Due Diligence in Deals: Questions businesspeople should ask their lawyers!
By: James Raanan
Tags: Contracts, Due Diligence, Customer, Corporate, Deal

CUSTOMER CONTRACTS

In our last article, we provided an overview of key questions to ask the legal team conducting due diligence — in regard to vendor contracts.

In this article, we will focus on customer contracts in the business to business context.

Unless the rationale behind a deal is to acquire or invest in a particular asset, such as unique technology, the quality of a company’s customer contracts may be the single most important area of any due diligence review. This becomes more important where the valuation of a company is predominantly based on a forecast of its current cash flows.

Those cash flows do not exist in a vacuum but are tied very closely to the quality of the underlying customer contracts.

In order to assess the quality of a customer contract we suggest focusing on the following three areas:

· Commitment and stability of revenue.

· Price

· Scope

1. Commitment and stability of revenue

Let’s start with an example.

Company X is in the Flugelbinder (word invented in the movie Cocktail) business. A flugelbinder is “a small plastic or metal sheath typically used on each end of a shoelace”. The primary purchaser of the X Flugelbinder is customer Y, a distributor to the shoe industry. In a financial presentation made by the company’s management, it was disclosed that Y represents 60% of X’s revenues.

Many other companies manufacture Flugelbinders, so vendor substitution is not an issue for Y.

Armed with these facts, it becomes crucial to understand Y’s contract — in particular, the extent to which the cash flows from this contract are stable. Here are some questions you might want to ask your legal team:

What is the term of the contract? This is a threshold question. If the term is short, say month to month, or even a year, the customer will have a lot more flexibility to take its business elsewhere. In the context of Y a short contract term is an area of concern that should be considered in forecasting the future value of the cash flows from this contract.

Are there any provisions which allow Y to exit the contract before the end of the term? Let’s assume that Y’s contract term is relatively long — say 3 years — and we are at the beginning of those 3 years. Sometimes a contract term may appear to be long but in reality, it is not. There may be a right to — terminate for convenience — which is a right to terminate the contract at any time upon notice. Alternatively, the right to terminate early may be tied to quality parameters on the part of the vendor (such as the ability to supply a software enhancement or variant of a product) or external factors relating to the customer’s own business (such as orders the customer itself is reliant on). If the vendor fails to deliver on these parameters, the customer may have the right to terminate the contract early. This analysis is extremely fact-specific — but if you ask this simple question your lawyer should be able to run the analysis for you.

Is there a minimum purchase or volume commitment? Is Y required to purchase a minimum quantity of Flugelbinders? If so, what is the penalty if it does not? Does the marginal price increase, or is there a requirement to pay a certain minimum amount? If there is no commitment whatsoever, then, on paper at least, there may be little difference between a 3-year contract and an ad hoc purchase order.

Is there exclusivity? Exclusivity commitments are another tool to help a company secure the potential cash flows in a contract. In our example, exclusivity would mean that Y is not able to purchase Flugelbinders from any other vendor. Like the case of the minimum purchase commitment, it is important to understand the definition and extent of the exclusivity. It may be closely tied to certain vendor deliverables (eg. provided X can ship Flugelbinders to anywhere in the world, Y agrees to purchase Flugelbinders exclusively from X). There may also be certain carveouts like the ability to purchase certain quantities elsewhere or to manufacture the goods being purchased itself — which may further give Y the ability to wriggle out of an exclusivity commitment. A contract without exclusivity or purchase commitments is not a bad contract per se — but understanding how these provisions operate is crucial to understand the true future value of the contract.

2. Price

Price is the area of a contract where most business people feel at home. However, contracts can often contain seemingly innocuous clauses that may have a major impact on price.

Is there an MFN clause? An MFN (most favored nation) clause, allows customers to require that the vendor matches the price to the lowest price offered to any other customer. If a company’s largest customer has an MFN clause in its contract the company will have to wary of providing better pricing to other customers — so as not to trigger the MFN.

Does the vendor have the right to change the price? Is the price in the contract constant or is there a built-in price increase? Where the production cost of the company’s products are highly reliant on the cost of certain raw materials — the absence of the ability to increase prices in line with the movements in the underlying costs of materials exposes the vendor to losing money under the contract.

What happens to the price on a renewal? Most B2B contracts contain a provision which provides that the contract may automatically renew unless terminated by either party. There are several ramifications to this but here we will focus on price. If the contract contains a fixed price, and the contract renews, that price will carryover into the new term. Typically, a vendor will not want to terminate a contract unless it is really losing money — so a vendor will be very reluctant to use its ability to terminate as a tool to persuade the customer to accept a higher price. To mitigate against this concern, some contracts contain a price escalation clause which kicks in upon renewal, thereby protecting the vendor from being locked into a price over a very long period.

3. Scope

Scope refers to the definition of the products and services provided under a contract. This is an extremely context-specific issue. However, there are some common themes which crop up. This issue is more common in more early-stage companies in which the first few customers have a lot of negotiating leverage and the contracting process is less structured.

Is there any commitment to provide new products, services or features outside of what the company currently offers? In our example — let’s assume that company X which currently only produces Flugelbinders with a metal sheath — commits to supply company Y, within six months of signing the contract, Flugelbinders that have a hard plastic sheath. It will be important to understand the effort level and cost involved in doing so. In software deals, this issue often comes up — when features that have not yet been developed are committed to by the software provided. It is not uncommon for software development to take more time than initially predicted. Not meeting that commitment may result in a breach of contract — which may have a number of consequences from the renegotiation of price to termination or even a damages claim.

What are the support obligations in the contract? Are they included in the price or extra? Can these obligations be serviced by the existing support resources of the company or might they require additional development or dedicated resources? These items are often left by lawyers to the domain of the businessperson. However, it’s important to ask the questions. Sometimes the answers are not obvious and can be buried in the language of the contract. Overcommitting support resources can be very costly and an obligation which is difficult to get out of.

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This is a taste of just some of the key issues to consider when reviewing customer contracts during a due diligence review.

If you have any questions about the issues raised here or would like us to review any customer contracts as part of a due diligence review or in preparation for one, please contact James Raanan at james@parnesraanan.com.

About the author: Admitted to practice in New York and Israel, James Raanan has over 20 years’ experience dealing with the varied legal and financing needs of Israeli and US tech companies. James served as General Counsel of IDT Telecom, Inc. (IDT Corp: NYSE) for over ten years before establishing Parnes Raanan Lawyers & Advisors. Much of his work today involves negotiating and structuring complex commercial and corporate transactions on behalf of his clients in both Israel and the US.