To enable and enhance growth, tech start-ups generally reach the point where they look to outside investors for capital. The influx of cash supplies the financial boost needed to reach the next level, while providing investors with a stake in the company’s future success.

Understandably, prior to completing any transaction, investors (or their counsel) will look “under the hood” to identify any potential pitfalls or negative issues that may impact the company’s success (and the success of their investment).

Part of that due diligence involves a detailed review of the company’s regular, day-to-day contracts that secure sales commitments and keep ongoing operations moving forward. This review is not insignificant — it can materially impact the terms of the contemplated transaction. 

Ultimately, the contract obligations being reviewed are a key aspect of what the investors are buying. Indeed, I have seen deals fall apart based solely on the (poor) legal commitments within a company’s routine contracts.

With that in mind, as a company founder or principal, it’s in your best interest to know where your contractual weaknesses may lie and to avoid missteps in future contract negotiations that may cause a potential investor to invest elsewhere.

Subtle, But Significant

First off, investors will investigate the most prominent business terms in place with your key customers — items such as price, subscription term, volume commitments, etc. Beyond these, however, additional, more subtle terms can equally impact an investment decision.

Here are four issues I encounter frequently in these situations…

#1. Acquisition of IP Rights from Consultants 

When an external consultant is hired to write code, complete research and development, generate marketing programs, or otherwise develop deliverables on behalf of your company, it’s critical you retain the necessary rights to anything developed. A properly drafted agreement is the most effective and clean-cut way to ensure your company acquires these important rights from the consultant.

Failure to include proper terms conveying the necessary rights could, and most likely will, allow the consultant to retain ownership of these deliverables, potentially enabling the consultant to sell or license certain rights to others, including your competitors. Not having proper contractual terms in place for key items could quickly chill an investor’s desire to move forward.

#2. Most Favored Nation Pricing

Often, large vendors with significant negotiating power request (or require) that your company provide “most favored nation” (MFN) pricing. This arrangement can compel your company to provide your products or services to that customer at the lowest price offered to any other customer. 

Avoid MFN pricing obligations within your revenue contracts because these terms may: 

• Limit your ability to offer discounts or negotiate prices with other customers

• Result in other customers demanding similar terms, thus eroding profit margins and placing you at a competitive disadvantage (and thus, a less attractive investment opportunity)

• Require additional administrative resources as you strive to honor the MFN commitment moving forward

• Restrict your ability to adjust pricing as market conditions change and potentially impact revenue recognition

Investors are wary of MFN clauses because these commitments introduce risk, complexity, and negative consequences for your company’s financial performance and competitiveness. All of which make for a less attractive investment opportunity.

#3. Assignability of a Contract

Often, customers request terms that limit a provider’s ability to assign a contract to a new company following an investment, sale, or other change in control. The customer may be worried that an acquirer may offer inferior service levels, change focus regarding which products or services are supported, or potentially serve as a competitive threat to the customer.

These limitations can serve as a significant burden when seeking outside investment. Indeed, investors will be wary if key customers can walk away following the investment or acquisition. Not only is it difficult and resource-consuming to obtain prior approvals, but if approvals are withheld, the company’s balance sheet could be negatively impacted.

As a practical matter, I have found that if you explain your situation during negotiations — and the value of being able to grow — prospects will ultimately permit some type of assignment. 

#4. Right to Terminate “For Convenience”

Customers often request the ability to terminate an agreement on relatively short notice (“for convenience”) to avoid a costly, long term commitment if the vendor’s offering doesn’t work as expected or the customer’s plans change.

As in #3 above, investors dislike these arrangements because the ambiguity leads to revenue uncertainty. If a significant number of customers can simply walk away, investors have little assurance as to the long term value of what they are buying.

When confronted with a request for termination for convenience, explain that it’s a two-way street — both parties benefit by establishing a mutual commitment for a reasonable period. This serves the customer and the vendor because the vendor can provide established and well trained resources for onboarding and maintain training and quality service operations going forward.

If a vendor finds it has minimal leverage and/or the customer won’t budge, seek some minimum commitment (e.g., no termination for convenience in the first 12 or 24 months) so that, worst case, you’re able to recoup onboarding and customer start-up expenses if the customer decides to exercise its right to terminate for convenience.

Final Thoughts

Your customer and day-to-day contracts represent an important part of your business that investors will evaluate before making a commitment to move forward. 

By understanding and anticipating the perspective of potential investors — and by keeping these needs in mind as you negotiate future contracts and arrangements (i.e., avoiding gotchas) — you will build a better foundation to obtain financing or achieve an exit down the road.