We encounter contracts much the same way that fish encounter water. Contracts are everywhere—so much so that we often forget what they’re for. We most often conceive of contracts as “deals.” The gist is to hold the other side’s feet to the fire. Rarely do we step back and think about what a contract is and how it is structured.
At a basic level, a contract allocates risk between the parties. If you go to a barber to get a haircut, your promise to pay secures the barber’s services (a higher price may get you a better haircut). The barber cutting your hair triggers your obligation. If you don’t pay—or if you prepay and the barber doesn’t cut your hair—someone may have a breach of contract claim.
To control downside risk, you have three contractual tools in your toolkit: (1) price; (2) control; and (3) liability. We look at each of these in turn:
- Price. If our barber is afraid of customers walking out without paying, he can charge a higher price. This is why many lenders charge higher interest to borrowers with lower credit scores. If a manufacturer is afraid that a retailer won’t buy more goods, it can charge more. In sum, price is a contractual tool for managing non-payment risk.
- Control. Control can take a few forms:
- Satisfaction. The most extreme form of control is a satisfaction clause. This clause allows Party A to condition Party B’s performance on Party A’s approval. If you ask me to bake you a cake to your approval, I’ve only done my contractual duty if you are satisfied with the cake (often subject to a good-faith or reasonableness standard).
- Direct Control. Direct control involves placing express conditions on the other side’s performance. A buyer may impose logistical and quality requirements on its vendor. An Airbnb host may require guests to clean up after their stay. A landlord may require a tenant to carry insurance and name the landlord as an additional insured. These express terms allocate performance risk by specifying what must be done.
- Indirect Control. When monitoring is difficult, a party has a few indirect options. They can rely on industry standards. They can also use termination rights to walk away if performance slips.
- Liability. When you can’t manage risk through price or control of the counterparty, you turn to remedies. This is where liability comes in. While guaranteeing that the other side does what you want is difficult, you can control what happens if something goes wrong. Liability can take many forms. A few important ones are: (1) liquidated damages for defined breaches (a topic for a future post); (2) indemnity for third party claims; and (3) reps and warranties with remedy for breach.
The above three-part toolkit gives us a good framework for understanding and dealing with risk. But how do we apply it to actual contracts? Here is a framework:
- Understand Risk. Each contract presents a unique set of risks. If you are concerned about securing payment for your products/services, does your contract address that? If you are concerned about getting sued over your vendor’s use of third-party IP, does the contract protect you? Understanding these risks sharpens your negotiation chops.
- Address Risk. Contract negotiations are recalibrating the risk allocation of an initial offer. If you think a party is difficult or a credit risk, you can ask for more money or up-front payment. If you think their tech stack has hidden landmines, you can ask for both reps and warranties on ownership and indemnity for third-party claims.
- Reevaluate. Many startup founders believe contracts are one-and-done and that revisiting is only necessary if there is a catastrophic failure. This is not true. Risk changes. A once healthy partner may become insolvent. Experienced companies learn to address these issues through new contracts and amendments to existing ones.
Warren Buffett famously said that “risk comes from not knowing what you’re doing.” Many companies enter contracts without assessing risk. By using price, control, and liability to manage identified risk, companies can come out ahead. A fish is better off knowing what’s in the water.
Disclaimer: This blog is for informational purposes only and does not constitute legal advice. Reading or interacting with this content does not create an attorney–client relationship. You should consult a qualified attorney for advice regarding your specific situation. Mehaffy, PLLC disclaims all liability for actions taken or not taken based on this blog.