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Keeping IT services live: sticks vs carrots?

How much risk are you prepared to take to balance the relationship with your third-party IT provider? A new study gives insights using game theory.

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“The system’s down!” Few words in today’s business world incite more frustration and despair. But even the biggest and the best technology systems crash every now and again – and it can affect hundreds, thousands, even millions of your customers. Obviously you need to get it back up as soon as possible – and that means it’s crucial to strike the right service deal with your IT provider in advance. Rather less obvious is how to get that contract to work for both of you.

Marc Jansen

Marc Jansen

“Firms who outsource their systems technology need to have a deal with the vendor that gives them a balanced co-dependent relationship in which they can share the risk,” says Cambridge Judge PhD candidate Marc Jansen. “But as one of these companies will be bigger than the other, and potentially less risk-averse than the other, it’s not a question of meeting in the middle. It’s more complicated than that.”

The art of negotiating the right deal is hot news at the moment – earlier this month Cambridge alumnus (now Harvard professor) Oliver Hart and Finnish economist Bengt Holstrom won the Nobel Prize for economics for their 30 years of research on contracts. Their studies, which the Nobel committee said had given the world “theoretical tools to analyse both financial terms as well as allocation of control rights, property rights and decision rights in contracts”, have primarily focused on deals within organisations – notably in the field of performance-related pay and how the right deals encourage executives to be innovative but not reckless. But they share Jansen’s themes of pitching risk against incentive to ensure a fair deal for all parties.

Said Hart: “Contracts are just an incredibly powerful way of thinking about parts of economics. They’re just fundamental to the whole idea that trade is a quid pro quo and that there are two sides to a transaction.”

While some organisations pay IT providers a fixed rate to buy in technology, and others ‘rent’ it with a subscription, the vast majority fall somewhere in the middle, especially if mergers and acquisitions have left a company with a hotch-potch of different historical IT contracts. And that is where understanding what is a truly fair deal becomes vital.

Using game theory, Jansen studied the effects of contracts and incentives on how organisations and their IT providers collaborate to manage the risk of system disruption. Based on his findings, he developed a model contract that employs equations to work out how much risk each company needs to take on to balance the relationship.

“Organisations are hardly ever the same size and rarely agree on how much risk to take,” he says. “Particularly in the fintech startup space, smaller firms may be providing technology to much larger organisations. Or it may be that a small startup is using, say, a giant like IBM to look after its systems. This imbalance means the two parties have different risk preferences. One can soak up risk far more readily than the other, so meeting in the middle will not make for an equal relationship. It’s got to be in both companies’ interest to keep that IT system up and running.”

So how can firms create an equal relationship? “By getting round the table,” says Jansen. “They need to discuss relative risk preferences – which can be complex as many organisations will not want to share particular facts or figures about how their business runs. But they need to say to each other: ‘Where do we sit with the current contract? Have we had problems? Can we increase or reduce the penalties for system failures and the time taken to address it? These questions will show if the collaboration is working and worthwhile.”

Of course this means one of the companies giving ground to the other. But, says Jansen: “The provider could do that by, say, committing more engineers – or if the client is bigger, it could make concessions, which will in turn make the vendor more inclined to solve the problem quicker.”

Some industries do already operate seemingly unequal contracts that, on closer inspection, are fairer than if both sides shared the risk equally. Car insurance firms, for instance, impose excess charges to get drivers to take some responsibility for the risk – if the insurer covered all the cost every time, with no penalty of increased premiums, human nature would inevitably over time encourage us to be less careful.

Jansen is keen for more organisations to use his findings to examine their own contracts, particularly with technology providers, explore the risk to both sides and strike a genuinely fair and balanced deal. “Just because one side does appear to be conceding ground to the other does not weaken its position, or make the other party’s position stronger,” he says. “In reality, a fairer deal for both parties makes the contract stronger for everyone.”

And by doing so, the agreement gives organisations an IT contract, and a system, to swear by – rather than at.