I often hear from founders of B2B companies, especially in the early stages, about the difficulty of negotiating customer contracts. As a startup, negotiating is tough because you are not yet established or trusted in the marketplace. When a customer buys a product from your company, they are taking on risk: risk that your startup may fail, leaving them with an unsupported product; risk that your product won’t work as advertised or that it will mismanage private data, open up security holes, infringe on IP, or cause collateral damage to other critical business systems; risk that your company won’t patch bugs on time or respond to support calls when issues arise; and so on.
With all these risks, many founders and startups make the mistake of being overly accommodating during initial contract negotiations. The best approach, however, to writing a sales contract is to think of it as a system of interconnected components and levers that work together to achieve an acceptable level of risk and reward for both you and your customer. “Put everything on the table. Be open to negotiating everything as long as it’s within the acceptable boundaries. The customer’s got to give to get,” advises Mark Cranney, CRO at Signal Fx.
To help startups navigate the risk and reward trade-offs of customer contracts, I interviewed lawyers, founders, and CROs about their experiences and what they learned about winning the deal without taking on contractual risk. In this post, I look at 16 of the most important sales contract clauses and how to approach each.
1. Warranties and Remedies
Warranty and remedy clauses are your first line of defense against unacceptable risk for your company. Warranties describe what your product will do and how it will work (“conforming to spec”) as well as what your Service Level Agreement (SLA) covers. Remedies describe how you will compensate the customer if your product does not work as defined by the warranties. By clearly defining your warranties and remedies, you avoid the risk of an unhappy customer suing you for damages when your product breaks down or does not work as expected.
- What will your product do and how will it work?
- What kind of performance guarantees (e.g. uptime) should the customer expect?
- How will the customer be compensated in case these expectations are not met?
- Protects you from being sued for covered issues
- Sets customer expectations and improves satisfaction
- Specify warranties as clearly and completely as possible. Incomplete warranties can leave gaps for which you can be sued.
- A warranty should typically come with a specific, limited remedy. “Providing warranties without specific remedies is problematic because it opens you up to all available remedies, including termination of contract and indemnification. Make sure your remedies are specific and limited,” says Stacey Giamalis, Chief Legal Officer at PagerDuty.
- Remedies should be limited to credits on product usage (e.g. 1 month free) or some other forward-looking discount.
- Remedies specified as money back to customers may have revenue recognition implications. Accounting standards (FASB Standard: ASC 606) as of 2019 (2017 for public companies) require companies to constrain recognized revenue to the amount for which “sufficient” confidence exists that no reversal will be made at a later date.
- “Warranties and remedies, limitations of liability, and indemnities are interrelated so read them together to make sure you understand your company’s full risk exposure. What you give in one section, you may be able to cap or limit in another,” advises Patty Downey, the Principal for Downey Legal Solutions.
2. Limitations of Liability
The next most negotiated clause in the contract is the limitations of liability clause (aka LOL). Limitations of liability set a cap on how much you, as the vendor, can be sued for. Usually, there’s a general catch-all cap and a higher super cap for specific items related to negligence, misconduct, and breach of confidentiality.
- If you are sued, how much can you be sued for?
- Establishes the upper limits on how much money you can lose if you are sued
- Translates to the legal risk exposure an acquirer might have, so acquirers and investors look closely at limitations of liability
- Both the general catch-all cap and the super cap are best negotiated as a multiple of fees paid in some previous time period. The standard clause is 1x the fees paid in the previous 12 or 24 months, and for certain other items, perhaps 2x those fees.
- Early stage startups with little negotiating leverage may be forced to negotiate caps that are absolute and unrelated to fees paid. These caps are often so high that paying them would be ruinous for the startup. In this case, Paul St. John, VP of Worldwide Sales at GitHub, suggested mitigating the risk: “Buy an insurance policy that covers the liability and split the cost of the insurance with the customer.”
- While renegotiation is tough, it is possible. Renegotiate limits after you’re more established and after you get an in-house general counsel. Dan Wright, AppDynamics COO and former General Counsel, relayed his own experience with renegotiations: “It was brutal. We spent a year going through and renegotiating all those contracts. Customers are usually amenable to reason. It takes work, but it can happen.”
Indemnities provide an insurance policy for your customer in the event that they are sued for something related to their use of your product. For instance, if your product infringes on a third party’s intellectual property or mishandles private data, indemnities establish what your responsibility is. Damages that a customer might expect you to compensate them for can be direct, such as settlement amounts and legal fees, or indirect, such as reputational loss and business impact.
- What’s your responsibility if your customer is sued because of their use of your product?
- Just as limitations of liability protect you from legal exposure, indemnities protect your customers.
- Acquirers and investors eye these clauses carefully to assess their exposure if your customers get sued.
- Limit coverage to direct losses (e.g. legal and court fees). Avoid covering indirect losses, such as reputation or business impact. These are hard to quantify and can be significantly larger.
Require that you agree to any settlement amounts.
- Caps are determined by precedent in the market, so refer to what larger companies in your space are giving as indemnities.
- Some indemnity clauses might be completely uncapped such as IP infringement.
- Consider using geo-specific clauses for indemnities. Sowmya Bala, Associate General Counsel at PagerDuty, identifies this as a recent trend in SaaS sales contracts: “Vendors are moving away from world-wide indemnification for IP infringement to geo-specific ones to be able to better manage and understand exposure.”
Entitlements establish boundaries around what the customer gets. It’s important to have these boundaries so that you can later upsell the customer on new features/capabilities and experiment with packaging and pricing over the lifetime of the company.
- What is the customer entitled to?
- What are the limits of those entitlements? Which features and updates are included? For how long?
- When an early stage company secures a potentially large deal, entitlements are important and prevent you from giving away the goose along with golden eggs.
- Limiting what the customer gets in a single transaction allows you to later upsell the customer on new features/capabilities and to change your pricing as you experiment with packaging and pricing over the lifetime of the company.
- Failing to deliver promised features can have revenue recognition implications, especially if a customer can cancel the contract. Entitlements can protect you from overpromising.
- Rely on your help/usage documentation for descriptions of what the product does, then “tie entitlements to whatever is in the documentation to make the definition tightly defined in order to protect the company’s future revenue streams and IP,” suggests PagerDuty’s Bala.
- Delineate between updates that existing customers have a right to (like security patches and bug fixes) and new features that might require additional payments. One way to do this is to define updates as what is available to other customers at no additional cost.
- Avoid promising to deliver certain features for a single customer, unless you are certain that it is needed by other customers and you are committed to working on it. Sometimes priorities change, and if the delivery of a feature is in the contract, you can find yourself having to return a large check.
- Make sure that your sales team does not add promised features, upgrades, or other entitlements in attached letters or Statements-of-Work (SOWs).
5. Data Use
With the rise of machine learning, the ability to train models based on customer data and reuse those models across customers is a strategic capability. At the same time, customers will often refuse to allow you to use their data due to privacy and litigation concerns. You need to think carefully about what it takes to win the contract and maintain a long-term strategic capability, then have a plan for negotiating with customers who are hesitant to share their data.
- How can you use your customer’s data?
- Data use is the foundation of strategic analytic capabilities.
- Your ability to use customer data can really impact how your company is valued and how it performs.
At a high level, there are three types of data use agreements:
- You own the data and can do whatever you want with it as long as it is not directly shared with other customers.
- Your customer owns the data, but you are free to train models on it and can reuse those models across customers.
- Your customer owns the data, and you are not allowed to reuse any derived works across customers
- Large companies will often require the third option and not allow any use of their data or models trained using their data. Smaller companies will be more open to negotiate use of their data.
- When a company will not allow you to use their data, you can look at alternatives, such as charging them higher fees or limiting their access to models trained using data from other customers.
6. Contract Term
Contract term defines the length of the contract. The length of the contract term should be based on your expectation of leverage in future contract negotiations. On the one hand, your product may become more business-critical to the buyer or they may want to expand significantly, thus increasing your leverage. On the other hand, the renewal or expansion revenue from the customer may become critical to making or breaking your numbers, thus decreasing your leverage. In general, if you expect more leverage in the future, you will want to negotiate shorter contract terms.
- What is the contract length?
- Will the contract automatically renew?
- The contract term can help guarantee a level of income over a period of time, but it can also lock a startup into unfavorable terms and hinder your ability to renegotiate.
- The contract term should be negotiated based on the expected changes in the value of your product to the customer and your leverage in negotiations.
- Longer-term contracts (usually multi-year) guarantee a level of income over a longer time period, but risk underpricing your products or compromising on certain clauses. A longer-term contract is preferable if renewal or expansion revenue from the customer is critical to making your numbers.
- A shorter-term contract is preferable if you expect the software to become business-critical to your customer or if you are significantly expanding your product’s capabilities.
- If you set a longer contract term, negotiate for payment upfront so you can invest it back into the business earlier. Make sure you have solid limitations of liability and indemnities clauses because of the larger exposure.
- PagerDuty’s Giamalis gives this advice: “If you’re an early-stage startup, you may have deep discounts in your early contracts that you’d want to renegotiate sooner rather than later and your views on pricing and packaging are constantly changing. Be thoughtful about whether to include auto-renewal so you can force that renegotiation to happen.”
Often overlooked, publicity is one of the more important clauses for early stage startups. Early stage companies should ask customers to participate in marketing activities, including displaying a customer’s logo in marketing materials, developing case studies and joint press releases with the customer, and quoting the customer in product testimonials. Unfortunately, publicity clauses are often the first that a sales rep will redline because they can cause friction in the sale. Luckily, there are tactics for making sure these make it into the final contract.
- Can you use the customer as a reference in marketing materials? If so, how?
- In the early life of a startup, customer references are extremely important for building credibility.
- Customers may hesitate on these clauses because they view them as additional work and don’t want to expose what software they use to the rest of the world.
- Large customers are often the hardest to work with. Some large global enterprise software companies are even known to refuse to participate in joint marketing activities unless the product is free for them.
- Allow sales reps to offer a discount as an incentive to the customer to participate in marketing activities, but make it a one-time discount, so as not to impact your leverage for the renewal negotiation.
- Alternatively, you can make securing customers for marketing activities part of your sales team’s quota or compensation structure. For example, Joyce Solano, CMO at Ironclad and previously SVP Marketing at Leanplum, calculated the ROI of a customer quote at Leanplum to be about $15k and was able to offer spiffs to sales reps who did get a customer quote.
8. Source Code Escrow
This clause defines the terms under which a customer can access product source code. Large customers will sometimes negotiate source code escrow clauses to protect themselves in case your company disappears or terminates a product and they need to support the software themselves. In reality, it’s very unlikely they would be able to do that, and these clauses are typically ones to avoid.
- Under what conditions does a customer get access to your product’s source code?
- Source code escrow clauses create risk for a potential acquirer.
- These clauses can also create misalignment between the customer and the vendor and provide incentive for a customer to bankrupt you to gain ownership of your source code.
- Generally, startups should avoid source code escrow clauses like the plague.
- If you can’t avoid including a source code escrow clause, the terms must be very strictly defined. “Make sure it’s limited only to when the company goes bankrupt, and only in non-competitive uses, so your customer can’t bankrupt you and then turn around and resell your software,” explained AppDynamics’ Wright.
9. Most Favored Customer
The “Most Favored Customer” clause guarantees the customer the best price the vendor gives to anyone. Apple, for example, is known to require this from vendors.
- Does the vendor guarantee the customer the best price it gives anyone else?
- Complying with this clause is operationally very difficult, especially for an early stage startup that doesn’t yet have good processes for tracking what prices are being given to what customers.
- This clause makes it very hard to give differentiated pricing to different customers.
- Patty Downey said in her experience customers sometimes try to sneak this clause in, so be careful when using a customer’s contract.
- Negotiate hard against this clause, and unless it’s a major customer, flatly refuse it.
- If you have to accept it, restrict the definition of “other customers.” For example, you can make the clause apply only if the better pricing is given to a customer of a similar size in the same industry in the same geographic region with consistent liability terms.
10. Assignment Provisions
Many startups are eventually acquired. If you are acquired, what does it mean for your customers? Assignment provisions set out in advance what happens to a sales contract if you are acquired.
- If you are acquired, does your contract get assigned to your acquirer?
- Under what acquisition conditions does a customer not have to abide by a contract or certain contract clauses?
- Customers may be concerned that your startup will be acquired by a competitor and want to mitigate risk with an assignment provision.
- An acquirer will lose revenue streams if customers leave and so assignment provisions can lead potential buyers to undervalue your company.
- If a customer asks for assignment provisions, try to limit the clause to specific cases where you are acquired by a competitor and spell out who qualifies as competition in the contract.
11. Termination for Convenience
Customers will often want the freedom to terminate the contract for any reason. The termination of convenience clause allows them to do this. Like source code escrow and most favored customer clauses, it’s another one startups should avoid, if possible.
- Can customers terminate their contracts for no reason?
- Termination for convenience clauses increase the risk of losing customers in the event that you are acquired. As a result it can lower your valuation by potential buyers.
- This clause can make revenue recognition difficult under the FASB’s ASC 606 accounting standards that require “sufficient confidence” in future revenue.
- Push against these clauses very hard as it could impact your ability to recognize revenue. If a customer is insistent, PagerDuty’s Bala recommends, “replacing it with a shorter contract term or no refund rights for pre-paid amounts.”
12. Right of First Refusal (ROFR)
If an interested party makes an offer to acquire your company, a Right of First Refusal (ROFR) clause allows a customer to acquire the company if they make the same offer. You should generally say no to these types of clauses because they can significantly impact the acquisition process.
- Does a customer have a right to match an offer made to acquire you?
- Can a customer block an acquisition of your company?
- Customers might ask for this to reduce their exposure to an acquisition by a competitor.
- ROFRs can significantly complicate and delay the acquisition process.
- The only time you should consider this clause is for a very strategic customer.
13. Support Terms
Support terms define what your customer should expect from your support team and what happens if they don’t meet those expectations. These are similar in spirit to warranties and remedies, but rather than covering the product and its capabilities, they covers the promised support around your product.
- How long should it take for a support ticket to be answered?
- How are support requests or problems escalated?
- What kind of remedies can a customer expect if support is not adequate?
- Defining your support helps you clearly set expectations and avoid disappointment and potential demands for money back.
- Inadequate support can make it very hard for you to renew the contract.
- Customers may require the ability to terminate a contract for inadequate support. There may be implications for your ability to recognize revenue paid upfront if you agree to this.
- As with warranties, be very clear in your definition of what is and is not covered by support.
- Remedies for failing to provide timely and sufficient support should typically be credits on the product. For instance, Salesforce sets the standard for service levels in SaaS and limits remedies to credits.
- Include disclaimers and specific measurements to prove a service level break to prevent customers taking advantage of this clause.
14. Roll-out and Payment Milestones
Some sales contracts have clauses so that you don’t get paid unless you meet certain roll-out or milestone requirements. Unfortunately, rolling out new technology in an enterprise is tough. There’s often legacy compatibility issues, user training, and a constant deluge of fires for IT to fight. Hinging payment on deployment is risky.
- Are there any conditions or milestones that you need to meet before your customer pays? If so, what are they? And what happens if you fail to meet them?
- Are there any milestones the customer has to achieve? What are the penalties if the customer does not meet them?
- This clause can disincentivize customers to effectively deploy and drive adoption of your product.
- Fight hard against milestone-based payments, but in some very risky large deals, these may be an unavoidable standard clause.
- If you do end up with milestone-based payments, add in reciprocal customer milestones and penalties to incentivize successful adoption of your product.
Arbitration is a process by which parties that may have otherwise gone to court instead go to a third-party neutral judge who decides on the outcome. Arbitration clauses prevent both parties in a contract from filing a lawsuit and require that they use an alternative, such as a third-party neutral judge, to resolve certain disputes. These clauses are common (and controversial) in employment contracts. More recently, they have started to appear in sales contracts to reduce the financial risk in the event of a dispute.
- If there’s a disagreement between you and your customer, can the customer sue you in court or do they have to go to an arbiter?
- Under what conditions is arbitration used?
- Who chooses the arbiter and who pays for them?
- What is the arbitration process?
- Arbitration can significantly reduce your and your customers’ legal exposure. Arbitration is much less random than a jury and arbiter-determined fines and awards are much smaller than jury-determined ones.
- Arbitration clauses are most advantageous when you have the most to lose in the relationship, such as when your customers are individuals or small businesses.
- If you’re a bottom-up type company where you have hundreds of thousands of customers with individual users or small businesses, add an arbitration clause to your click-through contracts. It can shield you from a disaster if you have an issue impacting all those users.
- Beware of customers forcing arbitration clauses on you. It may be a red flag that they have a history of being a difficult customer.
Pricing is one of the most important contract clauses. Nothing impacts what type of business you build and its economics as much as pricing. Too often, my partners at a16z and I observe early-stage companies underprice their offerings. Pricing is also a deeper and longer topic than I can completely cover, so here I’ll focus only on the contractual aspects of pricing — for a discussion of the full topic of pricing, check out the a16z “Pricing, Pricing, Pricing” podcast and “The Price Is Right: And for Early-Stage SaaS Companies, It Needs to Be” article.
- What is your customer paying for and how much are they paying?
- What do you meter and how do you price per unit of consumption?
- Is there a threshold of consumption beyond which pricing changes (i.e. pricing tiers)?
- Is there a prepaid part and a “true-up” billed for the actual consumption? How is overconsumption priced?
- Setting clear expectations for what a customer owes and how they will pay helps ensure timely payment and keep your finances in good order.
- Pricing goes hand in hand with packaging. You can sometimes use packaging to force a change in pricing. For instance, “Blue-washing,” a term used to describe how after someone acquires a company, they change the sales contracts (washing) through slight changes in packaging to have more favorable (blue) pricing terms.
- If you need to agree to a lower price, especially for early customers, make sure it’s written up as a discount rather than a lower price. This makes it easier to negotiate it back up.
The sooner you can put together a standard contract and a strategy for negotiating with your customers, the better. As an early startup, you may have very little leverage in sales negotiations, but thinking through your contract clauses will help you get a strategic balance of risk and reward. This won’t just keep you in business, it will also set the stage for a successful exit strategy.
Many thanks to the folks who have helped me to put this together: Sowmya Bala, Martin Casado, Mark Cranney, Patty Downey, Stacey Giamalis, John Gilman, Juleen Konkel, Peter Levine, Paul St. John, Sheena Weinberg, and Dan Wright.
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