Henry and Peter have negotiated the key financial terms of Montero’s offer. On behalf of the corporation, Henry sent Peter a “nonbinding letter of intent” outlining their understanding, which included the following:
• “You will be Executive Vice President and Chief Operating Officer, reporting directly to the CEO and the Board of Directors.”
• “You will be paid a yearly base salary of $475,000, with an additional discretionary annual incentive bonus to be determined by the Board’s Compensation Committee.”
• “Upon signing, you will receive options to purchase 100,000 shares of Montero West’s stock at the current price of $30 per share. Twenty percent of these shares will vest each year over a five-year period.”
• “In the discretion of the Board’s Compensation Committee, you may also be awarded additional options in the future on an annual basis.”
• “You will also receive the company’s standard executive benefits package, including disability, life and health insurance, and retirement benefits. The firm also agrees to pay your reasonable relocation expenses.”
• “Our agreement will be documented in a written employment contract with a five-year term.”
Peter hired Janice Dobson, a partner at a mid-sized Denver law firm, to represent him in negotiating his employment contract. The company referred the matter to Bill Stodds, a partner in the Denver law firm that is Montero West’s outside counsel, to handle the contract for Montero West.
REVISITING THE OPPORTUNITIES AND CHALLENGES IN DEAL-MAKING
Our focus in this chapter is on how lawyers can best take a problem-solving approach in negotiating the legal language used to implement deals. In many transactions, as in our example, the clients have already negotiated a preliminary understanding of the basic terms without the direct involvement of lawyers. Clients bring lawyers into the transaction to create the written documents to formalize the deal.
Why Deals May Be Easier to Negotiate than Disputes
To some extent, problem-solving should be easier in deal-making than in dispute resolution. In deal-making, the parties see the possibility of joint gains and value creation almost by definition. Parties enter deals because they each see themselves as better off doing business together than not. They want the deal to go through, and they want to capture the value of their proposed transaction. Thus, the whole enterprise of deal-making is often oriented toward value creation.
Second, in deal-making the principals have often reached agreement about the distributive dimensions of many important issues before lawyers are even brought into the negotiation. Peter and Henry, for example, have settled the most conspicuous basic terms of their deal: the salary amount, length of the contract, and so on. Although their lawyers have a great many remaining issues to address, the parties are likely to see those issues as secondary to the substantive core terms that have already been tackled.
Third, in deal-making the parties often anticipate that they will have a future working relationship. Peter and Henry, for example, expect to work together for the next five years. Neither wants the negotiations over Peter’s employment agreement to undermine that budding relationship. In cases like this where the shadow of the future is long, clients may be less tempted to behave opportunistically or to push for what could be perceived as unreasonable distributive gain. They are more likely to collaborate to resolve their differences amicably, fairly, and efficiently.1
Finally, problem-solving can be easier in deals than in disputes because attorneys often have an economic incentive to get deals done. Transactional lawyers, even if generally paid by the hour, often must significantly discount their fees if a deal falls apart, and they may earn a premium if the deal goes forward. The reality is that some lawyers will be paid only when and if the deal goes through. Unlike a litigator who is paid by the hour and will earn less if there is an early settlement, transactional lawyers often have a strong incentive to reach a negotiated agreement.
The Challenges for Lawyers in Deal-Making
Despite these advantages of deal-making over dispute resolution, negotiating the language of documents that will implement a deal is often difficult. Lawyers face two basic challenges. First, they must communicate with their clients clearly about the risks that might affect the client down the road. Second, they must manage the strategic challenge inherent in all negotiations: what we have called the first tension.
LAWYER-CLIENT COMMUNICATION
Transactional lawyers are experts at thinking about what might possibly go wrong with a deal and how to protect their clients from avoidable risks and unwise commitments. The hard question is what level of risk a client should accept—which risks are important and which less so.
To make wise decisions, a lawyer must learn his client’s priorities and preferences, and the client must learn how different legal arrangements may shift risk and affect the value of the transaction. But this kind of learning requires that the lawyer and client communicate effectively and efficiently as the negotiation with the other side unfolds.
Many lawyers and clients don’t manage their communication very well. Often lawyers don’t probe for their clients’ interests deeply enough. Sometimes clients are unsure about their interests and have difficulty setting clear priorities. Moreover, lawyers often find it trying to explain to clients how different legal provisions would affect the probable outcomes should a particular contingency arise in the future. Some subjects and risks may be hard to discuss because they may trigger an emotional reaction in the client. For example, a client may be reluctant to focus on provisions that relate to his being fired for incompetence or to his being terminated in the event of disability. Particularly when a client sees certain risks as remote, lawyers and clients can become frustrated with each other. The lawyer may feel that the client does not take a given risk seriously enough. And the lawyer may fear that even if a client agrees to forgo protective language today, he will still blame the lawyer later if the contingency in fact arises. On the other hand, clients sometimes feel that their lawyer is making a mountain out of a molehill or simply trying “to cover his own tail.”
THE STRATEGIC CHALLENGE
In addition to managing this communication challenge behind the table, lawyers face a strategic challenge across the table in negotiating deal terms. After reaching an agreement in principle on the major terms, one or both clients may wonder “What greater concessions might I have gotten from the other side had I pushed harder?” Some clients are tempted to use the legal phase of negotiations to seek further distributive gains on secondary terms. One or both sides may believe, “Even if my lawyer proposes secondary terms that are highly favorable to my interests, the other side obviously wants this deal—they will ultimately concede rather than walk away.” For example, Montero West may think, “Peter is very eager to come work for us—we might have been able to get him to work for less than $475,000. Even if we insist on rather one-sided provisions relating to stock options and termination, he’ll still agree to the contract.”
The dilemma is compounded because some lawyers—or clients—are willing to make concessions if pushed. Deal-making negotiations may thus begin with one or both lawyers trying to assess how sophisticated, smart, and aggressive the other side is in order to decide how much pressure to apply. If the other side looks like a “sucker,” or seems overly eager to do the deal, pushing for concessions might make sense. To avoid this dynamic, each lawyer may assume a highly aggressive posture so as not to appear weak or unsure.
As a consequence, negotiations over legal terms in deal-making—like any negotiation—can become highly adversarial. The parties may build one-sided demands into their initial drafts that they really don’t care about but hope to concede away later as bargaining chips. On provisions that they do care about, each side may open with an extreme position and concede very slowly in hopes of wearing down the other side. The negotiation may become a game of chicken, where various terms are characterized as deal-breaker
s or “not subject to negotiation.” Each side may try to create the impression that it has less to lose if the deal doesn’t go through. Each may believe that the other side will blink first. Neither side learns much about the other’s true interests or concerns, and creative trades to resolve their differences go unexplored. In the end, the lawyers may deadlock, with each side unwilling to back down and yet unsure just how far the other side can be pushed before they walk away from the deal. The clients may need to get involved—often to their annoyance—to get the deal moving again and save the transaction. And sometimes deals still blow up, even when any number of arrangements would have made both sides better off than no deal at all.
PREPARING TO PROBLEM-SOLVE
In deal-making, the challenges behind the table and across the table are clearly related. To minimize the risk of stalemate, lawyers must work with their clients to identify key risks, learn their clients’ interests, and draft contractual language to bring to the negotiation table.
Identify Issues and Risks
Lawyers are involved in a variety of kinds of deals, including complex leases, real estate sales, loan agreements, mergers and acquisitions, corporate financing, compensation contracts, partnership agreements, and licensing of intellectual property and patents. Each context has its special risks and opportunities. How can a lawyer best identify the critical issues and risks in a particular transaction?
Probably the most important way that attorneys come to understand these risks is through past experience—working a particular kind of deal repeatedly, perhaps initially with more senior colleagues who can identify typical problems. Experience with a given type of deal can help a lawyer know what the distributive issues are in that context and what value-creating trades are often found. Similarly, experience will help the lawyer identify which risks his client should worry about most.
In addition to calling on their experience, lawyers often identify a transaction’s risks by using check lists, form books, and drafts of similar agreements used in the past. By looking at examples of similar deal terms—including the “boilerplate”—a lawyer can usually uncover the risks and concerns that the parties were trying to address through contractual language. And of course there’s no point in reinventing the wheel. Often, looking at forms will give an attorney useful insight into how various risks in a deal can be constrained or allocated.
A third way to identify risks is simply to imagine that a year from now, looking back, you realize that this deal—and the contract that formalized it—was an unmitigated disaster for your client. She lost money, she was victimized by the other side’s opportunism, and she would have been better off if she had never done the deal at all. How did this happen? What caused this reversal of fortune, given that today—going into the deal—the terms of the contract seem attractive?
A final, and related, way is to consider the incentives that might operate on the other party in various contexts. How might the other side try to take advantage of your client if they set out to be unscrupulous and strategic? In any deal, each party should ask itself how the other might already be acting strategically by withholding information about the quality of the goods to be traded (the lemons problem), or might act strategically in the future by taking advantage of incentives and provisions in the deal (the moral hazard problem). By looking at a deal’s terms from the other side’s perspective—by asking why the other side is so eager to sign—a lawyer can often spot risks that need to be addressed.2
In Peter French’s negotiation with Montero West, an experienced lawyer will realize that a critical set of risks relates to what will happen if Peter works for Montero West for fewer than five years. Under what circumstances, and with what consequences, can the company dismiss Peter? What happens if Peter resigns? If an employment contract doesn’t explicitly address these issues, background legal standards might provide one side or the other with a breach of contract claim for damages. The parties could litigate such claims, but there would often be a great deal of uncertainty about liability and the amount of damages. For this reason, executive compensation contracts usually contain explicit provisions spelling out the consequences of contract termination by either party.
With top executives, most corporations insist on the right to terminate the employment relationship early, not just for cause if the executive breaches the contract but also without cause if the corporation simply wants to make a change. What remains to be negotiated is what consequences will flow from a dismissal. The convention is that if a corporation terminates an employee for cause, the employee receives little or no severance pay or additional compensation. Executive contracts also provide, however, that if the employer dismisses the executive without cause, then the executive will receive severance compensation—spelled out in the contract—in lieu of damages or other claims.
An analogous set of distinctions governs resignation by the employee. Typically, if an executive voluntarily quits, she forfeits her severance package and has no claim against the corporation for future compensation. On the other hand, many executive employment agreements provide that if the executive quits her employment for what constitutes “good reason,” she will be entitled to a predefined severance package, which may be the same or may differ from the without-cause termination package.
Not surprisingly, Peter and Henry did not discuss these issues of early termination when they hammered out the basic deal terms. Just as a couple about to marry rarely wants to think about the terms of a potential divorce, businesspeople about to work together rarely enjoy discussing provisions for termination or for allocation of risks if a deal fails.
Nevertheless, Peter’s lawyer understands that defining what constitutes “for cause” and “good reason” and the amount of these severance packages is often at the heart of a lawyer’s negotiation in such deals. The scope of these definitions will have serious distributive consequences in the event of eventual termination. If Peter is terminated without cause, how long will his salary continue after he’s no longer working for Montero? For one year? Two years? Until the end of the five-year term? And what happens to his unexercised stock options? Does he keep only those that are already vested? Or does he also keep those that have been awarded but are not yet vested? Peter’s lawyer expects that these issues will be central to negotiations with Montero West.
Understand and Prioritize Your Client’s Interests
With these issues in mind, Jan Dobson has her first meeting with Peter. Peter explains that he’s excited about the prospect of working at Montero West, that he expects the company to do very well, that he’s quite happy with the salary he’s been offered, and that he’s entirely satisfied with the company’s fringe benefits package. As he talks, Jan listens and probes for any concerns Peter may have about the transaction. She learns two things of considerable importance. First, a primary reason Peter is taking this job is that he hopes to become the CEO of a publicly-traded company. “That’s always been my ambition,” Peter says. “If I stayed in my present job, I’d eventually run a division, but I’d never be CEO.” Peter explains that in hiring him, Montero’s board has made it clear that he is being groomed to be the next CEO. “No promises, but it’s mine to lose.” Jan asks Peter about what he would do if Montero brought in someone else to become CEO when Henry retires. “If it starts to look like I won’t become CEO, I’ll go somewhere else,” Peter says. “I can’t imagine that I’d want to stay at Montero in the number two spot. I’d want the freedom to leave Montero West before the five years are up if someone else is brought in.”
Peter describes a second concern. Montero West is a leader in agricultural biotechnology, and therefore it may be a prime target for acquisition by a larger chemical company sometime in the next five years. The Phills family controls a majority of the outstanding stock shares, and so the board of directors can prevent a hostile takeover. But if in the future the family decided it wanted out, the family could use its control to implement a sale. Peter is concerned that he
would then be left either without a position or in a position he wouldn’t want. “Rather than being CEO of an independent Montero West,” Peter explains, “at best I could end up running a division of a larger chemical company. I don’t want that.”
Jan then raises the issue of the board’s firing Peter before the end of his five-year term. “It’s not going to happen,” Peter says. “I trust Henry Phills completely, and I know we’re going to work together well.” Notwithstanding Peter’s optimism, Jan emphasizes the need to plan for this contingency. She explains the distinction between for-cause and with-out-cause termination, and she points out that while negotiations over the definition of “cause” may seem dry and technical, there’s a great deal at stake. Even though Peter’s relations with Henry and the board are now all very friendly, things could change. Henry could die. Board membership could turn over. Relationships could deteriorate. If sometime in the future the company wanted to get rid of Peter, the board might seek to cut its costs by claiming there was cause for termination. Jan says, “Once the company decides that you’re not working out, then there’s no more future relationship to worry about. It can be very tempting to play hardball and save a few dollars when the employment relationship is basically over.”
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