CONTRACTS CHECKLIST: HOW TO ANALYZE A CONTRACT
In this article I'm going to show you how I look at a contract. I've done this thousands of times, but I generally follow the same fundamental structural approach to it. As a corporate attorney I have a lot of suggestions regarding contracts, but here are the basics of what to do.
TABLE OF CONTENTS OF CONTRACTS CHECKLIST: HOW TO ANALYZE A CONTRACT
I. Contract Dark Arts
II. When to Use a Lawyer to Analyze a Contract
III. Contract Analysis Checklist
___ 1. Understand what's reasonable in a contract
___ 2. Don't come with an open mind when reading a contract
___ 3. Glance at the whole contract
___ 4. Understand that any contract is only about three things
___ 5. Read the most important provisions of a contract
___ 6. Detach the definitions section of a contract
___ 7. Read the whole contract carefully from the beginning
___ 8. Make changes to the contract
___ 9. Execute the contract
IV. KEYS OF HOW TO ANALYZE A CONTRACT
LONGFORM & EXPLANATION OF CONTRACTS CHECKLIST: HOW TO ANALYZE A CONTRACT
Most contracts are garbage.
They're unclear, confusing, and unnecessarily a billion pages long.
But a good contract is a work of art. A well-drafted contract is efficient, elegant, and clear.
I. Contract Dark Arts
There are also the dark arts when it comes to contracts. There are ways to commingle promises as declarations or to draft provisions that seemingly bind someone to take an action but really have no effect. I have seen these types of methods. They can be evil to the unsuspecting.
II. When to Use a Lawyer to Analyze a Contract
Use a lawyer to analyze a contract if any of the following are true:
1. the dollar amount in the contract is more than a couple of hundred dollars; or
2. the relationship between the two contracting parties is important; or
3. the contract is extraordinarily lengthy or has unfamiliar terms; or
4. the contractual matter, even if small, has substantial risk or consequence (e.g. contract for a long period of time, potential for employment litigation, etc.)
You know that I keep it straight with my readers, even if it means I potentially leave money on the table so here's the deal: don't bother using a lawyer if none of those points are true. It's just not worth it.
So if you're going to analyze a contract for yourself, here's how to do it:
III. Contract Analysis Checklist
___ 1. Understand what's reasonable in a contract
The name of the game for contracts is reasonableness. Even if the language for a contract is perfectly acceptable you can still get screwed if a term is way out of the norm. If a contract has a lot of terms that you've never dealt with before and you don't know the scope of what's reasonable, get a lawyer.
___ 2. Don't come with an open mind when reading a contract
This is not a marriage counseling session where you need to come with an open mind and an open heart or whatever.
No; when you're given a contract draft you need to NOT come with an open mind.
The first thing you do should NOT be reading a draft of the other party's contract. Why? Because:
If you read the contract from the other party before doing anything else, then you let it become your mental anchor.
Don't let this happen. If you come with a clean mental slate, that mental slate will be filled by what the other party wants--not what you want.
So here's what you need to do:
___ a. Understand the power dynamic. Know who the other company is and understand their relationship with your company. Who needs each other more? This is going to tell you how much you can tailor the terms.
___ b. Avoid biasing in favor of the other party. Think and write out what terms and provisions you expect there to be in the contract. Make a list of all of the issues that are important to you BEFORE you read through the entire contract. This lets you filter through and not get bogged down by a contract's legalese and bullshit. By writing out what you expect to see before reading the contract, you avoid biasing in favor of the person who gave you the contract.
___ c. Start over. If you've already read the contract before reading this article, then just put aside the contract for now. Clear your head space, take a walk, and start from point 1 of this article.
___ 3. Glance at the whole contract
This takes literally 10 seconds. Get a feel for the document. It's the same thing you do when you pick up a book--you look at the beginning section such as the table of contents and then just flip through it.
You don't need to read the whole contract yet. You don't even need to skim it. This is just a brief overview. You want to get an overall idea of what you are dealing with--how everything is organized and what terms and clauses are included and their general location.
___ 4. Understand that any contract is only about three things
Before you read the contract, I want you to be conscious of three key concepts. These concepts are going to underly every single contract you come across. And when it does come time to read the contract, you need to CONSTANTLY be thinking about these issues. Here are those concepts. Know them. Understand them. Internalize them.
___ a. Flow of money in a contract
Understand the money at stake and how it's flowing--to whom, when, how, and why. If it's not a contract for money, then understand what action you want vs. what action the other party wants and again--how, when, why, etc.
___ b. Control in a contract
This is about how a party controls risk, protects itself, and controls the triggers that require a party to take action. A company wants to limit its risk in case their engagement with your startup turns out to be disadvantageous.
The contract drafting party will use certain standards and qualifiers. Almost every adjective can establish some kind of standard. Do you have to use good efforts in some task or best efforts?
So with every provision or even every sentence you look at, you need to have in the back of your mind how the other party is using words and terminology to mitigate risk, to give protection, and to control the situation.
Here's the deal:
There's ALWAYS going to be risk and you can't eliminate it 100%. You have to keep in mind to not overblow risk factors, standards, and qualifiers and kill the deal. The main thing to keep in mind is REASONABLENESS. Does the terminology sound reasonable to you? If not, see about getting it changed. However, keep in mind your place and your negotiating power. If you don't have much power and it's a small point, all drawing someone's attention to a certain term may do is make them adjust the terminology to favor them even more. Analyzing these issues is all about having a balancing act.
___ c. Time provisions in a contract
As we've talked about before here on Startup Legal Stuff, time is what it's all about. How long is this contract going to be in play for? How can that time be extended or cut short and what are the consequences for that?
___ 5. Read the most important provisions of a contract
Read these first because the whole contract is going to be structured around these provisions.
___ a. Introduction of a contract
This is usually the first paragraph. It gives basic information about the parties and the subject matter of the contract.
___ b. The most important business provisions of a contract
This is the stuff you really care about. This will give you a good understanding for what's going on.
___ c. Termination provisions of a contract
All relationships come to an end. Get a good feel for this now.
___ 6. Detach the definitions section of a contract
This section defines certain terms in the contract. Don't trip up on this section. A term may be defined differently from how you know it. In fact it may be defined differently from anything you've ever come across.
What to do with definitions in a contract:
___ a. Skim the definitions section. Get a general feel for how that term is being defined in that document.
___ b. Detach the section. Physically put it side by side to the contract. You need to have this handy.
___ c. Cross reference. When you come across a defined term (often these are in bold), then go to the definitions section and make sure that it lines up to your understanding of what the term should be.
___ d. Be cautious. Watch out for a scenario where a word is defined one way in the definitions section, but another way informally elsewhere. Additionally, definitions of words can expand or contract the meaning of certain words. As a party to a contract, figure out what is in your best interest--if its better for a term to be narrowly or broadly defined.
___ 7. Read the whole contract carefully from the beginning
While you read the contract, you can jump from reading one section to another if they are related and separated. Once you have done that, go back to where you left off. Make a notation after you've read every section.
Here's how to approach different ideas and sections you'll come across.
___ a. Names & recitals of a contract
This is going to be the basic information--generally at the beginning of the contract. It will contain background information on the contract.
What to do:
___ i. Check accuracy in this section of the contract. See if all of the names, dates, and such are correct. You would be surprised at how often these facts are incorrect. Make sure that they are consistent and correlate across documents.
___ ii. Check Substance in this section of the contract. Be wary of overly lengthy recitals and be cautious here. Recitals actually do not carry as much weight as you think they might as they are not enforceable provisions. They don't provide rights or remedies. Make sure there is nothing too substantive here that should instead be in the action sections.
___ b. Representations & warranties in a contract
Representations are statements of past or present fact; not future facts. Warranties are promises that if a statement is false the maker of the statement will indemnify the other party for damages due to that false statement.
What to do:
___ i. Control risk with reps and warranties. Decide which side of the representation or warranty you are on. Broaden or narrow the statements as necessary. Remember what I said about using language and adjectives to control your risk.
___ c. Contract provisions that call for agreement to perform and consideration
These sections, labeled in various ways, are where the main ideas underlying the contract are called for. This is where the parties agree to perform the actual matter (i.e. seller agrees to sell property) and the consideration section (which describes what is being exchanged between the parties--usually money.)
What to do:
___ i. Check Accuracy. These sections need to perfectly reflect the deal. Make sure that everything is accurately stated. Important business provisions are here and at the end of the day this is the heart of the whole matter.
Make sure all of the numbers are as concrete as possible. Try to be as unambiguous as possible with money. Follow the money. Think about the timing of the flow of money.
Pay attention if there's a mathematical formula. An incorrectly stated formula can fuck things up. If there are formulas present for calculating compensation, run different hypothetical numbers and see if it makes sense.
___ ii. Ask Questions. Make sure the consideration section answers as to who is getting what, when, how, and why. Write it out on your own paper.
___ d. Promises or rights
Promises, aka covenants, are actions that a party must or must not take. The opposite of a promise is a right. A right entitles a party to something.
What to do:
___ i. Check Reasonableness. The main thing to keep in mind with covenants is that they need to be REASONABLE. Provisions such as non-compete agreements need to be reasonable in order to be enforceable. This means that non-competes should not extend past two years after you leave the employer.
___ ii. Limit Scope. Beware of any promises or rights that aren't limited or scoped in any way. Always use who, what, when, where, why, how, and how much when thinking about these issues.
___ e. Conditions in a contract
You might see these scattered throughout. A condition is a scenario or fact that must be true before a party must perform.
What to do:
___ i. Control the Trigger 1. If you have to satisfy the condition, make it easy.
___ ii. Control the Trigger 2. If not, figure out how difficult it should be for the other person to satisfy.
___ f. Termination and end of a contract
As mentioned, every contract comes to an end at some point.
What to do:
___ i. Check Clarity. Terms of length can often be ambiguous. Try to make this more clear. Be clear as to how and when the contract renews, if it does.
___ ii. Address Questions. Figure out the timing of the contract--the term of it, how it could end early, how it can renew, what causes default or cause, what the remedies are, how you can terminate the contract and what happens in that case.
___ iii. Control Risk. Adjust the termination provisions to line up with your risk tolerance.
___ g. Boilerplate provisions of a contract
Towards the end of the document you will see what are "boilerplate provisions" of the contract. It will not explicitly state the word "boilerplate" but these are terms that are usually somewhat standardized. If you're operating in the state of Texas then you will often see a jurisdictional provision about the contract being governed under the laws of Texas. Or maybe you'll see Delaware. It all depends. You might also see a provision saying that the contract can be signed in counterparts. There are other boilerplate provisions as well. Make sure these are reasonable. These provisions generally are relatively standardized. For more complex contracts have your startup lawyer take a look at them.
___ h. Signature blocks of a contract
You know what this is.
What to do:
___ i. Check Accuracy. Make sure the signature blocks are correctly set up and that names match those at the beginning of the document. I've seen contracts where the names don't match up. It's EXTREMELY amateur.
___ ii. Address Signatory. Make sure that there is a line for the title of the person who is signing on behalf of the organization. Remember that you are not signing on behalf of yourself personally. You are signing on behalf of the company. Don't bind yourself. Bind your company.
___ 8. Make changes to a contract
Here's where you look at your concerns and address the changes you want to see with the other party.
Remember what I said about drawing attention to matters when your side is relatively powerless.
___ 9. Execute the contract
Once you have understood the terminology of the contract, you're satisfied with the terms, and you've evaluated the contract and it all seems reasonable and correct, all you have to do is sign the contract and you're done.
IV. KEYS OF HOW TO ANALYZE A CONTRACT
I know that I just went over a lot. Here are the things to keep in mind:
a. Deal killing. Remember, here at Startup Legal Stuff, we don't mess around. There's a lot of stuff in contracts and there's no avoiding that. Keep your eye on the core of the deal and the power dynamic between the parties--these are the things actually that matter. If these are fine, you're fine. DON'T BE A DEAL KILLER BY OVERLY SCRUTINIZING BULLSHIT.
b. Ambiguity. This is a problem. Address it and fix it.
c. Vagueness. This, on the other hand, doesn't necessarily mean anything that bad.
d. Mental anchoring. Look for what's missing in the contract, not just what's in there. Remember what I told you about mental anchoring and making your own list. DO THAT FIRST.
e. The only things that matter. Always keep in the back of your mind during the whole contractual process:
Money: how, when, how much, where is it flowing
Risk: control, standards, qualifiers, and how each party is limiting their risk
End game: how people are getting out of the deal
If you make sure these factors are in your favor, you will be fine.