10 Common Mistakes in Business Contracts
Having to negotiate and formalize a contract is great news for a startup. What it means is, we’re in business! But it also means you’ve come to a place where your choices and actions have real consequences.
Make no mistake, one badly constructed contract absolutely has the power to undo every minute of work you’ve done with every other aspect of your business or product.
The goal is to make sure it doesn’t happen to you! The point of this blog post is to point out some of the most common errors and teach you first steps in how to avoid them and when to seek counsel to make sure you get it right.
1) Not having a contract at all
A promise is a noble thing. It’s a commitment to do something without any expectation of reward or payment. And people who keep their promises should be lauded for their character and integrity. In life, we should seek out those who keep their promises and appreciate them for who they are and what they do.
In business, however, a promise is not what you want with your business partners. That’s because a promise is not enforceable under the law. Someone who makes a promise can change their mind at any time and leave you without any recourse to move forward with the expectations you had for your business.
Business is at least in part about money. Otherwise, it wouldn’t be business.
Starting a successful business is hard. And no matter how smart and dedicated you are, there will be moments when you think to yourself, “why am I doing this?” And while almost entrepreneurs will tell you it’s worth it in the end, almost all would agree that the challenge is more daunting than they had initially thought.
If you’re going to put in the work, you need to know that your business is protected if one of the founders leaves. You need to know you can rely on your vendors and contractors, and if they flake out, you can quickly move on to someone else. Well-written contracts prepare for life and business uncertainties and allow the business to move forward regardless. Good contracts don’t distract from the underlying value of a business, they allow the business to move forward seamlessly no matter what happens.
Furthermore, putting together a business contract forces the parties to think through all the relevant issues of a business relationship in a way that many new entrepreneurs don’t think to do instinctively. That thought exercise strengthens the business relationship and forces the parties to confront tough issues before it’s at a mission-critical point in the business.
In this vein, one of the ultimate truisms with startups is that friends and family make dangerous co-founders and business partners. Often, it’s because they assume that because of their history, they don’t need to formalize their relationship. Co-founders who don’t know each other understand the importance of setting out expectations. Co-founders who do know each other frequently skip this step. Because of the friendship, the founders frequently avoid the issue to avoid hurt feelings. And the issue only comes to the surface when it has boiled over and tensions are beyond repair.
And this is why startup founders who are friends and family have lower success rates than non-friends and family. And why founders who start off as friends frequently lose both the business and their friendship.
2) Not considering what constitutes a breach
Okay, so you’ve decided to enter into a business relationship with someone. And you’ve decided to formalize that relationship. Great! The next step is to think about what would make you want to end that business relationship.
What if your counterparty doesn’t pay?
What if the company you hired doesn’t deliver the product as expected or is late?
What if the quality isn’t what you’d hoped for?
What if the person ends up being a jerk?
Does thinking about what might go wrong make you a pessimist? Absolutely not! It makes you practical. Most importantly, by thinking through the worst-case scenarios at the beginning of your relationship, you lower the probability that the worst-case scenario will occur. Also, thinking through the worst-case scenarios, you’ll have a clear process in place for dealing with them. This forces everyone to be on their best behavior. And it gives you options if things go wrong.
3) Failing to provide for a clear opportunity for termination for each party
Sometimes, it’s not about you. It’s about me.
Not all business relationships end because someone’s a jerk. As with love and relationships, sometimes you learn over time that you’re just not right for each other.
What if you learn, six months after you sign a contract, that a competitor offers a better product at a lower price?
What if you learn someone else can do a better job?
What if you decide to change your business strategy or pivot and the company you’re working with is no longer the right fit?
Far too many startup and small business contracts only allow for termination only in the event of breach. This is very shortsighted. Every business contract should have a way for both parties to exit the contract – not just because the counterparty committed some sort of horrible misdeed – but simply because it makes business sense for them to do so. This is true even if the other party is doing their best to make the business relationship work. Sometimes it’s time to move on. And in every business relationship, each party should be have the opportunity to give their business partners reasonable notice and terminate their relationship, for no other reason than because it makes business sense.
4) Not thinking about appropriate dispute resolution mechanism given the size of your business
You know how much it costs to litigate any sort of civil legal dispute to the point where a judge or a jury makes any sort of actual decision on the facts?
The answer is in the ballpark of $50,000-$100,000. And that’s if you hire a cheap law firm.
Yet, most business contracts (particularly the ones drawn up by amateurs) fail to consider the best way to resolve disputes that may arise under the contract. The whole point of having a contract is to make an agreement that’s enforceable under the law. But there’s little point in having a contract if the cost to enforce it is prohibitive for your business.
Most early-stage startups do not have the means to litigate. That means you need some other way to resolve disputes that you can afford.
My first recommendation for cash-poor businesses is mediation. Mediation is a voluntary dispute mechanism, where the parties are not usually bound to achieve a resolution (although mediation agreements, once made, are binding), if they choose not to do so. But for parties who are willing to negotiate in good faith, this is often an effective mechanism of resolving a dispute that seemed beyond the reach of the parties.
The second alternative is arbitration. Arbitration is a relatively low-cost, binding dispute resolution system where a hired arbitrator hears arguments from both sides of a dispute and renders a final decision in favor of one of the parties.
Both are imperfect, but so is litigation, and these mechanisms afford the parties some opportunity to be heard at a price that may be accessible.
5) Picking the wrong venue or no venue at all
As previously mentioned, it’s important to think through which dispute resolution mechanism you’re going to use if things go bad with a contract. But that’s not the last step. Each contract should specify not just how you want to resolve your disputes, but where.
This shouldn’t be too complicated. If you’re in Colorado, you should choose Colorado as your venue for dispute resolutions.
If you and your counterparty are on the other side of the world, consider allowing a mechanism for remote or virtual mediation or another means of resolution that doesn’t require you (or your counterparty) to physically travel to the other side of the world.
6) No consideration or inaccurate consideration
As we mentioned earlier, the difference between a contract and a promise is that a contract is enforceable. What’s the thing that separates a contract from a promise? Consideration: It’s the thing you give in exchange for what you get in a contract. It doesn’t have to be much, but it has to be something, or there’s no contract.
The scenario where I’ve seen this come up with startups most often is with early consideration for IP assignment agreements. Each startup must own its own IP. And each startup founder must receive something in exchange for the IP that they’re giving to the Company. But in the early stages where a founder might not be getting paid, it isn’t always clear what this is. Is the founder getting equity? Then make that the consideration for the IP transferred to the company. But make sure you do it at the beginning and make sure you write it down.
If the founder isn’t getting paid and he or she isn’t getting equity, well, then you may have a problem. This is why, from a fairness perspective and from a legal perspective, you provide some compensation for every person who contributes to your startup. Because if you don’t, you may not own your startup.
7) Can the contract be assigned?
The most common successful exit for startups is an acquisition from another company. And if you’re a startup, you need to have this in mind every time you enter into a contract from the day you start up. When an acquirer looks to acquire, one of the most important things they’ll consider is whether they’ll retain your current contracts and business relationships you had prior to acquisition.
Contracts are all over the place in whether they can or cannot be assigned. But when you’re a startup, if an acquisition is the goal, you’ll want to make explicit that every contract you enter into can be assigned in the event of a merger, sale, or purchase of all the assets of the company.
Otherwise, you may find that you were your own worst enemy in negotiating a potential acquisition of your company.
8) How does this relate to prior/future contracts?
This is probably the simplest of the ten mistakes, but it’s easy enough to get wrong. If you have other agreements with the same business partner, how does this relate to the others? If you have only one written agreement, your contract should say, “this Agreement replaces and supersedes all other agreements between the parties, whether written or oral,” or something along those lines. This is to prevent the parties from using emails or other conversations as a mechanism to undermine anything that’s in the contract.
9) Failing to consider all the issues to negotiate
Negotiations aren’t always a zero-sum game, but many lawyers and entrepreneurs view them as such. Rather than looking at each contract by dissecting only the few key terms that are at the forefront of any negotiation, take the time to make a list of all the variables at play, and explore with counterparties whether value can be created to both parties’ mutual advantage. This is a creative exercise, but one that with modest effort can create extraordinary results. Try inverting, twisting, and playing around with the variables to see if there’s a different way at looking at the issues that can help everyone at the table.
The first step in any negotiation should be to break out not just the salient variables, but all variables involved in the negotiation. Put them on the table and then try to get a sense of what matters most to you and your counterparty. You’ll never know what you can get from any negotiation until you ask.
10) Forgetting intellectual property or assigning it to the wrong person or company
For an early-stage startup, more often than not, the only real asset it owns is its intellectual property. But nearly as often, when you dig down, the ownership of that intellectual property is less than clear. The reason for this is simple: most startups eschew formalities in the earliest stages of growth. They’re busy doing the common lean-startup stuff, such as customer development and interviews, development of the product, and early marketing and promotion. That’s what a startup should be doing.
Unfortunately, an early-stage startup that doesn’t own its intellectual property usually doesn’t own anything. And a company with four part-time founders toiling away without any written agreements doesn’t own its own intellectual property. If one of the founders walks away and refuses to assign the work they’ve done after the fact, you will find yourself at the mercy of that founder in the negotiation. And if that founder refuses to assign the work they’ve done, guess what? You don’t own your own company.
If there’s one type of contract you have on day one as a startup, it should be a contract that memorializes the assignment of IP to the company. And every person who works on the company should sign it, not just the technical people. This includes contractors, developers, marketers or anyone else who contributes to what you do. Make sure you own their work. Or they’ll end up owning your company.