How to Properly Leverage Contracts to Transfer Risk Away from Your Company

When you run a small business, contracts are everywhere. They govern your relationships with employees, customers, suppliers, contractors, financial institutions, insurance providers, and more. You could say that contracts are the glue that holds businesses – and, as a result, our nation’s economy – together.

When utilized correctly, contractual risk transfer is one of the better risk management strategies out there. Contracts are incredibly powerful tools. Unfortunately, they are often treated as a formality rather than an essential function of your business.

Take your insurance policy, for example. It is a black-and-white agreement between your carrier and you, the policy holder. In other words, it’s a contract – and an important one at that. Some insurance policies are required before you can even open your doors, and other insurance policies protect you from disasters that could close your doors forever.

But we’ve spent enough time on insurance for now. 

Today, I want to look at how small businesses can take a holistic approach to contracts – when you create them, when you sign them, and when you review and update them. Before we start, a quick word on how to think about contracts.

How You View Contracts Matters

For some people, contracts are just a formality – something to get past so they can get paid. They’re not worried about the fine print, they just want the work. 

This hopefully goes without saying at this point, but I don’t recommend that approach. Ignoring contracts puts your entire business at risk. That’s why it’s so important that you approach every legal agreement you enter – service contracts, subcontractor agreements, release of liability forms – with the right perspective.

Essentially, contracts determine how risk will flow between all parties in an agreement. At the end of the day, if something bad happens, attorneys will look to the contracts to determine how everything will play out. Especially in the construction world, when something goes wrong, responsibility flows uphill – and proper risk transfer is your greatest defense.

Whether it’s financial, legal or other risk, your contracts determine who will be on the hook for what – whether things go as expected or things go wrong. As a result, due diligence is a must both before and after you sign anything.

Before You Sign

When you’re creating and/or considering signing a contract, you want to make sure you have a deep understanding of how it will impact your business going forward. 

Understand which parts of your business are bound by contracts

Lease agreements, service contracts, contractor agreements, release of liability contracts, non-disclosure agreements – depending on your business and your industry, you may enter into multiple contracts across multiple categories with multiple vendors. 

I highly recommend getting a lawyer and a risk management team who can work together to outline which areas of your business are impacted by contracts so you can be sure to maximize your risk transfer. With a complete picture, you can identify and prioritize areas where you need protection and where you may not. 

Risk flows both ways in contracts. Some contracts transfer risk away, some transfer it to you, some do both simultaneously. Your job is to figure out what risk you’re okay taking on and what risk you can transfer away.

Ask yourself 3 key questions

Question 1: What risk can you pass on?

Of course, you can’t transfer all risk to another party. Every contract contains some give and take. But you want to transfer as much risk as you can to other parties, especially risks that are controlled by the other party. 

For example, if you’re signing a lease agreement for a warehouse, you’ll probably assume the responsibility of damage to the building in the course of doing business, but maybe you can transfer some of the risk for standard wear and tear due to the elements and aging of the building.

Question 2: What risk are you assuming?

Again, you have to assume some risk. Figure out what seems fair and what kind of risk you’re comfortable taking on. 

Try to take on less risk than the other party whenever you can. It’s not always possible, but it’s not always impossible.

Question 3: Are you leaving anything out?

Keep in mind, nothing is enforceable that isn’t spelled out in a contract. If and when something goes south, all non-written “understandings” between parties are completely irrelevant. That’s why it’s so important that you make sure your contracts are airtight, which brings us to our next subject…

Review Business Contracts Regularly (with the Help of Your Lawyer)

Depending on which industry you’re in, you may want to review your contracts more often than others. 

I highly recommend reviewing contracts on some sort of regular basis. Have your lawyers put it on their calendar so it happens automatically. I want to underline that point: work with your lawyers when reviewing contracts. They can highlight potential issues for you and then you can make the call on what to do, but if you try to review contracts yourself, there’s plenty you could miss.

What to look for when reviewing contracts

As you review contracts, you want to consider multiple factors, including (but not limited to):

• New legislation that could affect employment contracts (e.g., the FTC’s proposed ban on non-competes)
• Regulatory changes that impact subcontractor agreements (e.g., updates to OSHA’s rules of construction)
• Changes in your business (organizational, leadership, geographical changes, new divisions, etc.)
• Changes in your personal life (health issues/relocations that may require you to sell or change your role in the near future)

The impact of legislative and regulatory updates can have a ripple effect across a multitude of contracts, which is one of many reasons you want to lean on legal experts when reviewing contracts. Business lawyers can help you see every part of your company touched by the latest changes. 

2 common contract types to review most often

This is by no means a complete list, but we find the following pair of small business agreements benefit the most from reviews:

1. Subcontractor agreement

I’d put subcontractor agreements up there with Apple’s Terms & Conditions for how many people agree to them without understanding (or even reading) them. What you don’t understand, you don’t comply with. What you don’t comply with, you can be sued for.

The most common deficiency we see here is subcontractors who don’t have insurance that meets the requirements of the contract. Whether they know it or not, they are entering an agreement without meeting the terms from the start. That may not seem like a big deal – assuming nothing goes wrong – but it can actually keep you from getting paid if the contractor or owner decides to do an audit.

If something does go wrong and you’re the subcontractor, whether you meant to do it or not, you could suddenly find yourself with a very large bill that your insurance company won’t cover. And if you’re the hiring contractor, you likely won’t be free from liability. You hired a subcontractor with insufficient insurance, which could void other terms of the contract – and the owner who hired you will likely notice.

Insurance and contracts are the belt and suspenders of risk management, working together to protect your business. If you’re the hiring contractor, the people you hire need to have proper insurance to appease the regulators and cover any mishaps – that’s the belt. And you want to make sure that risk flows away from you as much as possible when the unexpected happens – that’s the suspenders.

2.Operating agreement (buy/sell agreement)

When it comes to perpetuation planning, outdated contracts are like ticking time bombs. 

All too often, business owners draw up an operating agreement when they start a business and then forget about them. Then, 20 years later, after your partner dies unexpectedly, you find that what made sense two decades earlier makes zero sense now that your revenue has increased 15x and you employ dozens of people.

For starters, that life insurance policy you took out on each other when you started out is now way undervalued and in no way makes up for the absence of your partner. Plus, the operating agreement gives your partner’s half of the business to his surviving spouse and she’d rather sell now than wait around for that internal succession plan you and her husband were working on for the last few years.

It may sound impossible, but I’ve personally seen that exact scenario (and ones like it) happen to multiple businesses. That’s why it’s so important that you review contracts frequently and thoroughly.

Good Contractual Risk Transfer can Lower Costs (Among Other Things)

Every impact area of risk overlaps, and contractual risk transfer is no different. Good contracts mean less risk which means lower insurance premiums. 

An underwriter will definitely look at your contracts and if they don’t see sufficient risk transfer, they’ll either deny you or increase your premium quite a bit. It makes sense if you think about it: If something happens and your insurance company doesn’t have to get involved because you have good risk transfer, that’s going to make a big difference to them. 

That’s especially true now because we’re currently in a very hard market in the insurance space. Costs are going up and underwriters are under a lot of pressure to control risk.

Good contractual risk transfer can also have a huge impact when it comes to other areas too, like business continuity or exit planning. If you don’t set those contracts up correctly, it could cost you millions. 

For example, if you sell your business to someone and then they turn around and sell it to someone else for a lot more money, a clawback provision could help you get the additional compensation you deserve. With no clawback provision, you would have no grounds for recompense.

Contractual risk transfer can reduce the cost of risk in every area of your business – but you have to do it right. With a little legal help, you can protect your company and keep it running well into the future.

Want to Talk About Risk Transfer and Your Business?

We’ve helped countless companies navigate contractual risk transfer with the help of legal professionals. Contact us to speak with a risk management expert today.