote a brand and provide excellent customer service, while minimizing the risks to the brand’s goodwill.

 

Jonathan Lemberg is a partner in the business transactions group of Farella Braun + Martel in San Francisco. He has worked on a variety of complex outsourcing arrangements for well-known brands.