PROTECT YOURSELF AND YOUR COMPANY: HOW TO MINIMIZE PERSONAL LIABILITY OF EXECUTIVE DIRECTORS IN B2B CONTRACTS

Concluding business contracts in a B2B environment is part of every managing director's routine. However, few people realize when signing a contract that a single unfavorably drafted contract can cause significant financial losses to the company – and in extreme cases even affect the personal assets of the managing director. The Czech legal system stipulates that a company executive is liable with their private assets for the company's debts if the debts arose from a breach of their duty to act with due diligence and the company does not have the assets to pay them. One of the most common situations where damages may be claimed directly from the executive is precisely the conclusion of an unfavorable contract. In other words, a poorly handled contract can jeopardize not only the company's finances, but also your personal liability.

An unpleasant scenario is when a company invests in fulfilling a contract (materials, labor, time) and the customer ultimately does not take delivery of the goods or services or does not pay. Such an unpaid invoice can jeopardize the cash flow of even well-established companies—even a single unpaid invoice can get you into financial trouble or even drive you into insolvency. As a managing director, you must not underestimate this possibility. The key is to prevent risks at the stage of negotiating the terms of the contract. Below are some practical examples from the construction, IT, and manufacturing industries where incorrect contract terms led to problems. We will also show you what a contract should look like – in particular, the role that advance payments, contractual penalties, and severance pay play in protecting your company.

Author of the article: ARROWS  (JUDr. Kateřina Müllerová, office@arws.cz, +420 245 007 740)

When prevention is lacking: Three stories from practice

First, let's look at real or model situations from various industries. We will see how the absence of preventive measures in a contract can lead to unenforceable claims, losses, and even jeopardize the company. These examples highlight why thorough contract drafting is so important.

Case from the construction industry: An order without a deposit and a “disappeared” customer

The owner of a small construction company accepted an order to repair a warehouse for a new business partner. He completed the work properly and issued an invoice for CZK 300,000. However, the payment did not arrive after the due date. The customer made excuses and asked for a postponement, after which he stopped communicating altogether. The contractor eventually discovered that the customer's registered office was empty and that the original owner had quickly sold the company to a front man. In other words, the construction company did the work but did not receive a single cent. There were no guarantees whatsoever – no advance payment was agreed in advance, the contract did not include effective penalties for non-payment, and the managing director did not even check the reliability of the new customer. The result? The construction company had to laboriously collect the debt, the chances of success were very low, and a considerable loss was incurred. The managing director found himself in an unpleasant situation where the company's cash flow could easily have turned into insolvency – and thus the risk of personal liability.

Lesson learned: In this case, properly set payment terms would probably have revealed or mitigated the problem. An advance payment before the start of work would have deterred an unserious client or at least covered the cost of materials. A contractual penalty for late payment or clearly agreed interest on late payments would have created pressure to pay. Last but not least, a basic check of the business partner in the registers could have revealed warning signs in advance. However, none of this happened – and the company and its managing director suffered the consequences.

IT case: Software development without clear boundaries

Similar mistakes happen in the IT sector. Imagine a small company developing custom software (e.g., a web application) for a larger client. Excited about the new order, they start work without requesting a deposit. The contract is vague and does not specify in detail when the work is considered complete. The project drags on; the client repeatedly comes up with further changes and refuses to pay the final invoice until “everything is as expected.” The company has put in hundreds of hours of work and has actually delivered a functional product, but due to the vaguely defined end of the project, payment is still being postponed. Such a scenario actually occurred with one designer whose clients kept returning the project with comments and refused to pay the rest, even though the website was already up and running. The lack of a deposit and ambiguous terms of completion meant that the contractor was not paid on time (or at all) for a significant part of the work. For a small IT company, this means a threat to employee salaries and its own obligations. In addition, the managing director of such a company faces the question of whether he neglected his duty to protect the interests of the company—if damage resulted, he could be held liable.

Lesson learned: A precise contract for work in IT could have prevented this situation. On the one hand, an advance payment (e.g., 30–50% of the price in advance) would ensure that the company does not take the risk entirely “at its own expense.” Furthermore, a clear definition of the term “completion of the project” in the contract would prevent endless revisions – the contractor could demand additional payment after meeting the defined milestones. A contractual penaltyfor unjustified delays or non-cooperation on the part of the client (e.g., the client repeatedly expanding the scope of the order beyond the agreement) would also help. Finally, the supplier could agree to hand over the final output (source codes, access) only after full payment – this would give them leverage to motivate the client to pay. Properly set boundaries therefore protect the IT company from non-payers and keep the project within the scope agreed by the parties.

 

Case study: Uncollected goods and loss for the supplier

In the third story from the field of manufacturing, let's look at the supplier-customer relationship. An engineering company entered into a contract with a customer to supply several hundred pieces of a specialized component. Production was custom-made – the supplier had to purchase materials and reserve capacity. However, the contract did not require any advance payment or any contractual penalty or compensation. When the goods were manufactured, the customer unilaterally withdrew from the contract (simply “changed its mind”) and did not take delivery or pay forthe agreed quantity. The supplier was left with expensive products in stock that had been designed for a specific customer and were difficult to sell to anyone else. The company thus suffered not only direct costs but also lost profits that it would have earned from the order. The Czech Supreme Court has dealt with a similar dispute in the past, where the buyer failed to take delivery of the agreed quantity of products and the supplier suffered damage (lost profit) of approximately CZK 1.7 million. Due to the undelivered goods, the manufacturing company could have found itself in secondary insolvency – it owed its suppliers for materials but did not receive payment from the customer. The managing director thus dealt with a crisis situation and exposed himself to the risk that the partners or creditors would claim damages directly from him for underestimating the contractual guarantees.

Lesson: This fiasco could have been avoided with appropriately set terms and conditions. An advance invoice before the start of production would have covered the cost of materials and verified the seriousness of the customer. The contract could have stipulated that the customer could not cancel the order without consequences – either not at all (only in the event of a fundamental breach of contract by the supplier) or only at the cost of a severance payment (agreed lump sum compensation) to the supplier. For example, the parties could agree that in the event of cancellation of the order, the customer would pay compensation amounting to, say, 30% of the order price. This would compensate the supplier for costs and, in part, for lost profits. Furthermore, a contractual penalty for delay in taking delivery of the goods would motivate the customer to take delivery of the products on time or at least pay storage fees. Last but not least, the supplier could reserve ownership of the goods until full payment or reserve the right to sell the goods to another customer if the original customer fails to take delivery within the deadline (always applicable to the specific case and circumstances). These safeguards would significantly reduce the risk of goods remaining unpaid in storage.

How to protect yourself from defaulters: key tools in contracts

The above examples reveal a common denominator – underestimating prevention when negotiating a contract. The good news is that there are a number of tools available to minimize the risk of non-payment or non-acceptance. As a manager, you should insist on incorporating these protective elements into every major contract. Let's look at the three most important ones: advance payments, contractual penalties, and severance pay. When used correctly, they will help motivate your business partner to perform properly and ensure that you don't lose out if a problem arises.

Advance payments – the first line of defense

Advance payment is one of the simplest and most effective measures to prevent unpaid invoices. It is a payment of part of the price in advance, before the goods are delivered or work begins. Advance payments significantly minimize the risk of non-payment and protect the supplier's financial stability. For the customer, the advance payment represents a commitment – they have “skin in the game” and fewer reasons to back out of the contract. For you as a supplier, the advance payment means better cash flow (you don't have to finance everything from your own resources) and cost coverage if the deal falls through.

How to set up advance payments: The amount of the advance payment should correspond to the nature of the order. It is common to agree on 20-50% of the contract price in advance, or even more for riskier deals. For longer projects, multiple partial payments can be agreed (e.g., 30% before commencement, 40% halfway through, and 30% upon completion). It is also important to clearly define milestones upon completion of which further payment will be required. For example: “A 40% advance payment upon signing the contract, another 30% upon delivery of a functional beta version, and the remainder upon final delivery of the work.” Such an arrangement protects both parties—the supplier receives payment on an ongoing basis and the customer can see the progress and quality of the work. Don't forget to include a provision in the contract stating that ownership of the goods or outputs passes to the customer only after payment of the full price. Similarly, you can agree that the final results (e.g., source codes, project documentation, tangible products) will be handed over only after the last invoice has been paid. This will increase the customer's motivation to meet their obligations on time.

Contractual penalty – motivation to fulfill obligations

A contractual penalty is a proven tool for getting a business partner to comply with their contractual obligations. It is a penalty payment that becomes payable if the other party fails to fulfill a specific obligation properly or on time. A contractual penalty is one of the most effective ways to motivate a debtor to fulfill their obligations. Its very existence has a psychological effect – a partner will think twice about breaching the contract if they know they will have to pay a penalty. Moreover, if a breach occurs, the creditor (the injured party) can effectively enforce the penalty through the courts, as it is a contractually agreed claim.

How to use a penalty: A contractual penalty can be agreed for various types of breaches depending on the nature of the transaction. Typically, a penalty is specified for delay – e.g., for each day of delay in paying an invoice, completing work, delivering goods, or, conversely, accepting delivery. Another option is a penalty for breach of a prohibition (e.g., a contractual penalty if the customer copies software or passes on know-how to a third party, etc.). It is important to set the penalty appropriately – it should not be ruinous, but at the same time high enough to have a deterrent effect. In the case of monetary performance, a penalty is often agreed as a percentage of the amount due or a fixed amount for each day/month of delay. For non-monetary obligations (e.g., failure to meet quality standards, breach of exclusivity), this may be a one-time amount. Example: A contract for work may stipulate that for each week of delay in the customer's acceptance of the work, the contractor is entitled to a contractual penalty, say 0.5% of the price of the work. Or that for each breach of confidentiality, the party shall pay a penalty of CZK 100,000. The contractual penalty should be agreed in writing in the contract and precisely define the situation and amount in which the claim arises. Remember that payment of the contractual penalty does not affect the right to compensation – if the damage exceeds the penalty, you can claim it in excess (unless you agree that the contractual penalty is a lump-sum compensation). A properly set contractual penalty therefore serves as insurance and leverage: your partner knows what to expect if they fail to comply with the contract, and you have an easier path to compensation.

Severance pay (cancellation) – insurance in case of order cancellation

Another useful institution is severance pay. This should not be confused with severance pay in employment contracts – here it is a contractual provision in a commercial contract that allows one or both parties to withdraw from the contract for a predetermined financial compensation. The purpose of the severance pay clause is to give the contracting party the option to unilaterally terminate the contract by paying the agreed amount. This amount effectively acts as lump-sum compensation for non-performance of the contract. Severance pay is useful in situations where the transaction requires investments that would be lost if canceled – thanks to severance pay, the other party can be sure that if the partner withdraws, they will not be left empty-handed.

When and how to agree on severance pay: Severance pay is typically used in custom orders, long-term projects, or generally where you want to allow withdrawal from the contract without breach, but not for free. You can agree in the contract that, for example, the customer has the right to withdraw from the contract at any time, but will pay the supplier compensation amounting to X% of the total price (or a fixed amount). Such a provision motivates the customer to reconsider canceling the order, as it would have financial consequences. At the same time, if they really have to withdraw (due to a change in conditions, budget, etc.), the supplier will receive compensation for their time, capacity, and lost profits. Compensation can also be agreed upon by the other party—for example, the supplier may have the right to withdraw if they discover serious problems (and provide compensation to the customer). In practice, however, it is more commonly used to protect the supplier who invests resources in the performance.

Example: A manufacturing company stipulates in the contract that if the customer cancels the order after production has been confirmed, they will pay compensation of, for example, 25% of the order price. This 25% covers the costs of production already in progress and also partially compensates for the margin lost by the company. It is important to agree on the compensation clearly in writing in the contract, including the amount or method of calculation. If the contract is terminated, it expires upon payment of the compensation and the parties settle only what has been fulfilled up to that point. For the sake of completeness, severance pay applies without the need for a breach of contract. It is not intended to replace a contractual penalty, but rather to extend the options for terminating the commitment out of court under predetermined conditions. For you, it is a safety net: if the deal falls through, you are not left completely without compensation.

Prevention and legal consultation pay off

As executives of B2B companies, you bear a great responsibility—for the success of your business, for the company's finances, and for its obligations. Well-drafted contracts are your first line of defense. Investing time and attention in contractual terms and conditions pays off incomparably more than dealing with damages and litigation later on. Be proactive: pay attention to risk prevention when negotiating a contract.

Let's summarize the most important steps you should take before signing any significant contract:

• Check the creditworthiness and reputation of your partner: Find out as much as you can about the other party – there are debtor registers, references from other suppliers, financial statements, etc. Even a small warning sign is a reason to be cautious.
• Set clear payment terms: Agree on advance payments and a payment schedule. Never start working on a large contract without at least a partial payment in advance.
• Include contractual penalties and interest on late payments: Give the contract some teeth. Your partner will respect the contract much more if they know that any delay or breach will have financial consequences.
• Cover the possibility of contract cancellation: If the other party wants to withdraw, have an agreed severance payment or cancellation fee that will cover your costs.
• Thoroughly document and define performance: Describe the subject matter, quality, deadlines, and method of delivery in the contract. Insist on a handover protocol or acceptance test so that you can prove that you have fulfilled your obligations.

By following the above principles, you not only minimize the risk of your company losing out, but you also protect yourself as a manager. You avoid situations where someone could say that you have neglected your duty of care. You build your company's credibility with your partners and your own confidence that you have things under control.

Don't leave protection to chance. Consult a lawyer or contract expert before signing any contracts. A professional will help you identify weaknesses in the contract and suggest amendments tailored to your industry. Such an investment is a fraction of the amount you could lose on a poorly handled contract. Build a culture of prevention – with the right contractual terms in place, you can embark on even large deals with peace of mind, knowing that you have done everything possible to protect your company and your assets. A good manager thinks several steps ahead – and that's exactly what you do when you don't underestimate contractual risks.