Impact of Separating Business and Legal Terms on Contract Values

This series of blog posts stems from an ongoing conversation with George Triantis, Professor of Law and Associate Dean at Stanford Law School.

Legal agreements facilitate the exchange of trillions of dollars of goods and services. Despite their critical importance to commerce, we lack clear understanding of how the documents impact the value of the transactions.

1. Multi-Stage Process

Albert Choi and George Triantis describe contract negotiations in complex transactions as a multi stage process. The principals—typically business people—first settle the business terms, representing “the core issues of their contract, such as the type of project and the price.” In later stages, often separated due to the complexity of the issues, the process involves experts, particularly lawyers, who add and negotiate the legal terms to protect their client’s interests in the transaction. Multi-Stage Contracting in Complex Transactions, a preliminary paper, January 2, 2014.

2. Consequences of Separation

The separation of the business and legal terms frequently means that lawyers, when negotiating non-core terms, generally lack the ability to revisit and adjust the price. Choi and Triantis observe: “while the negotiations in the later stages can be quite contentious and can often affect the structure of the deal, parties often do not (or rarely) revisit the initially agreed upon terms, sometimes even willing to jeopardize the entire deal.” Id

3. Impacts of Separation

The separation of core and non-core terms, without price adjustment raises two main possibilities. First, we can consider the possibility that legal terms do not affect the price, instead they have the effect of shifting risks between the parties. Or, second, we can examine whether the non-core terms do, in fact, adjust the monetary worth of the consideration, either adding or deducting value.

3.1 Non-Price Terms Shift Risks

The first possibility is that the non core terms shift risk between the parties.

Describing the non-core terms as adjusting risk is consistent with their character. The Contract Standards Framework presents the non core terms as insurance and assurance protections that safeguard the parties interests in the bargain and seek remedies in the event of failure in the agreement. In other words, the essence of these terms is protect the parties interests and mitigate risk.

In addition. treatment of the non-core terms as adjusting risks is also consistent with behavioral evidence. When we negotiate agreement, we evaluate both the financial benefits of the consideration and the probability that the hoped for value will be realized. We assess whether the terms are more favorable to us or are more weighted to favor the other party. Most importantly, we assess whether the terms falls within the comfort zone or cross the tipping point threshold where the risks outweigh the benefits and we will walk away from the deal.

3.2. Non-Core Terms Adjust Contract Values

Alternatively, we can assess whether non-core terms have a monetary impact, which can adjust contract values.

As discussed in an earlier post, contracts are legal vehicles to exchange value and each term has at least some economic impact of the transaction. And, even if some terms have only marginal value, many non-core or legal terms have significant value, such as a warranty or an indemnity.

It can be asserted that those terms that have significant and identifiable value are, in fact, part of the core business terms, irrespective of where they appear in the agreement. If so, the value of the such measurable terms can be added or deducted to the monetary value of the consideration given and received. For example, a non-compete provision in an employment agreement has quantifiable value to both the employer and employee and its present value (discounted by the probability of occurrence and discounted to net present value) can tabulated against salary and benefits.

However, while it is theoretically possible to put a price on the legal terms, there is no evidence that the parties, in fact, create a spreadsheet to compute contract values by assigning economic value to each. More work needs to be done in the area of contract behavioral models, however, one possibility is that the parties weigh both the financial benefits with the risks in order to assess their negotiation strategies and whether they will come to an agreement.

The next question is whether a practical model for contract valuation can be found.