The Termination Fee Trap

What is a termination fee? Simply, it is the pre-agreed fee that is paid by the buyer to the provider to prematurely terminate an outsourcing contract. There are actually several types of termination fees: termination for convenience, termination for cause, and termination for change of control (ownership). By far, the most important, and the focus of this article, is the termination for convenience fee.

Why are termination fees necessary? Providers claim the fees are necessary to recover sunk costs, reallocate resources, and to compensate them for the loss of revenue. While we agree that these claims have some validity, we believe that the primary reason providers insist on termination fees is to make changing providers difficult and to help lock the buyer in for the contract term.

The main reason to focus on termination fees is to maintain buyer flexibility. There are many reasons that a buyer may want to terminate for convenience. Some of the most common are: dissatisfaction with the provider’s performance (but not to the level of termination for cause), pricing exceeds the current market prices, merger and acquisition activity, divestiture of a business unit and major changes in business revenue.

So are termination fees a bad thing? No! Buyers want to be able to terminate the agreement at any time, for any reason without cause. Without termination fees, the buyer is committed to a multi-year contract that they cannot terminate. Unfortunately, providers will not agree to termination for convenience without a fee. That said, even the worst termination fees are significantly better than “buying out the contract.” But remember for the provider, termination fees represent a set of golden handcuffs that make termination or potentially even renegotiation very expensive.

So why then are termination fees a “trap?”

Because the amounts associated with termination of convenience almost always spring up during the last-minute negotiations. So in retrospect, they feel like a trap.

But why is this allowed?

Because, in the last-minute euphoria of getting to contract, the buyer is not really thinking about termination. The fact is, very few people enter into a “marriage” contemplating a divorce.

Interestingly, most legal counsel does consider termination conditions and termination assistance, but in most cases they leave determining the appropriateness of termination fee dollar amounts to the business buyer. From a buyer’s standpoint, the buyer enters into the contract believing the provider will deliver a solid service and the termination fees will never be paid. As a result, fees often do not receive the appropriate scrutiny.

We think this logic is interesting. Most lawyers have been schooled to pay special attention to the amounts associated with limits of liability. However, in actual practice, limits of liability rarely come into play. On the other hand, termination fees (or at least their consideration) come into play frequently. Since the buyer and their lawyers don’t give termination fees the same level of scrutiny as most contractual items, it becomes a provider strategy to provide the amounts at the last minute. This often results in needlessly high termination fees.

Part of the issue with a termination for convenience fee is that the buyer and provider have very different objectives. The buyer would like a termination for convenience fee that is zero. The provider on the other hand would like the originally planned revenue stream.

So what is the right amount? That’s a question we frequently receive, and it is a hard question to answer as a generality. Unfortunately, there is no “rule of thumb” that can be applied. We have seen termination fees vary from 3-40% of the total contract value (TCV) or even higher. Many factors come into play in determining what is a reasonable amount, including: the contract term, investments made by the provider, provider’s loss of profits, third-party commitments, notice period, dedicated asset residuals, staff reassignment, and possibly even severance cost. Assuming that none of the items in the proceeding list have a large monetary value, an amount equal to 5-10% of the TCV in year one of the contract is probably defendable. In any case, the fee should ramp down to zero by the end of the contract term and linearly in most cases. In all cases the termination fees should be prorated by year and never a step function (the same fee for an entire year).

Our best advice is for the buyer to retain an advisor who specializes in outsourcing. An advisor can review the specifics of the situation and help you determine what a reasonable termination fee is.

The bottom line is providers do many deals a year, but most buyers do a deal once every five to 10 years at most. Advisors generally do more deals in a year than the providers. Given these facts, who do you think has the natural advantage?

About the Author: John Meyerson is a senior research analyst for Alsbridge, Inc. and ProBenchmark, which supports Outsourcing Leadership. Outsourcing Leadership, , is the unbiased source for information on outsourcing, benchmarking and shared services. Find the latest news, trends and sources of research and consulting through our home page, newsletter and events.

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