30 September 2010
If you are contracting to have software developed or implemented, you likely are uncertain both about how you want the software to function and the work required to get it to function that way. That uncertainty can translate to scheduling and budgetary risks. However, those risks can be mitigated with the right deal structure (or heightened with the wrong deal structure) in your contract with the developer, systems integrator or other contractor. The available deal structures fall into the following three high-level categories:
- Shared Risk
This article describes those three deal structures and the key contract provisions that help make each of them effective in securing benefits and mitigating risks.
Under the “assist” structure, the contractor works at your direction to assist you in completing the project. You pay the contractor on a time-and-materials basis. This structure is well-understood and offers the benefits of allowing you to start a project quickly, with only a limited view of the desired outcome, and make changes in scope and direction at your discretion.
With the assist structure, the risk of budget overruns and schedule delays is entirely yours. The assist structure’s time-and-materials pricing approach increases that risk by giving the contractor an incentive to provide an optimistic initial estimate (to win the business) and to expand the project (to increase its revenues). A well-crafted contract can mitigate that risk by allowing you to control scope, schedule and staffing. For example, it can give you the right to:
- Suspend or delay work or change the scope of services at your discretion
- Require the contractor to complete the project at committed hourly or daily rates
- Decide on the mix of on shore and off shore personnel
- Require the contractors to retain key individuals on your project for the duration of your project and limit turnover of non-key resources
- Receive reports and briefings, and inspect the ongoing work, as required to manage the project
To make the assist structure effective, you will need the knowledge and skill required to exercise this control and flexibility. Thus, the assist structure works best on projects where you know how to run the project and merely need to augment your staff. If you are relying on the contractor’s expertise in running the project and making key decisions, this structure provides little certainty on schedule or price.
The “deliver” structure is the most direct way for a customer to seek certainty on schedule and price. Under this structure, you agree to pay the contractor a fixed fee for defined end results. Payments are made only upon achieving milestones (such as acceptance of deliverables). Making the contractor’s ability to charge for services depend on timely completion shifts the schedule and cost risks to the contractor. Because additional effort can reduce the contractor’s profits, the contractor has a strong incentive to complete your project quickly and efficiently.
The primary risk in the deliver structure is that you will end up signing change orders that increase the fixed fee and extend the schedule because you failed to clearly and completely define your desired end results or because your desired end results changed mid-project. There is a further risk that the contractor will charge high prices for changes because you have few options but to enter into the change order. These two risks are heightened by the fact that the contractor has a financial incentive to under-scope the project initially (to win the business) and then to sell increases in required scope. Finally, there is a risk that the project will not meet your needs, even if delivered on time to specifications, because the specifications were inadequate.
In order to secure the benefits and mitigate the risks of the deliver structure, you will need to describe in detail the services to be performed, the deliverables and milestones that will result from the services, and the time frame in which those deliverables and milestones must be delivered or achieved. You will need clearly defined acceptance procedures with a right to accept or reject deliverables and milestones, either in your reasonable discretion or in accordance with acceptance criteria that will not be met unless your needs are met. Without these provisions, there is considerable risk of dispute over whether the contractor has achieved the milestones and thus earned payment.
You will also need specified change-control procedure, where changes to the scope or timeline are reported, with a threshold at which such changes will affect the schedule or the fixed fee. To the extent that your fixed fee is subject to change due to a scope change, those fee changes should be anchored in your contract by a committed rate card to be used either to track and pay for actual work associated with such change or to estimate work associated with such change to create an updated fixed fee.
These key contract provisions need to be clear and practical enough to be used for day-to-day management of the project. They also need to be drafted well enough to stand up in court, or in a less formal dispute resolution process. Otherwise, you will have agreed to pay a fixed price without obtaining the end results you need. However, drafting and negotiating these contract provisions require an investment in investigating your desired end results and negotiating and carefully drafting the contract provisions.
The primary drawback of the deliver structure is that the contractor will charge a risk premium. This premium covers the risk that the contractor underestimated the work. However, the risk premium also covers the risk that the customer will not do what the customer needs to do to make the implementation succeed, perhaps because the customer sees the schedule and cost risk as having been transferred to the contractor. Thus, you are to some degree insuring the project against the risk of cost overruns.
The “shared-risk” structure is designed to reduce overall risk by aligning incentives. For example, a shared-risk structure might include:
- A target budget for a well-defined process and result (with clear customer responsibilities)
- Clear allocation of control over scope, staffing and other key cost drivers
- A right to charge for hours spent up to the target budget at defined hourly rates
- A sharing of the “savings” if the project is completed under budget
- Bonuses for early delivery (if that provides business value) and credits for late delivery
- Hourly rates reduced in stages over the target price, perhaps even to zero at a “not to exceed” price
- Clear boundaries on chargeable and non-chargeable changes
The shared-risk structure reduces overall risk and creates a spirit of partnership by giving each party a clear financial incentive to complete the project on time and under budget. However, like the deliver structure, the shared-risk structure requires an up-front investment in defining the process and the outcome. In addition, the shared-risk structure will require more sophisticated contracting to address changes in scope and direction because those have greater implications with this more complex structure.
This structure requires the contractual elements from both the assist and the deliver structures. As with the assist structure, you are concerned about staffing because you share in the cost of turnover and excess staffing. As with the deliver structure, you will need a clear definition of the end result and an effective change control mechanism. Because it requires both ongoing governance similar to the assist structure and the up-front investment similar to the deliver structure, the shared-risk structure is best used for projects of particular importance.
The Right Structure for Your Software Project
The right structure for your project depends on your situation. In the right situation, each of these structures can secure benefits and mitigate risks.
Additionally, you can combine these three structures by phase. For example, you could use a shared-risk structure, but hold back some payments for achieving milestones; or you could use the assist structure for the initial scoping phase (to get a quick start), the deliver structure for the design phase (because it’s entirely within the contractor’s control) and the shared-risk structure for the implementation and testing phases (to reduce risk). However, combining contract provisions from one structure with pricing from another structure can increase risk. For example, an assist structure without adequate control provisions in the contract would increase the risk of cost and schedule overruns.
Regardless of the structure you select, your contract should include standard services agreement provisions such as performance and conformity warranties, infringement indemnities, limitations on liability (including exceptions to those limitations) as well as provisions to protect the confidentiality of the project and your business data and the privacy and security of any personal data that may be accessed by the contractor.
Each of these structures has been used successfully when paired with contract provisions to secure the benefits of the selected structure. The best choice depends on your project, your skills, your risks and your contractor. Success comes from investing at the start in contracting for a value-maximizing deal structure.