Six Things Startups Need to Know About Commercial Contracts

Many thanks to Liza Hadley and the team at Izba for their contributions to this article.

1. You are never too small for a commercial contract

Commercial contracts help define the rules of the road for your business relationships. They establish a framework for how the parties are going to work together, what each side is going to do for the other, and when and how you are going to break up. Everyone hopes that a relationship will be perfect and frictionless, but that’s just not reality.

Contracts often don’t have to be long or complicated. Even a simple agreement that covers the basics – what each party has to do and when it has to do it – is a big step in the right direction.

2. Understand your bargaining position

As you prepare for and go through negotiations, you need to be able to understand where the other side is coming from. 

If you’re approaching a billion-dollar company with a $50k opportunity, you may have to accept more risk or less favorable terms than you would prefer in exchange for the benefits of partnering with a big player. You need to have realistic expectations from the start – and remind yourself of these expectations throughout the process. Getting bogged down fighting battles that don’t get you much in the end is inefficient and expensive, and may damage the relationship before it even gets off the ground. Remember, after the contract is signed, you’ll hopefully be working closely with the other side for months or years to come.

This isn’t to say that you should roll over on issues that are, or may become, crucial for your business. Negotiations on critical points, including terms that likely will be a “red flag” to future investors or acquirers, might be a bit painful to work through, but it’s important to set up your business and stakeholders for future success.

Other factors also may contribute to your bargaining power. If you establish a good relationship with the opposing business lead, they may be able to effectively communicate the business rationale of your point of view to their legal team to help drive a workable compromise.

If your prospective business partner recognizes the value your company brings to the table, has just recently lost a big customer or key vendor, or is fending off competition, they may be more open to coming your way on the contract terms. For example, a foreign medical device manufacturer who has struggled to break into a new market may see a small, unproven startup as their way to break into this market and could be more open to working together even if the initial volumes are low.

Spend time listening and learning about why the other side is interested in working with you so that you don’t overplay your hand or leave opportunities on the table. While everything is negotiable, it’s important to pick and choose the battles worth fighting.

3. Use a term sheet in most negotiations

Commercial contracts define the rules of engagement and how the relationship should function over time. You need to plan for the business you want, while being realistic about the business you currently have. During the course of business-level discussions, there may be a lot of hypotheticals given and promises made that you don’t want to lose sight of as the legal documents are prepared.

A term sheet (or letter of intent) can be a very useful tool to establish a framework for the proposed business relationship at the beginning of negotiations. Simply put, a term sheet is a relatively short document that summarizes the intent of the parties regarding the main pieces of the future relationship. Term sheets typically include things like each party’s key rights and obligations, pricing, ownership and licensing of intellectual property, exclusivity, etc.

Term sheets, or portions of them, can be binding or non-binding on the parties. Even if non-binding, term sheets should speed up the contract negotiation process by establishing each party’s expectations for some of the key terms of the contract. Getting a well-thought-out term sheet in place early on often leads to smoother, more efficient contract drafting and negotiation, ultimately saving you money that you would have spent on legal fees.

4. A commercial contract sets the tone for a relationship

Another key reason for negotiating and getting a contract in place is that it will likely give you useful insight into an organization before you actually start working together. Because this is the start of a new relationship, you generally find people on their best behavior. However, if the contract drafting and negotiation process is lengthy or burdensome, or the other side is generally unyielding, that will help paint a picture of what your future relationship may be like – and the culture of the company you’re going to be working with. This may be exactly what you want from a partner if you’re working in a tightly regulated market with exacting quality standards, but not what you want out of a simple fulfillment center or standard parts supplier.

The contracting process also may reveal hidden land mines or third rails that may not be readily apparent on the surface. For example, issues such as exclusivity, capacity, supply chain problems and intellectual property ownership rarely come up in an initial quote or simple purchase order. However, these types of issues likely will surface when it comes time to put pen to paper regarding the counterparty’s contractual obligations. And they’ll be infinitely easier to work through when negotiating the contract terms than doing so after you’ve committed your company to the relationship.

5. A second (or third) pair of eyes is always a good idea

Even if you are a skilled negotiator with years of experience, it is always worth the investment to have an expert with working industry knowledge on your side of the table. Sometimes it may be as simple as “Please give this contract a quick review to make sure we’re not missing anything.” Other times, they’ll help drive the entire process, clarify the contract language around your specific rights and obligations, or identify areas of concern because the terms are “off market” from industry standards or could have a chilling effect in a potential investment in or acquisition of your company. It’s also important to remember that being an expert in some areas doesn’t make you an expert in all areas. Would you trust your doctor to diagnose what’s wrong with your car?

One thing that I have done when working with clients is divide and conquer which parts of the contract each of us “owns.” For example, with some clients, I’ll do a deep dive on the legal terms and aspects of the agreement, and do a higher-level review of the commercial terms like pricing, while the client does the opposite. This allows us to be the most efficient with our time – and for each of us to focus on what we know best.

6. You should be on your best behavior after a contract is signed (and the other side should be too)

A contract can be the start of a new or expanded business relationship. And if negotiations didn’t go as smoothly as you had hoped, signing the agreement can act as a reset going forward. Throughout the negotiation and within the contract, both sides promised to do certain things. The effort you’ve put into establishing and growing your business has gotten you to this point, and hopefully you’ve established a level of trust with your new business partner. But now it’s time to nurture and protect that trust. It may be obvious, but it is very important that you do what you said you were going to do in a contract at the times and with the effort that you said you’d do them. If you promised to send a forecast each month, send a forecast each month. If you promised to pay on time, pay on time.

Even if an obligation in the contract seems small to you, it may not be small to your partner. Honoring your contractual obligations not only helps to build trust, but also will mitigate your risk and avoid giving the counterparty an “out” from the contract. And if you need a business favor after something has gone wrong or an amendment to the contract, the goodwill you’ve built with your actions may very well come in handy – and the same holds true for your new business partner. Remembering that there’s a contract in place should keep both parties on their best behavior.

A version of this article originally appeared on Izba’s blog.