How to Protect Long-Term Investments in Operational Contracts (Full Article)

Consider one of the most difficult issues you’ll ever encounter when negotiating a contract: one party must make a large, long-term investment for the deal to work, but won’t sign the contract unless its investment (and its return on the investment, or ROI) is adequately protected.

Introduction

This article discusses several practical ways to protect that investment and get your deal done.  I focus on long-term investments made as part of an agreement concerning a company’s operations, such as an independent contractor agreement, technology development agreement, distribution agreement, or purchase and sale of products or services.

Operational agreements are different from investment contracts, such as stock purchase agreements or loans to a corporation, partnership (limited partnership or general partnership) or limited liability company (LLC).   Investment contracts raise additional questions under corporate/partnership, tax and securities laws.  For example, long-term cash investments can be protected using preferred stock in a corporation or special provisions for capital accounts in partnerships and LLC’s.  Loans may be protected by taking an interest in collateral, such as real estate (e.g., a mortgage on a commercial building).  By contrast, this article focuses on provisions of non-financial contracts used in operations.

By considering the 3 approaches that I describe, you’ll be far ahead of many other deal makers.

You can make a long-term investment in a couple of ways:

*    Investment in the Other Party. You could pay the other party to enable it to perform a project for you.  For example, you could pay an advance to a contractor so that it will undertake a long-term software development project for you.  Similarly, book publishers often pay an “advance against royalties” to an author to enable the author to write a book.   Because funds are advanced, these are similar to loans, but the main goal is not to lend money and make a financial return.  The main goal is to get software developed or a book written.

*    Investment in Your Own Company to Support a Relationship. You could invest in your own infrastructure to support a deal with someone else.  For example, if you are a service provider, you might make extensive — and expensive — one-off, custom changes to your platform and business processes in order to provide service to a large customer.

In either case, you expect a return on your investment.  You rely on your contract to make sure you receive that return.

 3 Key Approaches

You can better protect your investment in operational agreements by applying these 3 key approaches:

1.      Match the Contract Duration to the Investment Horizon, or Lay Out an Early Exit Path that Works

2.       Focus the Relationship

3.      Leverage Other Relationships Between the Parties

Let’s go through these in turn.

 Approach #1: Match the Contract Duration to the Investment Horizon, or Lay Out an Early Exit Path that Works

Match the Overall Term. You generally should match the contract duration (known as the “term”) to your expected investment horizon.  If you put $5 million into a deal, and expect to receive back your $5 million plus your expected ROI in five years, you’re asking for trouble if your contract lasts only one year!  This is the kind of simple mistake that can easily happen when the business people are focused on major terms in a term sheet.  Keep your eye on this ball, especially as your deal changes.

Match the Payment Timing. Where possible, payment timing also should match up to the timeline for your desired ROI.  For example:

*    Consider replacing a fixed monthly fee with a fee based on the number of customers acquired which might could front-load or back-load the payments, depending on the timetable of marketing and promotion.

*    Step up or step down payments over the duration of the contract to match anticipated sales or revenue trends, instead of fixed identical payments throughout the contract term.

Talk with an accountant before becoming too adventurous with these alternatives. Some alternatives might seem too artificial, and might not square up with accounting requirements for revenue recognition.

Early termination of the contract, in other words, an early exit path from a business relationship, creates more difficult questions.

Termination for Convenience and Kill Fee Workaround. Termination for convenience means termination by a party “for any reason, or no reason at all.”  You’ll often see it written this way in a contract.  In some contracts, the clause is written so that either party can terminate for convenience.  In others, only one party can terminate for convenience.  (If only one party can terminate for convenience, then that party essentially holds an option for the entire deal.)

Here’s how it can harm you.  Suppose you make an investment as part of a five-year operational contract, and you expect to receive a return on your investment over the five-year term.  However, both parties can terminate for convenience on 30 days notice.  Watch out!  The other party can pull the plug, terminate for convenience at any time, and your “five-year” deal is gone.  You won’t be happy if it happens to you.

If the parties absolutely need the ability to terminate the deal for convenience, here is a workaround that’s often useful.  It comes from the world of magazine publishing.  A magazine may commission an article from a writer.  However, the magazine’s needs for specific articles can change, such as last-minute advertising insertions or cancellations that affect the number of pages available for articles. The magazine needs the flexibility to “kill” (not run) the article, and so it pays a “kill fee” to the writer if the article does not run.  So it goes with other contracts.  If you make a large investment in a deal, and the other party needs the ability to exit the deal early at its whim, then it can pay for the privilege.  If it kills the deal early, it pays you a pre-set kill fee to compensate you for all or part of your investment, or even your lost revenue expected over the life of the deal.

Termination for Change of Control. What happens to your investment in the deal if the other party is bought by another company?  In our interconnected global economy, this happens all the time.  Virtually any company, public or private, can be acquired in a merger & acquisition (M&A) transaction, often on very short notice.

Even companies that are closely held within a tight-knit family are subject to a change of control, when the controlling shareholders die or become disabled, and the shares pass to another family member.  If this happens, your wonderful long-term contract may no longer be held and managed by the friendly people whom you’ve known for 20 years, but by a faceless bureaucracy known for dropping long-time partners to save a few pennies on the dollar.  Or, worst of all, your cooperative partner of 20 years may transfer your wonderful long-term contract to… your closest competitor.

That is why many contracts, especially long-term contracts, contain the ability for a party to terminate upon the change of control of the other party.  Sometimes the change of control provision is triggered only on a change of control to a competitor, either defined generically or as specified on a list.

Including a provision to terminate for change of control may enable you to exit the deal, but possibly not recoup your long-term investment, unless you include a kill fee.  Compared to kill fees for termination for convenience, I see kill fees less often for a change of control.  Instead, the parties may work out a way for the contract to continue in some isolated fashion.  Or, the parties just look for a replacement deal with someone else.

Termination for Breach. Most contracts, except the very simplest and smallest, will specify how to terminate if the other party breaches.  (A few will rely on the underlying law instead of a specific contract provision.)  If the other party wrongly backs out of your long-term deal, it probably will renege on any remedies and any other protective mechanisms you have in place, but the mechanisms are useful if you must go to court.

Sometimes, a party will propose a “liquidated damages” clause.  This type of clause attempts to make one party pay a pre-set amount to the other party for breach of the contract, in order to avoid the expense, difficulty and delay of proving damages.  (Liquidated damages are different from kill fees above, because kill fees are not triggered by a contract breach.)  Liquidated damages should never be characterized as “penalties,” which are not legally enforceable.  Instead, they are intended to estimate the amount of damages that might occur.   Just try estimating them, though.  Oftentimes, this is an attempt to place a dollar figure on an event that is unlikely and has no clear value.  Business people quickly lose patience when asked to put a price tag on such a hypothetical event.

Liquidated damages can be useful where the parties have a general sense of the magnitude of possible harm, and want to pin a number to it.  They also can be useful as a way to measure and add up many small breaches.  However, I have seen situations where liquidated damages led to a business mindset of “keeping score” over trivia, a distraction from the more important goals of the relationship.

Make Termination More Difficult. Another workaround is simply to make the process of termination more difficult.  That gives the parties the incentive and chance to talk … and talk … and finally to resolve the issues without going to court.

*    Mediation.  You can agree to mediation before going to court.  For mediation, a third party mediator is brought in (for a fee), hears both sides of the issue, and tries to get the parties to agree to a solution.  Sometimes mediators are accused of just splitting the solution down the middle.  This is fine in many situations, but won’t necessarily work if one party is clearly and deeply in the wrong.  However, it does encourage the parties to talk and resolve.

*    Management Escalation Process.  You can agree to a management escalation process before going to court.  This can work well when dealing with large companies.  Many times, lower level managers who don’t (or can’t) see the big picture in a contract relationship will take overly aggressive actions, and threaten breach and litigation, and so forth.  An escalation process enables more senior personnel to discuss and resolve.  Just don’t let your escalation process become an escalator to nowhere, with no timeline or end point.

If all else fails, the parties can at least provide for an orderly transition after termination.  The party who made the long-term investment may be able to reuse its investment to some extent, particularly with the cooperation of the other party.  The parties can agree to reasonably cooperate over a period of six months, one year, or longer as needed.  Both parties should keep in mind that their customers don’t necessarily know — or care — about the relationship and its problems, but they will care deeply — and complain vocally — if their experience is negatively affected.

Working out the duration and timing is relatively simple and straightforward.  Once you have worked them out, you should then consider how focused the relationship can be.  Negotiating an appropriate focus can be much more difficult.

Approach #2: Focus the Relationship

You can protect your long-term investment in an operational contract by having the parties focus particularly on each other, to make sure that relationship achieves their business and financial goals.  There are at least five ways to do this: Exclusivity, Semi-Exclusivity, Most Favored Nation (MFN), Required Minimum Purchase, and Recoupment.

Exclusivity. One of the best ways to protect one party’s long-term investment is to receive exclusive rights from the other party.  For example, you agree to make a significant investment in customizing and marketing the other party’s software.  In return, the other party agrees not to grant rights in the software to anyone else.  Or, a distributor agrees to make a large marketing investment in a particular territory, and to support this investment, the manufacturer grants an exclusive distribution rights to that distributor in that territory.

Don’t grant exclusivity lightly, though.  I have seen many deals where one party granted exclusivity, but there was no investment or special effort by the other party.  The exclusivity was simply a “give” to the other side.  The party may come to regret that concession, if better opportunities come up and the party holding the exclusive rights doesn’t exercise them.  The “give” becomes a wasted opportunity.  You should always ask why exclusivity is necessary.

On the other hand, when one party makes a clearly-defined long-term investment in connection with a contract, it can be reasonable to grant an exclusive — at least until the expected ROI of the investment is obtained.

Try to match the scope of the exclusivity to the scope of the investment.  Mismatched exclusivity and investments can lead to resentment, attempts to work around the contract requirements, and even breach.  For example, if one party makes a long-term investment in one particular field of use of a patented technology, but doesn’t care about the other fields, then the other party should not grant an exclusive license to all fields of use in broad-brush fashion.  Likewise, if a party invests only in a particular territory, think long and hard before granting exclusive rights worldwide.

Sometimes business people will seek “exclusivity” by proposing a broad non-competition clause.   Non-competition clauses are not enforceable in California under California Business and Professions Code Sections 16600 to 16602.5, with limited exceptions for certain sales of businesses and dissolutions of partnerships and limited liability companies (LLC’s).  Such clauses are enforceable under the laws of many other states, however.

Semi-Exclusivity. In many cases, the investment doesn’t justify full exclusivity, or the opportunity is at such an early stage or is so vaguely defined that an exclusive could severely limit the granting party in unforeseen ways.  In those cases, the exclusivity itself can be narrowed.  The party could grant “semi-exclusive” rights, e.g., granting rights to two companies, and no more.   Or, exclusivity could be granted for certain fields of use of a technology, but not others, as mentioned above.

Most Favored Nation. If you agree with one company that you will not grant better terms to other companies in other contracts, then that company has “Most Favored Nation” (MFN) status with you.  MFN clauses are comparable to semi-exclusive rights, because the benefit can affect several parties.  MFN clauses can be somewhat weak, but at least the other party knows that it won’t be getting a worse deal than other partners.  MFN clauses are used most often for pricing, and are called Most Favored Customer clauses when used between seller and buyers.  Generally, if a buyer has Most Favored Customer status, the seller won’t sell to other buyers on better terms, including a lower price.   MFN clauses must be carefully drafted and negotiated, because they can impact other contracts and relationships with other customers.  They also can be cumbersome and time-consuming to monitor, unless they are very narrow.

Required Minimum Purchase. Let’s say you are thinking about building a factory, but you need a certain number of orders for the factory to break even.  A customer would like for you to build the factory, because the factory can produce more products at a lower cost than existing methods.  To help guarantee that you make the return on your investment in the factory, the customer agrees to purchase minimum quantities from the new factory.  This is not as restrictive as an exclusive, because the customer can still buy from others, as long as it makes the minimum purchase from you.  Of course, depending on the numbers, a required purchase can result in an exclusive relationship for all practical purposes.

Recoupment. One party advances money to another person, so that that other person can develop a product.  The person advancing the money gets the first proceeds of the product sales until its advance is repaid to it in full, and then the parties share revenues (the upside) from there.  For example, a publisher advances $25,000 to an author to enable the author to write a book.  When the book is sold, the publisher receives the first profits to recoup its $25,000 investment.  Then, the publisher and the author share profits above $25,000, usually by the publisher paying the author a (small) royalty on sales of the book.

Once you have determined an appropriate focus for the contract, you can then review other contracts between the parties to see whether they support a stable long-term relationship.

Approach #3: Leverage Other Relationships between the Parties

If the parties have other contracts or relationships, they may create momentum so that the parties will not work with others, keeping both parties in all their relationships with each other, and enabling the party who made the long-term investment to recover it, regardless of kill fees, exclusivity, required purchases, and other legal terms and conditions.  In essence the other contracts raise the switching costs of working with another company, and create a practical barrier known as “lock-in.”

Depending on your perspective and needs, you may want to encourage or discourage lock-in.  A couple of contract provisions encourage lock-in:

Cross-Collateralization. This means that the payments or assets under one contract can be used to satisfy the obligations under another contract.  In other words, the payments due or assets under one contract serve almost like collateral for satisfying the obligations under another contract.  Although it is clearest if cross-collateralization rights are written into a contract, the law includes general rights of setoff that achieve much the same purpose.  See, for example, California Code of Civil Procedure Section 431.70.

Cross-Default. This means that the breach of one contract creates an automatic breach under a second contract.  This is often used in corporate finance transactions, where breach of one loan document (such as failure to maintain a specified financial condition) will result in a cross-default of another document (such as an agreement governing collateral, so that the lender can now foreclose on the collateral).  It is not limited to financing documents, however.  Many operational agreements can be written so that they cross-default one another.  This can create a powerful incentive not to breach any of the agreements.  This provision should be used with care, because it might facilitate an antitrust issue if one of the parties has significant market power in businesses covered by some of its contracts, and uses that power to leverage its market power in unrelated areas.

Conclusion

Whenever a party needs to protect its long-term investment in an operational contract, keep these three approaches in mind.  First, match the contract duration to the investment horizon.  If necessary, lay out an early exit path that works, considering termination for convenience with a kill fee, a liquidated damages clause, mediation, a management escalation process and a transition process after termination.  Second, focus the relationship by wisely choosing whether to use exclusivity, semi-exclusivity, a Most Favored Nation (MFN) clause, minimum required purchase or recoupment.  Finally, look at other contracts between the parties to see if the parties’ relationship should be strengthened by cross-collateralization or cross-default provisions.

 

This article is mentioned in artTechnology Law Letter No. 10.

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