Structuring Sourcing Projects
Structuring Sourcing Projects
In Part 1 of this series I looked at the different options for structuring sourcing projects (you can read the full post here). This inevitably leads on to the question of how to choose between them, and that’s the subject of this second post in the series.
The most important point is that the options are rarely prescriptive. In fact there are only two occasions when there is genuinely little choice. One is where both parties are flying solo, in which case there has to be a single supplier/single customer arrangement (Option 1 in the previous post). The other is where legal requirements dictate the use of local entities (in which case Options 4 or 5 (as illustrated in Part 1) will be needed). In all other cases the parties can use pretty much whatever structure they want.
The customer’s viewpoint
From the customer’s perspective a key factor is the degree of centralisation which is necessary or achievable. In practice this breaks down into four issues:
1.Centralised contract governance
The more the customer wants to control its procurement behaviour from head office, the more likely it is to prefer the contract options which channel governance and other operational relationships through one agreement. This allows a more straightforward approach to termination and re-tendering, for example, because there is only one contract to consider. Of course some organisations have a more localised culture where management control is devolved. For these, a call-off arrangement operating directly between users and supplier will probably work better.
2.Standardised services
The greater the customer’s desire to purchase a single product for use across its whole group (e.g. to reduce training costs and increase interoperability) the more suitable it will find the contract options which centralise purchasing decisions.
3.Buying power
Where the customer wants to drive a lower price by aggregating and therefore maximising the buying power of the whole group, the single contract routes will be more attractive. There is a clear benefit to this approach when purchasing standardised products because group purchasing will increase volumes, thereby (in theory) reducing the overall cost.
4.Liability
Inevitably, the supplier’s willingness to accept liability will be proportionate to the commercial benefit it receives under the contract. Liability caps are therefore often expressed as a proportion of total or annual revenue. A structure which channels all the value through one contractual link will usually result in a higher cap. Conversely, where there are many contracts, the supplier will argue that each should have its own (smaller) discrete cap. From the customer’s point of view this is less satisfactory: the supplier’s overall exposure may be the same, but it will be divided up into individual portions not all of which will be available to every claim.
In fact liability is a good example of where the chosen structure is not decisive. It’s entirely possible to use a structure with lots of contracts for local delivery of services, and yet provide that an aggregate cap on all liability applies to all of them together. One can add cross termination provisions so that if there are grounds to terminate one contract, then all can be terminated. And one can provide either that all disputes have to be resolved through the central contract or that the main customer and supplier parties are the only ones who can enforce any of the local agreements.
As emphasised above, the contract structure does not determine the commercial result. But the parties should recognise that some contract structures fit more naturally with specific approaches, whereas in other cases the desired result has to be imposed on the structure.
Factors influencing the choice of option (numbers
below correspond to Options 1 - 4 as illustrated in Part 1)
The supplier’s viewpoint
From the supplier’s point of view the issues are very similar to those which will matter to the customer. The supplier will want to consider the governance costs of the arrangement and the advantages of a single central relationship. It will want to consider whether it’s being asked to provide a single standard product under a single global implementation project, or a highly bespoke product to individual local users. And doubtless it will prefer to see its liability carved up into small chunks, each related to the value of particular service components.
There is one additional factor which applies only to suppliers and that is management of the supply chain. This arises because liability is usually accepted only in proportion to the commercial benefit a party receives.
The issue for suppliers is that the customer will expect the supplier to accept liability in proportion to the overall contract value. However, the supplier will be managing various subcontracts in order to deliver the service. Often, a failure by one subcontractor could have serious implications for the whole contract, yet each subcontractor will only want to accept liability relative to the value of its own agreement. This leaves the supplier exposed. In the example below, a default by subcontractor 1 could be entirely responsible for exposing the supplier to a £1,000 claim, but the supplier could only recover £150 of this from the defaulting subcontractor.
Part of this is of course the price a supplier pays for acting as a prime contractor, and prime contractors typically build a risk premium into their price to reflect the value their financial muscle brings to the customer. There are, though, some situations where the prime contractor takes this position because of its role as an integrator of the supplies made by other consortium members - in which case the monetary value of its services may be relatively small as a proportion of the whole. This is known as a ‘thin prime’ and the dislocation between the prime’s liability to the customer and the value of its own retrieved revenues is greatest in this sort of arrangement.
The supplier may try to address this problem at its source by using an SPV structure. This is particularly useful where the various suppliers are comparable in both their financial substance and the value of their contribution to the services. An SPV arrangement involves the suppliers together setting up a jointly owned vehicle for the specific purpose of contracting with the customer and other users. There is a good deal of complexity then to be addressed.
The most common points are that a well advised customer will not want to rely on a ‘newco’ to support its outsourced services and will insist on parent company guarantees from the SPV’s backers. It may also require ‘direct agreements’ from those backers which require them to step up to the newco’s obligations if there’s a failure. On the supplier side, the consortium members will need to agree how they will deal with liabilities as between each other.
Another angle on the SPV structure is known as ‘design, build, operate and transfer’, which I will examine in detail later in this series. For now we need only note that where the purpose of an outsourcing deal is for the supplier to set up an operation that may in future be transferred to the customer, then the SPV provides a very useful mechanism. It allows the current running of the business to be ring-fenced within a stand-alone entity, and it means that the future acquisition could be as simple as completion of a share transfer form. On the other hand, when the customer acquires that company it will also acquire responsibility for all its actions and liabilities accrued during the supplier’s ownership - whether connected with its legitimate business or not. The customer should be at pains to make sure the company it acquires is ‘clean’. This could happen through a hive down of the business into another newco, or through wide ranging indemnity protection from the supplier.
The structure also allows the SPV’s assets to be charged to finance providers without directly exposing the core business of the supplier to this liability. This is the basis of its use in private finance initiative and project finance transactions. A further advantage for the supplier of having the contract ring-fenced in an SPV is that it makes it easier for the supplier to scrutinise the revenue flows.
There are two other factors which may influence the decision about which structure to use. Legal and tax requirements is one, and the other is exchange rate risk.
Legal requirements and tax implications
While many issues may be influential, legal requirements are one of the few that even on their own can be decisive.
It sometimes happens that a particular country regulates a particular sector and requires that only domestic companies operate in that space. In other cases (local loop telecom services are one example) only the end-user can purchase the service in some jurisdictions. This means the customer has to buy directly from an end-supplier rather than through the main supplier. Where this is the case there is no option but to adopt a contract structure which complies with the rules.
It also happens that countries usually view companies carrying out operations in their territories as being subject to local tax. This is not strictly a legal restriction (it’s not a prohibition on conducting business) but the prospect of becoming tax resident in multiple places will usually be so unappetising for a global supplier that it takes on the status of an actual legal restriction.
Exchange rate risk
This is another consequence of delivering services internationally. If services are being supplied in local jurisdictions, and therefore the supplier is incurring costs in local currency, the parties have to decide whether to bill in local currency or in a ‘home’ currency such as sterling or dollars. If they use local currency then the customer must accept that the actual price will vary as exchange rates move. If the customer insists on a fixed ‘home currency’ then the supplier must take the risk. In each case one party must either accept the risk or buy hedging protection - and either way the risk will inflate the cost of the deal.
There is actually a third option which is that if the parties both have local entities which are incurring costs and generating revenue in local currency, it may be acceptable to use local-to-local billing.
Current and future services?
One final point is whether the customer knows on day one what it wants to buy? In many cases it will be contracting for a specific need which has been validated through a detailed business case and set out in a comprehensive requirements document. In this scenario the parties can discuss a concrete proposition and agree a firm price and delivery schedule. But there are other occasions where although the customer knows that it will need to buy services in future, it will be uncertain about volumes, location or the timing of its needs. Sometimes, in fact, the customer may have only a vague outline of its requirements.
These situations require flexibility and may call for a ‘framework’ agreement. This is simply any arrangement which puts in place a mechanism (a framework) under which future services can be supplied. The extent to which matters need to be agreed up front varies widely. Some frameworks are little more than a preferred supplier relationship - they may contain standard contract terms and some day rates but leave all the key matters still to be decided. Others are at the opposite end of the scale: an agreed catalogue of goods and services available for purchase, with pre-determined lead times and prices and overarching volume discounts. Another variation is a combination of current and future needs: a fully defined and priced service to be supplied initially, with flexibility for adding on more options as required.
Any of the contract structures discussed previously can be set up as a framework agreement. The impact of a framework is more on the form of the documents than the contractual structure per se and I’ll be looking at this in detail in Part 3 of the series.
Structuring Sourcing Projects (Part 2)
13/10/2010
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Part 2
Choosing the Right Structure