Today, Material Change of Control Clauses Really Matter

With all of the M&A activity flaring up in the software space, some customers are scouring their license contracts to see what rights they'll have (or not). Did you do a material change of control clause?

Whenever you buy anything big – really big – you need to consider what happens should the vendor/manufacturer be sold or fail outright. It’s just good business sense to plan for these things (and pray you’ll never need to revisit these items).

Software is an interesting space as most every vendor you’ll encounter has either had venture capital backing, private equity backing or is a publicly traded firm that could be acquired in an open market transaction. Make no mistake, when venture capitalists or private equity firms put money into a software firm, they expect to have a ‘liquidity event’ in a few years so that their previously illiquid investment can now be sold at many multiples of their original investment. By and large, these investors do not intend to hold these investments indefinitely and will likely drive a liquidity event in a few years.

The fact that these firms want to get some or all of their investment money out is not a bad thing. That's the vehicle funding many of today's biggest and best innovations. Ignoring this fact of life is bad thing for software purchasers to ignore, though. While a software founder may want to keep their investment in a company for decades, not every other investor can and will share that view.

So, this leads to an obvious issue for software purchasers: Should you be insisting on a material change of control clause in your contract/license. The answer is absolutely YES.

Starting back in the early 1990s, I insisted that clients get one for application software they licensed. Why? The client is 'investing' a small fortune in an upfront license, implementation fees with a consultant (possibly some 20X the license cost and first year's maintenance) and a lot of internal costs for a product that they expect will get a lot of support, upgrading, care and feeding, etc. for maybe 10 years or more.

If a new company acquires this software firm, then the 'investment' may go down the drain as the new acquirer could:

- kill off the product and force march the installed base to their product instead (hence, doubling the implementation cost) - be one of the companies the customer previously eliminated from the selection as being inferior or poor functional fit - cease to maintain the acquired product - etc.

Since none of those alternatives are good for the customer, the customer needs something to offset these risks. The material change of control clause is the ticket.

If the vendor is financed with venture or private equity money, then expect them to throw a first class hissy fit over this. In one spectacular negotiation session I led, the CFO and CEO of a software company dismissed this need. I countered that their PE financing was now in its 5th year and that their investors have got to be itching for a liquidity event.

They sat there and told me that even if the company were sold that the management team would remain in place and no changes in product direction/support would occur. My clients and I died laughing as none of us could believe this whopper. Even these software execs backed off and privately admitted that the company would likely be sold soon.

Vendors, to a one, absolutely hate these clauses. They believe that if too many of their contracts contain language that a potential acquirer would find economically challenging, then the value of their firm is adversely affected. This would be the case should your material change of control clause require the vendor to refund monies based on how soon the firm was sold. The theory behind such a clause is like a sinking bond fund requirement: the longer you get to use and get value out of your software ‘investment’, then the lower your liquidated damages are. If the vendor is sold after ten years, for example, you may get nothing for damages as you got full value for your investment. However, if the vendor is sold within the first year of your licensing, shouldn’t you get something for all of those implementation fees, license fees and maintenance monies paid to get this now obsolete solution partially installed?

Vendors aren’t entitled to a pass on this matter. They’ll throw their customers under a bus to get a huge deal valuation, a pile of cash and an early retirement.

A good material change of control should cover more than the sale of the software company. It should also cover the loss of key software executives (e.g., how would your firm react if it signed with Apple last week to be an all Apple shop only to see this week that Steve Jobs may be absent from the firm for a good period of time?).

I like to give vendors 2-3 choices in how to mitigate this risk. Generally, they hate them all but it sets the tone that we're going to insist on something here and they need to pick the one that's least offensive to them.

When a discussion on this subject popped on the Enterprise Irregulars internal discussion group yesterday, I saw that HR analyst Naomi Bloom opined that she and I must have “shared a brain in an earlier life” and offered her post on Vendor Consolidation Fairy Tales as proof.

Naomi’s right to point out that the flurry of HR acquisitions of late (and something Katherine Jones recently commented on in this blog) should make some software customers think twice about not insisting on these clauses. Seriously, if your deal helped make this vendor a rising star in their space, shouldn’t your firm get some of the upside that accrues to them when this growth triggers a meteoric market valuation for the company?

Good luck getting the terms you want and be strong!