The three scariest words in outsourcing

A long time ago, I used to work for a very large, very well-known business services firm. It’s still one of the best places I’ve ever worked, with some of the very best people. You’ve probably heard of them too.

I worked in this firm’s procurement services business, and established a name for myself as a procurement outsourcing expert. I made a living working with clients across a range of industry sectors and geographies, travelling the world designing procurement services solutions and business cases, and closing the contracts with the client’s lawyers and procurement teams. It was a fun job, and I was damn good at it too.

However, there was one regular topic of discussion at this firm that would always send shivers down my spine. They typically came from a senior executive fresh from a client meeting. The three words?

“Innovative commercial model”

The client ask would typically go something like this.

“We love your capabilities and your solution. But our CFO needs an ‘innovative commercial model’ in order to approve the deal”

Of course, they were talking about gain share.

Don’t get me wrong. I don’t have any inherent beef with gain share, value share, outcome-based deals or whatever we are calling this particular pricing model this week.

And to be clear on definitions, what I mean by “gain share” is a pricing model where the provider’s fees are wholly or completely dependent on the delivery of a financial business outcome to the? client. This isn’t a “fee at risk” service level model, where say 10% of the provider’s monthly charges are at risk against a bundle of service levels. This is a much riskier model for the provider, where unless they deliver a minimum level of signed-off financial benefits, they may not get paid at all.

So what’s my problem with gain share?

Three things actually:

1. Gain share is not innovative.
2. Gain share is a nightmare to manage.
3. Gain share is used by clients and providers to mask a fundamental defect in the business case.

Let me deal with the first point about innovation. I remember working on a value-based contract when I was working as a procurement manager for a large energy company. We were consolidating our construction services supply base from a series of regional panels into a sole-source “partnership” with a single provider. The core construct was that the provider would make most of their profit from ongoing cost reduction on the construction projects. This was in 1996. So this model has been around for a long time. Spoiler: my former employer and their partner flipped back to a fixed price model after a couple of years.

The second issue is the administration. Gain share creates a lot of work for the client and the provider in setting baselines, tracking benefits, getting sign-offs etc. You might think this is par for the course, especially in sourcing programs. And that’s a fair point. But what’s different about gain share is that suddenly the client has a series of weird incentives. If the provider has “100% skin in the game”, then how much “skin in the game” does the client have? What incentive do they have to deploy their stakeholders and go with the consultant’s recommendations if suddenly they have to pay your large invoice?

And here’s the other dirty little secret about gain share - it’s a nightmare for the provider’s cashflow. Most services firms pay their staff monthly. However in gain share projects, not only does the provider not get paid anything until the project completes, and then you have to wait until the benefits are signed off, and then you have to wait for your payment terms of thirty to ninety days. This puts a big strain on the working capital of the provider, who has to fund the project until the client starts paying out.

But the third issue is the most pernicious. It’s the most dangerous because it involves confronting two ugly truths about the underlying business case. Clients are keen on gain share when two conditions are met:

1. They don’t have any budget.
2. They don’t have confidence that the project or solution will deliver.

Think about it. This sounds like quite a confrontational pair of statements, but you know it’s true. If the client did have budget for the project, then surely a fixed price model would be more cost-effective? This is especially true if they had confidence in the project and the provider to deliver.

But they don’t. Probably because they’ve tried it before and failed. And how do they manage their risk? They ask the provider to consider an “innovative commercial model”, which pushes both funding and delivery risk onto the provider.

And that’s what would scare me if I was a commercial leader considering a gain share deal. Who wants to take on and fund a project where your client doesn’t have budget, and who doesn’t think it can be delivered?

If you are a provider with a genuinely unique solution, that can deliver results that the client and other providers can’t, and if you have the balance sheet to fund the project, then go ahead and give gain share a go.

But make sure you protect yourself in the deal:

1. Ensure your expected margins from on-target delivery include a premium for your delivery risk and funding costs.
2. Insist on upside, so that over-delivery (up to a reasonable cap) is rewarded with additional revenue.
3. Agree clear client dependencies. The client has to show up.
4. Make sure the accounting and sign-off processes are well-defined.
5. Insist on termination for convenience rights so you can exit the project if you conclude that the expected benefits can’t be delivered.

As a commercial professional, you should have a kitbag full of different pricing models and deal-structuring techniques to choose from. Gain share is one of them. But it brings with it a whole series of commercial challenges to manage.

And it is absolutely not innovative.