A performance-based contract is a mechanism that allows a financier, usually a philanthropic or governmental/public entity, to hire and pay for the services of a service provider, such as an impact-oriented enterprise or NGO, to execute a socially or environmentally beneficial initiative during an agreed-upon timeline. Contrary to traditional development funding, the donor is not paying for certain activities. Rather, a goal (output or outcome) is articulated, and the service provider is given relative flexibility in terms of how this goal will be achieved. In the water sector, such goals can be linked to e.g., Non-Revenue Water Reduction or extension of services. Notably, the enterprise that provides the service will only receive payment once certain indicators for success have been met. Pay-out will accordingly often be broken down into several instalments that are tied to concrete milestones.
When is a Performance-based Contract a suitable financing option?
The fact that investments will not have to be repaid and there is no interest tied to financing makes PBCs suitable for NGOs or young impact enterprises which may be cost recovering, but do not make a profit (yet). The financing entity needs to have a certain level of trust in the service provider, which usually means that there have been prior working relations, or the service provider can otherwise convincingly provide testimony to their capacity to implement and achieve the desired outputs or outcomes. While a financing entity would only enter into a PBC with a trustworthy and reputable service provider, the latter actually bears the primary financial risk in case the intervention does not reach the expected outcomes, as that would mean that under PBC terms, the financier would not need to pay up. Financing entities would consider a PBC as the pay-for-success scheme provides an extra incentive to the service provider to deliver results (Invest in Results).
The following (non-comprehensive) characteristics and implications provide you with an overview to analyse the pros and cons for this investment instruments:
Depends on scope of intervention
Pay-back period (Maturity)
Maturity depends on length of intervention; no pay-back responsibility for the enterprise
Use of funds
Source: Based on (Roots of Impact, 2020)
The following table summarises some key characteristics of a Performance-based Contract and implications you should consider:
What does this mean for your enterprise
Risk is shifted to the service provider.
If you don’t reach the outputs or outcomes you set out to meet, you will not get reimbursed. Contrary to other results-based financing approaches, the main risk lies with you as the service provider, rather than with an investor who has put up-front financing into your solution. This means that you also need to have a strategy in place to absorb the risk if you cannot deliver on your contractual terms.
Input and activities are flexible.
The destination matters here, not the journey. In other words, how certain outcomes are achieved is less relevant than the quantifiable results of the project. Of course, project goals shouldn’t be reached through unethical means. Thorough monitoring and reporting will still be a prerequisite to make sure milestones are achieved.
Results are verified independently.
An external party will normally be put in charge of measuring and verifying your intervention’s output or outcomes. Make sure that you have a full grasp on the metrics they will be applying.
Relationship management is less complex.
When only the service provider and outcome funder are involved in a PBC, partnership management is much less strenuous on the service provider. Sometimes, multiple service providers may be involved, but coordination with them is still less resource-heavy than with multiple financiers.
Potentially long payment period.
It takes some time until outcomes to your intervention are visible and measurable. This means that your last instalments could be coming in months after your project-related activities have concluded. Make sure to account for this in your organisational budgeting.
- While the service provider is often expected to cover the cost for the first project phase, a PBC can also be hybrid, thus making it suitable for NGOs and younger enterprises that do not possess the capital to cover an initial round of activities/input until the first instalment comes in. This means that the compensation is partly paid upfront on good faith, and then partly upon the delivery of certain agreed-upon outputs or outcomes.
- There are some key similarities to impact bonds, such as the focus on outcomes, however, a PBC doesn’t require private/commercial investment. The service provider can leverage the PBC to raise funds to finance, for example, the first phase of activities, but carries the main risk if funding falls through in case the desired results cannot be achieved (Roots of Impact, 2020).
- PBC are a great way to build your portfolio together with trusted partners. cewas funded a series of small-scale projects under the title of “WASH vs. COVID-19” in 2020. Five early- or growth-stage enterprises from cewas Middle East’s network received project funding in several instalments to deliver interventions related to the mitigation of the pandemic’s effects on the sustainability of environmental enterprises. The goal of the projects was defined jointly by cewas and the implementing enterprise and ranged from workshops on menstrual hygiene to building an MVP for a decentralized water treatment system. cewas provided an up-front instalment, if needed, to finance the first activities, and brief mid-term reports had to be submitted to unlock the second instalment. Upon project conclusion, a no-frills final report was submitted by the enterprise. Throughout all of this, the focus was on keeping the partnership management load light and instead focus all resources on quickly and smoothly achieving the project’s goals.
Tips to build your investment case as a young water-related enterprise
Performance-based contracts are wonderfully flexible and suitable to a broad range of entities, ranging from pure-bred NGOs all the way to commercial companies willing to engage in impact-oriented activities. What makes a PBC desirable is that the financing entity trusts in the service provider to work out the best way of achieving the desired outcomes, thus giving organizations with on-the-ground experience the freedom to design their interventions with as much benefit to the intended target audiences as possible. This is in stark contrast to traditional development funding, where donors are known to exercise control over each activity and input related to a project, often undermining the service provider’s ability to meet the target audiences’ real needs with too much micromanagement and high-level assumptions.
Let’s take a look at a few examples of how this plays out in the water sector: In the water sector, performance-based contracts have been particularly popular when it comes to reducing non-revenue water (NRW) of water utilities. There is a multitude of reasons, why public water utilities struggle to effectively manage NRW (including insufficient incentives or chronic under funding) despite the clear and significant benefits of doing so. This is where utilities may turn to entrepreneurs, e.g., for leak detection and reduction, metering accuracy or replacements, or event to increase service continuity or revenue generation.
As they are directly linked to cost savings, NRW-reduction programs can “pay for themselves”, allowing an increasing number of water-service providers or government institutions to engage specialized private-sector contractors in performance-based contracts (PBCs) for NRW management. The involved enterprise(s) takes some of the performance risk of achieving NRW reductions for a share of the upside. (PPIAF, 2016)
Beyond NRW management, PBCs have been applied, to extend services to underserved communities. In Morocco, GPOBA for example cooperated with two operators under a results-based financing scheme to connect peri-urban households to water and sewerage services. Under this scheme two water operators received 60% of payments upon the verification of individual connections to water and sewerage services to an eligible household, and the remaining 40% upon verification of at least six month of sustained service provision. (GPOBA, 2014)
Container Based Sanitation services are the basis of a range of emerging business models that pursue a similar aim with a less CAPEX intensive business model. Recognizing CBS enterprises will likely not be covering their full costs in the short term—and that most urban sanitation services are subsidized—PBCs have been established as a promising financing instrument for public authorities and/or utilities to explore ways to ensure that CBS services are sustainably financed. In situations where governments contract CBS service providers for delivery in specific areas, such arrangements could be structured as performance-based contracts so as to introduce incentives for greater efficiency, cost reductions, and greater accountability (WORLD BANK 2019).
Performance-based contracting has also shown promising results for operation and maintenance of rural water points. Building on the experiences of a range of relevant enterprises, UPTIME has developed detailed guidance for the design and pricing of performance-based contracts for rural water services (Uptime, 2020).
Leveraging your impact profile to access performance-based contracts
To this background, you should explore performance-based contracts if…
…you are confident that you have the capacity to deliver.
Don’t bite off more than you can chew. Be realistic when assessing your capacity to make the desired project outputs or outcomes happen in the form and shape that your funder expects you to. While a large financial injection may sound great, small and young enterprises are often not able to absorb large amounts of money and do not have the management structures in place to guarantee sound planning, budgeting, implementation and reporting. When reading a tender or discussing terms with a potential funder, make sure you fully understand what you are committing to, as you are the one bearing the majority of the risk in case your project results are unsatisfactory to your financier and they refuse to pay out.
… you are flexible and able to adjust your activities.
What matters in a PBC are the results, and you are expected to provide evidence to demonstrate that your results match your financier’s expectations. If you realise halfway into a project that you are not going to be able to meet the desired outputs or outcomes on your current trajectory, you need to be able to learn, pivot and adapt your activities to ensure success. This may also mean budgetary shifts and new partnerships, so it might make sense to plan for various scenarios in advance to ensure you are prepared for possible changes. Having conducted a thorough stakeholder mapping during the preparatory phase, for example, means you won’t need to scramble to find new partners in case one of your partnerships falls through.
… you have a financial cushion or alternative funding sources and could survive without the project funding.
There are many reasons why a project may not lead to the results you and your financiers are aspiring to. Of course, the bulk of the responsibility lies with you as the service provider to design your activities in such a way that the outcomes are quasi-guaranteed. Yet, the recent COVID-19 pandemic has been an illustrative example of force majeure – events that are out of your control but may have a devastating effect on your intervention. Make sure you provision for such events in your performance-based contract’s terms, so you will not be held accountable for the consequences. On the other hand, sometimes you may overestimate your capacities, evaluate a determining factor incorrectly, or underbudget. In short, you are not meeting the stipulated results and your financier refuses payment. While such a course of events is of course regrettable and should force you to re-evaluate your enterprise on a broader scale, this can happen. What is important is that your entire operations are not dependent on this singular project funding. Before going into a PBC, consider how you can plan for such events and put a contingency plan in place.