Managing lower tier subcontractor risk in Contracts.

Just as suppliers can impact your supply chain, their subcontractors can also impact your supply chain. How do you manage that risk?

The first step in the process is supplier qualification which means not just qualifying the supplier but also looking at the subcontractors they use. Consider those subcontractors based upon their criticality, whether the supplier has alternative sources, and how much spend you the do with them. This should help identify how much risk there is. The more difficult,costly or longer time it would take to switch suppliers, the greater the potential risk, Consider that in your sourcing and award decisions.

Contractually you want to have approval over the subcontractors they use and require approval over any changes to those as a starting point. If you approve things the primary responsibility remains with the supplier or contractor. If you instruct or control who they must you may be assuming responsibility for that supplier's performance or lack of performance. For example in construction in the UK if the Owner specified a subcontractor that had to be used by the contractor, that becomes a "nominated subcontractor".The Contractor's responsibility for nominated subcontractors is different than ones that they selected,even if owner approved them.

In production procurement contracts you would want to approve a number of things and check even more. Not just that a Supplier is ISO Certified, but who their suppliers are, what they provide, whether they are single or multiple sourced, have multiple production locations and where the items are produced. A material supplier may have multiple production locations and some you may not want to have your materials coming from because either that site's reputation for quality or concerns about other things that could impact the supply such as political risk, labor relations issues, ability of materials to freely flow in and out of the country, political instability, economic instability. You would also look at how the products are designed and the raw materials or sub items used to see if there are any potential source issues for those. You could also be looking at the impact other industries may have on the availability of materials.

Ideally you want a supplier that has multiple good suppliers and subcontractors where they could quickly move the business if there was a problem with one. You want to avoid wherever possible custom or unique products that are single sourced and if you must use them you may want them to produce the product for you in multiple locations or license someone else to produce it so you have multiple sources. The more critical a supplier is to your supply chain, the lower you should go in the subcontract tiers. Just like any other chain, a supply chain is only as strong as it's weakest link.

There could be situations where you might need to take action directly against a subcontract. For example if you bought a product with a field replaceable unit (FRU) that was produced by the subcontractor where you were having problems getting replacements from your supplier you might consider requiring that you be named as a third party beneficiary to the agreement between your supplier and the subcontractor. Being a third party beneficiary provides you with privity that you could use to enforce the agreement so you get what they committed to provide the supplier.Being a third party beneficiary creates no liability for you with the subcontractor and has no impact on the supplier or subcontractor’s independent contractor status.

Managing Compliance

Managing risk and managing compliance frequently follows the same path.

In a recent White Paper, entitled “Third Party Essentials: A Reputation/Liability Checkup When Using Third Parties Globally”, authors Marjorie Doyle and Diana Lutz prepared a list of things to check in managing compliance with the Foreign Corrupt Practices Act in hiring third parties around the world to sell products or services on your behalf.

I wanted to pass this on to readers who may be involved in negotiation and managing sales channel types of contracts. I also think that most of the points they make in the white paper are also good suggestions for procurement risk management.

The full post is available at:
Corporatecompliance.org/staticcontent/thirdpartyessentials-doyle.pdf

Some of the things they recommend are
Databases of third parties and all their information,
Risk assessment of the third parties and priority for their management
Due diligence processes in selection of third parties.
Documentation of the due diligence.
Contracts to establish expectations.
Individuals to manage the third party.
Being vigilent to potential red flags that should warrant further investigation.

All of these are activities that supplier management should be doing with a focus on potential supply chain risk.

Standards of Care

In contracts depending upon what you are purchasing there can be three different standards that may be used. There are standards of commitment that define the degree a party is committed to provide a product of perform a service. Those can range from absolute when you use the words will or shall all the way down to intend.The second standard is the standard of performance. These are used more frequently in service type contracts where the standard of performance can range at the highest to a standard being performed by an expert down to ordinary performance for a company in the industry. Standards of care address the degree of care that must be used in performing the work so that individuals are not injured or property is not damaged. The standard of care that you require will depend upon the circumstances and what you are purchasing.

If you were silent in a contract the courts would use the requirement that the care used in performing the service be that which a reasonable person would exercise under the circumstances. Buyers may want a much higher standard such as the highest standard of care or using the care of an expert. Supplier’s may want to reduce their potential liability by reducing the standard of care they want to provide.One example of that could be wanting to include a standard of ordinary care.One of the readers provided me with another example of a supplier attempting to reduce their potential liability by reducing the standard of care..

“Consultant and its Subcontractors will conduct all Work under the Agreement in accordance with the applicable professional standard of care of … to the best of Consultants knowledge.”

For the consultants the highest standard care would be that of an expert, so the first thing that are doing is reducing the standard of care that they use to only the applicable standard of care for the industry standard that they made reference to. That may be acceptable if you know that 1) there actually is a standard of care and 2) The standard of care is acceptable. If something is written by and industry group always remember that it is written for the benefit of the members of that industry, not the customers.The worst part of the language is they added a knowledge qualifier which would even excuse them further if they didn't have knowledge of the requirements in that standard of care for the industry. That is what I call Ostrich management where if you bury your head in the sand you won't know what's going on around you. Standards of care are like standards of commitment, the better one you can get,the better off you are.

When I write warranties for consulting services or software, the minimum I want is for them to use "reasonable care and skill" in performing the services. Most consultants will balk at including "expert" as that is the highest standard commitment. What you do want is for the work to be performed using the standard for the type of person you are contracting for to perform the work.

For example: If you were hiring and paying for an experienced consultant you might say "All work and services shall be performed using reasonable care and skill of an experienced consultant in __________________. The blank would identify the type of consulting they perform.

If there was an industry standard that worked, I might consider using something like "All work and services performed shall be performed using reasonable care and skill as specified in ____________ for an experienced consultant / engineer.

Knowledge qualifiers are not good in any standard.The reason is they can argue that that didn’t have knowledge so they are not responsible. If you are ever forced to include a knowledge qualifier, you want also include a statement that the supplier has performed reasonable diligence to discover the knowledge. For example the supplier may want to say:

“To the best of Supplier's knowledge, Supplier’s work and services shall performed shall be performed using reasonable care and skill as specified in ____________ for an experienced consultant / engineer.”

To include reasonable diligence it would be:

“After performing reasonable diligence and to the best of Supplier's knowledge, Supplier’s work and services shall performed shall be performed using reasonable care and skill as specified in ____________ for an experienced consultant / engineer.”

The impact of including the reasonable diligence commitment would be that if a reasonable person using reasonable diligence would have discovered the issue, the supplier can’t argue that they didn’t have knowledge. If they argue that they didn’t have knowledge, what they are saying is that they didn’t perform what they represented which was that they performed reasonable diligence.

What is the difference between a warranty and a guarantee?

While some people may think they are the same, they are not and the two terms are not interchangeable. Under law, a warranty is a commitment that goes to the heart of the agreement where the breach of a warranty gives rise to the right to terminate the agreement and claim damages.

There are two types of guarantees.

One type is a financial commitment. A parent guarantee is a commitment that makes the Parent Company liable for the performance of their subsidiary. It makes the parent company a party to the transaction. If the subsidiary breaches the agreement and you terminate the agreement with the subsidiary and pursue damages that you sustained. If the subsidiary is unable to pay the amount of the damages and you have a parent guarantee you can then go against the parent company to collect the difference. Without the parent guarantee you would not have privity of contract with the parent and would be limited to only what you can collect from the subsidiary.

The second type of guarantee is used with respect to performance. In many locations a guarantee may not be considered to be at the heart of the agreement where a breach would give rise to the right to terminate. If a supplier breached a guarantee you would always have the right to claim money damages.

The only way to make a guarantee have the same standing as a warranty it to make it clear in your agreement that the guarantee goes to the heart of your agreement where the breach of the guarantee gives you the right to terminate the agreement and claim damages.

The only time a financial issue may come into play with respect to a performance guarantee that's included in the agreement would be if the parties agreed upon a specific financial remedy for the breach of the guarantee similar to a liquidated damage. Otherwise the remedy for the breach of a guarantee would be limited to the damages sustained from the breach that are allowed by the limitation of liability.

Can you use Six Sigma Methods with Contracts and Contracting?

Six Sigma projects follow two methodologies The DMAIC methodology is the approach that would be use to improve both contracts and contract processes as it is focused on improving an existing business process. DMAIC methodology has five phases that make up the acronym.

Define the problem and the goals
Measure the current process and collect relevant data.
Analyze the data to find verify cause-and-effect relationships. Seek out the root cause of problems.
Improve the current process based upon analyzing the data analysis and implement
Control the future process to avoid deviations and monitor progress.

While there are many tools that may be used, the primary ones that I think apply are

1. The five whys. The “five whys” was invented by Toyota to understand the root cause of a problem. You first start with a statement of a problem and keep asking why until you understand the root cause of the problem. I think 5 may have been a common number, the key is you need to keep asking why until you find the root cause of the problem and sometimes why that root cause exists. Borrowing from an example in Wikipedia here is and example of the 5 whys.
The vehicle will not start. This is the problem that you need to correct.
Why won’t the vehicle start? - The battery is dead. (first why)
Why is the battery dead? The alternator is not functioning. (second why)
Why is the alternator not functioning? The alternator belt has broken. (third why)
Why is the belt broken? - It was old and not been replaced. (fourth why)
Why was the belt not replaced? (fifth why)
a)The vehicle was not maintained according to the recommended service schedule.
b)Replacement parts are not available because of the extreme age of the vehicle.
If the answer was a) the next why would be: Why was the service schedule not followed? That would identify the root cause or the problem.
If the answer was b) that would be the root cause which would then lead to a discussion about what can be done to solve the problem.

You could use the “five whys” to question whether certain contract terms are needed or whether they actually match the way the business is being conducted.


2. Business process mapping. Business process mapping documents all the steps that you do in performing each task. When you map business processes you can identify dependencies between steps, deliverables that must be provided, what processes can be done in parallel and which need to be done serially. You can also look at the business processes for duplication, consider them from a value added perspective and look at where control points are or should be. Business process remapping is an activity that is frequently used in re-engineering activities to eliminate redundancies and low value added activities and reduce cost.

You could use business process mapping to analyze all the steps in your contracting process to do things like understand whether the steps are needed, whether there is redundant activity or to see whether the value added from the steps are worth the investment of time and resources to perform.

3. Cause and effect or fishbone diagrams that are also called Ishikawa diagrams. In this activity at everything from the perspective of what caused you to do something and the effect that has. Causes could come from a number of sources and part of this activity could be to consider whether what caused something to be done and the affect that has still applies. I wrote a separate blog about cost drivers which are things that drive costs in relationships. There are also causes that can have a huge impact on your contracts or contract negotiations because of the activities they drive. A manager or group may require something to be done without fully understanding the impact or cost of meeting that or the real value that it will provide. If they become aware of the affect and the cost, the value from that may not warrant the expenditure or complexity it drives. Within companies the sales terms and risks a company accepts in their sales terms will have an effect on what procurement contract terms are needed to support those sales. Cause and effect is everywhere and almost every cause has an effect and those effects have costs associated with them.

Using these three simple tools individuals that do contracting can work to solve problems with their contracts or contract management. They can be used simplify contracts and contracting processes. They can be used to potentially simplify negotiations. Let me give you a few examples of what I mean.

Contract Templates.
Many companies have standard contract templates. Every time a new activity, program or problem occurs there is usually a rush to address the new activity or program or to solve the problem. The problem is that business continually continues to evolve and change, so how you managed things in the past that drove what you did and how you did it, may not be what’s needed today. In fact what you have may no longer be needed as the activity or program may have come and gone. The problem may have been a single or point in time occurrence. You simply may not be having the same problem as your business model or approaches to doing business may have changed. Everything that doesn’t match how you are doing business today provides no value and adds to the time and complexity to your negotiation.
Not matching the business model also leaves potential gaps or problems that could occur in the future or as I refer to it create “an accident looking for a place to happen.” Everything included in your contracts that were driven by an activity or program may either be too costly for the value it provides or it may no longer be needed. Leaving those in your contract can be driving costs to your supplier that increases your cost. Leaving them in also adds more time and complexity to your negotiations. Suppliers constantly improve or they shouldn’t be your supplier long. This means that problems you may have had in the past may no longer exist. If they don’t exist, why do you need terms in place to manage them?

Buying approach affect on terms.
A change in your buying approach will significantly change what you need. When you outsource manufacturing and have the contract manufacturer perform procurement on your behalf what is needed in contracts changes. You can have the contract manufacturer manage all that under their agreements with suppliers. If suppliers will agree to it, you could have the contract manufacturer purchase off your agreements. If the suppliers won’t allow that you may need an alternative model in effect where the Supplier will sell to the CM at your pricing but under the supplier’s standard terms and still have an agreement in effect with the supplier so you can enforce certain key terms directly against them on CM purchases. This would be especially true if the supplier provides you with terms that they wouldn’t provide to the CM. As you can see, each approach has different contract needs. If they will do it all under their agreement, you would no long need to have agreements with the suppliers. If they purchase against your contracts it would be business as usual and they only thing you would need to address is that specific activity. If you had a mix where the CM did the purchasing but you retained certain commitments you need to be able to enforce directly with the supplier, you clearly need those terms, but you would no longer need many of the terms you would traditionally need if you were doing the purchasing. The circumstances no longer require it. Leaving terms you don’t need or won’t use in a template means you are wasting time negotiating for things you don’t need and won’t use. You may also be adding costs to the supplier for benefits you simply don’t get. It can also be including thing in your contract that you will get audited for compliance against even though you no longer use them. Things like outsourcing require that you take a hard look the terms you use.

Impact of goals.
I worked for a company where a major goal was to drive payment terms to 60 days. It was a measurement that was tracked and reported frequently with great management interest. We had a large number of suppliers who would sell directly to CM’s at our price but not with our terms. Since management had the goal of 60 days to meet those goals we had to negotiate 60 day payment terms with all suppliers, even the ones that we were no longer were purchasing directly from and even though those terms would not be extended to the CM’s. Extending paying terms is a credit worthiness decision and many suppliers didn’t feel the CM’s financials warranted extending that much credit. We also included 60 day payment terms in the CM agreements to meet the 60 day goal. What that meant since CM’s were not getting those terms from some of the suppliers it added to their cost. On suppliers where they had more leverage they were paying those suppliers in terms longer than 60 days. Those suppliers undoubtedly would take that additional cost and reflect that in their prices to the CM. The CM would wing up making more money as part of their compensation (overhead and profit) was based on percentages of the cost of the materials they purchased. If you ever did a six-sigma audit on the real benefits that the requirement for 60 day payment terms actually provided the results would have been interesting. On paper it may have looked good. In reality it probably added to the cost of the purchases.

Six sigma is a quality management tool. In contracting quality means that you have contracts that are effective and match the way you are doing business. It means that contracts are current and don’t include out of date or unnecessary requirements that add cost or unneeded complexity. Quality in contracts further means that your terms are managing costs, risks or programs that are real.

Thoughts on Negotiating Supplier Managed Inventory, Pull’s, Pull Liability

Supplier managed inventory or VMI programs are where the Supplier stocks product at certain agreed locations for the Buyer to pull the products when needed for their use.

Standard Buyer purchase templates usually need to be modified to implement these programs:
•Instead of ordering, the Buyer Provides forecasts.
•Instead of having delivery at the Supplier’s dock, delivery occurs when the product is pulled from the Hub.
•Instead of the inventory needed for production being held by the Buyer, it’s held by the Supplier.
•The Supplier’s ability to get paid is based not when it left its dock, but when it was actually pulled.
•The warranty period for the product that traditionally would be measured from when the Supplier ships it, needs to be measured differently based on when it was pulled or the lag time it will spend in transit and in the Hub needs to be built into the warranty.
•Because the Supplier is responsible to get it to the Hub, all shipping costs and risk of loss transfer to the Supplier.
•If a third party manages the Hub, additional issues of insurance and risk of loss at the Hub come into play.

Since the Buyer isn’t actually purchasing the product until the pull, Suppliers also are concerned with:
•Liability for custom product in the event of a termination of the program
•Obsolescence of a product
•The impact major reductions in volumes of consumption may have on the inventory levels
•The accuracy of Buyer’s forecasts
•Their ability and costs to do re-balancing of inventory for standard products.

Most of these negotiations will focus on these issues and the extent and nature of the product profile (Items held, quantity), but especially Buyer’s liability when pulls simply do not happen as they were forecasted.

Battle of the Forms & Writing

Battle of the forms describes is a situation that occurs when a purchase order is issued and an acceptance or confirmation is sent with additional or different terms and the work is still performed. Contractually the acceptance or confirmation with the different terms is a counter offer that should be accepted or rejected by the buyer. However since performance has occurred there is a contract, it’s just not clear what the real terms are. If there is a problem the buyer argue that only their terms should apply. The supplier would argue that their performance was based upon their acceptance or confirmation. The courts or an arbitrator would need to decide which applies and would look at things like standard practices in the industry and prior dealings between the parties to determine who wins in the battle of the forms.

When you have a contract you can eliminate the potential for any battle of the forms and usually both parties are willing to do that. The way this is done is by simply including language in the contract to the effect that any additional or differing terms in either buyer’s purchase order or supplier’s acceptance shall be void unless accepted in writing by both parties. This protects the Supplier from having to be vigilant and closely review every order to make sure the buyer hasn’t changed or added terms. This also protects the buyer from having the supplier include additional or different terms in their confirmation or acceptance. It eliminates any potential battle of the forms. It doesn’t prevent the parties from agreeing to something different. It does require the change or additional requirements be agreed be in writing by both parties to the agreement.

Having a document be actually signed in writing by both parties can be cumbersome and slow. That doesn’t work well in today’s real-time world. Contractually the parties can agree to establish alternative method of agreement that constitutes “a writing signed by both parties”. I worked with a group that had a electronic quoting tool that allowed authorized parties of the supplier to access to the tool to provide quotes and updated pricing. As prices changed frequently and new items were constantly being added that would have required a blizzard of paperwork to get mutual agreements in writing on each change. To make this more efficient I included language in our contracts that establish an alternative method for changing pricing. The suppliers agreed their placement of a quote in the tool was a written offer to make that change. Then we established that our acceptance in writing would was accomplished by either an email or by our issuance of a purchase order at the quoted price. If we didn’t agree with the pricing the supplier inputted we would negotiate with them and have them re-input the new pricing into the tool. To close the loop and not be totally dependent upon electronic files we required that there be a periodic print out of all prices that were in effect at a specific date and had both parties sign that to reaffirm the agreed pricing. We were able to manage it that way because the access to the quote system was limited to only employees of the supplier that were authorized and the system allowed us to track when changes were made and who made the changes.

Yields

In procurement there are two ways that you can pay for something that is performed or produced for you.You can pay a fixed price for the final accepted product or service performed or you can pay for the processes and services performed in producing the product or final service. The difference between the two approaches is risk. If you pay a fixed price for accepted products or services performed, the risk of yield in performance is with the Supplier. If you pay for individual processes or services performed in the manufacture or performance of the service, you bear the risk of yield in performance.

Few products or services are performed totally error free. Some errors may be corrected. Some errors can require the work to be scrapped. Yield is measured as a percent of the total output. Yield can be measured at the end of each process step where you measure the total number of items that started the process versus the number of items that successfully completed the process. Yield can also be measured based upon the number of units that started the process in comparison with the number of completed acceptable products at the end of all processes.

For example, if you were using a third party semiconductor foundry to produce a chip, you could pay them only for acceptable finished chip. You could also pay for all the processes they performed that are required to produce the chip. If you are paying for processes, what you are doing is paying the supplier whether the outcome of the process is good or bad so in those cases it’s important to get commitments from the supplier about the yield of each process will be or what the final yield will be to ensure that they have the quality management processes, procedures, controls and measurements to perform each of those tasks so they have a high percentage of yield to keep your cost of production down.

Why would a buyer ever want to consider entering into an agreement based upon paying for process costs and yields? The simple answer is if you are contracting to have the supplier produce something that they have never produced before they may not have a good idea of the types of yields that they can expect and may need to include contingencies. Yields can vary greatly based upon the design of the product, the complexity of the product and the processes used. Yields will also vary based upon the materials used, the volume of production and the learning curve of individuals that are involved in the production. In the production of a new product you could agree to pay based upon process costs simply because you have no history of what the yields will be so you use that to start production, determine what the yields are so you can fix the price based upon actual yields versus projected yields. You may also take that approach to take any contingencies that would have been build into a fixed price for expected yields out of the cost. If you did that, you would be assuming some, if not all, of the risk if there are production problems that cause the yields to be less.

As with any other risk, the risk of production yields is not a good risk to accept if you don’t have the ability to control the risk. One way to manage or control the risk is to establish minimum standards that must be met. With minimum standards you create a sharing of the risk. You assume the risk and cost as long as the production falls within the standards. The supplier assumes the risk and cost for defective items in excess of the agreed standard. The second way of managing the risk is control.If you are going to be assuming the risk and cost of quality yields, you need to make sure that everything related to the production is agreed, documented and cannot be changed without your approval as changes can change the yields.

The other main difference between the two is quantity. If you purchase on a fixed price basis you order your needed quantity only and the supplier needs to determine what quantity they need to start to achieve the ordered quality. If they achieve higher than expected yields you have no obligation to purchase those and they become supplier’s inventory that they can use to fulfill any future orders. When you purchase based upon processes, you and the supplier will determine the quantity you need to start to meet you desired quantity of completed products without defects. You pay for the quantities that are run through each of the processes. If the processes yield less than your desired quantity, unless you have a sharing of the risk you still will pay but may get less than the desired quantity. If the yield is higher than expected you get that extra quantity delivered.

While I have talked about yields from a production perspective, the concept of yields can be applied in a number of non-production areas. For example you could hire a marketing company for a program to generate sales leads by a targeted mailing to potential customers. They perform a number of tasks to do that. The “yield” for that activity would be the number of confirmed sales leads that get generated against the total they marketed to. That would show how effective their performance of those tasks was. When you pay a fixed price for their services, you are taking the risk on yields. You could pay them based upon the actual number of yields they generate where they are taking the risk on yields. You could also have an incentive based structure where you share in the risk of yields where you pay some of their production costs, and make them earn the rest based upon the yield of the activity – the number of confirmed sales leads they generate.

Supplier Managed Inventory

In a number of procurement activities it has become more frequently for suppliers to stock items either at or close to the buyer’s location and operate under a form of pull replenishment ordering system. I decided it would be worth talking about how this needs to work from a contract perspective.

The driving force behind what needs to be included to address supplier-managed inventory is whether the materials are unique to the buyer. Items that are unique would be defined to include items that are not returnable, resalable, nor readily usable by either the buyer or the supplier. The reason for this is with unique materials if the buyer does not consume them by pulling them from the supplier managed inventory, the supplier doesn’t get paid and the supplier winds up with items that have no value. If an item isn’t unique, the potential risk to the supplier is far less as they can re-deploy any excess at much less of a cost. For non-unique items what is required contractually will be less than any unique items.

A second force is managing costs. Suppliers do not want to be carrying large inventories that aren’t being consumed. If the buyer has required quantities that are in excess of their demand a supplier may want the buyer to pay either an inventory carrying cost on aging inventory or pay the costs to re-deploy the items to where they may be sold. As buyers may have to pay for 1) any excess unique materials that are not consumed, 2) carrying costs on aging inventory and 3) costs to have the materials redeployed, buyers need to have terms that manage those costs by managing the inventory levels being held by the supplier.

Normal purchase terms like delivery and lead-time take on a new meaning when you have supplier-managed inventory. Delivery doesn’t mean taking delivery at the supplier manufacturing location, it’s taking delivery at the stocking hub where the items are pulled from. As you are doing pulls from inventory, there is not traditional lead-time as it should be available in stock for you to pull from. The lead-time you need to be concerned with is the replenishment lead-time. That is the period from when the product is pulled from the inventory until it’s replaced in the stocking hub. That is longer than a supplier’s normal lead-time for a product as that needs to include all the in-transit time until it is received at the stocking hub. If you will have both traditional purchasing and supplier managed inventory occur under an agreement, you’ll need to have a separate appendix that defines the terms you will use and establishes the parties responsibilities for the supplier-managed inventory.

With supplier managed inventory everything starts with the “planning schedule”, which means Buyer’s forecasts of projected quantities required over time. Before being able to establish a supplier managed inventory the parties need to establish a number of things in their agreement:
1.The initial quantity to be placed in inventory.
2.The responsibilities of the buyer to provide updated forecasts.
3.Responsibilities of the supplier to adjust the quantities based upon changes to the forecasts, actual demand, and any changes to their known lead-time for replenishment.
4.For unique items the liability horizon the buyer will have so they understand their maximum potential liability. This is because liability is based not just on inventory in stock but also work in process required to meet replenishment commitments. Buyers want to have the right of approval over anything that would increase the liability horizon.
See the not below for a further discussion on liability horizons.
5.Where the materials will be stocked. This could be a supplier location, a third party warehouse, or the buyer’s location. If they will be stocked at the Buyer site it will require additional provisions for how that will be managed, who insures the materials etc.
6.For unique items, what constitutes obsolete inventory that the Buyer must purchase.
7.For any excess or aging inventory of non-unique items, what the options are:
7a.If the Buyer wants the inventory held, how long the supplier must hold it, the carrying cost, and when the buyer must pull and pay for it, or
7b.What the buyer’s liability is if the item is re-deployed by the supplier.
8.The mechanism for pulls. How pulls are communicated, requirements for pull purchase orders to bill against, pull notifications of intent to pull, pull delivery obligations, and invoicing procedures for pulled product.
9.The agreed replenishment process and time for the supplier to replenish the pulled product with a new one in inventory at the stocking hub (the replenishment lead-time).
10.If the supplier will hold product in addition to the liability horizon for additional flexibility.
11.The obligations of the parties for the supplier managed Inventory in the event the contract is terminated or a purchase order is cancelled.
12.Adjustments the buyer or supplier can make to the quantities held in inventory that will impact the liability horizon.
13.Remedies buyer has if the supplier fails to meet their obligations to replenish the inventory within the agreed replenishment lead-time.

A note about “liability horizon”. Very few products start their production as a unique product. The uniqueness does not occur until the product has a manufacturing process performed that makes it unique to you. That is the point after which the item cannot be used for other purposes. In establishing liability horizons for unique product that are being manufactured to meet replenishment obligations, you only want to be liable for those products where the work in process (WIP) has been performed that makes the item unique to your use. If the work in process has not been performed, you want the supplier to use that work in process for other purposes. It’s a way of mitigating the potential cost and risk to you.

Here’s an example. A Semiconductor manufacturer’s total cycle time for production of a semiconductor product may be sixteen weeks. The sixteen weeks will include time for each of the processes that are serially performed in the manufacture of the wafer, the cutting of the finished wafer into die, having the die be packaged, and having the packaged chip tested. It may take another week to get the tested chip to the stocking location. So if you had a supplier-managed inventory for that semiconductor the replenishment lead-time would be seventeen weeks. Semiconductors are manufactured in a number of layers. For this example let’s say this semiconductor has 24 layers. Semiconductors are usually designed using standard building blocks. The first 20 layers of the chip may be the standard building blocks. The last four layers may be the processes that make the product unique to you. So if you were negotiating the liability horizon for that product under a supplier-managed inventory, you would determine the period of time that it takes from the completion of the 20th layer (where it is still not unique) until you would get delivery of the replenishment product at the stocking point. That duration should be your liability horizon. You don’t want to be liable for the full value of the product up to that WIP point as the Supplier can use it for other purposes. To get that you may have to agree to pay a carrying cost until they can use it elsewhere as they are helping you mitigate your cost. Once the product falls within the liability horizon window where any processes have been performed make that unique to you, the chip either needs to be scrapped or it needs to be completed. For unique products held in supplier managed inventory the supplier will want you to be liable for any items held in inventory that you haven’t pulled. They will also want you to be liable to either purchase the completed item or pay their costs in any volumes held in WIP that exists because of the requirement to replenish products. It’s not any different than having liability for cancellation of orders. The only difference is instead of your issuing purchase orders for that work, you have required replenishment by the supplier.

Raw Material Adders and Surcharges:

When you are purchasing items that are subject to frequent changes in the cost of materials or labor used or where the supplier is responsible for the payment of freight, you may need to include a provision that adjusts pricing accordingly. In a way this is similar to needing to manage currency exchange when you have a supplier or buyer that operates under a different currency where changes in currency can affect their costs or profits.

The first thing to consider is which party should take the risk. If the buyer expects the supplier to assume all the risk, you can expect that the supplier will build contingencies into their price to cover the risk. As long as the contingency covers their costs the supplier will never lose. If the changes to the raw materials are less,the supplier makes more of a profit. So having the supplier take all the risk is the lowest risk but highest potential cost for the buyer.

If the buyer assumes all the risk, it’s not much different than agreeing to pay in a foreign
currency, the key question is what steps can you take to hedge against the risk. Unlike currency exchange where you can hedge against the risk by purchasing the foreign currency at forward rates, hedging against changes to material costs are harder to manage as in most cases you would hedge against the risk by making firm commitments today that the supplier can also use to make firm commitments to their material suppliers at today’s prices for delivery in the future so you are not impacted by the change. You may not need or want to make a firm commitment for all you expected volume, and you can always have some portion hedged by advance purchases and some that you have as floating where the price will be adjusted based upon what the costs are at the time.

Any time you agree to allow for price changes for things like raw materials or other items that are subject to their prices being changed, your contract need to establish a baseline for measuring the amount of the changes to the price. For raw materials you need to establish
the quantity that will be consumed or scraped in the process so you understand the true impact of the change in the price in what you are purchasing. If you were buying a product that had a bill of materials, you would also identify how many of the items that were subject to changes in pricing would be affected. Next you want to understand what impact a Supplier’s inventory has on their cost. Just because the price of the material has gone up or down when they need to make future purchases of it does not impact the cost the supplier had for what they paid for any existing inventory. Next you need to establish the basis for the cost adjustment. Are you paying it based upon their actual cost they paid or is it based upon quoted market prices or market indexes? If its based upon actual cost you would want to have the right to audit that cost. The last things to decide is the frequency of price changes that would be allowed and how any additional costs or credits will be managed. All these things would need to be included in the contract.

In activities like contract manufacturing the price paid will frequently be a combination of a percentage or firm amount for both overhead, profit, a firm amount for manufacturing value added and the actual cost of the materials used. There are requirements that on some period such as monthly, the supplier must disclose the actual costs of both the inventory they consumed and new purchases to agree upon any adjustment required for what has been been shipped and to set the price for future purchases. Adjustments (either additions or reductions) may be made as a separate payment to the supplier or refund to the buyer, or the parties could agree have the adjustment be applied to the price of future purchases. However you manage it any time you agree adders or surcharge you want to make sure that it goes both ways so if their costs go down your price goes down.

To make sure you only pay what you need to pay or get back what you should get back, you need to manage the activity. You also need to make sure that your contract and contract file makes it clear what your price is based upon so anyone that assumes responsibility to manage the contract in the future will know it needs to be managed just like if you amortized one time costs into the price so the price gets reduced once those one time costs are liquidated. It’s like many things where you may need to tell them they need to provide it or they might conveniently forget about it, This is especially true when forgetting about it would be to their benefit.

Contract drafts – when do you provide them?

My opinion is that unless the scope fo the agreement is in flux, the draft contract should be provided with the Invitation for Bids, Request for Proposals or other for bid or quotation documents. The reason for that is two-fold. First, half of negotiation is setting expectations of what you need and want. The specifications or statement of work set the expectations of what you need. The contract sets expectations for how you want that to be performed and the standards you expect it to be performed to.

The second reason is the contract document sets the baseline from the perspective of price. If the supplier provided no exceptions or no assumptions with their bid or proposal, the price should be based upon you getting your contract terms. If you don’t set those expectations and standards in advance, the supplier will argue that to give you what you want in the contract it will cost you more as their price wasn’t based upon those requirements. By including the contract terms with those standards in the contract and advance, if the supplier wants to provide you less that what’s in the draft contract, you should demand to pay less as the price quoted should have been based on the contract.

Another advantage of providing the contract as part of the bid or proposal documents is if the supplier will have major problems in giving you what you want, you will know that in advance. You can help them avoid wasting their time and money preparing a bid for a contract they won’t ever agree to. On the Buyer’s side it also gives you more to consider than price alone as you can see not just the price differences between the suppliers but also the potential cost and risk differences in the terms they want changed or the assumptions or exceptions they make. If there is going to be a significant problem with getting you what you need, it's best to know that up front so you don’t waste time heading down the path with one supplier where the contract terms will be a problem. If there are non-negotiable terms you have that the Supplier doesn’t want to accept, you can focus on those right away and let them know that if you can’t get over those hurdles, there is no sense in wasting time negotiating anything else.

If I was a supplier I would also be leery of a customer that wanted to delay my seeing the proposed contract. The customer could be using that delay to get the supplier so committed to performing the work. When that happens you have two options.One is you can walk away and lose what you have invested. The other is you can stay and try to negotiate from a potential position of having less leverage. Neither of these options are good.

Confidentiality Agreements – Public Information Exclusion

In a LinkedIN group an individual posed the question about the use of non-public information. It seemed that non-public information was used in describing what needed to be held as confidential and want to understand the relationship between that and the exclusion for information that becomes public.He questioned whether it was superfluous.

My first thought was that non-public information is extremely broad description of what is to be held as confidential. As you assume potential liability with the receipt of confidential information its also not a good idea to agree to hold all non-public information as confidential. Any definition of what is to be held as confidential needs to be more clearly defined and much more limited. The simple fact is that not all non-public information of a company is information that needs protection. NDA's are used to protect trade secret information that can't be protected by Patent, Copyright or other IP protection. Its also to protect information which if disclosed could harm the discloser. They are not to protect any information that simply isn’t made public. You protect only the information that would harm your business if it was disclosed.

If the language did not go on and further define the scope of the of what was being disclosed it is not superfluous. In that case the use non-public was to describe the type of material that is being considered as confidential. The exclusion portion is an example of a condition subsequent. Conditions subsequent can be used to either create obligations or to excuse a party from an obligation. In confidentiality agreements conditions subsequent such as the information being made public is to excuse the receiver from responsibility to maintain that information as confidential.
If the language went on to further define the scope of what was being held as confidential, then the use of "non-public" would be superflous.

Conditions subsequent are used in confidentiality provisions because you can be provided information that is confidential at the time when it is disclosed to you. Events can occur after that point that make the information no long be confidential of the need to maintain it as confidential. Once that happens and the condition subsequent has been met the recipient may be excused from the obligation depending upon the facts.

For example, you could be provided with information about an unannounced product that a supplier wants you to hold as confidential because of the potential impact to them if the information were made public. That would be a good example of trade secret information. Once they announce and begin to sell the product any details about that product that they make public or that could be reasonably discovered with the purchase of the product would then be considered as public information. If you received no greater information than what at that point would be consider as public information, that would relieve the receiver from having to maintain the information as confidential.

However, If you received more trade secret information than what they disclose to the public or that which could be reasonably be identified with the purchase of the product, you would only be excused from having to maintain the public information portion as confidential. Any confidential information that you received in excess of that now public information would need to continue to be held confidential. For example if you were provided information about how a product works internally that could not be determined by a purchaser of a product and that wasn’t disclosed, that would need to be still held as confidential. If you were provided with information about how the product was made and the materials that were used, that type of information would not need to be held as confidential as a tear down analysis of the product would be able to identify the processes and materials used Once the product is sold that type of information would be consider to be public. It is also fairly common for companies to purchase their competitors products to see what they can learn about the materials and processes used.

Software – Termination and Miscellaneous Terms

Unlike the purchase of goods or services where you keep what has been provided up to the date of termination, with software if there is a termination it may eliminate your right to use it in the future.

Termination without cause. Since you pay the license fee once the software has been tested and accepted there would be no good reason for a licensee to want to terminate the license without cause. For maintenance services you could include a termination without cause right, but if you do that depending upon how the license is structured the worst case is you could be forced to stop using and return the software or certify that it has been destroyed. The second alternative is
you might be able to continue using the software, but that would be on an as-is basis with no support from the licensor. You would never want to provide the licensor with the right to terminate the license or maintenance services without
cause as that would dramatically reduce the value to you even if you could retain the software for use.

Termination for Cause. Both the licensor and the licensee will want the right to be able to terminate the license agreement for cause. As with any other thing you purchase, you need to establish:
1. What constitutes a material breach which if uncured will be cause to terminate the license?
2. What the cure period is to remedy the breach.
3. What the rights or remedies should be if there is a failure to cure the breach.

Licensor’s will want the right to terminate the license if the licensee uses the software in a manner that is not authorized by the license grant, or if the licensee
breaches other material obligations they have under the license, such failing to paying fees, or failure to maintain confidentiality obligations. In a termination the licensor will want the licensee to stop using the application and to either return or certify destruction of the media, documentation and all copies.

Licensees will want the right to terminate the license and maintenance services for cause in the event of a material breach of the license and maintenance agreement that is not cured. Material breaches would include breach of the licensor’s warranties, indemnities, failure to correct material errors during the warranty period, and failure to perform maintenance services as required. Licensees could have additional terms where the breach of those by the licensor would be cause for terminating the agreement. For example a licensee may not want their use of the application publicized and may want the breach of that obligation to be a cause for termination. For licensees an important consideration is what rights do they want or need in the event they need to terminate the agreement. For example if you needed to use the application, you may want the license grant to survive the termination so you may continue to use the application on an as-is basis. You would also want to be provided with source code needed to support the application. If you have those rights it could reduce the amount of damages you may be able to claim. The advantage of getting those rights is it allows you to continue to use the application. The disadvantage of getting those rights is they will limit some of the damages you could claim for the breach.



Miscellaneous Terms:
Just like the purchase of goods or service a traditional license will also include a number of standard legal terms
a. Governing law and jurisdiction to determine what law will be used to interpret the agreement and what jurisdiction would be used for any disputes that wind up in litigation
b. Force Majeure to excuse delays in performance caused by acts outside of their control
c. Assignment rights or restrictions for both parties. As a licensee you would not want the licensor to be able to assign the license or maintenance agreement unless there was a sale of the business, assets and transfer of personnel to a third party. Licensee’s may want the right to assign the agreement in the event
the business using is sold and assets are transferred to a third party or if the license was for an application that was used in conjunction with a piece of capital equipment where the failure to provide the software would significantly diminish the value of the equipment.
d. Order of precedence to create a priority in interpretation in the event of a conflict between the license agreement and any documents incorporated by reference into the license agreement.
e. Merger of terms to ensure that the license agreement represents the entire understanding of the parties.
f. Survival to identify any additional terms should survive the termination of the license, or the end of the term if the application was licensed for a limited term.
g. Waver to address who can waive rights under the license and what impact a waiver has on the future rights and responsibilities of the parties
h. Notices to address where any legal notices must be send such as cure notice.

Last, but most important, is making sure that you incorporate by reference the application’s specifications, acceptance and test requirements and any other documents that make up the entire agreement between the parties.

Software - Software Source Code Escrow

As source code is the inner workings of the licensor’s intellectual property, most licensors are unwilling to provide source code except in special circumstances. Those situations are when the Licensor is unable or unwilling to support the product such as bankruptcy. Buyers may also not want to receive source code as the is confidential information and there is always a risk in receiving confidential information. The most common approach with respect to source code is to have a requirement that it be escrowed.

When you deal with commitments to escrow source code you need to address several key items.
1, What materials will be included in the escrow package that the supplier must place into escrow. As you may need to support the product on your own, you want everything that would be required to do that and you want it updated each time there is a change..
2, Who is escrow agent and location? Who is responsible to pay the escrow agent? For standard applications the licensor may already be holding the source code in escrow so the only time you would want to pay would be if it was unique to you.
3. You need to establish the specific actions called “triggers” where once the trigger has occurred you can demand the release of the source code? Bankruptcy is not a good trigger. That’s because once the licensor has filed for bankruptcy, all decisions are managed by the trustee in bankruptcy and they do not have to honor your agreement or the agreement with the escrow agent. It would be better to have triggers be things like breaching the warranties or maintenance agreement and failing to cure within the allowable period, or having a substantial deterioration in the licensor’s financial status to a point where its only a matter of time before they would need to file for bankruptcy..
4. What are the provisions for release? This means what steps do you need to do to be able to demand release from the escrow agent and what do they have to provide you.
5. What rights and obligations do you have in using the released source code? This can include things like:
a) Standards of confidentiality for maintaining the source code.
b) Restrictions on use such as using it strictly for the purpose of supporting the licensed software application.
c. What is the license grant that you have with the source code. As you will be supporting yourself with the source code if you don’t have the right to create and own derivative works under the license grant, you could demand that possibly subject to a restriction on use to internal use only.

Many companies may want software licensors to escrow on all the packages they purchase. To me it’s a business call that should be driven by several factors:
1.How critical is the application is to your business?,
2.How long and what cost would it take to change to another application?
3.How stable is the software?
4.Will you need to modify or change the software in the future?
5.What is the cost to have the materials held in escrow?
6.How long would it take your people or a third party to understand the application and how it works to be able to support it or to make changes. For complex applications unless you were able to hire someone that thoroughly knew the source code it could take multiple years to understand the program and its structure enough to make changes.

I’m a firm believer that if someone is prepared to provide something to me for no additional cost, I’m happy to let them do it even if I don’t need it or plan on relying upon it. If a supplier puts a master copy in escrow for all customers to potentially access, its an easy decision to make. For escrows that would require payment of escrow agent’s cost I would go back to the business to review the real benefits and costs of requiring an escrow.

Is it critical? If no, I probably would not recommend paying for holding the materials in escrow.

Can it quickly and cheaply be replaced? If yes, I probably wouldn’t recommend paying for materials to be held in escrow?

How financially stable is the developer? If they are strong financially I probably wouldn't recommend paying for it..

How stable is the software? If it’s stable, I may not need the materials to be held in escrow so I wouldn’t pay for it.

Do I need to be able to modify or change it in the future? If I did I would want to have it held in escrow.

How long would it take to use it? If it was going to require years and a substantial investment of people to be able to use it to support, modify, or change it, I would want to take that into account in terms of which is better. Continuing to support something that will be unique to you or investing in a new application where the supplier will be making and selling upgrades to their customer where it will cost much less for support.

Having an escrow does not provide you 100% protection if there is a problem. It provides you only part of what you may need. The key to its value is how long will it take for you to understand what you received so you can potentially use it. The second key is how much will it cost you to use and support it. It may be more than you want or can afford to pay.

These are decisions that the using business needs to decide.

Software - Maintenance, Training, Documentation, Media

Maintenance
As with any service, software maintenance required that you have clearly defined scope of what the licensor is required to perform and the services that they provide as part of the purchase of maintenance services. For example what type of errors is the licensor required to correct during the maintenance period. Here the definition of material defect versus minor defect or bug is very important as many times the commitment is primarily to correct material defects in the software and provide revisions that they routinely provide to all customers.
For material defects you want to know the response times they will provide for correction or a work-around. For major problems you may want to include a specific escalation process based upon how long it is taking to correct the material defect. As part of maintenance just like any other service you want to establish how problems get reported and how the licensor provides support. Are there on-line help or hotlines available? Are they 24x7? Do they maintain a user accessible data base of common problems and solutions?

Maintenance services do normally not include Upgrades. (changes that add substantial value) but they may include enhancements (changes that improve the product without adding substantial value). It’s important as part of understanding your potential life cycle cost to understand whether enhancements are included as part of the maintenance fee and that you have clearly distinguished enhancements from upgrades. Licensors have a variety of ways that the may want to charge for maintenance services. What you want to pay should be consistent with the value you will receive. For example, if a licensor wants to charge for both
Enhancements and Upgrades, your costs will be more and the value they are providing is less.
Another key question to ask and make sure you include in the maintenance portion of the license agreement is the period that they will continue to support the version of the license you purchased once they introduce enhancements (if not included in the maintenance fee) and upgrades. This has a major impact on how long you can use the application without being forced to purchase an enhancement or upgrade. The reason why that’s important is once they discontinue support for a specific revision you are left with two options. You either must purchase the enhancement or upgrade or you will need to operate the product on an as-is basis without support. As maintenance services are traditionally billed on one year increments in advance what you don’t want is to be paying for maintenance services and not be getting support as they no longer support the revision level you have.

Training
Prior to negotiating a license for software you also need to understand all the specifics about training as training costs can also a significant potential portion of the life cycle cost of the licensed software. I would first want to understand what all the recommended levels of training are for users and personnel that will need to support the software. What are the courses involved? What is the cost of each course? Where are the courses held? How many students are involved? What is the instructor to student ration. I would want to understand what if any of the training is included with the payment of the license fee and what the costs of additional training would be. Since it is a cost issue this is one area where you may want to push for either a reduced license fee because of having to pay for the cost of the training or looking to get free training as part of the license fee. If there is a competitive application use the life cycle cost of what you would have with that application as leverage to get a better deal.

Documentation, Media and Method of Delivery.
Before the internet and on-demand printing the issues of documentation and media were significant. As computer memory devices used different types of drives, you needed to specify a media format that was compatible with your operating system and drive. Documentation would also come in a box or many boxes of manuals, guides etc. With the internet many smaller application are delivered over the internet and much of the documentation is also
On-line with access available to customers. While you still need to make sure that the software
Is compatible with your operating system. For major applications you would still need to specify the specific type of media that the software will be delivered on for installation.

For documentation the key issue you may negotiate are:
a. What documentation is provided with the initial license fee? What is the cost to purchase additional documentation? This again is a life cycle cost issue
b. Can you reproduce excerpts from the documentation for internal training? Whether this will be a problem for a supplier will depend upon how much they want to force you to purchase their training or purchase more documentation. This is another life cycle cost to take into consideration,
c. Do you have the right to make derivative works of the documentation so that it better fits your needs? Whether a licensor will allow you to make derivative works of copyrighted material is up to the licensor. The licensor should not have a problem with allowing it as long as they get a license to use the derivative work royalty free. The use of that derivative work is limited to training your employees. Plus the requirement that you include appropriate copyright notices and legends on the work to show their underlying copyright.
d. Do you have the right to make and keep archival copies for things like disaster recovery. This should not be a problem.

For media the only issue you may negotiate is the right to make copies for both back up and archival purposes, Both of these you should get.

Software Indemnities, Confidentiality, Limitation of Liability, Insurance

Indemnities.
Similar to the purchase of products, with the licensing of software the licensee will still want the licensor to provide both a general indemnification against personal injury or property damage that is caused by the product of the negligence of the licensor’s personnel. The importance of the general indemnification will vary based upon two factors. One is whether the licensor’s personnel will be traveling to the Licensee’s site and doing business there, such as performing installation. The second factor would be what the risks would be in the use of the application and whether third parties could be impacted. It’s best to err on the side of caution and include it. As software is a copyrighted material, the intellectual property infringement indemnity is important. As with products if there is a claim of infringement you want the licensor to either get a license to use the product, or change the product so that it is non-infringing. For products
the various options to correct the infringement may have a significant cost impact to the buyer so you need to establish a priority in the actions. As the cost to make corrections to software is usually minimal to the licensee, it shouldn’t make any difference whether the licensor gets the rights to use the software or whether they modify it to make it non-infringing as you already have the commitment that it must meet the specification. Licensors may want the right to provide a refund rather than having to license of correct the infringement. They may even want to have that refund be on an adjusted basis where they will pay less, based upon the period during which you used it. In determining whether the refund approach would be acceptable you would need to consider all the investments that you have made to use the software; where and how the software will be used and what the impact would be if you were no longer able to use it. Offering to provide you with a refund in the event of an infringement may only cover a small portion of the cost to you. My preference is to not agree to a refund as a cure for infringement so if they are unable to get the license or are unwilling to make the change it constitutes a breach of the agreement where I can collect damages. To make sure that the types of damages that you can sustain and claim aren’t limited you need to carve the indemnities out of any limitation of liability provision.

Confidentiality.
Most of the time in licensing software the licensee is not sharing any confidential information with the licensor. The licensor in sharing both the software and documentation already has the protection of both of those being copyrighted. As such the only time a licensor should want you to maintain confidentiality responsibilities is when they are providing you with highly sensitive information such as source code or they are allowing you to make copies of the materials. For things like source code a licensor may want you to manage that as confidential. If you were to agree to that, a normal standard would be that you agree to manage that in the same manner as you manage your own confidential information. As to copies you should have the right to make copies for both archival use and for disaster recovery purposes. If you make copies the licensor will also want to protect their intellectual rights in those materials by requiring you to include copyright and proprietary legends on any licensed copies. As the licensor considers those materials to be confidential they will further want you to return or destroy materials upon termination. The exception to that should be for situations where you as the licensee are terminating the license for cause where in your termination for cause provision you would retain the right to use the software and documentation on an as-is basis. If you agree to hold any of the materials as confidential you should establish a term after which they no longer need to be maintained as confidential and you would also want to include the traditional confidentiality exemptions such as the information becoming public through no fault of the licensee.

Limitation of Liability.
Limitations of liability for software licenses are no different than for the purchase of goods. They traditionally involve three elements. What type of damages may be claimed by the parties. Are there any clauses in the license where there is an exception or carve out from the limitation on the types of damages that may be claimed. The last element is whether there is a financial limit on the amount of damages that may be claimed. The indemnifications should be carved out of the limitation of liability as those are not direct damages that the licensee sustains, those are third party claims. Further as they are third party claims the licensee has no ability to control the amount of those claims so all a limitation will do is make the licensee potentially liable for the licensor’s acts. As to other potential sources of liability the licensee should consider the impact a breach may have and the types of damages they might sustain to determine whether other section of the license need to be carved out and what’s appropriate if there is a breach. Licensors may want to limit their liability to what you paid for the license. Licensees need to think about what the financial impact would be if you weren’t able to use the software. The licensee may have much greater invested than what they paid for the initial license fee.

Insurances Required of Licensor
Traditional insurances that a buyer may want a supplier to provide when you purchase goods is no different than what the licensee should want the licensor to provide under a software license. To make them more acceptable or applicable you can always make them conditional requirements. For example a licensor may not want to be forced to carry automobile insurance in the amount you require, especially if they won't be using automobiles in performing work for you. To deal with that you could make that requirement a conditional commitment such as: “To the extent Licensor uses a vehicle in the performance of installation, acceptance testing or performance of services for Licensee, Licensor shall carry automobile liability insurance ……” In establishing it as a condition, if the licensor does none of those they don’t have to maintain the insurance or maintain it at your required limits.

Software Warranties:

Just like the purchase of products you have the issue of when the warranty starts and how long the warranty period will be. Normally you would not want the warranty to commence until acceptance and testing has been completed so that you are not losing time from your warranty during the period when you aren’t able to use the software. When the warranty starts and the duration of the warranty are both cost issues.If the cost of maintenance is fifteen percent of the license fee, each month that the warranty is reduced costs you 1.25% of the license cost as it will force you to purchase maintenance that much sooner.

What are the responsibilities to correct minor errors versus material errors? In any license you need to define what constitutes a material error in the software that the licensor must correct.
Similar to a product you also want to include a period that the licensor has in which to correct those material errors that are affecting your being able to use the product. Failing to correct those errors within the allowed period should be a breach of the license agreement and provide you with normal remedies such as potential termination of the license, damages, etc.

Are you relying on the software product to be fit for a particular purpose? Does the specification define that purpose? Many standard software licenses may disclaim the implied warranties of merchantability and fitness for a particular purpose. If you are relying upon the licensor’s representations that the software will provide you what you need, make sure those representations are made part of the agreement or the specification clearly identifies all the things you need the software to do. If you don’t, once you have accepted the software your sole rights will be under warranty. That warranty is to correct material errors, not to make the software meet your needs. This means that if the software isn’t meeting your needs but it doesn’t contain a material error, you have no right to demand that it be fixed. One of the reasons why acceptance and testing is so important is to make sure that it does in fact meet your particular purpose. That way if it doesn’t you can reject the product and not wind up paying for something that doesn’t meet your needs.


Legal warranties
The most common legal warranties that get included in a software license agreement are:
1. The licensor has the right to enter the license agreement. This means that the individual signing the license agreement does in fact have the requisite authority to enter into the license agreement.
2. Sufficient rights in the licensed product to make the grants and commitments. This means that if any third party software is included in the licensor’s product, the licensor is making the warranty they have the necessary licenses with those third parties with the right to sublicense that to you.
3. Conform to the specifications when used unmodified. This expands upon the warranty to simply fix material errors and would require the supplier to either correct errors that are causing the program to not conform to the specifications or be subject to the breach of the warranty which would provide the licensee with the right to terminate and claim damages. It also highlights the need for the licensee to make sure that they have good specifications.
4. No security measures, restrictions or limitations have been incorporated. A software developer can write code where they could remotely disable the use of the program. As a licensor you want to be assured that the licensor does not have any of that code in their product. If the licensee breaches their obligations, the licensor still has their rights to terminate the license.
5. No harmful code. This warranty is more about forcing the licensor to manage their code and programmers to ensure that they are not including things within the code that could be harmful to the licensee. For example a Trojan Horse is code that could be used for data theft, installation of malware, downloading or deleting files, crashing a computer, viewing a users screen or logging keystrokes. All of these would be considered harmful code.

Some companies may also include restrictions against using open source code. Open source code is code that is made public under a General Public License. The risks associated with open source code depend upon how you will use the code. If you are using it in an application that you have licensed the primary risk is potential infringement with another party’s intellectual property rights. That risk can be managed through an intellectual property infringement indemnity. If you were licensing code to use within code that you were to write and license to others the risk is by using it, you could be making your code subject to the General Public License which means parties could get it without paying a license fee.

Warranty on services (such as maintenance). For any services that are purchased with the license you would include a normal services warranty such as use reasonable care and skill in performing the services
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Warranty redemption rights and remedies. Similar to purchasing a product where you address warranty redemption rights and procedures, the same applies to software license. The primary responsibility of the licensor during warranty is to correct material errors in the software and correct any problems where the software is not complying with the specifications. As such you need to have a process to notify the licensor of problems. You may want to include an escalation process for major problems. You also want to establish a period by which the licensor needs to provide you with a correction or the error or a work around. Unlike products where you could potentially have another party repair or replace the product, with Software unless you had source code and were thoroughly familiar with the product where you could make the correction, there really isn’t a good warranty remedy if they fail to correct the error within the allowed time frame. What you do have is contract remedies for breach of the agreement. If correction is important, you want to make sure that the failure to correct a material defect within the allowable period constitutes a material breach of the license agreement.

Is there a difference between the book and the blog?

I had a question from one of the blog readers whether there was a difference between the blog and the book. As other may have the same question I thought I would add a post to clarify this.

On some of post I add a comment that if you learned from the blog, think about how much more you could learn from the book. Its a comment that I really mean because the blog was written to be complimentary to the book. What you learn from the book helps you better understand the blog posts. There is some duplication, but the book addresses many topics I won't include in the blog, It also goes into more detail that I want to do in a blog format where I want to keep those fairly short and be a quick read that people can learn from..

Much of the blog material is things that I couldn't fit into the book because of size and cost constraints with hard copy production. I wanted to keep the book a reasonable size and also be able to price it as low as I priced it.

The blog also contains my comments on issues people had questions about in on-line groups like LinkedIN. Rather than respond to them only online, I write a blog post, and then point people to that blog post. That way I can share the information with a broader audience and also make sure the content isn't lost over time as would occur in these forums

I hope you enjoy the blog and all the work I've put in to making it a robust easily usable resource. I'm sure you have learned from many of the posts as I get comments like huge information, phenomenal, awesome.

People who read the book and either follow my posts on LinkedIN or the blog have shared unsolicited comments such as "I highly recommend if for contracting management", "I carry it around like a dictionary. reference tool,"

I like to think I'm providing the greatest value in teaching people about contracts and contract negotiation. Universities charge up to $6,000 for a 3 course contract management program. I think that's outrageous. ISM's contract courses would cost you over $2,000. I sell a book for $24.95 and provide a free blog that I'm confident provides you more than both of those combined,

Software - Fees, Payment, Taxes, Installation, Acceptance

License fees, Payment, Taxes
What is the cost of the license? When you license software one of the things to be concerned about is the life cycle cost if being able to use the application. For example, you
may be required to purchase maintenance service. If you are not required to purchase maintenance services and you elect not to buy it you would be operating the software on an as-is basis one the warranty period has ended. Another thing that will impact your cost is the period of time that the licensor is committed to support the revision you purchased once a newer version is released. That impacts whether you will be forced to purchase upgrades to get continuing support. If you don’t upgrade and they no longer support the revision you have licensed, you would have the right to use it on an as-is basis.

Similar to hardware or equipment in licensing software one of the first considerations is do you need the right or options to purchase additional licenses? If you do, how long will those license fees remain firm?

What are the payment terms for the license, maintenance fees and other services? In most situations the licensee would not want to make payment until such time as the software is installed and accepted. Licensor’s just like suppliers always want payment to occur as soon as possible. The leverage you have in the situation will determine what you can negotiate. The key is if you do need to pay the initial license fee prior to acceptance, you would want to include the right to a full refund in the event the software fails to meet the acceptance test. In software maintenance fees are usually paid annually with the first payment due at the end of the warranty period. This means that you need to take the term of that warranty period into account in figuring out the life cycle cost of the purchase when you are negotiating the fee. The shorter the warranty period, the sooner you need to purchase maintenance. The actual payment term should be based upon what your normal payment terms are. Agreeing to shorter terms both adds to your cost and can cause complications with your accounts payable function.

Obligations of the parties to pay any applicable taxes. Depending upon who you are licensing from and the location of the sale, the license may also be subject to sales or value added taxes. If the software is purchased for use in another country it may also be subject to duties.
If either of those would apply to your license, the licensing agreement should specify which party is responsible to pay for those. Licensees should want to only be responsible for taxes associated with the use or and import if they are requiring import.

Delivery and Responsibility to Install.

What is the lead-time for delivery? As with any item that you purchase or license the first thing you want to know is when will you get it. As production of media and documentation can be almost immediate this is a lesser concern. For consumer applications most are capable of being downloaded immediately.

Whose responsibility is it to install the software (licensor or licensee)? The more complex the application, the more you may want to may want to have the licensor install the application so
there is no doubt that the supplier is fully responsible in the event the application fails to meet the agreed acceptance test. If responsibility is with the licensee, you need to understand what the requirements for customer installation are so that you can comply with them. That ties back to acceptance. If you comply with those requirements and there is a problem with acceptance it is the licensor’s problem. If the licensor will perform the installation you want to know if the installation cost included in the license fee or is that a separate charge? If there is a separate charge, that’s an addition cost to the purchase and the life cycle cost. If the licensor will perform the installation you want to clearly know when the installation will be performed or what is the lead-time for installation that you can rely upon. If you have to pay a portion of the license fee prior to installation or acceptance, you want this period to be short. Otherwise you are paying a fee for something you don’t have the ability to use.

Acceptance / Acceptance Test:
The right to perform acceptance, and have and agreed acceptance test is the way to make sure that the software is actually meeting your requirements that must be included in a specification. Acceptance test should be designed to reasonably show that the product does in fact meet those requirements. For example, if you licensed software to meet certain speed, transaction volume and performance requirements, you want the time to verify that if does in fact meet those requirements. Those would be established as part of the acceptance and test criteria. As part of any acceptance term you would want to establish how long after delivery do you have to commence the acceptance and testing process, and how long you have to complete the testing. If there are material errors discovered, you should establish how long the Licensor has to correct them? If Licensor corrects the defects your agreement should decide whether the test period re-starts giving you the full duration to perform the testing or whether
You just get added the time it took to get the error corrected added to the period. If the licensor fails to correct errors within the period allowed to correct them the licensor should have the right to terminate the license and get a full refund for any fees paid.

Similar to the purchase of goods, the right of acceptance is critical. That’s because once you accept an item you are fully responsible to pay. Once accepted your future rights to correct problems that exist is based upon the rights you have under warranty.