Basic Tools for Dealmakers – Part 2 of 2

Continued from Part 1

You can use an Escrow to ensure the payment of money or delivery of property (such as source code of software) based on future conditions. The escrow agent, which may be a title agent, an escrow company or even your attorney, is the third party that holds money or property for delivery upon specific conditions. Essentially, the escrow agent “guarantees” the party’s delivery of money or property.

Required insurance is a type of third-party protection if the other party harms someone (e.g., personal injury) but does not have the assets to remedy the harm. For example, if one party is a large company perceived as a “deep pocket” to pay damages from lawsuits, and the other party is small company that could cause harm but has no assets to pay damages, then the large company may require the small company to obtain insurance to protect against the small company’s harmful actions, and to add the large company as an “additional insured” to the small company’s insurance policy. Another example is a homeowner using a contractor for construction work; the homeowner demands to become an additional insured to the contractor’s liability and workmen’s compensation policy in case the contractor injures someone and cannot pay damages.

Tools to relieve harm to third parties. Business people’s eyes glaze over when lawyers negotiate and debate “indemnities.” They don’t appreciate what the fuss – and legal expense – is about for hypothetical events that probably will never happen. Usually though, they take interest when they understand that indemnities are similar to insurance protection against the other party’s harm to third parties, and that negotiating an indemnity is similar to buying insurance. An “indemnity” from the other party is very similar to an insurance policy – the other party agrees to defend any lawsuits and pay relevant damages or settlement amounts. Injuries can include personal injury, or commercial injuries such as a negligent error or omission (e.g., posting incorrect information to a website), or intangible injuries such as trademark infringement (e.g., using a brand name without the legal right to do so). Indemnities may be limited in amount, or “capped,” which is similar to insurance policy limits. I’ve resolved many difficult negotiations by asking the business people to assume an “insurance buyer’s mindset” to obtain the indemnities they need to protect their businesses. Of course, indemnities often are supplemented by traditional insurance coverage from insurance companies (see the note above about required insurance).

Tools for the exit strategy. Every business and every business project has an exit strategy. For some, the strategy is thought out, clearly expressed and written down. For others, the opposite is true – the business or project is like an individual who could “die without a will” – and, like an individual who dies without a will, these businesses and projects will have their strategy written for them, by the law. Here are a few other tools to help you make sure the exit strategy written in the contract reflects your desired exit strategy.

Practically every agreement can be terminated for breach by the other party, if the breach isn’t cured within a reasonable time period (or within the cure period written in the contract). Termination for Convenience (or “at will”) is the right to terminate a contract for any reason, or no reason, at any time. There is no need to prove breach by the other party. It can cover many problems in an agreement, since the party with the right to terminate can do so at any time, and isn’t locked into a long-term relationship. Even if the party just wants to renegotiate, it can terminate for convenience (or threaten to terminate) and renegotiate. Obviously, this approach won’t work if one party is making large fixed investments that must be recouped or if the parties otherwise need a long-term agreement. Adding a minimum notice period of 30 – 180 days enables the parties to find substitute relationships while termination is pending.

Many business people just accept termination as the standard remedy for a contract problem. But termination often may not be a remedy at all, if the party with the legal right to terminate is not in a practical position to terminate because it needs the other party (e.g., the other party offers unique services, customer service etc.) In these cases, the following alternatives can help.

Liquidated damages provide for one party to pay the other a stated dollar amount if a well-defined problem occurs, even if the contract remains in force. To be legally enforceable, such amounts should not be excessive “penalties” but should be based on an estimate of damages that would otherwise be payable if they were not so difficult to calculate. For example, liquidated damages could be estimated based on the injured party’s lost profit for the period or estimated cost to obtain replacement performance from someone else. In practice, liquidated damages may provide the wrong incentive, giving the paying party a way to “buy itself out of breach” or motivating the injured party to nickel-and-dime the other party with complaints and demands about every problem, rather than working in good faith to find and resolve the root causes of disagreement.

Partial termination is often a good solution. For example, you may not wish to terminate the relationship altogether, but just to terminate the exclusivity: if an exclusive supplier breaches, the customer may still need the supplier and from a practical standpoint cannot terminate the relationship entirely, but the customer may obtain the freedom to terminate the exclusivity and purchase from second source as a backup.

Forced consultation is often used by large companies. In those cases, to prevent termination or even lawsuits resulting from disagreements by lower-level employees of each party, the contract can require senior executives from each party to meet and discuss the problem before the contract can be terminated or any lawsuit filed. With very large companies, there may be several discussions by increasingly senior executives that are required by an escalation clause. Also popular are mediation clauses that require the dispute to be submitted to a neutral mediator before termination or litigation. (Mediators act as intermediaries and facilitators to the parties, and not as judges or arbitrators.)

Tools to enforce the deal. Explicitly choosing where and how any disputes are handled can be a useful tool. Many business people leave these choice of forum and choice of law decisions up to the lawyer, without thinking about their business impact. Some clients may need a speedy resolution above all else. Some may desire a thorough, but slow and expensive, process (e.g., if the contract breaks new ground and the stakes are high). Others may prefer the confidentiality afforded by arbitration. If a party is concerned that the other party will bring frivolous claims or if it is concerned that the other party will abuse its power by overspending it on attorney’s fees, it may want an attorney’s fees provision, in which the loser pays for the winner’s attorney’s fees if any lawsuit is brought.

In the Deal for Future Deals
Often the parties can agree on all issues except for one or two deal points. Or, they may need a trigger event to occur before a part of the deal can be completed, but they don’t want to wait for it to occur before completing a larger transaction. Or, they just want to leave their choices open for the future. That’s where options, rights of refusal and related rights come in. Below, I refer to the party granting the option or right as the “owner” and the recipient or holder of the option or right as the “holder,” since in many cases the party granting an option owns an asset (such as real estate or shares of stock).

Option. This generally gives one party (the holder) the right but not the obligation to require the other party (the grantor of the option, or owner) to complete a transaction within a set time period and on predefined terms and conditions. For example, if an owner of real estate grants an option to an option holder, the holder pays the owner for the option, and the holder can force the sale by the owner of the real estate within the set time period and on the predefined terms and conditions in the option. Options can also include terms and conditions determined by a formula applied in the future (such as a pricing formula based on a set price adjusted for inflation in future years). Options are often used for sales of real estate, and the familiar “put” and “call” options are heavily used for stock and other securities. Options can cover much more than asset sales.

Options provide an inexpensive way to “buy time” in a relationship. The holder may want an option if it knows it wants to do a deal for a certain price or at a certain time in the future. The holder generally must pay for this right, but the amount is less than the full cost of the ultimate transaction. The owner receives some payment now for the burden of dealing with the option, but does not receive the full value of the transaction unless and until the holder exercises the option. An option may “buy time” for the holder to raise the funds to close the transaction, or to negotiate with other parties for other assets or better terms.

Options must be drafted carefully, because a well-written option can often make the difference between great loss – and great profit. And, if the market changes rapidly, the timing of option exercise may be crucial.

Right of First Refusal (“ROFR”). This right is weaker than an option. The holder cannot force the owner to complete a transaction. However, if the owner decides to sell, the owner must take the deal to the holder before anyone else; the holder has the first right to the transaction on the terms offered (or any better terms that the owner later offers to others, such as lower price). For example, the holder of a right of first refusal to purchase land cannot compel the owner (the grantor of the ROFR) to sell the land, but if the owner desires to market the property, the owner must take its terms first to the holder. This imposes a burden on the owner, because other potential buyers will not want to waste time talking with the owner if they know another party has a right of first refusal and can “take away” the deal. Also, if the owner receives an offer from a third party, the owner must notify the holder, who could then match the offer. If the holder matched the offer within the right of first refusal period, the holder could close the transaction. In effect, the ROFR limits the owner’s potential marketing and negotiations with others.

A ROFR is often priced less than an option to purchase. As with options, a ROFR may give the holder time to raise funds for the transaction before owner begins to market the asset. Unlike with options, the ROFR may expire worthless if the owner decides never to market the asset.

For issuances of corporate stock, stockholders often receive “preemptive rights” or anti-dilution rights to purchase additional shares in order to maintain their percentage of ownership in the corporation. The preemptive rights are a form of right of first refusal.

Right of First Negotiation (“ROFN”). With this right, the owner must notify the holder of the owner’s intent to market the asset. Then, for a limited time the parties must negotiate exclusively with each other. The holder has no assurance that it will conclude a deal with the owner, however. (The owner generally is obligated to negotiate in good faith, and cannot simply terminate negotiations in bad faith to avoid the ROFN.) Once the ROFN period expires, the owner is free to market the asset.

Right of First Offer (“ROFO”). With this right, the holder has the right to make an offer to the owner before the owner can complete a deal with a third party. This right forces the holder to “name its price.” The owner has a specified time period to accept or reject the holder’s offer, and if the owner rejects the offer, the owner can complete a deal with a third party, as long as that deal is not at a lower price or more favorable terms than the holder’s offer. This right also imposes less of a marketing burden on the owner than the ROFR, since the owner is not required to accept the holder’s offer. The owner controls the timing of any deal and need not reduce its asking price in order to accept the holder’s offer – even if the holder’s offer is perfectly reasonable and market-based.

Right of Last Refusal. The holder has the right to match the last third-party offer made to the owner. Compared to a Right of First Refusal, the holder gets the last word on any offer.

Of course, options and refusal rights can be combined, and creative dealmakers will want to do so. The Right of First Refusal and Right of First Negotiation are often combined with the Right of Last Refusal. Careful drafting by counsel is critical, however. Without it, courts have ignored “creative” approaches. Dealmakers often exclude certain transactions from these options or rights, such as parent-subsidiary transactions, bundled multiple-asset transactions, transfers upon death, transfers to trust beneficiaries, or M&A transactions.

Conclusion
Keep these tools in mind when commencing and negotiating your deal. As you start, list your major deal goals and use a non-binding term sheet whenever you can. It does not need to be complicated or long, just in writing, clear and to the point. Apply the right deal tools when the business need requires: non-competition clauses and their alternatives using intellectual property; Most Favored Nation (MFN) clauses to protect cost structures; protections against future changes to the parties (assignment prohibitions; change of control clauses); tools to ensure performance (guarantees, Letters of Credit, escrows and required insurance); indemnities as an “insurance policy” between the parties for harm to others; and exit strategy tools (termination for convenience, liquidated damages, partial termination and forced consultation). If you expect follow-on deals or your deal is conditioned on future events, consider options, rights of first refusal, first negotiation, first offer and last refusal. Used with care and with advice from your attorney, these tools will help you close better deals, more quickly.

References
For options, rights of first refusal and related rights, see John C. Murray, Option or Right of First Refusal: Which Is It?” The First American Corporation, http://www.firstam.com/faf/html/cust/jm-options.html (2004); B. Findlay and A. Hillyer, “Here Today, Here Tomorrrow: Legal Tools for the Voluntary Protection of Private Land in British Columbia,” Chapters 9 and 10, West Coast Environmental Law Research Foundation, http://www.wcel.org/wcelpub/5110/5110c10.html (1994); M. Diener, “Keep ‘Em Coming,” Entrepreneur Magazine, May 2004 http://www.entrepreneur.com/article/print/0,2361,315216,00.html

This article was originally written in October 2005 and transferred to www.BoadweeLaw.com/blog on January 3, 2012.

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