Basic Tools for Dealmakers – Part 1 of 2

As a dealmaker, you have several tools at your disposal. They are often applied reactively as a deal progresses. If you survey your toolkit in advance, and apply the right tool to the right business need, you will close better deals, more quickly. Here are some helpful tools to keep close at hand. They are organized by tools used before the deal (i.e., before a contract is signed), in the deal itself, and in the deal for future deals.

Before the Deal

List of major deal goals. Listing your major deal goals in writing is very basic. But it isn’t done often enough. Include your “must-have” points and areas where you can be flexible. This is especially useful for team negotiations. This will be your checklist to keep you and your negotiating team honest with yourselves about whether you are reaching the goals originally set for the deal. And, it will help you remain persistent, consistent, and insistent as the deal progresses – you will more easily show that you mean what you say, and can’t get sidetracked. It works. My client once won several critical points in a deal because our team started with a list of major goals, shared many of those goals with the other side at the very first negotiating session, and focused consistently on the goals throughout the entire deal. (Obviously you won’t share the full list with the other side, but you may want to provide some of them at various points in the negotiation.)

Due diligence as an interactive tool. Due diligence, that is, an intelligent review of the facts, documents and parties critical to the deal, is obviously needed in large transactions such as mergers & acquisitions. However, this basic tool is often neglected in smaller transactions. Due diligence raises questions such as these: How much do I really know about the other party – should I run a credit report or search for lawsuits filed against them? Have I spoken to all the right people and seen the necessary documents to obtain all the facts? Does this deal have unique facts? Since due diligence and deal points often go hand in hand, due diligence should be an interactive activity, not a static “check-the-box” exercise divorced from the critical issues in the deal. Remember, a good contract can’t make up for a bad deal. Learn as much as you can about the other party. The learning is much easier and cheaper before there is a problem in the relationship.

Non-binding term sheet. I often hear two questions at the beginning of a deal: Should we bother with a term sheet? Can’t we just sign the term sheet (or make it binding)? My answers are almost always “yes” to the first, and “no” to the second.

Even for the simplest deals, a written term sheet can clarify the parties’ intentions and help them reach agreement. A “term sheet” can be as simple as a quarter-page of bullet-points listing major items of agreement – as long as it’s in writing. Of course, complicated deals may require more formal and longer term sheets. A term sheet may go by other names, such as a “letter of intent,” “deal memo” or internationally, “heads of agreement.” Term sheets always contain some looseness, but the parties will have a rough roadmap to guide them through the deal, and counsel can make the clarifications in the final (or “definitive”) written agreement.

Because of this roadmap aspect, I generally don’t recommend signing a term sheet. A signed term sheet isn’t just a rough roadmap for the business people – it’s a contract! If you or the other party really want to sign as a showing of good faith, then have a lawyer add a qualification to indicate that the term sheet, though signed, is not intended to create a binding contract. At other times, you or the other party may simply need a binding contract now, even if all the legal niceties are not filled in and the parties understand the risks they are taking.

So, when should a term sheet not be used? The best examples are contracts where there is little or no room for negotiation, such as form contracts or simple renewals of an existing contract. In those cases, your term sheet would simply be the terms to fill in or renew. (Of course, if you have the power, you still might negotiate the entire contract and need a term sheet.)

In the Deal Itself

Non-competes and their alternatives. Of course, most businesses would love to minimize competition. Many try to do it through contracts. In California, Business and Professions Code Section 16600 makes most non-competition agreements illegal, with certain exceptions for partnerships and sales of businesses. Also, even outside of California, many non-competition agreements are illegal under U.S. and state antitrust laws. However, intellectual property (patents, trademarks, copyrights and trade secrets) can be a tool to limit competition legally and legitimately.

The rights to use intellectual property can be further customized as needed via licenses, which may be exclusive or non-exclusive, and which may cover different geographic territories, products or fields of use. An “exclusive” license simply means that the recipient of the right to use the intellectual property (the licensee) is the only recipient of the right – the owner cannot grant licenses to others while the exclusive license is in force. Exclusive licenses should be used with care. Vague language in an exclusive license that was perfectly fine when an agreement was negotiated may block the owner’s entry into an unforeseen new market or product line – even years later. I have found that many businesses grant exclusive licenses too willingly and without a real need, just because they were asked. For example, it often makes sense to grant an exclusive license to a party who is making a large fixed investment to support the relationship. Conversely, granting an exclusive license to a party who is not making a fixed investment or has no incentive or ability to perform may simply lock up rights that could be profitably licensed to others.

Most Favored Nation (MFN) clauses. An MFN clause enables one party to receive the most favorable price or terms and conditions offered by the other party to others. An MFN clause from a seller to a customer is often called a “Most Favored Customer” (MFC) clause. It essentially is a best price (or best terms) guarantee, and means that the seller won’t sell to anyone else for less (or on better terms and conditions). This is obviously a good deal for the customer, and may simply reflect the customer’s favored trading status. However, there is often a deeper business need. If the goods or services are unique or difficult to obtain elsewhere, then a customer might negotiate better pricing and terms from the supplier in order to obtain a cost advantage over the supplier’s other customers. To prevent this, a customer may demand an MFN clause to stay on an equal footing with other customers of the same supplier.

MFN clauses contain several potential traps. First, make sure that the party receiving the MFN protection is compared against the correct group. For example, if you have separate pricing and terms for two groups of customers, such as large companies and non-profits, the MFN should be written so that a large company gets only the best price and terms for large companies and not the pricing and terms offered only to non-profits. Second, some MFN clauses are retroactive (looking backward in time), which can result in large refunds or adjustments. Third, recipients of MFN terms may need some way to audit compliance.

Protections against future changes to the parties. Business people are often so focused on closing the deal and making it succeed that they neglect to consider the future of the parties and the contract. With constantly changing business conditions, parties may sell portions of their assets, or they may be sold or merged with other companies. Several tools can help your deal weather this constant storm.

First, consider restricting assignment of the agreement. Generally, with some exceptions, a party can assign a contract to someone else if the contract is silent on assignment. That is, the other party could “sell off” your contract to another company and you would need to deal with that other party going forward, even if you aren’t happy with that other party’s business practices or creditworthiness. The simple solution to this is to add an explicit prohibition on assignment without your consent. (Larger companies often will obtain an exception that permits them to assign to subsidiaries and other affiliates, so that they can restructure without seeking consent.) Even with this protection, in some cases, such as Bankruptcy, you may not be able to block the assignment without unique circumstances and properly worded contracts.

Second, even if the contract cannot be transferred as an asset, the other party’s business may be sold to another person by means of a stock sale or a merger. This is commonly known as a “change of control.” Again, after a change of control you may have to deal with a different party or face the oversight of a new corporate parent of the other party. To address this, you may want the ability to terminate the contract or automatically to modify it (e.g., special pricing or exclusivity could terminate) on a change of control. Consider a kill fee for change of control. I once had a client who would lose revenue as a result of the other party’s change of control, because any new owner probably would not perform the contract as well as the original owner. My client negotiated a kill fee of over $1,000,000 for a change of control, and collected on it when the other party’s business was purchased. Consult your lawyer for help with any change of control provision.

Tools to ensure the other party’s performance. Businesses have to take risks, and one of the greatests risks a business may face is whether the other party to a contract will perform – or even remain in business. This is particularly true for small companies with little credit or financial resources. There are several tools to address this situation, and they rely on the help of others.

Another entity, such as a shareholder or corporate parent company of a party, can provide a guarantee of the party’s obligations, so that if the party breaches the contract, you can look to the shareholder or corporate parent. (Small businesses see this often with the request for a “personal guarantee” from the owner of the business to cover the business’s obligations or loans.)

A party also can guarantee its payment obligations by obtaining a Letter of Credit from its bank (for a lending fee). In effect, the bank “guarantees” the party’s payment of money, if certain very specific trigger events occur. Letters of Credit are often used in international transactions, but I have used them successfully in U.S. transactions where future payment may be doubtful.

Continued on Part 2

This article was originally written in October 2005 and transferred to on January 3, 2012.

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