SIDEBAR: Risk/Reward Contracts: Laying the Foundations
By Bart PerkinsUnder the right circumstances, risk/reward contracts can provide significant benefits to both buyers and sellers. Because these contracts withhold a significant percentage of the fees until the project is successfully completed, they offer a way to share both risks and rewards with your supplier. Risk/reward contracts are more complex to negotiate and manage, however, and require careful consideration. Here are some steps you can take to minimize difficulties.
Determine whether you have a good candidate for a risk/reward contract. Do this before you pursue contract negotiations. Risk/reward contracts work best with:
• High-risk projects with significant business benefits. Use risk/reward only when the potential benefits warrant the additional effort.
• Established suppliers. Because of the complexity of these contracts, you will do better if you select a supplier with an excellent track record, preferably one you already have a strong relationship with.
• Companies with strong internal relationships. Risk/reward contracts require significant internal cooperation and work best in companies where legal, finance and HR departments already have a strong working relationship with IT.
Use clear metrics. The success of your risk/reward contract will depend on it. These measures form the basis for determining whether additional financial payments are warranted. They are particularly necessary in multiyear contracts, where management changes are almost sure to occur. Having clear metrics can help you avoid being at the mercy of widely differing interpretations of whether success has been achieved.
• Choose metrics that reward specific behaviour. For example, metrics for a new application might specify an average response time of two seconds. If you want to eliminate large deviations in response times, add a related metric specifying that 95 percent of the transactions will take place within one to three seconds.
• Develop metrics to eliminate arguments with suppliers regarding whether their incentive payments should be made. Clear metrics remove ambiguity. Imprecise measures are often subject to debate.
• Design metrics carefully. Poorly designed or insufficient measures may result in unintended consequences or give suppliers the ability to play games with the numbers. One company tried to motivate data entry operators by paying a bonus for more than a certain number of keystrokes per hour. The operators soon learned they could "increase productivity" by repeatedly tapping a single key.
Define counterbalancing measures of success. Make sure that your metrics take into account and accurately reflect multiple goals. For example, if the only measure of success is response time, a systems integrator might require faster processors and higher bandwidth, thereby making the ongoing operating costs higher than they should be.
Get interdepartmental support early.
• Finance. Since benefits often accrue over several budget years, the finance staff will need to accept multiyear "at risk" accruals that represent contingent liabilities on the balance sheet (that is, payments you will make only if the vendor performs well). In some cases, it may take several years to construct and install a new system and start reaping the benefits. Finance will need to accrue potential additional payments as soon as the endeavour starts, rather than waiting until the end and being surprised by the total fees.
• Legal. In addition to normal contract terms, you will need to negotiate special situations. For example, if your risk/reward endeavour is cancelled through no fault of the supplier (for example, your company is acquired and the new owner decides to shut down the project), the supplier will want to be paid some portion of the potential additional fees it might have received at normal project completion.
• HR. Some internal incentive programs may need to be adjusted. Suppose, for example, you construct a joint project team in which everyone works hard to deliver the project early. If the systems integrator's staff gets a bonus and your HR policies forbid you to pay a bonus to your staff, that could create resentment.
Risk/reward contracts require more preparation, precision and cooperation. But when they are used appropriately, they motivate suppliers to deliver successfully. This leverage serves as an insurance policy against failure and provides incentives for joint success.
Bart Perkins is the managing partner at US-based Leverage Partners, which helps CIOs manage their IT suppliers. He was CIO at Tricon Global Restaurants and Dole Food
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