Startup legal playbook

Negotiating commercial contracts


  • Torys’ Emerging Companies and VC Group

Watch this if: you are preparing commercial contracts for your startup

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Tyler Cassack (00:05): Whether it's an agreement with a supplier, or a customer, or a vendor, clear, well-written contracts are key to the success of just about every company, regardless of its size. And as founders grow their startups, clear contracts help them reduce their risk, protect their bottom line, and also set them up to be able to answer many of the questions that investors will have for them when sourcing their data room.

I'm Tyler Cassack and I'm here with Steven Slavens to discuss what founders should focus on when thinking about their contracts.

Steven Slavens (00:35): Startups, like any kind of company, need to think strategically when it comes to their supply chain and when it comes to their customer agreements. They have to ask themselves: how can I manage risk, realistically? What do I think my customers want me to provide to them? And how can I work with my suppliers to enable that?

There are going to be contracts that come into play as you work through these different areas of your supply chain and your customer relationships. So, while what's going to be important is going to be a little different for every business, there are some things that we're always going to be concerned about and that we're always going to look at closely. So, data and IP-related provisions are always important, as are indemnity and limitations of liability. Another area to really focus on would be restrictive covenants like exclusivity provisions or territorial restrictions. Anything that's going to limit the scope of where your company can go and how it can grow. One way to think about these things is: what sorts of provisions would give an investor pause if they saw them in the data room?

Tyler Cassack (01:35): So, that means as a founder, you should be turning your mind to things like change of control provisions or assignment provisions. You know, whether a particular transaction gives rise to notice requirements or consent requirements, maybe even termination rights under a particular contract. Relatedly, you should probably also consider the term length of your contracts and what each party's termination rights really look like underneath each of those.

The timing of renewals and how locked in a company is in respect of its contracts could be especially important if the company foresees an exit event in the near future. In saying all of this often investors aren't necessarily interested in every detail of every contract disclosed in the data room. And so, Steven, what are some of the things that they usually focus in on and how should startups be thinking about each of these topics?

Steven Slavens (02:19): I'd say there are two big ideas to get across on this topic. The first is the interaction between restrictive covenants, so things like exclusivity provisions or other restrictions, and the change of control provisions as they apply in different scenarios. The second thing is thinking about the reps and warranties that an investor is likely going to ask of you when you find yourself trying to raise money or selling your business.

So on the first point, restrictive covenants, I think what's important is to think about the relationship between those things and a change of control provision and understand that it can be difficult to piece together how your company is going to evolve in the future when you're negotiating an agreement today. So, it may seem an “easy give” in your contract negotiation, if you either restrict your business to a certain geography based on present scope, or if you're in a niche business like, say, manufacturing and distributing technologically advanced toilets, it may be easy for you to say that you won't issue a credit card.

But I do urge founders to not only think about, you know, how big their business may get, but also to think about how big a potential investor may be. The company that decides you’re the perfect strategic target could be a large international retailer with a bank affiliate that issues credit cards or the private equity firm that wants to become your controlling shareholder may have portfolio companies that operate all over the world, or they may operate in financial services. Because exclusivity provisions and territorial restrictions and other types of restrictive, restrictive covenants are generally drafted broadly enough to capture affiliates under the same ownership umbrella. You would be restricting those portfolio companies too.

All of a sudden, those “easy gives” aren't so easy to live with. On the second point, what reps and warranties an investor would expect from you, I think that most targets should expect some sort of rep that you're complying with your most material contracts. So, things like your top customer agreements, I think generally most companies are pretty good about this. But if you plan to sell your products or services to large customers, especially in regulated industries like financial services or health care, founders need to plan ahead when they're developing their supply chains. Those customers will ask a lot of startups, and in turn, when negotiating their agreements with suppliers, startups need to ask a lot of their suppliers.

Most banks will have stringent requirements not only for how a startup runs its business and stores its data, but will also expect every one of a startup’s suppliers to live up to the same requirements. The same may be true for other large customers in any industry, not just financial services. As a startup, you have to build your web of suppliers in a way that will allow you to grow your customer base without signing up for obligations that you can't meet, whether it's data security, business continuity, data location or audit rights. All these things are going to be important.

If you don't think about these things when you're negotiating your supply and your customer agreements, you're going to have trouble living up to the sorts of reps that an investor or a potential acquirer would typically expect you to make.

Tyler Cassack (05:17): So, I know we're always super focused in on restrictive covenants, and you're right, but thinking ahead to the reps that are going to be given to an investor in connection with a purchase agreement is a good idea. From a corporate perspective, I'd also add that investors are always keen to understand the full scope of the company's liabilities.

They'll ask questions like: has the company undertaken to do anything in the future and failed or forgotten to deliver on that promise? If contractual covenants have been breached, have they been waived by the particular party? If not, what's the particular dollar value that the company has potentially been exposed to? Does the contract contain a limitation of liability clause that caps the company's exposure at a price for the services rendered? Is that uncapped?

Steven Slavens (05:56): Exactly. You know, we're always thinking about those things when we work with clients to get their customer and their supply agreements negotiated properly. It has to be right for their business, and ultimately it has to look right for future investors too.

    Well-written contracts can help any company mitigate risk. For startups in particular, contracts also play a large role in how investors will assess them for funding.

    In this video, Tyler Cassack and Steven Slavens discuss key contract considerations founders should keep in mind when navigating customer agreements, supply chains and investor due diligence.

    Topics include:

    • strategic questions to ask as you scale
    • the key elements your contracts should include
    • what investors see as red flags

    To discuss these issues, please contact the author(s).

    This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

    For permission to republish this or any other publication, contact Janelle Weed.

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