How to Be a Lawyer. Jason Mendelson
however, have some form of dispute where one party calls the other party to complain. This is way short of filing a lawsuit. In areas such as mergers and acquisitions, however, the dispute percentage is 25% to 35% according to SRS/Acquiom, the leading merger and acquisition platform that coincidentally was co-founded by Jason.
What we have seen is the following: almost never are the disputes around mutual assent, expressed by a valid offer and acceptance; adequate consideration; capacity; and legality. Let's face it: the bar is pretty low to create a binding contract. Disputes aren't about if there is a contract, but rather what does the contract mean. Who is right and who is wrong about the interpretation of a valid contract? What should be taught in law school is how to better construct and draft contracts to minimize disputes. This isn't about advanced drafting, either, because most experienced lawyers can use English as a weapon to twist meanings. We're talking about knowing the key concepts. Keep these four things in mind right out of the gate and you will be automatically way ahead of other lawyers:
Constraining behavior and the alignment of incentives.Transaction costs.Agency costs and information asymmetry.Reputation constraints.
As we dive into these in detail, we borrow heavily from Jason's other book Venture Deals: How to Be Smarter Than Your Lawyer and Venture Capitalist, Fourth Edition (Wiley).
Constraining Behavior and Aligning Incentives
Any good contractual relationship strives to be a win-win situation for both parties, where each party is incentivized to act in each other's best interests. Many things can drive this. It could be that the business relationship is so important to both parties, so everyone will be a good actor. There can be reputational constraints involved. However, neither of these have any legal teeth to make sure everyone behaves. Consequently, contracts were developed to make sure that if something went awry, that good behavior, to some extent, would be enforceable. Think of it this way. The contract is the backstop if folks can't play nice.
While it's nice to think that people are generous of spirit, it's a fact of life that most people, especially in a business context, are driven by self-interest. That's not a bad thing, but it's useful to always keep this in mind. The first thing to think about is, how aligned are people's motivations at the beginning of the relationship? The more alignment, then the smoother the relationship should be. The less there is, then proper contract drafting is even more important. So, if you are wondering “how much lawyering” you should put into a contract, consider this: Is this a “win-win” relationship (like a joint business venture) or is this a “winner take all” relationship (like a settlement agreement)?
We encourage you to deal with misalignments like this openly and directly. Ultimately, if you can't reach an agreement on how to address them, the situation will be bounded by the contractual terms that you have agreed to beforehand. Because of this, it is critical to think about how contracts constrain bad behavior and align incentives. Whenever you are trying to figure out if a particular term is good or bad for you, consider how this will either proactively or negatively decrease the ability for people to behave poorly, or whether the term improves the alignment of your incentives with your counterparty.
If something feels out of whack and you think a particular provision divides the sides' incentives, be careful about accepting it. It's in this vein that you have a very powerful negotiating tool. You don't have to say, “I don't want this term.” Instead, try the approach of, “Wait a minute, this term starts the relationship by dividing us and resulting in our incentives being misaligned.”
Outside of these considerations, every good contract should deal effectively with transactions costs, agency costs, and information asymmetries, which we'll discuss next.
Transaction Costs
There are different definitions of transaction costs, but for our purposes transaction costs are the cost—in both time and money—associated with creating a relationship between two parties. For instance, in closing a venture deal between an entrepreneur and a venture capitalist, transaction costs will include not only the costs of lawyers for both sides but also the costs of meetings, the time involved to complete due diligence, and every step of the process from that first meeting to the signed definitive documents.
When entering a contractual relationship, consider that all good contracts minimize current and future transaction costs. This might mean you choose a different structure on a deal because the structure, itself, is cheaper to paper than another structure. Always consider the value you bring to a contract. If the value of the contract is $10,000 consider how many hours are appropriate versus a merger worth $100,000,000.
We find future transaction costs to be even more important to consider. For instance, you should negotiate a detailed merger letter of intent (LOI) to avoid too much negotiation ambiguity while drafting the definitive documents. As you have more negotiating power during the LOI stage, what would take two hours to negotiate now could save you tens of hours later. In short, you are defining the relationship up front so that you don't have to run up huge costs, both in time and money, figuring who has which rights and who receives what consideration.
Agency Costs and Information Asymmetry
Agency costs are costs associated with an agent acting on behalf of a principal. Some of these costs are direct. If we hire a stockbroker to buy stocks for us, we must also pay them a fee to complete the trade. Some of these costs are indirect and hard to spot.
Let's use the example of a “walking dead startup company.” This is a company that is still in business, but just limping along with no clear path to an outcome. It would probably be in the startup investors' best interest if the company shut down so the investors could recoup whatever money is left in the bank account and take the tax loss.
Let's consider the investors the principal in the scenario. The CEO of the company, however, has other incentives. He still has a decent salary and gets to walk around town with his CEO business card. His incentive is to keep the company alive as long as possible. The CEO in this case is the agent.
Regardless of the amount of time the investors and the entrepreneur spend together, there is no way either party will know as much about the other's business—and motivation—as they know about their own. This information asymmetry, like agency dynamics, results in a misalignment of incentives.
Consider how contractual provisions could help alleviate this conflict. A contractual right to a board seat for the investors would be helpful. An odd number of board members, with at least one independent board member might be useful. Perhaps a term that says the company will give investors their money back in X years would protect against this situation.
Reputation Constraints
If you are playing a long-term game, reputation constraints can be even more important than a specific term in a contract. For instance, the venture capital industry is small, and reputation matters a lot. Bad behavior gets talked about, even if it's done behind closed doors and not out in the open. The smaller the ecosystem, the more this phenomenon exists, so as you focus on smaller geographies, the importance of reputation increases.
While there are some people who care less about their reputation than others, your reputation will be established over a long period of time. No contract is airtight, but how you deal with ambiguity and conflict will help define your reputation. This impacts both entrepreneurs and investors.
When considering how to create a contract, again, forget about most everything you learned in class and ask yourself: Does reputation matter to both of these parties? Will reputation constrain bad behavior here, or not? If we take the joint venture scenario where the relationship is a true win-win, then perhaps we have less to concern ourselves about. If this is a divorce (personal, business, or otherwise), then perhaps neither party cares about their reputation. The really interesting situations are where