Contracts 101

Startups typically begin with limited resources but have many mountains to move.  Thus, startups regularly reach out to external contractors to assist with various to-dos.  Engagement with these external parties come with contractual obligations and many startups are unaware of what contract types are available when making a request for help.

My earlier experiences with contractors began with merely handshakes but quickly learned that if it isn’t in writing then it was never agreed to.  Take the time to outline the scope, include everything you expect from the third party, and then put it in writing.  Clearly defined expectations, timelines, and deliverables set forth in the beginning makes everyone’s life much easier as the project nears the end.

“There are several types of contracts to be used in various situations and each have a different risk profile (Paul Cook, 2010).  The following article breaks down some of the most widely used contract types for services and things to remember for quick reference.

 

Fixed Price Contracts

The two most commonly used fixed priced contracts are firm fixed price and fixed price incentive.  Both of these contract structures provide the final total due to the external contractor before the work gets started.

A) Firm Fixed Price (FFP)

A Fixed price contract is a contract where the contractor has to complete all the work for one flat fee.  This creates an incentive for the contractor to finish ahead of schedule and properly manage resources. However, though the risk of losing money is on the contractor, a risk for the client is sub-par work.  “[T]his approach could lead to reduced performance or poor quality of the product” (Risk Management Basics, 2006).

“This contract type places upon the contractor maximum risk and full responsibility for all costs and resulting profit or loss.  It provides maximum incentive for the contractor to control costs and perform effectively and imposes a minimum administrative burden upon contracting parties” (DLA, n.d.).

B) Fixed Price Incentive (FPI)

A fixed price incentive contract allows the client to pay the contractor a fixed amount.   “[H]owever that this particular set amount may waver of vary if the seller meets some sort of pre-designated criteria related to the performance” of the contractor (Project Management Knowledge, 2010).

There is a risk of the final price being higher than original negotiated in the fixed price but would be based on performance of the contractor and most likely has a ceiling.  Thus, it would be feasible for the client to calculate the maximum amount of money that could be paid under this contract. (i.e. contractor finishes a month early, meets the deliverables, and there is a 5% bonus).

Cost Plus Based Contracts

The following three contract types, CPIF, CPFF, & CPPC, are cost plus contracts meaning the client maintains the highest risk because the total amount is unknown during negotiations.

A) Cost Plus Incentive Fee (CPIF)

“A cost-plus-incentive-fee contract is a cost-reimbursement contract that provides for an initially negotiated fee to be adjusted later by a formula based on the relationship of total allowable costs to total target costs” (DAU, n.d.). The client carries “the bigger risk as the total cost is uncertain” (Dhanasekaran, 2008).  Not only does the client not know the total amount of fees to pay the contractor there are also the associated unknown costs which have to be reimbursed.

B) Cost Plus Fixed Fee (CPFF)

The Cost Plus Fixed Fee contract is not a set amount for the total dollars spent.  More burden is on the client to manage expenses and can result in paying much more money than originally anticipated.  Additionally, “[t]he contractor is reimbursed for allowable, allocable costs” though the “[c]ontractor’s profit is fixed” (DLA, n.d.).  This is the less riskiest Cost Plus contract for the client because the exact contractor price is known and only unknown reimbursements remain.

C) Cost Plus Percentage of Costs (CPPC)

The Cost Plus Percentage of Costs is the lowest risk contract for the contractor. “This is very similar to the cost plus fixed fee contract except that the contractor bears even less risk. Their fee is calculated based on a percentage of actual costs. It is generally believed that having a fee at risk is a motivating factor for contractors, so this approach is not allowed for federal government contracts (Dahlgren, 2007).

Things to Remember

Never leave any detail out of a contract even if it was verbally agreed upon or is assumed!

– Always include deliverables into the contract.
– Always have a deadline for completion.
– Always have a method for resolving a dispute.
– Be specific on payment terms and methods.
– Have both parties sign it and make copies.

 

Conclusion

Don’t be strong-armed into a contract without knowing exactly what is to be expected by both parties.  Fixed Price is usually the best structure for a startup since all known costs are identified up front.  Always perform some research before moving full steam ahead, don’t be afraid to ask for references, and if term are negotiable.

What successes or failures have you encountered with third parties and contracts?