For any venture, there is much to celebrate in signing a new business contract, whether these are for customers, suppliers, premises, or loans. Each contract takes your business forward and, for a new business, your concept begins to feel real.
At this stage, it’s easy to lose sight of the risk associated with entering into those contracts and to focus just on is the upside. However, there are risks in every contract you sign, and it is critical from the outset to understand and evaluate those risks, so that you can effectively manage and mitigate them. By doing that, you will be able maximise the opportunity and value of each contract and mitigate the risks to your business.
Our team of commercial solicitors can help you to identify risks, make recommended amendments and then assist in negotiating to get the right deal done.
What is a contract risk profile and why do you need to know yours?
Risk is inherent in every contract that you sign, but the risk profile will be different from one contract to the next. This depends on various factors, such as whether you are the supplier or the customer, and the subject matter of the contract. If you are a supplier, it could be that the most fundamental risk is exposing your business to a higher level of liability than is justified or acceptable to you. In other cases, it could be a key risk is non-performance by your business or the other party, such as by failing to deliver on time or at all, not meeting a quality specification or order volume, or by the payments not being made. In other contracts, it could mean you not getting the rights you think you are getting (such as ownership of intellectual property rights or a licence that is wide enough) - or inadvertently giving away your current right. These are just a few examples.
It is important to understand your risk profile in relation to every contract that you sign so that you can put in place processes to manage those risks. Fundamental to this is understanding your own attitude to risk.
A contract risk profile is a matrix through which you understand the risks, the probability of each risk occurring and the consequences if the specific risk does occur. This matrix allows you to rank risks in terms of importance and also likelihood. So, for example, the risk of non-payment of a loan or overdraft repayment may be low, however if it were to occur, then the consequences could be severe - your lender could potentially freeze your bank accounts, prevent you from doing business and seize any assets offered as security for the loan. In this example, ensuring that you meet your monthly loan repayments will therefore be a business priority for you.
Knowing your risk profile enables you to be proactive, rather than reactive, when it comes to managing the risk flowing from your contracts and also your overall business activity. It also allows you to prioritise and to put in place mitigation strategies and contingency plans.
How your risk profile impacts your ability to do profitable deals.
If you do not fully understand the risks associated with the contracts that you enter into, it could lead to value leakage. In other words, the ‘upside’ is eroded by the ‘downside’.
If you don’t understand the risks associated with a customer contract, you may fail to fulfil your obligations resulting in either a reduced payment or no payment at all, a claim for damages or it costing you more than anticipated to fulfil the contract.
Even if you fulfil your customer contracts perfectly and realise profits, if your other business contracts are not fully understood and the risks are not mitigated, then you the profits you make could be eroded.
What are the different types of contract risk you should consider?
In pulling together your risk profile, the types of risks that are most often associated with contracts are the following:
Financial risks are contract risks that mean that you lose money, whether this is from a customer failing to pay you, a customer bringing a claim against you, or a supplier failing to perform or deliver.
Other examples include losing money if you miss key elements of a contract, such as contract renewal options or, equally, the ability to terminate a disadvantageous contract.
Equally, if you do not fully understand your contract obligations then performing the contract may cost you more than you quoted or you may find yourself in breach of contract with potential associated damages and warranty claims.
You can find more detail in our guide to assess and mitigate the risks associated with supplier and customer contracts.
Legal risks arise when there is a breach of contract with associated legal claims and potential litigation.
If you fail to meet your contractual obligations, you run the risk of a claim for damages and litigation. Equally, if a supplier fails to deliver, then you face making claims and incurring legal costs, and the failure could then cause you to breach your contracts with your customers.
Contract disputes often arise when there is a difference of opinion between you and the other party as to whether a contract has been properly fulfilled. In other words, have you done exactly what you said you would do in the contract? This can relate, for example, to confidentiality, quality or timeliness.
Contractual disputes can be costly and time consuming. These risks can be mitigated by adopting contract lifecycle management, which includes the standardisation of contracts, so as to make it easier for you to understand and manage risks. Our article, contract lifecycle management, outlines the basics of what you need to do.
Other legal risks stem from compliance and regulatory obligations, infringement or misuse of your intellectual property or you infringing the intellectual property of others.
Security risks stem from failure to protect sensitive contractual or personal information, as required by the contract or by data protection legislation.
This can lead to financial and legal consequences as well as impacting your brand and reputation.
Operational risk involves loss caused by inefficient internal or third party processes.
For example, if the sales team do not communicate key contract dates and requirements to the operations team, then the operations team may well overlook these. This may lead to additional and unnecessary resources being spent at the last minute to make the product or service fit for purpose or facing disputes and claims for damages for poor performance or quality.
Operational risk often relates to the performance of your suppliers and effectively managing the supply chain process. For more details on how this risk can be managed, please see our article on risks in supply chain contracts.
Brand risk is associated with all the other risks listed above and results from negative public, supplier and customer opinion.
If your brand becomes known for poor performance, for slow payment or for data breaches, then suppliers, customers, lenders and investors will be reluctant to trust you and do business with you.
Mitigating brand risk involves managing all the other risks above.
Risk management is a term familiar to every business owner. The management of contractual risks should form part of every over-aching risk management process or plan. Our team of commercial solicitors can help you to establish effective contractual risk management.