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When the Red Gorilla Internet site went blank in mid-October, its customers were stunned. They had no idea the time-tracking and billing service was in financial trouble and had no way to access the data they had stored there. Two weeks later, the site was back up, courtesy of OfficeTool.com, a virtual office ASP that purchased the Red Gorilla moniker and application from its founder. But the reprieve was short-lived. Last month, Red Gorilla announced it was going under again, this time for good. Customers now have the option of transferring to yet another time and billing application, run by Elite.com, before the Feb. 28 shutdown date.
This harrowing roller-coaster ride is symptomatic of the turmoil affecting many e-service providers, including ASPs, ISPs and Web integrators. Over the past few months, several ASPs have folded or have begun making preparations to fold—among them are Pandesic, a joint venture of Intel and SAP; and HotOffice.com, a five-year-old virtual office provider. Those are hardly fly-by-night providers.
Meanwhile, at least four ISPs have filed for Chapter 11 bankruptcy protection: Flashcom Communications, Zyan Communications, Relay Point and FastPoint. All are partners of DSL provider Covad Communications, which is still waiting for back payments from those companies.
And, finally, theres the plight of specialty Web consultancies, which has already been well-documented in the pages of Sm@rt Partner. Although no major integrator has gone out of business yet, many are knocking on deaths door.
Vendor business failures and reorganizations can be disastrous for customers, robbing them of key data and applications, and causing severe losses in time and money. Clients of Red Gorilla, for example, couldnt post their time and expenses—or invoice clients—for two weeks in October. And business users of DSL provider Rhythms, using Flashcom as their ISP, had to scramble to find another ISP because Flashcom suspended their service.
Partners also face disruptions when a company goes under or cuts back services, and that, too, can adversely affect customer service. Covad, for example, had to revise its Q3 revenues downward, due to its deadbeat ISP partners. Covad also created a special “Safety Net” program, allowing customers of those ISPs to switch to another provider or remain with Covad.net without any disruption in service, all the while waiting for bankruptcy court to distribute the money it is owed by those ISPs.
How can customers and partners protect themselves from such problems, which are likely to spread if the public market continues to lag? A white knight could help, of course. OfficeTool.com initially played that role for clients of Red Gorilla, and Intranets.com did the same for clients and partners of HotOffice.com. In both cases, the company coming in paid the one that was on its way out, and no customer data was transferred until after the customer had signed up with the new service.
But as a customer or partner, you cant depend on fairytale endings, so your best bet is to take some preventive measures. Monitor your service vendors and partners very closely and maintain a strong defense in case any of those relationships sour.
Focus on Financials The first step toward insuring your business is to choose your allies carefully.
“Were very selective in how we pick our partners, especially when we rely on them for a net revenue source rather than getting paid through a third party,” notes Jodi Maxson, VP of sales and business development for NetLedger, an accounting, payroll and e-services ASP. “We look at their financials, product, user base, bankers and anything else we need for our due diligence.”
Rick Faulk, VP of marketing at Intranets.com, focuses on how much cash a partner has on hand. “Do they have enough money in the bank to be here for the long term, and what is the pedigree of the investors?” Faulk also has begun examining the pedigree of his partners clients, a necessity driven home by the ongoing dot-com fallout.
Customers should apply the same due diligence in choosing their vendors, adds Bob Zahler, a Washington, D.C.-based attorney who specializes in negotiating IT services contracts.
Such due diligence should include a study of a vendors financials, to make sure it collects enough revenues and has enough cash on hand—and a low enough burn rate—to remain in business for at least as long as the contract lasts. Also, examine the vendors funding sources and watch for stock sales by insiders.
“Customers are looking at financials closer than ever, asking themselves if they want to do business with these companies,” says Dave Boulanger, service director at AMR Research, about ASP clients. “They are looking to see if there is a profitability model.”
Once youve received income statements and balance sheets, ask your vendor or partner for monthly accounting reports, in addition to regular quarterly reports. Publicly held companies must report on a quarterly basis; private companies dont have to report at all. Still, you can request their financial reports and, at least, read their Dun & Bradstreet credit profiles.
“Build in an early-warning system,” counsels Dan Mummery, an attorney at Milbank, Tweed, Hadley & McCloy, who represents Fortune 2000 customers on large outsourcing deals. Have your vendors provide advance notification of financial problems, and include in your contracts a right-to-terminate if the vendors financial condition severely deteriorates, suggests Mummery.
Is the Model Sound? After a thorough review of the financials, consider whether a vendor or partner has a viable business model. Clearly, poor business models have contributed to the recent failures of some ASPs and ISPs.
One popular model, for example, had companies giving away services for free in the hopes that paid-for premium services and advertisements would more than make up for the shortfall. They didnt, of course. There werent enough ads or paying customers to foot the bill.
“The Internet model is dead,” says Mickey Freeman, former senior VP of the now defunct HotOffice.com “You cant just generate value by bringing people to your Web site.”
Other ASP models also have backfired. Pandesic, for example, skimmed 1 percent to 6 percent off the top of what customers earned on their Pandesic-hosted Web sites. This payment structure turned off potential clients, and those that did sign up didnt generate enough online business to fill Pandesics coffers.
Some customers may have thought that Pandesic would succeed anyway because of the deep pockets behind it, but that was a faulty assumption.
“Corporations set up joint ventures to insulate themselves,” says Zahler. He advises customers to ask about a vendors corporate structure and find out exactly who is responsible in the event of a contractual dispute. If you seek a parental guarantee and dont get it, then you can assume the kids are in charge, explains Zahler.
Still, clients of large vendors that go under may be better off than those with smaller, sinking vendors. Pandesic is taking six months to wind down operations, giving customers a significant amount of time to transition to new providers. By contrast, customers of other failed ASPs have had to scramble for new providers.
Expect the Worst Customers and partners should consider the consequences of a service provider going under, filing for Chapter 11 bankruptcy or slashing services to save itself. What do they need to get their hands on, in order to limit the negative effects?
In the case of customers, the biggest need is to ensure continuity of service. ASP customers should have access to the source code of the software their ASPs use as well as to the data conversion.
“You want to have this access agreed to in the beginning. You dont want to ask for the conversion of the data when the vendor is breaking up,” warns Boulanger of AMR Research.
Depending on the software used, you can buy either the application or its license (in perpetuity) up front, or have the source code or converted data deposited into an escrow account, overseen by a neutral third party. Such access will cost you—a license could run as high as $500,000—and possibly meet with resistance from your provider.
“Youre taking away the source of value of an ASP, and they may not want to give it up,” says Ted Chamberlain, an analyst at Gartner Group. The vendor also may not be able to deliver any software. If the source code is built into a Web site, as it was for HotOffice.com, the software cannot be separated and put into an escrow account. The best a customer can do in this case is get its data downloaded to a CD—a function HotOffice.com offered until it ran out of funding.
If youre a large customer and, naturally, have more leverage, you could ask to have all of the resources for your account put into a separate corporation in which you have a security interest, suggests Mummery of Milbank Tweed. Then, if theres an interruption in service, you can claim ownership of the third company, just like a bank could repossess the home whose owners ceased their mortgage payments.
Regardless of your size or the size of your provider, attorneys suggest that you include in your contract a requirement that the service provider help you transition to a new provider should it go out of business. Some failing ASPs, such as Pandesic and HotOffice, have followed this practice.
As for consulting customers, continuity of service means access to the people involved in a project, which is much more difficult to guarantee than software availability. Zahler suggests including in your contract the right to have people remain on the project and, if the consulting firm goes under, the right to hire those consultants as your own employees or as independent contractors.
Prakash Parthasarathy, an analyst at Banc of America Securities, says hes seen contracts where specific consultants are named and required to remain with projects until their completion. “Its not necessarily legally enforceable, but it sends a message,” he notes. ” If we dont get that person, you wont get the next contract. “
Other protections for ASP and consulting customers are shorter-term contracts and “back-out” clauses, which enable a customer to walk away from, say, a five-year deal after two years if the service provider hasnt achieved certain service levels.
Who Owns Whom? A partner, for its part, needs to ensure that it has access to the customer after the firm it has been working with goes out of business. To do that, the vendor must access the data and software that its partner used, and, more important, must know which vendor partner actually “owned” the customer. This ownership should be specified in a contract.
Another way to clarify the issue is to avoid certain kinds of deals that confuse the customer-vendor relationship, such as co-branding initiatives.
Opendesk, an ASP, has abandoned co-branding in favor of private labeling, because it was “concerned about partners going out of business” and found that co-branding was “confusing to customers,” says James Dodwell, VP of marketing. He adds that co-branding is expensive because it requires an ASP to maintain many versions of the same site.
NetLedgers Maxson says her company wont do any co-branding or private labeling until a potential partner has proven itself. Initially, it steers such potential partners into its affiliate program.
Vendors also need to be concerned about the vulnerability of their revenue streams if one of their partners goes under.
“If Im concerned about your ability to pay, the sooner I get paid my money, the better off I am,” says attorney Mummery. Experts suggest you get paid every two weeks, or monthly, at the beginning of the month, before services are rendered.
Like customers, partners also can protect themselves with shorter-term contracts. “Most of the partner contracts we sign are for about one year,” says Maxson. “That absolutely protects both partners.”
Other protections she uses are audit clauses, which allow NetLedger to check on a partner when the two companies disagree on the number of customers that have been served, and limited-liability clauses, which absolve NetLedger or limit its liability for mistakes committed by a partner.
Preemptive Strikes The right to terminate is becoming a standard contractual provision. It gives customers and partners the right to end a relationship if certain levels of service specified in the contract are not being met (i.e., uptime guarantees, milestones and project deliverables). The right to terminate also may kick in if theres a change of control at the vendor.
“Try to identify those things that are causes for concern and write them into the contract,” says Mummery. “Then, if they happen, you have the right to terminate the agreement.”
But even if you choose not to end the relationship, just having those provisions in the contract can help. “I call it the squeaky wheel position,” says Zahler. Simply threatening to terminate, he says, increases the likelihood that youll get the service you need.
And, finally, say industry observers, the market itself may yet provide the best protection for customers and partners. The shakeout among consultancies and ASPs is driving a flight to quality, with customers gravitating toward established services firms such as the Big Five, IBM and EDS. Moreover, resulting consolidation will witness strong firms taking over weaker ones and reducing the risk. Microsofts pending $1.1 billion acquisition of Great Plains Software is one such move.
Gary Dean, an analyst at Robert W. Baird & Co., says this merger will “make the channel much more efficient.”
