Can we use automatic renewal contract clause to cut contracting lead-times and to build bargaining power for buyer?
Automatic renewal clause, also known as self-renewal or evergreen clause, acts to perpetually renew a contract if notice to terminate is not provided within a generally specific and relatively small window of time.
An automatic renewal clause typically reads as following: This contract will automatically renew at the end of each term for a further term of one year unless one of the parties gives the other written notice of termination at least 30 days prior to the end of the relevant term.
It can come handy to procurement professionals for a number of reasons, but it also raises certain risks, so it should be handled carefully.
WHEN is IT fit for use?
Cutting contracting lead-times
How complex and time-consuming is contracting process in your organization? Let’s imagine a buyer who should go through following steps for creating a new contract:
- exchanging emails with seller to reach a consensus on commercial terms of contract
- aligning the draft with his colleagues at legal, accounting and other non-commercial functions,
- collecting approvals of budget-holders, and perhaps some other executives,
- getting signature of the authorized person in buyer’s company,
- sending supplier the contract signed from buyer’s side, and waiting for confirmations and signing on seller’s side,
- waiting for the delivery of his own copy of contract when the seller sends signs and sends contract by mail
- handing the contract signed from both sides to accounting department or to mail room
- waiting for accounting department to enter contract into corporate ERP system
To make things more complex, people involved in the process might be located in different towns, or even in different countries and time zones. So the whole process might take up to a couple of months!
Although top management on both sides agree on main commercial terms such as volume and price during the main negotiations, buyers still spend a lot of time negotiating other terms, such as transfer of property rights, treatment of scale differences, etc. at a later stage during contract signing. Upon prolongation of an existing contract, some suppliers are okay with copying previous terms, but it is not always the case. I often see suppliers challenging minor terms of contract although we simply prolong the same price and volume terms to following period. This can happen due to changes in either business conditions or management teams on supplier side. Or simply, the supplier might be reading the contract more carefully this time and recognizing some risks that he or she had not noticed earlier. No matter how small these issues can be, they stop buyer’s organization to buy through main contract and buyer should temporarily switch to a less optimal sourcing until the main contract is prolonged manually.
Strengthening buyer’s position during price negotiation for next period
Buyers are usually quite busy in last months of the year, as most contracts expire by 31 December. And what response does a buyer get approaching a supplier for prolonging the contract to next year? “We are happy to continue our cooperation. We budgeted 7% price increase to cover inflation in our costs. Shall we sign an addendum right now?” This is not the response buyers hope for, especially if they contact supplier two weeks before contract expires and the company is rushing with the next order. Buyers might be obliged to comprimise unnecessarily due to insufficient time for proper negotiations and bidding.
In an inflationary environment where prices tend to move only upwards, it is generally wise for buyers to have supply contracts automatically prolonged. In this case buyers have a stronger position. The clock ticks against the supplier, because he or she should initiate negotiations if current price is not satisfactory.
WHAT ARE PITFALLS?
Risk of contradicting contracts in parallel
The company may get into tens or hundreds of contracts with the same counterparty over a long period. All those contracts are legally binding if they include automatic renewal clause. The company might face serious commercial and legal risks if some contracts contradict others. Let’s imagine a case where the company contracted different prices for the same goods or services over a period of ten years. Cleaning up this mess can be a real headache. One way of tackling with this problem is numbering contracts properly. Another important thing is not to skip terminating previous contracts whenever a new one is in place.
Difficulties with contract management
Let’s imagine a contract with renewal clause to prolong over a period of 5 years or more. It might well be the case that management teams on either side have changed. They may not be familiar with contract terms or their background. For example, they might skip giving written notice for termination although the initiators of the contract intended to do so at a certain stage. Hard copy contract might not be around any more, so if the company does not have a well functioning electronic archiving system, new manament might even be fully unaware of the contract.
Risk of skipping bids or tenders
A diligent buyer reviews supply markets regularly and seeks to improve buying conditions. Most companies require bidding or tendering before signing new contracts. On the other hand, bidding can be forgotten or ignored with contracts with automatic renewal. As a result, not only the company risks buying at terms worse than market, but also the buyers may be sanctioned for policy violations.
Further issues to consider
Volume commitment or exclusivity for supplier
If buying organization commits to a certain annual volume or exclusive business with supplier, then automatic renewal clause should be evaluated with additional caution. Buyer should consider not only the present, but also potential changes in business goals and environment in coming periods.
Price fluctuations for commodities
Prices only increase but also decrease on commodity markets and they fluctuate in a wide range over a short periods of time. It is a good idea to review contract terms more often with commodities instead of using automatic renewal to fix terms over longer periods.
IT tools for assistance
Planning for bids might be tricky if buyer executes hundreds of contracts. Moreover sometimes it is a department other than procurement executing the contract. Contract expiry date is often neglected and bidding requirement is noticed too late. On the other hand, knowing requirement in advance and investing enough time to negotiations is critical to successful bidding results. There are many IT tools which send warning messages to employees when a contract is close to expire. Some of these tools are integrated to company’s ERP. There are also some tools that inform also about upcoming periods for termination notice for contracts with automatic renewal.
Defining constraints on renewal clause
If you want to be cautious on renewal clause, you may want to evaluate a shorter renewal term (for example, quarterly instead of yearly) or put a cap on total period of time that the contract might be prolonged (for example, prolongation up to a maximum of five years instead of an infinite period of time). You may also want to make automatic renewal clause subject to written notification by the supplier of the upcoming termination window.
icon-key KEY LEARNINGS
- Use automatic renewal clause if you want to optimize complex contracting work.
- Evaluate not only present business environment, but potential change in future before applying automatic renewal.
- Ensure that your document archiving is of high standards, preferably fully electronic.
- Be cautious with commodities and contracts with exclusivity or with periodical volume commitment.
- Do not rely solely on memory. Consider using IT tools that warn in advance about running a bid or giving termination notice for the contracts with automatic prolongation.
- Consider increasing control by limiting renewal periods, or total length of time that contract may be prolonged, etc.
icon-road Way forward
I find automatic renewal clause interesting, especially the leverage it gives to buyers in terms of using time to their advantage. Yet, it has also major pitfalls. So it is interesting to hear different ideas. Please leave a message below if you want to discuss more about it.