In the sourcing world where applications development and maintenance is the prime objective of companies outsourcing IT services, a recent report by the Aberdeen Group finds that companies mainly outsource these services to enhance their internal IT skills. Sixty-two percent of the respondent firms, which outsource such services, state that they do so to enhance internal skills and gain cost arbitrage (See Chart 2).
Interestingly, 46% of the polled companies outsource the majority of their applications development and maintenance services to India, while 30% outsource it within the U.S.A. The research finds that companies that outsource to Indian suppliers are slightly more satisfied with the quality of work than the firms outsourcing to U.S. providers.
1/03/2007
Outsourcing Deals Go Hybrid
The last few years have seen a clear growth in the number of hybrid outsourcing transactions — deals that involve both a services offering and a related corporate deal between a service provider and its customer. Among other reasons, one of the key factors fueling the growth of these types of deals is the increasing number of spins off and other monetizations of captive service providers, many of them in India.
By all accounts, this trend towards hybrid deals is just in its infancy stage, and we can expect more — and more varied — transactions of this type in the near term. As spin offs continue, service providers will search for new vehicles to expand their service offerings and the private-equity funds, flush with seemingly limitless cash, will seek to repeat the success of some of the recent deals.
What are a few of the key issues and lessons learned from these transactions?
While the hybrid-type arrangements outlined above can take many forms, one aspect of the deals remains fairly consistent: A hybrid deal will layer on additional complexity to what will typically be a pretty complex business transaction in the first instance. While offering great upside potential, it cannot be overlooked that hybrids also take more time and effort to structure.
The customer will under most circumstances want to define the scope of the services offerings of any jointly created new venture fairly broadly to maximize the business opportunities.
When considering any hybrid transaction, a customer should consider two critical threshold points. First, in most deals, the services agreement should be evaluated independently of the rest of the deal and should be able to stand on its own. The value of the services agreement will typically be greater than the equity or asset piece — in both monetary terms and in terms of its criticality to the overall business objectives of the customer. As a result, if the business case for the services agreement cannot be justified, the overall transaction most likely will not make sense. What that means is that, the customer should insist that its service provider provide arms-length, market terms. As a minority owner of any newly created Joint Ventrue (JV) or other corporate entity, which has typically been the norm, the customer will not have a sufficient, or in some cases any, ability to control the quality of the services or direct those additional resources be deployed to address areas of concern if the services are not meeting acceptable standards. So, as a practical matter, the various contractual levers in the services agreement may offer the only ability to control the quality of the services.
In structuring the overall arrangement, a customer should also pay particular attention to the areas within the contractual arrangements that may generate potential conflicts between the shareholder relationship, on the one hand, and the services agreement, on the other. Some of the most important such areas are set forth below.
Termination. Perhaps the most complex issue in negotiating hybrid transactions will be the interplay of the termination rights amongst the various agreements. From the customer’s perspective, in the event the service provider commits a material breach of either the services or other material transaction documents, it will usually be the case that the customer will want the option to trigger some kind of a liquidity right in respect of its equity interests. If the services arrangement is not working, it is hard to imagine the customer remaining committed on the equity side. This liquidity right could take the form of a put of the interest at a specified price, or the automatic termination of any restrictions on transfers to third parties.
The release of transfer restrictions may not, however, as a practical matter, be of great value to a customer in the case of privately owned entities, particularly if the customer has a minority stake, as any sale of the interest could well come with a steep discount. Similarly, if the customer has the right to terminate the JV arrangement for breach, insolvency or some other specified event, it should consider whether it should also have the right to terminate the services agreement. A cross-termination right of this type may, as a general matter, not be an appropriate remedy if the customer’s equity stake is small. Depending upon the nature of the deal, the parties may conclude that the appropriate outcome should be that the relationship should not grant either party the right to terminate, on the rationale that limiting the exit rights would make the parties more committed to ensuring the success of the overall venture. This may especially be the case for true JVs. Needless to say, in negotiating these types of deals, the cross termination events will need to be handled and addressed on a case by case basis.
Exiting the deal. The parties to the transaction will also need to address the various rights and remedies that will come into play in the event of any termination. A balance will need to be struck between the interests of the service provider in retaining any assets and employees that are essential to its continued operation, with the customer’s interest in continuing to receive the benefit of, or in being able to re-create the services, post-termination. If the customer contributed most of the assets and employees to the service provider upon the creation of a new JV, a return to the customer of those same assets upon termination could call into question the continued viability of the service provider. Among other possible solutions, in the case of intangible assets, such as software and business processes, the parties could address the competing interests regarding use through joint ownership or licensing rights that would enable both parties to continue to exploit the key materials.
Non competition. In these types of hybrid transactions, the parties must address the scope — both business and geographic — of their venture and competitive restrictions. Failure to do so early on in the process will almost certainly lead to conflict and discord later on. The customer will under most circumstances want to define the scope of the services offerings of any jointly created new venture fairly broadly to maximize the business opportunities. The parties should exercise caution, however, in granting any venture a mandate that is too broad; the customer, for example, should be wary of allowing any venture the right to compete with its own business or, in some cases, deliver services to certain of its key competitors. To align the interest of the parties, the agreements should also restrict the shareholders from competing with the business of the JV and prevent the service provider or its parent from diverting business opportunities to other affiliated entities.
Damages. One of the potential conflict areas in hybrid deals is that the customer could indirectly bear the economic burden of any damage or indemnity payments made by the service provider, as a result of a possible diminution in the value of its ownership interest. The potential risk, of course, would vary depending on the relative size of the service provider and damage award. It is not always clear as a business matter that absorption of this business risk would be appropriate, especially in the case of newly formed ventures. A customer can protect itself by either having the damage payments grossed up to reflect this diminution, or otherwise being compensated for the economic loss, for example by adjusting the relative ownership stakes of the parties in the JV.
Dispute mechanisms. The parties to any hybrid transaction should have clear, consistent and predictable rules to resolve disputes over service delivery and other matters. It is simply a fact of life in these deals that disagreements, particularly over operational matters, will arise with some frequency. Whatever mechanism the parties adopt should be consistent throughout all of the JV documents; any serious dispute will likely involve issues under all of the major transaction agreements and it would be inefficient, at the very least, to resolve potentially related disputes under competing principles or in different jurisdictions.
IP ownership. An increasingly important question for hybrid and other technology deals involves the allocation of ownership in newly developed Intellectual Property (IP). In providing services to the customer, the service provider may develop software, processes or other IP that could well have commercial application beyond the customer’s own use. The parties should therefore allocate ownership, set out any royalty arrangements and address competing use rights. As discussed above, ownership of newly created IP following a termination event should also be considered by the parties.
Intercompany arrangements. Another potential conflict area in any equity-based transaction may arise if the service provider subcontracts services from its affiliates. To protect against discriminatory pricing policies, the shareholders agreement should provide that the affiliates of the service provider can only provide services on same terms and conditions as provided to its other affiliates. Similarly, the shareholders agreement should require that any services provided by the JV to the affiliates of the service provider be structured on an arms’ length basis.
Structuring the Terms of the Acquisition
Due diligence. As is the case in most corporate-acquisition transactions, a due diligence investigation of the business of the entity that will be issuing the securities, as well as its parent corporation, should be conducted. In these types of transactions, the customer should pay particular attention to the intercompany arrangements amongst the service provider’s affiliates to ensure that they are at fair market value, and do not otherwise permit the issuer to distribute value to certain shareholders or their affiliates at the expense of any other equity owner.
Acquisition agreement. The nature of the acquisition agreement for the equity interests or assets in a hybrid deal can vary greatly depending upon the percentage equity stake that the customer will be purchasing and the form of JV entity, among other matters. As a general matter, the representations and warranties provided by the selling parties have not been terribly rigorous, when compared to a stand-alone acquisitions of businesses. The parties to any hybrid deal should also ensure that the closing under each part of the transactions occur simultaneously and are linked to each other.
Shareholders Agreements
If the hybrid outsourcing deal involves the creation of a JV or investment in an existing private service provider, the parties will also need to enter into a shareholder or similar agreement establishing the ongoing governance, liquidity and other rights and obligations as equity holders. As a general principle, parties should try to achieve efficiency, responsiveness and flexibility — goals that are often competing — in the governance model.
The JV or other entity should have an ultimate decision-making body and a mechanism, preferably agreed in advance, for the governing body to resolve fundamental issues. Among other matters, the shareholders agreement should establish the time period for making decisions, the responsible parties and the consequences to the JV of the failure to reach a satisfactory resolution. There will be a tension in any JV between structuring a clear decision-making process with a relatively predictable set of rules on the one hand, and creating a process that will have a sufficient degree of flexibility and responsiveness to meet the demands of a competitive marketplace, on the other hand.
If the customer will be a minority party, which has been the case with most of the hybrid transactions to date, the customer will ordinarily want to ensure that the shareholders agreement provides it with certain control and other rights. As a general matter, minority approval rights have typically been of a limited nature in most hybrid deals to date.
Exit rights/transfer restrictions. In structuring any venture, customers should recognize that, even with the best governance procedures and other intentions, the parties may not be able to reach agreement on all issues. In the event that a disagreement arises between the parties, the customer will want to ensure that the service provider will continue to provide services under the services agreement without interruption.
In addition, a customer with a minority stake will ordinarily be concerned about its ability to exit the venture in the future, especially given that it may not be able to exert great influence over its strategic direction. The customer should therefore consider requesting securities registration rights as well as “tag-along” rights on sales to third parties. “Put” arrangements that would enable the customer to sell its equity interest to the service provider at an agreed price upon the occurrence of certain events, such as a disagreement over a fundamental issue, may also be appropriate.
In structuring the put mechanism, the parties may want to include a mechanism to value the securities of an issuer that is not public, an exercise itself that can get complicated in light of minority discounts, the lack of liquidity and the like.
While a customer that is a minority party will ordinarily want to ensure that it will have appropriate exit rights, on the flip side, it will also typically want to make certain that the service provider and its parent remains fully committed to the transaction. Most customers will therefore want to restrict the transfer of equity interests by the major shareholders of the service provider.
As the outsourcing marketplace matures, becomes more international, and covers more processes and functions, we are likely to see the continued growth of complicated hybrid deals. Structured properly, these hybrids can well serve the interests of both service providers and customers and could well be the emerging vehicle of choice for many future services transactions.
By all accounts, this trend towards hybrid deals is just in its infancy stage, and we can expect more — and more varied — transactions of this type in the near term. As spin offs continue, service providers will search for new vehicles to expand their service offerings and the private-equity funds, flush with seemingly limitless cash, will seek to repeat the success of some of the recent deals.
What are a few of the key issues and lessons learned from these transactions?
While the hybrid-type arrangements outlined above can take many forms, one aspect of the deals remains fairly consistent: A hybrid deal will layer on additional complexity to what will typically be a pretty complex business transaction in the first instance. While offering great upside potential, it cannot be overlooked that hybrids also take more time and effort to structure.
The customer will under most circumstances want to define the scope of the services offerings of any jointly created new venture fairly broadly to maximize the business opportunities.
When considering any hybrid transaction, a customer should consider two critical threshold points. First, in most deals, the services agreement should be evaluated independently of the rest of the deal and should be able to stand on its own. The value of the services agreement will typically be greater than the equity or asset piece — in both monetary terms and in terms of its criticality to the overall business objectives of the customer. As a result, if the business case for the services agreement cannot be justified, the overall transaction most likely will not make sense. What that means is that, the customer should insist that its service provider provide arms-length, market terms. As a minority owner of any newly created Joint Ventrue (JV) or other corporate entity, which has typically been the norm, the customer will not have a sufficient, or in some cases any, ability to control the quality of the services or direct those additional resources be deployed to address areas of concern if the services are not meeting acceptable standards. So, as a practical matter, the various contractual levers in the services agreement may offer the only ability to control the quality of the services.
In structuring the overall arrangement, a customer should also pay particular attention to the areas within the contractual arrangements that may generate potential conflicts between the shareholder relationship, on the one hand, and the services agreement, on the other. Some of the most important such areas are set forth below.
Termination. Perhaps the most complex issue in negotiating hybrid transactions will be the interplay of the termination rights amongst the various agreements. From the customer’s perspective, in the event the service provider commits a material breach of either the services or other material transaction documents, it will usually be the case that the customer will want the option to trigger some kind of a liquidity right in respect of its equity interests. If the services arrangement is not working, it is hard to imagine the customer remaining committed on the equity side. This liquidity right could take the form of a put of the interest at a specified price, or the automatic termination of any restrictions on transfers to third parties.
The release of transfer restrictions may not, however, as a practical matter, be of great value to a customer in the case of privately owned entities, particularly if the customer has a minority stake, as any sale of the interest could well come with a steep discount. Similarly, if the customer has the right to terminate the JV arrangement for breach, insolvency or some other specified event, it should consider whether it should also have the right to terminate the services agreement. A cross-termination right of this type may, as a general matter, not be an appropriate remedy if the customer’s equity stake is small. Depending upon the nature of the deal, the parties may conclude that the appropriate outcome should be that the relationship should not grant either party the right to terminate, on the rationale that limiting the exit rights would make the parties more committed to ensuring the success of the overall venture. This may especially be the case for true JVs. Needless to say, in negotiating these types of deals, the cross termination events will need to be handled and addressed on a case by case basis.
Exiting the deal. The parties to the transaction will also need to address the various rights and remedies that will come into play in the event of any termination. A balance will need to be struck between the interests of the service provider in retaining any assets and employees that are essential to its continued operation, with the customer’s interest in continuing to receive the benefit of, or in being able to re-create the services, post-termination. If the customer contributed most of the assets and employees to the service provider upon the creation of a new JV, a return to the customer of those same assets upon termination could call into question the continued viability of the service provider. Among other possible solutions, in the case of intangible assets, such as software and business processes, the parties could address the competing interests regarding use through joint ownership or licensing rights that would enable both parties to continue to exploit the key materials.
Non competition. In these types of hybrid transactions, the parties must address the scope — both business and geographic — of their venture and competitive restrictions. Failure to do so early on in the process will almost certainly lead to conflict and discord later on. The customer will under most circumstances want to define the scope of the services offerings of any jointly created new venture fairly broadly to maximize the business opportunities. The parties should exercise caution, however, in granting any venture a mandate that is too broad; the customer, for example, should be wary of allowing any venture the right to compete with its own business or, in some cases, deliver services to certain of its key competitors. To align the interest of the parties, the agreements should also restrict the shareholders from competing with the business of the JV and prevent the service provider or its parent from diverting business opportunities to other affiliated entities.
Damages. One of the potential conflict areas in hybrid deals is that the customer could indirectly bear the economic burden of any damage or indemnity payments made by the service provider, as a result of a possible diminution in the value of its ownership interest. The potential risk, of course, would vary depending on the relative size of the service provider and damage award. It is not always clear as a business matter that absorption of this business risk would be appropriate, especially in the case of newly formed ventures. A customer can protect itself by either having the damage payments grossed up to reflect this diminution, or otherwise being compensated for the economic loss, for example by adjusting the relative ownership stakes of the parties in the JV.
Dispute mechanisms. The parties to any hybrid transaction should have clear, consistent and predictable rules to resolve disputes over service delivery and other matters. It is simply a fact of life in these deals that disagreements, particularly over operational matters, will arise with some frequency. Whatever mechanism the parties adopt should be consistent throughout all of the JV documents; any serious dispute will likely involve issues under all of the major transaction agreements and it would be inefficient, at the very least, to resolve potentially related disputes under competing principles or in different jurisdictions.
IP ownership. An increasingly important question for hybrid and other technology deals involves the allocation of ownership in newly developed Intellectual Property (IP). In providing services to the customer, the service provider may develop software, processes or other IP that could well have commercial application beyond the customer’s own use. The parties should therefore allocate ownership, set out any royalty arrangements and address competing use rights. As discussed above, ownership of newly created IP following a termination event should also be considered by the parties.
Intercompany arrangements. Another potential conflict area in any equity-based transaction may arise if the service provider subcontracts services from its affiliates. To protect against discriminatory pricing policies, the shareholders agreement should provide that the affiliates of the service provider can only provide services on same terms and conditions as provided to its other affiliates. Similarly, the shareholders agreement should require that any services provided by the JV to the affiliates of the service provider be structured on an arms’ length basis.
Structuring the Terms of the Acquisition
Due diligence. As is the case in most corporate-acquisition transactions, a due diligence investigation of the business of the entity that will be issuing the securities, as well as its parent corporation, should be conducted. In these types of transactions, the customer should pay particular attention to the intercompany arrangements amongst the service provider’s affiliates to ensure that they are at fair market value, and do not otherwise permit the issuer to distribute value to certain shareholders or their affiliates at the expense of any other equity owner.
Acquisition agreement. The nature of the acquisition agreement for the equity interests or assets in a hybrid deal can vary greatly depending upon the percentage equity stake that the customer will be purchasing and the form of JV entity, among other matters. As a general matter, the representations and warranties provided by the selling parties have not been terribly rigorous, when compared to a stand-alone acquisitions of businesses. The parties to any hybrid deal should also ensure that the closing under each part of the transactions occur simultaneously and are linked to each other.
Shareholders Agreements
If the hybrid outsourcing deal involves the creation of a JV or investment in an existing private service provider, the parties will also need to enter into a shareholder or similar agreement establishing the ongoing governance, liquidity and other rights and obligations as equity holders. As a general principle, parties should try to achieve efficiency, responsiveness and flexibility — goals that are often competing — in the governance model.
The JV or other entity should have an ultimate decision-making body and a mechanism, preferably agreed in advance, for the governing body to resolve fundamental issues. Among other matters, the shareholders agreement should establish the time period for making decisions, the responsible parties and the consequences to the JV of the failure to reach a satisfactory resolution. There will be a tension in any JV between structuring a clear decision-making process with a relatively predictable set of rules on the one hand, and creating a process that will have a sufficient degree of flexibility and responsiveness to meet the demands of a competitive marketplace, on the other hand.
If the customer will be a minority party, which has been the case with most of the hybrid transactions to date, the customer will ordinarily want to ensure that the shareholders agreement provides it with certain control and other rights. As a general matter, minority approval rights have typically been of a limited nature in most hybrid deals to date.
Exit rights/transfer restrictions. In structuring any venture, customers should recognize that, even with the best governance procedures and other intentions, the parties may not be able to reach agreement on all issues. In the event that a disagreement arises between the parties, the customer will want to ensure that the service provider will continue to provide services under the services agreement without interruption.
In addition, a customer with a minority stake will ordinarily be concerned about its ability to exit the venture in the future, especially given that it may not be able to exert great influence over its strategic direction. The customer should therefore consider requesting securities registration rights as well as “tag-along” rights on sales to third parties. “Put” arrangements that would enable the customer to sell its equity interest to the service provider at an agreed price upon the occurrence of certain events, such as a disagreement over a fundamental issue, may also be appropriate.
In structuring the put mechanism, the parties may want to include a mechanism to value the securities of an issuer that is not public, an exercise itself that can get complicated in light of minority discounts, the lack of liquidity and the like.
While a customer that is a minority party will ordinarily want to ensure that it will have appropriate exit rights, on the flip side, it will also typically want to make certain that the service provider and its parent remains fully committed to the transaction. Most customers will therefore want to restrict the transfer of equity interests by the major shareholders of the service provider.
As the outsourcing marketplace matures, becomes more international, and covers more processes and functions, we are likely to see the continued growth of complicated hybrid deals. Structured properly, these hybrids can well serve the interests of both service providers and customers and could well be the emerging vehicle of choice for many future services transactions.
订阅：
博文 (Atom)
