Software Development Contract: Types and Main Points to Include

What is a software development contract?

According to Statista, the global outsourcing market amounted to USD 92.5 billion in 2019. Meanwhile, a recent study shows that the average share of IT budgets spent on outsourcing increased from 11.9% in 2017 to 12.7% in 2019.

Outsourcing services are becoming popular, especially for software development, as outsourcing is an effective and efficient way to minimize costs and work with a global talent pool without hiring in-house developers.

However, companies looking to outsource software development will need to exercise due diligence in the vendor selection process.

Some projects have clear requirements. Developers just need to track the development process as efficiently as possible. Others are controlled by clients. Thus, the project schedule and detailed content will help you identify the main project requirements. This also allows all parties to better build an overall plan and diagram.

Why is a software development agreement important?

By signing a software development contract, you can protect your business from some setbacks. If you don’t do it right, you may be wasting time in litigation. But don’t worry. A contract is your best defense against inevitable conflicts on issues such as:

• Intellectual property rights. Who stores the software and code?
• Stages of work. How do you determine how much work needs to be done at each stage of the project?
• Payment. What kind of payment terms are acceptable to both parties?
• Copyrighted material. Who owns the copyrighted material used in software development?
• Characteristics. This is one of the most important parts of the contract. Well-written specifications define exactly what the finished product will be like.

Types of software development outsourcing contracts

In the world of IT outsourcing, the type of contract is highly dependent on the client’s business goals. Typically, companies choose an outsourcing partnership either to expand their software development capabilities, to create a software product, or to provide a business solution.

The types of outsourced software development contracts are based on three main collaboration models: dedicated development team, time and materials, and fixed price. Any of these models can be used to achieve a variety of business goals. However, in certain situations, some are more effective than others.

Fixed price

Fixed-price contracts are best suited for small to midsize projects with well-defined requirements. Usually, the client needs to develop a solution and has a certain budget but does not have sufficient experience and opportunities for this within the company. Thus, the client trusts a vendor with the success of the project. In return, the vendor guarantees to meet the buyer’s expectations.

In fact, this is the least flexible model, since any deviation from the plan requires a complex change request approval process.

With a fixed-price contract, both parties must agree from the outset on the detailed project scope, requirements, budget, and timeline. In addition, this is a rather expensive model of cooperation, since the vendor assumes all risks and bears full responsibility for the project’s success. Since most businesses today prefer an agile methodology, this type of contract is rarely used.

Dedicated development team

In contrast to fixed price, the dedicated development team model is a viable solution for long-term projects with changing requirements where a client needs to develop a product or expand their software development capabilities. The client gets a team of software development professionals fully focused on the project, works closely with them to define the project roadmap, either participates in managing the team or delegates management to the vendor, and has full control over the software product.

This model is flexible and fully adaptable to any changes. What’s more, it leads to the most consistent results when it comes to outsourcing software development.

Time and materials

By signing a time and materials contract, you agree to pay for the time your partner spends on your project: the number of hours multiplied by the hourly rate.

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However, there are some points to consider when signing a contract for time and materials. The very nature of this approach suggests you agree to pay more if the project takes longer than expected. Of course, you can control the development progress, especially when your vendor is using an Agile methodology. With Agile development, you’ll receive a demo of completed features every two weeks and will be able to estimate the time remaining reasonably well.

This approach to deadlines and materials ensures that the supplier is in no rush to complete the project, thereby maintaining high quality. It’s also easier to enter into a temporary time and materials contract, as it requires less upfront preparation and planning. However, be prepared to make changes as you go.

The time and materials model is often used when a client needs a temporary expert on a project. Let’s say you need an experienced UX designer, DevOps engineer, or solution architect. There’s usually no point in adding these talents to a dedicated development team on an ongoing basis because you’ll incur unnecessary costs.

It’s more efficient to hire part-time specialists and pay only for the work done at an hourly rate. This ensures cost-effectiveness, transparency, and timely completion of tasks.

Key points of a standard software development contract

Now that you know the possible types of contracts, you should already have an idea of which will work best for you and your supplier. Let’s get down to the contract and see what software engineering-related points you should include.

Services to be provided

A contract should describe the development services you expect from your partner. Typically, this section of a contract refers to a specification that is an integral part of the contract. The specification should clearly indicate the scope of the project to be implemented. Try to make the specification as detailed as possible so you don’t get into fights with your partner.

In the services section you should also describe the procedure for amending the scope of work. It’s recommended to indicate that any changes proposed by either party should be made in writing. We recommend you include a statement that any change request must contain the following:

• Description of the change
• The effect that the change has on the project’s cost and time frame

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Acceptance testing

Indicate if acceptance tests will be conducted on your side or on the supplier’s side. Acceptance testing is usually done at the end of each development phase, so this section of the contract may also link to a detailed project plan.
In the context of acceptance testing, the contract should specify:

• Who conducts testing
• How long the testing will take
• How the test results will be reported (the best way is to notify the other party of test results in writing)

Payment terms

One of the common problems associated with IT outsourcing contracts has to do with costs. Both parties must clearly understand how, when, and where billing takes place. To avoid ambiguity in your contract, set strict invoicing and payment deadlines. There are many options available depending on the type of contract.

Sometimes, vendors may require customers to make a prepayment before starting work. The buyer and seller should be on the same page about this in advance. Nobody wants a missed payment due to a communication failure.

Clients should also be aware of the consequences of missed payments, which should be specified in the contract. A vendor generally reserves the right to terminate all services to the customer and disband the IT team if payment is delayed for more than a specified period of time. So pay attention to this period when signing the contract.

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Liability and warranties

In IT outsourcing contracts, liability clauses are the most important, as they clearly define the limits of liability for both parties. When concluding an IT outsourcing agreement, it’s important to pay attention to the liability limits. The upper limit of liability helps balance the risk between the parties, mutually limiting their liability to each other to a certain amount.

The liability amount can be a fixed amount or a percentage of the commission. In fact, limitation of liability is a useful risk management tool that helps businesses control their maximum potential financial risks. In addition, IT outsourcing contracts often include warranty clauses whereby the vendor guarantees that a certain piece of software or hardware is of a certain level of quality and reliability.

Please note that warranty clauses are usually only included in lump sum contracts where the supplier assumes responsibility for the overall success of the project and ensures that the project is delivered to quality expectations. For time and materials contracts with a dedicated development team, the supplier’s team is only responsible for the timely completion of tasks in accordance with the requirements set by the client.

Notice periods

The notice period is the period of time the client provides the supplier to change the team’s composition. The length of the notification period is important, as it affects the smooth execution and delivery of the project. The contract should include a reasonable notice period for the supplier to ensure easy implementation and handover of the project.

One type of notification is related to increasing or decreasing the number of third-party developers. It’s important for fast-growing companies to be able to scale up and downsize a team in the shortest possible time. Depending on the technology stack and local tech talent market, the length of the notice period for a team expansion or layoff with one IT professional can be anywhere from one to three months.

Another type of notice concerns the termination of the contract. Notifying the customer in advance of team disbandment is important for suppliers to manage a seamless transfer of knowledge. The knowledge transfer process requires a phased approach and can last from one to five months, depending on the size of the project.

As practice shows, the stronger your partnership with the supplier, the longer the notice period for team disbandment should be. For contract terms of three to seven years, the notice period is usually six to twelve months.

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Confidentiality and data protection

The vendor must set high standards for data protection and security across the organization. First of all, IT outsourcing companies should conduct periodic internal audits of their compliance with security measures and policies. They should also implement an information security management system that complies with international standards, laws, and regulations.

For example, if a company is ISO / IEC 27001 certified, it means that it implements a wide range of administrative and technical controls to ensure the confidentiality, integrity, and availability of information assets. Another standard, PCI DSS, is required to process credit card data.

HIPAA compliance is required when dealing with protected health information in the US.

To ensure data protection and GDPR compliance, a vendor should consider de-identifying, re-identifying, and anonymizing data in big data sets. Suppliers must protect data from loss, destruction, tampering, and unauthorized access in accordance with legal, regulatory, contractual, and business requirements.

Vendors should provide secure login procedures, password management, cryptographic key management, network security, and information asset management. And whose employees must sign a nondisclosure agreement that prohibits the exchange of confidential business information with people who do not have access to it. In addition, salespeople must ensure the security of the office to keep unauthorized visitors out.

Intellectual property rights

When it comes to outsourcing software development, clients often express concerns about ownership of the source code. To prevent any unforeseen intellectual property issues, a contract should explicitly provide for the client’s ownership of any intellectual property created during contract execution.

Note that in the event of a delay in payment or when there’s good reason to believe that the client will not make further payments, suppliers generally reserve the right to reuse any intellectual property that remains unpaid. However, when all invoices have been paid in full by the client, the supplier must waive this re-use right and the client will have all rights, ownership, and interests with respect to the project’s results.

Under such circumstances, reusing intellectual property can give rise to IP lawsuits which often start by receiving a cease and desist letter from the client. If you have received one already, you may want to talk to an IP lawyer to help you understand what to do managing a cease and desist letter and how to avoid costly mistakes.

Non-solicitation clause

People are the most valuable resource for software outsourcing companies, which is why vendors usually impose high penalties for poaching employees.

A bid rejection penalty is a fee a client pays to a supplier if they hire a supplier’s employees or if those employees are hired by a third party (another supplier). Outsourcing providers spend a lot of money on hiring, training, and managing their employees. Therefore, they should receive fair compensation if employees are poached.

However, if a client wants to bring outsourcing specialists in-house and continue working with them on other projects without the help of the supplier, both parties can agree on terms under which the supplier permits direct collaboration between the client and the supplier’s employees. All this should be clearly stated in the contract. So don’t overlook this point when contracting with a software development outsourcing service provider.

Jurisdiction

The software development outsourcing market has become global. IT outsourcing contracts are often international, with the client and supplier located in different countries. Thus, one of the cornerstones of your contract with an IT outsourcing provider is their jurisdiction.

It’s extremely important for parties to agree on what laws will regulate the contract as well as what the dispute resolution process will look like if necessary.

Parties can go to local courts or opt for international arbitration in countries that provide neutral forums for resolving disputes.

Final thoughts

We hope we were able to help you better understand what to think about when preparing a contract with your supplier, and now you should know how to successfully outsource IT development. At the same time, we recommend you further consult with a lawyer about these matters. While the type of contract, scope of the project, testing rights, and intellectual property rights can be negotiated between you and your supplier, a lawyer will be able to verify the legal aspects of a contract.

You can use one of the many software development contract templates on the internet to draft a simple software development agreement. However, always read the template and modify it to fit your needs. Again, ask a lawyer to take a look at it to make sure it doesn’t contain hidden terms that are not relevant to you.

If you’re interested in signing a win-win software development contract but don’t know where to start, contact Mobindustry for a free consultation.