Key Takeaways

  • A take-or-pay contract guarantees revenue for the seller and cost certainty for the buyer, even if goods or services are not fully taken.
  • These contracts are most common in industries with high upfront investment, such as energy, natural gas, and manufacturing.
  • They provide financing confidence by assuring lenders of predictable revenue streams.
  • Buyers benefit from supply security and potential pricing advantages but accept significant payment obligations.
  • Well-drafted clauses include terms on minimum purchase volumes, payment schedules, exceptions (like force majeure), and renegotiation mechanisms.
  • Risks include market volatility, regulatory changes, or shifts in demand that make the agreement financially burdensome.

A take-or-pay contract is an agreement between a buyer and seller, in writing, that requires the buyer to pay even if the seller fails to provide the item or service. Typically, the buyer is not obligated to pay the full amount, but the intention is to protect the seller in case the buyer decides to refuse the good or service at the time of delivery.

This is also referred to as the “killing clause.” These agreements are usually signed by companies when their suppliers require them to purchase a certain amount of items by a specific date, and a fine is imposed if they do not. In this type of agreement, the seller is protected from potential loss of money from the production of the item that the buyer was supposed to purchase.

Why Take-or-Pay Is Used

Take-or-pay provisions in a contract are intended to facilitate predictable results from a financial perspective, particularly when debt is involved. If a supplier requires a loan to finance the production of a buyer's order, the lender may be unwilling to offer the funds needed without a take-or-pay provision in the contract. This provision ensures that the supplier will be able to pay the loan as anticipated.

The energy sector makes frequent use of take-or-pay provisions because supplying energy requires a large overhead investment in natural gas, crude oil, or other resources. Without this means of assurance that they will have some return on their investment, they would have no incentive to spend capital up front for production.

Due to the unpredictability of energy markets, where the price may fluctuate due to demand vs. supply, the sellers rely on take-or-pay contracts to ensure their revenue is secure and constant. For suppliers of energy who use pipelines, oil, or natural gas to produce electricity, the huge expenditure of overhead requires some assurance that they will receive income as expected over the long term.

There are three factors that explain the need for take-or-pay clauses in energy supplier contracts:

  • Energy projects require high expenditures of capital.
  • Energy projects take place over long periods, potentially 20 to 30 years, and usually require loans to finance them. Therefore, they need to make sure their investments are recovered, and they can pay the lender for the amount borrowed plus accruing interest.
  • With a take-or-pay provision, the buyer has no choice but to accept delivery of the minimum quantity or pay for the difference between what was agreed upon and what is accepted.

Key Features of a Take-or-Pay Contract

A take-or-pay agreement typically contains several essential elements that define how the buyer’s payment obligation works and how risk is allocated between the parties:

  • Minimum Quantity Obligation: The buyer commits to purchasing or paying for a specified minimum quantity, ensuring predictable revenue for the seller.
  • Payment Obligation Without Delivery: Even if the buyer doesn’t take delivery, they must still pay for the agreed minimum amount. This reduces the seller’s exposure to market risk.
  • Excess Purchase Flexibility: Many contracts allow buyers to purchase additional quantities beyond the minimum at pre-agreed terms, often at favorable prices.
  • Carry-Forward Provisions: Some agreements allow buyers to apply unused purchases to future periods, providing flexibility while maintaining revenue predictability for the seller.
  • Credit Support Requirements: Given the significant payment obligations, buyers may be required to provide credit support such as bank guarantees or letters of credit to secure performance.

This structure not only protects the seller but also helps the buyer secure supply at stable prices and demonstrates creditworthiness when seeking project financing.

Why Long-Term Contracts Are Used

Major projects with returns on investment that take long periods use long-term contracts to assure the lender that payments will be made on a predictable, reliable basis. A long-term contract is typically one with a 20- to 30-year duration.

This is what a take-or-pay long-term contract does for the parties:

  • Protects the seller's stream of revenue.
  • Convinces the bank to approve financing for the project.
  • Facilitates decision-making and planning, particularly with regard to budgets.
  • Minimizes risk to the seller by transferring some of it to the buyer.
  • Assists in mitigating other expenses, some of which are unforeseen and unpredictable.
  • Eliminates competition for the term of the contract.
  • Creates less of an impact on the credit-worthiness of the seller.

Industry Applications and Examples

Take-or-pay agreements are widely used in sectors where suppliers face significant upfront costs or need to ensure steady cash flows over long periods:

  • Energy and Utilities: Natural gas, oil, and electricity projects rely heavily on take-or-pay structures due to high infrastructure costs and long project lifespans. Pipeline operators, for example, often require such agreements before investing in construction.
  • Mining and Commodities: Mining operations frequently use take-or-pay clauses to secure long-term buyers for minerals or metals, ensuring financial viability of the project.
  • Manufacturing and Chemical Supply: Producers of specialized chemicals or materials may use take-or-pay contracts to justify capital-intensive plant investments.
  • Transportation and Logistics: Rail and shipping providers sometimes include take-or-pay clauses in long-term service contracts to guarantee revenue even if customers do not use the capacity reserved.

By locking in revenue streams, these contracts reduce financial risk and can attract lenders or investors, which is vital for capital-intensive industries.

Risks of Take-or-Pay Contracts

Because take-or-pay contracts are long-term agreements, they are vulnerable to unforeseen events that were not covered in the contract. Such external events include political circumstances, commercial developments, geological occurrences, etc. When one of these takes place, the contract may no longer be practical or viable for one or both parties. In this situation, one of the parties may terminate or withdraw from the contract.

However, maintaining the contract often has benefits for both parties, even if an unforeseen event should occur. It's better for both parties to be reasonable and cooperative, maintaining a good reputation within the industry and among the business community. Therefore, most companies, governments, and other entities will allow for renegotiation when external events cause disruption.

Take-or-pay contracts typically include clauses that define under which circumstances they will be renegotiated. These include the following:

  • Force majeure clause, also called “act of God,” which must state a requirement for notice to be given, the types of situations that would constitute force majeure, and the effect of the event on both parties' obligations.
  • Price clause, which protects both parties against unforeseen fluctuations in market prices. This includes the price escalation clause and price reopener clause.
  • Review clause, which subjects a long-term contract to regular renegotiation every few years.

Negotiation Strategies and Best Practices

Because take-or-pay agreements can impose significant obligations, careful negotiation is essential. Parties should consider the following best practices when drafting and reviewing these contracts:

  • Define Clear Minimum Obligations: Specify how the minimum quantity is calculated, and include provisions for measurement and verification.
  • Incorporate Flexibility Clauses: Consider mechanisms like make-up rights, allowing buyers to recover payments by taking additional quantities later.
  • Include Force Majeure and Termination Rights: Clearly outline exceptions for unforeseen events and establish fair exit terms to manage risk.
  • Address Price Adjustments: Use escalation or price review clauses to account for inflation or changes in market conditions.
  • Set Renegotiation Triggers: For very long-term agreements, periodic renegotiation clauses can help ensure the contract remains commercially viable.

Thoughtful drafting ensures that both parties benefit from stability while retaining flexibility to adapt to changing circumstances.

Frequently Asked Questions

  1. What is the main purpose of a take-or-pay contract?
    It guarantees the seller a minimum payment regardless of whether the buyer takes delivery, providing financial security and encouraging investment.
  2. Who benefits most from a take-or-pay agreement?
    Both parties benefit: sellers secure predictable revenue, while buyers gain reliable supply and potential price advantages.
  3. Can a buyer exit a take-or-pay contract early?
    Typically, early termination is difficult and may involve penalties, though force majeure or renegotiation clauses can provide exceptions.
  4. What industries commonly use take-or-pay contracts?
    They are most common in energy, mining, manufacturing, and transportation—sectors with large capital investments and long-term supply needs.
  5. Are take-or-pay payments refundable if the buyer doesn’t take delivery?
    Usually, no. However, some contracts include make-up provisions allowing buyers to apply unused payments to future purchases.

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