This post is intended to make entrepreneurs and service providers aware of ten essential clauses in any contract which affect the commercial aspects of a transaction, so that they can negotiate better and with more confidence, without any prior knowledge of law.
1. Why entrepreneurs should be able to negotiate
From the earliest stages of a startup, an entrepreneur is required to enter into a variety of contracts with a wide range of stakeholders – employees, vendors, consultants, partners, agents, distributors and customers (apart from investors). While funded startups may have access to their investor’s lawyers for occasional guidance, actual negotiation of a deal at the table and thrashing out the commercials, and sometimes inserting clauses to protect their interest (and probably ensure an upside in future) is often left to the entrepreneurs to handle by themselves.
Often, contracts have to be largely finalized and drafted in a hurried manner by entrepreneurs themselves (feedback from lawyer friends or family members is always good but is a minimum necessary input, but may not be sufficient), which is why it always pays off well if an entrepreneur has hands-on understanding of negotiating contracts. The example which shows how even Steve Jobs failed to realize the importance of a clause in a deal with Disney explains the point.
2. The mistake Steve Jobs made while negotiating with Disney
When he was negotiating a deal with Disney for Pixar (founded after he was fired from Apple, this was the same company which made the hit movie Toy Story), Steve Jobs’ (who is considered to be one of the best negotiators in Silicon Valley at that time) readily agreed to a clause inserted by Disney at the last moment, giving Disney the sole right to retain profits from sale of any merchandize (e.g. t-shirts, cups, etc.) on animated characters that were created by Jobs’ team at Pixar.
It turned out that revenues from merchandising far exceeded box-office revenues, which Steve Jobs had failed to negotiate at the last moment. Jobs had only focussed on a profit-sharing arrangement with Disney on box-office sales (Ironically, this was despite having the assistance of some of the best entertainment lawyers in the US. Later, Steve Jobs had to come back to Disney and renegotiate the deal, once he realized the potential he had missed).
3. Which are the most important terms of a deal that entrepreneurs/ service providers should negotiate on?
Here are some of the terms and concerns that need to be thought out well and should not be just left for your lawyer, or worse, the other party to decide, for a very simple reason – they affect your commercials directly. These will require negotiation, and it’s best for you to understand what these terms are all about and the options available to you.
Term and renewal:
This is a very basic commercial issue in any agreement – the term of the agreement must be decided by the parties. What they often don’t decide on is renewal. Be it a supply agreement, a service agreement or a franchise agreement – it is always a good idea to put in a clause with respect to renewal. I often put in provision for automatic renewal which can be prevented by a notice by any party. The clause usually states that the agreement will be automatically renewed at the end of the term for an indefinite period unless any of the parties gives a notice to the other party stating that the agreement should not be automatically renewed. In agreements based on long term relationship between the parties, it is a good idea to have an automatic renewal clause. This saves procedural hassles and potentially stamp duty costs for new agreements at the time of renewal.
Retainers/ suppliers/ service providers love such hassle free automatic renewals and should insist on them. It is totally fair – if the other party does not want the automatic renewal – all they need to do is send you an email and say so. This makes things convenient for both parties.
This is a crucial clause. A party to a contract may terminate a contract under two circumstances. One is when there is a breach by the other party – which should enable immediate termination or termination by a short notice even when there is no fault or breach by the other party. There should be another clause that enables your client to terminate the contract at his/their convenience with a longer notice. This is also known as a no-fault termination.
Recently one of my friends wanted to terminate a contract because he found a service provider who would provide services at a cheaper rate. His contract allowed him to terminate the contract on a three months notice. This meant that he could not terminate the contract before three months after giving notice and pay a higher rate for that period. This is a reality that needs to be taken into consideration while opting for longer notice periods for no-fault termination.
We generally insert a specific termination clause for failure to make timely payments under a contract.
Consequences of termination
You know when you can terminate the contract, but what exactly happens after termination of contract? Do any obligations of either party survive? What about the obligation to maintain confidentiality or to not solicit employees of the other party?
What happens to payment for unfinished works or possession of products which have already been imported for delivery? What happens to any third-party contracts that one party has entered into in reliance of the contract which is now being terminated?
The contract should address these issues in details in order to ensure a smooth termination. Let’s look at a clause that states that the client does not have ownership if he does not pay the Retainer.
Illustration: “The Client can claim work products in the Retainer’s control only if all dues to the Retainer or any third party service provider engaged through Retainer is paid.”
Now, a clause which requires the client to pay a retainer for unfinished work:
Illustration: “Upon termination, Client shall be under an obligation to compensate the Retainer reasonably for all costs incurred by the Retainer towards unfinished work or products.”
Specific payment obligation
It is important to identify a specific date/ time on which payment obligations will arise. Failure to do this leads to severe complications. When a date cannot be identified at the time of entering into the contract, specific events are identified. For instance, read the following clause:
“The fee will become due and payable on 5th October 2013 or on delivery of the services whichever is earlier.”
Sometimes, the payment obligation is linked to rising of invoice, as below:
“On completion of the work, the Service Provider will raise an invoice immediately according to the terms and rates specified in this agreement. The Client will make payment within 7 days of receipt of invoice, failing which an interest rate of 18% per annum will be paid on the amount due on a monthly accrual basis.”
For the sake of certainty, parties should specify the payment method which is to be adopted. In certain sectors, payment of the entire amount by cheque after the services have been performed is customarily acceptable, while in other situations a party may insist on advance payment of a portion of the amount. In case of complex transactions involving large sums of money, such as investment agreements, lending agreements and escrow agreements, payment method, bank account and number of days in which payment is to be made are fleshed out in great details.
Cost escalation/ Third party costs /right to know actual costs
This is a major issue with many long term contracts. If one party is carrying out some work on behalf of another person or entity, not being a party to the contract, and input costs which are not in control of the parties increase – the contract price may not remain justified. Hence, cost escalation clauses are introduced in a contract which provides for such situations.
Similarly, when one party is supposed to employ third parties to get a part of the work done (and the other party is required to pay these third parties), a contract may require submission of third-party invoices and proof of payment, to determine actual cost incurred. Sometimes, service providers charge a commission/ mark-up on the costs – they can negotiate for it and insert a clause allowing him to charge the same into the contract at this stage.
Service providers/ suppliers may also want advanced payment before they pay third parties for the work/ goods/ components. This should also go into the contract.
Use of Trademark
The importance of this clause is often completely neglected. Many service providers use the trademark of the other party while providing services (example: SEO services/ marketing services/ design services). Sometimes, logos are also used for displaying their existing portfolio of clients to potential customers. The contract should authorise consultants to use brand names, logos and other relevant proprietary names (whether they are registered trademarks or not) for the purpose of carrying out their obligation under the contract. If this permission is not given, the service provider would be in violation of the trademark of the other party in course of its work.
Quality standards/Service Level Agreement
In contracts involving supply of goods or services, this is a crucial aspect. Quality standards should be carefully specified. In case of agreements for services, a service level agreement (SLA) is entered into to provide minimum acceptable standards for the services being provided. Deviations from minimum acceptable service levels usually result in free credits to the client, or pre-agreed penalties (which could even require the service provider to make financial payments) to be paid to the client.
Representations and Warranties
This is relevant for any contract. Parties take representations and warranties from each other. While many lawyers/ parties just copy paste these clauses from another contract, this is where a lot of risks can be covered and minimized. However, while there are some common clauses that can be repeated in almost every contract unchanged, almost invariably each contract has scope for taking some special representations and warranties.
Make sure that the other party is authorized to sign the agreement
If you are entering into a transaction with a company, ask for a board resolution authorizing the concerned person to sign the agreement for the company – you should also see the Articles of Association of the Company to know if there is any specific direction there on who is empowered to enter into contracts.
[Guest post by Ramanuj Mukherjee and Abhyudaya Agarwal – co-founders of iPleaders, started in 2011 with the vision to make law accessible. iPleaders is currently teaching practical aspects of business law to entrepreneurs, managers, working professionals, engineers and innovators. It started an online diploma course in Entrepreneurship Administration and Buinsess Laws in collaboration with NUJS, one of the best law universities in India in July 2011. Enrolments to the second batch of diploma course are now open. Visit http://startup.nujs.edu for more details.]