3.2 HOW DO WE NAVIGATE PROCUREMENT AND SELL OUR PRODUCT TO A CORPORATE?
LICENSING – PROCUREMENT
One of the main challenges for entrepreneurs running startups and scaleups is to navigate complex and burdensome procurement processes of corporates.
Very often these procurement processes make no distinction between large and small suppliers, placing a considerable and sometimes insurmountable burden on startups.
Corporates desiring to do business with startups need to be flexible and be willing to simplify the application of their procurement processes to accommodate small suppliers.
The startup will have the following objectives while offering and selling its products and services to corporates:
• Obtain the corporate as reputable (launch) client, allowing it to further fine-tune and enhance its product/service offering.
• Navigate burdensome procurement policies and obtain exemptions from standard procurement requirements.
• Negotiate acceptable licensing, support and maintenance terms adapted to the size of the licensor.
• Achieve a workable collaboration with the corporate as a large, hierarchal and sometimes bureaucratic organization.
The corporate will have the following objectives while procuring products and services from the startup:
• Enable the corporate to enhance its business by procuring novel and innovative technology solutions.
• Obtain certainty about the viability and staying power of the startup from a business continuity perspective, in particular when procuring business critical solutions.
• Achieve a workable collaboration with the startup as a young and less organized organization.
Licensing – Procurement Best Practices
Procurement – Contracting Process
As stated above, startups and scaleups often have a hard time satisfying lengthy and complicated procurement requirements.
They need to be well aware that considerable time and effort needs to be devoted to the procurement process, thus requiring full focus and attention of its senior management.
To increase the chances of doing business with a startup or scaleup by allowing it to successfully navigate the procurement processes, the corporate would also be well advised to establish a “light” procurement process which takes into account the nature and size of its supplier. This should allow the partners to avoid lengthy and protracted negotiations with the smaller partner (cfr. “battle of the forms”).
In addition, startups and scaleups are often very strapped for cash and applying standard payment terms of 60 or 90 days following the invoice date is likely to pose significant cash flow problems. Corporates should be sympathetic to these cash flow constraints and take them into account in determining their payment terms.
The appointment of a Single Point of Contact by each party which centralizes the business dealings for business, legal, risk and other procurement aspects is crucial in this respect.
All startups and scaleups are recommended to develop and implement throughout their (sales) organization mandatory contracting guidelines which distinguish between the ideal contracting scenario, a fall back scenario and a no-go scenario.
The guidelines allow sales teams to negotiate products sales without having to continuously cycle back to the legal and finance teams, but also allows the licensor to clearly track, per contract, to which extent such contract deviated from the ideal contracting scenario. Such tracking will prove an invaluable asset when being audited for financing or M&A purposes.
Any startup or scaleup should clarify which tangible gains the corporate can derive as licensee from the use of its products and services. One of the common mistakes made by entrepreneurs is to not clearly examine and articulate which potential gains the corporate can derive from such use, and to focus only on how great their technology is.
It is crucial for the partners to describe in detail the expected gains for the corporate, as well as the functionalities and associated specifications of the products to be licensed or services to be provided (in a SaaS mode or otherwise). To ensure that product or service delivery takes place in a smooth manner, the licensor and licensee should agree on clearly defined and balanced acceptance criteria and procedures.
The nature of the rights being licensed depend on the type of intellectual property which is being licensed. For a patent, the licensee should in principle have the right to make, use and sell a patented product or use a patented process, while in the case of a copyright license, the rights can also include the right to reproduce, display, modify or distribute.
Entrepreneurs need to be careful in scoping the license rights. For example, a license which permits the licensee to make, use, reverse-engineer, modify, enhance, copy, reproduce, distribute, display, export, import and sub-license intellectual property rights is akin to an outright sale of ownership in the intellectual property rights.
Specific care should apply in respect of sub-licensing rights as such rights could permit the licensee to enter into the core business of the licensor and become a competitor in the process.
Licensors can construct their license as an exclusive, sole or non-exclusive license:
• Non-exclusive: permits the licensor to enter into several licenses for the use and exploitation of the products and services, allowing for the spreading of risks and rewards to several licensees. It avoids dependence on a single licensee, giving the licensor stronger control over the products and allowing for a better, overall development of the product based on feedback of multiple customers.
• Sole: gives the licensee the sole right to use the products of licensor in a certain territory to the exclusion of any other licensee.
• Exclusive: gives the licensee the exclusive right to commercialize the products to the exclusion of any other licensee and the licensor. In view of the strong dependence on one licensee, the licensee agreement should include incentives and penalties to protect the licensor against non-performance by the licensee.
You can achieve anything if you dispose of sufficient time, money and knowledge. With more money you can buy more knowledge and gain time. Too little knowledge leads to time waste with an immediate impact on the bottom line. Reducing or increasing one of these key ingredients has an immediate impact on the other ingredients.
Well defined commercial licensing deals with corporates, with balanced rights and obligations, enable for the sales process to accelerate exponentially (time). Corporates know the pressure points and needs of their clients (knowledge) and can provide much needed leverage to a startup by providing qualified leads.
The collaboration shortens the sales cycle and increases the conversion rate in a significant manner (money), leading to a win-win for both parties. Corporates maintain the relationship with their client by offering new and innovative products, while startups gain exposure and confidence through the collaboration, resulting in increased business.
Olivier Seynhaeve, Co-Founder BrightAnalytics
Intellectual property rights (IP) are valuable assets that enable the startup to pursue significant revenue streams and leverage reliable, proven deliverables for customers in a timely and cost-efficient manner.
Corporate customers regularly argue that they should own all IP rights to the software or deliverable, because they paid for it. This position, however, is not accurate. The amount paid for software or a deliverable usually equates to the purchase of a license only. The price for owning all intellectual and industrial property rights should be considerably higher and take into account lost opportunities for the startup to resell or license the software or deliverable, and additional costs incurred by the startup in future transactions, because it cannot copy or reuse certain intellectual property rights or leverage the knowledge and experience gained by its personnel on a particular project.
Therefore, in order not to compromise its ability to resell its products and services to other potential clients, it is crucial for ownership of the intellectual property rights underpinning the products and services to remain with the startup.
Usage rights should be carefully defined and not be structured as a de facto ownership transfer, creating a competitor in the process. Usage should be limited to internal use by the corporate without commercialization rights for the corporate, through sub-licensing arrangements or otherwise.
Software pricing is challenging, even for the most experienced entrepreneurs. The marginal cost to copy and provide software is virtually zero. However, the cost to develop, test and sell it – and the value of the intellectual property that goes into its creation – is far greater. These two tensions have created a range of models that vendors use to price software and hence the complexity of pricing.
1. Perpetual license pricing
A perpetual license gives the user the right to use a certain version of the solution indefinitely, including the right to upgrades and minor updates.
In principle, such type of license would not automatically entitle the user to major new releases or technical support beyond an agreed upon time frame in respect of versions which at a certain point in time will cease being supported.
A common example of this type of arrangement would be the licensing of ERP systems, although such systems are currently also made available in different pricing models.
Perpetual licenses often are combined with “maintenance”, being the right to get the latest software updates, and “support”, being the right to access technical support. Licensors require an annual payment for the provision of maintenance and support ranging from 15 % to 30 % of the perpetual license fee.
2. Subscription license pricing
Subscription license models are very prevalent in the software industry, especially with software as a service (SaaS) models.
The subscription license model typically involves purchasing the combination of a software license along with all updates for a period of time, such as on a “per month” or “per year” basis.
The subscription pricing ensures the licensee access to the latest version of the solution and access to technical support. A common example of this type of model is the Microsoft Office suite.
3. Purchasing considerations
When pricing its solution, a startup or scaleup needs to assess which model is more interesting for the potential customers. A number of considerations are relevant in this respect, including but not limited to the following:
• Budgets: capital purchasing decisions are very often subject to stringent procurement decision-making procedures. This can take a long time in large corporates with no success guaranteed. A perpetual license is usually considered a capital acquisition, while a subscription purchase is an “operating expense” and thus avoids these requirements.
• Cash: A perpetual software license requires a higher initial expense while the subscription model spreads the costs.
• Accounting treatment: the purchase of software on a subscription basis is treated as an operating expense for the company, and only for the portion actually used during the period. A perpetual license, in addition to impacting the capital budget, would instead result in a depreciation / amortization expense which may impact the P&L measurement for the licensee.
In short, there are many variables clients consider when choosing a pricing model. Each of these considerations will have different importance depending on the situation – including cash flow, risk tolerance and measurement objectives of the decision-maker.
Most Favored Customer and Benchmarking Rights
A typical requirement in procurement processes is to demand most favored customer (MFC) rights guaranteeing the corporate the benefit of the most favorable pricing conditions offered by the startup. In addition, benchmarking rights allow the corporate to renegotiate the pricing arrangements on a periodic basis.
MFC clauses restrict a supplier’s discretion to price its services and can result in an unforeseeable adverse impact on pricing stipulated in its contracts and on its financial models. Given the fundamental uniqueness of most contracts, exact comparison for pricing purposes is virtually impossible. No two deals are truly alike and therefore direct pricing comparisons are practically always impossible.
A startup or scaleup needs to clearly state from the outset that MFC provisions pose an insurmountable problem. It can certainly help to stress to a corporate that the financial health and stability of its suppliers is crucial and that MFC clauses are likely to create significant issues for future fundraising or M&A activities.
A typical sticky point in contractual negotiations between corporates and smaller partners are endless discussions on indemnification and (capped) liability arrangements. Corporates often take an aggressive stance in such negotiations with demands for extensive indemnification obligations and uncapped liability arrangements which are appropriate for large technology vendors.
From the smaller company’s point of view such arrangements pose an unacceptable and unquantifiable risk which is likely to bankrupt them if the risk materializes. Venture capital investors are also typically concerned about such liability exposure, which might lead them to refrain from investing and providing much needed capital, which certainly is not in the interest of the customers of the startups.
An acceptable indemnification and capped liability arrangements could be structured as follows:
• Inclusion in all customer contracts of a limitation on the startup’s liability for all events, acts and omissions arising out of or relating to the contract, up to the annual contract value (or a low multiple thereof), with the exception only of fraud, third-party IP infringement claims and bodily injury.
• Exclusion in all customer contracts any liability for indirect, incidental, special, consequential, exemplary or punitive damages, including loss of income, business, profits, revenue or anticipated savings, loss of goodwill.
While it is fair for corporates to be concerned about the staying power of startups and their ability to honor their contractual commitments to provide products and services, in particular in respect of business-critical software, it is not acceptable to demand that they should acquire possession or control of the proprietary source code of the startup in circumstances other than significant continuity issues.
Any startup needs to carefully control its proprietary source code and avoid disclosing its source code to the corporate except on clear escrow conditions. Customers are entitled to appropriate source code escrow arrangements with a reputable and reliable escrow agent, with such source code to be released only in the event of significant financial problems which have a material adverse impact on the ability of suppliers to service such customers.
Choice of Law and Jurisdiction
It is standard practice in commercial agreements to choose the law that will govern contractual arrangements and to determine how any potential dispute on these arrangements will be dealt with.
Although Belgian, European and international law contain a full set of provisions determining the applicable law and the forum having jurisdiction in default of contractual clauses, the parties as such intend to avoid that technical disputes arise and slow down the resolution of the dispute on the merits.
When drafting license agreements, but also partnering agreements, investment agreements, share purchase agreements, management agreements, or a combination of those contracts, the choice of the applicable law and the dispute resolution mechanism are often filled in as rather trivial paragraphs. However, in case of disputes, these provisions can heavily impact the position of the parties and their ability to enforce their rights.
Attention should therefore be given to these clauses, taking account of the interest of the startup or scaleup.
Parties that decide to submit any possible disputes to state court litigation, should determine which forum will have jurisdiction territorially. In an international context, that implies the choice for the jurisdiction of one particular country, and a location within that country. In a national context, it implies the choice for a specific location. Parties can also opt for a neutral country, which is done sometimes if they distrust each other’s forum. The choice of forum should be aligned with the law applicable to the contract(s), in order to avoid that courts are compelled to rule based on foreign law (which they normally do not master).
State court litigation has the benefit or disadvantage, depending on a party’s position, of appeal proceedings, allowing a party to demand that its case is fully re-assessed. This comes at a price, in particular the length of the proceedings. It is not unusual for appeal proceedings to take more than 2 years. Proceedings are usually much cheaper than arbitration, but the possibility to recover lawyer’s fees remains rather limited (at least in Belgium) and the pre-defined fixed amounts seldom cover the actual cost.
Entrepreneurs need to be aware that in the event of choice of law and forum of the foreign country where the client or other counterpart is established, it becomes exceedingly more difficult and expensive to enforce contractual agreements in a foreign country.
Parties can also decide to step away from state court litigation and opt for arbitration. Arbitration is generally not the preferred option in rather straight forward transactions, that do not require a certain level of confidentiality. The higher the complexity, the more partners will benefit from arbitration.