How business lawyers create value?
In the context of an M&A transaction a business lawyer is often perceived as necessary evil, a hardly justified cost. Even experienced market operators, when reflecting on how counsels contribute to their deals, seem to only focus on the most obvious, technical aspects of our job. “We have to engage and pay lawyers because they know the exact words that need to be put to paper for things or money to change hands and for us to be able to seek recourse” their reasoning seems to go. In more extreme cases clients are certain that lawyers, by definition, always impair the prospects of their enterprise.
Ultimately, this line of thinking will often lead to a simple question: what is the justification for the lawyers’ expansive (and sometimes expensive) presence at the negotiating table? In 1984 Ronald J. Gibson, a Stanford University scholar, attempted to answer this in a now seminal paper “Value Creation by Business Lawyers: Legal Skills and Asset Pricing” (The Yale Law Journal, Volume 94, Number 2, December 1984). There, he elaborated on a fairly straightforward idea: if what business lawyers do has value, a transaction must be worth more, net of legal fees, as a result of their work.
This is a short summary of the critical points made by Gibson, which revolve around business lawyers as transaction cost engineers, bridging the gap between assumptions made by models used to value capital assets and the harsh market realities.
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Gibson’s article begins its investigation of whether business lawyers can increase the value of a transaction by pointing out that the appropriate perspective “is not that of the client with the more talented lawyer, but the joint perspective of both clients”. This means, that in order for lawyers to be deemed productive, their abilities must translate into an increase in the overall value of the deal and not “merely in the distributive share of one of the parties” – they need to be able to enlarge the “pie”, rather than just split it to their client’s benefit.
In order to establish a hypothesis which explains the relationship between the size of that “pie” and the particular tasks performed by business lawyers, Gibson recognises that transactions usually entail capital assets, “whose value is determined solely by the income, whether in cash flow or appreciation, they are expected to earn”. What is termed an “M&A deal” is simply the transfer of a stream of these future incomes from one party to the other. The value of any such transfer is, thus, determined by the current value of that stream and the current value of that stream is, in turn, determined by the capital asset pricing theory. It follows, that “if capital asset pricing theory can identify the factors that determine transaction value”, then these factors can be examined to establish if “business lawyers can influence them in a way that will alter transaction value”.
The capital asset pricing theory is an economic model which assumes that the return on, and therefore the price of, a capital asset depends on how much systematic risk is associated with it (this is known as “beta” – beta’s primary effect is on the asset’s expected rate of return and discount rate, while its secondary effect is on the asset’s valuation). Like any economic model, it is also an imperfect rendition of the reality it attempts to describe and, consequently, “can be derived only after a number of important simplifying assumptions are made”. Most importantly, these “simplifying assumptions” provide that:
- all investors have a common time horizon;
- all investors have the same expectations about the future and in particular, about the future risk and return on a given asset;
- there are no transaction costs;
- all information is costlessly available to all investors.
The more these assumptions hold, the more reliable valuations are derived under the capital asset pricing theory. But, since “the world in which capital assets are priced and transactions actually carried out differs in critical respects from the world of perfect markets in which capital pricing theory operates”, this is unlikely to be the case. As Gibson puts it, investors “do not have the same time horizons; indeed it is often precisely because they do not (…) that the transaction occurs in the first place”. Neither do investors have “homogeneous expectations; the phenomenon of conflicting forecasts of earnings or value even among reputed experts is too familiar for that assumption to stand. Transaction costs (…) are pervasive [and] information is often one of the most expensive and poorly distributed commodities.” This means that, absent outside interventions that improve market performance and realign the model with the reality (or, rather, the reality with the model), valuations based on the capital asset pricing theory would have little practical significance.
This is exactly where business lawyers step in and Gibson’s passage on that deserves extensive quotation:
“I suggest that the tie between legal skills and transaction value is the business lawyer’s ability to create a transactional structure which reduces transaction costs and therefore results in more accurate asset pricing. Put in terms of capital asset pricing theory, the business lawyer acts to contain the extent to which conditions in the real world deviate from the theoretical assumptions of capital asset pricing. (…) Lawyers function as transaction cost engineers, devising efficient mechanisms which bridge the gap between capital asset pricing theory’s hypothetical world of perfect markets and the less-then-perfect reality of effecting transactions in this world. Value is created when the transactional structure designed by the business lawyer allows the parties to act, for that transaction, as if the assumptions on which capital asset pricing theory is based were accurate.”
In order to validate his point, the author moves on to prove how some of the key mechanics of any standard acquisition agreement are (or at least should be) designed to alleviate the discrepancies between the assumptions of the model and the reality of the transaction. The examples that resonate most include:
- earn-out, which Gibson uses to illustrate how different approaches to the future performance of the business might render parties unable to agree on the price and how a lawyer can increase the value of the transaction if he can “devise a transactional structure that creates homogenous expectations” and align their time horizons. The central insights here are:
- that “the difference of expectations between the parties as to the probabilities assigned to the occurrence of future events will ultimately disappear as time transforms a prediction of year’s sales into historical fact”; and
- that a complete earn-out formula is a delicate balancing act, a “complicated state-contingent contract that (…) substantially reduces the incentives and opportunity for the parties to behave strategically” in the period in which the final price is determined.
- representations, warranties and indemnification, which reduce the cost of acquiring information necessary to value capital assets (“The agreement would allocate the responsibility of producing information that neither the seller nor the buyer already has to the party that can acquire it most cheaply.”) and facilitate its exchange. The article also goes into interesting detail on the overall significance of the “materiality” and “best knowledge” qualifications (“The agreement would try to control overspending on information acquisition by identifying not only the type of information that should be acquired, but also how much should be spent on its acquisition.”).
- post-closing arrangements – such as purchase price retention, escrow or engagement of outside experts – which serve to further eliminate final-period problems stemming from the fact, that ”the seller has no expectations of future transactions; for the seller, a corporate acquisition is, virtually by definition, a one-shot transaction”.
This way, in the hands of a skilled business lawyer, the provisions of an acquisition agreement become tools to reconciling “the perfect market assumptions of capital asset pricing theory and the drastically less-then-perfect market conditions in which transactions actually take place”. By doing this, the lawyer is instrumental in enabling the parties to effectively price a capital asset, which translates directly into value created.
As such, for any legal professional, Gibson’s argument is as much comforting as it is challenging.
Michał Gintowt, adwokat, M&A and Corporate practice, Wardyński & Partners