When outsourcing, forget software licences at your peril

Software licences are often overlooked when outsourcing business applications and processes. To avoid costly mistakes, make sure you understand your licence restrictions and the options available from your outsourcer. By Alexa Bona, Gartner analyst

The desire to reduce costs is helping to drive interest in the outsourcing of enterprise applications from vendors such as SAP, Oracle, PeopleSoft and Siebel, and in full business-process outsourcing (BPO) for finance and accounting, human-resource management and customer-relationship management.

However, amid the discussions about facilities, capital equipment and people, software is often forgotten. Millions of dollars have been saved by those organisations that think about their software options early on, and negotiate outsourcing protection in their software contracts before making outsourcing decisions.

Most software licence agreements do not include rights that cover outsourcing, and some expressly exclude it. Most contracts only give usage rights to the organisation, its subsidiaries with over 49 per cent ownership, and sometimes customers or trading partners. There is no standard right to allow outsourcers to use the software, or to transfer the licences to an outsourcer.

Organisations that wait until the outsourcing arrangement is completed before thinking about software could find that they are breaching their licence terms. To make matters worse, the software vendor’s salesperson will probably know that an outsourcing decision has been made, giving the organisation little room for manoeuvre to negotiate a reasonable deal. Some organisations have had to buy software licences again on outsourcing.

External-services providers (ESPs) and, more recently, BPO providers have begun to negotiate special licensing agreements with independent software vendors (ISVs), which can yield better prices than organisations themselves can achieve.

In the past, many software vendors were wary of BPO providers. They feared the threat to customer account control, and some saw a fall in maintenance revenue when customers outsourced and software licences were consolidated. In some regions, like Europe, moving to an outsourcer meant licences were relocated across borders and the local vendor of the original licensee experienced a loss in revenue. But more recently, ISVs have begun to accept that software outsourcing and BPO is not going away, and revenue will be lost unless they make special deals with outsourcers. At the same time, a growing number of outsourcers are recognising that writing software code is not their core business, and they often have to inherit software that organisations have developed prior to outsourcing. By negotiating special deals with these ISVs, outsourcers can lower per-unit costs for the software.

Given the exposure and the potential opportunity to save money, the important question is: Who should own and manage the software licences when outsourcing, and what are the most cost effective options?

To help decide which option is appropriate, it is useful to ask: Who do you think you will have a longer relationship with – the ISV or the outsourcer? If the answer is the ISV, then Option A is probably the best choice, because you cannot foresee uninstalling and replacing the software, even if the outsourcing relationship fails. Options B or C may be more attractive if you think that the outsourcing relationship will last longer, because leaving software outsourcing and BPO deals is difficult and expensive.

Option A: Software licences remain in-house and licensed to the organisation, but the outsourcer is allowed to use the software exclusively to process the organisation’s business

Benefits: The organisation keeps its existing agreement intact, maintains a direct relationship with the ISV, and is aware of the rights and entitlements if the outsourcing deal ends, or there are disputes between the ISV and outsourcer.

This option can be useful if future key entitlements or flexibilities are required from the ISV, as the organisation will still have a direct relationship with it. It may also be key to retaining leverage with ISVs whose portfolio includes in-house applications and processes as well as those that are outsourced. If the outsourcing arrangement ends, the licences are kept, eliminating the risk of needing to buy them again. But this approach does require that the organisation has managed to negotiate a clause that allows an outsourcer to use the licences. This clause should state that an outsourcer has the right to use some, or all of the licences, on their equipment or the organisation’s equipment, on their premises or the organisation’s premises, with their users or the organisation’s users, as long as the licences are only used on behalf of and for the benefit of the original licensee.

Although these clauses are not standard in most licence agreements (see below), some outsourcers have arranged customised deals with specific ISVs to allow this. Investigate this early.

Risks: Some major ISVs, like PeopleSoft, allow outsourcers to access licences on behalf of licensee, whereas others, such as SAP, Oracle and Siebel, don’t. Terms that allow outsourcers to have access to licences can often be negotiated at no extra cost when the licence is first acquired. It is not so easy to negotiate after an outsourcing decision has been made. For example, Gartner has seen fees for these clauses range from 10 per cent to 100 per cent of licences. There should be no fees if you are outsourcing to the software vendor’s services division.

Most business software vendors do not use metrics based on the number of central processing units (CPUs) or capacity as the main constituent of licence fees. But many integration vendors and database vendors, and some business-intelligence vendors, do. There is a further risk if there is a CPU component to the licence metric, because if the outsourced application is run on the outsourcer’s equipment (as often happens), it will often run the licences on a larger, partitioned machine. Some ISVs do not recognise physical partitioning and most don’t recognise logical partitioning, or sub-CPU partitioning. The organisation will need to pay for the entire capacity, obliterating any savings.

Organisations should try to negotiate rights to pay for only physical partitions (or logical, which is still very difficult), or make clear at the start that if the software is moved to a larger machine, to give the outsourcer better economies, the outsourcer will cover any fees.

Equally, if the software or some component application has been licensed based on business metrics (for example, annual revenue, number of sales orders processed, number of employees) it should be clear that these are being measured based on the licensee’s business, not on the outsourcer’s.

Before completing any such agreements, organisations should think about what resources will be kept in-house to manage software contracts and how they will resolve disputes between the outsourcer and the software vendor if the latter fails to deliver according to the software licence or maintenance agreements.

If an organisation thinks there won’t be enough skilled resources to manage software contracts, a practical alternative would be to assign licences to the outsourcer (Option B).

Option B: Transfer or assign licences to the outsourcer

A license assignment is similar to the approach taken by Option A, except that the outsourcer takes over the organisation’s licences and becomes the licensee. This means the software contract must include a clause that allows licences to be assigned to a third-party outsourcer exclusively for the purposes of processing your business.

Benefits: Potential cost savings, because the organisation would not have to manage licences and software vendors on a routine basis.

Risks: Organisation loses direct contact with the software vendor and may not be able to negotiate with it when the outsourcing arrangement finishes. There is also the risk that the selected outsourcer does not have as sophisticated a negotiating approach as your organisation. On balance, it is probably a risk worth taking for a BPO agreement, especially if the principles of how the outsourcer will manage the software vendor contracts are included in the outsourcing contract. This should include detailed principles and ground rules for further purchases, including standard software licence terms.

Care must be taken when preparing the assignment documents to make sure that all third-party access rights (for example, licensee’s subsidiaries and affiliates) and other special concessions are kept for the original licensee’s benefit. Provision must be made to sign the licence back for an agreed value to the original licensee, or an alternative outsourcer, on termination of the outsourcing contract. Establish the right to transfer the licence back to the organisation if the outsourcer is bankrupted, or the deal is terminated. Usually, specialised legal support is needed to help protect an organisation’s interests.

Most major ISVs do not allow licences to be transferred in their standard contracts. The right to assign software licences to an outsourcer at little or no charge can be done at the time of purchase, or at subsequent negotiating opportunities. But the ISV may charge transfer fees for this type of licence. Fees can range from zero per cent to 100 per cent of list price, but careful negotiation can reduce this to zero per cent to 50 per cent.

Option C: Use the outsourcer’s licences

Outsourcers, especially the larger ones, are increasingly negotiating for organisation licences for the most commonly used software, with substantial discounts based on their large volumes.

Benefits: Outsourcers can sometimes negotiate far better prices (for example, cost per user) than an individual organisation. But the outsourcer does not always pass on all of this discount, and sometimes the ISV prohibits them from doing so to protect licence revenue.

Risks: Most of the risks are related to licences that the organisation already has. If this is the case, they risk double-buying them.

If an organisation chooses to keep its licence entitlements to avoid the expense of re-buying them if the outsourcing relationship ends and they return to in-house processing, or move to an outsourcer that does not have the same software licence options, they will have to pay back maintenance charges to reactivate the licences. In some cases, like with SAP, a reactivation penalty is payable if organisations choose to keep licence entitlements to avoid re-buying licences.

Oracle’s policy is to re-price the maintenance on any remaining licences in line with current (usually lower) discounts. If organisations are not outsourcing all of their enterprise applications, this can add significant costs to the maintenance on the retained licences. Organisations should try to include terms that state if they use the outsourcer’s software licence, they can suspend maintenance on their perpetual licences and reinstate it later at no charge, or negotiate a reasonable charge for any upgraded functionality made available during the suspended term. The maximum should be the years in maintenance that would have been due had the licences been current.

Most organisation licences are perpetual. But if non-perpetual licences have been bought (for example, from SAS Institute or Oracle) then failure to pay monthly or annual fees will result in the complete loss of licence rights.

Organisations should investigate software-licensing issues early to avoid extra payments. Outsourcer requests for proposal should include proposal questions that clearly set out what licensing options the outsourcer has negotiated and how the pricing benefits will be passed to the organisation. Understanding these scenarios allows an organisation to negotiate from a stronger position, and helps them avoid or reduce extra software licensing costs. The bottom line is that organisations will pay a premium of between 10 per cent and 150 per cent of licence fees if they do not anticipate the potential for full or partial outsourcing when negotiating software licences, or do not include dealing with licence issues as an integral part of their outsourcing plans. Opportunities to partner with an outsourcer that can cost effectively manage an organisation’s software licence portfolio will be reduced.