Transferring responsibility for a business function through an outsourcing agreement with an outsourcing supplier may be one of the most important commercial contracts you enter into to scale up your business. An outsourcing agreement helps to ensure the arrangement meets your current and future business requirements.
Here, we look at some key considerations when agreeing to outsource services. And remember, our team of friendly, experience commercial solicitors can help explain, advise on, negotiate, draft or review your outsourcing agreement to ensure a successful relationship between parties.
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What is outsourcing?
Outsourcing involves the delegation of responsibility for a specific business task to a supplier. It can include the transfer of employees or assets or software used to carry out the outsourced function from the business to the supplier.
The outsourcing agreement is one element of a successful outsourcing arrangement. It is essential you take time to:
- Understand your business’s outsourcing requirements and goals
- Check the supplier has the capacity and ability to meet your outsourcing needs. Outsourcing contracts should be preceded by a tendering process or detailed negotiations so the agreement is clearly scoped and defined and expectations managed and refined in the outsourcing agreement
- Consider confidentiality of information. The negotiation process should be accompanied by a non-disclosure agreement when commercially sensitive business information is disclosed as part of the due diligence process
What should be included in an outsourcing agreement?
An outsourcing agreement allows a business to confidently hand over a function of the business with contractual guarantees on service and price and for the supplier to accept responsibility for the business function knowing what is contractually expected of them and the outsourcing pricing structure.
The outsourcing contract should carefully define the parties to the agreement when the business or the supplier is part of a group of companies. Guarantees for liability may be required from the parent company if the outsourcing supplier is a subsidiary company.
The outsourcing agreement should also cover:
The term
When outsourcing a business function, the length of the agreement needs to be carefully assessed to meet your current and anticipated business needs. For example, you may be anticipating a change in the business model that will enable you to move the function to an overseas supplier with enhanced cost savings or technological advances through automation will negate the need for outsourcing. Therefore, you need to look at the length of the outsourcing agreement and the termination provisions.
If flexibility is required, a business may negotiate a clause giving the ability to terminate the contract on notice to the supplier before the end of the contract in circumstances where there has been no fault or breach of contractual obligations by the supplier. This type of termination clause may need to be negotiated if the outsourcer is taking on some of the business’s assets and employees as the supplier will want assurances that they will not incur significant set-up costs only to find themselves with business assets and transferred employees they no longer require.
One option to satisfy the competing needs of the business owner and supplier is to agree on a sliding scale of termination charges if the business gives early notice without fault to the third party. That way the supplier is recompensed for the losses they will suffer if the contract is terminated early. Termination charges may be more cost-effective for the business if, for example, the direction of the business changes (to no longer require the outsourced function) or outsourcing overseas or the use of automation offers a significant reduction in overheads.
A business owner, whilst wanting flexibility, may also value continuity of supplier. The outsourcing agreement may therefore include a minimum contract term but with rolling notice at the end of the fixed term.
The outsourced services and level of service by the supplier
The outsourcing agreement should include:
- The outsourced services – these should be clearly described so there is limited scope for a commercial contract dispute
- The implementation and transition time with milestone dates - the contractual penalties for failure to meet milestone dates should be specified
- The key performance indicators of successful service delivery - it is critical that service levels are clearly defined as service level non-compliance can then trigger service credits. Alternatively, if KPIs are continuously not met, the agreement should include a provision for contract termination
- Redress for poor service of outsourcing – depending on the severity of the issues the contractual redress could range from service credits to damages to early termination of the contract
- Business or customer responsibilities – in most outsourcing arrangements the supplier is reliant on the business to act (for example, provision of data by agreed deadlines) to enable the supplier to meet their agreed service levels. Therefore, the responsibilities of each party need to be clearly defined
- Reviews and changes - an outsourcing agreement should provide for reviews and changes. A change request process can ensure that changes can be actioned. Whilst it may be impossible to predict every change, thought should be given to any anticipated changes in industry-specific regulations or legislation or an increase or reduction in demand for the outsourced service
- Specifying whether the supplier can use sub-contractors – this should includewhether the identity of the sub-contractor company has to be approved by the business in advance. In some situations, a business might experience reputational damage by a third party subcontracting the outsourced work to a sub-contractor. For example, if the sub-contractor is employing workers who do not have the right to work in the UK
Pricing and charging
It is important to both business and the supplier to get the pricing structure right so that outsourcing is a cost-effective solution for the business and the returns to the supplier ensure they are motivated to meet agreed service levels.
Price and charging regime options include:
- Fixed-price
- Part fixed base and part variable with a minimum fixed base price
- Cost and an agreed margin
- Cost with an added element of profit sharing or bonus
When considering pricing, some suppliers try to agree on an upfront payment to cover set-up costs for supplying the outsourced service. It is a matter for negotiation if installation costs are paid upfront, paid in instalments over the life of the contract or the contracted price simply reflects the supplier’s initial and ongoing costs.
The business and supplier also need to consider cost review clauses to provide for price increases in line with the retail prices index or other sector-relevant indexation. Commercial solicitors will look at how termination clauses (such as termination by notice where there is no breach of contract) fit with price escalation clauses. In a period of rising prices, your business may not want the third party to have the right to terminate on notice as you may not be able to match the outsourcing price when looking for an alternative supplier to take over the outsourcing function.
The transfer of employees
When employees are transferred from the business to the supplier it needs to be carefully managed and handled to avoid the business suffering adverse publicity. The outsourcing agreement should address:
- The transfer of the employees and their identity
- Any continued obligations in relation to employees and their provision of the services to the business
- Warranties from the business on the accuracy of the due diligence information provided in relation to the employees
- Indemnities from the business for liabilities relating to any employee who is transferring to the supplier under TUPE if the liabilities arose before the commencement of the outsourcing contract. The business may require similar indemnities if the outsourced function returns in-house
- Arrangements and liabilities for transferred employees at the end of the outsourcing agreement
TUPE normally applies to the transfer of employees in outsourcing arrangements so the contracts of employment of employees involved in the outsourcing function transfer from the business to the supplier at the start of the outsourcing agreement. Importantly, if the outsourced services go back in-house to the business, the employees are subject to TUPE provisions again. For more information on how TUPE can affect a business and its employees read our article on the TUPE provisions.
Asset transfers
If the outsourced business function involves the use of property or equipment then the business may choose to sell, lease or loan the property to the supplier or they could provide their own equipment or premises. The outsourcing agreement needs to address:
- If assets are to be transferred or lent to the third party as part of the outsourcing agreement. If a property is being sold or leased a separate deed of transfer or commercial leaseshould be negotiated. The lease terms need to be consistent with the outsourcing agreement
- The party responsible for the upkeep and maintenance of the assets
- What happens to the assets at the end of the outsourcing arrangement
It is best to consider all options as, for example, lending equipment that will be surplus to the business’s requirements once outsourcing has taken place may drive down the price of the outsourcing contract.
Intellectual property rights
It is best to check and address any IP issues in the outsourcing contract. For example:
- The IP rights in software or equipment and whether software or other licenses gives the business the right to sublicense the software to the supplier. If it does not, the business could be in breach of its SaaS contract by providing the supplier with the use of existing software. Any sublicence needs to terminate at the end of the outsourcing agreement
- If the business requires an indemnity that the supplier will use the IP rights in accordance with the outsourcing agreement and will not infringe the intellectual property rights of the business or any third parties
- Ownership of any existing IP or IP created during the life of the outsourcing agreement when the contract is terminated
Data protection
If the supplier will be processing personal data on the business's behalf as part of the outsourcing function, then the supplier must be GDPR compliant. The GDPR states what contractual terms a business must include in their data processing contracts and specifies matters such as how the supplier (data processer) should process the data, the maintenance of records and security, systems in place to respond to data access requests, and for the deletion or return of data to the business.
Outsourced data processing must comply with The Data Protection Act 2018 and The General Data Protection Regulation (GDPR). Under the GDPR, a supplier is subject to direct compliance with GDPR obligations on data protection. Non-compliance could result in the supplier facing penalties. For more information on data protection read our articles on handling personal data and supplier data protection breaches.
Warranties and liability clauses
It is usual to include industry-specific and general warranties and liability clauses in outsourcing agreements. It is preferable to negotiate warranties rather than rely on warranties implied by law. Common warranty and liability clauses include:
- The supplier giving a warranty that services will be provided with reasonable skill and care, or that they will comply with industry-specific regulations
- The business giving warranties about any equipment, assets, or third-party contracts transferred as part of the outsourcing agreement
- Liability and limitation of liability clauses depend on the extent of the loss that could be suffered if the outsourced business function is not operated at service level standards or ends in breach of the outsourcing contract. Normally some aspects of liability are capped or limited to an insurable figure whereas liability for other aspects may not be limited. For example, the supplier's indemnity in relation to intellectual property rights is often unlimited as the business would be liable to potentially unlimited third-party liabilities which the supplier can prevent
Monitoring and audit provisions
The ability to monitor performance and conduct audits enable the business to review the supplier's performance and compliance with agreed service levels. Through effective outsourcing contract management, any potential issues can be identified and resolved before escalating into a potentially costly dispute.
It is best practice to record matters such as:
- Reporting duties and audits
- Service disruption reporting procedures
- Increased monitoring provisions if service levels fall below the agreed standards or if the supplier does not meet KPIs
- The internal dispute management system
In some outsourcing agreements, where the outsourced business function is critical to the success of the operation of the business as a whole, it may be prudent to include step-in rights as part of the outsourcing contract. That means that if the level of service by the supplier remains below-agreed standards, despite an increased level of monitoring, the business can exercise step-in rights and take over management control of the outsourced services until the supplier can show it can meet service levels.
Termination and exit management
Early termination of an outsourcing contract enables a business to take the function back in-house or open up the outsourcing tendering process again or offer the outsourced function to a second preferred supplier. The termination provisions and rights must be carefully drafted and take into account any industry-specific issues. For example, the impact of the supplier losing professional or industry-related accreditation or being unable to secure insurance.
On a practical basis, ending outsourcing normally cannot occur instantly so it is important to ensure the outsourcing agreement contains an exit plan so the termination of the outsourced function takes place in an orderly fashion without too much damage to the business. The exit management plan should cover matters such as:
- If relevant, the return of any equipment or assets
- The transfer back of the outsourced function to in-house provision or a new supplier and continuity
The plan can go into more detail depending on the significance of the outsourced function to the business and the likely complexity of any transfer back in-house or a new supplier.
For more information on termination clauses read our article on terminating a commercial contract.
How can Harper James help with your outsourcing agreement?
Our team of commercial solicitors provides joined-up commercial law advice on all aspects of negotiating the agreement and resolving any employment, IP, or GDPR aspects of the contract as well as advising on dispute resolution if there is a falling out between business and supplier. We also can help you review your existing outsourcing agreements to ensure they remain fit for purpose and provide you with the agility and pricing and termination structure that ensures outsourcing remains a viable option for your business.
