6 Types of Contract Risks Every Small Business Should Know
As a time-strapped business owner, you don’t have time to read every contract word for word. But can you afford not to?
Contract risks can kill your business. So it’s vital that you understand the types of contract risk hidden in your contracts, how to identify them, and what to do about them.
Let’s get started.
What Is Contract Risk?
Contract risk describes the possibility of loss that results when you sign a contract. There are six types of contract risk that are inherent in contracts, and all of them can add unnecessary risk to your business.
The key is to identify and manage risks before you sign a contract.
Otherwise, you end up with poor deals, bad clients, or situations where you or the counterparty can’t fulfill your contractual obligations.
6 Types of Contract Risk
There are six domains (or types) of contract risk. Each can impact your ability to enjoy the benefits you expected when you signed a contract. Let’s take a quick look at each.
1. Financial Risk
Financial risk refers to any current and future financial costs that could result from a contract. However, this risk doesn’t just refer to the amount of money you’ll receive or the fees you’ll pay. It also covers the cost of doing business, based on the requirements of your contract.
When you sign a contract, you’re agreeing to certain obligations. Some will result in financial gain. Others might cost you money. For example:
- Additional insurance coverage
- The requirement to use specific software or tools
- Responsibility for taxes, fines, or penalties
- Payment terms
- The ability to raise or renegotiate rates
Not all financial risks are obvious. Missed contract dates can lead to fines or missed opportunities. Automatic renewals can extend contractual obligations without your knowledge. And ignoring financial regulations can raise disputes.
To manage and mitigate financial risk, you must continuously monitor key contract terms, analyze past deviations, and keep track of all financial regulation changes.
2. Operational Risk
Operational risks are losses that result from poorly managed processes, policies, systems, or market exposure.
In contracts, some clauses can impact your ability to operate. Or they can leave you exposed if unexpected events shut you down temporarily. For example, a storm or flood could make it impossible to work until power or internet is back online.
If you’re a service provider, these clauses are key to containing operational risks:
Non-solicitation clause: Without this clause, a client could hire your best employees or solicit your customers.
Force majeure clause: This protects you when a disaster disrupts your business operations. If it’s missing, you may have no recourse but to breach or terminate the contract because you can’t fulfill its obligations.
Termination for breach cause: This clause gives you the right to terminate the contract when a client fails to meet their obligations - such as paying your fees on time.
Bottom line, you need to ensure you have the right clauses, written in the right way, to protect your business if operational issues arise.
3. Commercial Risk
Commercial risks refer to the risks that impact your brand, your reputation, your ability to be competitive, your strategy for growth.
To minimize this type of contract risk, you need to be sure your contracts protect your strategic and commercial positions. These clauses are a good example:
Disputes: If they arise, it needs to be clear how they’ll be handled. This clause outlines how disputes will be escalated and adjudicated, whether they will be arbitrated or litigated, and who will pay for them.
Officer personal guarantee: The other party may insist that you personally guarantee your business’s performance of its obligations. Be careful! This clause may also make you (and your assets) personally responsible for the business’s liabilities.
Non-Compete: This clause may limit your ability to acquire additional customers. You may want to limit this as much as possible.
4. Technological Risk
Technology risks refer to the risks that arise from the selection and use of technology. For example, it might include intellectual property rights (IPR) infringement or the use of open-source software.
Some contracts specify the types of technology the counterparty can use. Remember to check all technical specifications in your contract review.
- Are they acceptable?
- Will they create financial risk by adding to your expenses?
- Will they fit into your current tech stack?
Be sure to specify limits on liability or exclusion of liability for IPR infringement. And if you use open-source software, make sure it isn’t prohibited.
5. Legal/Regulatory Risk
Regulatory risk results from laws and regulations that impact your industry, business, or ability to meet your contracted obligations.
In contracts, regulatory risks arise if the contract isn’t compliant with the latest regulatory standards and legally preferred language. But this type of contract risk includes other situations, as well, depending on your industry and the product/service you provide. For instance:
- Willful misconduct
- Intellectual Property Rights (IPR)
- Compliance in regulated industries such as financial services and healthcare
Make sure your contract includes clauses that spell out each party’s obligations for these and other regulatory risks.
6. Data Risk
Data risk refers to any risks associated with data processing, data transfer, and confidentiality.
Parties to a contract share sensitive business and personal data for the transaction to take place. That data should be encrypted, so it can be stored, processed, and transmitted safely. There may be limits in how the data can be used or shared.
Contract clauses related to data risks include:
- The use of subprocessors
- Penetration testing
- Data transfer
- Data processing agreement
- Minimum-required data security measures
It’s important to understand the data processing provisions in your contract. Make sure the language in these clauses aligns with legal standards.
How to Identify and Manage Contract Risks
Managing contract risk starts with prevention. You must be able to identify risks and negotiate better terms before you sign a contract.
That’s why it’s never too soon to develop a contract review process. Unless you set aside time to read every word of your contracts, you’ll end up agreeing to terms that put your business at risk.
As you review a contract, look for inherent risks. Ask yourself:
- What obligations are you agreeing to? Do they introduce other risks?
- Which clauses could be a problem? How significant is each risk?
- Which clauses place unnecessary risk on your business? How can you change that language to ensure you’re protected?
While it’s important to mitigate contract risk, it’s impossible to remove it entirely.
Every contract you sign is an opportunity. But it also adds risk, because you’re accepting obligations to perform and deliver at a specific level or under conditions that you can’t control.
Your job is to understand the risks and to do your best to manage them.
That’s where Delino can help. If you’re looking for smart contract review that helps you identify and mitigate risks, join our beta today.
DISCLAIMER: Delino is not a lawyer and makes no warranties that its advice will protect your business from lawsuits or damages. Users rely on contract feedback at their own risk. Please consult your attorney for legal advice.