8 June 2011
Due diligence involves:
- The customer’s investigation and analysis (i) of those aspects of its business that it intends to outsource, which will help the customer to prepare for the request for proposal (RFP) and negotiation process and to determine if its objectives can be achieved through outsourcing: and (ii) of the service provider, in order to determine if the service provider’s approach, solution and costs will meet the customer’s needs.
- The service provider’s investigation and analysis of the customer and its business, in order to develop a solution that will fit the customer’s needs.
The results of the customer’s due diligence of the business it plans to outsource will help form the RFP. Both parties will use the results of their due diligence efforts to determine appropriate solutions, charges, service levels, governance and other key aspects of the outsourcing transaction.
Customer Due Diligence
The customer should conduct due diligence on the business to be outsourced and with respect to the service provider.
Customer Due Diligence of the Business to be Outsourced
The customer should start its due diligence by investigating those aspects of its business that it intends to outsource. The customer needs to have a complete understanding of those aspects, and the objectives to be achieved through outsourcing, to determine if an outsourcing solution will provide the desired results. The best due diligence starts early. In fact, as a customer, the best time to start is before the customer even begins the RFP and negotiation process.
Customers should adhere to a practice of maintaining complete and accurate records of their findings. These should include:
- Physical assets, including servers, equipment and other tangible assets and the locations of each;
- Requirements of the business, including interoper ability requirements between the customer’s assets and networks being outsourced and other customer and third-party systems with which those assets and networks need to interact;
- Intangible assets, including the customer and third-party software used in the outsourced business; and
- Third-party contracts, including software licenses, maintenance and support contracts and other third-party contracts relevant to the outsourced business.
The customer should also determine which of its employees perform services for the outsourced business and identify policies and procedures that may have significant impacts on the solution.
The customer should use the results of its due diligence to build its base case. The customer should determine the costs it is currently incurring for the services, the requirements for the services and service levels, and whether the assets and employees associated with the outsourced business are also required for retained customer functions. This internal investigation and analysis is critical for building an effective RFP. The more complete and accurate the information provided in the RFP, the better the responses that the customer will receive from potential service providers.
Customer Due Diligence of the Service Provider
The customer should also conduct due diligence to determine if the service provider has the expertise and qualifications necessary to perform the services and meet the customer’s objectives. Due diligence will also help the customer to fully understand the costs associated with the outsourced solution and to determine if the service provider’s processes, procedures and approach will fit with those of the customer. The customer should probe the service provider on its proposed solution to confirm that it meets the customer’s requirements and that the proposed processes and timelines can realistically be met.
To obtain the material needed to make an informed choice among potential vendors, customers need a strong RFP coupled with conversations with the service provider’s relevant personnel. The RFP should require each potential service provider to explain, among other things: how it will meet the customer’s requirements; its qualifications; the methods and processes it will use in performing the services; its staffing plan for the services; its use of onshore and offshore resources; and its pricing methodology.
Service Provider Due Diligence
While the service provider should be an expert in performing the outsourced services, it will need to carefully review the particularities of the customer’s business and the requirements for successfully handling the outsourced function.
Service ProviderDue Diligence of the Customer’s Business
The service provider should review the customer’s requirements, physical and intangible assets, and third-party contracts. The service provider should also review the current processes and procedures used by the customer (or by an incumbent service provider) to perform the relevant services and should meet with the employees who perform the services, functions and responsibilities to gain an understanding of their roles and responsibilities.
The service provider should conduct due diligence to determine the accuracy of, and fill in any gaps related to, the baseline numbers and costs that were provided by the customer or included in the RFP. Pricing under most outsourcing agreements is based upon unit(s) of resource consumption. As the resource units increase above specified amounts, the monthly charges increase by additional resource charges; and as the resource units decrease below specified amounts, monthly charges decrease by reduced resource credits issued to the client by its service provider. In order for this process to work, it is important that the baselines be established using accurate information.
Once the third-party contracts used in the outsourced business have been identified, those contracts will need to be reviewed to determine whether they can be used by the service provider in performing the services and/or whether third-party consents will be required. The definitive agreement should specify which party is responsible for obtaining those consents and who will bear any associated costs. The extent and criticality of consents required and alternatives when consents are delayed or are not obtained should be considered in the development of the solution.
Regulatory Requirements of Countries in Which the Customer Operates
The service provider should know the legal requirements applicable to the services and should take responsibility for obtaining necessary regulatory consents and for complying with the laws of countries in which the services are to be provided.
Service Provider Acquisition of Assets
In certain outsourcing transactions, the service provider may actually acquire assets of the customer, take assignment of third-party licenses and acquire employees used to perform the services prior to the outsourcing of the business. In any case, the service provider may need to utilize certain customer assets in order to provide the services. The service provider should consider whether the customer’s assets are sufficient to meet the purposes they will serve.
Lack of Appropriate Due Diligence
A primary goal of an outsourcing transaction is for the service provider to develop a solution and perform services that meet the business objectives of the customer at charges that provide a profit for the service provider while meeting the customer’s financial objectives. Failure to conduct accurate and complete due diligence can result in numerous unwanted consequences that jeopardize the ability of the parties to achieve this goal, including the following:
The parties should seek to investigate all necessary matters in order to avoid the need for assumptions in the definitive agreement. However, the less the service provider knows about the outsourced business and the more gaps in its information, the more the service provider will attempt to include assumptions in its statements of work. Including assumptions in a statement of work (in particular where the assumptions are critical to the performance of the services) can greatly increase the risk of disputes between the parties as they attempt to negotiate changes to services and charges if the assumptions are not accurate.
In extraordinary cases where there is a lack of complete and accurate information, a service provider may also request that the parties “true-up” baseline numbers (i.e., adjust the baselines and make corresponding adjustments to the charges, ARCs and RRCs) after the definitive agreement is signed. Leaving baselines subject to true-up can also lead to dispute as the parties deal with the impact of changes in the baseline numbers.
If a definitive agreement is not based upon accurate and complete information, there are likely to be a high number of change orders. If the customer has negotiated a strong contract, the risk of additional costs for changes resulting from a lack of information should generally be placed upon the service provider. However, the need for additional resources and efforts that result from factors that were unknown at the time a contract was signed may not be covered under the scope of the contract. As a result, disputes may arise as the parties discuss how to deal with these service and cost adjustments.
If the customer is required to cover the costs of changes in the solution arising from information discovered after the agreement was signed, the customer may no longer be able to achieve its outsourcing objectives. Even if the service provider must absorb the additional change-related costs, the customer will be faced with a provider looking to find ways to maintain a profitable relationship after absorbing those costs.
A good contract will include appropriate incentives for the service provider to meet go-live dates, such as withholding of payment unless and until critical milestones are met and/or deliverable credits associated with a failure to meet critical milestone dates. However, if a lack of proper investigation leads to unexpected delays, the service provider may not be able to meet go-live dates, regardless of whether such incentives are built into the contract.
From the customer’s perspective, the ability to institute penalties against a service provider, or even pursue damages against that provider, in the event go-live is delayed is no substitute for a smooth-running business. In addition, many of the consequential damages that a customer could suffer may not be recoverable under the terms of the contract.
While considerable effort is required for effective due diligence, the long-term benefits of thorough and complete investigation and analysis will certainly outweigh those efforts. In the long run, effective due diligence by both parties will reduce the risk of disputes between the parties and will result in a more successful relationship.