Contract Tips for the Little Guy

So often, when we talk about the terms of an agreement that one of our portfolio company is negotiating, we hear advice that just isn’t helpful. There are plenty of unfavorable terms that startups must accept in their early agreements. It’s just the reality of being the smaller party with little history, credibility, or alternatives. My points below assume that this is your first or one of your first big deals. It could be a direct sale or a distribution agreement. These points also assume you’re an early-stage company with a minimal (say $20k to $200k/yr) legal budget. And, while we’ve certainly seen our share of fair-play and reasonable partners, I’m assuming the worst (we’ve seen that too) will come out from your much-larger customer or business partner.

We’ve negotiated many deals on behalf of our companies with bigger players like Microsoft, Standard & Poors, or General Mills. Many of these deals were company-makers for our fledging startup while they barely mattered to the other side. So, what can you do when you have no leverage but need the deal?

Focus on the LOI. Get all the deal terms that matter to you in the letter of intent. It needn’t be a document you’ll sign (it needn’t be binding) but you discuss the terms here. Once the LOI is done, you’ll find that negotiating omitted terms will take much longer and these discussions will be more costly and probably harder for you to get what you need.

Save attorneys fees. Let Bigco do the drafting. Paying your counsel to review is cheaper than drafting. If you have gone through this and have a standard agreement you like, then use it. You can plug in Bigco’s name and pricing by yourself and have your counsel review any material changes.

Venue and choice of law for dispute resolution. Forget about it. Bigco has a standard for this and unless you’re dealing with an overseas entity, it’s just not worth the fight. Give it up but…

Arbitration. This can work either way but I believe that, in general, arbitration favors the startup. If Bigco ends up being evil and disputes are to be resolved through the courts, then they can tie you up and quickly exhaust your miniscule legal budget. They may also seek an injunction. Even if their accusations have little truth, you may be unable to afford a defense. Binding arbitration is typically a little gentler and less painful to you if Bigco lacks a valid case. We usually ask for terms whereby the loser pays all costs of both parties in the arbitration. We don’t try to write the arbitration clause; instead, we ask if they have an arbitration clause they can insert in lieu of other remedies. We’re successful with this about half the time. If they tell you that they have a corporate policy that forbids arbitration, see my point on Venue, above.

Term and termination. Let’s face it: if Bigco wants out of the agreement, they’ll likely get out. They may just stop paying, stop re-selling, or stop supporting or stop using your product. One way or another, you should assume that the fact that your contract is still active won’t be enough to compel a larger partner to continue to honor the agreement. Sure, you might have grounds to sue but look again at your legal budget. Now, if the deal turns out to be sweet for them and takes advantage of your startup the situation will be different. You can expect Bigco to enforce the agreement. Shorter terms and easier outs benefit the smaller company. Note that you might have a work-around to this problem if you can negotiate the ability to raise prices with moderate notice (you could raise prices to an untenable point as a means to force a termination). And as for termination, contracts are often written to allow for termination either on n days’ notice (often 30 or 90) or to allow for termination within n days of the anniversary (otherwise, they renew for another year or more). You’ll want language that allows you to start the termination clock at any time, not just during a window prior to the anniversary date.

Exclusivity. Brrrrrr – just hearing the “E” word sends shivers, doesn’t it? The reality is that many exclusivity deals are far less worrisome than they may appear. First, exclusivity need always be described with these (maybe others as well) parameters:

• Geography. Usually a sales territory. Can be defined at the customer’s headquarters.
• Time. How many months or years is the deal exclusive?
• Products. Be sure to note that the deal isn’t necessarily exclusive to all products and address derivative or ancillary products. Your exclusive agreement may allow you to provide free demo products by disallowing any “sales”.
• Customers. You can often carve out listed customers or groups of customers.
• Applications. Your partner may be interested in only certain applications of your product.
• Channel. You may be able to continue to sell directly, while giving limited exclusivity for resales.
• Performance. Probably the most important aspect and it’s often overlooked. If you’re granting an exclusive for distribution, ask Bigco for their volume estimates. Then add a performance requirement to their exclusivity such that they must pay you x% (maybe 70% or so) of the estimate in order to continue to retain the exclusive.

A great example of exclusivity came at Connected Systems. When I got there, the CEO had negotiated a deal with our launch customer. That customer agreed to pay most of the NRE to develop our core product and in exchange we agreed not to sell production volumes (it allowed demonstration sales) to any company for a year. The sales cycle in this industry was about nine months. By the time we had a concept we could demo and a salesteam to show it, the year didn’t matter.

Assignment. This varies a good deal in each situation. In general, Bigco won’t care much about whether they can assign the agreement to an acquirer if they sell, so if you care, they might agree not to assign without your agreement or that they cannot assign to a certain list of potential buyers or those in a given industry. Bigco will, however, care if you can assign and they’ll normally say that you cannot without their approval. The most significant issue here is the potential automatic assignment to your acquirer. You’ll want to avoid that. You may sell to Bigco’s competitor and that buyer won’t want to be forced to provide product or services to their competition. If you’re unable to get your deal signed without such automatic assignment, you should try to get a buy-out or a time limit associated with it.

IP Ownership. The term you care about here is “derivative works” and this is a tough one. Who will own the intellectual property associated with modifications made to your product. If your distributor or customer gains ownership in these, it can be disastrous. The circumstances vary widely here. In many cases, you’ll be able to own the IP. If you cannot, spend some time on this by really thinking through the likely outcomes.

Use of their name. You’ll probably want to list them as a customer. We’ve often found that Bigco doesn’t like this however, we have routinely been able to get an exception that allows us to disclose the relationship to existing or potential investors.

Payment terms. Be mindful of the logistics and admin you’re getting into with regard to payment terms. With many reseller agreements, it’s just not worth it to create monthly payments and quarterly payments will make more sense. Payments should be made within, say, 15 days of the end of the period and should be accompanied by a report that describes the activity and the calculation.

Audit. If the payments made to you are based on activity by Bigco, then it’s reasonable to have a right to audit their reporting. Usually, this right is limited to once a year (unless you’ve discovered an error in that year) and is performed by a third party. Bigco should be liable for any under-payments you find, sometimes with fines or interest and if the underpayment is large (maybe 5% or so) or intentional, then they should pay for the audit as well. This might all sound overly paranoid but these terms are fairly common.

Lastly, of course, these contracts are vital legal documents. Get qualified help from counsel. A solid CFO can lead the negotiations and help with much of this but don’t sign a document like this without an attorney’s review.