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Understanding the Legal and Strategic Issues in Entrepreneurial Outsourcing

Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP

Outsourcing has become a hot political topic as well as a strategic challenge inside the boardrooms of our nation’s early-stage and emerging growth companies. Critics are worried about job erosion and loss of tax dollars here in the United States, as leaders of companies look for ways to save costs by delegating certain business functions abroad. Although I am not very political by nature, last time I checked it was every entrepreneur’s legal and strategic right to develop strategies that will reduce costs and increase margins!

Outsourcing provides a solution to a wide variety of tasks that may not be efficient for a company to handle itself, especially an early-stage business that needs to focus on its top priorities and let others more competent than itself handle the functions for which they have greater expertise and economies of scale. Outsourcing also offers opportunities for entrepreneurial companies to be a provider of outsourcing services as a means of getting new customers and fueling business growth.

Strategic Analysis

Before turning to some of the major legal issues that must be considered in connection with the establishment of an outsourcing relationship, let’s first take a look at the major strategic issues that need to be considered. Specifically, companies should conduct an analysis of critical needs based on the answers to the following questions:

  • What are your company’s core competencies? How do you determine your internal strengths and weaknesses? What are the outsourcing trends in your industry?
  • What important and non-critical tasks and functions can be better handled elsewhere? What are the costs/benefits of trying to develop an internal capability in the area that you are considering outsourcing? Are resources even available to develop these capabilities in-house?
  • What direct and indirect cost savings can be accomplished if these tasks were to be outsourced?
  • What are the issues and risks of delegating these responsibilities to a third party?
  • What process will be developed for selecting the right outsourcing partner? What due diligence will be conducted? How and by whom? What criteria will be developed to drive the selection process?
  • To what extent will geography and logistics be important variables? Which functions may lend themselves only to local outsourcing (e.g., accounting and bookkeeping services?), domestic outsourcing (e.g., customer service call centers), or global outsourcing (e.g., writing software code)?

The answers to these questions will help you determine whether outsourcing is a beneficial option for your company and help you develop your outsourcing strategic plan. Once this analysis is complete and you have selected a critical function that makes sense to outsource, you will work with the provider and each party’s lawyers to negotiate an Outsourcing Services Agreement.

Legal Issues

There are a wide variety of complex issues to be negotiated in an Outsourcing Services Agreement, or OSA, some of which are outside the scope of this article. A few of the more critical issues include the following:

  • Clearly Define the Scope of the Assignment and Responsibilities. There is no room for ambiguity in the OSA. A common mistake occurs when the OSA is surprisingly vague as to the exact responsibilities of the outsourced services provider. This leads to confusion in the execution of important tasks, thereby leading to finger pointing by and among the parties and, worse, defeats the original objective in outsourcing the task or function in the first place. Related issues include the need to define measurable goals and benchmarks to determine the success or failure of the outsourcing and the degree to which the customer will retain control over the day-to-day functions of the services provider. In fact, the overall decision-making process should really be articulated in the OSA.
  • Length of Commitment. Do not get trapped into a long-term relationship from which it will be difficult or costly to extract your company if things are not working out. It is only natural that providers of outsourced services will tell you that they will be making a big investment upfront and that they need a long-term commitment to make the relationship worthwhile. Even in cases where this may be true, be careful. Changes in management, changes in technology, changes in the marketplace, or just plain lackluster performance may be driving a need to exit the relationship early. Try to build that flexibility into the commitment.
  • Lock Down Your Intellectual Property (IP) Rights. If the nature of the outsourced engagement has to do with the development of intellectual property, such as research and development, new product design, software programming, or related tasks, be sure that the contract clearly establishes your ownership rights. This applies to intellectual property rights at the outset of the relationship as well as anything that may be modified, developed, or improved during the course of the relationship. Be sure to include strong covenants of confidentiality and non-disclosure. Also include a statement that your IP rights will be respected and enforceable under the law, from both an IP and quality control aspect, if the service provider subcontracts its tasks and responsibilities.
  • Security and Privacy. The OSA should include provisions that address the steps and procedures that will be in place by the provider of outsourcing services to protect the security of your information technology systems as well as the privacy of your confidential customer information. If the outsourcing services provider will have direct or indirect access to sensitive (or even non-sensitive) information regarding your employees, customers, vendors, or partners, a mutually acceptable protocol for handling and processing this information must be put into place. If the data will be crossing borders and your company is based in the United States, make sure that the protocols adhere to U.S. data privacy laws.

Conclusion

Outsourcing is not a trend or a fad or a political issue that will fade away–it appears to be here to stay as a core management function. A compelling case can be made for the ability of both entrepreneurial and more established companies to transfer non-core functions to third-party service providers, or to be that service provider, in order to reduce costs and achieve better performance. Outsourcing, however, must be conducted properly and pursuant to a well-drafted Outsourcing Services Agreement.

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