Hi-Tech Commercial Contract Issues

The purpose of this article is to highlight four relatively heavy areas of negotiation that invariably arise in negotiating commercial licensing agreements. The areas of negotiation are:

    • Intellectual Property and Scope of License,
    • Acceptance/Warranty,
    • Term, Termination and Consequences, and
    • Manage Exposure (Liability, Indemnity, and Escrow).

I. Intellectual Property and Scope of License.

A. Besides getting the deal done, the most important objective in any commercial license agreement is to preserve the client’s intellectual property, which represents the client’s core business asset. The job is relatively simple when the contract is a straightforward license agreement for an “off the shelf” product that does not require customization work or support services. However, the job becomes more complicated when a contract calls for delivery of a solution including customization work or consulting services deliverables. Invariably, parties enter into a tug-of-war over the intellectual property rights to the specific customizations or “work product” that is produced for the customer.

A number of creative arguments can be made to advance licensor’s position that it should be entitled to all intellectual property rights in the solution. Short of convincing the customer to relinquish all intellectual property rights to the licensor/vendor, which is the optimal outcome, a reasonable conclusion is for the licensor/vendor to retain intellectual property rights while granting the customer a fully paid perpetual license to use the customization work and/or “work product”.

A Practical Pointer: This issue may affect the core asset of the licensor’s business. A detailed understanding of exactly what needs to be protected in the licensor’s technology as well as a good understanding of the licensor’s business model is highly recommended before attempting to negotiate intellectual property rights. The time invested in gaining an understanding of a client’s technology and mode of licensing is rewarded exponentially when it comes time to reach conclusions and compromises on intellectual property issues at the time of contract.

B. The scope of license is another critical issue. Is the technology going to be licensed based on CPUs, users, scheduled resources, transaction volume or one of several other alternatives? This issue runs to the basic licensing and business model of the licensor and needs to be carefully guarded in the contract in order to avoid the loss of potential revenues from follow-on or distinct licenses.

The software industry in general is moving at an uncharacteristically glacial pace towards limited term licensing as opposed to perpetual licensing. This is by nature a business rather than legal issue but the legal implications in the contract are critical. Contractual matters such as renewal, support, and caps on price increases, among others, all hinge on the duration of the license.

II. Acceptance/Warranty.

When is the product or customization accepted? This critical question may impact payment, warranty, maintenance and term of license provisions, among others.

If the product being licensed is an off-the-shelf, shrink-wrap or click-wrap product, the answer to the question is very simple: The product is accepted upon delivery. The issue becomes more complicated when dealing with licensed software that is not “plug and play”, but instead requires customization or configuration to meet the client’s needs. When you consider the beginning of warranty coverage and the payment of maintenance and support fees, the trigger of acceptance becomes a key commercial term in the contract.

In fairness to the client, the business expectation is to receive licensed software that works within the client’s production environment even though it may take six months, a year or even more to achieve that objective. The software provider, on the other hand, is typically anxious to confirm acceptance of its software, to be paid for its intellectual property, and to recognize revenue from the sale. One approach to resolving the legitimate conflict of interest of the software provider and its client is to limit the window of acceptance while expanding the protections of the warranty provision, both quantitatively and qualitatively.

This all-encompassing issue of acceptance and acceptance testing needs to be addressed with the utmost care in any license agreement that does not involve a plug-and-play product.

III. Term, Termination and Consequences

The term of the license goes to the heart of the commercial deal. While the perpetual license model prevails in the software industry, particularly enterprise software, a concerted effort is being made by software vendors to transition to fixed-term licenses. Similarly, the subscription-based model is gaining in popularity. This issue is more of a commercial/revenue-recognition issue than a legal issue, but the legal impact of these divergent models is of critical importance.

To list a few:

    • The renewal terms of fixed-term licenses;
    • License fee escalation caps;
    • The impact on support of sequential versions of the software; and
    • The consequences of termination or expiration of the license such as return of software, documentation and related materials.

IV. Licensor Exposure

While these issues are not the only sources of commercial exposure in a license agreement, they are very often heavily negotiated areas in the license agreement. Beginning with limitation of liability, the vendor has a distinct interest in limiting liability to “the benefit of the bargain”, namely the amount of proceeds that it received from the licensee. The customer, on the other hand, often demands a multiple of the fees paid to the vendor, while totally excluding claims of infringement, willful misconduct, and negligence/gross negligence from the liability cap. The customer will often argue that so long as the vendor has adequate insurance coverage the amount of the liability cap is less important. This does not take into account the extensive insurance application process that each and every vendor must pass in order to obtain adequate insurance coverage at somewhat reasonable rates. Standard limitation of liability provisions, along with claims history, lie at the focal point of the application process.

A related provision is the indemnity obligation in licensing agreements. It is straight forward that the vendor must indemnify the customer for claims of infringement, but it is important to carve out exceptions related to any unauthorized modification or misuse of the software product by the customer.

Another area of exposure is the protection of vendor’s source code. In larger-scale license agreements the customer will often request the deposit of vendor’s source-code with a software escrow agent, such as Data Securities International in the United States or National Computing Center in Europe. The negotiation typically revolves around the “release conditions” pursuant to which the customer may be entitled to a release of the source code. While bankruptcy/insolvency are undisputed bases of source code release, the parties often have trouble coming to an agreement on release of source code in the event of failure or cessation of support. As counsel to vendors, I insist on limiting the release conditions while protecting the customer through maintenance and support obligations.

To conclude, a practical approach to the negotiation of licensing agreements requires an understanding of the overlap among various critical provisions within the four corners of the agreement. If approached correctly, this overlap may be used to find ‘win-win’ resolutions to seemingly intractable commercial difference.

By: Steve Kronengold. © February, 2006. All rights reserved
This article is provided for educational, informational and non-commercial purposes only. The content of this article is not intended to provide legal advice on any subject matter and should not be relied on as such.

Share this post