Key Service Agreement Issues: Service Providers Checklist
This article addresses the key service agreement provisions from the service provider’s perspective and identifies the risks and consequences of such provisions, and is essential to take note and include in your service agreements to avoid problem situations.
1. Master Agreements
The best business practice is to use a master agreement so additional services or projects can be performed for the same customer simply by adding an agreed-upon statement of work which is signed by both parties. This will lower the cost and reduce the time to document additional deals with the same customer. Any changes in the allocation of risk for a specific project can be made in the applicable statement of work.
2. Revenue Recognition
Avoid broad customer remedies that postpone revenue recognition. For example, if the customer may receive a full refund upon a breach of a performance warranty at any time during the agreement, recognition of the revenue from the agreement may be delayed until the end of the agreement. Another example is a provision that provides a full refund if a software deliverable is not accepted by a customer even if interim deliverables have been accepted and payments made upon such deliveries.
3. Agreement Signing
Make sure the agreement or statement of work is signed by the customer before beginning work. While there are legal theories (quasi contract, quantum meruit) that may provide a means of recovery in the absence of a signed agreement, the best business practice is to have a signed agreement in place. Ignoring the temptation to begin work before an agreement is signed may be difficult but you will be at risk if you start work prematurely.
4. Customer Credit Risk
You may need to do fundamental financial due diligence on the credit risk of a potential customer. Some potential customers may represent they have funding when they do not. While you may need to take some credit risk, do so on an informed basis by having access to basic financial information to evaluate this risk.
5. Termination Rights & Payment
Be sure the agreement can be terminated or at least work can be suspended within a reasonable time if the customer fails to pay you in accordance with the payment schedule. For example, if payment terms are net 30 days and there is a 30 day notice and cure period before termination is effective, you will have to continue work through at least a 60-day period before termination is effective. At a minimum, this means you have to keep working and have a high risk receivable for the 60-day period before termination can be effective. This period should be shortened to reduce your exposure. Sometimes a customer proposes a provision that provides there is no right to terminate if the payment obligation is disputed by the customer. Such a provision means you have no leverage to be paid and could be obligated to keep working indefinitely. To provide leverage to be paid, assignment of IP ownership to the customer should be conditioned on receiving full payment.
6. Operational Coverage
Ensure the agreement permits delivery of the services in the manner that you operate. For example, if an offshore subsidiary corporation will actually deliver all or part of the services to the customer, the agreement must permit subcontracts so delivery can be accomplished that way. Subsidiaries are separate legal entities and you must have a subcontract in place to cover their responsibilities. Confidentiality provisions are another example. They must permit disclosure of the customers’ confidential information to the extent needed to protect all parties in the delivery cycle. The agreement would be breached if confidential information is released to a subcontractor when disclosure is permitted only between the parties to the agreement. Unless expressly allowed, only the parties and their employees (but not subcontractors or consultants) are covered.
7. Service Level/Performance Warranties
Define the level of service performance and schedule as clearly and realistically as possible. The performance level is sometimes referred to as an express performance warranty. Delivery metrics such as response time, service results, network or application downtime percentages, etc. should be defined as objectively as possible to reduce disputes over measurement. Exaggerated claims of performance will be quickly discovered and will destroy the ongoing relationship, so be realistic and precise. When using a master agreement, performance levels can be addressed in the applicable statement of work since requirements may vary by service engagement even for the same customer.
8. Implied Performance Warranties
Disclaim implied performance warranties of merchantability and fitness for a particular purpose to avoid the possibility that there are performance requirements beyond the express warranties. The Uniform Commercial Code (“UCC”) is intended to apply to products but you should assume it will apply to a services agreement at least when software or other technology is being developed.
For example: “EXCEPT AS OTHERWISE EXPRESSLY PROVIDED IN THIS AGREEMENT, SERVICE PROVIDER HEREBY DISCLAIMS ALLWARRANTIES, OF ANY KIND, EXPRESS OR IMPLIED INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE.”
Similar provisions under the Competition and Consumer Act 2010 (Cth) may be applicable for your services agreement.
9. Intellectual Property
Make sure you continue to own all pre-existing patents, copyrights, trade secrets and other intellectual property (“IP”) before entering into the agreement and also, to the extent feasible, (1) any improvements or derivative works to such pre-existing IP and (2) other IP developed that may be repeatedly used in your business. In addition, to provide leverage to be paid, any assignment of IP ownership to the customer should be conditioned on being fully paid. Sometimes “joint ownership” with the customer without any duty of accounting to the other is an acceptable compromise at least as to the improvements to pre-existing IP. As a practical matter, there will be intense pressure from the customer to own IP. The best practice may be to allocate IP ownership in the applicable statement of work since it may vary by service engagement. The service provider will likely have to bear the risk of any claims of IP infringement or misappropriation in its deliverables.
10. Damages Exclusions and Limitations
Economic exposure varies widely depending on the type of service. For example, the exposure from a tax return preparation service is considerably different from a call center business doing outbound sales calls. In all cases, exclude consequential, special, indirect and incidental type damages and, to the extent feasible, cap direct damages. Try to cap direct damages at the amounts paid in a payment period (month, quarter) rather than the total payments made under the agreement. Otherwise, the economic effect is that you have not been paid even for the good service you provided.
11. Insurance Requirement
Comply with the worker’s compensation and liability insurance requirements of your customer. Work with an insurance broker who fully understands your business. Make sure your insurance covers all parties in the delivery process.
12. Force Majeure
Use a force majeure provision, particularly for service offerings involving delivery over a network. For example, if you are using overseas affiliates to provide services and there is a disruption in service caused by an earthquake, the agreement should not be terminated. The agreement should provide an opportunity for recovery within a specified period. Termination may occur only if recovery doesn’t occur within the period.
13. Governing Law
Rule of thumb, choose a governing law which you are familiar with to provide more certainty to the interpretation of the agreement and, to be sure it will apply.
14. Dispute Resolution
Adopt a dispute resolution procedure that elevates the resolution process in an orderly, timely way. The first step could be a discussion between CEOs and the next step, non-binding mediation. Use binding arbitration as the ultimate mechanism to resolve disputes in order to increase the chances of maintaining the relationship. You may follow the ACDC (Australian Commercial Disputes Centre) model, or the model the parties mutually agreed upon. Have litigation subject to first attempting alternative dispute resolution process, in order to minimise time and costs.
15. Entire Agreement
Include an entire agreement provision so that verbal agreements do not become part of the agreement and amendments may only be implemented in writing.
“This Agreement and the exhibits hereto constitute the entire agreement and understanding of the parties with respect to the subject matter of this Agreement, and supersede all prior understandings and agreements, whether oral or written, between or among the parties hereto with respect to the specific subject matter hereof. This Agreement may be amended only in a writing signed by both parties.”
A service provider’s credibility and business acumen is visible in its agreements and negotiation positions. Because of the competitive environment there may be a great temptation to accept almost any terms or credit risk in order to get a deal. You need to make sure risk allocation is balanced. Securing a deal on any terms may mean you work for free.
Service agreements are the key documents a service provider relies upon in delivering its products and services to customers. An effective service agreement will demonstrate a service provider’s credibility and business acumen and a well drafted and negotiated agreement can lead to a stronger long-term business relationship.