Understanding The Differences Between Outsourcings And Traditional Corporate Transactions

Sunday, August 1, 2004 - 01:00

Over the past two decades, several approaches have been developed to effectively manage the outsourcing process. Recently, there have been calls to attempt to manage an outsourcing transaction in the same manner as a more traditional corporate transaction, like a merger or an acquisition. This approach has some instant appeal, because many outsourcings involve the transfer of a business unit to a third party. However, it is misguided, as it fails to consider the complexities of the outsourcing paradigm, which mandates the use of a highly specialized, proven approach to an outsourcing in use by outsourcing lawyers today.

Outsourcing involves the delegation of a significant portion of a company's business function(s) to a third party who will perform the same services as the company previously performed at the same or a better level of performance for the same or, preferably, a lower price. While cost savings are a primary driver for outsourcing customers, there are many additional elements to consider, such as converting fixed costs to variable costs, preserving capital, shifting costs to later years, improving chargebacks to business units, and leveraging the outsourcer's economies of scale. A company may also want to "transform" existing business processes, which usually require non-financial justification such as: improving time-to-market, creating business flexibility, responding to competitive pressures, and focusing on core competencies. With these numerous drivers in mind, it is clear that a company's decision to outsource requires significant organizational visibility and analysis.

Proponents of the use of standardized, M&A-type methodologies correctly point out that many of the financial and business drivers for outsourcings also apply to most M&A transactions. However, given the complex nature of the outsourcing paradigm, these general transactional similarities by themselves are not significant enough to warrant the adoption of the more traditional corporate approach to manage the outsourcing process.

Recent criticisms leveled at the outsourcing industry allege that the outsourcing customer and its counsel do nothing more than beat the outsourcer into submission for the sake of lower costs, better service levels and legal remedies not relevant to the engagement. These critics assert that outsourcings, like M&As, should instead be driven by senior-level management who can achieve high-level, strategic business objectives more smoothly and expeditiously than this "brute-force" approach.

Fortunately, the brute-force, "we win, you lose" scenario simply does not exist in highly visible, multi-million dollar outsourcing transactions where both parties strive for a "win-win" scenario where the outsourcer is incented, both financially and contractually, to provide continuously improving services during the term. In addition, this notion that outsourcing customers and their counsel cannot reach a "meeting of the minds" with the outsourcers because they are too focused on nuts and bolts operational issues and legal remedies also belies a misunderstanding of the activities that must take place before a company hands over critical business functions to an outsourcer.

Unlike traditional corporate transactions, outsourcing lawyers work closely with the client's non-legal personnel who have responsibility for the functions being outsourced. This enables the lawyers to create customized contract documents that reflect a customer/outsourcer relationship organized around how the customer's business actually operates, rather than senior management's perception of how the business operates. This process also brings additional critical issues to the fore, including technology refresh, tax issues, employment issues, and intellectual property issues, each of which requiring input from subject-matter experts. Thus, any concern that important issues will be ignored if this type of approach is used by counsel to manage the outsourcing process is misplaced.

Outsourcing lawyers use these customized methodologies to ensure that proper scoping and due diligence takes place prior to the pricing of the transaction. Conversely, in a merger or acquisition, deals are generally negotiated based on the value of assets and/or income as set out in financial statements. In an outsourcing, determining the value of the transferred assets is just the beginning of the exercise. The scope of the services to be performed must be precisely specified, and the costs related to that scope, less promised savings, are then modeled for the term of the proposed agreement.

It simply would not be prudent to apply a formulaic, traditional corporate approach to an outsourcing, especially when outsourcing lawyers have developed and successfully implemented methodologies that are uniquely tailored to each customer's specific business practices, as well as industry-specific best practices. These types of methodologies provide a complete mapping of the outsourced activities and business practices, making data collection during the due diligence phase easier for both parties. The outsourcer can readily access precise data needed to develop informed service and price proposals, thereby further increasing the efficiency of the process and significantly increasing the parties' chances of creating a "win-win" relationship.

Kevin E. Colangelo is a Member of Kramer Levin Naftalis & Frankel LLP's Technology Transactions and Outsourcing Practice. He represents clients in a wide variety of complex technology transactions.

Please email the author at kcolangelo@kramerlevin.com with questions about this article.