This is probably not that exciting a topic to write about, so you will most likely skip this one. However, I find these sorts of things fascinating. Yesterday, in a business meeting, we were discussing potential business models and how we would contract with our customers to provide a service. We were running into a classic dilemma. We want the customer to sign up and use our service, but we also need to invest heavily in order to fulfill that service. Clearly, the service is not yet at the level that would produce the value we believe we have the potential to deliver, but if we had a commitment from enough customers to use this service, then with that guarantee we could invest the time, money, and resources into the service so that we could deliver that value proposition at some point in the future.
This is what I call the good enough problem: when you have developed something that is good enough for people to use but is not complete. As is typical, the last 20 percent of effort is the hardest and the most expensive to accomplish. As a consequence, we need to start securing contracts, but we need to do so in a way that allows us to invest heavily in getting from 80 percent, good enough, to 100 percent, where the product delivers the full value people are committing to pay. This is a strategy of shifting risk back to the customer. As a company, we reach a point where we cannot take any further risk, so we want our customers to shoulder some of the risk in reverse. This sounds rather absurd, but in reality this has become a highly common strategy for companies that find themselves in the “we are good enough” situation. The best example would be Microsoft in the 1990s, when they moved to what was called an Enterprise Agreement for clients above a certain user count. This is a basic economic model nowadays, and I see many startups trying to follow in these footsteps, but do they really understand why they would do this in the first place?
To properly frame this, we need to go back to the 1960s and the explosion of U.S. natural gas usage. After World War II, we saw a massive demand boom for natural gas. Suburban sprawl was at an all time high, and heating these homes, plus new industrial fuel switching and increasing power demand, created a perfect storm in which U.S. companies were rapidly trying to build out a mainline pipeline network that could reach these new population centers. This happened, and in reality most of our gas pipeline network across the United States was built during this decade. However, this was extremely expensive. So how did these companies figure out how to afford to put all this infrastructure in place to meet the demand? Enter the precursor to Microsoft’s EA commit licensing agreement, the ToP contract, commonly called take or pay.
The ToP contract is effectively the same instrument that Microsoft popularized in the 1990s. It is a commit to consume obligation that a customer takes on. It helps to offset the costs associated with building a capital intensive supply chain, in this case the massive natural gas pipelines being built out. In this situation the basic agreement was this: we are going to deliver natural gas to you; that is going to cost us considerable capital. In return you are going to commit to a minimum quantity and agree to pay the contract price for that quantity. If you have a shortfall, meaning that you do not consume the quantity you promised, you will pay for the deficiency or cover the gap you did not meet. The beauty of this vehicle is that the company would frame the primary payment on the minimum amount as debt, not damages. Therefore the pipeline company could enforce this contract as a debt obligation.
This was a massive shift, as purchase volume risk moved to the buyer. Often the buyer in this instance was not a direct consumer but other companies, organizations, states, and large municipal governments that would then provide a service to their consumers. This vehicle allowed the gas pipeline companies to underwrite all of these contracts as cash flow and therefore finance a massive capital program to build out these pipelines. So next time you walk by the side yard at your house and see that gas meter, realize that it was this ToP contract arrangement that made the vast natural gas pipeline network throughout the United States possible.
Of course, when people and companies started getting hit with their deficiency bills, they were confused and upset by the arrangement. There are hundreds of state, federal, and Supreme Court cases where the merits of these contracts were litigated in the 1960s, 1970s, and 1980s. However, the contract language ultimately won out and passed the test. The next industries to take advantage of this were telecommunications, software, wireless communications, and then the cloud infrastructure business. This is no small matter. The United States absolutely dwarfs all other countries in terms of infrastructure buildout, in every category. When you look at natural gas pipelines, the European Union in aggregate comes close, but every other country is nowhere near the level of natural gas distribution we enjoy in the United States. If you want to know why some countries struggle to develop urban centers, it is in part for this reason. Access to low cost energy and communication infrastructure in the United States is perhaps one of our greatest assets, and much of it can be attributed to the creativity behind the ToP contract.
I know we startup founders roll our eyes at all the legal speak, all the contract language, and the $1,000 plus hourly rates that transactional attorneys charge nowadays, but we must pause and realize that contract instruments absolutely matter. Just look at what this did to the natural gas industry in this country. When you walk around and see cell towers all over your city, understand that this all had to be financed somehow. I do not know exactly who was the brainchild behind the Microsoft EA contract structure, but the ability to capitalize on unearned revenue was nothing short of genius. Microsoft was able to take a software suite that was considered just good enough and launch it into hundreds of millions of dollars in annual revenue by 1998. They went from a typical boxed software company to a full annuity style licensing company. In 1999, when Microsoft started reporting organizational licenses on their 10-K as accounts receivable, the software business as we know it changed. Billions of deferred, unearned revenue took Microsoft into the next stratosphere. All of their competitors were shell shocked that this mediocre software company could rise so quickly and get so many enterprise adopters so rapidly. They did not understand; the magic was in the ToP contract.
So here is my simple encouragement to every founder who thinks contracts are dull. Sit with them anyway. Contracts are the bridge between belief and reality. They turn the promise of future value into present fuel. They let you move from good enough to truly great because they give you the right to invest with courage. The gas meters on our homes and the cell towers on our skylines did not arrive by accident. They were pulled into being by clear promises on paper that lenders could trust and that operators could build against.
If your product is not yet complete, do not hide from that truth. Write it into the deal. Define what the customer will receive now, what you will improve, and what each side will commit to so that the final result is worth the price. Put a number to the commitment. Put dates to the milestones. Put teeth in the payment terms. This is not busywork. This is the operating system of your growth. When the world asks if you are serious, your contracts answer with a calm and steady yes.
Make this practical. Block time with your counsel. Draft one standard agreement that matches your model. Add a commit to consume exhibit that is fair to both sides. Spell out what happens if either side falls short and what remedies will put the plan back on track. Create a version for small customers and a version for large customers. Revisit the language after every deal and keep improving it. Each small refinement widens the bridge.
In the early days it will feel slow. Keep going. The habit of thoughtful contracting will sharpen your thinking about value, risk, and sequence. It will align your team, reassure your customers, and unlock capital you cannot reach any other way. Paperwork does not dim your vision. It focuses it. Put your ideas into clauses and schedules and signatures, and watch how the future becomes buildable.
Do the boring work. It is how you earn the right to do the thrilling work. Contracts are not the enemy of innovation. They are the scaffolding that lets it rise.
