By Brad Peterson, Partner and Gregory Manter, Associate, Mayer Brown LLP
If you are a customer contracting to implement an ERP, CRM or other large system, few issues are more important than the deal structure. With these projects, you face uncertainty about both your desired end result and the effort required to get there. That uncertainty translates to schedule and budget risks. Those risks can be mitigated with the right deal structure (or heightened with the wrong deal structure). The available deal structures fall into the following three high-level categories:
• Shared Risk
Under the “assist” approach, the implementer works at your direction to assist you in completing the project. You pay the implementer based on the time that its people spend. This approach is well understood, and you can start a project quickly with only a limited view of the desired outcome. A well-crafted contract will give you substantial flexibility and control.
However, with that flexibility and control comes full responsibility for managing the implementer to achieve your budget and schedule objectives. The risk of budget and schedule overruns is entirely yours. Making matters worse, the time-and-materials pricing increases that risk by giving the implementer an incentive to increase cost (and thereby its revenues). A well-crafted contract will allow you to mitigate that risk by controlling scope, schedule and staffing, but you will need the knowledge and skill required to exercise that control.
Since the “assist” model provides no pricing certainty, customers often look for alternative approaches.
The “deliver” approach is the most direct way for a customer to seek price certainty. Under this approach, you agree to pay the implementer a fixed fee for defined end results. Payments are made only upon achieving milestones (such as acceptance of deliverables). The implementer bears the risk because the implementer’s ability to charge for services depends on finishing the project. Additional effort reduces the implementer’s profit. The implementer thus has a strong incentive to complete your project quickly and efficiently.
All of the benefits of the “deliver” approach depend on clearly and completely defining the desired end results. This isn’t easy, partly because defining specifications with a contract level of clarity is difficult and partly because the desired end results may change mid-project. If the desired end results aren’t defined clearly, you’ll pay more in change orders. That can erase the benefits of price certainty.
The primary drawback of the “deliver” approach is that the implementer will charge a risk premium. This premium covers the risk that the implementer underestimated the work. However, the risk premium also covers the risk that the customer won’t do what the customer needs to do to make the implementation succeed. After all, the customer has little incentive to help the project once the price is fixed. Customers thus seek ways to reduce the level of the risk premium.
The “shared-risk” structure is designed to reduce overall risk by aligning incentives. For example, a shared-risk approach 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 risk overall, and creates a spirit of partnership, by giving each party a clear financial incentive to complete the project on time and under budget. However, the “shared-risk” approach will require an up-front investment.
You need to define the process and outcome. In addition, this structure will require more sophisticated contracting to address changes in scope and direction because those have greater implications with this more complex structure.
The Right Structure for Your Deal
You can combine these three structures. For example, you could use a "shared risk" approach, but hold back some payments for achieving milestones. As another example, you could use the “assist” approach for the initial scoping phase (to get a quick start), the “deliver” structure for the design phase (because it’s entirely within the implementer’s control), and the "shared risk" model for the implementation (to reduce risk).
Each of these structures has been used successfully. The best choice depends on your project, your skills, your risks and your implementer. Success comes from investing at the start in contracting for a value-maximizing deal structure.