Three Contract “Watch Outs” When Negotiating Deals as a Startup (Part 1 of 2)

Disclaimer: I am not a lawyer and this article should not be considered legal advice. Always consult with your legal counsel when negotiating a contract.

Negotiating contracts as a startup is particularly challenging because the other side will often believe (and sense from your behavior) that they have more leverage. When negotiating with large established Fortune 500 corporations like Disney, Walmart, and Johnson & Johnson, the power imbalance can be immense. Often large companies will try to nudge startups into unreasonable terms: no liability caps, excessive indemnities, and extra contract terms that are unnecessary and risky. Another common tactic is for a large company to push a startup into using their stock contract template. Here are three “watch-outs” to consider:

  1. Using the other side’s contract template for the deal: this is incredibly common, and sometimes the provided template will include terms that have nothing to do with your business. For example, a large company tried to push our startup into using their contract template for a digital marketing program that included terms on how we would deal with perishable inventory. The challenge often comes in two forms: 1. the other side’s legal team will tell you that they never use another companies’ contract template (which is often not true), and send you a new template to review, or 2. they will effectively “red line away” your entire contract, and replace it with their own language. The more nuanced your business, the less likely the other side’s template will align with your expectations. If the template looks reasonable, then maybe it is fine, but you need to review the language carefully with your attorney and make sure it aligns with your business objections. 
  2. Liability exposure: most deals have a liability cap of some kind to protect the vendor/provider. As the service provider, the liability cap puts a maximum ceiling on the amount your startup can be sued for in the case of a contract breach. Many times big companies will push for no-cap — allowing them to sue you for an unlimited amount of money. You need to negotiate a reasonable cap in order to protect your company from being bankrupted in the case that something goes wrong in the future. I would discuss a reasonable cap with your legal counsel, but generally, I have seen anywhere from 1x to 5x the total deal size as the cap.
  3. Indemnities: In a nutshell, an Indemnity is “a contractual obligation of one party (indemnifier) to compensate for the loss incurred to the other party” (Wikipedia). Often times big companies will put unreasonable indemnities on the shoulders of the startup. For example, an obligation to pay the other side’s legal defense costs in the event of a breach or negligence by your company (and note: this is for a breach or negligence not yet proven, but only alleged by someone). Often this requested defense clause will allow the other side to select the law firm that will represent them–instead of your company selecting attorneys. Fortune 500 companies often use very expensive attorneys. The risk with a broad indemnity is that if a specific event occurs, you may be agreeing to pay the other side’s defense costs and a potential settlement or judgment without much control over the cost or result. You need a clear understanding of your indemnity obligations in order to protect your startup from unreasonable financial harm.

The goal of most startups is to pay back their investors through a sale to another company (or sometimes an IPO). Keep in mind that your acquirer will read every single contract you ever signed. The more worrisome your past history of negotiating bad deals, the larger the holdback will be when the deal is inked — a hold back occurs when an acquiring entity holds a portion of the sale price for your company in reserve for a long period of time (usually 24 months) to handle any disputes that may arise. On top of this, the acquisition may fall through if the acquirer realizes they are purchasing a landmine of risk. You must always consider the impact that your present contracts will have on a future potential acquisition, and weigh the risk of closing the deal now for short term revenues that result in larger long-term risks. Make smart decisions in the present or you may deeply regret it in the future.

In my next post on Tuesday, February 11th I will tell you how I have successfully handled each situation.

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