Not too lax. Not too rigid. A contract that falls somewhere in the middle is the one that works best when a company is turning over its information-technology activities to an outside firm.

Contracts are critical to IT-outsourcing success because they help organize the relationship between client and vendor, providing companies with protections against unwarranted fees and subpar service.

But contrary to popular belief, a contract that tries to anticipate and address every contingency that might arise during the course of a business relationship can be just as damaging as one that leaves too much to chance. It can create an atmosphere of distrust that saps a vendor’s motivation to provide good service and go the extra mile when a client needs it most, such as when the business environment changes unexpectedly.

A look at the the history of IT outsourcing at a French company between 1994 and 2007 shows the benefits of striking the right balance between “too little” and “too much” contract. The firm remains anonymous at its request.

A ‘Standard’ Contract

In 1994, this French company decided to outsource its entire IT department. It picked a vendor and signed that firm’s standard contract, the usual practice at the time. But costs spiraled as the vendor demanded payment for even the most minor service not covered in the agreement. In addition, IT equipment became obsolete as the contract made no provision for upgrades.

Fed up with continuing problems, the French company paid a penalty to terminate the contract in 2001, three years before it expired. By that time, it had become clear that loose IT-outsourcing contracts were detrimental to performance, so the French company set out to fix the mistakes it had made in 1994.

Among the changes: The company hired two different IT providers and, according to its then-chief information officer, drew up contracts “with obsessive attention to detail.” The contracts were for shorter periods of time and contained airtight clauses spelling out, among other things, agreed-upon service levels and penalties in the event of substandard performance.

The contracts “put us in a stronger position,” the chief information officer says.

Atmosphere of Distrust

Still, key problems remained. In particular, the relationships with the new vendors were strained. “We were suspicious of each other from the word go, and the extreme rigidity of the contracts prevented any thaw in relations,” the chief information officer says.

The rigid contracts didn’t take into account that business conditions and technologies might change over the course of the business relationship. Because there was no flexibility built into the contracts regarding changes in the business environment, the French company ended up paying substantial excess fees for services it hadn’t anticipated needing.

The vendors, meanwhile, felt that the service-level agreements were unrealistically high and that their client was too demanding. When the previous vendor’s unhelpfulness made the new vendors’ jobs more complicated than expected, the French company refused to budge: It enforced penalty clauses for substandard performance instead of helping the new IT providers get the cooperation they needed from the old one.

The result was that instead of warding off poor service, the focus on enforcing a rigid contract had the exact opposite effect: The vendors became less cooperative and started shirking on effort.

Getting It Right

In 2004, the French company switched vendors once again. It also dramatically changed its approach. Rather than striving to define everything in the contracts, the chief information officer left them more open. For example, he allocated a certain budget to bring about technology changes, but left it up to the IT provider to determine the best approach. Various committees were established to develop more cordial relationships with the vendor and to build trust.

Three years later, the French company says, the vendor had achieved a level of performance that the French company couldn’t have achieved on its own. The contracts led to cost savings of several million euros—even though costs had increased 15% in the first year. As a vendor’s manager explains: “To bring costs down, you need a real transformation in the activity you take over. The costs of that transformation must be taken into consideration.”

In 2001, the French company never would have accepted this kind of reasoning from a vendor. In 2004, it put full trust in its vendors, and the bet paid off.