Businesses entering into development or licensing agreements for business-critical software must face the issue of what happens if one party becomes insolvent or unable to fulfill its contract obligations at some point during the period of performance. Especially for the party that has engaged the services of an outside software developer or vendor, the cost of the other party’s insolvency, absent adequate protections, can be significant: having spent what may have been a substantial amount of money in fees or expenses to license a product or to move a development project toward completion, it may find itself left with an unusable or unavailable product, questionable rights to use what it does have going forward, and no-one to sue to recover any of its losses. For these reasons, it often makes sense to incorporate a source code escrow agreement into the terms of the parties’ contract.

Under a source code escrow agreement, the developer or vendor agrees to deposit into the custody of a neutral, third-party escrow agent a copy of the current source code for the product that is at issue in the relationship and, at defined intervals, to update the deposit with the then-current version of the code, assuming changes have been made following the date of the original or previous deposit. Then, going forward, the escrow agent is under instructions to maintain, for a reasonable fee, the security, confidentiality and integrity of the source code until the term of its agreement with the parties ends or until it receives notice of the occurrence of an event giving the non-depositing party the right to obtain the source code. This sort of arrangement serves to give the business contracting with the developer or vendor peace-of-mind that its past investments in the software will not have been wasted and that it will have the tools its needs to continue to serve its customers without a significant lag or gap in delivery.

However, there are a number of potential pitfalls of which businesses must remain aware in order for source code escrow to provide meaningful protections. First and foremost, it is vital that the parties to a transaction actually agree on, draft and sign the escrow agreement with the escrow agent. It is not at all uncommon even for otherwise knowledgeable businesses who know to seek third-party escrow services to forget to secure a signed, enforceable escrow agreement. It is too easy for the escrow agreement to be pushed aside in the rush of activity that can follow the execution of a substantive development or licensing deal. However, the absence of that signed agreement likely means that the purchasing party is left with no recourse in the event of what otherwise would have been a release event under escrow. If at all possible, businesses should include the agreed escrow contract as an exhibit to their agreement in order to increase the likelihood that it will be remembered at closing.

In addition to execution, the terms of the escrow agreement also can present potential traps for the unwary on both sides of the transaction. It is especially important that the escrow agreement carefully defines what does and does not constitute a release event and that it provides a transparent process for providing notice of release events to the agent, any response or objection to such notices, and the agreed dispute resolution procedures. In addition, it is critical that the purchaser’s rights to use the source code following release be clearly stated, either with ownership rights vesting in the purchaser or (more commonly) with the purchaser obtaining a license to use and/or modify the source code to meet its needs and to allow it to obtain its value from the transaction.

A business contemplating a significant software development or licensing transaction should thoroughly explore source code escrow and other protective measures with counsel before proceeding with the deal.