Incentivisation Methods in IT Contracts

August 31, 2001

Without incentives, we might lie in bed instead of bouncing joyfully to work. Christian Bartsch considers how best to draft a contract to include enough incentive to put the bounce into an IT project.

The main objective for an IT project, like almost any other commercial project, is to ensure that it is completed within a certain set of parameters, such as time, budget, and specification. In order to facilitate this, the parties involved may agree upon some form of incentivisation method via the contract provisions as a means of assuring the client that the supplier will utilise its ‘best efforts’ to achieve the stated goals. Of course, incentivisation methods are not solely used to ensure completion of projects. They can also be employed to differentiate the supplier in the market-place by suggesting and offering innovative ways to meet and address a client’s business needs. In today’s competitive market-place, flexibility on issues such as pricing and resourcing can be key to securing work.

This article explores and comments upon some of the more usual types of mechanisms which can be employed during the lifespan of an IT project. However, it is important to point out at the outset that the parties will need to give serious thought to the actual circumstances in which the project is being carried out, in order to determine whether a particular proposed means of incentivisation is suitable. For example, if the supplier’s role in a particular project is so small that it cannot contribute to the ‘success’ of the project in a substantive way, it may be inappropriate to agree to tie any contractual provisions to the ultimate delivery of work products over which the supplier may have no significant degree of control.

Delivery to Timetable

A supplier may be asked to provide its services within a certain timetable. Provisions can be inserted into a contract to incentivise or even require the supplier to achieve completion of the project within the envisaged time.

At the top end of the scale, delivery times could be stated to be ‘of the essence’, thus entitling the client to terminate the contract the moment the dates are missed. There then follows a ‘sliding scale’ of obligations relating to time, ranging from making deadlines contractually binding (such that missing them will be a breach of contract, but not such as to justify immediate termination of the contract), requiring the supplier to use ‘best endeavours’ to meet them, or perhaps only ‘reasonable efforts’, or finally having the supplier make no commitment as to the time of its performance at all.

There are however several downsides in using the mechanisms referred to above from the point of view of ensuring completion of the project. For example, if a supplier feels that it is being ‘bashed over the head’ with contractual wording such as ‘time being of the essence’ then it may lead to resentment or demotivation of the supplier and its personnel. Similarly, if a ‘them and us’ culture starts to develop within the project team (ie between the supplier and its client), this could actually delay the project, with the supplier ensuring that every single change to the project no matter how small is documented and every single failure of the client team is documented (increasing the cost and delay of the project through focus on its administrative side), so as to ensure that ‘blame’ for delay is not attached to the supplier.

Alternatively, a system of liquidated damages could be inserted into the contract. Such a system could, for example, oblige the supplier to pay to the client a sum of money for each day the project runs over the agreed end date. Obviously, such payments would ideally reflect a genuine pre-estimate of the likely loss to be suffered by the client in the case of such delay. If such a system was unduly penal a court could determine that the clause relating to payment of such sums was not a liquidated damages clause, but rather a penalty clause – and thus potentially unenforceable. It will equally be essential to ensure that the supplier is not penalised in respect of events beyond its reasonable control (including force majeure, defaults by the client or changes in the scope of the required services).

Sharing in the benefits which the project brings to the client

This sort of incentivisation mechanism is suitable in IT projects where there is a measurable benefit to the end client following the completion of the project. For example, one of the primary objectives of a project may be to save the client costs in a certain area (such as in its internal accounting function). Others may be more externally focused, for example generating additional revenue for the client in a certain product area. As an incentivisation method, the parties could agree to share a certain part of the savings made or new revenue created from selling additional products.

It is important to ensure that the criteria for such a mechanism are carefully documented and the impact of non-project related points taken into account. For example, where the ‘benefit’ to be shared is measured by reference to the projected increase in earnings of a particular business unit over a period of time; obviously there can be several non-project related issues which may impact upon the revenues of such a business unit and which may need to be ‘filtered out’ of any calculation, if the supplier is not to suffer by reason of events outside its control. Accordingly, such benefit-related mechanisms may be appropriate only in relatively limited circumstances, and preferably where there is some prospect of being able to at least partially ‘ring fence’ the results of the supplier’s work.

Sharing the risk in completing the scope of the project within an agreed budget

Using this model, the parties would agree a ‘target’ budget for the completion of the project. If the supplier is then able to complete its work for less than the target budget, it would receive a percentage of the savings (eg by way of a ‘bonus’ payment of, say, 50% of the difference between the targeted budget and the amounts actually billed). Where the project is completed for more than the targeted budget, then under this model the supplier would only charge a percentage of its normal charge-out rates for any services which were provided after the targeted budget had been exceeded. Obviously the clearer the scope, the more opportunity the parties will have to come to a clearer determination of exactly what the budget should be (and the parties should not proceed with such a model until such time as the scope has been agreed and clearly documented). In this sort of arrangement, failure by the client to perform its side of the bargain or factors outside the supplier’s control should also be documented and their impact on the agreed budget evaluated so as to vary the target budget accordingly.

‘Leaving it to the client to decide’ – subjective criteria

In certain cases it may be appropriate to leave the amount of incentivisation in the hands of the client only (ie using purely subjective criteria to measure the supplier’s performance). The criteria used in such models can be highly subjective, although from a supplier’s point of view there are certain words of comfort which can be built into the contract; for example, the client can undertake to exercise its judgement in ‘good faith’ and ‘acting reasonably’. This kind of incentivisation should really be operated only in circumstances where the client is a sophisticated and professional user of IT services which is interested in creating ‘partnerships’ with its suppliers, rather than a client who is naive and will see this arrangement simply as a form of discount on the supplier’s normal charge-out rates. From the supplier’s side, if such a mechanism is operated on a monthly (or other regular) basis, it can lead to potential issues and disputes being raised at an early stage, rather than leaving them to become bigger problems later on down the line. At the bidding stage, it can also show the confidence which a supplier has in its ability to deliver.

Service credits

Where the services being provided to the client are of an ongoing nature (eg a maintenance and support agreement or an outsourcing arrangement), the client will obviously be interested in obtaining an agreed level of service, which will invariably be set out in some form of service level agreement. The question then arises as to what remedy the client will have if the expected standards of service are not met (especially as the prospect of terminating what will often be a long-term arrangement will not be palatable to the client in all but the rare cases where the level of service is hitting disastrous levels). A series of ‘service credits’ may therefore be used to incentivise a supplier; if the supplier fails to deliver an agreed level of service, then the supplier can be ‘fined’ by way of imposition of service credits. Alternatively, if the client delivers a superior level of service the supplier can receive a bonus payment (although this latter form of incentivisation is not so common). Obviously, careful consideration must be given to the level at which such service credits should be set, to attempt to avoid the argument that the service credit regime is so onerous as to amount to a penalty clause.

In this type of incentivisation scenario, it is essential for the supplier to ensure that it is protected from the impact of circumstances beyond its control. The relevant provisions must be carefully drafted so as to ensure that the supplier is not deemed to be in breach of contract immediately a targeted service level is not met (although the client may wish to define a ‘threshold’ level of poor performance which, if breached, would enable it to terminate the contract). Obviously, the parties will need to determine how the ‘fines’ and ‘bonus’ are to be paid, – by way of a discount, immediate cash payment or addition to next invoice etc.


If incentivisation methods are appropriate, properly thought out and both parties ‘buy in’ to the main objective of the incentivisation method (ie to deliver the project according to agreed sets of criteria), they can be a very useful spur to the project. Incentivisation can result in both parties working in partnership to achieve the aims of the project, as opposed to working at arms length. However, badly thought-out criteria can often lead to disputes, as the meeting of minds which the parties believed they had at the beginning of the project in terms of scope, timings, responsibilities etc evaporates as soon as the project gets into difficulty and financial penalties are imposed or expected benefits are foregone, giving rise to a ‘blame’ culture, and a breakdown of communication and trust.

Christian Bartsch is a Solicitor in the IT and E-commerce Risk Group at Barlow Lyde & Gilbert.