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Tech & Sourcing @ Morgan Lewis

TECHNOLOGY, OUTSOURCING, AND COMMERCIAL TRANSACTIONS
NEWS FOR LAWYERS AND SOURCING PROFESSIONALS

There are two primary models by which vendors will make software available to customers (1) software as a service (SaaS); and (2) on premise. In a SaaS model, the vendor provides, maintains, and hosts (either itself or through a hosting SaaS vendor) the desired software, and grants the customer access to the software functionality via the internet. In an on-premise model, however, the vendor will deliver the software (either physically or through a file transfer system) for the customer to install on its servers behind the customer’s firewall.

Before reviewing a software agreement, it is important to understand whether the vendor is providing the software through a SaaS model or an on-premise model (or possibly a combination of both). This will have implications on how the contract is structured and the terms a vendor is willing to provide. Here are a few contract terms that highlight the differences between these two models.

Fees

In a SaaS model, vendors will often charge for the software based on a subscription where fees are charged on a recurring basis, e.g., monthly, quarterly, or annually. Within the subscription model, there are a variety of ways that the fees may be structured, e.g., per-user pricing, flat or tiered pricing, or usage-based pricing. These fees will usually include maintenance and upgrades. In an on-premise model, however, the vendor will typically charge a one-time fee for the software; however, the vendor will often charge a separate recurring fee for any maintenance and upgrades to the software.

License

In a SaaS model, the vendor will typically provide the customer with a limited right to access and use the software only during the term of the agreement. In an on-premise model, however, the vendor may provide the customer with a perpetual license right to use the software beyond the term of the agreement. Importantly, SaaS vendors will typically avoid providing the customer with a “license” to use the software and will state only that the customer has a right to “access and use” the software functionality. SaaS vendors do this to avoid any implication that a customer has the right to install the software (which the customer shouldn’t need because the software is hosted by the vendor) and to potentially avoid the vendor having the obligation to continue providing access to the software in the event of a vendor’s bankruptcy.

Security Requirements

In a SaaS model, the vendor will normally agree to maintain certain security commitment regarding the delivery and the customer’s use of the software functionality throughout the term of the agreement. These security protections will normally extend to the customer’s data that is provided to the vendor through use of the software. In an on-premise model, however, vendors often won’t agree to any security commitments regarding the software because the software is hosted by the customer and installed behind the customer’s firewall. Therefore, the vendor doesn’t have ability to implement and maintain security features with respect to how the software is used by the customer.

Acceptance Testing

In a SaaS model, customers purchase access to the software functionality, which is based on the vendor’s standard specifications for how the vendor will deliver the services to all of its customers. As a result, vendors typically won’t provide customers with an acceptance period to test the services once an agreement is signed. Instead, vendors may offer customers a free trial license during which period the customer should conduct any necessary testing to determine if the customer wants to move forward with the purchase.

Contrasting this with on-premise software, vendors are often willing to provide customers with a limited period (e.g., 30 or 60 days) after the agreement is signed to test how the software functions in the customer’s environment. Unlike in a SaaS model, on-premise typically requires some level of integration into a customer’s infrastructure, which is why vendors are willing to provide a testing and accepting period. If a vendor offers an acceptance testing period, the customer typically does not have to pay for the software until the customer “accepts” the software. If the parties agree to an acceptance period, it would be a good idea to also agree on the type of tests that the customer will perform and what the acceptance criteria will be.

Warranties and Service Level Commitments

In a SaaS model, the vendor will typically represent and warrant that, through the term of the agreement, the software will function in accordance with the documentation describing the particular functionality of the software. Conversely, in an on-premise model, the vendor will typically represent and warrant only that the software will function for a limited time period (e.g., 90 or 180 days) once the software is provided to the customer for installation and is free from defects, such as viruses, bugs, malware, or “time-bombs.”

The reason for the different positions is that in a SaaS model, the vendor hosts the software application and controls the related components for delivery of the software. In an on-premise model, however, the software is installed by the customer behind the customer’s firewall where the customer controls the software and how it is used and operates within its systems.

What is more, in a SaaS model, vendors will frequently provide customers with some type of service level commitment, which is typically an availability commitment. For on-premise software, however, vendors do not have the same type of control over software, and therefore, can’t make the same type of availability commitment. However, where the customer also purchases maintenance services, vendors frequently provide service level commitments regarding response times to address different severity incidents.

Extraterritorial Considerations

For cross-border arrangements and contracts with governing law outside the United States, it is important to note that these two models may have significant differences with respect to tax and legal implications. In Russia for example, SaaS contracts are classified as a services contract, and therefore, are subject to value-added tax (VAT) and terminable by the customer at will. To the contrary, on-premise contracts are usually structured as a software license and may be VAT-exempt.

This post is part of our recurring “Contract Corner” series, which provides analysis of specific contract terms and clauses that may raise particular issues or problems. Check out our previous Contract Corner posts on the Tech & Sourcing @ MorganLewis blog for more on contracts, and be on the lookout for future posts in the series.