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Contracting as a SaaS Vendor

When contracting as a SaaS vendor there are a number of key elements you must include in any transaction. Below are five common legal issues in the SaaS startup context.

1. TERM AND TERMINATION; REVENUE RECOGNITION

a. Termination for Convenience. Typically in a SaaS business arrangement, the services are offered for a committed service term (usually one year or more) and the pricing is reduced based on the customer’s commitment to this term. The customer is therefore receiving a discount on the services compared to if they had purchased the services on a month-to-month basis. This is beneficial to you, because it allows you to recognize the full revenue of the sale at the outset of the contract.

The customer will often include language that they may terminate “for convenience” at any time with no liability or penalty. If left alone, this language would allow the customer to walk away from the contract despite having received a discount on the services rendered and the you will not be able to recognize the revenue, which could be very critical for the business. There are two ways to deal with this request: (1) you can push back and not allow any termination for convenience by the customer, or (2) you can add language stating that the customer is locked in for pricing for the entire contract initial term. As a result of this clause, many SaaS vendors also require payment in advance for the full term of the contract, so as not to have difficulty collecting in the event of a termination for convenience.

The following is an example of language added to a termination for convenience (in bold) to secure a full term commitment: “Customer shall have the right, without any obligation to assign any reason, at Customer’s sole option, to terminate this Agreement for convenience by giving thirty (30) days prior written notice to Supplier, provided however, that Customer shall remain liable for all Fees for the remainder of the then current Term and Customer shall not be entitled to any refund or credit for any unused Term.

b. Initial Term; Renewal Term; and Pricing Increase. The contract should clearly set forth the length of the initial term of the agreement and whether or not the term will renew automatically on the same terms. Typically a party should provide notice thirty days in advance of a renewal term in order to cancel the renewal. It is also important to include a clause allowing you to change its pricing in subsequent renewal terms by a certain percent, in order to account for increased costs of doing business in the future.

EXAMPLE CLAUSE: Term. The term of this Agreement shall commence on the Effective Date/the start date specified in the applicable Purchase Order/Statement of Work and continue for the subscription term specified therein (the “Term”). Except as otherwise specified in the applicable Purchase Order, the Term shall automatically renew for additional periods equal to the expiring Term unless either party gives the other notice of non-renewal at least thirty (30) days before the end of the relevant Term (“Renewal Term”). The per-unit pricing during any such Renewal Term shall be the same as that during the prior Term unless Supplier has given Customer written notice of a pricing increase at least thirty (30) days before the end of such prior Term, in which case the pricing increase shall be effective upon Renewal Term and thereafter. Any such pricing increase shall not exceed seven percent (7 percent) of the pricing for the relevant Services in the immediately prior Term, unless the pricing in such prior Term was designated in the relevant Purchase Order as promotional or one-time.

2. INTELLECTUAL PROPERTY OWNERSHIP

a. Importance. It is essential to ensure that the company retains ownership of its intellectual property (IP). IP is your main asset, but it is also intangible. Thus, an error in clauses relating to licensing and IP ownership is one of the few errors that can destroy a new business if executed incorrectly. It is particularly important for VC-backed companies, which must retain the integrity of their IP as their most important asset, and which must have clauses relating to intellectual property written unambiguously and without any room for interpretation as to the proper ownership.

b. Customizations. Sometimes, when a customer has requested and paid for specific customizations to the services or product offered, that customer expects to have ownership of these customizations as deliverables on the grounds that they paid for the IP. It is important, however, to keep these customizations developed as part of the underlying IP of the services so that the company can build on the service offerings to its other customers. When negotiating this issue with a difficult customer, remind the customer that they are paying a much lower cost for this customization integrated with the services than they would have paid to receive the IP exclusively.

c. EXAMPLE CLAUSES:

i. Reservation of Rights. Subject to the limited rights expressly granted hereunder, Supplier reserves all rights, title, and interest in and to the Services and the Site and all related intellectual property rights. No rights are granted to Customer hereunder other than as expressly set forth herein.

ii. Restrictions. Customer shall not (i) permit any third party to access the Services except as permitted herein or in a Purchase Order, (ii) create derivative works based on the Services, (iii) copy, frame, or mirror any part or content of the Services, other than copying or framing on Customer’s own intranets or otherwise for Customer’s own internal business purposes during the subscription term and for the exclusive use of Customer’s Users, (iv) reverse engineer the Services, or (v) access the Services in order to (a) build a competitive product or service, or (b) copy any features, functions, or graphics of the Services.

3. LIMITATION OF LIABILITY (LoL)

a. Importance. The limitation of liability section (or “LoL”) is essential to the risk management of the company. The purpose of the LoL is to limit your liability to a certain amount in case of a breach of contract and to prevent your company from being completely exposed to an unlimited liability. This element is particularly important in the realm of online technology which is susceptible to hacking by malicious third parties despite your best efforts. You must therefore assess the risk you are willing to take and limit your damages in the event of a breach. This risk should parallel your insurance coverage. Drafting a favorable LoL is also important for VC-backed companies, whose contracts will be reviewed by future investors, shareholders, and potential buyers. An open-ended claim is a serious risk which may deter investors, who are much more comfortable with a clearly stated monetary cap on damages.

b. Elements of the LoL. The limitation of liability is typically comprised of three parts: (i) a base cap, (ii) the carve-outs, and (iii) the optional higher cap. The base cap is the general cap which covers all liability not mentioned in the carve-outs or higher cap. It is usually limited to the fees paid, or some multiple of the fees paid (x2/x3) as negotiated between the parties. The carve-outs are those items for which the vendor’s liability is not limited by the base cap. These generally include: fraud, willful misconduct, gross negligence, infringement of a third party’s intellectual property rights, breach of confidentiality obligation, and breach of data privacy and security obligations. Rather than leaving all of these items uncapped with no limit on liability, it is best to push back with a higher cap than the base cap, often at the vendor’s insurance limit, in order to keep the vendor from being liable to an unlimited extent for these breaches.

c. EXAMPLE CLAUSE: “IN NO EVENT SHALL SUPPLIER’S AGGREGATE LIABILITY ARISING OUT OF OR RELATED TO THIS AGREEMENT, WHETHER IN CONTRACT, TORT OR UNDER ANY OTHER THEORY OF LIABILITY, EXCEED THE TOTAL FEES PAID TO SUPPLIER BY CUSTOMER FOR USE OF THE SERVICES DURING THE PRECEDING TWELVE-MONTH PERIOD, [base cap] PROVIDED HOWEVER THAT WITH RESPECT TO SUPPLIER’S (i) GROSS NEGLIGENCE OR (ii) BREACH OF ITS CONFIDENTIALITY OBLIGATIONS HEREUNDER, SUPPLIER’S TOTAL LIABILITY TO YOU WOULD BE LIMITED TO THREE MILLION US DOLLARS (US $3,000,000) [Higher Cap] AND WITH RESPECT TO AN INTELLECTUAL PROPERTY INFRINGEMENT CLAIM AGAINST SUPPLIER’S SERVICES SUPPLIER’S TOTAL LIABILITY TO YOU WOULD BE WITHOUT LIMIT [Full Carve-Out]”.

4. ASSIGNMENT IN THE EVENT OF A MERGER OR ACQUISITION

A contract will typically include an assignment clause, stating that neither party may assign the agreement without the consent of the other party. While this clause appears harmless, it is in fact very important if you plan to seek an eventual M&A (as most startups do). The standard clause will restrict you from keeping its M&A path clear, because it would require the you to obtain consent from every single customer with which they have such a clause before they may effect an assignment. To prevent this issue, the following clause should be added in order to allow the company to assign in specific scenarios, such as a change of control: “Notwithstanding the foregoing, either party may assign this Agreement in its entirety, without consent of the other party, to its Affiliate or in connection with a merger, acquisition, corporate reorganization, or sale of all or substantially all of its assets.”

5. GOVERNING LAW

As a SaaS provider the presumption is that Internet-based services are “located” at the location of the data center or the infrastructure for the service provided. You can therefore initially request the local law and venue of the company’s home state. If the other party is unwilling to submit to that jurisdiction, or is seeking foreign jurisdiction, the next step is to try a neutral jurisdiction. New York law is a good alternative to other US state law in order to keep the jurisdiction within the United States. Generally speaking, when dealing with European and other western foreign entities who will not accept United States law, the laws of the UK or Hong Kong are more neutral. It is best to avoid setting the governing law in the customer’s home jurisdiction if it is not one of these neutral locations, as the law may be biased favorably to the customer in dealing with US-based internet companies.