Software Contracts 101: What To Look For

Before signing on the dotted line, evaluate these contract provisions. First of a two-part series.

You're about to sign a software contract for a core application. You've already done your homework on the software itself: thoroughly reviewed its current and future capabilities, performed due diligence on the depth and knowledge of the vendor and its staff, and checked references and assessed the vendor's financial stability.

Now you're ready to sign on the dotted line. Do not minimize the importance of this step. Your job -- and even the future profitability of your company -- could be on the line.

Even if you implicitly trust the vendor you've chosen, you'll no doubt seek legal assistance, preferably from attorneys familiar with computer software contracts. Still, you must re-read the contract to be sure you understand all of its clauses. Is the contract straightforward and easy to understand? Does it include all of the negotiated or agreed upon issues?

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One or more of your lines of business must review all the provisions of the contract, whether it covers on-premises or hosted software. Below I'll discuss the major terms and conditions. In a subsequent column, I'll go over the other three major provisions of a software contract: warranties and maintenance liability; training and education; and testing and service-level agreements.

Payments and term
The schedule of payments and the term of the contract depend upon each other. You can negotiate for a lump-sum payment or an installment schedule. The amount you wish to pay depends upon your cash flow needs (with appropriate present value analysis) and the term of the contract. If you select a longer-term contract (more than the standard four or five years), insist on substantially lower annual payments.

It's important that the contract distinguishes between payments to buy the software and payments to maintain the software. Some vendors will aggregate the purchase and maintenance amounts. However, for you to properly evaluate the cost of the software and its future maintenance compared with similar software, the contract must spell out these two components separately.

Whether you purchase the software in a lump sum or under an installment plan, the contract will require an up­front payment, usually one-half of the first year's payment. The other half will usually be due 30 or 60 days after you sign the contract. This is an important point to resolve with the vendor: The balance of the up­front payment, whether on a lump-sum or an installment basis, shouldn't be due until after you complete acceptance testing. More on this point later.

Licensed machines or servers
Make sure you may operate the software on more than one machine. Even if you have little intention of expanding your centralized mainframe processing, you may have future needs for remote or even correspondent processing. Either of these circumstances could require multiple versions of the software.

If your software vendor won't provide this flexibility at the same price, ask for a compromise. Include a clause that provides the vendor with an equitable percentage of the proceeds, above some threshold amount, received from processing for external customers.

Price escalator
Many of today's software contracts include a price escalator clause, which lets the vendor increase the annual purchase installment (another factor to be considered in the lump-sum versus installment payment decision) and maintenance fees. The escalator is usually based on some well-known index, such as the consumer price index.

If you think your company's costs more appropriately reflect another index, such as the GNP deflator, discuss it with the vendor. In any case, compute a trend over the last 12 to 20 quarters of the proposed indexes to determine which might be the least costly to your company.

Most customers receive discounts from the software's list price (sounds like buying a car, doesn't it?), provided they buy several applications concurrently or within a set period of time. Obviously, check that these discounts are true reductions in the price of the software and not just a means of striking parity with the vendor's competition.

Also, do the discounts apply only to the purchase of the software or to the maintenance as well? This is another point of negotiation, particularly if your company is acquiring several applications. Does the annual maintenance cost, usually between 15% and 20% of the purchase price, apply to the vendor's list or discounted price?

Identifying applications
This may sound like a no-brainer, but be certain that the contract specifically identifies the application or applications you're acquiring. Make sure that the modules or other interfaces you may assume are part of the application are indeed listed or described in the text or as an appendix to the contract.

Merger or acquisition
What happens to the vendor's obligations should it become the division of another company or get reorganized in some other major way? Your company may want to include wording in the contract that terminates, reduces, or modifies any further obligations should this change occur.

Legal expenses
Who incurs legal expenses in the event of a dispute between the vendor and customer? Are they borne separately? Is the software vendor limited only to the amount of its out-of-pocket legal costs and revenues received from your company?

These are issues you will need to resolve within your company and with your prospective vendor. In my next column I'll discuss warranties and maintenance liability, training and education, and testing and SLAs.

Bennett Quillen, a former CIO for a leading mutual fund processing firm, has more than 35 years of experience in financial industry technology, operations, cash management, and compliance. Today he provides financial institutions with project management and technology advice, specializing in system evaluation, development, conversions, and security and compliance management.

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