Negotiating Enterprise Sales Contracts Is About Choosing Your Battles

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Editor's note: Dror Futter is a partner in the Rimon, PC law firm, where he is a member of the firm’s Venture Capital, Blockchain and Israel practice groups. He advises growth companies and their investors on both their financing transactions, as well as their daily commercial, corporate and IP needs.

Sometimes it just feels unfair. Your big Fortune 500 customer has agreed to buy your product, and all that remains is for the purchasing department to send over their form agreement. High fives all around. Then with a thud, a 40 page document lands on your desk. You can almost hear the air seeping out of the deal.

When you are a startup, the reality is that in most circumstances you need the deal more than your customer. In addition, it is very likely that your customer – with their in-house purchasing and lawyers – has more resources it can devote to negotiations. You may also have to hire an attorney on an hourly basis, and lengthy negotiations can distract important management, product, and sales resources. Finally, speed is critical to a startup and taking tough contract positions will inevitably delay closing. The net of this imbalance means that it is likely you will have to live with an unbalanced contract.

Responses to this reality vary. Some ventures just throw up their hands and sign anything. At the other extreme, startups ignore the imbalance and fight on every point. In my experience, this rarely results in a materially better contract - but rather, protracted negotiations. The smartest ventures come prepared to pick their fights and have realistic outlooks on what they can achieve.

Assuming that the parties have agreed to deliverables and price, ventures should apply 2 criteria in determining which provisions to negotiate: (i) does the provision significantly impact the economics of the deal, and (ii) is the provision likely to be of concern to future investors and potential acquirers when they perform diligence on your company?

Based on these criteria, the following provisions should be at the top of your list.

Impacting Deal Economics

1. Payment Terms - when can you bill for your product/service (the invoice date) and when is the customer obligated to pay? Obviously, shorter payment periods help the venture’s cashflow.

  • What do you want? Ideally you would ask for “Net 30 Days” (payment in 30 days). In some situations, when your customer has shaky credit, or with international customers where collecting outstanding amounts is difficult, you may insist on cash in advance or a Letter of Credit.

  • What are you likely to get? Compromise at Net 45 Days may be possible, but there are some companies that insist on Net 60 or even Net 90. Smaller companies may agree to cash in advance/Letters of Credit, but they are much more difficult to obtain from large companies in developed markets.

2. Acceptance Testing - addresses the customer’s right to test the product before accepting it and triggering a payment obligation. This often will create a revenue recognition issue since even though the product has shipped, you cannot bill and revenue cannot be recognized until the end of the acceptance period.

  • What do you want? Short acceptance period, with acceptance deemed to occur if not rejected during the acceptance period. What constitutes “short” will depend on the complexity of the product - rarely less than 10 days, sometimes as much as a month or more.

  • What are you likely to get? If the customer wants an acceptance period, your focus should be on getting the shortest period possible and limiting the customer’s potential basis for rejection.

3. Calculating Royalties - your customer is paying you a royalty or other fee based on the revenue they receive as a result of their sale of your product.

  • What do you want? Royalty applies to all amounts invoiced by the customer (customer bears the collection risk) with as few exclusions as possible

  • What are you likely to get? Customer will often require that the royalty be based on amounts they actually collect (you share the collection risk) and may require that expenses, such as shipping, insurance and credits for returns, are deducted from revenue before the royalty is calculated.

4. Warranties/Disclaimers - your customer is going to expect you to stand behind your product/service in case something goes wrong. Many agreements warranty that the product/service will function in accordance with its “specifications.” However, many startups do not actually have specifications for their products/services – sales materials often make big claims (“world best hotel database”) which makes them a poor substitute for specifications.

  • What do you want? You want to clearly specify what your product/service will do and what your responsibilities are in the event that the product/service fails. You also want to disclaim all other warranties, including some warranties which are otherwise implied by law.

  • What are you likely to get? As long as your specifications are reasonably detailed and include the features included in your sales pitch, most customers will agree. In terms of other warranties, customers are usually willing to agree to most disclaimers, notable exceptions are warranties of non-infringement and compliance with laws.

Future Diligence Issues

1. MFN or “Most Favored Nations” Clause - a MFN clause requires you to give the customer the best price you are giving anyone for your product or service. If you give a new customer a lower price, you will need to lower the price of the customer with the MFN clause. MFN’s are a red flag to potential investors/acquirers because they reduce your pricing flexibility.

  • What do you want? Simply, you want no MFN clause. You should not even consider it unless the customer is very important. An MFN clause reduces your pricing freedom and if you grant it to multiple customers, it triggers a race to the bottom on your pricing every time you cut a good deal with a customer.

  • What are you likely to get? If your customer insists on an MFN clause and you really must have the deal, seek to soften the blow by conditioning the MFN clause by narrowing when it applies. Usually customers will agree that the MFN only applies if the new customer is (i) purchasing similar volumes; (ii) in the same geography; and (iii) under similar terms. Sometimes, customers will only agree to 2 out of the 3.

2. Exclusivity - especially if your product is unique, an early customer may insist on exclusivity either for a period of time or within a given vertical. Their argument is that they are taking a risk going with a startup company and want an advantage over their competitors in return.

  • What do you want? Like the MFN clause, don’t go there. There are few circumstances which justify limiting yourself to one customer.

  • What are you likely to get? If granting exclusivity makes sense, try to limit its scope. Try to have it apply only (i) to a specified geography; (ii) in a narrowly defined vertical; and/or (iii) for a short period of time. In addition, the customer should be required to earn ongoing exclusivity. If certain order volumes are not reached, exclusivity should go away.

3. Source Code Escrows - when you sell to established customers, some customers may be concerned that the startup may go out of business. To protect themselves, they may insist that you place your source code with a 3rd party escrow agent. Your agreement will specify the conditions under which your software comes out of escrow. Since your source code is usually your “crown jewel,” giving third parties potential rights to it should not be taken lightly. Potential investors/acquirers may be concerned if multiple customers have this right.

  • What do you want? Ideally you would prefer to have no source code escrows, or at least grant them to a handful of critical customers. The point to make to customers is that while source code escrows sound good in theory, in reality they are very rarely exercised. If your company goes out of business, your customer is more likely to buy a substitute product than get your source code and hire a staff to maintain it.

  • What are you likely to get? If you cannot convince a customer to drop a source code escrow requirement, you should work to limit the situations in which the source code is released from escrow. Escrow release should not be a remedy for ordinary failure to perform. It should be a remedy if you really do go out of business or stop supporting the product for a long period of time. The escrow release conditions should reflect this standard.

4. Limitation of Liability - contracts almost always include limitations on damages. These are caps on the amount one party can be liable to the other. Damages fall into 2 categories – direct and indirect/consequential. Direct damages are the difference in value between what was promised and what was delivered. For example, I sold you a product for $5 that was supposed to do 5 things, but the product only did 3 things. The price of a product doing 3 things is $4, so your direct damages are $1. Indirect/consequential damages are damages that are not a direct result of an act, but a consequence of the initial act. For example, I sold you software that did not work. As a result, your factory shut down for a week and you lost $1M in revenue. The $1M in lost revenue is a consequential damage. Very often, consequential damages can be many multiples of the underlying contract value. If you agree to high caps of liability, your venture could be subject to large claims in the future which would be a red flag to investor/acquirers.

  • What do you want? You would like to preclude all indirect/consequential damages and limit your direct damages to an amount that reflects the value of the contract – typically the amounts the customer has paid over the last 12 months.

  • What are you likely to get? Most customers will agree to the limitations of liability outline above. However, there are likely to be 2 major exceptions (i) customers often will insist on a higher dollar cap for direct damages – for example amounts paid during the life of the contract or during the preceding 18, 24 or 36 months; and (ii) customers will often require exclusions to the caps. An exclusion to a cap is like a double negative, it essentially creates areas where your liability is uncapped. This is often the last “battle-ground” of most contract negotiations. A common and generally non-controversial exclusion from the cap is confidentiality: other common exclusions include: IP infringement, violations of law, damage or injury to person or property. You should be sure to fully understand any exclusions you agree to – understand how large claims are likely to be and how likely they are to occur. Then you can make an informed risk-based assessment of whether the value of the contract justifies taking on the risk.

5. Assignability - most startups in the venture space are formed with an eye towards either IPO or sale. Many contracts include restrictions on a venture’s ability to assign a contract without customer’s approval. Depending on how this provision is phrased, it may be violated by either a sale of the company or all of its assets or an IPO.

  • What do you want? You want as few things as possible standing in the way of an IPO or sale.

  • What are you likely to get? Customers will argue that they are entering into the deal with you and if management changes, they want to have the right to evaluate the buyers and see if they are comfortable with them. However, for the venture, giving the customer the right to approve an assignment gives the customer the ability to extract new concessions in return for agreeing to the assignment. Also, customers may not be immediately responsive to requests for approving an assignment, which could delay a sale of your company. If there is a prohibition on assignment, you should add language that (i) requires the customer to have a reasonable basis for refusal; and (ii) specifies that if the customer has not responded within X days, it is deemed to have approved.

The good news/bad news is that a subset of these issues is likely to come up in any sales agreement you negotiate. The bad news – the pain of negotiation – is fairly self-evident. The good news is that after several negotiations, you will develop a better understanding of the sensitivity of customers in your target market to these business/legal concerns. Over time, well managed startups will modify their form documents and their bargaining positions to anticipate these concerns and reduce the negotiating friction.

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