Deals: The Economic Structure of Business Transactions

Michael Klausner & Guhan Subramanian’s Deals: The Economic Structure of Business Transactions is a collaboration between academics who offered a course of the same name at their respective institutions. It first began as a course offered by Klausner twenty-five years ago at the Columbia Law School and Columbia Business School. It integrated economics and actual deals. Later Klausner continued with this course when he began teaching at Stanford Law School. Over time, these case studies became the bulk of the materials included in the course, of course with new ones added every year. He shared his resource materials widely with other faculty members. Guhan Subramanian was one of the first to use the materials at Harvard Law School and Harvard Business School, adding some of his own case studies too. Deals includes many of the case studies that the two authors engaged with over the past two decades.

The relationship between deal terms and underlying economics is timeless. Deal terms may change over time, in response to changing economics or perhaps just fashion, but the logic of how deal terms respond to underlying economics remains constant. In this book, the authors show that there is an underlying order to business transactions, and there are basic commonalities across transactions which, once understood, expose a degree of elegance and even simplicity buried deep within masses of paper.

The objective of any deal is to carry out an exchange between parties. It could be a purchase of services or assets for cash, it could be a sale of securities, it could be a license of technology, it could be a combination of assets and services to create a business -- the list could go on. An exchange occurs when both parties to a deal expect to be better off as a result. In economic terms, deals are expected to increase joint value or equivalently, to create joint surplus – more aggregate value than the parties held before they entered into the deal.

The exchange can be simple or complex. But even in a deal that is complex overall, the exchange itself is often simple and may account for just a few lines of an agreement that spans dozens or hundreds of pages. Mergers and acquisitions are among the most common business transactions and often involve exchanges of billions of dollars in value, and hundreds of pages of documentation. The exchange, however, is typically quite simple. In an acquisition for cash, the acquiror buys all shares or assets of the selling corporation for an agreed-upon prize.

Whether in an acquisition or in any other sort of exchange, a consistent set of economic challenges must be addressed for a deal to be struck and the exchange to happen. There are many challenges viz., there is a basic negotiation framework and the concept of bargaining power. Some of those that are discussed in Deals and illustrated magnificently by case studies are worth recounting. Alas, due to the lack of space constraints it is not possible to share the cases mentioned in the book, some of which are discussed clearly giving their real names and some wherein the details are accurate but names are fictitious to protect their identity. For instance, the case studies cover Microsoft’s acquisition of LinkedIn, Scarlett Johansson’s contract dispute with Disney over the release of Black Widow, litigation surrounding LVMH’s pandemic-disrupted acquisition of Tiffany, the feud between George Norcross and Lewis Katz over the ownership of Philadelphia Inquirer, NBC/Viacom’s negotiation with Paramount over the final three seasons of Frasier, and many other deals.

The prime focus of this book is to discuss the challenges that negotiating parties may encounter. For example, parties often face challenges in advance of a deal as a result of having less than complete information about the exchange that they are considering. Parties may have asymmetric information about the value of the exchange, a situation in which an adverse selection can occur. In the course of negotiations, adverse selection can be amplified in the bargaining process. It is called reactive devaluation. The seller’s signal of receptivity to a deal provides new information that can lead the buyer rationally to reconsider its terms. Of course, if taken to the extreme, reactive devaluation would be a complete barrier to any deal’s getting done when there is information asymmetry between seller and buyer. Asymmetric information is pervasive in business deals, which often involve valuation challenges that are very complicated.

There are also situations in which both parties lack information on some salient aspect of a deal. In a complex business deal, symmetric uncertainty on certain points can coexist with asymmetric information about others. Responses to incomplete information, whether asymmetric information or symmetric uncertainty, parties must find ways to inform themselves and each other. Remembering at the same time that information advantage may not be actually advantageous. Some of the ways in which responses are done is via signalling hidden information, direct disclosure of information, due diligence, third party assurance, price discover via auction and finally, agreeing to wait and see.

Two mechanisms that can address such ex ante information challenges – earnouts and contingent value rights – which defer finalizing a price until after an exchange is made and more information is available. In light of how often ex ante information is incomplete, one might expect these mechanisms to be used frequently. In fact, because they can introduce more problems than they solve, they are not all that common.

An earnout is a contractual arrangement under which an acquiror makes a supplemental payment to shareholders of an acquired company if the post-acquisition company’s performance meets specified goals over a specified period of time. Because the acquiror must be able to locate the former owners of the acquired company to make such a payment, an earnout is practical only when the acquired company is either privately held or a subsidiary of a public company. A contingent value right (CVR) performs this same function as an earnout in the context of a public company acquisition. It entails issuing a security to the shareholders of the company being sold, rather than setting up a contractual obligation to them. The holder of a CVR is entitled to receive a payment if the company achieves specified performance objectives by a specified date. Some CVRs trade like a share of stock, and others much be held until maturity, at which point the post-merger company makes any payment that is due. The payment provided for by an earnout or CVR may depend on measures of post-acquisition financial performance, such as revenues or earnings, or it may depend on the occurrence of a specified event that will affect the value of the acquired company.

At first glance, an earnout or CVR would seem to be a sensible pricing mechanism in cases where the value of a company being sold is uncertain – as is typically the case. After all, other sorts of transactions use pricing mechanisms that depend on measures of value that will materialize after a deal is made. When they are based on financial metrics, however, earnouts and CVRs can be difficult to design and implement. It is often hard for parties to agree upon a financial metric or combination of metrics that they expect will reflect the value of the post-acquisition company.

In information related challenges the question is whether the parties will be able to observe —and if necessary, prove to a court —each other’s performance after they begin implementing the deal. Is each keeping up its end of the bargain? What if ex post information is unavailable? What are the concerns about a moral hazard impeding the deal from the being struck in the first place?

Moral hazard refers to a setting in which the self-interest of a party leads it to take actions that are contrary to the intent underlying the dead and possibly contrary to the explicit terms of the deal, and where the counterparty cannot fully observe those actions and cannot prove in court any violation of the contract. The actions must be unobservable and unverifiable in court. Like adverse selection, moral hazard is a problem of asymmetric information. But while adverse selection involves precontractual asymmetric information, moral hazard involves asymmetry in post-contractual information.

Like adverse selection, the concept of moral hazard was developed in the context of insurance – specifically nineteenth century fire insurance. At that time, the term moral hazard covered what is now understood to be two distinct problems. First, it referred to a concern that insurance would attract people of immoral character – people who were dishonest or so careless that they would pose a greater risk to the insurer than would individuals of ordinary character. Such “moral hazards”, to the extent that they could be identified would not be insured. That concern was later recognised as adverse selection. The second concern was that insurance would lead to a “temptation” to incur losses for which insurance would pay, even among people of good character – good people with insurance might act immorally. In the 1960s, economists Kenneth Arrow and Mark Pauly, while recognising that insurers face both challenges, differentiated between the two. Consistent with the economics framework, they described the “temptation” concern as a matter of incentives, and took morality out of the picture.

Then there are deals in which at least one party needs to make an investment in whose value depends on the actions of this counterparty – and where that dependency creates potential vulnerability. Economists refer to such investments as asset- or relationship-specific. One response is to protect these investments with long term contracts. In some situations, for an exchange to take place between two parties, one or both must make an asset-specific investment (or, equivalently, a relationship-specific investment). This is an investment whose value is dependent on the cooperation of another party; it would have substantially lower value and perhaps no value, outside the relationship with that party.

The economist Oliver Williamson initially developed the concept of asset specificity, which he defined as “the degree to which an asset can be redeployed to alternative uses by alternative users without sacrifice of productive value”. In economics, the danger inherent in an asset-specific investment is that, absent protection, the party on which the investment depends may “hold up” the party that has made the investment – that is, it may act “opportunistically” after the investment has been made to exploit the dependence of the latter. Asset-specific investments may also be made over the course of a long-term business relationship as opposed to at the start.

Asset specificity can also be bilateral, where each party’s investment is dependent on the other party. In that case, opportunism may not be a problem, or at least not as large a problem as with one-sided asset specificity. One party’s threat not to deal with the other would not be credible, since that party, lacking good alternatives, would suffer too. The balance of dependence between two parties can change over time, however, so the fear of holdup could still deter one or both from investing if the holdup possibilities are not addressed in advance.

There are two potential responses to a business situation in which asset-specific investment is needed. One response is integration – for one of the two companies to acquire the other. The second response is for the parties to enter into a long-term contract that provides assurance to the party making the asset-specific investment that the relationship will continue long enough to justify the investment.

Analysing long-term contracts by investigating how those between buyers and sellers provides for adjustments in price and quantity as changes in the business environment occur. Without such adjustments, a long-term contract would be infeasible, but making the adjustment can be a complex and imperfect effort. A long-term contract is a means of providing the assurance needed for a party to make an asset specific investment. And even without the latter, a long-term contract can also be useful in promoting a mutually valuable working relationship in which cooperation is engendered. To accomplish these objectives, a long-term contract locks in elements of a deal. Yet to the parties to a long-term contract often know that market and other conditions surrounding their exchange will not be static, and may want certain elements of their deal not to be locked in. Two elements of a deal that may required adjustment are the parties’ commitments regarding what quantity of goods or services will be sold over the contract period and at what price. Failing to allow for such adjustments in response to changes in the business environment can lead to value-destroying conduct as cooperation ceases and one party or the other seeks to get out of the deal.

When parties to a long-term supply contract expect changes in market supply or demand for a product, they will likely want to provide for flexibility in the quantity of goods sold under the contract. Such a contract may provide for delivery of a specified quantity of goods at designated times over the term of the contract. Such a fixed quantity contract makes sense only if the supplied as a reasonable certainty regarding its ability to produce that quantity over time, and the buyer has reasonable certainty that it will need that quantity. There are other contracts too: such as a requirements contract and an output contract that define the relationship between the buyer and the seller. But the financial benefit of these contracts is wholly dependent on a set of external factors defining the market at any given point of time.

Exit mechanisms can be challenging particularly in settings where exit can result in a loss in value. Smart transaction design incorporates exit mechanisms that preserve value for both the party seeking to exit and the party that would prefer to remain. The terms under which a deal can be terminated can be as critical to transaction design as the terms that govern its performance. From the narrow perspective of one party, there is often value in having an unconditional right to terminate when a deal is no longer beneficial. In any deal requiring an asset-specific investment, the extent to which a party is willing to make that investment will depend in part on termination terms. Exit rights are important in supporting value-increasing incentives while parties are engaged in a deal, btu they are also important because they can go wrong.

The last but not least are the economics of how a contract is drafted, with particular focus on the use of specific rules versus broad standards. Rules can be difficult to write comprehensively, while standards can lead to uncertainty in performance and enforcement. Ideally, a contract will achieve an optimal tradeoff between these costs and benefits. Economic analysis of contracts often begins with the theoretical ideal of a complete, state-contingent contract. This is a contract that unambiguously assigns obligations to each party under all possible states of the world, and that will be enforced costlessly (or equivalent, that will need no enforcement).

In drafting and negotiating contractual rules and standards, lawyers and their clients make decisions by instinct or experience. But if the benefit of the rule is clear, so too is the cost. In a business deal of any size and complexity, it is difficult for contracting parties to foresee most, let alone all, contingencies and details of performance. Attempting to do so entails costs in terms of parties’ and lawyers’ time, and it may delay the transaction. Another problem with a rule is that changes in circumstances can expose gaps in the contract. If a scenario is not explicitly covered, no performance is specified and none needs to occur. The specificity that makes a rule desirable can also make it easy to avoid when one party has no incentive to avoid it.

An alternative to a rule is a standard: rather than specifying performance in detail, parties can agree to a broad statement of what they expect from each other. Not all terms of all deals can be codified with standards. But in many situations’ standards can be used appropriately. If a deal unfolds as expected, there will be no disagreement regarding fulfilment of a standard and the parties will certainly have gained by saving themselves the trouble of specifying all the details. If circumstances change, a standard can allow for adaptation and an alignment of expectations better than a rule world. But it also might not. Standards leave the details for later and, if the parties do not agree with how those details are filled in, a judge may have to decide for them.

The disadvantage of a rule, then, is that it may leave gaps, especially if circumstances change, while the disadvantage of a standard is its vagueness and associated uncertainty. One way to minimize these disadvantages and exploit the advantages each has to offer is to combine the two by backing up a rule with a standard that will fill gaps that the rule may leave open. There is one last alternative to rules, standards, and simplified rules. Parties may deliberately leave a contractual issue unresolved. It is a strategic omission.

Ultimately, Deals is a book that is a fine masterclass in understanding what is required to negotiate a deal, not necessarily always in a business environment, but in other scenarios too. The fact remains that there some basic economic principles underlying these negotiations with some economic and legal challenges too. Taking these into account, would help strategize better particularly when external factors are evolving rapidly. Some of these factors are human behaviour and expectations, interpretation of specific terminology in the contracts drafted at a future date, increasing use of AI, emerging technology, markets, information gathering, data collection, information dissemination and analysis etc. All these are playing an increasing critical role in taking decisions. Yet the fact remains that whether you are a business person, an economist, or a legal professional, experience and informed judgement matters.

Authors: Michael Klausner & Guhan Subramanian
Publication details: Harvard University Press, 2024. Pp. 164. Hb. Rs 599.