Software Financing: The Perplexities of a Program Agreement


Software Financing can take many different forms and software financing issues can arise in the context of many different types of financing transactions. The purpose of this article, however, is to examine in detail one particular structure. Perhaps the most common structure involving the 100 percent financing of software in which software is financed pursuant to a software financing program agreement.

Where the software is expensive (anything over $100,000), the software company may decide to offer financing to its licensee customers as an alternative to paying cash up front, as a means of increasing sales. If the licensee chooses to take advantage of this vendor financing, then it will enter into a financing contract with the software company (or with a captive finance company), usually in the form of an installment payment agreement (IPA) or, alternatively, a master payment agreement with schedules executed in connection with each funding. The software company (or the captive finance company) will then sell the payment stream under the IPA to a bank or leasing company.

One critical point to keep in mind is that the software company and the licensee will usually use the IPA to finance both the upfront license fees and future maintenance and support. In some transactions, 50 percent or more of the amounts financed under the IPA may in fact relate to future maintenance and support services to be provided by the software company.

The lessor and the software company will typically enter into a software financing program agreement setting forth the terms and conditions upon which the lessor will purchase the payment stream generated under the IPAs.

Typical Software Financing Program Structures

Typical software financing includes the following programs and structures:

Nonrecourse Programs

If the software being financed is mission-critical software and the licensees are investment grade credits, then the lessor may be willing to purchase the payment stream under the IPAs on a nonrecourse basis. By "nonrecourse" the lessor means that it will assume the credit risk of the licensee and that there will not be recourse back to the software company for a mere failure to pay on the part of the licensee. Naturally, the financing will still be full recourse to the software company for a breach of any representations, warranties, and covenants set forth in the software financing program agreement.

Therefore, as discussed in more detail below, it is important to understand what sorts of representations, warrants, and covenants should be included in a software financing program agreement, in addition to the provisions that would normally be found in any equipment financing program agreement.

It is also essential from the point of view of the software company that the financing be on a nonrecourse basis, so that the software company can recognize revenue under FASB 125 when the payment stream is sold to the lessor. Significant recourse back to the software company would jeopardize revenue recognition.

Partial Recourse Programs

Even if the software is not mission critical and the licensees are not investment grade credits, it may still be possible for the lessor to provide financing to the software company on a partial recourse basis through a pooling arrangement or some other form of credit enhancement. The idea behind the pooling arrangements is that a small number of high-risk IPAs, in a structure where the first losses under the pool up to a certain fixed percentage would be borne by the software company. The key here is to select the pool carefully and to come up with the right percentage amount of recourse back to the software company.

Other possible forms of credit enhancement include guaranties, a security interest in the software copyrights, other property as collateral, pooling of software IPAs with equipment leases, and, in the case of smaller venture backed companies, warrants to purchase stock.

Full Recourse Programs

Where pooling is not feasible or where revenue recognition is not critical, programs are often structured with full recourse back to the software company. Although full recourse, such programs may still be more attractive to the software company than a full recourse line of credit with a bank, with negative covenants and financial covenants, secured by a blanket lien on the software company's assets.

Critical Legal Issues

Will the Payments Be Treated as "Hell or High Water" Payments?

From the point of view of the lessor, perhaps the most critical legal issue is whether or not the payments owed by the licensee under the IPA will be noncancellable come "hell or high water." A related issue is whether or not a "waiver of defense" provision in the IPA would be upheld by the courts. With the waiver of defense provision in the IPA, the licensee waives as against an assignee any defenses that the licensee may have against the software company. The current provisions of the Uniform Commercial Code do not validate waiver of defense provisions in the context of software financing transactions.

In any event, until these issues are settled by case law or statute, the lessor should insist that the IPA contain well-drafted "hell or high water" and "waiver of defense" provisions, including specific mention that the IPA is noncancellable even in the event that the software does not perform up to specifications, the software license is terminated, the software is upgraded, or the maintenance and support obligations are not performed satisfactorily.

To further strengthen the "hell or high water" nature of the IPA payments, many lessors are willing to purchase only that portion of the IPA payment stream that represents payment for up-front license fees as opposed to payment for future, unperformed services and support.

What Remedies Will the Lessor Have if the Software Does Not Work or the Software Company Fails to Perform Maintenance and Support Services?

Given the concerns over whether or not the payments under the IPA will be treated as "hell or high water" payments, it is understandable that lessors are adamant that the software company be willing to stand behind its product. After all, if the licensee fails to make payments under the IPA (and the licensee is not bankrupt or insolvent), such payment shortfall is most likely to have resulted from a problem with the performance of the software or the rendering of services.

Therefore, the software financing program agreement will often require the software company to repurchase the payment stream under the IPA if the software does not work or if there is a good-faith dispute over the rendering of services.

Critical Terms to Consider

Although the provisions included in a software financing program agreement will vary depending on the circumstances, the lessor should consider the following provisions at a minimum (in addition to normal program agreement provisions).

Representations and Warranties

The software company (or the captive finance company) should represent and warrant that:

  • There are no liens on the IPA, the assigned payments, or the nonassigned payments.
  • The financing contract is an enforceable, noncancellable payment obligation of the licensee for the amounts purported to be owing thereunder.
  • There is a cross-default provision in the license and support agreement that allows an assignee of the IPA to cause the software company to terminate the license and any related support and maintenance.
  • The software has been delivered and accepted by the licensee and any services have been, or will be, accepted by the licensee.
  • The software company owns the software or has the right to license the software to the licensee. (This can be critical if there are third-party software components included in the software that are sublicensed by the software company to the licensee.)

Negative Covenants

The software company (or its captive finance company) should covenant that it will not do any of the following.

  • To the extent that any payments or rights under an IPA are not assigned to the lessor (e.g., future support and maintenance), create or permit to exist any security interest or lien on such nonassigned payments or rights.
  • Permit any early termination of the license as a result of an upgrade except as expressly permitted under the terms of the IPA.

Affirmative Covenants

The software company (or its captive finance company) should covenant to do each of the following.

Take any actions necessary or advisable to perfect the lessor's interests in the assigned payments and the nonassigned payments.
Promptly fulfill and perform all obligations in connection with the IPA and any related maintenance or support agreement.

Remedies

  • Upon a licensee default, the lessor should have the right to terminate the license and to require the software company to terminate the license and any related support and maintenance.
  • If any representation or warranty made by the software company (or its captive finance company) shall prove to be false or misleading when made or if the software company (or its captive finance company) breaches any covenant in the software financing program agreement, the lessor should have the right to cause the software company (or its captive finance company) to repurchase the assigned payments at the lessor's net book value.

Other Provisions

  • The software company, the captive finance company, and each other affiliate that generates IPA should be a party to the software financing program agreement.

Right to Terminate the License and Support

There is one technical issue worth mentioning in connection with software financing vendor programs operating through a captive finance company. If the lessor is counting on being able to cause the software company to terminate maintenance and support for the software, then the lessor should verify that the captive does in fact have the legal right to cause the software company to terminate such maintenance and support.

Unfortunately, some software companies do not make any reference in the license and support agreement to the fact that the software is being financed pursuant to an IPA. On the face of such a license and support agreement, payment would have been due up front and presumably the software company would have received payment. Without a cross-default provision stating that a failure o the licensee to pay under the IPA is a default under the license, there may not be any contractual basis upon which the software company can terminate the license and related maintenance and support!

Subject to the possible perfection issues discussed below, the lessor may still be able to terminate the license as against the licensee. The lessor, however, would not have any legal right to force the software company to cooperate in terminating the license or in terminating support if the license were not drafted properly to include a cross-default to the IPA.

Financing Resellers and Distributors

Another special case to consider is the financing of resellers and distributors. Depending on the circumstances, the reseller or distributor may be either:

  1. an independent contractor or agent of the software company who arranges for the licensee to license the software directly from the software company; or
  2. a licensee and sublicensor of the software.

If the reseller or distributor is a sublicensor, then the lessor who finances the acquisition of the license by the distributor will probably not have any right to terminate the sublicense if the reseller or distributor fails to pay the lessor.

Perfection Issues Under the Uniform Commercial Code

Under the Uniform Commercial Code, the assignment of the payment stream under the IPAs would be classified as a sale of general intangibles. Under the current Uniform Commercial Code, a sale of general intangibles is not a secured transaction under Article 9. Therefore, perfection of the sale of general intangibles will be governed by other state law.

The proposed revisions to Article 9, however, would classify license fees as "accounts" and would thereby bring a sale of license fees by a licensor within the scope of Article 9.

Note, however, that if the software company finances the software with a promissory note instead of an IPA, then the lessor must take possession of the note in order to be perfected.

Perfection in Proceeds of Copyrights

If the payments under the IPA are deemed to be proceeds of copyrights, then the lessor must file pursuant to the federal Copyright Act in order to perfect its security interest. Although the trend in recent cases has been to deem license fees and royalties to be proceeds of copyrights, there is one recent case that may allow lessors to argue that an assignment of license fees should be perfected under state law rather than under the Copyright Act.

Perfection of a Security Interest in the Nonassigned Support and Maintenance Payments

As mentioned earlier, the fees that are financed under an IPA typically include both up-front license fees as well as fees for future maintenance and support to be provided by the software company. Since the lessor often purchases only the portion of the payment stream that relates to the license fees, there is potential for disputes between the lessor and other creditors of the software company (or its captive finance company) if there is a shortfall in the payment made by the licensee. Therefore, the lessor should consider taking a security interest in the nonassigned payments.

Perfection of a Security Interest in the Financed License

One issue that is the subject of much debate is whether or not a party financing a software license should take a security interest in the license itself. In the case of a licensor financing its own software, the prevailing view is that there is no added benefit to the licensor taking a security interest in the nonexclusive license, since:

  • the licensor can terminate the license and any related support if the licensee fails to pay under the IPA; and
  • the licensor (assuming that it owns, or has an exclusive license with respect to, the software) already has the right to license unlimited copies of the software to its customers and therefore has no need for the remarketing rights provided under the UCC.

It is less clear whether or not the financier should take a security interest, however, when it is a captive finance company that is financing the software. This is especially true when the captive immediately assigns all of its rights under the IPA to a third-party lessor. As mentioned earlier, in some cases where a captive is providing the financing, there is no cross-default provision in the license. As a result, if the captive has any right to terminate the license, such right is being granted to it by the licensee and is not derived from the licensor.

One of the unresolved issues in the cases and statutes is whether or not the mere right to terminate the software license should be considered a "security interest." Until this legal issue is resolved, the better view is that if there is no cross-default provision in the license and support agreement and express delegation from the licensor to the captive finance company (and its assignee) of the right to terminate the license, then the lessor would probably be in a stronger position if the captive finance company were to take a security interest in the license and assign such security interest to the lessor.

In any event, even if the lessor has a security interest in the nonexclusive software license, the lessor will not have any rights to remarket the software without the consent of the licensor.

Should Software Financing Documentation Be Entitled to "Chattel Paper" Treatment Under the UCC?

The software financing documentation under the typical software financing program agreement will not constitute "chattel paper" under the current definition in Article 9 because there is no security interest in or lease of "goods." Under the current draft of the proposed revisions to Article 9, this characterization would not change. Therefore, if there is an existing blanket lien or lien on general intangibles of the software company (or its captive finance company), the lessor will need to obtain a consent and release of lien.

Should a Financier of Software Be Entitled to the Benefit of the "Purchase Money Security Interest" Rules Under the UCC?

Even if the lessor takes a security interest in the nonexclusive software license (and obtains the software company's consent to the security interest and obtains remarketing rights), under the current rules in Article 9, the lessor cannot obtain purchase money priority over other creditors of the licensee. This is so because the purchase money security interest definition is limited to "goods." This rule would not change under the proposed revisions to the UCC.

Conclusion

Although there are a number of legal obstacles in the world of software financing, there is a hope and an expectation that many of these legal issues will be resolved in a satisfactory manner in the revisions to the Uniform Commercial Code that are currently being drafted and that could possibly become law within the next two years.

In the meantime, it is incumbent upon the lessor to perform a substantial amount of legal due diligence and to rely upon careful drafting when entering into a software financing program agreement.