Beware of a contract’s exclusivity clause

contract

Writing about strategic alliances brings up the issue of exclusivity clauses in distribution and sales agreements. Someday, I hope, someone will write the full story of Software Arts, Inc., the company that invented the first electronic spreadsheet, VisiCalc, and foundered on the shoals of its original distribution contract. In brief, the founders of Software Arts had no interest in sales, marketing or distribution. Upon the advice of a Harvard Business School professor, they entered into a contract with Personal Software, Inc. to distribute VisiCalc. That was in 1979 or 1980. By 1984 that exclusive distribution agreement resulted in a deadly embrace that ended up killing off both companies.

The period when VisiCalc was launched was the dawn of the personal computer era and attorneys who understood both intellectual property law and software were scarcer than women software engineers of color.  During my time working at Software Arts and after its demise I was often asked the question why didn’t they patent the spreadsheet? Then Lotus, Microsoft, and any other company would have had to pay the inventors royalties, making the founders multi-millionaires if not billionaires. They did consult an attorney who told them software could not be patented, so no filing was made.

But that’s a side note to the crux of the issue: Software Arts entered into an exclusive contract with Personal Software, later VisiCorp, to market, sell and distribute its invention. When the two companies wanted to go their separate ways a few years later litigation over that ironclad contract knocked both companies out of the game, leaving a clear field for Mitch Kapor to dominate the corporate PC software market with his
Lotus 1-2-3 spreadsheet, a brilliant blending of an advanced version of VisiCalc with Mitch’s first successful product, distributed through Personal Software, VisiTrend/VisiPlot.

When mentoring founders who are in discussions or preparing to sign a contract with another party I ask them one simple question: What is the most important part of any contract? The answer is in my post; it’s the termination clause. In my view contracts are analogous to insurance policies. You hope to never have to pull out your home insurance policy to refresh your memory for what it covers because that means you must have had some untoward incident in your home – fire, theft, vandalism, etc.  Similarly with a distribution contract, when all is going well you have no need to try to enforce its terms and conditions. But when the parties have a falling out you need to pull out that contract and read the termination clause, because if all else fails that’s your one and only recourse. Suing a large company is just slow motion suicide for a startup. Large companies have in-house attorneys – a sunk cost – who will litigate you to death as you pay legal fees to combat them. Stay out of court at all costs!

The trap that Software Arts fell into, and here I would definitely fault their legal counsel, was to make the term of the contract co-terminus with the copyright to the VisiCalc’s code.  That was a huge mistake,  as we are talking many years here! So that brings up to the nut of this post: how do startup companies deal with prospective partners who insist on an exclusive agreement? No one likes competition, let alone sales or distribution companies. They want the whole market and nothing but the market.

The VCs who trained me hated exclusivity and constantly reminded me of this as I entered into contracts with Lotus, Software Publishing Corporation, and other PC software pioneers. But if you are really desperate for the help a large partner can give you then their demand for exclusivity must be met or countered. Here’s how:

Term: the length of the period of exclusivity should be limited in time. And that time should range from about one to three years. Do not tie the term into some other exogenous factor like the length of copyright!

Territory: startups by their nature lack reach. That’s why they enter into distribution contracts with large partners. By granting your large partner exclusivity in a territory you would have trouble reaching anyway you can hope to satisfy their need to protect their investment in sales and marketing. Typically for a U.S. startup granting exclusivity to one or more international markets is a good strategy. Just keep in mind that you must also apply a restricted term, as in the future your venture may be big enough to serve international markets itself.

Type of customer: often startups will decide to negotiate exclusivity around the type of customer they target, believing that if they can maintain exclusivity for those customers they aren’t giving up anything by granting exclusivity for other customers. For example, if you have developed a new social media platform aimed at millennials you might rightly feel that you aren’t giving up anything by allowing your partner to have exclusive rights to sell to corporations. But there are two problems with this strategy. One, it can be hard to predict who will actually end up being the users of your product. By locking out a market segment like corporations you will never have the opportunity to discover if they would be good customers. The other issue is that there are other markets you may not even be thinking about, such as government or education. By ceding all other markets than consumers to your partner you may well be giving up great opportunities in unexplored or untapped markets.

Version of the product:  at Addison-Wesley Publishing Company, where I invented the student edition of professional software products, we were able to convince developers like Lotus to provide us with a different, more limited version of their crown jewels, in the case of Lotus it was 1-2-3. You can modify software in many different ways: capacity and features being two of the most common. But taking this tack puts a development, testing and support burden on your venture – a cost you might not want to bear. And your market may rebel against getting an older or less capable version of the software. So granting exclusivity to a different version of your product can work, just be careful of those two issues. An interesting twist on this idea is how Tesla sells their vehicles. All Teslas have the same basic features and performance. But Tesla can “turn on” new features and enhance performance through remotely unlocking software – if the customer is willing to pay. This clever tactic can be used in other markets to sell different versions of the same product at different price points.

Performance:  my preferred way to grant exclusivity is to make it performance based. Thus your distributor can only maintain exclusivity by selling X units in a set period, usually one year, or they risk losing their grant of exclusivity. A good twist to this is to enable your partner to “buy up” – meaning if they don’t meet the agreed upon sales targets they can pay you as if they did.  Performance is also the best way to manage term. Your partner can maintain exclusivity so long as they meet agreed upon targets, which should grow year by year. The trick to this is it is very hard to forecast sales of new products from a startup, so you need to be careful about how you handle this condition of the agreement.

The bottomline is to avoid exclusivity agreements whenever you possibly can. The main reason is that it is so difficult to predict who or where your best customers will come from and to forecast revenues for a new product. But exclusivity can be a strong motivator for sales and distribution companies – it gives them a monopoly, the best way for them to profit by selling your product.  But no matter what type of agreement you negotiate – non-exclusive, exclusive or conditionally exclusive – make sure you have an escape hatch if things don’t work out. Get a lawyer who is familiar with sales, marketing and/or distribution contracts and knows how to craft that termination clause. That’s really your only protection from entering into an agreement that you find significantly disadvantageous, but it’s vital as and those of us who lost out big-time through Software Arts’ bad contract with Personal Software learned the hard way. As the saying goes, “Those who do not learn from the past are condemned to repeat it.” And the first priority of all startup is to learn!

 

Author: Mentorphile

Mentor, coach, and advisor to entrepreneurs, small businesses, and non-profit organizations. General manager with significant experience in both for-profit and non-profit organizations. Focus on media and information. On founding team of four venture-backed companies. Currently Chairman of Popsleuth, Inc., maker of the Endorfyn app for keeping fans updated on new stuff from their favorite artists.

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