When entering into arrangements with clients or engaging vendors, startup companies may be faced with a confusing array of contractual terms, including terms that reference various types of damages. Such terms are worthy of attention due to their potential financial implications. For example, an agreement might include a limitation of liability clause that reads something like this:

IN NO EVENT WILL LICENSOR BE LIABLE UNDER OR IN CONNECTION WITH THIS AGREEMENT OR ITS SUBJECT MATTER UNDER ANY LEGAL OR EQUITABLE THEORY, INCLUDING BREACH OF CONTRACT, TORT (INCLUDING NEGLIGENCE), STRICT LIABILITY, AND OTHERWISE, FOR ANY…CONSEQUENTIAL, INCIDENTAL, INDIRECT, EXEMPLARY, SPECIAL, OR PUNITIVE DAMAGES …

You may understand that this provision purports to eliminate the software vendor’s (licensor’s) liability for these types of damages if there is a problem with the product in question. But what, for example, are consequential damages? Obtaining an attorney’s advice when signing contracts is advisable—particularly when they contain terms such as these. However, having a very basic understanding of these types of damages concepts is also helpful.

Following is a very general, limited overview of damages concepts. Keep in mind that the meaning of these terms and the applicable categories can vary from jurisdiction to jurisdiction and based on the type of contract in question (e.g., a services contract versus a contract involving commercial goods, such as software).

Measures of Damages

There are a variety of theories and approaches to measuring damages used by courts in different contexts. The most common approach in situations involving the breach of a contract is to attempt to define the aggrieved party’s “expectation interest” and put them in the same position they would have been in had the contract not been breached.

For example, Startup Company signs a contract with Slipshod Software, under which it pays Slipshod $100,000 for a software license. However, the software does not function. As a result, Startup Company incurs $10,000 in personnel costs finding and vetting alternative software with comparable features for its business, which it licenses for the best available price of $115,000. Due to the delay in securing the software, which Startup Company needed for its business, Startup Company loses two clients, which would have yielded $50,000 in profit.

Startup Company/Slipshod Example

$100,000 licensing cost for nonfunctioning software
$10,000 additional expense in personnel costs
$15,000 above $100,000 for licensing new functioning software
$50,000 profit loss from clients who leave

= $175,000 expectation damages

Startup Company can argue that its expectation damages total $175,000, including the $100,000 it had paid Slipshod Software, the $10,000 in personnel costs in finding comparable alternative software, the extra $15,000 for the alternative software, and the $50,000 in lost profits.  Awarding these expectation damages approximates the position Startup Company would have been in if Slipshod Software’s product had functioned properly.

Direct Damages 

In the previous example, Startup Company can argue that it suffered $115,000 in direct damages (the $100,000 original licensing fee and the extra $15,000 it had to spend to obtain comparable alternative software). Direct damages, also called “general damages” in some contexts, are damages that naturally result from a breach of contract (i.e., the damages any party would usually incur in this situation). Here, any company that requires this type of software for its business would need to recoup its licensing fee from Slipshod Software and would need to obtain comparable alternative software at the best available price.

Indirect Damages

On the other hand, Startup Company’s other damages—personnel costs and lost profits—depend on other intervening factors that may not be typical or usual for other companies in this situation. Different companies’ exact personnel costs and lost profits may vary based upon a variety of factors. So, these damages are considered indirect damages, which are also referred to as “special” damages in some contexts. These particular indirect damages fall into two categories: incidental damages and consequential damages.

Incidental Damages

Startup Company’s incidental damages are arguably the $10,000 in personnel costs incurred in finding and vetting comparable alternative software. These are the damages (such as costs) that a company incurs to avoid other losses that would otherwise result from the breach of contract. Here, for example, Startup Company might have lost more than the two clients, and therefore incurred much greater lost profits if it had not invested personnel time in finding other software. These damages are not the direct and natural consequence of the breach because they depend on Startup Company’s particular personnel situation (what it pays its own personnel based upon experience, credentials, location, etc.).

Consequential Damages

Startup Company’s consequential damages are arguably the $50,000 in lost profits. Distinguishing between consequential damages and other types of damages can be challenging, and lost profits do not fall within the consequential damages category in every situation. However, consequential damages (i) do not fall into the direct or incidental damages categories and (ii) are not the damages that would naturally flow from a breach because they depend on Startup Company’s circumstances or the nature of the particular breach. Here, the $50,000 in lost profits arguably do not fall within the incidental damages category, and the lost profits resulted from Startup Company’s particular client service situation (e.g., it lost two clients, but another similar company may have lost more or fewer clients).

Punitive Damages

Although not necessarily present in the hypothetical above, punitive damages (also sometimes referred to as “exemplary” damages) are worth mentioning. Unlike the categories above, which are designed to compensate the aggrieved party, punitive damages are awarded to the aggrieved party in order to punish egregious conduct on the part of the breaching party. Although some courts may award punitive damages, such awards are rare. Furthermore, the special factors that must be present for such an award, and the possibility of seeking such an award, will vary from jurisdiction to jurisdiction.

Bottom-line

You should now have a better understanding of what the limitation of liability clause cited above means. If the clause was present in Startup Company’s contract with Slipshod Software, and assuming for purposes of discussion that the clause would be enforceable, it would eliminate Slipshod Software’s liability for the incidental and consequential damages discussed above, as well as for punitive damages (which would be difficult to obtain anyway) – meaning Slipshod is not liable for those types of damages. That would obviously be a problem for Startup Company, and Startup Company needs to understand the risks associated with agreeing to this type of clause on the front end. On the other hand, the clause arguably would not limit Startup Company’s ability to recover the direct damages discussed above, unless there is other language in the contract limiting the ability to recover direct damages.