Surprising Contract Risks in Portfolio Company Contracts – Part 4

When purchasing a company (the “Target”), most institutional buyers (e.g., PE firms, hedge funds, and family offices) understand that the Target’s customer and vendor agreements can present significant issues depending on how the Target manages those agreements daily. Although the Buyer’s counsel will have an opportunity to diligence the Target’s contracts, budget constraints, document availability, and other factors can limit a thorough review. As a result, Buyers often close deals with the understanding that their new portfolio companies may have some contractual “warts” to address post-closing.

In the first three posts of this series, we dove into three common contractual “warts” - the Most-Favored Nation clause, limitations of liability, and payment terms. Now, let's focus on termination, examining some of the common contractual “warts” that arise in this area, and suggest a few strategies for addressing them.

Understanding Termination Provisions & Their Consequences

Termination provisions generally outline the circumstances under which a party can terminate the contract before its natural expiration and what happens when terminated. While seemingly straightforward, many companies neglect this area during their review and don’t understand the implications of certain termination rights until it’s too late. Here are a few termination provisions to keep in mind:

• Termination for Convenience: this type of termination provision allows a party to end the agreement without providing a specific reason or justification (i.e. they can terminate simply because they want to). While offering flexibility to adapt to changing business needs, such a termination could cause the other party significant disruption or financial hardship. For example, if the non-terminating party is relying on the goods/services of the terminating party, a significant operational disruption could occur if the termination comes as a surprise and they are not able to pivot quickly to an alternate vendor. On the flip side, if a customer terminates an agreement early, the service provider may be stuck in a position where it hasn’t recouped its investment yet working with that customer. When deciding whether to include a termination for convenience provision, parties should always consider the possibility that it will get exercised and what the consequences of an early termination could be for their business.

• Termination Fees: these are fees that the terminating party may have to pay due to its early termination of the agreement.  Termination fees are designed to protect and compensate the non-terminating party for losses that it would otherwise incur due to the early termination. Termination fees can come in various forms, including flat fees, prorated fees, or a percentage of the overall contract value. If not carefully negotiated at the outset, such a fee could be an unwelcome surprise for a party wanting or needing to terminate.  

• Refund Rights: these rights allow a party to receive a full or partial refund upon termination and are commonly included in situations where one party is prepaying for goods or services. For example, upon termination, the service provider must provide the customer with a refund of all prepaid fees associated with the remaining term. It is important to be aware of these rights at the outset to avoid issues caused by having to issue a refund.  For example, if a party is potentially required to issue a refund, it can affect the party’s financial planning, as they may need to hold larger reserves and delay revenue recognition to a degree.   

Failing to consider the full impact of certain termination provisions can severely impact operations, cash flow, and growth plans. Please don’t take them lightly the next time you are presented with a contract.  

Treatment Plan

If a Buyer discovers that their newly acquired portfolio company has not properly negotiated termination clauses in its customer or vendor agreements, there are several steps to consider taking to address the issue:

• One recommendation is to conduct a thorough review of all existing agreements to identify any termination clauses that could potentially expose the company from a financial or operational perspective. During contract renewals, problematic terms should be renegotiated promptly.

• Another suggestion is to engage cost-effective external counsel that is experienced in customer and vendor agreements to assist with negotiations on a go-forward basis. This will help ensure that future contracts are structured to protect the company and there are no surprises upon termination.

Closing Thoughts

At GTX Legal, we have negotiated thousands of customer and vendor agreements, enabling our clients to reduce their contractual risks. Our tailored strategies help ensure that companies maintain robust risk management practices, which contribute to long-term profitability and stability. Our team at GTX Legal is ready to help you navigate customer and vendor agreements and safeguard against unforeseen liabilities, including those caused by unfavorable termination provisions. If you have any questions or want to discuss ways to improve your portfolio company’s customer and vendor agreements, please feel free to contact us (info@gtxlegal.com) – we’d love to help.

Up Next

We’ll continue our contractual hygiene journey next time with confidentiality provisions. Until then, keep those contracts clean!

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