For nearly 40 years, scholars have debated whether business lawyers add value to transactions. The debate essentially started with an influential article by Professor Ronald Gilson, who characterized business lawyers as “transaction cost engineers.” These engineers optimize the costs of a transaction, he argued, by helping contracting parties efficiently break negotiation stalemates, thereby creating more valuable deals.
Gilson’s theory spurred meaningful insights into sophisticated corporate law practice, where outside lawyers parachute in to make one-off deals happen. However, the existing literature fails to explain how many business lawyers, and particularly startup lawyers, operate. Startup lawyers are able to engineer the cost of their client’s ultimate exit (e.g., an acquisition or an initial public offering (IPO)) well before that transaction materializes, and in doing so, they engineer the value of the startup itself. These lawyers are not just transaction-cost engineers, they are exit engineers.
In a new article, I re-examine what it means to be a transaction-cost engineer for venture-backed startups operating rapidly to develop and commercialize their products in preparation for an exit transaction. Rather than engage in traditional M&A or capital-markets practices, startup lawyers develop long-term relationships with their clients by advising them on day-to-day routine commercial matters related to their growing business and product operations. In the absence of this counsel, startups are prone to making mistakes that will, unbeknownst to them, ultimately affect the efficiency and value of a future exit.
For example, a startup will enter into numerous commercial transactions as it matures, such as intellectual property assignments, open-source software licenses, customer contracts, and agreements with service providers. Each of these has the potential to increase the costs of an exit and reduce the value of the startup. An intellectual property assignment might be legally sufficient, but fail to reflect the expectations of potential acquirers and IPO underwriters. Free open-source software may be inadvertently used under licensing terms that require the company to make its proprietary source code available to the public for free. A customer may insist the startup grant an overly broad intellectual property license that devalues its product. The startup may agree to contracts with boilerplate provisions that have no bearing on immediate performance obligations but directly implicate a future exit, such as clauses relating to a change of control, restraints that limit the company’s ability to organically grow its revenue and customer base (e.g., “most-favored-nation” or non-competition clauses), or language that binds the company’s future, unknown acquirer.
In the article, I deconstruct each of these missteps in detail and illustrate how they can individually (and in the aggregate) affect the efficiency of an exit. In an acquisition, for example, any of these circumstances will generate additional transaction costs. Both parties will expend resources on enhanced due diligence and drafting and negotiating special indemnification provisions or bespoke closing covenants. The parties also risk running into third-party hold-up scenarios for any consents to a change of control or confirmatory intellectual property assignments that are required before closing. Critically, an acquirer may also adjust its valuation of the company (i.e., the purchase price) if it determines through due diligence that it should pay less than intended for the startup.
Similarly, for a company undergoing an IPO, each diligence issue also generates needless costs. The parties may need to draft additional, nuanced, and tailored risk factors for the registration statement; securities laws favor over-disclosure of issues in registration statements to mitigate underwriter liability. Yet, the more robust the registration statement, the more likely there is to be more back-and-forth with the Securities and Exchange Commission in advance of approval. And, as with the acquisition scenario, the valuation of the company is jeopardized. Scholars have previously unearthed a relationship between increased disclosure and reductions in share price. Any decrease in the initial share price reflects a decrease in the value of the company.
Engaging a startup lawyer early in a company’s lifecycle, however, enables a startup to avoid these results. Startup lawyers create value by preserving the efficiency of an exit transaction and a company’s value by spotting and mitigating issues as they arise in the ordinary course of business. They have the benefit of having represented startups repeatedly and seen how issues play out in an exit. Because of their experience, an acquisition or IPO can proceed without avoidable costs.
Moreover, in future-proofing clients against the long-term consequences of ordinary course transactions, the exit engineering startup lawyer plays a critical role in preserving the vitality of the venture capital network. Venture capital funds (VCs) use the exit proceeds from one startup to invest in new startups: Successful exit transactions enable more successful ventures. By engaging a lawyer to provide commercial counsel, a startup is better able to ensure that its short-term decisions are consistent with its long-term commitment to its investors (as well as employees) to conclude a successful and efficient exit transaction. Otherwise, as a startup’s commercial mistakes accumulate, the cost and inefficiency of an exit rise and, in some cases, decrease the startup’s valuation. In other cases, the exit may not be able to happen at all and the startup may fold or be forced into bankruptcy. But in either scenario, VCs’ returns are impaired, jeopardizing the reinvestment cycle that powers the broader ecosystem.
This post comes to us from Rachel Landy, visiting assistant professor at Yeshiva University’s Benjamin N. Cardozo School of Law. It is based on her recent article, “Exit Engineering,” available here.