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 these agreements daily. While a Buyer’s counsel will have the chance 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 company may have some contractual “warts” to address post-closing.
In the first two posts of this series, we took an in-depth look at two common contractual “warts” - the Most-Favored Nation clause and limitations of liability. Now, let's turn our attention to payment terms, exploring some of the contractual "warts" we sometimes see in this area, and offer a few strategies for treating them.
Understanding Payment Terms
Payment terms outline when, how, and in what form payments should be made to the party providing goods and/or services. Payment terms can also address what recourse is available if payment is not made timely. While they might seem like a mere formality, payment terms play a pivotal role in maintaining healthy net working capital (NWC) and a company’s overall financial health.
There are several key components to payment terms, including:
Schedule: Specifies the timeline for payments, including due dates, any required deposits, frequency of payment, and the period within which payments must be made (e.g., NET 30, NET 60, EOM, etc.);
Method: Outlines acceptable payment methods (e.g., check, credit card, wire transfer, etc.);
Fees, Interest, and Collection Costs: Details any late fees, interest charges, collection costs (including attorney’s fees and court costs), and other expenses incurred by the company due to late or unpaid invoices; and
Early Termination Fees and Payments: Details financial consequences of early contract termination, including any applicable termination fees, refunds for prepaid services, and payment for work completed up to the termination date.
Why it Matters
Overlooking problematic payment terms can lead to cash flow issues, disputes, and ultimately a potential reduction in a company’s value. Consider the following two scenarios:
Scenario 1: Your company is planning a significant event that is six months away and books a substantial block of rooms at a hotel. The hotel requires a 100% deposit upfront, despite allowing for 20% attrition (meaning your company can later reduce its room block by up to 20% of the reserved rooms). By requiring a 100% deposit upfront, the hotel (1) may be holding more of your money than is ultimately owed to them (leaving you chasing them for a refund), and (2) is tying up valuable capital for an extended duration (six months here) that could be used elsewhere in the business. Neither are great from a NWC standpoint. The timing and amount of a deposit is usually negotiable with hotels (and other vendors), but you need to know what to look for and what is standard.
Scenario 2: Picture a company who is quickly growing and financially successful, but amongst the chaos of growth, has not invested in their own legal terms for customers. The company has grown accustomed to working off their customers’ purchase orders and the legal terms attached thereto. While the company is great at reviewing pricing in the PO, they tend to skip the “legalese” in the attached T&Cs, and they don’t have counsel to review them. What they could be missing in those T&Cs is terrible payment terms - so, while they desire Net 30 payment, they unknowingly end up agreeing to Net 90 (or worse). They also may inadvertently agree to overly generous refund terms which can throw off the company’s revenue recognition amounts. Both are not great outcomes and they generally can be avoided.
Treatment Plan
If a Buyer discovers that their new portfolio company has not adequately negotiated payment terms in its customer or vendor agreements, here are a few steps to consider taking:
1.) Address the Source
Many companies lack internal legal resources to scrutinize customer and vendor contracts. This often results in accepting disadvantageous payment terms like in the scenarios discussed above.
One suggestion is to train internal sales and procurement teams on the importance of payment terms and how they can help/hurt the company’s financial position (i.e. price is important, but it is only a piece of the puzzle).
Another suggestion is to collaborate with cost-effective external legal counsel with experience in customer and vendor agreement negotiations to ensure payment terms (amongst other things) are vetted and adjusted going forward.
2.) Localize the Impact
Existing contracts with unfavorable payment terms can have negative consequences across the business. As such, companies should prioritize tracking renewals and renegotiating problematic payment terms at the earliest opportunity.
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 termination provisions. Until then, keep those contracts clean!
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