The long-term trend in the economy toward service and service related businesses is not likely to change anytime soon. Service contracts obligate one party to provide future work to another party for a price. The risk on both sides of the contract is significant. Careful management of service contracts protects you from financial harm.
There are three strategies to ensure a successful service contract:
It is important to distinguish between types of service contracts. There is a class of service contracts sold to consumers as part of product purchases, such as extended warranties. These types of service contracts are regulated by Federal and state agencies. This article focuses on business-to-business contracts.
B2B service contracts are critical to the operation of the business. Whether you provide service as part of your business or purchase services to deliver your products, Service contracts can make you more efficient and profitable when they are well-managed.
Service contracts often try to balance the need for predictability and flexibility. At the start of any project based Service agreement, the customer is uncertain about the details of the work. The service provider may also be uncertain about the amount of time and effort required to complete the project, even when the customer is reasonably specific.
Both parties would like to know precisely how much time and effort will be required. At the same time, both parties know that service requests change over the course of a project and things happen for the service provider. A rigid service contract prevents the necessary flexibility; a vague agreement opens the door to excessive overruns.
To address this tension between predictable work and flexible requirements, contracts often include one or more statements of work (SOW). The agreement is structured as an umbrella of legal terms that govern the relationship between the two parties. However, the details about the work to be performed move from the main agreement to an exhibit or schedule.
Separating the terms of the work from the legal terms of the relationship has several benefits. First, the parties can carve up the project into different segments each with their own statement of work without renegotiating the underlying agreement.
Second, this approach allows the business people to sort out the details of the work without requiring deep engagement with legal counsel, who can focus on the terms of the umbrella agreement.
Third, the separate SOW approach allows the parties to agree to the future work, not originally contemplated, without negotiating a new contract. They can simply add a new SOW as a schedule to the original agreement.
The contract risk from SOWs stems from poor contract management. Some problems arise just from document management failures. For example, SOWs executed long after the original agreement are often stored separately and lost. With a change in Kermit personnel or business managers responsible for the contract, this problem occurs every day in businesses in every industry.
Keep all schedules, exhibits, and amendments to a contract with the original agreement.
The second type of contract risk is more important. It is substantive. It is easy for one or both parties to lose sight of details of the SOW that affect the financial benefits of the overall contract.
There are a few things to look for in a statement of work from a contract management perspective:
This is obviously not an exhaustive list. The type of service, industry, business, and legal advice will all shape what you need to look for in a statement of work. To manage a service contract successfully, however, these three principles are common to SOWs.
The unexpected happens. Lawyers draft contracts to provide for the unexpected. One of the most reliable ways to “expect the unexpected” is to require that the service provider purchase insurance that covers some risks.
One simple technique for insurance provisions is to require the service provider to maintain insurance with certain characteristics and then include a representation from the provider that it has the requisite insurance.
You will only learn if that representation is true or not when there is an event and you want to make a claim against the provider’s policy. If it turns out there is no insurance or inadequate insurance, then you might have a claim for breach of contract. The point, however, of requiring insurance in the first place is to give you someone other than the provider to pursue.
To manage this risk, a service contract could obligate the provider to deliver evidence of the insurance policy in the form of a Certificate of Insurance (COI). There are many types of insurance and a COI for each. Three common types include:
A certificate of insurance provides important information about the coverage and limits of the policy in question. For contract management purposes, it also includes the term of the insurance. This data point is critical for managing contract risk from service contracts.
Schedule automatic alerts for certificates of insurance to manage contract risk.
The insurance policy expires on a completely different cycle than the service contract. The purchaser of the services should receive the COI as part of the contract execution. That COI might say the policy expires in 30 days or 9 months. It is imperative that you capture that expiration date and schedule a reminder. The agreement obligates the provider to keep insurance current during the term of the contract, but you need to verify that fact by requesting an updated COI each time they expire.
Auto-renewing contracts are the bane of every contract manager. Even in companies that have a policy of not agreeing to auto-renewal provisions, they still creep into the contract portfolio. Auto-renewal provisions pose financial risk for both the service provider and the business customer.
Auto-renewal provisions usually say that the contract will renew at the end of the term unless one party sends notice to terminate by a certain date.
Parties to service contracts are particularly sensitive to auto-renewals because human capital is involved. While recurring revenue stabilizes a business, a provider might find that the terms of the contract impose unexpected costs such that they cannot continue providing profitable services on the current terms.
On the other side of the contract, business purchasing services might not be satisfied with the quality or price of the services. While not a breach of contract, letting a contract renew potentially locks the parties into the terms of the agreement for at least another period.
Auto-renewals are structured in a variety of ways:
Your contract management software should notify you of the expiration and each renewal. The automatic renewal should roll forward when the expiration date for the contract expires.
As important as service contracts are, they pose contract management challenges. Effective service contract management requires that you track Statements of Work, Certificates of Insurance, and Auto-Renewal provisions.