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 this post on limitation of liability terms, we continue our deep dive into some of those contractual “warts” and strategies for mitigating them. Institutional buyers dedicate substantial efforts to value creation through improving portfolio company operations. Addressing a company’s contractual hygiene can effectively complement those efforts.
Understanding Limitation of Liability Terms
Limitation of liability terms typically take two forms. The first is a Dollar Cap, which sets a maximum amount that one party can recover from another (e.g., “the Company shall not be liable for any damages in excess of $500”). The second is a Damage Exclusion, which limits the types of recoverable damages (e.g., “the Company will not be liable for any loss of profits, loss of revenue, or consequential damages”). Limitation of liability terms allocate risk between parties to an agreement when things go wrong. As illustrated below, overlooking these terms could expose a party to huge losses.
Why It Matters
Consider this example: suppose a company is hosting a conference and hires a vendor to build a small stage with overhead lighting for $8,000. Forgoing a thorough review, the company signs the vendor’s standard agreement, which includes a Dollar Cap set at “fees paid” (i.e. $8,000) and a Damage Exclusion limiting liability to direct damages. During the event, a lighting malfunction causes a fire, resulting in $50,000 in property damage and an injured employee who subsequently sues for $100,000 to pay for medical bills, lost wages, and pain and suffering. Pursuant to the contract, the vendor’s liability is limited to $8,000, leaving the company exposed to $142,000 in potential losses that it must cover through insurance or pay out-of-pocket, both of which are unsavory options that could have been mitigated.
Had the vendor in the example above failed to include limitation of liability terms in its customer agreement, it could be held responsible for all $150,000, despite the contract only being worth $8,000 in fees.
As these examples show, addressing limitation of liability terms in your customer and vendor agreements is a very important risk mitigation tactic that should not be overlooked.
Action Steps for Buyers
If a Buyer discovers their new portfolio company is not adequately negotiating customer or vendor agreements to address limitation of liability terms (or others), here’s a few steps to consider:
Address the Source:
Companies often lack internal legal resources to thoroughly review customer and vendor agreements, which can lead to the acceptance of unfavorable liability terms. To address this, engage cost-effective external counsel with experience in customer and vendor agreement negotiations to ensure liability terms are vetted and adjusted going forward.
Localize the Impact:
For existing agreements with inadequate liability terms, minimize future risk by renegotiating these provisions at renewal. Additionally, seek additional insurance coverage to manage liability exposure until improved terms can be secured.
At GTX Legal, we have negotiated thousands of customer and vendor agreements, enabling our clients to reduce their contractual risks. Our tailored strategies help ensure that companies maintain robust risk management practices, contributing to long-term profitability and stability.
Our team at GTX Legal is ready to help you navigate customer and vendor agreements and safeguard against unforeseen liabilities. Connect with us today to protect your investments by ensuring your portfolio company’s agreements are secure and optimized for success.
Up Next
In our next post, we’ll explore another critical aspect of contractual hygiene: Payment Terms. Stay tuned to learn how proactive measures can further strengthen your portfolio.
Keep those contracts clean!
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