ConTraps Part I: Contract Traps Entrepreneurs Should Avoid At All Costs

Note: This is part I of a four part series. Access part II HERE, part III HERE, and part IV HERE.

Agreements with Big Dumb Companies (BDCs) are like DC Comic’s evil villainess, Poison Ivy. Both are seductive and alluring and both are potentially fatal.

Poison IvyA startup’s most meaningful agreements are often struck with BDCs. You will no doubt craft agreements with companies of similar or even smaller size to your own. However, your greatest risks and greatest opportunities will arise from the deals you cut with larger entities.

Fortunately, it is possible to craft lucrative deals with BDCs that do not limit your adVenture’s ability to charter its own destiny. Just as Batman repeatedly avoids Poison Ivy’s kiss of death, so too must entrepreneurs avoid the Kiss of Death provisions which BDCs attempt to include in their agreements.

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Kiss of Death Provisions

“Ever negotiate with lawyers at a huge company? If they saw you drowning 100 feet from the shore, they’d through you a 51-foot rope and say they went more than halfway.”
Paul Somerson, Author

The allure of a company-changing deal with a BDC is strong. Big companies make seductive promises, including access to large markets, significant financial resources and vital public validation (see Pulp Facts for tips on how to maximize such validation). However, resist the urge to close such enticing deals on the BDC’s terms. Stand your ground and negotiate a mutually advantageousagreement, even if it requires you to expend more time and energy than you would otherwise prefer.

To this end, never agree to any of the following Kiss of Death Provisions when negotiating with a BDC, no matter how lucrative the potential relationship:

  • Allow the Other Side to Draft the Agreement
  • Deploy a Free Pilot
  • Cut a Multi-year Agreement
  • Lock Down the Escape Hatches
  • Give up Branding
  • Relinquish Press Release Capabilities
  • Approve Unilateral Provisions
  • Surrender Arbitration
  • Accept Unlimited Liability
  • Forgo Change of Control or Agree to a ROFO or ROFR
  • Grant World-wide Distribution
  • Relinquish Joint Intellectual Property Rights
  • Execute an Ambiguous Statement of Work
  • Agree to Bundling Without a Minimum Price
  • Grant Most Favored Nations Status
  • Issue Unmitigated Exclusivity

Do Not Allow the Other Side to Draft the Agreement

As discussed in The Bro Factor, you can greatly enhance the effectiveness of your negotiations by establishing a strong rapport with the folks on the other side of the table. If you do your job well, the BDC negotiators will consider you to be a “Bro” – a colleague with whom they have a strong, personal relationship. However, despite your attempts to ingratiate yourself and gain their trust and respect, never forget that your Bros are also your Bro Foes.

Insist on creating the initial draft of the Agreement in order to gain the following important advantages:

  • Control the tempo of the discussions – if you rely on the other side’s lawyers to create the agreement, the deal may lose momentum as it sits in the lawyer’s In-box
  • Establish fair, bilateral covenants –  agreements from large companies generally come with numerous unilateral covenants that can cost you valuable negotiation currency to unwind
  • Ensure the spirit and integrity of the business terms are not hijacked. A BDC lawyer who is not closely involved in the negotiations may, inadvertently or otherwise, craft an agreement that modifies some of the negotiated deal points.
  • Shade minor aspects of the deal in your favor, such as: payment terms (i.e., 30-days vs. 45-days), percentage of irregularities which dictate who pays for an audit (i.e., 3% vs. 7%) the manner and venue in which disputes will be resolved (i.e., arbitration vs. litigation), etc.

As you draft the agreement, include specific examples, especially when numeric formulas and calculations are involved. For instance, if you are describing the terms of a licensing fee, add one or more real-world examples which utilize real numbers. This ensures that everyone understands the key formulas, and thereby avoids a common point of contention in deals that go awry.

Do Not Deploy a Free Pilot

A “Pilot” is BDC speak for a test of your solution. If you allow your prospective partner or customer to milk the cow for free, they will resist paying for it. As noted in Frugal Is As Frugal Does, after cash, an entrepreneur’s most valuable asset is time. You cannot afford the opportunity cost of a project that does not generate revenue. Thus, if your adVenture must expend resources in conjunction with a Pilot, insist on being compensated for the use of such resources.

  • If your Bro Foe does not have skin in the game, it is highly likely that your Pilot will become derailed and overtaken by other priorities. The best way to ensure that your potential partner has sufficient incentive to guarantee the Pilot’s success is to require them to invest cash upfront. Ideally, this cash should find its way into your pocket in the form of a Pilot Implementation Fee.
  • Forcing the other side to pay a meaningful upfront fee requires them to determine the merit of a potential relationship with your firm at the outset – before you invest either your time or money. If you enter into a development or trial partnership for free, you are allowing the BDC to forestall its ultimate determination of the value of the partnership.
  • Clearly communicate that you are not attempting to get rich on the Pilot Fee. Rather, you are simply assigning a cost to your company’s time, in order to mitigate your downside risk and to ensure that both parties properly evaluate the economic viability of the deal upfront. It may be necessary to apply a portion of the Pilot Fee toward the ultimate license / purchase price, in order to obtain an up-front fee.
  • Insisting to be compensated for your time will also help elicit the necessary respect from the BDC. By demanding a payment that is meaningful to you yet nominal to the BDC, you are conveying that your company is in demand and that you do not have to give away your time or technology in order to entice BCDs to partner with you. As noted in Private Means Private, in order to ensure a healthy partnership, avoid becoming the BDC’s Corporate Beyotch.

Oh, but you scoff. I have negotiated deals with numerous high-profile BDCs that included significant Pilot fees. In one instance, we were paid $50,000 and the Pilot was never implemented due to the fact that the BDC was acquired after the Pilot Agreement was finalized.

Do Not Cut a Multi-year Agreement

In the life of a typical adVenture, a year is an eternity. Thus, it is imprudent to limit your future prospects by entering into a multi-year deal. BDCs generally prefer long-term agreements because such deals reduce their uncertainty and thus lower their risk. Conversely, multi-year deals reduce your flexibility and potentially increase your opportunity costs.

Some BDCs may attempt to force you to agree to an evergreen termination provision. Such covenants require written notice of termination within a specified period of time, prior to the end of the term, in order for a party to terminate the agreement. If such written notice is not made, the agreement is automatically extended, usually for an additional year.

Never agree to such a provision. BDCs can afford to hire large staffs to adequately track all of the evergreen provisions in their contracts. You will not have that luxury. The chances of your company missing a termination deadline are high, which could result in your adVenture being locked into a disadvantageous deal for an additional year.

Rather than agreeing to an evergreen provision, suggest that both parties mutually agree upon additional one-year increments in writing, at the end of each term. If the other party insists on an evergreen term, negotiate a reasonably conscribed no cause termination clause. This will significantly reduce the risk associated with inadvertently rolling into an additional year, as you can simply exercise the “out” clause and terminate the agreement.

Do Not Lock Down the Escape Hatches

Agreements are obviously intended to bind both parties. However, avoid writing contracts that may contractually hold the other party to an economically infeasible deal. If the relationship is not advantageous for the other party, there are many legal ways a BDC can undercut and effectively terminate the deal.

As noted in Roping in the Legal Eagles, successful entrepreneurs are generally not litigious. Even if you are a mean cuss, your startup will likely not have the financial resources to hold a BDC to disadvantageous deal terms. Thus, you gain nothing by crafting an agreement that contractually forces the other party to work with you, irrespective of the financial outcome of the relationship.

Ideally, either party should be free to terminate the agreement, after a reasonable notice period. By allowing either party to walk away, you force both parties to continually strive to maintain a mutually beneficial relationship.

One exception to this easy-out philosophy is with respect to recouping any substantial investments you make on behalf of the partnership. Irrespective of the easy-out clause, ensure that your costs are reimbursed in the event of early termination by the BDC. Such reimbursement might be in the form of a walk-away fee to be paid by the party who terminates the relationship. If the walk-away fee is unreasonably large, it is possible that the BDC will breach the agreement and refuse to pay the fee. As such, keep any such fees reasonable.

Part II of this series discusses the following contract traps:

  • Powered-by Branding
  • Press Release Rights
  • Unilateral Provisions
  • Arbitration
  • Unlimited Liability
  • Change of Control

Part III addresses:

  • World-wide Distribution
  • Joint Intellectual Property Rights
  • Statements of Work
  • Product Bundling
  • Most Favored Nations Status
  • Exclusivity

Part IV addresses:

  • Issue Unmitigated Exclusivity

Contractual Antidotes

Batman thwarted Poison Ivy’s deadly kiss by coating his lips with an antidote before taking her up on her seductive offer of romance. By effectively structuring your agreements, you too can enjoy a relationship with a BDC without suffering the potential deadly consequences.

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John Greathouse is a Partner at Rincon Venture Partners, a venture capital firm investing in early stage, web-based businesses. Previously, John co-founded RevUpNet, a performance-based online marketing agency sold to Coull. During the prior twenty years, he held senior executive positions with several successful startups, spearheading transactions that generated more than $350 million of shareholder value, including an IPO and a multi-hundred-million-dollar acquisition.

John is a CPA and holds an M.B.A. from the Wharton School. He is a member of the University of California at Santa Barbara's Faculty where he teaches several entrepreneurial courses.

Note: All of my advice in this blog is that of a layman. I am not a lawyer and I never played one on TV. You should always assess the veracity of any third-party advice that might have far-reaching implications (be it legal, accounting, personnel, tax or otherwise) with your trusted professional of choice.

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