There are differing opinions on the value of negotiating benchmarking rights into an IT services or outsourcing contract. This post will look at the rationale behind benchmarking, the factors that can undermine its utility and the circumstances in which benchmarking can be used effectively. The next post will provide ten tips on negotiating benchmarking clauses.
What is Benchmarking?
A benchmarking is a process through which the competitiveness of a contractual arrangement is assessed, usually by an independent third party, by comparing the arrangement to other comparable deals in the marketplace. The results of the assessment may lead to a binding requirement to make changes to the terms and conditions of the contract (typically, only changes that benefit the customer) to make the contract more competitive in the market. The processes, scope and contractual outcomes of benchmarkings vary widely.
The primary purpose of benchmarking rights is to provide deal value protection to customers. Despite whether or not they actually provide effective protection, benchmarking clauses tend to give customers comfort that they will have a market competitive deal over the life of an agreement. Technology, levels of service and prices may dramatically change during the term of a contract and a benchmarking may be the only lever a customer has to ensure it is not trapped in a non-competitive deal which is overpriced, delivers too little and jeopardizes its ability to compete.
What are the Challenges with Benchmarking?
Benchmarkings tend to be complex, expensive and resource intensive. Further, the benchmarking clause may end up being ineffective because properly comparable data is not available to make the required assessments. For a benchmarking to be useful, it must be possible to identify a sufficient number of comparable deals for which the benchmarker can obtain data in order to perform a comparison. Unfortunately, comparing deals is often difficult for a number of reasons:
- Vendors are masters at complicating their pricing and service descriptions so as to make them difficult to compare against competitors.
- There is often a limited pool of market data because most of the comparable deals are confidential or there is no mature market for the relevant service.
- Services are often customized for the customer (e.g., are dependent on unique aspects of the customer’s environment, processes and requirements).
Vendors are generally reluctant to agree to the inclusion of a benchmarking clause in an agreement and as a result, benchmarking clauses tend to be heavily negotiated.
Vendors are especially fearful of giving up control of their pricing by allowing a third party to price their services, especially given that the pricing they charge one customer may impact the pricing they provide to other customers (e.g., if bound by most favoured customer covenants).
If a vendor cannot negotiate away the inclusion of a benchmarking clause, it will often seek to restrict the comparable deals to a small pool and thus reduce the utility of the benchmarking. Other aspects of benchmarkings that are commonly contentious are:
- how often the benchmarking should occur
- who should pay for it
- who should act as the benchmarker
- the level of control over the selected benchmarker
- whether services should be benchmarked on an overall versus service category basis
- what remedies should flow if the benchmarking determines the contract is out of line with the market
When Should Benchmarking be Used?
In my view, negotiating benchmarking rights is worthwhile where the customer is captive to the vendor under a long term agreement, especially where the vendor has exclusivity rights, and there is a material risk that the pricing negotiated may not remain competitive in the market over the term.
While benchmarking rights are rarely exercised, I have found that the real value of benchmarking rights is that they can be used to leverage the negotiation of changes. Given the cost and the unpredictability of the outcome, often the threat of the exercise of a benchmarking right, is enough to incentivize the vendor to agree to contractual changes that satisfy the customer’s market-based concerns.