Contracts establish a financial framework for your business to flourish or flounder. Contracts with disadvantageous terms obviously drain success from a business. Steep price escalation provisions, early termination rights held by the counterparty, inadequate indemnification clauses, and poorly drafted performance obligations can all harm your business.
Even good contracts can jeopardize financial success. It’s all about management. Not management of people; management of contracts. Contracts are often “filed and forgotten” after signing. Poor contract management causes four financial problems:
- Revenue contracts expire unintentionally.
- Expense contracts renew automatically without evaluation.
- Contracts fail compliance reviews.
- Legal risks remain unidentified and unmanaged.
Contract management software can transform these four common financial management mistakes into sharp competitive advantages.
Revenue contracts expire unintentionally
Revenue is precious: hard to get; easy to lose. For the owner of an asset, there are several classes of contracts that support revenue. Digital goods and intellectual property bring revenue through license agreements. Equipment and supplies are sold through sales contracts. Real estate leases are revenue contracts for the owner.
Beyond direct sales, businesses generate revenue through distribution agreements within a given territory or for a particular market. Joint ventures and alliances also produce revenue that supplements the core business.
Revenue contracts that provide recurring revenue are particularly valuable. They provide financial stability in future years with a baseline for revenue. They often increase the lifetime value of a customer relationship. Recurring revenue contracts can also grow initial sales because they lower the perceived risk for first time buyers.
Without effective contract management software, revenue contracts in general, and recurring revenue contracts in particular, are at risk of expiring without notice. The contract expiration date is too often left to human memory, recorded in a personal calendar or a spreadsheet file. As time passes between the contract execution and expiration dates, roles and responsibilities change and memories fade. When payments stop or notice arrives from a customer, then the organization learns that the contract has expired.
Contract management software prevents unintentional, and all too common, contract expiration with automated alerts created at the time of contract execution. Contract management software can also track each milestone during the contract lifecycle, such as amendments.
Expense contracts renew automatically without evaluation
The converse of unintentional contract expiration is absent-minded auto-renewal. Auto-renewal provisions are the drafting solution to contract expiration dates. They provide convenience to the parties by extending the life of the contract. The cost of that convenience is the risk that the contract will run longer than you want when circumstances change. At the time of contract signing, auto-renewal provisions seem like a good idea.
Most auto-renewal provisions give one or both parties the right to terminate the contract, if the terminating party provides advance notice (usually 30, 60 or 90 days prior to expiration). To prevent auto-renewals, contract management software should provide you with three notifications:
- Internal review so that your organization can decide whether it wants to renew the contract
- The notice due date so that you remember to send the decision to the other party
- The contract expiration date so that you know when the contract ends based on your decision
With these automatic notifications, contract management software can prevent unwanted auto-renewals.
Contracts fail compliance reviews
Many businesses operate in highly regulated industries, including financial services, health care, and transportation. The nature of certain laws can also impinge on your business regardless of industry. For example, the Foreign Corrupt Practices Act (FCPA) is part of the compliance program for every business based in the United States that sells products or services overseas.
The terms of contracts and the conduct of the parties need routine compliance reviews with a panoply of regulations. It’s not unusual for contracts to contain compliance terms by reference to a statute or regulation, instead of spelling out the obligation. For example, a Representation or Warranty (“rep and warrant”) might provide that the Party A is and shall remain in compliance with “Section 123 of the ABC Act.”
Suddenly, Party A needs to ensure that it is in continuing compliance with that section. Otherwise, Party A will breach the agreement and trigger remedies for Party B. Party B might also invoke audit or review rights elsewhere in the contract to evaluate Party A’s compliance with the same section.
To monitor compliance, your contract management software should:
- Store details of the regulatory requirements, including the legal citation
- Link the regulatory requirement to the contract details
- Schedule and notify your organization of compliance review due dates
- Capture compliance review details, including recommended action
- Automatically alert senior management to compliance issues
Compliance tracking is a vital part of contract management software.
Legal risks remain unidentified and unmanaged
There are four types of legal risk: structural, litigation, regulatory and contract. “Structural legal risk” is rare for most organizations. Structural legal risks arise from uncertainty about the underpinnings of a particular industry, technology or method of doing business.
“Litigation risk” is the most discussed legal risk in organizations. Litigation is often public and always distracting. The range of events that cause litigation is broad: employee misconduct, accidents, product liability and so on. The list can seem endless. Remedies can range from compensatory damages to punitive damages and injunctive relief.
“Regulatory risk” represents the uncertainty of the consequences of an agency’s action. Penalties range from fines to administrative orders.
“Contract risk” is the most pernicious and difficult to track among legal risks. The traditional approach to contract risk focuses on a breach of contract by one party and the extra-contractual liabilities that might arise.
Most organizations focus their contract risk management strategy on drafting effective agreements. There are cases where one contract can create significant risk, such as:
- An exceptional share of revenue is tied to one contract
- A procurement or service contract for critical components allows for disruption or price escalation
- The counterparty does not indemnify you for damages that carry exceptional consequences like unpaid taxes and environmental problems
In many cases, however, individual contracts often do not, on their own, have the gravity of litigation. Contract risk is really about managing the entire contract portfolio. Contract management software must help you identify, measure and manage legal risk from contracts. It should also provide you with risk management reporting capability.
Contract management software bolsters your financial performance, by protecting revenue, controlling expenses, monitoring compliance and managing risk.
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