Pitfalls to look out for when entering into business contracts

Article by David Irving

Mundays

Both franchisors and franchisees regularly enter into business contracts as part of their franchise business. For example franchisors may contract with suppliers to provide certain goods for their franchisors and franchisees would regularly contract with clients to provide various goods and services.

When entering into any contract with a new business partner and/or client, it is extremely important to be aware of areas where you need to be on your guard. This is not to say that your new partner is out to deceive you, but there are many pitfalls within the process of signing a new contract that, if you slip into, can be difficult to get out of.

You should have in mind a basic checklist of issues you need to be aware of. Not all are legal but all certainly represent good commercial sense and will help avoid problems, whether of a legal nature or otherwise.

You must know who you are signing your agreement with

This sounds obvious but how much do you really know about the other party? Many businesses fail to spend enough time ‘checking out’ their prospective business partners.

It is well worth researching their past deals, the current work they are undertaking and the sort of businesses they currently have contracts with in the same way that franchisees originally researched their franchisors.

Through identification of their past and present business partners you can obtain references, which are a vital resource when validating the credibility of your potential new partner.

A credit check and review of their statutory accounts will also aid in this evaluation as it is an indication of a company’s creditworthiness and the potential financial risk of dealing with them particularly if they have the potential of owing you money. You should also get details of their corporate structure and ensure you are dealing with the main trading company in the structure.

Next steps after initial research

Once you have done your “homework”, the next step will often be the signing of a non-disclosure agreement (NDA), or confidentiality agreement (CA) which will be similar to that which a franchisee signs with a franchisor before being provided with a franchise agreement.

An NDA/CA can be mutual, meaning both parties are restricted in their use of information exchanged, or one way which restricts only one of the two businesses. The issue for each party is to make sure that the information provided is used for a specific purpose, cannot be passed to or used by a third party and that it remains confidential whether or not the deal proceeds.

Do bear in mind that when passing over information, and regardless of how watertight your NDA or CA is, you should never disclose any more than you have to and certainly not find yourself in a position where you end up having given away the “family silver” for example in the form of sensitive commercial information in your contracts which your prospective partner would like to get hold of.

Understand expectations

It is surprising how often the parties do not really understand what their respective obligations are to each other and what is expected of them. The more detail included in the agreement the better.

It will be more beneficial in the long run for both parties if the objectives are clearly set out in the contract. Key Performance Indicators (KPIs) and Service Level Agreements (SLAs) can be a useful tool as they force the parties to think exactly what is required, agree the service level standards (often by reference to time) to which they will work and in so doing clarify issues that might otherwise not have been thought about, or resolve something that had been misunderstood and could have become an issue at a later stage.

Clear provisions regarding payment terms need to be set out detailing what is due and when. This is important to both parties as the payer should be legally bound to pay contractual payments due when required and the payee must have the security of knowing that it will be receiving the money agreed upon on a certain date.

Also written into the contract must be the auditing of the financial statements of the payer, any interest added to the required amount if a late payment occurs and, where possible, a guarantor who can pay the sum required if the business partner is unable to. If you are working with an overseas company, bear in mind the currency for payment and whether you may be taking a currency risk which should be hedged.

Clearly states terms

The term or length of the contract must be clearly stated in the agreement and understood by both parties, as this recognises the commitment that the business partners have to each-other.

When thinking about the term bear in mind the length of time it might take you to recover your set up costs. You should also consider the reliance you might have on your new business partner, particularly if that partner will represent your biggest client.

Any agreement will have termination provisions which could inevitably leave you exposed particularly if there is a termination for convenience clause included. You should also consider whether the contractual arrangements should be exclusive so that you know you have all the business in question. Such a request is likely to be met with a demand for strict performance criteria on your side.

Clarify termination process

The termination process will tend to concentrate on circumstances when the agreement will terminate automatically. For example, if one of the parties goes into liquidation then the agreement should terminate immediately.

However, there are more subtle termination processes such as those where a party fails to meet a sales target or is in breach of another term of the agreement and fails to remedy it. You need to make clear the circumstances in which you want the agreement to terminate especially if you need to appoint a third party to replace your business partner.

The termination provisions should also consider the consequences of termination in terms of liabilities and how you might wish to limit the liabilities that you have. For example, you would not want to leave yourself open to open-ended claims for damages where the other party claims that their whole business collapsed as a consequence of you not performing your contractual obligations.

Cater for potential disputes

The contract should contain provisions for dealing with disputes. In practice, one hopes that the parties will be talking to sort out any issues. However, sometimes it is useful to have an escalation provision within the agreement setting out how disputes will be dealt with, starting with, for example, two senior representatives of each party meeting together to try and resolve the issue.

Following that, many people believe that courts are the last place where commercial disputes should be resolved and therefore recommend mediation to deal with any problems. The provisions of such terms need to be carefully set out and in particular address whether the outcome of such discussions will be binding on the parties. Whatever happens, you need to set out the law which will govern the terms of the contract and, regrettably, which court or arbitration process will deal with any dispute in the event that the resolution provisions have not been successful.

Benefits of contracts

Contracts between businesses are what keeps the franchising world spinning, but they also provide a potential minefield for both parties. By making a contract as clear and specific as possible, it will help in the long run when clarity is needed on a matter that may arise.

As beneficial as it could be to form a new business partnership, without getting the contractual agreement correct from the beginning, it could do more harm than good. The best sort of agreement is one which is put straight into a drawer and forgotten about and the parties get on and do business based on the understanding they originally agreed and talk as and when there is any issue. However, you need that contract in case it does all go wrong which should tell you what happens in such a situation and how to deal with it.

Author: David Irving is a Partner at Mundays LLP