Advanced Deal Structuring15 January 2010 Anirban Dutta
Anirban Dutta and Hetzel Folden discuss the finer points of creating innovative engagement models and of being customer financiers.
We would like to believe that pricing a solution right will help us win business. Our experience tells us, however, that if you offer simple pricing, you will be used as a benchmark to compare other bids, but you probably won’t win. We have fallen victim to that many times in our deal-making careers.
Big Deals require innovative pricing models. Global sourcing customers expect service providers to offer some form of pricing that encourages the service providers to invest in the deal as well. Tech Mahindra, a global sourcing player with a niche, made headlines in early 2008 by winning a Big Deal from British Telecom (BT). The deal was unique at that time because Tech Mahindra paid $100m up front as part of future savings to clinch the deal. But that situation is not unique anymore. Many large IT outsourcing customers are demanding hefty up-front savings payment from service providers to tide over the global slowdown and credit squeeze.
"One large insurance company, currently discussing a contract, demands over $100m upfront payment as part of the savings promised by a vendor," said a top executive of a leading tech firm who did not wish to be named. Service providers must be creative in deal structuring in order to support such heavy investments in customers.
Our advice would be to put in some innovative deal structuring with every bid, even if your customer asks for a simple rate card.Service providers also need to use creative structuring so that they do not fall victim to a price war. It is always an art to set the right margin targets. We believe there needs to be a ‘reasonable’ margin if long-term growth is to be sustained. We used the word reasonable here because there is really no clear definition of what a margin should be for a Big Deal. We have seen Big Deals carry margins anywhere from 5% to 45% of earned revenue. Reasonable margin should be set on the basis of assessing market realities (economic condition, customer’s business condition, and so on), desperation to win the deal, and last but not least consensus on a margin percentage. That third point is critical because corporate finance, business unit leaders from the involved business units, and deal group leaders need to agree on the margin before building the proposed price.
To make innovative pricing effective, service providers have to understand customer cost structure. Even if you cannot get the data yourself, you must go to a TPA or an industry analyst firm, such as Gartner or Forrester, to get benchmark data. You should understand where your base costs lie compared to your customers. Innovative pricing also brings in new business models, which can help the customer with process innovation. Here, we address some innovative models:
- Incentive-based or gain-sharing model
- Joint-sourced model
- Strategic alliance model or joint venture (JV)
Incentive-based or gain-sharing model: the carrot-and-stick approach
One such popular pricing model for Big Deals is incentive-based pricing. Colloquially, deal makers say it is the carrot-and-stick model. Most of the incentives are designed to yield continuous benefits for the customer. In the early years, the global sourcing industry made a clear distinction between incentive-based models and gain-sharing models. Incentives were designed only to reward service providers, but gain-sharing had both reward and disincentive components, thereby helping customers and service providers. Gradually, we have seen these models merge to a point where they are interchangeably called incentive-based or gain-sharing models.
However, some customers feel that we service providers can somehow magically con our way around metrics into getting greater rewards. Customers generally force service providers to put a cap on their incentives. Instead of simply agreeing to a cap-on-incentives approach, we favour a different one. Why not bargain for getting the most rewards but base it on customer savings? Let’s demonstrate this with a real-life example.
Although you may think it is not wise to go into a reward-sharing agreement, it can actually be quite profitable if done right. You just need to ensure that certain best practices are followed. The next section describes some best practices that we believe in.
Align risks and gains to incentives and penalties
When writing contracts, the focus should be on structuring the deal in such a way that the rewards and penalties are directly aligned to customer objectives. If the customer wants to improve resolution time for severity one tickets, the incentives and disincentives should be based on doing so. But this needs to be realistic in nature. Although it might be tempting to bet the farm—that is to say, take big risks in the hope of getting handsomely rewarded, but also face the heavy consequences of failure—you are best advised to adopt a moderate strategy.
For example, if the customer is adamant that you resolve all severity one tickets within fifteen minutes, you need to find out what happens if the time is delayed. How much does the customer lose for delays to resolution? Once this is established, you can work out a disincentive plan. You should never agree to accept the entire liability. Similarly, if you beat resolution times, you need to work out an acceptable reward. The best way to align gains and disincentives is to tie them directly to the customer’s business performance.
An example of this is when a particular service provider works with some energy and utility (E&U) customers. The gain-sharing strategy is aligned to common industry E&U metrics: earnings per share (EPS) and cost of per kilowatt-hour. In this way, the customer executives and this service provider are aligned linearly on gains. There is motivation on both sides to do the right thing. Although one may question the practicality of tying the customer’s end business performance with that of the service provider, in a true collaborative model the service provider and the customer should agree on the metrics. After all, the goal of the customer is to improve its business performance.
Objectivity prevails (almost)
The key here is to establish the measures objectively and quantifiably. They must never be subjective. If you fall into that trap, customer middle management will always kill you with complaints. Our recommendation is never to base an incentive clause on subjective customer satisfaction. However, objective models cannot be rigid mathematical contracts either. There needs to be an element of ‘normalisation’ involved. Quarterly or monthly strategic meetings will resolve what element of rewards or penalties can be applied for specific outcomes. Collaboration is the key to creating the measures.
Balance duration and incentives
Customers often tend to furnish incentives that are based on long-term or short-term goals but don’t balance them as a pair. Let us illustrate this with an example. Suppose you, as a service provider, signed up to do some innovation for the customer. Now, to innovate, you might have to tweak things a little bit. The tweaking may lead to some deviations in the original customer-defined metrics. If you are punished for all of these infractions, you will focus only on short-term target achievements. Then you will miss the long-term innovation target. By the same token, short-term actions should also have rewards and consequences. Service providers must work with customers to align incentives according to both short-term and long-term outcomes.
To summarise: in any incentive-based pricing the service provider incentives have to be tied with direct customer benefits. The pricing does not necessarily have to be cost-driven; it can be market-driven as well. Collaboration with the customer will result in the ultimate win-win model.
Excerpted from Winning Strategies: Secrets to Clinching Multimillion-Dollar Deals, by Anirban Dutta and Hetzel Folden. © 2010 John Wiley & Sons (Asia) Pte. Ltd. To learn more about the book, please visit www.winningstrategiesbook.com