When negotiating vendor agreements it is common practice for the vendor to request some protections in the event of a termination. Generally, these protections are designed to compensate a vendor when one side decides they want to end the agreement early. However, some vendors often seek termination protections that exceed what would be considered reasonable.
Suppose a company is entering into a two-year vendor agreement with a drug manufacturer and the drug manufacturer includes a clause such as “if Company terminates during months 1 through 12, the Company must pay any fees outstanding for months 1 through 12, plus 75% of the fees for months 13 through 24, and also 50% of fees months 25 through 36, if any.” This is quite the vexing clause in an agreement that would otherwise last two years if the contract ended in due course—without an early termination—because the clause seeks additional compensation for a hypothetical third year. Vendors justify this added protection for a variety of reasons: they want the manufacturer to demonstrate commitment, common practice dictates that these agreements are often renewed, such terms are industry standard, etc.
Terms like these, however, need not be accepted and manufacturers should understand when it is reasonable to pay for early termination and when it is not. Below are a few scenarios where it is reasonable to expect some sort of termination fees.
- When dealing with a vendor that dedicates slots for your company.
Vendors, like any business, have limited capacity to take on new clients. However, they may be willing to make space for a particular client if that client is willing to pay more or give the vendor some added protections. This is common for drug manufacturers, for instance. If a drug manufacturer commits to making your drug in an open slot, schedules you for that slot, but you terminate, then the drug manufacturer may not be able to get another company to take that slot in time. As such, it is reasonable for vendors—such as the drug manufacturer—to seek reasonable termination fees if your early termination prevents them from obtaining business.
- When a vendor hires personnel specific to your project.
Often companies seek vendors to help develop highly technical products. Continuing with the drug manufacturer example, suppose a company uses a drug manufacturer to help the company manufacture a new vaccine. Relying on that agreement, the drug manufacturer hires engineers to help with the vaccine production. If you terminate early in this situation, then the vendor may still be on the hook for paying the engineer despite not needing that employee. Because they relied on your agreement—and because they needed the engineer to complete their obligations under the agreement—it is proper for them to include a termination fee that provides remuneration for such a hire.
- If the company gets a substantial discount based on a committed term.
Finally, it is not uncommon for vendors to provide discounts based on the continued use of their facilities. For instance, it might be cheaper for the drug manufacturer to make the one vaccine for three years rather than retooling their manufacturing plant annually to accommodate a drug for a new client. For instance, suppose the drug manufacturer normally charges $100,000 for a 12-month term but realizing it costs the drug manufacturer $50,000 annually to set up the facility to manufacture a different drug, they grant you a 36-month term for $250,000 paid over three years. This saves you $50,000 and it saves the drug manufacturer $100,000. If you terminate early, however, the manufacturer will be left worse off because the pro-rated price was designed to account for two years of turnover savings. Accordingly, you should be willing to accept a termination fee where a vendor is willing to provide a discount on the overall cost.
When considering a termination fee it ultimately boils down to whether the vendor is incurring a cost or providing you with a benefit. If so, you should feel comfortable in accepting such provisions. However, if the clause is meant to demonstrate your commitment or is based on some future action you should think twice before accepting.