Clients who agree fancy deal terms: when should you pour cold water?

An easy way of ‘getting a rise’ out of IP Draughts (one of many) is to comment in his hearing that lawyers like to make things complicated.  No they don’t, he is likely to reply, in a style that has been compared to Hillary Rodham Clinton answering a Republican question at a Congressional enquiry.  It is clients who make things complicated, with their innovative deal structures.  If only they stuck to ‘plain vanilla’ deal terms, the contract drafting would be so much easier, and the bill so much smaller.

This thought crossed IP Draughts’ mind more than once in recent weeks.  The deal that prompted it related to an early-stage technology company that was ‘boot-strapping’ with a modest loan and the goodwill of some individuals who were not being paid for their services.

These individuals were to receive some ‘sweat equity’ as compensation for their past efforts, and some further shares that were to be linked to the future performance of the company.  The conventional way of structuring the latter would be to issue share options whose exercise is conditional upon future performance.  In the UK, share options typically have tax advantages for the individuals who receive them, compared with a simple issue of shares.

For reasons that are entirely understandable, the parties to this transaction did not agree on share options.  Instead, they agreed that the individuals would receive shares now, which would be returnable to the company if performance targets were not met.  This is known as a share ‘buy-back’ arrangement.  The company’s chairman, who negotiated the basic deal structure, had experience of such an arrangement in previous transactions.

Until fairly recently, it was very difficult for a UK company to buy-back its own shares.  While it is now easier to do so, company law has required the parties to go through additional corporate procedures before such an arrangement is valid.  The tax treatment of such an arrangement has its own complexities that need to be considered.  Moreover, as the individual owns the shares, additional steps need to be taken to ensure that the company can recover them in situations where they are forfeited.

As if this did not add enough complexity to the transaction, there was also complexity in the performance targets and the precise number of shares to be forfeited if they were not met.  While it was fairly simple to describe the arrangement in high-level terms, the detailed drafting took several hours to get right to our satisfaction.  When we showed the drafting to colleagues they scratched their heads until we explained the deal to them.  At that point they said they thought the drafting worked and was clear and accurate, which was reassuring.  But we were left wondering whether it was right for parties to enter into arrangements so complex that the drafting cannot be immediately understood by an experienced corporate lawyer.

Naturally, we pointed this concern out to our clients and suggested a more simple structure.  However, the negotiations were too far advanced to make changes.  The clients’ response, once they had reviewed the detailed wording, was that both parties were “very pleased” with the drafting and that they recognised that the deal terms were “logically complex”.

In the end the deal (which had other elements to it, not mentioned here) required us to prepare 29 separate documents for signature.  Once signature had taken place, the client thanked us for our efforts and suggested that the deal structure would be “an interesting exam question for company secretaries and corporate lawyers”.

IP Draughts agrees that there is an exam question (or several) in this deal.  The question could focus on how to structure and document the transaction.  But a more interesting question would be what the role of the lawyer should be when faced with such a deal structure.

How far should the lawyer interfere in a structure that apparently experienced and sophisticated parties have agreed?  Should he make clear his reservations and then get on with making it happen?  Or should he devote a considerable amount of time into trying to persuade the parties to think again and come up with a simpler structure?

What do you think, dear reader?