Termination Clauses in IT Managed Services Contracts
Monthly recurring revenue and multi-year contracts have been the driving force behind managed services for years. They have been the basis for the tremendous growth in managed services over the years.
The length of the term of a service agreement is very important as it specifies how long the customer is going to be committed to the service.
Frequently, when on-boarding a new client, it can take many months to break even. If the customer can cancel for convenience without any liquidated damages provisions, the MSP could lose money. On the other hand, others like the fact that month-to-month contracts never create an artificial buying decision and therefore can be preferable from a business perspective.
At Scott and Scott, we recommend that IT managed service providers offer three-year term contracts to their customers at current market pricing. We suggest that MSPs offer one-year year and month-to-month options with a 20% and 25% premium over the 36 month term, respectively.
Not all agreements need to have a term.
The Master Services Agreement (MSA) can be “evergreen” meaning it has no set expiration date. It is in effect until cancelled by either party through written notice. However, the MSA is the only agreement that should executed this way. All other service attachments should be a defined term, three-year, one-year, or month-to-month. Those contracts will also have a clear commencement or effective date.
Term contracts also have a renewal date at the end of the current term. There are several ways to handle renewal. The agreement can auto-renew at the end of the term. Agreements can auto-renew on a month-to-month basis or can auto-renew for another specified amount of time, typically 1 year. It may be advantageous for the MSP to auto-renew the agreement for an additional one-year term as opposed to month-to-month. An agreement can also be set to not auto-renew. It simply expires at the end of term.
The term of the contract is one of the fundamental components of the contract.
Once the term is established, you can define the circumstances under which the client can cancel the contract for convenience or cause and whether there will be an early termination fee and how it will be calculated. This is what gives teeth to the customer’s commitment to the contract. It is very important that the contract clearly define the ramifications of an early termination both for cause and convenience.
Termination for Convenience
Termination for convenience occurs when the customer chooses to terminate the contract for reasons other than a failure on the part of the services provider. This could be due the customer hiring a resource in house, or perhaps the customer found comparable service at a lower price. The customer can serve notice within the specified cancellation timeframe, usually 60 days, and pay the early termination fee. The early termination fee is usually equal to a percentage of the fees remaining in the term. We recommend 50% of the remaining fees be paid at early termination.
Termination for Cause
Terminations can also be for cause. The grounds for cause must be defined. For example, If the MSP fails to live up to the terms of the contract through failures such as persistent failure to meet SLAs or becomes insolvent, the client can give notification of cancellation with no termination fee. However, termination for cause would not apply to a situation where the customer is simply “not happy.” It needs to be clear that a general lack of satisfaction or the availability of a lower price, does not constitute cause.
Termination clauses are contained both within the Master Services Agreement and the Managed Services Agreement Master Templates that we maintain. Our Master Services template is evergreen, it can be cancelled at any time. However, the cancellation does not become active until the end of any service period for any, then active, service attachments.
Length of Term
The length of term for service attachments and no right to cancel for convenience have an impact on the value of the MSP practice. Long term contracts along with a high customer retention rate is a formula for a highly valuable MSP practice. However, long term contracts should have pricing flexibility built in. The MSP should be able the escalate pricing during the term of the contract. Recent trends in the labor market have driven up costs for all Managed Service Providers. Traditionally, annual increases stipulated in contracts would range from 3% to 8%. Recently, we have increased our template to allow for annual increases up to 10%. Long term contracts without pricing flexibility can be a liability rather than an asset.
As Managed Service Providers negotiate contracts with perspective clients typical negotiating points will include the term of the contract, the grounds for termination with cause, the penalty for early termination for convenience, and the amount of annual escalation. Having a clearly defined contract can make the negotiation process much easier and accelerate the sale.
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