Bridging the gap: IT contracting between large companies and small emerging companies

Large companies may find it advantageous to utilize the innovation and flexibility of a small, emerging company when outsourcing research and development (R&D) of new technology. The large company secures access to new proprietary technology, and the emerging company is able to more rapidly develop its proprietary technology. However, issues often arise when these two very different parties enter into contractual negotiations.

Companies, regardless of size, may not agree on a contract for a number of reasons, but large companies and small emerging companies commonly have their own distinct set of issues due to the different abilities and limitations of each. Following are a few of the legal provisions that can stall negotiations.

Indemnification

Large companies typically want indemnification provisions to insulate themselves from any risk associated with the new technology. When dealing with emerging companies, however, it is crucial to reassess expectations with regard to indemnification. Indemnification is only as good as the financial strength of the indemnitor, and many emerging companies are not financially capable of meeting extensive indemnification obligations. In these situations, consider the use of insurance to cover some of the risk of the large company. Depending on the circumstances, such a policy can be purchased by the emerging company, added to the large company’s policy, or the cost can be split between the two companies. This ensures real protection for the large company, and eliminates the risk of insolvency as the result of an overly burdensome indemnification obligation for the emerging company. It is also important to remind large companies that accepting some risk is reasonable when contracting with emerging companies. It’s a cost of doing business, but if the proprietary technology is good enough it’s a price worth paying.

Representations and warranties — intellectual property

Technology contracts usually include a section stating that the licensor represents and warrants that its intellectual property (IP) does not infringe on any other entity’s IP. An emerging company may only have pending patents, or may only have patents in certain countries. This makes giving the standard IP representation difficult for emerging companies. Some emerging companies will agree to such a provision simply because they want to sign the contract, but there may be no real protection behind the representation. A large company should consider the value of the IP, where the emerging company is at with regard to patent protection, and how important the IP is to the large company. Perhaps most importantly, a large company should be willing to compromise.

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Patent protection

Emerging companies generally are financially constrained, and are often unable to file patents in all countries where a large company may do business in the future. A large company doing business with the emerging company can (1) accept the fact that the patent will not be filed in certain countries; (2) pay the filing fees for the emerging company to file for patent protection in certain countries; or (3) negotiate a fee-splitting structure to file the patent in certain countries. It is unreasonable to expect an emerging company to assume extensive patent costs without some level of guaranteed licensing fees or royalties. The goal in these situations is to develop a structure that gives the large company patent protection, while at the same time arranging for payment of patent costs in a manner that is consistent with the limited cash flow of the emerging company.

Limitation of liability

A limitation of liability clause defines the damages owed as a result of a party’s conduct or breach of contract, and large companies are used to fairly protective limitation of liability provisions. However, large companies must acknowledge that even capping damages at three times fees paid for the last 12 months may not be reasonable for an emerging company. The contract at issue may be the only, or one of the only, sources of revenue for the emerging company, and it is simply not in a position to assume such an extensive obligation. Outsourcing R&D doesn’t mean outsourcing all associated risk. If that is the large company’s expectation, then it isn’t ready to tap into the innovation offered by emerging companies.

Conclusion

Bottom line: Acknowledge the financial position of both parties, understand the relative value of the technology to the large company, and get creative with a realistic solution. This means large companies will need to change how they approach some of these standard technology licensing provisions.

Kate L. Bechen (kbechen@whdlaw.com) is an attorney with Whyte Hirschboeck Dudek S.C. She is the leader of the Emerging Companies Team, working with high-growth, early-stage, and scalable companies.

Trevor L. Currie (tcurrie@whdlaw.com) is an attorney with Whyte Hirschboeck Dudek S.C. He practices in the areas of corporate transactions and commercial finance.

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