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DROR FUTTERdfutter@sor inrand.com

© 2013 Sor inR and LLP, a l l r ights reserved

Proceed with Caution - Critical Terms of Sales

Agreements

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Disclaimer

Tell me you did not see this coming …Disclaimer

This presentation and these materials are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. The opinions expressed in this presentation are those of the author alone and may not reflect the opinions of the firm or any other attorney.

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Why Do Contract Terms Matter to Startups?

Impact your business Cash Flow Pricing Costs Revenue Recognition

Impact the Value of Your Company Diligence by potential investors and acquirers is very likely

to include a review of the terms of all material contracts Restrictive and unfavorable terms may be used by an

investor or acquirer to negotiate down a proposed valuation/purchase price

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Note

This presentation is written from the perspective of the Startup as a Supplier. If the Startup is the customer in the relevant agreement, many of the issues discussed “cut both ways” but not all.

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Payment Terms/Earliest Invoicing Date

Agreements Need to Specify Payment DatesTypically this is phrased as Net X, which

means payment no later than X days after invoicing

Supplier will generally want Net30. Larger Customers have pushed for Net60 and even Net90

Agreement needs to be clear when is the earliest date that Supplier can invoice Customer

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Multiple Orders Under a Single Contract

Agreements often provide that multiple orders can be placed by the submission of Purchase Orders by Customer

Important to make it clear that any supplemental terms on the Customer’s Purchase Order will not apply

Supplier should reserve the right to reject Purchase Orders. Potential reasons for rejecting invoices: Customer is in breach of the Agreement with respect to prior

orders Customer’s credit profile has changed and Supplier may want to

consider requiring cash pre-payment or be unwilling to sell at all Customer may not have sufficient inventory to fulfill the order

within the requested timetable

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Calculating Royalties

When the purchase price is a royalty rather than a fixed price, it is important to specify the basis for the royalty calculation

Often this is phrased as a percentage of Customer’s revenueThe Agreement should specify what is excluded from

“revenue.” Examples: taxes, insurance, shipping charges, and returns

The Agreement should specify whether the royalty is based on amounts payable to Customer or amounts received by Customer. Difference in who bears the risk of non-payment. Amounts payable =

Customer has to pay royalty even if its customer never pays. Amounts received = Customer only has to make payment if it has received payment from its customer

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Defining Specifications in a Performance Warranty

Products are commonly warranted to function “in accordance with their specifications”

It is often very unclear where you can find these “specifications”

Product documentation and sales materials are usually poor sources of specifications because they often include a great deal of additional information and more sales-oriented content

Ideally specifications should be in a clearly identified document stating precisely what a product will do and any minimum configuration required to support the proper functioning of the product

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Disclaiming and Conditioning Warranties

Supplier should attempt to disclaim any warranties it is providing in situations where the issue results from actions of the Customer or Third Parties. Examples: Modifications of the product by the Customer Damage to a product by the Customer or usage outside of its proper

operating environment Uses by the Customer of the product or service outside of its

intended purpose In the context of online services, issues arising from delays or drops

in Internet connectivityThe Agreement should also disclaim certain warranties

implied by law. If you fail to do so, the Courts will add these warranties to anything you agreed to. Example: “The warranty of merchantability and fitness for a

particular purpose.”

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Acceptance Testing

Customers may ask for the right to perform “acceptance testing” on products delivered to them

More common in situations of customer product development instead of off-the-shelf

Supplier cannot recognize the sale revenue until the end of the acceptance test period

Important to: Limit the duration of acceptance testing; and Make it clear that if a product is not rejected by the

end of the applicable acceptance testing period, it is deemed accepted

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Most Favored Nationals Clause (“MFN”)

An MFN Clause is an attempt by Customer to make sure that it will always get Suppliers lowest price

Typical MFN Clause states that Customer’s price will be lowered if Supplier offers a lower price to another customer

Impact can be mitigated if the clause is limited to: Other customers purchasing similar volumes, under

similar terms Specific markets

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Source Code Escrows

When licensing software from Startups, Customers may require that the Supplier deposit a copy of its source code in escrow

The most critical element of an escrow agreement is the conditions under which Customer can request a copy of the escrowed code. Release from escrow should not be a remedy for an ordinary breach by Supplier. It should be limited to situations where the Supplier fails to respond for a prolonged period of time/ceases to operate/enters bankruptcy

The escrow agreement should limit what the Customer can do with the code if it is released from escrow (example: use limited to servicing existing customers) and provide that the code remains subject to all relevant confidentiality obligations.

Exclusivity13

Customers may try to lock up a Supplier by requiring exclusivity and preclude Supplier from selling to other customers

This should be avoided because it limits the markets open to Supplier

If exclusivity is required, it should be narrowed as to: Duration Geography Market

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Caps on Liability

Cap on the maximum a Customer can claim from Supplier under the Agreement

Generally Suppliers should be able to get a complete exclusion of consequential/indict damages

Example: Software fails, brings down Customer’s production lineAll other liabilities can generally be limited to a dollar

amount, usually pegged to sales over a give period Example: Liability limited to all amounts paid by Customer to

Supplier during the 12 months before the claimCustomers may insist on exceptions to the cap. Common

exceptions: Gross negligence Breach of Confidentiality Intellectual Property Infringement

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Liquidated Damages/Penalties/Service Credits

Customers may ask for “liquidated damages” (specified dollar payments), penalties or service credits, instead of or in addition to the damages they suffer as a result of breach

Most often raised in the context of late delivery, delayed warranty/maintenance, or service downtime

If they cannot be avoided, important to cap the maximum amount that can be claimed per incident/per year. Also, preferred to offer credits against future amounts due rather than cash payments

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Data Privacy/Protected Health Information

Various State, Federal and International laws and regulations govern a party’s handling of personal information with respect to healthcare specifically (HIPAA) and data privacy generally

These requirements typically include Heightened confidentiality obligations Requirements for documented procedures for safeguarding the relevant

data and securing and limiting access to the devices where the data will be stored.

Given potentially significant penalties for non-compliance, it is important to understand what compliance requires

Increasing trend by healthcare, insurance and financial services customers to impose data privacy language on all Suppliers, even those that will not have access to personal information

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Shipping Terms

When shipping product, the parties need to determine Where/when the sale takes place (where Supplier makes it available for

Customer’s carrier or where Supplier’s carrier delivers it to Customer) Who handles export/import matters and customs clearance Who handles insurance Who is responsible for import taxes

There are actually 2 questions Who handles Who pays

There are standard terms (under the Uniform Commercial Code (UCC) and Incoterms) used as “short hand” to describe the allocation of these responsibilities Examples: FOB, Ex Works

See http://en.wikipedia.org/wiki/Incoterms for an informative summary

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Assignability

Customers will often try to limit the Supplier’s right to assign the Agreement without Customer consent

This clause can become a major issue when a company is being acquired

This clause gives the Supplier comfort that it can prevent transfer of the Agreement to an unreliable new Supplier. However, it can also be used by the Supplier as leverage to renegotiate the Agreement in return for consent to the assignment

If the clause cannot be eliminated, the Agreement should always specify that Customer’s consent may not be unreasonably withheld

Supplier should try to get an exception for an assignment made in connection with the sale of the company