Contract Corner 10: Performance 'Incentives' to Consider When Structuring Your System Development or Implementation Contract

Morgan Lewis
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Morgan Lewis

We have all heard the horror stories: system implementation deals costing 300% more than the original budget, go-live dates for development projects being way past the scheduled dates, and deliverables that do not meet the customer’s expectations. These are the stories that keep us lawyers up at night. So what can we do in the contract to incent timely, on-budget performance by the vendor? First, there is no substitute for a detailed and well-thought-out requirements document, which provides the roadmap that shapes the design, build, and deployment. Then, while there is no magic bullet, there are numerous contractual mechanisms to be considered that are designed to provide guideposts and checkpoints to enable success.

Set out below are 10 contractual mechanisms for providing meaningful performance commitments and consequences if the commitments are not met. Maybe you will not need to invoke these mechanisms, but having firm rules may help drive good behavior (you know the old adage, “good fences make good neighbors”). As is always the case, the appropriate mechanisms to be used are deal specific, and not all deals or relationships require the full spectrum of contractual commitments set out below (but some do!).

  1. Payment Structure: Perhaps more than anything, money drives behavior. So it follows that the release of money can be used to incent timely performance. There are a variety of options for how to structure payment, all of which can be tied to the completion of milestones, such as fixed fee, not-to-exceed, and time and materials with a band.
  2. Commitment to Design and Total Cost of Ownership (TCO): We have seen development activities come in at or about budget, but then the TCO ends up being far greater than anticipated. It is helpful to consider the all-in cost—hardware, capacity, third-party software, and ongoing upkeep—when establishing the overall budget for a project. You may want to think about building a requirement into the design phase that the TCO be assessed and calculated, and if the TCO ends up being over what was anticipated (maybe by a range) then the vendor should have skin in the game with respect to (or at least a share in) the overage.
  3. Milestones, Amounts at Risk, and Milestone Credits: Creating project plans and timelines based on milestones can help provide structure to what can otherwise be an unwieldy process. For the naysayers, even agile deals can have milestones and deliverables tied to milestones. Once milestones are established, an effective “incentive” is to apply credits payable to the customer if a milestone is not achieved on time. In most cases, there is an agreement to the total amount at risk for milestone credits (often a percent of the total transaction, with the greatest credits tied to final go-live and stabilization).
  4. Enhanced Credits for Extended Misses: Another tool in the toolbox for creating incentives is to have a mechanism for increasing milestone credits if a milestone is missed for excessive periods (e.g., if the date is missed then the credit is applicable; if it is still not achieved in 30 days, then another credit equal to 1.XXX% of the applicable credit is due; and so on). This structure addresses the concern that once a milestone credit is applied, there will be no urgency in completing the milestone.
  5. Holdback: Sometimes in addition to, and sometimes in lieu of, milestone credits, a percentage of the fees can be held back, to be paid upon the completion of the project. If the project is late, you may want to consider decreasing the amount of the holdback fees actually paid.
  6. Reimbursement for Retained Costs: Often the customer’s business case assumes that certain legacy systems and supporting infrastructure can be decommissioned (and no longer paid for) as of a point in time, such as the final go-live date or an interim milestone. If the go-live date is delayed, then the customer will continue to incur these costs. A provision requiring the vendor to reimburse the customer for such costs is another incentive mechanism that can be considered. While these costs are arguably direct damages that are recoverable in any event, calling them out specifically may highlight the potential liability of the vendor if go-live is not achieved on time.
  7. Right to Pursue Damages: Unless there is an excusing event, failing to achieve milestones on time is likely a breach of the agreement. Damages (at least direct damages) incurred in connection with a breach should be recoverable under the liability clauses of the agreement. It will be important to assess whether any caps are sufficient to allow for recovery of the likely damages that the customer could incur.
  8. Right to Put Project on Hold: If activities and deliverables are not progressing well or in accordance with the agreed timeline, then the customer may want to consider the right to put the project on hold—and without penalty—until the vendor provides the appropriate assurances (such as more qualified staffing) that the project is back on track.
  9. Step-in Rights: If the vendor is not performing in accordance with the agreement, another option may be for the customer or its designated third party to step in and take over the project or a portion of the project. Step-in rights may allow for a temporary boost to the project to ensure that it is progressing successfully.
  10. Termination and Repayment Remedies: The ultimate stick in a development contract may be the right to get out of the deal. Termination rights to consider include termination for convenience, for material breach, for repetitive breaches, for missed milestones, and for changes beyond the customer’s control. If termination is invoked, the customer may want to consider under what circumstances the vendor should be required to pay back any amounts paid by the customer. The repayment requirement may depend on whether there is any reuse value in any of the deliverables provided as of the termination.

While the above mechanisms are among the most effective ways to incent performance that we have seen, there are derivations of these and other innovative approaches that can be used to achieve similar goals. There also are instances when the real stick is a carrot—but that topic is for another post!

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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