Contracting Tips: Reducing Risk When Buying from Small Software Vendors
You’ve found a great niche software application for a critical hospital department. It’s sold by a small, privately held vendor. Will your CFO nix the deal because of the vendor’s size or its lack of publicly audited financials? They shouldn’t, says Jim Brennan, managing director of healthcare technology mergers and acquisitions at MidMarket Capital Inc. of Hinsdale, Ill., who’s done over 100 healthcare IT deals at the CEO and CFO level. Brennan believes that the risks involved in choosing a small vendor can be mitigated through due diligence and careful contracting.
Niche Applications: Buy the Best Product
Brennan acknowledges that big vendors have better access to capital. Their broad product lines and big marketing budgets are often appealing to hospital executives. For those reasons, he advises sticking with them for big-picture applications such as ADT, scheduling, and full-line hospital information systems.
For niche applications, however, Brennan says to go with small companies if they offer a better product. “The rewards of licensing technology from a small vendor far outweigh the risks in most cases,” he told us. Because of their narrow focus, small vendors often excel in their use of technology, their response to market needs, and their concentration on deeper departmental workflow solutions. “For niche areas, big vendor offerings don’t go deep enough into workflow to give the department heads the tools they need to run the business,” he explains.
Besides, big vendors themselves aren’t risk-free, Brennan declares. “I can name a bunch of big HIS companies that have dropped a business unit and left clients high and dry,” he told us. Purchasers may also experience unexpected integration challenges since a big vendor’s product line may have been cobbled together by buying the standalone systems of smaller companies.
Don’t Give CFO’s Review Too Much Weight
So how should a CIO involve a hospital’s CFO in the system selection process? “Use team input for IT capital decisions,” Brennan says. “Get the right group together and vote. The CFO will be happiest with good company financials, but they’re smart enough to realize that a team decision is better than theirs alone. It’s important for the vendor to have ratios that look right to a financial person, but product functionality and the company’s strategic direction are important.”
In other words, Brennan advises not overweighting CFO input. Its importance should be no greater than other considerations, such as capability to deliver, product readiness, and functionality. Any identified financial risk can be mitigated by other factors.
Still, be cautious about giving a small vendor a big deal, Brennan told us. “You don’t want to be a big percentage of a vendor’s revenue. Assume you’ve seen their financials and the ratios were OK. Sit down with the company’s CEO and ask: if I give you this deal, how will you handle it? Show me the processes and the resources I’ll get. Where else will the people be deployed? Is the product I’m buying off the shelf?”
Buying from a small company means that every one of their employees could be touching your deal, he warns. If their resources will be stretched, he suggests building funds into the contract to pay for new vendor employees who will work exclusively with your organization.
Check Access to Capital, Insist on Penalties
It’s also important to know what access to capital a vendor has. “If a vendor is losing money and needs research and development dollars with negative cash flow, you’ll want to look at their access to capital,” Brennan told us. “What if they don’t get a sale for six months? If they are venture capital funded with money in the bank, that’s OK. If they’re self-funded, walk away if the CEO won’t share data. What if the CEO’s uncle decides to pull his money out?”
Brennan says he is constantly amazed that hospitals sign mission-critical technology agreements without specifying vendor penalties. In his history with vendors, customers insisted on penalty clauses “only a handful of times,” he told us. Without them, the only recourse you’ll have is to claim breach of contract, which he says is a painful and usually unsatisfying experience.
Know the Vendor’s Organization — and Your Own
Evaluating a potential vendor doesn’t require PowerPoint presentations and Excel worksheets, Brennan insists. “Meet their leadership over dinner. Talk about their culture, core values, families, career progression, past failures and successes, employees, training philosophy, and future plans. Ask about their other strategic partners. These items will give you a peek into your future relationship.”
Part of striking a good deal involves knowing your own organization, Brennan told us. He recommends a commercially available two-day course called “The Ownership Spirit” that forces hospitals to go through the ownership experience in advance. “It helps you pick out who on your team see themselves as victims who will cry wolf instead of getting on the train. You need to take those people who are resistant to technology and organize their energy in a positive direction.”
Due Diligence and Contracting Tips for Small Vendor Acquisitions
Instead of accepting the vendor’s boilerplate contract, use your own as a basis for negotiation. Customers almost never do that.
Keep a copy of your own boilerplate contract that contains all your best-case terms so you can include them even when you start negotiations from the vendor’s standard contract.
Insist on reviewing the company’s financials. In Brennan’s 120 hospital sales of small-vendor software, he was asked to share financial information only twice. The vendor should not object if you offer to sign a non-disclosure agreement and review the documents in person.
Expect a small company’s financials to be unimpressive compared to those of a billion-dollar hospital business with thousands of employees.
If your organization is already a big customer of a small vendor, subtract what you’re paying them from their financials — you care most about how they’d fare without you.
Look for a positive net income on the profit and loss statement, or in its absence, considerable company assets.
Startup companies should have a huge research and development number, such as 40 or 50 percent, compared to large vendors, who may invest only five percent of revenue in R&D.
Access to capital (both debt and equity), sufficient lines of credit, and well-managed cash flow are the most important financial benchmarks.
Don’t be an alpha or beta site for a startup. Install on a generally available product.
Ask for shorter term agreements. Big vendors want five to seven years, but smaller firms may agree to shorter terms that put more pressure on them to perform.
Don’t sign a contract that contains an automatic renewal or extension clause. A one-year manually renewable agreement lets you get out of a bad implementation more easily.
Specify that payments will be made only when the vendor completes specific project milestones that provide value, not just signing a contract or loading code.
Define your objectives and the expected roles of both parties in the contract.
Demand penalties for product and service performance issues, with the highest penalties specified for the services that have the highest impact or are most likely to occur based on the vendor’s weaknesses.
Define your expected service responses to all potential problems and insist on having the home telephone numbers of vendor executives.
Require source code escrow and trigger its release upon company liquidation, underperformance in specified support metrics, or negative vendor announcements involving products or profits.
Require any litigation to take place in your own state to reduce trial expenses and travel time.
Include terms that protect your organization if the vendor is acquired and the new owner sunsets your product or requires a mandatory migration.
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