Strategies for Risk Sharing in Consulting Engagements

I am late is responding to a comment on this post, first in a series about Consulting Engagements. Earlier this week it was Intellectual Property, with another good comment … so, why all the harsh language about protecting IP that I probably can’t commercialize? Ah – welcome to the world of Risk Sharing.

The issue is that most businesses, especially SMBs that are simply not used to paying $200 an hour for labor, typically have a tough time wrapping their minds around a relationship that has such large invoices with no guarantee of success. It is easy for the cynical to see how a consulting firm can milk an arrangement for tons of $$ without delivering the hoped-for business benefit.

<aside> Please, no comments about the chronic lack of requirements and/or tight process. Yes, I am fully aware that many customers of professional service firms really don’t have a good idea about what they need or want, and don’t have a good understanding of the value proposition of a good consultant / developer / integrator. This is about how to bridge that gap … </aside>

First, get the fee structure in place (“not to exceed”) that will put some controls in, but give the contractor the proper trigger to control scope creep.

Next – how might we put something of interest into the agreement, that gives me, the customer, a little hedge against the risk of the unknown? This could and should work both ways – it gives the contractor a differentiating value proposition, while focusing their attention on the project, to see it though to the end.

I’ve seen a couple of different approaches …

1. Penalty / Bonus for Hitting the Date: This method will penalizes the contractor for failure to meet the time table [within it’s control], and reward them if deliverables and the work plan are met. This particular example provides a 2-to-1 incentive ratio in favor of the customer; we hold back 10% of the fees due to the contractor, and pay back the 10% plus 5% incremental upon periodic approval by a Project Steering Committee, which judges if performance is proceeding satisfactorily and on time.
2. Budget Risk Sharing: Given a project budget, the contractor agrees to a final review when work is complete. If the contractor comes in under budget, the customer agrees to pay 25% of the difference as a performance bonus. If, however, we blow the original budget, but the work needs to continue, the contractor agrees to discount their ongoing hourly fees by 25%. We can also agree to a max budget overrun beyond which no additional $$ are owed, but the work will continue until completion.
3. Gain Sharing: The typical project has a cost/benefit model that defines how long the payback is; these models are typically built with the help of the contractor. One way to keep the benefits estimates realistic would be to reward the contractor with a % of any additional savings beyond, say, 20% of the business-case estimate. Of course, could also penalize the contractor should the benefits come in less than expected.
4. IP Rights: Finally, realize the inherent value in the Intellectual Property created, and the fact that the contractor is typically (thank you Gemignani) better suited to commercialize the stuff, by granting IP rights in exchange for lower hourly rates.

Of course, all of these agreements will require lots of specific language and guidelines and limits and, above all, excellent levels of open, honest communciation through the life of the project – but hey, all that will do is foster an even better environment for a successful project!