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How to draft an outsourcing agreement to suit your business

Transferring responsibility for a business function through use of an outsourcing agreement can be one of the most important commercial contracts you enter into to scale your business, while keeping other costs, such as recruitment, to a minimum. But entering into an outsourcing agreement does bring its risks, so it pays to make sure the agreement is carefully drafted to suit your current and future business requirements. Here, we look at how to draft an outsourcing agreement that protects your business.

What’s involved in outsourcing?

Outsourcing is the transfer of a business function by a business to a third party supplier. Outsourcing involves the delegation of responsibility for a specific business task and therefore it can involve the transfer of employees or assets or software used to carry out the outsourced function from the business to supplier.

The outsourcing agreement is only one part of a successful outsourcing arrangement as it is firstly essential that time is taken to understand the business’s outsourcing requirements and goals. It’s also just as important that the third-party supplier has the capacity and ability to meet the business’s outsourcing needs. 

Outsourcing contracts should ideally be preceded by either a tendering process or detailed negotiations so that the outsourcing arrangement is clearly scoped and defined. During this process, both the business owner and third party can get a clear understanding of the other’s needs and objectives so expectations can be managed and then refined in the outsourcing agreement. That initial process should normally be accompanied by a non-disclosure agreement in cases where commercially sensitive business information is being disclosed by either the business owner or third party as part of the due diligence process.

Why do you need an outsourcing agreement?

If you have conducted your due diligence and concluded that outsourcing is the right route for your business then without a detailed outsourcing agreement in place you would be handing over a function of your business with no contractual guarantees of service levels and the real risk to your business if the outsourcing arrangement isn’t fit for purpose and your business suffers as a result. Likewise, the third party will be accepting responsibility for the business function, and potentially employees of the business, so the supplier needs to know what is expected of them, what they are taking on and the pricing of the outsourcing services.

The outsourcing contract needs to specify:

  • The parties to the agreement – this can be particularly relevant when the business or the third party is part of a group of companies. If the supplier of the outsourcing is a subsidiary company guarantees for liability may be required from the parent company.
  • The term of the agreement.
  • The outsourced services.
  • The level of service required from the third party.
  • How the outsourced services are priced and paid for.
  • The migration of any assets – this may form part of a separate transfer agreement.
  • The transfer of any employees.
  • Remedies for poor service.
  • Any limitation of liabilities and guarantees and indemnities.
  • Termination of the outsourcing agreement.

The term of an outsourcing agreement

If you are outsourcing a business function the term of the agreement needs to be carefully assessed as, for example, you may anticipate a change in business needs or technological advances that would enable you to move the function to an overseas supplier with enhanced cost savings or digitisation that ultimately will negate the needs for outsourcing.

From a business owner’s perspective if the outsourcing agreement contains the ability to terminate on notice to the third party before the end of the specified contractual term this gives the business the flexibility it requires, provided that notice can be served even if there has been no fault or breach of contractual obligations by the third party. This type of termination clause may need to be negotiated because if the third party outsourcer has taken on some of the business’s assets and employees it will want assurances that it won't incur significant set up costs only to find itself with business assets it no longer needs and transferred employees it has to make redundant in light of the cancellation of the outsourcing agreement.

One option to satisfy the competing needs of business owner and third party supplier is to agree on a sliding scale of termination charges if the business gives notice without fault by the third party. That way the supplier is recompensed for the losses they’d suffer if the contract is terminated earlier than its contract term. Even paying termination charges may be more cost effective for the business owner if, for example, the direction of the business changes (so as to no longer require the outsourced function) or outsourcing overseas brings massive cost savings.

A business owner, whilst wanting flexibility, will also require certainty of provision of outsourced services.  The outsourcing agreement may therefore have a minimum contract term but with rolling notice at the end of the fixed term. Most businesses, having carried out their investigations into their outsourcing needs and their due diligence on their preferred supplier, may find rolling notice provision preferable.

The outsourced services and level of service by the supplier

The outsourcing agreement should specify:

  • The outsourced services – these should be clearly described in the contract or in a separate schedule so there can be little room for dispute should the business allege that the supplier didn’t provide all the contracted outsourced services.
  • The implementation and transition time with milestone dates, stating that if the supplier fails to meet milestone dates what the contractual penalties are.
  • The key performance indicators of successful service delivery - it is critical that service levels are clearly defined as failure to meet agreed service levels can then trigger either service credits or, if warranted because of the poor service delivery, 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 – an outsourcing arrangement normally means that a supplier is reliant on a business taking some actions (for example, provision of data by agreed deadlines) for the supplier to meet its agreed service levels.
  • Reviews and changes - an outsourcing agreement should provide for reviews and changes. This can be achieved by a change request process to 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 the practical impact of Brexit (for example, on supply delivery or cost) or an increase or reduction in demand for the outsourced service.
  • Specifying whether the supplier can use sub-contractors, and if so, whether the identity of the sub-contractor company has to be approved by the business in advance (for example, because of concerns of potential reputational damage arising from issues with sub-contractors who haven’t been vetted by the business).

Pricing and charging in outsourcing agreements

It is important to both business and supplier to get the pricing structure right in an outsourcing agreement so that not only is outsourcing a cost effective solution for the business but the returns are at a level where the supplier is motivated to meet agreed service levels.

Pricing and charging often involve extensive negotiations to try and get the right regime whether that is:

  • 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 an upfront payment to cover set up costs for supplying the outsourced service. It is a matter for negotiation if any installation costs are paid upfront, paid by instalments over the life of the contract or the contracted price simply reflects the supplier’s initial and ongoing costs.

The business and outsourcing supplier will also need to consider if there should be cost reviews and if prices should be increased in line with the retail prices index or some other type of indexation.

The transfer of employees as part of an outsourcing agreement

If employees are to be transferred from the business to the outsourcing supplier then this needs to be carefully managed and handled to avoid the business suffering adverse publicity or concerns about job security from the remaining employees of the business.

The outsourcing agreement should address the following:

  1. The transfer of the employees.
  2. The treatment of and liabilities in relation to the employees.
  3. Any continued obligations in relation to employees and their provision of the services to the business during the outsourcing agreement.
  4. Arrangements and liabilities for transferred employees at the end of the outsourcing agreement.

Employment law solicitors advise that TUPE normally applies to the transfer of employees in outsourcing arrangements. This will mean that the contracts of employment of employees involved in the outsourcing function will transfer from the business to the third party supplier at the start of the outsourcing agreement. Importantly, if the outsourced services go back in-house to the business, then the employees would be 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.

If employees are being transferred to the supplier then normally the outsourcing agreement will cover these employment law issues:

  • The identity of the employees being transferred.
  • Warranties from the business on the accuracy of the due diligence information provided in relation to the employees.
  •  Indemnities from the business in relation to 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).

Asset and outsourcing agreements

If the business function that’s the subject of the outsourcing agreement requires the use of property or equipment then the business could sell, lease or loan them to the third party supplier or the supplier could provide their own equipment or premises. The outsourcing agreement needs to address:

  1. If assets are to be transferred or lent to the third party as part of the outsourcing agreement. If property is to be sold or leased, then there will need to be a separate deed of transfer or commercial lease. The terms of the lease will need to be consistent with the outsourcing agreement.
  2. Who will be responsible for the upkeep and maintenance of those assets?
  3. What happens to the assets at the end of the outsourcing agreement?

Commercial solicitors say 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.

Outsourcing and intellectual property rights

A business may think that there are no IP rights issues with its planned outsourcing to a third party supplier but it is best to check and address any issues in the outsourcing contract. For example:

  1. Any IP rights in software or equipment and whether your software or other licence gives you the right to sublicense the software to the third party supplier. If it doesn’t then the business could be in breach of its SaaS contract by providing the supplier with use of existing software. Will the sublicense terminate on expiry of the contract?
  2. Does the business require an indemnity in the outsourcing agreement that the third party will use the IP rights in accordance with the agreement and won't infringe the intellectual property rights of third parties? 
  3. Who will own any existing IP or IP created during the life of the outsourcing agreement when the contract is terminated?

Outsourcing and data protection

If the third party supplier will be processing personal data on the business's behalf as part of the outsourcing function then it is essential that GDPR legislation is complied with.

Both parties to the outsourcing contract need to ensure that any data processing complies with The Data Protection Act 2018 and the EU regulations, The General Data Protection Regulation (GDPR) that applies under UK law. Under the GDPR, the supplier is subject to direct compliance with GDPR obligations on data protection. If the supplier doesn’t comply then they could be in breach and face penalties. For more information on data protection read our article on handling personal data and supplier data protection breaches.

 The GDPR states the contractual terms that a business must include in their data processing contracts which 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. Importantly for GDPR compliance purposes the regulations say that the third party supplier can't engage a sub-contractor to work on the outsourced business function without first getting specific or general written authorisation from the business. If a subcontractor is appointed, then the subcontractor must be subject to mirror data protection clauses to the ones included in the outsourcing contract.

Warranties and liability clauses in outsourcing agreements

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 third-party 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 – these clauses will depend on the extent of the loss that could be suffered if the business function being outsourced either isn’t run effectively at service level standards or ceases altogether 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 third party supplier is able to prevent.

Monitoring and audit provisions in outsourcing agreements

The ability to monitor performance and conduct audits enables 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 at an early stage and resolved before escalating into a dispute requiring recourse to  litigation. Accordingly, it is best practice to record matters such as reporting duties, frequency of audits, service disruption reporting procedures, increased monitoring if service levels fall below the agreed standards and the suppler doesn’t meet KPIs and the internal dispute management system.

In some types of 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 outsourcingcontract. That means that if the level of service by the supplier remains below agreed standards, despite the 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 of an outsourcing agreement and exit management

Termination rights are important from a business’s perspective if the outsourcing arrangement isn’t working out and overall business performance is suffering as a result. For more information read our article on terminating a commercial contract.

Early termination of an outsourcing contract enables a business to take the function back in-house or to open up the outsourcing tendering process again or offer the outsourced function to a second preferred supplier. It is critical that thetermination provisions and rights are carefully drafted and take into account any industry specific issues, such as the impact of the supplier losing professional or industry related accreditation.

On a practical basis, termination of outsourcing normally can't take place instantly so it’s important that the outsourcing agreement contains an exit plan. That way the termination of the outsourced function can take 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 far more detail than set out above depending on the significance of the outsourced function to the business and the likely complexity of any transfer back in-house or to a new third party supplier.

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