When your outsourcer is acquired

If you asked Kevin Smith three years ago what it's like to have your outsourcer acquired by another company, he might have said, "No problem." Today, however, he's got a different tale to tell. That's because Smith, information systems director at U.S.-based Spyder Active Sports, has had the experience not once, but twice. And while the first transition couldn't have gone more smoothly, the second ended in disarray.

It all started six years ago, when the outerwear designer and manufacturer outsourced its J.D. Edwards ERP system to application service provider (ASP) Prentice Technologies. Three years later, when Prentice was bought by Fortrust Solutions, a data center management firm that wanted to move into the ASP arena, the handoff went fine. "It was all well managed," Smith says.

Then, in mid-2004, Fortrust sold its ASP business to a software-as-a-service provider in California. The transition itself went smoothly enough, but over the next year and a half, service levels dropped off, and gradually, nearly all the original Fortrust staffers left the firm, Smith says. "Several times, I asked their management, 'Are you guys serious about this line of business? Because it doesn't appear that way to me,'" he says. "On several occasions, I even offered to pay more for better service, but they never took me up on it."

With his contract up for renewal, Smith began looking for alternatives. This year, he signed on with a new outsourcer, OneNeck IT Services, with which he is currently satisfied.

Smith's dual experiences contain valuable lessons for outsourcing customers, given the consolidation activity in this arena. Outsourcers are eating up other outsourcers to increase scalability, expand global presence, take advantage of lower-cost skills and broaden service offerings, experts say.

"With increasing regulatory pressures, demand for encryption, fears of identity theft and the need for privacy, it's getting harder and harder to be a small service provider," says Dan Scheuble, president of the mortgage division at Fidelity National Information Services, a provider of information products and outsourcing services. Larger providers can leverage their investments across all of their product offerings, he explains.

And the mergers aren't just domestic. IBM, Electronic Data Systems and Accenture have acquired, partnered with or made moves to buy Indian outsourcers. And India-based companies like Wipro, Tata Consultancy Services and Mastek have bought service firms in other parts of the world.

"The race is on, and the goal is more efficient global delivery," says Paul Roehrig, an analyst at Forrester Research.

Here's what you can do now and later to minimize the pain that can occur when your outsourcer is acquired.

Play Detective

As soon as you hear rumblings that your provider is on the block, it's important to dig up as much information as you can about potential buyers.

"What customers want to hear is whether the acquirer will continue to grow the product or just wants the cash flow," Scheuble says. "They want to hear the business strategy."

This can be difficult if your provider can't or won't tell you who the potential buyers are. That's what happened to Maria Richards, director of IT at Trex, a manufacturer of alternative decking materials in the U.S.

In 2003, Richards knew that the ASP that Trex used for its ERP system was for sale, but she felt pretty secure, knowing her contract contained several protections. For instance, her provider was required to give her advance notice of a sale, and Trex could opt out of the contract in the event of an acquisition.

Richards had also stipulated that Trex's application run independently of other systems so it could be extricated if she transitioned to another provider. Finally, she had arranged a depreciation schedule for the equipment that hosted the application in case Trex needed to buy it back.

But there was one thing Richards didn't bargain on: the difficulty of doing due diligence on the buyer when you don't know who it is. "We knew they had three [companies] looking at them, but we didn't know who they were," she says. "And there was nothing in the contract that said they had to tell us."

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As a result, when the buyer was announced, there was a scramble to determine whether Trex would transfer the contract or find a new provider.

"We had to get out to their data center very quickly, hold meetings with their executives and people working on our account, check out their business plan and financials, check references -- all in a tight period of time," she says. "I would have rather had it spread out."

"It's terrible when you don't know who the acquirer will be," agrees Scheuble. "I'd be trying to figure out the likely buyer and creating contingency plans based on what I know."

Talk Early, Talk Often

An outsourcer acquisition brings FUD: fear, uncertainty and doubt. Customers may wonder whether to stick with the buyer or move to a new provider and just where they fit in the new provider's strategy.

"The level of fear and uncertainty is a huge issue," Roehrig says, "and a competitive differentiator is how the vendor manages that change."

To clarify the situation, the two parties need to talk early and often. Customers should expect open communication, visibility into strategy and financials, clear deliverables and a project plan to manage change, he says.

A common fear is that service levels won't continue to be satisfactory. But for the most part, Roehrig says, it's in the acquirer's best interest to maintain them in order to avoid breach of the contract. "The goal is to keep the customer and expand the delivery footprint," he says.

Scheuble agrees. When an acquisition occurs, "everybody's at risk," he says, "so it's important to get on the same page and identify the big issues early on. There's always a way to modify the contract so that everyone gets something they want."

The discussions should continue as the transition unfolds. At Trex, a big issue was getting a clear view of the new provider's policies and procedures, which were more formal than the previous ASP's. "They have a much more tightly defined and well-documented way of doing problem resolution and taking requests," Richards says. "There was a period of uncertainty where we had to get used to that."

As it turns out, the extra documentation is a benefit to Trex, because it helps smooth its auditing process -- a big concern, since Trex is subject to regulations such as the Sarbanes-Oxley Act.

Rein In the Staff

During an acquisition, another important issue is whether you'll be able to continue working with the staffers you've become familiar with and who have become knowledgeable about your company's needs. The good news is that in many cases, staff members get absorbed into the new entity. The bad news, however, is that the biggest changes often occur at the top of the organization, Roehrig points out. "If you're used to dealing with senior levels of the organization, you're going to have to meet new people," he says.

Smith had to get used to less-personal service when he moved from Fortrust to his new provider. With Fortrust, when there was a problem, he was accustomed to calling someone he knew by name, but with the new outsourcer, he was instructed to use an anonymous trouble-ticket system. "You ended up with a person whose capabilities you didn't know," he says. "It became more generic."

Trex was assigned a new customer manager to drive the transition, but its contract terms stated that it had to be notified in writing when there was a change in staff, which might give the outsourcer pause before making a staffing shift. "We wanted to make sure the people familiar with our environment stayed," Richards says.

Smith suggests building in a contract clause that specifies retention periods for staffers working with your application, with reduced contract payments if staffers leave sooner. "Service levels do change when people leave," he says. "Even if you end up with a better person, they still have to come up to speed."

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Manage the mOVE

Some acquisitions entail a move to a new data center, which everyone agrees is disruptive. For instance, when two major automated teller machine service providers -- Concord EFS and Star Systems -- merged and consolidated data centers in 2001, "it threw a wrench into our development plans," says John Dick, CIO at Regions Financial.

The bank wasn't involved with the heavy lifting, but it did have to do extensive end-user testing, which meant pushing other strategic projects to the back burner. The conversion also required negotiating over who paid for what and whether the bank would be compensated for its extra efforts.

"It was like any big conversion, except we weren't at the helm of it," Dick says. "We've performed a lot of mergers, so we're used to managing ourselves, but there's a level of confidence you have in yourself that you don't have in a vendor."

Scheuble suggests trying to get the vendor to time the transition to your benefit. For instance, when Spyder moved from its first ASP to Fortrust, the new provider timed the data center move to coincide with an upgrade that Spyder needed anyway, and then it ran the systems in parallel until Spyder was comfortable with the new setup.

"I was dealing with the same people, and even though the hardware had to be moved to their facility, it was well organized, so there were no problems," Smith says.

Richards also endured an interstate data center move, but the new provider maintained the existing facility for a year and a half.

The most important thing for customers of acquired outsourcers to keep in mind, Scheuble says, is that they have a lot of room to negotiate. "They have more leverage than they think," he says. "If a company just went out and paid a premium for another company, it needs to retain those customers."

Preempting problems

When should you start worrying about your outsourcer being acquired? When you draw up the initial contract. Here are some suggestions for heading off acquisition woes at deal-signing time.

- Advance Notice of a Sale

Stipulate that the customer must get advance notice of the outsourcer's acquisition or merger plans, says Neil Hirshman, a partner at Kirkland & Ellis in Chicago. This gives your company time to perform due diligence on the buyer or to review other options, such as insourcing, choosing another provider or negotiating for contract modifications.

- Exit Provisions

This is the best time to think about how you're going to end the deal, Hirshman says. "The pain one feels transitioning into these arrangements is the same as one feels getting out of them," he says. Establish how you will extricate all the things you need, including tangible assets, software licensing agreements, employee knowledge and data -- especially if you need it in a particular format. Knowledge transfer is a huge challenge, Hirshman says, because a lot of institutional knowledge is tied up with the outsourcer's employees. "You have to think about what kind of access you need to the provider's employees, for how long, which employees and what kind of documentation has to be put together," he says.

Many contracts have nonsolicitation provisions that prohibit companies from hiring the outsourcer's employees for the length of the deal, he adds, so make sure there are exceptions to those provisions. "There might be certain employees you absolutely need to bring in-house or transfer to the new provider," Hirshman says.

- Intellectual Property

Intellectual property rights can become a big issue, Hirshman says, because some outsourcers use proprietary processes. For the customer to continue operating the way it did before, it might be necessary to transfer a license from the old provider to the new one. "You'd want to negotiate access and license rights in advance, or you might have to transform your processes all over again," he says.

- Termination Rights

Include change-of-control rights, which enable the customer to terminate the contract if ownership changes hands. The terms can vary from absolute termination rights to conditional rights, such as those that would come into play if the acquirer were a competitor of yours. Some outsourcers may require a fee upon termination. In that case, ask that the fee be reduced if insufficient notice is given.

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Fight or flight

Many contracts include "change of control" provisions that release customers if an acquisition occurs. The question is whether to move away from the original provider. While some conditions are untenable -- like a defense contractor working with a U.S.-based outsourcer that gets acquired by an Indian firm -- it's often more beneficial to make the transition, says A.B. Maynard, president of Agilocity Consulting. "From a contract perspective, you want maximum flexibility," he says. "But you have to look at what you want to do from a practical standpoint."

For instance, there's often a fee involved for contract termination, even when change-of-control provisions exist, and switching suppliers can cause months of business disruption, says Paul Roehrig, an analyst at Forrester Research.

If you decide to walk away, it's likely that the vendor will help you with the handoff, says Dan Scheuble, president of the mortgage division at Fidelity National Information Services. "The market is small and getting smaller, so it's to the provider's benefit to make the conversion very smooth," he says. "Half a dozen times, we've seen customers circle back to us, and they remember we took care of them."