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1 Number 833 March 16, 2009 Client Alert Latham & Watkins Corporate Department Contracting Models for Systems Integration Projects to Meet the Challenges of ehealth A careful selection of the contracting model is a key aspect of a considered approach to a systems integration project that can help providers and payors meet the challenges of the ehealth initiative. Introduction The health provisions of the American Recovery and Reinvestment Act of 2009 focus on leveraging the capabilities of computer data sharing to improve health care outcomes and reduce costs (referred to in this Client Alert as ehealth ). In many cases, in order to be able to share data to the extent contemplated by the ehealth initiative, heath care providers and payors will have to implement and integrate new software systems and hardware. While some of the specific applications envisioned under the ehealth initiative may be new, complex implementation projects like these are not, and neither are the attendant challenges organizations often face in selecting and implementing the right system for the job. In choosing a solution, an organization must select both (1) a software package and (2) an implementation approach. Both are critical decisions. Sometimes a client chooses its internal IT team to implement a solution. Often, however, the solution will effect such widespread change across the client s varying business functions that a client requires outside expertise. In this case, an IT consulting firm is brought in to advise on and implement a system. This is likely to be the approach for clients addressing the more aggressive ehealth objectives. When engaging an IT consulting firm, a client has its choice among various contracting models. We often find that the client s selection of the most appropriate contracting model for its circumstances has a significant impact on the success of the systems integration project. In this Client Alert, we summarize alternative contracting models that we believe help our clients obtain the benefit of their systems integration projects while mitigating many of the risks inherent in such projects. We do this by first summarizing the two standard approaches to contracting for such projects the consulting model and the turnkey model and their attendant strengths and weaknesses. We then describe three alternative models that we believe deliver many of benefits of each standard model while avoiding the uncertainties of the consulting model and much of the risk premium and other costs associated with the turnkey approach. Traditional Contracting Models Consulting Model The consulting model is the typical time-and-materials contract with an outside IT consulting firm. Clients find the consulting model attractive Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2009 Latham & Watkins. All Rights Reserved.

2 if they want to retain full control over the project, including the flexibility to make major changes easily during the course of the project, and if they want internal personnel deeply involved in the technical aspects of the project. The consulting model lends itself to the participation of these internal resources, allowing the client, at least to some extent, to: (a) attain economies (client personnel generally cost less than provider personnel), (b) take advantage of its employees knowledge of the client s business and legacy systems, (c) improve employee morale (personnel enjoy the challenge and appreciate the experience), (d) ensure skills transfer (which can be very important if client personnel are to be in a position to support the new system after implementation), (e) avoid fixed-price risk premiums, and (f) retain control of the project. Finally, clients find the consulting model attractive because it does not require the client to describe its business requirements, including its to be business processes, before contract execution. Most clients electing the consulting model do so to avoid paying risk premiums and take advantage of this flexibility. There are, however, significant disadvantages to the consulting model. First, if the parties fail to detail in full the client s requirements before contract execution, the parties typically fail to achieve a real meeting of the minds regarding the system s ultimate functionality, the provider s full role, and the project s ultimate true cost. Second, because the provider is only responsible for its own output, and because the consulting model typically includes joint deliverables, the provider bears little accountability and project risk. Third, because charges are on a pure time-and-materials basis, the provider has little incentive to be efficient. Simply put, clients often find consulting model projects very difficult to manage, significantly over budget or lacking in functionality, and behind schedule. Delays and deficiencies in functionality can put a client s business seriously at risk. Turnkey Model In contrast to the consulting model, with the turnkey model the provider promises to deliver a working solution at a set time and place on a fixed-price basis. In this model, the provider is accountable for the cost and success of the project and acts more as a vendor than as a traditional consultant. For a provider to contract on a turnkey basis, however, the client must fully disclose and define its business requirements and system functionality in advance of contract pricing and execution. The turnkey model has two significant advantages over the consulting model. First, with the necessary pre-contract diligence, the client and provider are more likely to experience a true meeting of the minds and are therefore less likely to have serious disputes after contract execution. Second, the pricing structure used in the turnkey model gives the provider significant incentive to be efficient and allows the client to predict and control its costs to a greater extent than if the consulting model were employed. There are, however, significant disadvantages to the turnkey model. First, it takes a great deal of time and effort for a client to define in full both its business requirements and the new system functionality before contract execution. Many clients simply are not in a position to allow the contracting process to drive the timing of their business decisions. Second, providers charge premiums to account for the risk they assume the less detailed and precise the requirements definition, the higher the risk premiums. If the requirements definition is insufficiently detailed or precise (as is often the case when a client is preparing it without the 2 Number 833 March 16, 2009

3 benefit of the provider s expertise), the provider may rely on the inadequate requirements definition to justify a higher risk premium. Third, because a provider working on a fixed-price basis needs to manage its risk by controlling the work, it can be difficult to provide for substantial use of the client s own personnel. For all these reasons, the negotiation of a turnkey contract can be difficult and time consuming. Alternatives to the Traditional Models In some cases it is possible to structure an arrangement that provides many of the benefits of both the consulting and turnkey models without being exposed to all of the disadvantages of either model. These alternative models can provide: (a) the economies and opportunities for skill transfer that come from the use of the client s own people to perform some of the work (consulting model), (b) the retention of a fair degree of project control and flexibility (consulting model), (c) a meaningful degree of provider accountability for the work product (turnkey model), and (d) some ability to manage and control project costs (turnkey model). In fact, there are a range of contract models that can be employed to achieve these objectives. We describe three significant alternative models here. Major Milestone/Holdback Approach The major milestone/holdback approach is a form of modified time-and-materials contracting. Using this approach, the client and provider structure the contract around a series of major milestones for the project. The contract allocates an overall budget estimate for the project among the major milestones. The client pays on a time-and-materials basis upon completion of each major milestone, but may hold back a significant portion (for example, 50 percent) of any fees that represent hours or costs in excess of the milestone s budgeted estimate. The provider can recapture a portion of any holdback prior to the project s conclusion to the extent that its efforts for subsequent milestones come in below the milestone s estimated budget. At the end of the project, the client and provider assess the total fees as compared to the initial estimate, and any fees in excess of the initial estimate are discounted at a rate roughly equal to the provider s margin (for example, 20 percent). Similar holdback provisions may be employed with respect to the project s schedule. The holdback structure creates significant incentives for the provider to perform within the initial estimate and schedule for each milestone, despite the time-and-materials nature of the contract. With the ability to earn back any holdback by performing under budget or to make up lost time in subsequent milestones, the provider remains invested in bringing the project in under budget and on time. The client can therefore benefit from many of the consulting model s advantages while reducing its risks of significant cost and schedule overruns. Like other modified time-and-materials approaches to contracting, some of the risk of cost and schedule overruns shifts to the provider in the major milestone/ holdback approach. To compensate for this risk, providers typically provide higher estimates (or longer project schedules) to cushion any potential overruns, although the risk premiums sought are often significantly less than under the turnkey model. However, clients can mitigate the potential for excessive risk premiums by using a competitive procurement process and providing the prospective consultants a reasonable period to perform due diligence before submitting final bids. Although it is often challenging to schedule the time for due diligence and competitive procurement into 3 Number 833 March 16, 2009

4 the process, the due diligence reduces the consultant s perceived risk and associated premiums, while the competitive procurement drives such premiums down even further. In our experience, competition often remains the client s best cost control strategy. As an added and sometimes significant benefit we also find that projects that are properly diligenced and competitively procured can proceed quickly through the actual contracting process, compensating for the time spent on such pre-contract efforts. Staged Approach If the major milestone/holdback approach is a modified time-andmaterials model, the staged approach is a modified fixed-price model. Under the staged approach, the provider performs the work in a series of stages: (1) the due diligence stage, (2) the requirements and planning stage, (3) the functional design stage, and (4) the operational delivery stage. During the due diligence stage, the provider studies the client s business operations and needs to be met by the project. In the requirements and planning stage, the provider develops robust business requirements, recommends software if the client has not already designated a solution, and develops a detailed project plan. During the functional design stage, the provider develops detailed functional requirements, performs a gap analysis between the required functionality and the functionality of the packaged solution, and establishes a baseline design for the system. Finally, the provider develops, implements, tests, and delivers the system in the operational delivery stage. The client and provider enter into a contract before the formal due diligence stage and agree to an estimated price that is included in the contract. At the end of each stage, the parties agree to a revised price for each subsequent stage and for the project as a whole, with the increases for both the stage prices and the price for the project as a whole limited to a set percentage. The price agreed to at the end of the functional design stage, however, is a firm, fixed price for which the provider must complete the operational delivery stage without adjustment. Related contract rules require the parties to consider both increases and decreases in scope during each re-pricing. Incomplete diligence and scope creep during the requirements definition and design stages are the key components underlying the risk premiums providers build into traditional fixed-price contracts. By permitting adjustments to the price as the project becomes more fully defined, the staged approach reduces both the risk the provider will have to assume and the corresponding risk premiums. Because the contract rules restrict why and how the estimated price may change, however, the client retains much of the cost control benefits of fixed-price contracting while avoiding the often significant risk premiums that the traditional turnkey model usually entails. Mixed Approach For clients with longer lead times for their projects, the mixed approach is often the most attractive contracting model. This approach divides the project into two sequential stages and involves separate contracts for each stage. During the first stage, the client retains a provider using the consulting model to work with the client to prepare a project plan, define the client s business and functional requirements, and perform a gap analysis between the revised functionality and the functionality in any commercial software packages the client may be considering. Only once this work is complete does the client contract for the actual implementation of the solution. The two agreements may, or may not be, with the same consultants. 4 Number 833 March 16, 2009

5 Dividing the project into two, sequential stages with a separate contract for each may produce meaningful cost savings over the course of the entire project when compared to the standard models and mitigate much of the project risk for both parties. The work product from the project definition stage should enable the provider (either the incumbent or the winner of a competitive procurement) to reduce significantly its risk premium normally included in fixed-price, modified fixed-price, and modified timeand-materials transactions. Moreover, the work product prepared during the project definition stage puts the client in an excellent position to seek competitive bids for the second contract, a preferred approach that typically produces better pricing and more favorable risk allocation than a sole source procurement. The mixed approach requires the most advance planning by the client of any of the models we ve discussed here. The client must build its procurement model and timeline around the key elements of the mixed approach. The client must have sufficient time for the provider to execute the first stage in full or run the risk that an inadequate requirements definition precludes prospective implementation stage providers from discounting their risk premiums. The client must allow sufficient time between the first stage and the second stage for a competitive procurement for the second stage or run the risk of paying too much for the second stage. This model can produce a better product at a lower overall price, however, than any of the other approaches discussed in this Client Alert. Conclusion A careful selection of the contracting model is a key aspect of a considered approach to a systems integration project that can help providers and payors meet the challenges of the ehealth initiative. Like any significant endeavor, however, a good result requires not only good planning, but good execution. Experienced outsourcing counsel from Latham & Wakins can assist clients in identifying the contracting approach that will be best suited to their circumstances and provide strategic advice throughout the contracting and implementation process. 5 Number 833 March 16, 2009

6 If you have any questions about this Client Alert, please contact one of the authors listed below: Kevin C. Boyle Allen J. Klein Stephanie A. Roy Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. Abu Dhabi London Paris Barcelona Los Angeles Rome Brussels Madrid San Diego Office locations: Abu Dhabi Barcelona Brussels Chicago Doha Dubai Frankfurt Hamburg Hong Kong London Los Angeles Madrid Milan Moscow Munich New Jersey New York Northern Virginia Orange County Paris Rome San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Chicago Doha Dubai Frankfurt Hamburg Hong Kong Milan Moscow Munich New Jersey New York Northern Virginia Orange County San Francisco Shanghai Silicon Valley Singapore Tokyo Number 833 March 16, 2009