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Deflecting the dreaded technology escrow agreement

Whether mature, large, mid-size, or emerging startups, businesses will from time-to-time be pressured into signing technology escrow agreements with customers. Escrow agreements typically provide for the depositing of tangible items such as blueprints, sketches, quality, manufacturing and test instructions, and source code into an escrow account with an independent escrow agent.

An escrow agreement generally provides for the release of the escrow materials from the account to the customer on the occurrence of certain defined triggering events such as insolvency, bankruptcy, and failure to supply.

The customer is then licensed post-default to use the escrow materials to make product or have product made for it by third parties. The agreement will typically provide for a dispute resolution mechanism should the supplier believe the triggering event has not occurred, often including arbitration or mediation. The beneficiary is provided with the right to audit the account on a regular basis to ensure the materials have been properly deposited and are up to date. The supplier may be required to attend the audit.

Drivers

Customers decide to go down the escrow path for a number of reasons. Often the requirement is innocuous and arises simply because a new procurement officer has been hired and he or she is doing their homework. The customer may be on a drive to reduce the number of suppliers it relies on and may have decided to put escrow agreements in place with critical suppliers, for example those who supply products where a second source is not available. Or, the supplier’s fortunes may be waning. There may also be rumours circulating regarding the supplier being acquired.

The pressure to sign up to an escrow agreement may be quite intense, particularly where the customer threatens to terminate its business relationship with the supplier immediately or over time.

Escrow shortcomings

Escrow agreements can have significant shortcomings from both the supplier and customer’s perspective. They can be complex and difficult to negotiate.

The escrow agent is entitled to be paid a set-up fee and an annual maintenance fee. The escrow materials are often not up to date or poorly documented. Companies experiencing financial hardship and on the verge of insolvency or bankruptcy are not always motivated to honour their obligations with regard to making regular, complete deposits. The materials may ultimately prove to not be very useful because they lack show-how and know-how.

Perhaps the most serious concern however from an organizational perspective is that escrow agreements can be a serious sinkhole for engineers’ time, and the operations group. This is true whether the escrow materials include new products under development or products the customer has been purchasing for years. In both cases, the burden of properly documenting, or worse having to go back and document, how the products are designed, should be manufactured, tested, etc. can be very painful and time consuming, and therefore costly.

Letters of authorization

Bearing in mind the aforementioned shortcomings an alternative arrangement, which can sometimes usefully be dangled in front of a customer, is a letter of authorization. Letters of authorization work with regard to most technology including hardware but not with regard to source code. It is therefore not everyone’s cup of tea.

A letter of authorization is a tripartite agreement between the supplier, its manufacturing partner, and the customer. It authorizes the customer, following the occurrence of a triggering event, to place purchase orders directly on the supplier’s manufacturing partner and authorizes the manufacturing partner to use the supplier’s tools, jigs, masks, test programs and other intellectual property, and items in the manufacturer’s possession to manufacture products for the customer to fill those orders for as long as the triggering event continues to exist.

A letter of authorization ensures a number of things: There is no uncertainty as to whether the customer will be able to have product made as there is with incomplete escrow materials. Audit rights are not required since it is clear the intellectual property and other items are in the manufacturer’s possession since they are used on a regular basis to supply the customer.

Additional benefits are there are no fees involved, the letter of authorization is relatively straightforward to draft, and most importantly there is zero impact on engineers’ time. In some letters of authorization I put in place, the customer even agreed to continue to pay the purchase price for the product to the customer notwithstanding the triggering event.

Of course there are trade-offs in entering into a letter of authorization which may not be appealing to the parties, including the lack of a dispute resolution provision, questions around assignment, lack of representations and warranties, and indemnifications.

Summary

Achieving a balance between the competing interests of suppliers and customers with regard to escrow agreements will almost always be a complicated and sensitive issue for negotiation. Not only can such arrangements be a serious draw on in-house counsel’s time but, more importantly, in many cases they are distracting to engineers and other product development groups such as the operations team, particularly where a customer requires the supplier reach into the past and properly document and deposit escrow materials. In some cases they may no longer exist.

Though not practical in many cases, a letter of authorization provides an alternative approach which may have enough pluses going for it for customers to bite.