Contract and Legal Traps to Avoid (Startup Founder Sales Series, Part 11)
When I first started selling, contracts were simple. I would send over an order form with a page that outlined the license to use the software. They were typical things like not making unauthorized copies of the software, not using the software for illegal purposes, and not selling it to others. Customers signed the order form, and that was the contracts process.
Then, when I got into the world of enterprise sales, the stakes were much larger. Most of the first week of onboarding was spent as much on contract and legal issues as it was product. The two biggest things, however, that were drilled into us were never agree to side letters and to never negotiate a discount greater than the maximum allowed.
The ban on side letters made sense. If it is not in the contract in the first place, why add something else? It was not until later that I learned about the discount limits. I thought this had to do with keeping margins at certain levels. The actual reason was that contracts with the U.S. government included a “most favored customer” (MFC) clause and if any customer agreement had a higher discount, the government had the right to have all of their contracts repriced at the new best pricing.
Even if you never plan to sell to the government or to big companies, contracts are something you cannot avoid. Even in more transactional, self-service purchases, you still need customers to agree to terms & conditions that outline the rights defining the usage of the software and the responsibilities of both the customer and you as the provider. Transactional-type sales usually mean having customers click a box agreeing to terms. For more complex sales, however, you will often have to customize the agreement or use their agreement (sometimes referred to as “signing their paper”).
The rule of thumb is that the bigger the organization, the more complex the contract and the process to craft an acceptable contract. Even smaller businesses and startups can require lengthy contract reviews based on their needs, especially businesses that are involved in highly regulated industries like finance, life sciences, and government. Their regulatory and compliance burdens often mean they need to place greater scrutiny on their vendors, resulting in more complex contract requirements.
Where do you start if you are setting up a contract for the first time, though? A caveat upfront is that what is offered here is not legal advice. Always seek a licensed attorney for questions specific to your situation. Another caveat is that when crafting any legal agreement, beware of templates available on the Internet that might be overly broad or too generalized for your circumstances.
Keeping these caveats in mind, templates can be a good starting point. One useful template for SaaS startups is the Y-Combinator Sales Agreement. It covers most of the common clauses such as:
- Pricing – The fees for the software as well as discounts, pricing for add-ons or features, and fees related to support and implementation, if applicable.
- Services – What you provide to the customer, often specified in the Appendix along with Service Level Agreements for support and Statement of Work for implementation.
- Payment – Determines how a customer is to pay for services and the terms specifying when payment for fees is due and any penalties for late payment or discounts for early payment.
- Term – Covers the length of time the customer has use of the services as well as reasons to terminate an agreement before the term.
- Confidentiality – Defines the information that is considered confidential and the expectations for handling such information for both you and your customer.
- Intellectual Property – Specifies that the software, trademarks, documentation, and etc. you provide are your property and the rights you grant the customer rights to use these.
- Warranties – Agreement to support the product or services for issues that arise during allowed usage such as bugs, defects, and service interruptions service.
- Data – Your software will host or interact with the customer’s data, so these clauses specify the handling, ownership, transfer, and export of data.
- Indemnity – Protections each other for contract breaches and third party claims like security lapses and intellectual property infringement.
- Liability – When there are significant breaches, liability clauses define to what extent you owe damages to the customer.
- Statement of Work – Added as an appendix outlining the specific work to be done, focused on the implementation steps, timelines, resources, and deliverables.
- Service Level Agreements – Also part of the appendix and outlines how you respond to issues, the escalation procedures, and the remedies for missing SLA thresholds.
Even with a good template, customers often insist on using their own template. While it is fine to first offer your template, larger organizations will require using their paper. It is easier for them given the volume of agreements they process, and it already includes clauses that are specific for their needs. The term used for these agreements is a Master Services Agreement (MSA) as it governs not just the use of your product or services, but also the relationship between you and the customer.
When using their paper, or reading through edits of your paper (edits are referred to as redlines), you need to be careful of language that is used that can negatively impact your startup. Remember that legal agreements are binding, which can impact future customer agreements. Therefore, here are nine things to be aware of as when negotiations legal agreements with customers:
- Payment terms – Most companies insist on “net 90” or even “net 120,” meaning you do get paid until 90 or 120 days from when your product / service is delivered. You can negotiate this down in some cases however to net 60 or less.
- Intellectual property – If there are ways to customize or extend your product, you need to define ownership over those “derivative works.” Otherwise it could cause IP issues later when building features similar to those works.
- Source code escrow – For tech startups, this was a standard clause. In the SaaS world, this is a trickier since the software is rented. Bigger companies will still insist on escrow, but you can sometimes pass the costs of escrow onto the customer.
- Acceptance criteria – This defines when the software is considered ready for use by customer. It is important to clarify the criteria because payment for fee and start dates of renewals often hinge on the customer agreeing to acceptance.
- Termination for cause – In the case of serious contract breaches, terminating a contract makes sense. Sometimes the reasons are specious however and customers try to include language that borders on termination for convenience. Try to negotiate these reasons out of the contract, or at the very least add penalties for early termination for those reasons.
- Most favored customer – I mentioned this earlier, this gives a customer enormous pricing power because any better pricing you grant to later customer extends to them. Unless it is the government, do what you can to remove these clauses.
- Data privacy – If your product or services touches end customer information, you will have a higher bar in protecting data. You may not be able to waive requirements due to local laws, you can limit liabilities or pass on costs for additional data privacy measures.
- Insurance coverage – Often big companies will require their vendors to maintain adequate levels of Errors and omissions (E&O) insurance and other policies. You may not be able to avoid acquiring coverage, but you can reduce the type and limits of coverage required.
- Indemnification & liability – These are often the most contentious of clauses as customers often want their vendors to pay for all sorts of problems that might arise. You want to set a lower cap for limitation of liability and reduce the scope of items you indemnify your customers for.
There is a lot of information above and this does not even touch many other critical details in contracts such as assignment, sub-contracting, and non-solicitation. The best advice is to find a reputable attorney experienced with startups and understands your business. These professionals can guide you through specific questions and can help you when experience difficult legal negotiations with customers.
Having an understanding in sales agreements prepares you for building a solid long-term business by avoiding common mistakes that stall growth. Now you need to close the deal! That means negotiating, which is the next topic and will also conclude this startup founder sales series.