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Copyright David M. Schizer 2013. All Rights Reserved.

Deals Problem Set # 1:

Information and Incentive Problems: Venture Capital

These questions will help you focus on what is important when you do the reading. In addition, please bring this problem set to class because we will discuss these questions in class.

1. I offer to sell you a used car for $5,000. You need a car and the price is within your budget. Is there anything else you need to know or think about before you agree to purchase the car?

a. Would you be more comfortable if you can ask me questions? What if I am not honest in my answers?

b. Would you be more comfortable if we bring in a mechanic to look at the car? What if the mechanic is my brother-in-law?

c. Would you be more comfortable if I offer to let you pay only $2000 now, and to pay $3000 in a year if the car is still running well? Does it matter how we define whether the car is “running well”?

2. I offer to sell you a house for $500,000. You need a house and the price, again, is within your budget. What else do you need to know? If you see any problems, what steps could we (or our lawyers) take to address these issues?

3. I offer to sell you a business for $1 million. You are looking to buy a business and the price, once again, is in your budget. Do you have the same sort of questions that you had for the car and the house? If so, what steps do you think we should take to address these issues?

4. Please define the term “asymmetric information.”

5. Please define the term “moral hazard.”

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6. Why do you think stores that sell clothes online allow people to return them at no charge? After all, it costs them time and money to let people return them. Why give people a “money-back guarantee” of this sort?

7. If you sell clothes online, and someone who buys them spills wine on them, would you accept the clothes back? Do you think it would be a good idea to charge people more in order to let them return the clothes for any reason, including the fact that they stained them? What would you need to know in order to figure out how much to charge? If you sell people this right, do you think it will affect how careful they are with the clothes?

8. You want to go into business organizing outdoor concerts. A challenge, though, is that it sometimes rains, so the concert has to be cancelled.

a. Meanwhile, a performer who agrees perform has to commit to the night anyway, giving up other opportunities to perform. Do you think the performer will agree not to be paid if it rains?

b. You have to rent the outdoor arena for the night. If it rains, do you think the outdoor arena will agree not to charge you?

c. What about people who buy tickets? Should they have to pay anyway, even if the concert is cancelled?

d. More generally, how should we decide who is in the best position to bear the risk of bad weather? How does this risk compare with the risks involved in allowing clothing returns?

9. Ellen has an idea for a new business. She wants to hire professors to teach courses online, and to charge people for taking these courses. But Ellen needs money to start “Learn-online, Inc.” She has two potential investors. One, Schoolco, is an educational institution. The other, Pensionco, invests money for the police department in order to be able to pay pensions to retired policemen.

a. Which of these investors has potentially greater expertise about the subject of Ellen’s business? In what ways can investors potentially add value beyond their investment?

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b. If Ellen was also asking you to invest, would you care who the other investors are? Would you be more likely to invest if you heard that the other investor was Schoolco or Pensionco?

c. Ellen plans to be the CEO of this business. In addition to wanting the investment, she also wants to make sure she will not be replaced as CEO. In pursuing this second goal (of keeping her job), does she have a reason to prefer one employer over the other?

d. Please define the term “agency cost.”

10. On January 1, Ellen will need $200,000 to hire technology consultants for six months to prepare the website. The effectiveness of the website is going to be quite important in determining the success of the business. Six months later (on July 1), she will need $200,000 to hire faculty to teach the courses, which will begin on September 1. The quality of the faculty will obviously also be important.

In response, Pensionco offers to buy 500,000 shares of Learn-online, Inc. – representing half of the company’s 1 million shares – for $400,000. They would pay $200,000 on January 1, and $200,000 on July 1.

But Schoolco’s offer is different. They are offering to pay $250,000 on January 1 for two things: first, ¼ of the shares of the company (250,000 shares); and second, an option to buy another ¼ of the company (i.e., another 250,000 shares) on June 30 for $250,000. Although Schoolco would have the right to buy these additional shares, they are not obligated to do so.

a. Does each offer ensure that Ellen has the money she needs to launch the business?

b. Why might Ellen be tempted to take Schoolco’s offer? Why might she be worried about doing so?

c. Why do you think Schoolco is willing to pay more? What are they getting in return? Why do you think they value the extra business term they are seeking?

d. Let’s say Ellen makes a counteroffer to Schoolco, saying she will agree to their terms if they agree to decide whether to make their second investment – not on June 30

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(after six months) – but on January 6 (after six days). If you were advising Schoolco, would you think this change in timing is significant?

e. If Ellen is unwilling to take Schoolco’s offer, does that tell us something about her prediction for the business?

11. Assume that Ellen takes Schoolco’s offer. Assume also that six months later, Schoolco decides not to buy the additional 250,000 shares. At that point, Ellen goes back to Pensionco to ask if they want to invest. If you are advising Pensionco, would it matter to you that Schoolco had decided not to invest?

12. What is a “right of first refusal”? Why is it costly to grant one? If it is, why would anyone offer one?

13. Do you agree or disagree with the following statements?:

a. As long as the underlying business makes sense, it doesn’t matter who owns it or how the ownership is divided.

b. In structuring a new deal, we should use the structure from a past deal as a model (or “precedent’).

c. We need to structure a deal to reflect what each party brings to the table.

d. Current structuring can affect future bargaining.

e. When we structure a deal, we need to focus on the information each party has (or does not have).

14. Beth offers you the following proposal: If you invest $1,000, she will use it to develop a cure for the common cold. She is close to a cure, but there are no guarantees. If she is successful, your $1,000 will be worth $100,000. But she could fail, leaving you with nothing. What risks do you see in this proposal?

a. In dealing with these risks, are you comforted or are you more nervous if this investment is one of several that you make?

b. Does it matter if you personally have expertise about developing drugs?

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c. Let’s say that Beth is very wealthy and can finance the investment herself. Is that fact relevant to your decision about whether to invest?

d. Let’s say you learn that Beth is going to do some of the relevant research as part of graduate work she is doing in biochemistry. Is that relevant to your decision?

e. Let’s say you learn that Beth plays a lot of golf. Is that relevant to your decision?

f. Can we use a contract to address the risks you have identified? If this is hard to do, why is it hard?

g. Do you agree with the following statement and, if so, why? “An organization can substitute for a contract.”

15. What is venture capital? What type of businesses do venture capitalists (“VC’s”) finance?

16. Berle and Means identify a problem in public corporations. What is it? Does this problem arise when venture-capitalists make investments?

17. When an entrepreneur and a venture capitalist strike a deal, how is the entrepreneur usually paid? Why?

18. Venture capitalists often specialize in a particular sector. Why?

19. Do venture capitalists usually invest all at once or invest in stages? Why?

20. Who usually controls the board of directors when a venture capitalist invests in a “portfolio company”?

21. What are convenants and how do venture capitalists use them?

22. What risk does an entrepreneur take in giving venture capitalists control rights? When do venture capitalists lose their control rights? What incentive does this create for an entrepreneur?

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23. Are there reasons why a venture capitalist might hesitate to fire an entrepreneur, even if she has the legal right to do so?

24. Venture capitalists often have partners in their funds, like universities and pension funds. If you were advising a university about investing in a VC fund, what risks would you see for the university? What would they want to know about the VC’s? Are these risks different from the ones the VC faces in deciding whether to invest with an entrepreneur?

25. How do universities, pension funds, and other investors compensate venture capitalists? Why do you think the pay takes that form?

26. If a university invests in a venture capital fund, is there a particular date on which it is supposed to get its money back? Why are VC funds structured in this way?

27. What is a clawback, and why are they included in VC funds?

28. Is a general partner in a venture capital fund allowed to direct the fund to invest in the general partner’s business?

29. Can the general partner sell its interest in the VC fund?

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Adolf A. Berle & Gardiner C. Means. The Modern Corporation and Private Property

Chapter VI: The Divergence of Interest Between Ownership and Control

The foregoing chapters have indicated that the corporate system tends to develop a division of the functions formerly accorded to ownership. This calls for an examination of the exact nature of these functions; the inter-relation of the groups performing them; and the new position which these groups hold in the community at large.

In discussing problems of enterprise it is possible to distinguish between three functions: that of having interests in an enterprise, that of having power over it, and that of acting with respect to it. A single individual may fulfill, in varying degrees, any one or more of these functions.

Before the industrial revolution the owner-worker performed all three, as do most farmers today. But during the nineteenth century the bulk of industrial production came to be carried on by enterprises in which a division had occurred, the owner fulfilling the first two functions while the latter was in large measure performed by a separate group, the hired managers. Under such a system of production, the owners were distinguished primarily by the fact that they were in a position both to manage an enterprise or delegate its management and to receive any profits or benefits which might accrue. The managers on the other hand were distinguished primarily by the fact that they operated an enterprise, presumably in the interests of the owners. The difference between ownership and management was thus in part one between position and action. An owner who remained completely quiescent towards his enterprise would nevertheless remain an owner. His title was not applied because he acted or was expected to act. Indeed, when the owner acted, as for instance in hiring a manager or giving him directions, to that extent the owner managed his own enterprise. On the other hand, it is difficult to think of applying the title “manager” to an individual who had been entirely quiescent.

Under the corporate system, the second function, that of having power over an enterprise, has become separated from the first. The position of the owner has been reduced to that of having a set of legal and factual interests in the enterprise while the group which we have called control, are in the position of having legal and factual powers over it.

In distinguishing between the interests of ownership and the powers of control, it is necessary to keep in mind the fact that, as there are many individuals having interests in an enterprise who are not customarily thought of as owners, so there may be many individuals having a measure of power over it who should not be thought of as in control. In the present study we have treated the stockholders of a corporation as its owners. When speaking of the ownership of all corporations, the bondholders are often included with the stockholders as part owners. The economist does not hesitate for certain purposes to class an employee with wages due him as temporarily a part owner. All of these groups have interests in the enterprise. Yet a laborer who has a very real interest in a business in so far as it can continue to give him employment is not regarded as part owner. Nor is a customer so included though he has a very real interest in a store to the extent that it can continue to give him good services. Of the whole complex of individuals having interests in an enterprise, only those are called owners who have major interests and, before the law, only those who hold legal title. Similarly, the term control

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must be limited for practical purposes to those who hold the major elements of power over an enterprise, keeping in mind, however, that a multitude of individuals may exercise a degree of power over the activities of an enterprise without holding sufficient power to warrant their inclusion in “control.”

Turning then to the two new groups created out of a former single group,-the owners without appreciable control and the control without appreciable ownership, we must ask what are the relations between them and how may these be expected to affect the conduct of enterprise. When the owner was also in control of his enterprise he could operate it in his own interest and the philosophy surrounding the institution of private property has assumed that he would do so. This assumption has been carried over to present conditions and it is still expected that enterprise will be operated in the interests of the owners. But have we any justification for assuming that those in control of a modern corporation will also choose to operate it in the interests of the owners? The answer to this question will depend on the degree to which the self-interest of those in control may run parallel to the interests of ownership and, insofar as they differ, on the checks on the use of power which may be established by political, economic, or social conditions.

The corporate stockholder has certain well-defined interests in the operation of the company, in the distribution of income, and in the public security markets. In general, it is to his interest, first that the company should be made to earn the maximum profit compatible with a reasonable degree of risk; second, that as large a proportion of these profits should be distributed as the best interests of the business permit, and that nothing should happen to impair his right to receive his equitable share of those profits which are distributed; and finally, that his stock should remain freely marketable at a fair price. In addition to these the stockholder has other but less important interests such as redemption rights, conversion privileges, corporate publicity, etc. However, the three mentioned above usually so far overshadow his other interests as alone to require consideration here.

The interests of control are not so easily discovered. Is control likely to want to run the corporation to produce the maximum profit at the minimum risk; is it likely to want to distribute those profits generously and equitably among the owners; and is it likely to want to maintain market conditions favorable to the investor? An attempt to answer these questions would raise the whole question of the nature of the phenomenon of “control.” We must know the controlling individual’s aims before we an analyze his desires. Are we to assume for him what has been assumed in the past with regard to the owner of enterprise, that his major aim is personal profits? Or must we expect him to seek some other end-prestige, power, or the gratification of professional zeal?

If we are to assume that the desire for personal profit is the prime force motivating control, we must conclude that the interests of control are different from and often radically opposed to those of ownership; that the owners most emphatically will not be served by a profit-seeking controlling group. In the operation of the corporation, the controlling group even if they own a large block of stock, can serve their own pockets better by profiting at the expense of the company than by making profits for it. If such persons can make a profit of a million dollars from a sale of property to the corporation, they can afford to suffer a loss of $600,000 through the ownership of 60 percent of the stock, since the transaction will still net them $400,000 and

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the remaining stockholders will shoulder the corresponding loss. As their proportion of the holding decrease, and both profits and losses of the company accrue less and less to them, the opportunities of profiting at the expense of the corporation appear more directly to their benefit. When their holdings amount to only such fractional per cents as the holdings of the management in management-controlled corporations, profits at the expense of the corporation become practically clear gain to the persons in control and the interests of a profit seeking control run directly counter to the interests of the owners.

In the past, this adverse interest appears sometimes to have taken the extreme form of wrecking a corporation for the profit of those in control. Between 1900 and 1915 various railroads were brought into the hands of receivers as a result of financial mismanagement, apparently designed largely for the benefit of the controlling group, while heavy losses were sustained by the security holders.1

Such direct profits at the expense of a corporation are made difficult under present laws and judicial interpretations, but there are numerous less direct ways in which at least part of the profits of a corporation can be diverted for the benefit of those in control. Profits may be shifted from a parent corporation to a subsidiary in which the controlling group have a large interest. Particularly profitable business may be diverted to a second corporation largely owned by the controlling group. In many other ways it is possible to divert profits which would otherwise be made by the corporation into the hands of a group in control. When it comes to the questions of distributing such profits as are made, self-seeking control may strive to divert profits from one class of stock to another, if, as frequently occurs, it holds interests in the latter issue. In market operations, such control may use “inside information” to buy low from present stockholders and sell high to future stockholders. It may have slight interest in maintaining conditions in which a reasonable market price is established. On the contrary it may issue financial statements of a misleading character or distribute informal news items which further its own market manipulations. We must conclude, therefore, that the interests of ownership and control are in large measure opposed if the interests of the latter grow primarily out of the desire for personal monetary gain.

Into the other motives which might inspire action on the part of control it will not profit us to go, though speculation in that sphere is tempting. If those in control of a corporation reinvested its profits in an effort to enlarge their own power, their interests might run directly counter to those of the “owners.” Such an opposition of interest would also arise if, out of professional pride, the control should maintain labor standards above those required by competitive conditions and business foresight or should improve quality above the point which, over a period, is likely to yield optimum returns to the stockholders. The fact that both of these actions would benefit other groups which are essential to the existence of corporate enterprise

1See Chicago & Alton Railway Co. 12 I.C.C. 295-1907Pere Marquette Railway Co. 44 I.C.C. 1-1914Chicago, Rock Island & Pacific 36 I.C.C. 43-1915New York, New Haven & Hartford 31 I.C.C. 32-1914St. Louis & San Francisco Ry. Co. 29 I.C.C. 139-1915

All of these roads went into receivership or were in financial difficulties as a direct or indirect result of financial management of highly questionable sort.

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and which for some purposes should be regarded as part of the enterprise, does not change their character of opposition to the interests of ownership. Under other motives the interests of owner and control may run parallel, as when control seeks the prestige of “success” and profits for the controlled enterprise is the current measure of success. Suffice it here to realize that where the bulk of the profits of enterprise are scheduled to go to owners who are individuals other than those in control, the interests of the latter are as likely as not to be at variance with those of ownership and that the controlling group is in a position to serve its own interests.

In examining the break up of the old concept that was property and the old unity that was private enterprise, it is therefore evident that we are dealing not only with distinct but often with opposing groups, ownership on the one side, control on the other-a control which tends to move further and further away from ownership and ultimately lie in the hands of the management itself, a management capable of perpetuating its own position. The concentration of economic power separate from ownership has, in fact, created economic empires, and has delivered these empires into the hands of a new form of absolutism, relegating “owners” to the position of those who supply the means whereby the new princes may exercise their power.

The recognition that industry has come to be dominated by these economic autocrats must bring with it a realization of the hollowness of the familiar statement that economic enterprise in America is a matter of individual initiative. To the dozen or so men in control, there is room for such initiative. For tens and even hundreds of thousands of workers and of owners in a single enterprise, individual initiative no longer exists. Their activity is group activity on a scale so large that the individual, except he be in a position of control, has dropped into relative insignificance. At the same time the problems of control have become problems in economic government.

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Theodore Baums & Ronald J. Gilson, The Legal Infrastructure of the German Venture Capital Market: Replicating the U.S. Template (unpublished manuscript)

* * *I. An Overview of the Organizational and Contractual Structure of U.S. Venture Capital

An overview of the U.S. venture capital market begins with its funding sources. Institutional investors dominate U.S. venture capital. Over the four years between 1992 and 1995, institutional investors – pension funds, banks, insurance companies, and endowments and foundations – represented over 75 percent of the total capital raised by venture capital funds. In particular, pension funds alone on average represented more than 46 percent of total capital raised.1 These institutions typically invest through intermediaries – venture capital limited partnerships, usually called “venture capital funds,” in which the investors are passive limited partners.2 Venture capital funds are typically blind pools. At the time an institution decides whether to participate in a venture capital fund, it receives an offering memorandum that discloses the fund’s investment strategy – for example, that the fund will specialize in a particular industry, like the internet, or a distinct development stage, like early stage investments. However, the particular companies in which the fund will invest are not yet known. Consistent with the legal rules governing limited partnerships, the limited partners may not participate in the day to day management of the fund’s business, including especially the approval of particular portfolio company investments.3 In this respect, the venture capital fund’s governance structure formalizes the standard Berle-Means problem of the separation of ownership and control.4 The general partner (GP) puts up only one percent of the capital, but receives essentially complete

11 Black & Gilson, supra note 3, at 249 (Table 3).

22 Some institutions also make direct investments, often in the same portfolio company that a venture capital fund in which the institution is a limited partner, is simultaneously investing.

33 Under Delaware law, the limited partners can make certain extraordinary decisions, such as replacing the general partner or terminating the partnership. See 6 Del.C. §17-303(b)(8)(e). However, these rights are typically restricted by contract. See Michael C. Halloran, Gregg Vignos & C. Brian Wainwright, Agreement of Limited Partnership, in I Venture Capital and Public Offering Negotiation 1-1 through 1-218 (M. Halloran, R. Gunderson, Jr., & J. del Cavo, eds. 1998) (form of limited partnership agreement with commentary). Venture capital funds frequently do appoint advisory committees, usually made up of investor representatives, that monitor the fund’s performance. See William A. Sahlman, The Structure and Governance of Venture-Capital Organizations, 27 J.Fin. Econ. 473, 493 (1990).

44 Adolph A. Berle & Gardiner C. Means, The Modern Corporation and Private Property (1932).

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control over all of it.5 The particular terms of the fund’s governance are set out in the limited partnership agreement.6

The GP actually makes and monitors the venture capital fund’s investments. The GP is typically itself a company comprised of investment professionals, which expects to continue in the venture capital market by raising successive funds after the capital in a particular fund has been invested in portfolio companies. Commonly the GP will begin seeking investors for a successor fund by the midpoint of the existing funds fixed, typically ten year, term. At the close of the partnership’s fixed term, liquidation is mandatory. Indeed, the partnership will be in partial liquidation during much of its term because realized profits are required to be distributed to the limited partners on an annual basis.7 The GP’s principle contribution to the venture capital fund is expertise, not capital. This is reflected in the ratio of capital contributions. In most funds, the GP contributes one percent of the fund’s capital, while the limited partner investors contribute the remaining 99 percent.

The GP’s compensation is also skewed. The GP usually receives an annual management fee for its services, but the fee is relatively small, usually 2.5 percent of committed capital.8 The primary return to the general partner is a carried interest – that is, a right to receive a specified percentage of profits realized by the partnership. Twenty percent is a common figure.9 The GP generally receives its carried interest at the same time that distributions are made to the limited partners, subject to two limitations. First, general partners typically receive no distributions until the limited partners have received an amount equal to their capital contributions, sometimes with interest. Second, distributions to the GP are subject to certain “claw back” provisions that ensure that the order of distribution does not affect the ultimate percentage of profits received by the GP.

The venture capital fund’s equity investments in portfolio companies typically take the form of convertible preferred stock.10 While not required by the formal legal documents, the fund

55 Even if one treated the venture capitalist’s carried interest as a measure of the value of its human capital contribution, it is still putting up less than 20 percent of the capital but receiving control.

66 See Halloran, et al., Agreement of Limited Partnership, supra note __, in Venture Capital and Public Offering Negotion (M. Halloran, L. Benton, R. Gunderson, Jr., & J. del Cavo eds. 1998). Paul Gompers & Josh Lerner, The Use of Covenants: An Empirical Analysis of Venture Capital Limited Partnerships, 39 L.& Econ. 463 (1996), examines the terms of such agreements.

77 Sahlman, supra note _, at 491-92; Agreement of Limited Partnership, supra note ___, at 1-62 to 1-72..

88 Id., at 491; In most cases, the agreement provides for a breakpoint above which the management fee is reduced, either on funds under management of number of years after the partnership's formation. Halloran, et al., Limited Paratnership Agreement, supra note __.

99 Sahlman, supra note __, at 491; Halloran, et al., Agreement of limted Partnership, supra note __, at 1-46.

010 Paul Gompers, Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments, Harvard Business School Working Paper (Sept. 1997);

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is also expected to make important non-cash contributions to the portfolio company. These contributions consist of management assistance, corresponding to that provided by management consultants; intensive monitoring of the portfolio company’s performance which provides an objective view to the entrepreneur; and the use of the fund’s reputation to give the portfolio company credibility with potential customers, suppliers, and employees.11 While each investment will have a “lead” investor who plays the primary role in monitoring and advising the portfolio company, commonly the overall investment is syndicated with other venture capital funds that invest in the portfolio company at the same time and on the same terms.12

The initial venture capital investment usually will be insufficient to fund the portfolio company’s entire business plan. Accordingly, investment will be "staged." A particular investment round will provide only the capital the business plan projects as necessary to achieve specified milestones set out in the business plan.13 While first round investors expect to participate in subsequent investment rounds,14 they are not contractually obligated to do so even if the business plan’s milestones are met; the terms of later rounds of investment are negotiated at the time the milestones are met and the prior investment exhausted. Like the provision of non-capital contributions, implicit, not explicit contract governs the venture capital fund’s right and obligation to provide additional rounds of financing if the portfolio company performs as expected. The venture capital fund’s implicit right to participate in subsequent rounds is protected by an explicit right of first refusal.

A critical feature of the governance structure created by the venture capital fund’s investment in the portfolio company is the disproportionate allocation of control to the fund.15 In direct contrast to the familiar Berle-Means governance structure where the outside investors have disproportionately less control than equity, the governance structure of a venture capital-backed early stage, high technology company allocates to the venture capital investors disproportionately greater control than equity. It is common for venture capital investors to have the right to name a majority of a portfolio company’s directors even though their stock represents less than a majority of the portfolio company’s voting power.16 Additionally, the portfolio

Sahlman, supra note _, at 36.

111 Black & Gilson, supra note 3, at 252-255. See William D. Bygrave & Jeffrey A. Timmons, Venture Capital at the Crossroads ___ (1992); Christopher Barry, New Directions in Venture Capital Research, 23 J. Fin. Mngmnt. 3, __ (1994).

212 Josh Lerner, The Syndication of Venture Capital, 23 Fin. Mngmnt. 16 (1994).

313 See Paul A. Gompers, Optimal Investment, Monitoring, and the Staging of Venture Capital, 50 J. Fin. 1461 (1995).

414 Sahlman, supra note __, at 475, reports that venture capital funds invest one-third of their capital in new investments and two-thirds in later round financing of companies already in their portfolios.

515 Gompers, Ownership and Control, supra note __.

616 In Gomper’s sample of portfolio company investments, venture capital investors on average controlled

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company will also enter into a series of contractual negative covenants that require the venture capital investors’ approval before the portfolio company can take certain business decisions, such as acquisition or disposition of significant amounts of assets, or a material deviation from the business plan. The extent of these negative covenants is related to whether the venture capital investors have control of the board of directors; board control acts as a partial substitute for covenant restrictions.17

These formal levers of control are complemented by the informal control elements that result from the staged financing structure. Because a financing round will not provide funds sufficient to complete the portfolio company’s business plan, staged financing in effect delegates to the investors, in the form of the decision whether to provide additional financing, the decision whether to continue the company’s project.18

Two final characteristics of investments in portfolio companies concern their terms and their expected performance. While these are not short-term investments, neither are they expected to be long-term. Because venture capital limited partnerships have limited, usually10 year terms,19 GP’s have a strong incentive to cause the fund’s portfolio company investments to become liquid as quickly as possible. Assuming that the GP has invested all of a fund’s capital by the midpoint of the fund’s life, the GP then must seek to raise additional capital for a new fund in order to remain in the venture capital business. Because the performance of a GP’s prior funds will be an important determinant of its ability to raise capital for a new fund, early harvesting of a fund’s investments will be beneficial.20 Venture capital funds exit successful investments by two general methods: taking the portfolio company public through an initial public offering of its stock (an “IPO”); or selling the portfolio company to another firm. The likelihood of exit by an IPO or a sale has differed over different periods. Between 1984 and 1990, 396 venture capital-backed firms went public, while 628 such firms were sold to other firms before going public. Between 1991 and 1996, the order reversed, with 1059 firms going

the portfolio company’s board of directors, but held only 41 percent of the equity. The venture capital fund’s right to select a specified number of directors is contained in the portion of the portfolio company’s articles of incorporation that sets out the rights, preferences and privileges of the convertible preferred stock the investors receive. This portion of the articles will typically be added by amendment simultaneously with the closing of the venture capital investment. L. Benton & Robert Gunderson, Jr., Portfolio Company Investments: High-Tech Corporation, in Venture Capital and Public Offering Negotion (M. Halloran, L. Benton, R. Gunderson, Jr., & J. del Cavo eds. 1998), sets out a standard form of restated articles of incorporation in connection with a convertible preferred stock venture capital financing.

717 See Gompers, Ownership and Control, supra note __. The negative covenants are contained in a different closing document, the investors rights agreement. Benton & Gunderson, supra note __, sets out a form of investors rights agreement with illustrative negative covenants.

818 Gompers, Ownership and Control, supra note __; Anat Admati & Paul Pfleiderer, Robust Financial Contracting and the Role of Venture Capitalists, 49 J. Fin. 371 (1994).

919 Halloran, et al., supra note __, at 1-20,

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public and 524 being sold.21 While it is not uncommon for the terms of a venture capital preferred stock investment to give the venture capital fund the right to require the portfolio company to redeem its stock, redemption is not a viable exit mechanism because portfolio companies lack the funds to effect the redemption.22 Such put rights are better understood as a control device that can force the portfolio company to accommodate the fund’s desire to exit by way of IPO or sale.

The fact that portfolio company investments are of limited duration rather than long term is critical to the operation of the venture capital market.23 The non-cash contributions made by the venture capital fund to the portfolio company – management assistance monitoring, and service as a reputational intermediary – share a significant economy of scope with its provision of capital. The portfolio company must evaluate the quality of the fund’s proffered management assistance and monitoring, just as potential employees, suppliers and customers must evaluate the fund’s representations concerning the portfolio company’s quality. Combining financial and nonfinancial contributions enhances the credibility of the information the venture capital fund proposes to provide the portfolio company and third parties. Put simply, the venture capital fund bonds the accuracy of its information with its investment.

The importance of the portfolio company investment’s limited duration reflects the fact that the venture capital fund’s non-cash contributions have special value to early stage companies. As the portfolio company gains its own experience, and develops its own reputation, the value of the venture capital fund’s provision of those elements declines. By the time a portfolio company succeeds, and the venture capital fund’s exit from the investment is possible, the fund’s non-cash contributions can be more profitably invested in a new round of early stage companies. But because of the economies of scope between cash and non-cash contributions, recycling the venture capital fund’s non-cash contributions also requires recycling its cash contributions. Exit from a fund’s investments in successful portfolio companies thus serves to recycle its cash and, therefore, its associated non-cash contributions from successful companies to early stage companies.

The risk associated with portfolio company investments is reflected in the variability of returns. While some investments return many multiples of the original investment, a survey of the performance of venture capital-backed companies, not limited to early stage technology companies and therefore presenting less uncertainty than the category of investments that concern us here, reports wide variation in returns. In the sample studied, 50 percent of the total

020 Black & Gilson, supra note 3, at 255-57. This incentive may cause a GP without a performance record with prior funds to harvest investments earlier than would be optimal for the investors in order to establish a record sufficient to allow the raising of a new fund. See Gompers, Ownership and Control, supra note __.

121 Black & Gilson, supra note 3, at 248 (Table 1).

222 Black & Gilson, supra note 3; Gompers, supra note __

323 This discussion draws on Black & Gilson, supra note 3.

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return was provided by only 6.8 percent of the investments. Over a third of the investments resulted in partial or total loss.24

II. The Economics of Venture Capital Contracting: the Special Problems of Uncertainty, Information Asymmetry, and Agency Costs

All contracts respond to three central problems: uncertainty, information asymmetry, and agency costs. The special character of venture capital contracting is shaped by the fact that investing in early stage, high technology companies presents these three problems in extreme form. Precisely because the portfolio company is at an early stage, uncertainty concerning future performance is magnified. Virtually all of the important decisions bearing on the company’s success remain to be made, and most of the significant uncertainties concerning the outcome of the company’s efforts remain unresolved. To the extent the entrepreneur is beginning her first company, additional uncertainty concerns the quality of the company’s management, which takes on heightened importance because so large a portion of the portfolio company’s value depends on management’s future decisions. Finally, the technology base of the portfolio company’s business exacerbates the general uncertainty by adding scientific uncertainty – the entrepreneur’s beliefs about the underlying science sought to be commercialized may prove incorrect. Some evidence of the extent of uncertainty appears from the large variance in returns from portfolio company investments.25

The same factors expand the information asymmetries between potential investors and entrepreneurs, as intentions and abilities are far less observable than actions already taken. Similarly, the fact that the portfolio company’s technology involves cutting edge science assures that the information asymmetry between the entrepreneur, typically directly involved in the company’s research effort, and the venture capital fund, even if the fund employs individuals with advanced scientific training, will be unusually wide.

Finally, the importance of future managerial decisions in an early stage company whose value depends almost entirely on future growth options, creates potentially very large agency costs,26 which are in turn amplified by the significant variance associated with an early stage, high technology company’s expected returns. Because the entrepreneur’s stake in a portfolio company with venture capital financing can be fairly characterized as an option, the entrepreneur’s interests will sharply diverge from those of the venture capital investors, especially with respect to the risk level and duration of the investment.27

424 Venture Economics, Exiting Venture Capital Investments (1988).

525 See TAN __ supra.

626 Gompers, Ownership and Control, supra note __.

727 Fischer Black & Myron Scholes, The Pricing of Options and Corporate Liabilities, 81 J.Pol. Econ. 637 (1973).; Stewart Myers, Determinants of Corporate Borrowing, 5 J.Fin. Econ. 147 (1977). The application of option pricing analysis to transactional and contractual structuring is developed in Ronald J. Gilson & Bernard S. Black, The Law and Finance of Corporate Acquisitions Ch. 7 (2d ed. 1995).

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The organizational and contractual structure of the U.S. venture capital market responds to this trio of problems. The effectiveness of the response serves to make the venture capital market feasible. Absent a workable response, the extremity of uncertainty, information asymmetry, and agency problems likely would raise the cost of external capital to a point of market failure, leading to a similar collapse in the formation of early stage, high technology companies. Because of the link between firm size and innovation,28 institutional and contractual techniques thus have an important influence on the successful commercialization of cutting edge science.

The organizational and contractual techniques observed in the venture capital market reflect three basic characteristics. First, very high power incentives for all participants – investors, GPs, and entrepreneurs – are coupled with very intense monitoring.29 Second, the organizational and contractual structure reflects the use of both explicit and implicit contracts. Thus, the governance structure of both the portfolio company and the venture capital fund is composed of market as well as formal aspects. Third, a pivotal aspect of this mix of formal and market governance, especially repeat play and reputation mechanisms, is that the two contracting nodes which comprise the venture capital market – the venture capital fund limited partnership agreement and the portfolio company investment contract, are determined simultaneously. As we will see, this braiding of the two relationships facilitates the resolution of problems internal to each.

In this Part, we show how multiple forms of incentive and monitoring techniques, including contractual, control, and market mechanisms, operate in connection with each contracting node to resolve the problems of uncertainty, information asymmetry and agency associated with early stage, high technology financing. We consider first the venture capital fund-portfolio company contract and then turn to the investor-venture capital fund limited partnership agreement. Finally, we consider the importance of the braiding of these two contracts.

A. The Venture Capital Fund-Portfolio Company ContractFive organizational and contractual techniques discussed in Part I – staged financing,

allocation of elements of control, form of compensation, the role of exit, and reliance on implicit contracts – respond to the problems poseded by financial contracting in the face of extreme forms of uncertainty, information asymmetry, and agency costs.

1. Staged Financing. As discussed in Part I, venture capital investments are usually staged, with funding decisions keyed to milestones in the business plan. Because the venture capital fund has the right, but not the obligation, to fund subsequent stages of development, the structure gives the investor a valuable option to abandon. This structure responds directly to the uncertainty associated with contracting for early stage, high technology investments. The milestones in the business plan are keyed to events that, because their

828 See note __ supra.

929 This is consistent with Milgrom & Roberts “incentive intensity principle,” which predicts that because intense incentives give rise not only to incentives to perform but also to incentives to cheat, intense incentives require a significant investment in monitoring. Paul Milgrom & John Roberts, Economics, Organization & Management, Ch. 7 (1992).

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occurrence reveals important information, reduce the uncertainty associated with the project’s ultimate success. Thus, a first milestone may be the creation of an operating prototype, which eliminates uncertainty about the portfolio company’s ability to reduce its science to a commercial product. The decision about additional investment is then made only after the passage of time and performance has replaced projection with fact. The result is to reduce the uncertainty associated with the funding of further rounds of investment.30

Without more, however, staged financing does not increase the expected value of the portfolio company's project. To be sure, the investor receives an option to abandon, but the value of that option to the recipient is exactly balanced by the cost of option to its writer, the entrepreneur. Absent an unrealistic assumption about investor risk aversion, merely shifting exogenous uncertainty from the investor to the entrepreneur does not create value.31 For this to occur, staged financing must accomplish something more.

The first respect in which staged financing creates, rather than merely transfers, value is its reduction in the agency problems associated with the entrepreneur’s management of the portfolio company’s operation. Staged financing aligns the interests of the venture capital fund and the entrepreneur by creating a substantial performance incentive. If the portfolio company does not meet the milestone whose completion was funded in the initial round of financing, the venture capital fund has the power to shut the project down by declining to fund the project’s next round.32 Even if the venture capital fund chooses to continue the portfolio company’s project by providing another round of financing, a performance penalty still can be imposed by assigning the portfolio company a lower value for purposes of the price paid in the new round. To be sure, the portfolio company may seek financing from other sources if the existing investors decline to go forward, or are willing to go forward only at an unfavorable price, but the overall contractual structure significantly reduces the availability of a market alternative.

First, potential investors know they are being solicited only because investors in the prior round are dissatisfied with the portfolio company’s performance. Second, the investors rights agreement gives the venture capital fund a right of first refusal with respect to future financing that serves as a substantial deterrent to potential alternative investors. Such an investor will be reluctant to make the investment in information necessary to deciding whether to make an investment knowing that that investment will at least be significantly reduced if the terms negotiated turn out to be attractive, since the existing investors will have the right to take part or 030 Brealey & Myers contains an accessible discussion of how to value the option to abandon. Richard Brealey & Stewart Myers, Principles of Corporate Finance (__ ed., 199_).

131 Indeed, the more realistic assumption is that the entrepreneur is risk averse with respect to the success of the portfolio company since, unlike the venture capital fund, she will not hold a diversified portfolio of financial or human capital.

232 The venture capital fund’s non-capital contributions are also effectively staged. If the portfolio company has not performed satisfactorily, the GP can decline to make or receive telephone calls from the portfolio company or its suppliers, customers, or prospective employees. See Black & Gilson, supra note 3, at 254. Gompers, Optimal Investment, supra note __, at 1462, likens this incentive to that by the role of debt in a leveraged buyout. The need for additional funds provides a portfolio company the same “hard” constraint provided by the need to pay back debt in a leveraged buyout.

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all of the transaction for themselves. Moreover, a potential investor will confront a serious winner’s curse problem. The potential investor can anticipate that if the price negotiated is attractive, the existing investors will opt to make the investment themselves. Thus, the potential investor knows that it will be allowed to make the investment only if the existing investors, who have better information about the project, believe that the investment is unattractive.

Staged financing also reduces agency costs by shifting the decision whether to continue the project from the entrepreneur to the venture capital fund. Because of the option-like character of the entrepreneur’s interest in the portfolio company, she will go forward with the project under conditions that favor her and disfavor the venture capital fund. Shifting this decision to the venture capital fund reduces this source of agency cost.

The incentive created by staged financing in turn operates to reduce uncertainty in a manner that creates value, rather than merely shifting it from the investor to the entrepreneur. While staged financing only shifts risk with respect to exogenous uncertainty – that is, uncertainty which is outside the parties’ capacity to influence – it can serve actually to reduce a different kind of uncertainty. Some uncertainty associated with the success of the portfolio company’s project is endogenous: it can be influenced by the entrepreneur’s actions. Put differently, the likelihood of the portfolio company’s success is in part a function of the effort expended. By increasing the incentives to expend effort, staged financing reduces this element of uncertainty.

That brings us to the effect of staged financing on the information asymmetry between the venture capital fund and the entrepreneur. Staged financing serves to bridge the information gap in two important ways. The first information-related property of staged financing reflects the general principle that every incentive has an information related flip side that responds to adverse selection problems. In deciding which portfolio companies to fund, the venture capital fund has to distinguish between good and bad entrepreneurs under circumstances in which an entrepreneur has better information about her own skills than does the investor. Because the incentive created by staged financing is more valuable to a good entrepreneur than a bad one, an entrepreneur’s willingness to accept an intense incentive is a signal of the entrepreneur’s difficult to observe skills. The signal is particularly important for early stage and high technology portfolio companies because the absence of a performance history and the technical nature of the projects makes the entrepreneur’s skills particularly difficult to observe.33

The second way in which staged financing reduces information asymmetry is by its impact on the credibility of the projections contained in the entrepreneur’s business plan. These projections are critical to valuing the portfolio company and therefore pricing the venture capital fund’s investment. Yet, the entrepreneur obviously has better information concerning the accuracy of the business plan’s projections of timing, costs, and likelihood of success, and, without more, an incentive to overstate the hproject's prospects. By accepting a contractual structure that imposes significant penalties if the entrepreneur fails to meets specified milestones based on the business plan’s projections -- the venture capital fund's option to abandon then becomes exercisable -- the entrepreneur makes those projections credible.

333 The signal will result in a separating equilibrium, in which only high quality entrepreneurs will accept the incentive, when the low quality entrepreneurs’ alternatives are more valuable to a low quality entrepreneur than the incentive contract. See Gompers, Ownership and Control, supra note __.

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At this point, it is helpful to note a more general contracting problem associated with the allocation of discretion between parties to an agreement. Discretion creates the potential for the party possessing it to impose agency costs. Staged financing, like other organizational and contractual techniques we will consider, responds to agency problems that result from entrepreneur discretion by shifting that discretion to the venture capital fund. However, this technique has a built in limitation, which we might call the principle of the conservation of discretion. Without more, shifting discretion from the entrepreneur to the fund does not eliminate the potential for agency costs; it merely shifts the chance to act opportunistically to the fund. For example, staged financing coupled with a right of first refusal made potent by high information costs allows the venture capital fund to behave opportunistically in negotiating the price of a second round of financing. The fund is in a position to exploit its monopsony power by reducing the value assigned to the portfolio company even though it has met its projections.34 In such settings, the goal is to shift discretion to that party whose misuse of it can be most easily constrained. As will appear, misuse of the discretion shifted to the venture capital fund is policed by market forces in the venture capital market, whose functioning is crucial to the feasibility of the entire organizational and contractual structure.

2. Control. A central characteristic of the governance structure created by the venture capital fund-portfolio company contract stands the Berle-Means problem on its head. Instead of investors having disproportionately less control than equity as in public corporations, the venture capital fund has disproportionately more control than equity. Like staged financing, this allocation of control responds to the problems of uncertainty, information asymmetry, and agency associated with early stage, high technology investments.

Extreme uncertainty concerning the course and outcome of the project stage being financed creates discretion. The presence of uncertainty means that an explicit stage contingent contract that specifies what action should be taken in response to all possible events cannot be written. Thus, the contractual structure must deal with uncertainty by means of a governance structure: creating a process that will determine the response to an unexpected event. The particular allocation of discretion between the fund and the portfolio company reflects the influence of concerns over both agency and information asymmetry.

Two types of control are allocated to the venture capital fund as a response to agency and information asymmetry problems. First, as we have seen, staged financing allocates an important periodic lever of control to the venture capital fund. By reserving to itself the decision whether to fund the portfolio company’s next milestone, the venture capital fund takes control over the continuation decision; whether the portfolio company goes forward with its project is determined by whether the venture capital fund provides capital for the next stage. This power, in turn, gives the venture capital fund the incentive to make the investment in monitoring necessary to evaluate the portfolio company’s overall performance over the initial funding period. In the absence of the power to act in response to what it discovers, the venture capital fund would have no reason to expend time and resources in the kind of monitoring necessary to balance the intense incentives created to align the two parties’ interests.

Second, giving the venture capital fund disproportionate representation or even control of the portfolio company’s board of directors, and the restriction of the entrepreneur’s discretion 434 Black & Gilson, supra note 3, at 261-63.

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through the use of negative covenants, gives the fund interim control – the power to act to reduce agency costs in the period between decisions over whether to finance further stages. In its most extreme form, the venture capital fund’s interim control carries with it the power to replace the entrepreneur as the portfolio company’s chief executive officer. As with the allocation of periodic control, the allocation of interim control gives the venture capital fund the incentive to monitor the portfolio company’s performance during the course of reaching a funding milestone, and in response to the unexpected events generated by pervasive uncertainty. The discretion unavoidably given to the portfolio company’s day to day managers by the occurrence of unexpected events is policed by the disproportionate control and resulting monitoring activity allocated to the venture capital fund.

The periodic and interim monitoring encouraged by the disproportionate allocation of control to the venture capital fund also serves to reduce the last of the contracting problems – information asymmetry between the venture capital fund and the entrepreneur. The balance of information between the parties is not static as the portfolio company moves forward on its business plan. Ongoing learning by the entrepreneur increases the information disparity and therefore the entrepreneur's discretion, which in turn increases agency costs. Ongoing monitoring by the venture capital fund, made possible by the disproportionate allocation of control, balances that influence.

Finally, as with staged financing, the allocation of control serves to reduce information asymmetry by providing the entrepreneur the opportunity to signal her type. Giving the venture capital fund the power to terminate the entrepreneur in the event of poor performance gives the entrepreneur a powerful incentive to perform. The flip side of this incentive is a signal. By her willingness to subject herself to this penalty for poor performance, the entrepreneur credibly provides information to the venture capital fund about her own skills.35

3. Compensation. The structure of the entrepreneur’s compensation responds primarily to agency costs and information asymmetry problems. Perhaps more starkly than with any other organizational or contractual technique, the portfolio company’s compensation structure creates extremely high powered performance incentives that serve to align the incentives of the portfolio company management and the venture capital fund. In essence, the overwhelming percentage of management’s compensation is dependent on the portfolio company’s success. Low salaries are offset by the potential for a large increase in value of the entrepreneur’s stock ownership, and by the award of stock options to other management members.36 The performance incentive is further heightened by the practice of requiring the entrepreneur and other members of management to accept the imposition of a staged vesting requirement on some or all of their stock or stock options. The vesting requirement gives the portfolio company the right to purchase a portion of the entrepreneur’s or other management’s stock, at a favorable price, if employment terminates prior to a series of specified dates. It also

535 See Thomas Hellman, The Allocation of Control Rights in Venture Capital Contracts, __ Rand J.Econ. __ (1998).

636 Indeed, it is comonplace for stock options to be awarded to non-management employees, both to create performance incentives and to reduce the cash necessary to fund the portfolio company’s operations. [Cites]

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restricts exercise of options until after the manager has completed a series of employment anniversaries, following each of which an additional number of options both are exercisable and no longer subject to forfeiture if employment terminates.37

While aligning the interests of the venture capital fund and entrepreneur in some circumstances, the intensity of these incentives can also lead to agency costs in other circumstances. In particular, the option-like characteristics of the portfolio company’s compensation structure can lead the entrepreneur to increase the risk associated with the portfolio company’s future returns, because the venture capital fund will bear a disproportionate share of the increased downside but share only proportionately in the upside. Thus, the intensity of the performance incentives created by the compensation structure gives rise to a corresponding incentive for the venture capital fund to monitor the portfolio company’s performance. This monitoring, together with the signaling properties of the entrepreneur’s willingness to accept such powerful incentives, also serve to reduce information asymmetries.

4. Exit. Another powerful incentive is created for the entrepreneur by the terms of the disproportionate allocation of control to the venture capital fund. On the plausible assumption that the transfer of control to the venture capital is costly to the entrepreneur,38 the control structure created by the venture capital fund’s investment gives the entrepreneur a valuable call option on control.39 In effect, the venture capital fund and the entrepreneur enter into a combination explicit and implicit contract that returns to the entrepreneur the disproportionate control transferred to the venture capital fund if the portfolio company is successful. 40 The explicit portion of the contract is reflected in the terms of the convertible preferred stock which provide the venture capital fund its disproportionate board representation, and in those of the investors’ rights agreement which contains the negative covenants requiring venture capital fund approval of important operating decisions. Both documents typically provide for the termination of these levers of control on the completion of an IPO of a specified size and at a specified price. The terms of the preferred stock almost universally require conversion into common stock, with the resulting disappearance of special board representation, on a public offering. The negative covenants also expire on an IPO.41

737 Sahlman, supra note __, at 507; Benton & Gunderson, supra note __, at __.

838 A private value for control is a standard feature in models that seek to explain the incentive function of capital structure. See e.g., Bengt Holstrom & Jean Tirole, The Theory of the Firm III. Capital Structure, in I. Handbook of Industrial Organization 63, 79-86 (Richard Schualansee & Robert Willigs, eds., 1989); Milton Harris & Arthur Raviv, Corporate Governance: Voting Rights and Majority Rule, 20 J.Fin. Econ. 203 (1988); Sanford Grossman & Oliver Hart, One Share-One Vote and the Market for Corporate Control, 20 J. Fin. Econ. 175 (1988).

939 Black & Gilson, supra note 3, develop the concept of an implicit contract giving the entrepreneur a call option on control in venture capital contracts.

040 Some contracts also provide for automatic conversion when the portfolio company meets specified profit or, less frequently, sales targets. Gompers, supra note __.

141 The venture capital fund’s ownership percentage, and therefore control, is further diluted both by the

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The implicit portion of the contract operationalizes the definition of success that makes the entrepreneur’s call option on control exercisable. By triggering automatic conversion on an IPO, the measure of success is delegated to independent investment bankers who are in the business of identifying venture capital-backed companies successful enough to be taken public,42 and whose own incentives make their ex post determination of success credible ex ante. As we will see in the next section, it also allocates to the market enforcement of the venture capital fund’s implicit promise to agree to an IPO when one is available to the portfolio company and the entrepreneur exercises her call option on control by requesting one.

5. Reliance on Implict Contract: The Role of the Reputation Market. Crucial elements of the organizational and contractual techniques that respond to uncertainty, information asymmetry, and agency costs in the venture capital fund-portfolio company relationship, have at their core the transfer of discretion from the entrepreneur to the venture capital fund. Staged financing, by giving the venture capital fund an option to abandon, transfers the continuation decision from the entrepreneur to the fund. Board control by the venture capital fund, including the power to dismiss the entrepreneur herself, disproportionate to its equity, also transfers to the fund the capacity to interfere in the portfolio company’s day to day business. As a result, the effectiveness of these techniques is subject to the conservation of discretion principle. Reducing the agency costs of the entrepreneur’s discretion by transferring it to the venture capital fund also transfers to the venture capitalist the potential for agency costs – the opportunity to use that discretion opportunistically with respect to the entrepreneur.

For example, giving the venture capital fund an option to abandon gives the venture capital fund an incentive to monitor, gives the entrepreneur an incentive to perform, and reduces agency costs by shifting the continuation decision to the venture capitalist. But when coupled with the venture capital fund’s right of first refusal, this transfer of discretion also creates agency costs on the part of the venture capital fund. What prevents the venture capital fund from opportunistically offering to provide the financing necessary for the portfolio company’s next stage only at an unfairly low price? The entrepreneur could seek financing from other sources but, as we have seen, the venture capital fund’s right of first refusal presents a serious impediment.43 Similarly, the transfer of disproportionate control to the venture capital fund also creates the potential for opportunism by the fund. To align incentives, the entrepreneur’s returns from the portfolio company’s project take the form of appreciation in the value of her portfolio company stock and stock options. However, the venture capital fund’s power to terminate

number of new shares sold to the public in the IPO, and by the number of shares sold by the venture capital fund either in the offering or in the period following the offering. Black & Gilson, supra note 3, at 260-61.

242 See Alan Brau & Paul A. Gompers, Myth or Reality? The Long Run Underperformance of Initial Public Offerings: Evidence from Venture and Non-Venture Backed Companies, 52 J. Fin. 1791 (1997); William L. Megginson & Kathleen A. Weiss, Venture Capitalist Certification in Initial Public Offerings, 46 J. Fin. 879 (1991); Christopher Barry, Chris Muscarella, John Peavy III & Michael R. Vestsypens, The Role of Venture Capitalists in the Creation of a Public Company, 27 J.Fin. Econ. 447 (1990).

343 Need footnote text.

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entrepreneur, coupled with the vesting requirements that on her termination both give the portfolio company a favorably priced option to purchase the entrepreneur’s stock on termination and cancel all unvested options, gives the venture capital fund the discretion to behave opportunistically. What prevents the venture capital fund from unfairly terminating the entrepreneur so as to secure for itself the returns that had been promised the entrepreneur?

The conservation of discretion principle counsels that discretion be placed in the party whose behavior is more easily policed. In the context of the venture capital fund-portfolio company relationship, the presence of an effective reputation market with respect to the GP’s characteristics provides the policing that supports the transfer of discretion to the venture capital fund.

For a reputation market to operate, three attributes must be present. The party whose discretion will be policed by the market must anticipate repeated future transactions. Participants must have shared expectations of what constitutes appropriate behavior by the party to whom discretion has been transferred. Finally, those who will deal with the advantaged party in the future must be able to observe whether that party has behaved in past dealings in conformity with shared expectations.44 All three of these attributes appear present in the venture capital market.

Although it is unlikely that a GP will have future dealings with the same entrepreneur,45 as we have seen the GP will anticipate raising successor venture capital funds, which in turn will require future dealings with different entrepreneurs in connection with the investing the new funds’ capital. The requirements of shared expectations of proper conduct, and the observability of a GP’s satisfaction of those expectations, also appear to be met in the venture capital market. The community of venture capital funds is relatively concentrated,46 and remarkably localized. For example, the offices of a significant percentage of U.S. venture capital funds are found along a short strip of Sand Hill Road in Silicon Valley.47 Moreover, venture capital funds typically concentrate their investments in portfolio companies geographically proximate to the fund’s office.48 This geographical concentration of providers and users of venture capital facilitates satisfaction of the informational element of the structure of a reputation model. Saxanian notes

444 D. Gordon Smith, Venture Capital Contracting in the Information Age, 2 J. Small & Emerg. Bus. Law 133 (1998), examines the information characteristics of the reputation market for venture capitalists..

545 It is not, however, impossible. Both successful and unsuccessful first round entrepreneurs may found a new start-up company in need of venture capital financing. See Annalee Saxanian, Regional Advantage: Culture and Competition in Silicon Valley and Route 128 39 (1994).

646 See David J. Ben Daniel, Jesse R. Reyes, and Michael R. D’Angelo, Concentration and Conservatism in the Venture Capital Industry, working paper (1998). In 1987, the top five percent of firms acting as venture capital fund GPs controlled 20 percent of venture capital raised. The figure rose to 37 percent in 1992, and to 44 percent in 1997.

747 Saxanian, supra note __, at 39-40.

848 Lerner, supra note __, reports that venture capital providers located within five miles of a portfolio company are twice as likely to have a board representative than providers located more than 500 miles from a portfolio cocmpany.

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that geographical proximity has fostered in Silicon Valley extremely efficient informal transfers of information concerning the performance of GPs and entrepreneurs.49 Credible accounts of opportunistic behavior by particular GPs can be expected to circulate quickly among members of the entrepreneur community who must select a GP with whom to deal, and among members of the GP community, who must compete among themselves for the opportunity to invest in the most promising portfolio companies and therefore have an interest in noting and transmitting to the entrepreneur community instances of misbehavior by a rival.

B. The Investor-Venture Capital Fund ContractIn this part, we turn to the investor-venture capital fund contract. How do the

organizational and contractual techniques discussed in Part I – virtually complete control vested in the GP, incentive compensation, mandatory distribution of realized investments, and mandatory liquidation after a fixed term50 – respond to the problems of financial contracting in the face of extreme forms of uncertainty, information asymmetry, and agency costs?51

1. Control. Organizing the venture capital fund as a limited partnership serves to vest virtually complete control in the GP. Short of participation in largely inconsequential advisory committees and the right, typically restricted by the limited partnership agreement, to replace the GP, the legal rules governing limited partnership prevent investors from exercising control over the central elements of the venture capital fund’s business. Most important, the investors are prohibited from insisting on an approval right of the GP’s investment decisions. Thus, the venture capital fund’s formal governance structure presents an extreme version of the Berle-Means problem of the separation of ownership and control: the GP receives control grossly disproportionate to either its one percent capital contribution or its 20 percent carried interest.

The efficiency explanation for the allocation of control to the GP reflects in the first instance the extreme uncertainty and information asymmetry associated with investing in early stage, high technology portfolio companies. By investing through a financial intermediary, investors secure the benefit of the GP’s skill and experience that help to reduce the level of

949 Id. at.

050 A form of staged financing also appears in the investor-venture capital fund contract. The limited partners reetain the right to withdraw from completing their promised capital commitments, in effect staging the commitment of capital to the venture capital fund. Id. at 502. Sahlman, supra note _, at 494. Because of the penalties associated with an investor failing to make its contribution following a capital call, the investor’s option to abandon is of little value compared to the fund’s option to abandon written by the portfolio company.

151 Empirical evidence of the value of the organizational and contractual structure is beginning to emerge. Christopher Barry & L. Adel Turki, Initial Public Offerings by Development Stage Companies, 2 J. Small & Emerg. Bus. Laws 101 (1998), report that development stage companies that use an IPO as a substitute for venture capital on average experience poor long-term performance. In contrast, the portfolios of venture capital funds on average earn favorable returns. Ronald J. Gilson, Understanding the Choice Between Public and Private Equity Financing of Early Stage Companies: A Comment on Barry and Turki, J. Small & Emerg. Bus. Law 123 (1998), suggests that the different governance structures associated with the t wo forms of development stage financing could explain the different levels of performance.

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uncertainty and information asymmetry that must be addressed in the contract governing a portfolio company’s investment. However, securing the benefit of the GP’s expertise comes at a cost: the GP must be given the discretion necessary to exercise its skills and experience on the investors’ behalf. And consistent with the principle of the conservation of discretion, the allocation of control to the GP creates the potential for agency costs that must be addressed by other elements of the venture capital fund’s organizational and contractual structure.

2. Compensation. The GP’s compensation structure is the front line response to the potential for agency costs resulting from allocating to the GP the control necessary to apply its skill and expertise on behalf of the investors. The bulk of the GP’s compensation comes in the form of a carried interest, typically 20 percent, that gives the GP 20 percent of the venture capital fund’s ultimate profits, distributed to the general partner when realized profits are distributed to the investor limited partners. Thus, the compensation structure aligns the GP’s interests in the fund’s success with those of the investors: the GP earns returns that are proportional to those earned by the investors. However, other agency problems appear in the details of the carried interest. For example, suppose that the first investment realized by the venture capital fund yields a $1 million profit after a return to the investors of their $1 million investment. The GP’s share of the profit is $200,000. Now suppose that the next investment realized loses $500,000, leaving cumulative profits from the two investments of $500,000. If the GP keeps all of its first $200,000 distribution, then it ends up having received not 20 percent of the venture capital fund’s profits from the two investments, but 40 percent ($200,000/$500,000). This would give the GP an incentive to realize profitable investments before unprofitable investments, even if that meant realizing the profitable investments prematurely. Various formulations of what are called “claw back” provisions respond to the potential agency cost growing out of this element of uncertainty by in one fashion or another either delaying the GP’s distribution, or holding back some portion it, until the fund’s ultimate success is known.52

3. Mandatory Distributions and Fixed Term. While aligning the interests of the GP and the investors, the intensity of the GP’s compensation incentive in turn creates a different agency cost. The GP’s carried interest has option-like characteristics, which may cause it to prefer investments of greater risk than the investors. This is especially true with respect to the fund’s later investments if the early ones have done poorly. In that circumstance, the GP actually may be best served by making negative net present value investments if the investments are sufficiently risky. The same problem arises with respect to operating decisions that concern a portfolio company that is doing poorly. Then the option-like character of the GP’s carried interest may align its interests more closely with those of the entrepreneur whose compensation under the venture capital fund-portfolio company also has option-like characteristics. In that circumstance, both the GP and the entrepreneur will prefer a riskier operating strategy that than would best serve investors.

The venture capital fund’s fixed term, together with the operation of the reputation market, responds to this agency cost problem. The fund’s fixed term assures that at some point the market will measure the GP’s performance, making readily observable the extent to which the GP’s investment decisions favored increased risk over expected return. A GP’s performance 252 See Halloran et al., Agreement of Limited Partnership, supra note __, at I-64 to I-73.

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record as revealed by its performance in previous funds is its principal tool for persuading investors to invest in successor funds. Thus, the limited partnership’s fixed term assures that opportunistic behavior by the GP with respect to either venture capital fund investment decisions or portfolio company operating decisions will be punished through the reputation market when it seeks to raise the successor funds that justify the GP’s investment in skill and experience in the first place. The expectation of such a settling up helps support the use of intense compensation incentives by constraining option-induced GP opportunism.

Mandatory distribution of the proceeds from realized investments and the venture capital fund’s fixed term also respond to a different variety of agency costs resulting from the allocation of control to the GP. Because the GP receives a fixed fee, typically 2.5 percent, of committed capital, the GP would have an incentive to keep capital within the fund for as long as possible. If given the opportunity, the GP would simply reinvest the proceeds of realized investments. Moreover, that opportunity would make it unnecessary for GP’s to raise successor funds, the anticipation of which allows the reputation market to police GP performance. Mandatory distribution of realized proceeds and a fixed term respond to this potential free cash flow problem. Both devices require that the GP allow the investors to measure its performance against alternatives available in the market before it can continue managing the investors money. In this respect, mandatory distributions operate like debt in a company following a leveraged buyout in requiring profits to be first returned to investors before the company can seek to recover it through new investment. The fixed term operates like a contractually imposed takeover by forcing the GP to allow the investors to choose whether the GP should continue to manage their funds. The organizational and contractual structure assures that a time will come when market price serves as the measure of the GP’s performance.53

C. Braiding of the Venture Capital Fund-Portfolio Company and the Investor- Venture Capital Fund Contracts

A final means by which the organizational and contractual structure of the venture capital-portfolio company and investor-venture capital fund contracts responds to the contracting problems posed by extreme uncertainty, information asymmetry, and agency costs is through the braiding of the two contracts. By braiding we mean the fact that the structure of the two contracts are intertwined, each operating to provide an implicit term that supports the other, and thereby increasing the contractual efficiency of both. This characteristic is particularly apparent with respect to the role of exit and of the reputation market.

1. The Braiding of Exit. As we have seen, the obligation of exit from each of the two contracts comprising the venture capital market – the fixed term of the investor-venture capital fund contract, and the incentive to realize and then distribute the proceeds of the investment that is the subject of the venture capital fund-portfolio company contract – responds to contracting problems presented by each of the relationships. These two functions of exit complement each other. As we saw in Part I, by the time a portfolio company succeeds, the venture capital fund’s

353 The absence of these characteristics help explain why closed end investment companies, like American Research and Development Company, the first venture capital fund formed in 1946 before the limited partnership structure was invented, never caught on.

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non-cash contributions to a portfolio company can be more profitably invested in a new round of early stage companies. But because economies of scope link the provision of cash and non-cash contributions, recycling the non-cash contributions requires the venture capital fund to exit: to recycle its cash contribution from successful portfolio companies to new early stage companies.54 Moreover, the venture capital fund’s exit provides the means to give the entrepreneur an important performance incentive: a call option on control the exercise of which is implemented by the venture capital fund’s realization of its investment in the portfolio company by means of an IPO.

In turn, the recycling of investments from successful portfolio companies to new early stage companies supports the investor-venture capital fund contract. Realizing portfolio company investments provides a performance measure that lets investors evaluate the GP’s skill and honesty, and to reallocate their funds to the GPs with the most successful performance. And by providing the GP’s principal tool for persuading investors to provide capital for successor funds, exit supports the core of the incentive structure that aligns the interests of investors and the GP.

In sum, the braiding of the role of exit in the investor-venture capital fund contract and the venture capital fund-portfolio company contract increases the efficiency of both contracts.

2. The Braiding of the Reputation Market. The venture capital fund-portfolio company contract responds to a number of problems by shifting important elements of control to the venture capital fund. The venture capital fund’s option to abandon resulting from staged financing, its board representation and even control, and its power to replace the entrepreneur, combine to reduce uncertainty, and to reduce agency costs both by providing the entrepreneur powerful performance incentives including a call option to regain control and, by providing the venture capital fund the means and therefor the incentive to monitor. In turn, the entrepreneur’s willingness to transfer control, and to accept so heavily incentivized a contract structure, reduces information asymmetry by signaling the entrepreneur’s type. However, each of these transfers of discretion from the entrepreneur to the venture capital fund carries with it the potential for opportunistic behavior by the fund. The entrepreneur is at risk in connection with negotiations over the terms of the next round financing, in connection with the venture capital fund’s exercise of control through board influence and its power to replace the entrepreneur, and in connection with the fund’s ability not to honor the implicit call option on control it has written. The efficiency of the venture capital fund-portfolio company contract therefore requires a credible constraint on the venture capital fund’s misusing its transferred discretion.

454 Black & Gilson, supra note 3, at 254-55.

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The braiding of the venture capital fund-portfolio company contract with the investor-venture-capital fund contract supports a reputation market that constrains opportunistic behavior by the venture capital. Because the fund is unlikely to engage in repeated deals with any particular entrepreneur, the reputation market constraint instead grows out of the investor-venture capital fund contract. Because the GP needs to raise successor funds, it will have to make investments in new portfolio companies run by other entrepreneurs. If a GP behaves opportunistically toward entrepreneurs in connection with previous portfolio company investments, it will lose access to the best new investments that, in turn, will make raising successor funds more difficult. The impact of the GP's behavior toward current portfolio companies on the success of its future fund raising efforts serves to police the venture capital fund’s exercise of the discretion transferred to it in the venture capital fund-portfolio company contract. In turn, the investor-venture capital fund contract’s support of the transfer of discretion to the fund by the venture capital fund-portfolio company contract helps reduce uncertainty, information asymmetry, and agency costs in contracting with the portfolio company and therefore results in higher returns to investors. And this encourages investors to reinvest in the GP’s successor funds. Again, the interaction between the two contracts supports the efficiency of each.

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Deals Problem Set # 2

Acquisitions


1. Ben runs a business making orange juice. A key ingredient is the right orange, which has to be sweet and juicy. Assume that only the person who grows the orange knows how sweet it is (since she knows whether she has watered it sufficiently and taken the other steps necessary to ensure that it is sweet). Assume also that it is impossible to tell whether the orange is sweet by looking at the orange or to know whether a bunch of oranges is sweet by tasting only one of them. (Don’t worry about whether these assumptions seem true.)

a. If these assumptions are true, what can Ben do to ensure that your orange juice is of good quality? Can Ben use a contract?

b. Does Ben’s orange supplier have a reason to make sure the orange is sweet, even without a contractual obligation?

c. Assuming Ben can’t rely on a contract or on non-legal reasons to ensure that the oranges are sweet, what else can Ben do? Do you see a reason why the business of making juice might be paired with another business, so that the same owners own both?

2. What is “vertical integration”? What economic problem is it designed to solve?

3. Assume that Jim runs a law firm. He has 40 associates, but he has more work than they can do. Carla approaches Jim with the following idea: she runs an agency that can provide Jim with lawyers who take “freelance” assignments, which means they will come work temporarily for Jim (e.g., for a day or a few hours) to help with a specific assignment. They can help Jim draft a specific contract or motion or a will. Once they are done, they no longer work for Jim.

a. What might Jim like about this idea?

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b. Why might Jim hesitate to do this?

c. What else might Jim do if he has too much work? What are the benefits and costs of this alternative, compared with the idea described above?

4. What is “due diligence”? How does a buyer know that a seller is telling the truth when the seller provides information?

5. Assume that a company called “Buyer” buys the assets of a company called “Seller” for cash. What sorts of information do Buyer and Seller care about in negotiating this deal.

a. Assume Seller did not properly file a patent. Does Buyer need to worry about this?

b. Assume Seller has a cheap lease, but an acquisition would cause the lease to expire. Does Buyer need to worry about this?

c. Assume Seller has not paid its taxes for three years. Does Buyer need to worry about this?

d. Assume that one of Seller’s employees tends to make inappropriate jokes in the workplace. Does Buyer need to worry about this?

e. Assume Buyer has not paid its taxes for three years. Does Seller need to worry about this?

f. Assume Buyer is buying a drug patent from Seller. There is uncertainty about whether the drug will work, so Buyer is paying a first installment now, and will pay another amount in two years. The amount of this payment will depend on whether the drug works. Assume also that Buyer has not paid its taxes for three years. Does Seller need to worry about this?

6. Assume a company called Buyer is buying the stock of Seller for cash (instead of the assets). What sorts of information do the Buyer and Seller care about in negotiating this deal?

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a. Who is Buyer negotiating with and how is this different from the circumstance, described in the last question, in which Buyer is buying assets instead of stock?

b. Assume Seller did not properly file a patent. Does Buyer need to worry about this?

c. Assume Seller has a cheap lease, but an acquisition would cause the lease to expire. Does Buyer need to worry about this?

d. Assume Seller has not paid its taxes for three years. Does Buyer need to worry about this?

e. Assume that one of Seller’s employees tends to make inappropriate jokes in the workplace. Does Buyer need to worry about this?

f. Assume Buyer has not paid its taxes for three years. Does Seller need to worry about this?

g. Assume Buyer is buying a drug patent from Seller. There is uncertainty about whether the drug will work, so Buyer is paying an first installment now, and will pay another amount in two years. The amount of this payment will depend on whether the drug works. Assume also that Buyer has not paid its taxes for three years. Does Seller need to worry about this?

7. What is a merger and how is it different from a purchase of assets or stock?

8. In a merger, what information does a buyer care about and how, if at all, does a merger differ from an asset or stock deal?

9. Carol is an entrepreneur who is developing a cure for the common cold. She would like to sell her company, Seller, to Buyer, a pharmaceutical company. Doug, who works for Buyer, wants to see the clinical trials for the new drug. Carol knows that the results are mixed. They suggest the drug does cure colds, but they also suggest that the drug may have some bad side-effects.

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a. If Carol refuses to share the clinical trials, what will Doug assume about the trials?

b. More generally, what incentive does a seller have in sharing information with a potential buyer?

c. Let’s say Buyer wants to know about any litigation pending for Carol’s company. Carol can ask her lawyers, who know the details of the litigation, to write up a description, but the time they will spend will cost Carol $10,000. Alternatively, Carol can invite Buyer’s lawyers to come and read the litigation files (which are quite large). If she does this, Buyer is likely to have to pay their lawyers $50,000. What should Carol do?

d. Can you think of a reason why Carol might regret sharing clinical trials with Buyer if the deal does not go through? (Hint: Assume that Carol’s company and Buyer are competitors and that the trials contain valuable information.) If so, does this offer Carol a strategy for refusing to disclose the information? If Carol has more than one reason not to disclose the trials, can Buyer tell what the real reason is? What, if anything, can Buyer do in response?

10. Gilson says parties have the incentive to be truthful in due diligence? Do you agree?

11. Gilson says parties have the incentive to minimize the cost of disclosure. He says that a party that makes due diligence more expensive can be made to pay for this through an adjustment in the purchase price. Do you agree? Can you think of a reason why this might not happen?

12. How do parties exchange information in due diligence?

13. What is the difference between a representation, a convenant, and a condition?

14. Is the following language a representation, a covenant, or a condition?

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a. “Target and the Shareholder jointly and severally represent, warrant and agree as follows: Target is a corporation duly organized, validly existing and in good standing under the laws of the State of California, with the power to own its property, to carry on its business as now being conducted, and to enter into and carry out the terms of this Agreement.”

b. “Each balance sheet delivered to Acquiring pursuant to this Agreement shall reflect all claims, debts or liabilities of Target which should be reflected thereon in accordance with generally accepted accounting principles.“

c. “During the period from the date hereof to and including the Closing, Target will conduct its business solely in the usual and ordinary manner and will refrain from any transaction not in the ordinary course of business or except as otherwise permitted herein unless the prior written consent of Acquiring to such transaction has been obtained.”

d. “No action or proceeding before a court or any other governmental agency or body shall have been instituted or threatened to restrain or prohibit the Merger contemplated hereby.”

15. . You represent the buyer of a company. You send over the following representation: “Target is not subject to any material liability by reason of a violation of any order, rule, or regulation of any Federal, state, municipal or other governmental agency.” In response, the seller changes the language. Find the change. What do you learn from the change they made in the language, and what follow up questions do you want to ask?

a. “Target is not subject to any material liability by reason of a criminal violation of any order, rule, or regulation of any Federal, state, municipal or other governmental agency,

b. “Target is not subject to any material liability by reason of a violation of any order, rule, or regulation of any national governmental agency.”

16. Why do deal provisions often include the word “material”? What does it mean and why do the parties include the word?

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17. You represent the seller. Your client is asked to make the following representation: “Target has paid all taxes and assessments (including interest or penalties) owed by it to the extent that such taxes and assessments are due.” Why might you want to add the word “material,” so that the rep reads “Target has paid all material taxes . . . .”

18. Let’s say we define “material” as an issue involving at least $500. Do you see a problem with defining materiality in this way? Hint: does it matter how many nonmaterial facts are left out? How can we deal with this problem?

19. Buyer wants to buy a plot of land, and asks Seller to give assurance that Seller actually owns the land. Seller sends over the following representation: “To the best of my knowledge, I am the legal owner of this land.” You represent Buyer, who asks whether he should accept this representation. Are you comfortable with it?

20. Buyer wants to buy a business, and asks Seller to give assurance that no one has already sued the business, and that no one is threatening to sue the business in the future. Seller offers the following representation: “No one has sued our business and, to the best of the knowledge, no one is threatening to sue the business.” You represent Buyer. Are you comfortable with this representation?

21. What happens if a seller gives a representation that turns out not to be true?

a. Can you think of circumstances in which a buyer does not get any meaningful protection from a representation, even if he can easily show it was false?

b. How can a buyer plan in advance to prevent this sort of problem?

c. Explain why a buyer might demand the following language in an acquisition agreement: “Seller hereby agrees that at the Closing, upon receipt of the Merger Shares, he will immediately deposit 15,000 of such Merger Shares into escrow for a period ending no later than 42 months after the Closing at which time the escrowed Merger Shares then remaining in escrow will be returned to him.”

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22. Seller, a start-up company, is developing a new type of bus, which is supposed to be more fuel efficient. Seller has developed a design, and has made a few of the new buses in order to test them, but has not yet begun delivering buses to customers. New York City has ordered 10,000 of these buses, but no buses have been delivered yet. Buyer is a big company that makes buses, and wants the New York City contract.

Seller has begun testing the buses, and has discovered a problem with the wheels, which may be expensive to fix. Seller has not yet finished testing the buses.

The agreement has the following language: “Buyer has made a lengthy, detailed, and independent investigation regarding the design and specifications of the new bus,” and "Seller has not finished testing the new bus.” The agreement also says that “Seller shall continue to give Buyer access to inspect the new bus” and that "neither party is relying upon any warranty or representation of the other not fully set forth in this agreement." The agreement does not have any other representations about possible defects in the bus or about the tests Seller has been conducting.

After the deal closes and Buyer discovers the defect in the new bus, Buyer sues, claiming that Seller should have told Buyer about the defect.

a. If you are the judge, and you have to decide the case based only on the contract language quoted above, who do you think should win the lawsuit?

b. If you decide that Seller wins, are you rewarding sneakiness?

c. If you decide that Buyer wins, are you rewarding carelessness?

d. What language should Buyer have asked for in the agreement in order to avoid this problem?

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Ronald J. Gilson. “Value Creation by Business Lawyers: Legal Skills and Asset Pricing,”

94 Yale L.J. 269-280 (1984)

* * *

1. Costs of Acquiring Information

During the negotiation, the buyer and seller will face different costs of information acquisition for two important reasons. First, as a simple result of its prior operation of the business, the seller will already have large amounts of information concerning the business that the buyer does not have, but would like to acquire. Second, there usually will be information that neither party has, but that one or both would like and which one or the other can acquire more cheaply. The question is then how both of these situations are dealt with in the acquisition agreement so as to reduce the informational differences between the parties at the lowest possible cost.

At first, one might wonder why any cooperative effort is necessary. Assuming that the seller did not affirmatively block the buyer’s efforts to acquire the information the buyer wanted (and the seller already had), nothing would prevent the buyer from independently acquiring the desired information. Similarly, assuming both parties had the opportunity to acquire the desired new information, nothing would prevent both parties from independently acquiring it.

Actually, however, it is in the seller’s best interest to make the information that the seller already has available to the buyer as cheaply as possible. Suppose the seller refused to assist the buyer in securing a particular piece of information that the seller already had. If the information could have either a positive or negative value on the buyer’s evaluation of the worth of the business, a rational buyer would infer from the seller’s refusal to cooperate that the information must be unfavorable. Thus, the seller has little incentive to withhold the information.71 Indeed,

171See Grossman, The Informational Role of Warranties and Private Disclosure About Product Quality, 24 J.L. & Econ. 461, 479 (1981); Grossman & Hart, Disclosure Laws and Takeover Bids, 35 J. Fin. 323 (1980). The analysis becomes more complicated, however, if disclosure imposes other kinds of costs on the seller -- for example, disclosure of some accounting data might provide to competitors insights into the seller’s future strategy, and disclosure of product information might allow competitors more easily to duplicate the seller’s product. Where there are such proprietary costs to disclosure, the signal conveyed by nondisclosure becomes “noisy”: Non-disclosure may mean that the information kept private is negative; less ominously, it may mean that disclosure of the information would be costly. The result would be an equilibrium amount of non-disclosure. R. Verrecchia, Discretionary Disclosure, Working Paper No. 101, Center for Research in Security Prices (August 1983) (unpublished manuscript on file with author). While Verrecchia’s argument has important insights for the issue of voluntary disclosure in the setting of organized securities markets, it seems to me much less relevant in the acquisition setting. There the opportunity for face-to-face bargaining allows the use of techniques such as confidentiality agreements, see Business Acquisitions, supra note 45, at 399-401 (form of confidentiality agreement), that can substantially reduce such proprietary disclosure costs and, as a result, reduce any noise associated

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the same result would follow even if the information in question would not alter the buyer’s estimate of the value of the business, but only increase the certainty with which that estimate was held.72 Once we have established that the seller wants the buyer to have the information, the only issue that remains is which party can produce it most cheaply. The total price the buyer will pay for the business is the sum of the amount to be paid to the seller and the transaction costs incurred by the buyer in effecting the transaction. To the extent that the buyer’s information costs are reduced, there simply is more left over for division between the buyer and seller.

Precisely the same analysis holds for information that neither party has yet acquired. The seller could refuse to cooperate with the buyer in its acquisition. To do so, however, would merely increase the information costs associated with the transaction to the detriment of both parties.

There is thus an incentive for the parties to cooperate both to reduce informational asymmetries between them and to reduce the costs of acquiring information either believes necessary for the transaction. As a result, we would expect an acquisition agreement to contain provisions for three kinds of cooperative behavior concerning information acquisition costs. First, the agreement would facilitate the transfer of information the seller already has to the buyer. Second, the agreement would allocate the responsibility of producing information that neither the seller nor the buyer already has to the party who can acquire it most cheaply, thereby both avoiding duplication of costs and minimizing those that must be incurred. Finally, the agreement would try to control overspending on information acquisition by identifying not only the type of information that should be acquired, but also how much should be spent on its acquisition.

a. Facilitating the Transfer of Information to the Buyer

In the course of negotiating an acquisition, there is an obvious and important information asymmetry between the buyer and the seller. The buyer will have expended substantial effort in selecting the seller from among the number of potential acquisitions considered at a preliminary stage73 and, in doing so, may well have gathered all the available public information concerning the seller. Nonetheless, the seller will continue to know substantially more than the buyer about the business. Much detailed information about the business, of interest to a buyer but not,

with failure to disclose.

272In other words, the new information would not alter the mean estimate of value but would reduce the variance associated with the distribution of possible values.

373For the purpose of search costs in the acquisition content, see Easterbrook & Fischel, Auctions and Sunk Costs in Tender Offers, 35 Stan. L. Rev. 1 (1982); Gilson, Seeking Competitive Bids Versus Pure Passivity in Tender Offer Defense, 35 Stan. L. Rev. 51 (1982).

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perhaps, to the securities markets generally, will not have been previously disclosed by the seller.74

It is in the seller’s interest, not just in the buyer’s, to reduce this asymmetry. If the seller’s private information is not otherwise available to the buyer at all, the buyer must assume that the undisclosed information reflects unfavorably on the value of the buyer’s business, an assumption that will be reflected to the seller’s disadvantage in the price the buyer offers. Alternatively, even if the information could be gathered by the buyer (a gambit familiar to business lawyers is the seller’s statement that it will open all its facilities to the buyer, that the buyer is welcome to come out and “kick the tires,” but that there will be no representations and warranties), it will be considerably cheaper for the seller, whose marginal costs of production are very low,75 to provide the information than for the buyer to produce it alone. From the buyer’s perspective, the cost of acquiring information is part of its overall acquisition cost; amounts spent on information reduce the amount left over for the seller.

This analysis, it seems to me, accounts for the quite detailed picture of the seller‘s business that the standard set of representations and warranties presents. Among other facts, the identity, location and condition of the assets of the business are described;76 the nature and extent of liabilities are specified;77 and the character of employee relationships--from senior management to production employees--is described.78 This is information that the buyer wants and the seller already has; provision by the seller minimizes its acquisition costs to the benefit of both parties.

What remains puzzling, however, it is the apparent failure by both business lawyers and clients to recognize that the negotiation of representations and warranties, at least from the perspective of information acquisition costs, presents the occasion for cooperative rather than distributive bargaining.79 Reducing the cost of acquiring information needed by either party makes both better off. Yet practitioners report that the negotiation of representations and 474For example, the potential for synergy between the seller’s business and that of a potential buyer will become of interest to the market only at the point where the possibility of the acquisition comes to the market’s attention.

575The costs are still not zero. While the information exists, there are still costs associated with finding out where within the seller’s organization the information is located, putting it in a form that is useful to the buyer, and verifying it. As a result, even some information that already exists may not be worthwhile to locate and transmit. See infra pp. 278-80 (limitations on for what, and how hard, to look). Additionally, there will be situations where a third party will be able to produce the information even more cheaply than the seller. See infra pp. 274-76 (lawyer’s opinions). This qualification, however, does not alter the absence of conflict between the parties.

676See, e.g, Drafting Agreements, supra note 45, at 81-94 (warranties disclosing identity and condition of real property and leases; compliance with zoning; composition, condition, and marketability of inventory; personal property and condition; accounts receivable and collectability; trade names, trademarks, and copyrights; patent and patent rights; trade secrets; insurance policies; and employment contracts).

777 Id. at 76-81, 94-96, 118 (warranties concerning undisclosed liabilities, tax liabilities, compliance with laws, accuracy of financial statements, and pending or threatened litigation).

878Id. at 93 (disclosure of all employment, collective bargaining, bonus, profit-sharing, or fringe benefit agreements).

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warranties is the most time-consuming aspect of the transaction,80 it is termed “a nit-picker’s delight, a forum for expending prodigious amounts of energy in debating the merits of what sometimes seem to be relatively insignificant items.”81 And it is not merely lawyers who are seduced by the prospect of combat; sellers also express repugnance for a “three pound acquisition agreement”82 whose weight and density owe much to the detail of the article titled “Representations and Warranties of Seller.” As a result, seller’s lawyers are instructed to negotiate ferociously to keep the document--especially the representations and warranties short. Increased information costs needlessly result. Indeed, a business lawyer’s inability to explain the actual function of these provisions can often cause the buyer incorrectly to attribute the document’s length to its own lawyer’s preference for verbosity and unnecessary complexity. This failure to explain can prevent recognition of value-creating activity even when it occurs.83

b. Facilitating the Production of Previously Nonexistent Information

A similar analysis applies when the buyer needs information that the seller has not already produced. For example, the buyer may desire information about aspects of the seller’s operation that bear on the opportunity for synergy between its own business and that of the seller and that, prior to the negotiation, the seller had no reason to create. Alternatively, the buyer may be interested in the impact of the transaction itself on the seller’s business; whether the seller’s contracts can be assigned or assumed; whether, for example, the transaction would accelerate the seller’s obligations. Like the situation in which the buyer has already produced the information desired by the seller, the only issue here should be to minimize the acquisition cost of the information in question.

While the analysis is similar to the situation in which the seller had previously produced the information, the result of the analysis is somewhat different. Not only will the seller not always be the least-cost information producer, but there will also be a substantial role for third-party information producers. Returning to the synergy example, a determination of the potential for gain from the combination of the two businesses requires information about both. The particular character of the businesses, as well as the skills of their managers, will determine whether such a study is better undertaken by the seller, which knows its own business but will be

979I mean to put off for the moment the question of what happens when one of the seller’s representations and warranties turns out to be incorrect. I will take up the issue of indemnification for breach of warranty in connection with the verification function. See infra pp. 281-87.

080 See supra note 70.

181 J. Freund, supra note 45, at 229.

282 Id. at 233.

383 Freund, as usual is not guilty of this failure. His explanation for the phenomenon differs from mine, however. See J. Freund, supra note 45, at 230-34.

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required to learn about the buyer’s business, or by the buyer, which knows about its own business and is in the process of learning about the seller’s.84

The more interesting analysis concerns the potential role for third-party information producers. This can be seen most clearly with respect to information concerning the impact of the transaction itself on the seller’s business. As between the buyer and the seller, the seller will usually be the least-cost producer of information concerning the impact of the transaction on, for example, the seller’s existing contracts. Although there is no reason to expect that either party routinely will have an advantage in interpreting the contracts, it is predictable that the seller can more cheaply assemble the facts on which the interpretation will be based. The real issue, however, is not whether the seller is the lower-cost producer out of a group of candidates artificially limited to the seller and buyer. Rather, the group of candidates must be expanded to include third parties.

The impact of including third-party information production in our analysis can be seen by examining the specialized information production role for lawyers in acquisition transactions. Even with respect to the production of information concerning the seller’s assets and liabilities, the area where our prior analysis demonstrated the seller’s prominence as an information producer, there remains a clear need for a specialized third party. Production of certain information concerning the character of the seller’s assets and liabilities simply requires legal analysis. For example, the seller will know whether it has been cited for violation of environmental or health and safety legislation in the past, but it may require legal analysis to determine whether continued operation of the seller’s business likely will result in future prosecution.

The need for third-party assistance is even more apparent with respect to information about the impact of the transaction itself on the seller’s business. Again, however, much of the information requires legal analysis; there exists a specialized information-production role for third parties. For example, it will be important to know whether existing contracts are assignable or assumable: The continued validity of the seller’s leasehold interests will depend on whether a change in the control of the seller operates--as a matter of law or because of the specific terms of the lease--as an assignment of the leasehold;85 and the status of the seller’s existing liabilities,

484 The least-cost producer typically will be the buyer. Although the buyer will already know something about the seller, the seller will have had little reason to learn about the buyer’s business prior to initiation of negotiations. As a result, the amount that still must be learned about the other party’s business in order to evaluate the potential for synergy is likely to be smaller for the buyer than for the seller. This yields a prediction that should be subject to empirical testing. If my hypothesis is correct, I would expect to find few representations and warranties by the seller that could be understood to speak to conditions directly related to the manner in which the two entities could be combined. The absence of a representation by the seller, of course, leaves the information-production function with the buyer.

585 For example, would a general clause prohibiting assignment of a lease by a corporate tenant prohibit the sale of all the tenant’s stock, or a merger of the tenant, or even the dissolution of the tenant and the succession to the tenancy by the tenant’s shareholders? See 1 M. Friedman, Friedman on Leases 244-52 (2d ed. 1983).

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such as its outstanding debt, will depend on whether the transaction can be undertaken without the creditor’s consent.86

In both cases, the seller’s lawyer appears to be the lowest-cost producer of such information.87 As a result, I would expect typical acquisition agreements to assign lawyers this information-production role.88 And it is from this perspective that important elements of the common requirement of an “Opinion of Counsel for the Seller” are best understood.

Any significant acquisition agreement requires, as a condition to the buyer’s obligation to complete the transaction, that the buyer receive an opinion of seller’s counsel with respect to a substantial number of items.89 Consistent with my analysis, most of the matters on which legal opinions are required reflect the superiority of the seller’s lawyer as an information producer. For example, determination of the seller’s proper organization and continued good standing under state law, the appropriate authorization of the transaction by seller, the existence of litigation against the seller, the impact of the transaction on the seller’s contracts and commitments, and the extent to which the current operation of the seller’s business violates any

686 Loan agreements typically limit a debtor’s freedom to merge or sell its assets without the creditor’s consent. See Commentaries, supra note 47. From the creditor’s perspective, such protection is critical. The interest rate charged a debtor depends on the risk associated with the debtor’s business. If the business becomes substantially more risky after the credit is extended, the interest rate charged, in effect, is reduced. The consent requirement is designed to prevent a creditor from altering the risk of its business after the fact through acquiring, or being acquired by, a company with a riskier business. See Smith & Warner, supra note 47, at 126-27.

787 The seller’s lawyer will likely have been involved in the original preparation of the documents and, as a result, will have much better information concerning their contents and the context in which they were negotiated.

For present purposes, there is no need to distinguish between outside counsel and lawyers employed full time by the seller. The issue of whether a particular staff function, like legal work, should be handled inside the firm or acquired in market transactions from outside providers can issue of vertical integration that does not bear on the question of whether lawyers--inside or outside--serve a valuable function. The distinction will take on importance, however, with respect to the verification function. See infra pp. 289-93.

888 The information-production role for lawyers described in the text is not in itself sufficient to respond to my overall question of whether business lawyers can create value. The larger question, it will be recalled, focused on whether business lawyers had the potential to create value even in those situations where there is no traditionally “legal” role. Because the information-production role involves interpreting government regulations and construing the meaning of contracts--functions which are not responsive to the more difficult question with which I am especially concerned--they do not provide an easy way out.

989 There is a substantial practical literature. See A. Jacobs, Opinion Letters in Securities Matters: Text--Clauses-- Law (1983); Babb, Barnes, Gordon & Kjellenberg, Legal Opinions to Third Parties in Corporate Transactions, 32 Bus. Law 553 (1977); Bermant, The Role of the Opinion of Counsel--A Tentative Reevaluation, 49 Cal. St. B.J. 132 (1974); Committee on Corporations of the Business Law Section of the State Bar of California, Report of the Committee on Corporations Regarding Legal Opinions in Business Transactions 14 Pac L.J. 1001 (1983) [hereinafter cited as California State Bar Report]; Committee on Developments in Business Financing, Legal Opinions Given in Corporate Transactions, 33 Bus. Law. 2389 (1978); Fuld, Legal Opinions in Business Transactions--An Attempt to Bring Some Order Out of Some Chaos, 28 Bus. Law. 915 (1973); Special Comm. On Legal Opinions on Commercial Transactions, N.Y. County Lawyers’ Association, Legal Opinions to Third Parties: An Easier Path, 34. Bus. Law. 1891 (1979).

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law or regulation, represent the production of information which neither the buyer nor the seller previously had, by a third party--the lawyer--who is the least-cost producer.90

Just as was the case in our examination of the function of representations and warranties, this focus on the information-production role for lawyers’opinions also provides a non-adversarial approach to resolving the conflict over their content. Because reducing the cost of information necessary to the correct pricing of the transaction is beneficial to both buyer and seller, determination of the matters to be covered by the opinion of counsel for seller 91 should be in large measure a cooperative, rather than a competitive, opportunity. Debate over the scope of the opinion, then, should focus explicitly on the cost of producing the information. For example, where a privately owned business is being sold, the seller often retains special counsel to handle the acquisition transaction, either because the company has had no regular counsel prior to the transaction, or because its regular counsel is not experienced in acquisition transactions. In this situation, recognition of the informational basis of the subject matter usually covered by legal opinions not only suggests that a specialized third-party producer is appropriate, but also provides guidance about whose third party should actually do the production.

From this perspective, seller’s counsel typically will be the least-cost producer of the information in question. Past experience with the seller will eliminate the need for much factual investigation that would be necessary for someone who lacked a prior professional relation to the seller. Similarly, seller’s counsel may well have been directly involved in some of the matters of concern--such as the issuance of the securities which are the subject of an opinion concerning the seller’s capitalization, or the negotiation of the lease which is the subject of an opinion concerning the impact of the transaction on the seller’s obligations. Where the seller has retained special counsel for the transaction, however, the production-cost advantage in favor of seller’s counsel will be substantially reduced, especially with respect to past matters. In those cases, focus on the cost of information production provides a method for cooperative resolution of the frequently contentious issue of the scope of the opinion.92

090 The opinion of counsel also serves an important verification function. See infra pp. 290-93.

191 Typically there will be occasions that call for an opinion of buyer’s counsel as well. Consistent with an information-cost analysis, the scope of the opinion of buyer’s counsel increases as information about the buyer becomes important to pricing the transaction. This would be the case, for example, where the two parties are so close in size that the transaction is really a merger, or where the consideration to be given by the seller is the buyer’s stock. In virtually all transactions, the opinion of the buyer’s counsel will be required with respect to the impact of the transaction itself, such as proper authorization of the transaction by the buyer.

292 The role of information-producer also may be played by another third-party specialist: the public accountant. The accountant typically also renders an opinion concerning the transaction--the cold comfort letter--and easily can be imagined having an information-production role. The common presence of an internal accounting staff within the seller, however, persuades me that the transactional function of the public accountant is one of verification. See infra pp.290-93. Whether or not there is also an information-production role for the public accountant depends on the comparative information-production costs of the public accountant and the seller’s internal accounting staff.

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c. Controls Over What Information to Look for and How Hard to Try

Emphasis on the information-production role of the seller’s representations and warranties and the opinion of counsel for the seller leads to the conclusion that determination of the least-cost information producer provides a cooperative focus for negotiating the content of those provisions. The same emphasis on information production also raises a related question. The demand for information, as for any other good, is more or less price elastic. Information production is costly even for the most efficient producer, and the higher the cost, the less the parties will choose to produce. Thus, some fine tuning of the assignment of information-production roles would seem to be necessary. We would expect some specific limits on the kind of information required to be produced. And we would also expect some specific limits on how much should be spent even for information whose production is desired.

Examination of an acquisition agreement from this perspective identifies provisions which impose precisely these kinds of controls. Moreover, explicit recognition of the function of these provisions, as with our analysis of representations and warranties and opinions of counsel, can facilitate the negotiation of what have traditionally been quite difficult issues.

Consider first the question of limiting the type of information that must be produced in light of the cost of production. To put the problem in a context, we can focus on the standard representation concerning the seller’s existing contracts. The buyer’s initial draft typically will require the seller to represent than an attached schedule lists “all agreements, contracts, leases, and other commitments to which the seller is a party or by which any of its property is bound.” In fact, it is quite unlikely that the buyer really wants the seller to incur the costs of producing all the information specified. In a business of any significant size, there will be a large number of small contracts--for office plant care, coffee service, addressographs, and the like--the central collection and presentation of which would entail substantial cost. Moreover, to the extent these contracts are all in the normal course of the seller’s business, the information may have little bearing on the pricing of the transaction. As a result, it would be beneficial to both parties to limit the scope of the seller’s search.

It is from this perspective that the function of certain common qualifications of the representations and warranties of the seller are best understood. The expected response of a seller to a representation as to existing contracts of the breadth of those mentioned would be to qualify the scope of the information to be produced: to limit the obligation to only material contracts.93 If the contracts themselves are not important, then there is no reason to incur the cost of producing information about them. Variations on the theme include qualifications based on the dollar value of the contracts,94 or on the relationship of the contracts to “the ordinary course of business.”95

393 See J. Freund, supra note 45, at 272-74.

494 See 3 Business Acquisitions, supra note at 45, 96-97 (“Set forth as Schedule G hereto are complete and accurate lists of the following: (i) all arrangements of the Seller, except for purchase and sales orders that involve future payments of less than $250,000 . . . .”).

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A second common form of qualifications--a limit on the information costs to be incurred-- is best understood as an instruction concerning how hard to look for information whose subject matter cannot be excluded as unimportant ahead of time. Here the idea is to qualify not the object of the inquiry, but the diligence of the search.96 Consider, for example, the common representation concerning the absence of defaults under disclosed contracts.97 While it might involve little cost to determine whether the seller, as lessee, has defaulted under a lease, it may well be quite expensive to determine whether the lessor is in default. In that situation, the buyer might consider it sufficient to be told everything that the seller had thought appropriate to find out for its own purposes, without regard to the acquisition, but not to require further investigation.

This type of qualification, limiting the representation to information the seller already has and requiring no further search, is the domain of the familiar “knowledge” qualification. In form, the representation concerning the existence of breaches is qualified by the phrase “to seller’s knowledge.” In function, the qualification serves to limit the scope of the seller’s search to information already within its possession; no new information need be sought.98

595 See Drafting Agreements, supra note 45, at 94 (“Neither corporation nor subsidiary is a party to, nor is the property of either bound by . . . any agreement not entered into in the ordinary course of business. . . except the agreements listed in Exhibit .

696 This analysis, and that concerning the object of the inquiry, applies as well to the role of third-party information producers.

797 See, e.g., Drafting Agreements, supra note 45, at 94 (“There is no default or event that with notice or lapse of time, or both, would constitute a default by any party to any of these agreements.”)

898James Freund identifies another function for representations and warranties that suggests a different role for the knowledge qualification. Freund points out that an unqualified representation serves, in effect, as an insurance policy. Thus, an unqualified representation may be made even though the seller is aware of a possibility that the representation is incorrect, because the parties have determined that the seller should bear that risk and the absolute representation serves to allocate that risk to the seller. J. Freund, supra note 45, at 247-48. From an information perspective, however, Freund’s point is part of an approach to dealing with the problem of information asymmetry. Suppose both the buyer and the seller are aware that certain of seller’s trade secrets may be subject to a misappropriation claim, and that such a claim, if successful, would reduce the value of the seller’s business by $1,000,000. It would hardly be surprising if the buyer and the seller had different estimates of the probability of a successful misappropriation claim; after all, the seller has vastly more information concerning the circumstances in which the trade secrets were developed than does the buyer. Suppose further that the buyer, based on its information, estimates the probability of liability at .5, and therefore argues that the purchase price should be reduced by $500,000. The seller, however, based on its information, estimates the probability at only .15, which would justify only a $150,000 reduction in the purchase price. The effect of the seller’s making an unqualified warranty concerning ownership of trade secrets is to allocate the risk of liability to the seller, the party with the best information and, therefore, the party best able to price the risk. From the buyer’s perspective, the risk has been eliminated. From the seller’s perspective, $350,000 has been gained: The expected value of the purchase price--total price less expected liability--is $350,000 higher than if the buyer’s estimate was used. Thus, unqualified representations and warranties can serve, as Freund perceptively suggests, as insurance policies. However, the determination of which party should be the insurer turns on the determination of which party has better information and, as a result, is better able to price the risk.

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Recognizing the function of the knowledge of qualification also raises another question concerning the variation in form that the qualification takes in typical acquisition agreements. In fact, the knowledge qualification--the limit on how hard the seller must search for information--comes in a variety of forms. Often within the same agreement one will see all of the following variations:

“to seller’s knowledge”;

“to the best of seller’s knowledge”;

“to the best of seller’s knowledge and after diligent investigation.”

What seems to be at work, at least implicitly, is the creation of a hierarchy of search effort that must be undertaken with respect to information of different levels of importance.99

This result is perfectly consistent with a view of the business lawyer as a transaction cost engineer, and with a view of representations and warranties as a means of producing the information necessary to pricing the transaction at the lowest cost. However, it also raises the question of whether implicit recognition of the information-cost function of these qualifications might not facilitate the design of more effective cost reduction techniques. Although this is not the occasion to detail the changes in the form of acquisition agreements that might result from conscious attention to issues of information cost, it seems quite clear that once we understand more precisely what it is we are about, we should be able to do a more effective job.

Consider, for example, the qualifications that we have just discussed concerning how hard the seller must look. Given our understanding of their purpose, the problem of limiting the scope of the seller’s investigation might be better approached explicitly, rather than implicitly through a variety of undefined adjectives. If, for example, the concern is whether the lessor of a real estate lease, under which the seller is lessee, has breached the lease, why not specify the actual investigation the seller should make? Do we want the seller merely to inspect the premises to insure that the lessor’s maintenance obligations have been satisfied? Do we want the seller to go directly to the lessor to secure a statement by the lessor as to the lessor’s satisfaction of its obligations?100 Different levels of cost obviously are associated with the different inquiries; specificity about the desired level of cost, however, should allow further minimization of information costs. To make the point in a slightly different way, is it possible to say with any assurance which of the forms of qualification listed above imposes an obligation to inspect the premises, but no obligation to inquire directly of the lessor?

999 This proposition--that different forms of qualification reflect the different levels of intended search effort--also may be subject to empirical evaluation. If one of the parties to an acquisition agreement is a reporting company under the Securities Exchange Act, its Form 10K Annual Report typically would contain the agreement as an exhibit. Thus, one could gather a substantial sample of acquisition agreements to analyze whether there was a pattern to the types of information subject to qualification and to the form of qualification used.

0100 If information is too costly to produce, the issue shifts to who is best able to price and bear the risk, again information-cost issues.

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James Freund, Anatomy of a Merger, 242-248 (1975)

7.3. Every Seller’s Favorite Caveats

There are two recurrent themes sounded by every seller’s attorney who ever negotiated the representations article of an acquisition agreement. One is materiality and the other is knowledge. Some bitter pitched battles have been fought over these innocuous-sounding concepts, to which we now turn.

7.3.1. Materiality is in the Eye of the Beholder

First, materiality.20 The seller’s attorney argues that he should only be required to list material contracts, not every insignificant commitment. He wants the representation to read that the seller has no material liabilities other than those set forth on the balance sheet; or that the seller is not a party to any material litigation, except as set forth in the disclosure schedule; and so forth. A typical colloquy on the subject runs as follows:

Seller’s Attorney: “I would like the word ‘material’ inserted ahead [off-handedly] of the word ‘litigation’ in paragraph 3(h).”

Purchaser’s Attorney: “No dice, Harry. I want to know about all your [with a knowing smile] litigation; then I’ll decide what is material and

what isn’t.”

Seller’s Attorney: “Look, Joe, in the ordinary course of business [feigning irritation] we have a bundle of small litigation, penny ante

stuff. It’s handled by twenty-five different lawyers, all over the country. I’m not sure we could even compile a list of every matter.”

Purchaser’s Attorney: “Anyway, Harry, what is the test of materiality? Sure, you have a big company here, but if there’s a multiplicity of litigation, it might have significance in the aggregate--and perhaps it will educate us on some risks in your business--and maybe some of it involves basic

020 On the subject of negotiating a materiality caveat in the condition repeating representations at the closing, see Section 2.3.6.; see also Section 5.3.3.

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principles, although miniscule dollars. So I want to know all about it.”

Seller’s Attorney: “Come on, Joe, you’re going to make this deal for the same price whether you have all these details or not. And I don’t want you tracking down the seller three months after the closing because I forgot to include some two-bit claim in the schedule.”

All right, both sides have now staked out their position. The seller’s counsel has done his job in raising and arguing the point; the purchaser’s lawyer has performed yeoman service in resisting the change. How is the issue to be won, lost or compromised?

There are no comprehensive guidelines for dealing with the seller’s desire for materiality caveats in representations. It usually comes down to a question of identifying and attempting to satisfy, by one means or another, the real objectives of the parties (or rather their attorneys, since it is the lawyers who usually play this materiality game), without giving up what are considered vital protections.

To get at this question more analytically, let’s oversimplify the motives of the purchaser’s attorney in resisting materiality caveats by dividing them into one or more of three categories: P-1, he wants to unearth information; P-2, he wants to lay the basis for his client to walk away if things are not as represented; and P-3, he wants to set his client up for indemnification if there are any unpleasant surprises after the closing. The seller’s attorney, on the other hand, usually has one or more of these reciprocal concerns: S-1, he might want to conceal unpleasant information21 or simply avoid certain tedious tasks involving what he considers to be essentially trivia; S-2, he is not willing to furnish purchaser with an out over a minor misrepresentation, in the event that purchaser turns luke-warm on the deal and needs an excuse to call it off; and S-3, he is trying to guard against purchaser going after his client for indemnification down the road.

Now let’s examine the subject of the prior dialogue in light of these considerations. Assume in the first case that purchaser’s attorney is interested in complete information [P-1] while seller’s attorney is worried about small claims [S-3]. Well, the usual compromise here is to require seller to list all litigation, not just material lawsuits--but to provide in the indemnification section of the agreement for a “basket” or “cushion”;22 i.e., a provision to the effect that the purchaser is only entitled to be indemnified if the aggregate of the items seller has failed to disclose or otherwise misrepresented reaches a certain prescribed level.

Take a different case. Assume that purchaser’s lawyer wants his full pound of flesh under the indemnification provisions [P-3]; that seller’s counsel is not concerned about that

121 My experience is that this is not true of most seller’s lawyers who, if not always moved as one might hope by ethical considerations, take the practical view that it is better to disclose now--since the adverse fact is likely to come out later to his client’s financial discomfort.

222 See Section 10.2.1.

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problem, but is really bothered by the prospect that purchaser will use the omission of some trivial litigation (including lawsuits brought against seller between signing and closing)23 as the pretext for breaking off the agreement at the last moment because, for example, market conditions change [S-2]; and that the purchaser has told his attorney that he fully intends to close this deal, come hell or high water. What you work out here generally is the required listing of all litigation, with a flat indemnification against any omissions, but the inclusion of a provision in the conditions section to the effect that only a misrepresentation which has a material adverse effect on the financial condition or results of operations of the seller can furnish the purchaser with an out.24

Or assume a situation where seller’s attorney is truly troubled by the prospects of assembling a host of insignificant data [S-1], while purchaser’s lawyer, concerned that his investigation will uncover items which are ambiguous in terms of materiality, does not want to abdicate the right to decide what is sufficiently material to permit purchaser to walk away [P-3]. This kind of impasse comes up at numerous points in the representations article,25 as well as in those dealing with covenants and conditions. Whenever the parties are either unwilling or unable to decide between materiality and non-materiality, the usual solution is to fix an objective standard as the criterion for disclosure (and thus for indemnification and other purposes). So in this case, the compromise might be for the representation to require a listing of each item of litigation against the seller involving a claim in excess of, say, $10,000. If the purchaser really isn’t interested in the “small stuff,” why put the seller to the trouble of compiling a useless dossier of immaterial litigation? As a further precaution, to guard against a great number of individually insignificant small claims which are substantial in the aggregate, the purchaser could insists upon receiving a representation that the aggregate of the litigation omitted by reason of this exclusion does not exceed the sum of, say, $50,000.

Three final points on materiality. If, representing the purchaser you have acceded to a provision in the conditions article limiting the purchaser’s termination right to misrepresentations having a material adverse effect upon the seller, while at the same time in the representations article you have permitted the seller numerous materiality caveats, then you run the risk of double materiality-i.e., the aggregate total of omitted information which does not constitute misrepresentations can be quite large without acting as a partial trigger to the condition. If you find over the course of negotiating several representations that seller’s attorney is a bug on materiality you can suggest that, instead of negotiating this matter with respect to each representation, you will simply put that “material adverse effect” language into the condition section. Or, if he is worried about indemnification, you should hint at the strong possibility of a basket, the size of which will be determined “after I’ve heard all your problems.”26

323 See Sections 5.3.2. and 5.3.3.

424 See Section 5.3.3. and 7.3.1.

525 See various of the subsections of Section 7.4.

626 For an example of these techniques, see Chapter 14, p. 517.

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Second, you must remember to be precise grammatically in your use of the word “material.” It is one thing for the seller to represent that “there has been no material breach of any agreement” and quite another for him to say “there has been no breach of any material agreement.” In the former case, the discovery of a substantive breach of a minor contract could lead to dire consequences, while in the latter, although only major agreements are involved, even a technical breach would present problems. Seller’s counsel may well try to double up and ask for “no material breach of any material agreement.”

Finally, whatever the concept of materiality may mean, at the very least it is always relative to the situation. I remember well one particular day a number of years ago in which I was both assisting in negotiating a quite sizeable merger in one room and involved in a run-of-the-mill acquisition of a private company that was going on in another. The insurance company we represented in the large deal was concerned that, if it were called upon to pay a substantial claim prior to closing, that might constitute a material adverse event giving the other party an out. I raised the point. Counsel on the other side asked, “What is your largest single policy?” Our client replied that it involved certain atomic energy coverage. “How big a loss could you suffer?,” queried the other lawyer. Our client pondered this for a moment, and then answered that it could be in the neighborhood of $10,000,000. “Aha,” said opposing counsel, “that simply would not be material.” And, in the context of the numbers in that deal, he was absolutely right! Later in the day I joined the other negotiation, and participated for two hours in a vociferous fight over an additional $5,000 of salary for seller’s president. To him, it was extremely material; and I can’t say that I disagree.

7.3.2. A Little Knowledge is a Dangerous Thing

Turning now to the knowledge caveat, it is obvious that the seller would prefer everyone of his representations to be qualified “to the best of his knowledge”--the theory being that, although he would still be on the hook for items he knew about but failed to disclose, he would escape liability for undisclosed matters concerning which he had no actual knowledge. For example, if seller’s prior management had given a mortgage on certain corporate property, but for some reason the instrument did not appear in the corporate records and the mortgagee had never recorded the lien, seller would not be liable if he had represented that, to his knowledge, there were no such mortgages. Without the knowledge caveat, he would be stuck.

From the viewpoint of purchaser’s attorney, I think there is a common sense rule to be followed in this type of situation: the only time that you should voluntarily accept a knowledge caveat from seller is in a situation where, if seller does not in fact possess the information, he should not be required to stand behind the representation. The distinction can be seen in the usual litigation representation, where seller is asked to describe both pending and threatened lawsuits.27 The pending portion is almost always unqualified, but the seller is certainly entitled to a knowledge caveat with respect to threats; the fact that the potential plaintiff has been boasting of his litigious intentions at the neighborhood tavern shouldn’t matter a whit. Another example involves the sometime representation that there is no event or condition pertaining to

727 See Section 7.4.7.

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the business or assets of seller that may materially adversely affect such business or assets; the best seller can really say is that he doesn’t know of any problems along these lines.

Or take, for instance, the representation that the seller’s use of a particular trade name does not violate the rights of any third party. Now, assuming that seller has been using this name for a good while, and assuming that he is not aware of any other company using the name, and assuming that no third party has ever made any claim of violation (i.e., brought the matter to seller’s knowledge), and assuming that the trade name is not that vital to the seller’s business, it would not be inappropriate to accept a knowledge caveat from the seller in that situation.

On the other hand, in the usual case the purchaser is simply looking for a guarantee, and it becomes immaterial whether the seller actually has or hasn’t the requisite knowledge. In these situations, the purchaser’s attorney should refuse to permit the knowledge caveat to create ambiguity in the legal relations existing between the parties. For example, the purchaser should never allow the seller’s representation that his accounts receivable are current and collectible28 to be made to the best of his knowledge. The purchaser wants to be indemnified if those receivables turn out to be bad. The seller might well have no idea that the receivables will ultimately be worthless, and yet the risk of loss should fall upon the seller in that case. In more complex areas, such as unknown liabilities, unless there is a particular rationale to the contrary, I take the view that generally the seller (who is presumed to know his business better than purchaser) should bear the risk--and thus the purchaser should not agree to a knowledge caveat.29

828See Section 7.4.4.

929See section 8.4.2. for a somewhat more generous reaction to requests for knowledge caveats in connection with attorneys’ opinions.

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Form of Acquisition Agreement. Plan of Reorganization

This Agreement, made this day of , 19 , between Acquiring Corp., a Delaware corporation (hereinafter called “Acquiring”), Target Corp., a California corporation (hereinafter called “Target”), and Controlling Shareholder, a California resident (hereinafter called the “Shareholder”):

WITNESSETH:

WHEREAS, Target is a corporation duly organized, validly existing and in good standing under the laws of the State of California; and

WHEREAS, Acquiring is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware; and

WHEREAS, Acquiring will form a California corporation (hereinafter “Subsidiary”) which shall be a wholly-owned subsidiary of Acquiring; and

WHEREAS, if the conditions for the merger contemplated herein are satisfied, Subsidiary will be merged into Target pursuant to Section 368(a) of the Internal Revenue Code of 1954, as amended; and

WHEREAS, the respective Boards of Directors of Acquiring and Target deem it advisable for the general welfare and advantage of the respective corporations and their respective shareholders that, subject to the terms and conditions herein contained and in accordance with the applicable laws of the State of California, Subsidiary merge (hereinafter sometimes called the “Merger”) with and into Target, with Target being the surviving corporation (hereinafter sometimes called the “Surviving Corporation”);

NOW THEREFORE, in consideration of the premises and the mutual agreements, provisions, covenants and grants herein contained, the parties hereto hereby agree that if the conditions for the Merger contained herein are satisfied prior to the Merger, Subsidiary shall be merged into Target in accordance with the applicable laws of the State of California, and that the terms and conditions of the Merger and the mode of carrying it into effect are and shall be as hereinafter set forth:

I. COMPUTATION OF TARGET’S NET WORTH AND ACQUIRING’S NET WORTH

A. Acquiring shall cause a certified public accounting firm (the “Accountants”) of its own selection, at its own expense, to audit the financial position of Target as of

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December 31, 19__. This audit shall be of the financial position of Target prior to giving effect to the sale of certain assets of Target constituting its “Southward Division,” although all other references herein give effect to such sale having been consummated. In connection therewith acquiring and its representatives, and the Accountants, may make such investigation of the properties, books and records of Target and its legal and financial condition as Acquiring or the Accountants shall deem necessary and/or advisable to familiarize Acquiring and Subsidiary with said properties and other matters; such investigation shall not, however, affect the Shareholder’s and Target’s representations and warranties hereunder. The Shareholder and Target agree to permit Acquiring and said other parties to have full access to all premises occupied by and to all the books and records of Target, and the officers and employees of Target will be instructed to furnish them with such financial and operating data and other information with respect to the business and properties of Target as they shall from time to time reasonably request. The Shareholder and Target shall deliver to Acquiring unaudited interim financial statements of Target as they are prepared and shall cause such other reasonable financial information of Target to be prepared and delivered to Acquiring at any time during the term of this Agreement as Acquiring may request: provided, however, that the Shareholder and Target shall not be required to cause such interim financial information to be prepared more frequently than once each month. At any time during the term of this Agreement, but not more frequently than once each three months, acquiring may, in its sole discretion and at its own expense, cause a firm of independent certified accountants to audit the financial position of Target.

B. The audit of the financial position of Target as of December 31, 19 , to be conducted by the Accountants, shall be conducted in accordance with generally accepted accounting principles consistently applied. A balance sheet (the “Balance Sheet”) setting forth Target’s financial position as of December 31, 19 , shall be prepared based on the audit, and certified by the Accountants, without exception. The Balance Sheet, so prepared, shall be a final determination of the financial position of Target as of the date thereof, and shall be conclusive for purposes of determining Target’s Net Worth. Target’s Net Worth shall be the amount of the shareholder’s equity of Target as of December 31, 19 .

C. For purposes of this Agreement, Acquiring’s Net Worth shall mean the amount of its stockholders’ equity as of December 31, 19 , as presented on its unaudited financial statements as filed with the Securities and Exchange Commission on Form 10-Q. For purposes of this Agreement, Acquiring’s Book Value Per Share shall be that quotient resulting from dividing Acquiring’s Net Worth by the number of shares of Acquiring Common Stock which are issued and outstanding on December 31, 19 .

D. When Target’s Net Worth and Acquiring’s Net Worth and Book Value Per Share have been computed as provided in this Agreement, the Shareholder, Target and Acquiring shall

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execute Exhibit I to be attached hereto, acknowledging said Net Worth figures and Acquiring’s Book Value Per Share.

II. TERMS OF MERGER

Subject to this Agreement being consummated and to the terms and conditions herein stated:

A. At the Closing, all of the common stock of Target shall be converted as a result of the Merger into shares of Acquiring’s Common Stock. The number of shares of Acquiring’s Common Stock which Shareholder will receive as a result of the Merger will be equal to the amount computed by dividing Target’s Net Worth by Acquiring’s Book Value Per Share and adding 15,000 shares thereto. The shares of Acquiring Common Stock which are so computed to be due to Shareholder are hereinafter identified as the “Merger Shares.”

B. (1) The Shareholder hereby agrees that at the Closing, upon receipt of the Merger Shares, he will immediately deposit 15,000 of such Merger Shares into escrow for a period ending no later than 42 months after the Closing at which time the escrowed Merger Shares then remaining in escrow will be returned to him.

(2) The Shareholder agrees to enter into an escrow agreement substantially in the form of the escrow agreement attached hereto as Appendix A (hereinafter the “Escrow Agreement”), with National Bank (thereinafter “Depository”), which Escrow Agreement will provide that the 15,000 escrowed shares will be held subject to the following provisions:

(a) If during the first four full fiscal quarters of Target succeeding the Closing (“Year One”), the business operations which constituted Target on the date of the Closing (hereinafter the “Operations”) shall experience net sales equal to or in excess of 115% of those experienced by the Operations in the twelve full months (the “Base Year”) immediately preceding Year One and have pretax earnings (after elimination of all non-operating gains and losses) equal to or in excess of 3.4% of net sales, then 5,000 shares of Acquiring Common Stock placed in escrow by the Shareholder shall be released from the escrow and delivered to the Shareholder within 90 days of the end of Year One.

(b) If during the first four fiscal quarters of Target following Year One (“Year Two”), the Operations experienced net sales equal to or in excess of 132% of those experienced by the Operations in the Base Year, and pretax earnings (after elimination of non-operating gains and losses) equal to or in excess of 4.2% of such net sales, then 5,000 shares of Acquiring Common Stock placed in escrow by the Shareholder shall be released from the escrow and delivered to the Shareholder within 90 days of the end of Year Two.

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(c) If during the four fiscal quarters of Target following Year Two (“Year Three”), the Operations shall experience net sales equal to or in excess of 152% of those experienced by the Operations in the Base Year, and pretax earnings (after elimination of non-operating gains and losses) equal to or in excess of 4.8% of such sales, then 5,000 shares of Acquiring Common Stock placed in escrow by the Shareholder shall be released from the escrow and delivered to the Shareholder within 90 days after the end of Year Three.

(d) Notwithstanding subsections II.B.(2)(a)--(c) above, in the event that any Merger Shares received by the Shareholder at the Closing remain in escrow after the end of Year Three, all of such shares shall be released from the escrow and delivered to the Shareholder within 90 days after the end of Year Three, if the Operations shall experience net sales in Year Three equal to or in excess of 152% of those experienced by the Operations in the Base Year, and the aggregate pretax earnings (after elimination of non-operating gains and losses) of the Operations in the Years One, Two and Three shall equal or exceed the sum of (i) 3.4% of the Year One’s net sales (ii) 4.2% of Year Two’s net sales and (iii) 4.8% of Year Three’s net sales.

(e) Those escrowed Merger Shares which are not released from escrow and delivered to Shareholder pursuant to Sections II.B.(2)(a) through II.B.(2)(d) shall be returned to Acquiring 42 months following the Closing. Prior to such date all voting and dividend rights in the escrowed Merger Shares shall belong to Shareholder, as stated in the Escrow Agreement. Dividends, whether in cash, stock or other securities or property (other than Acquiring Common Stock) paid on, or in respect of the escrowed Merger Shares, shall be retained by Shareholder. Dividends in Acquiring Common Stock and Acquiring Common Stock issued as a result of a stock split shall be delivered by Shareholder to the Depository to be held in escrow and distributed with the Acquiring Common Stock in respect of which it was issued.

(f) It is agreed that until the end of Year Three, Acquiring shall not charge any general or administrative expenses of Acquiring to the Surviving Corporation nor shall it be reimbursed by the Surviving Corporation for any expenses other than those directly incurred on the Surviving Corporation’s behalf; provided, however, Acquiring shall be entitled to reasonable interest on any loans or advances made to the Surviving Corporation.

C. When this Agreement and the transaction contemplated hereby shall have been adopted, approved, executed, and an agreement of Merger filed in accordance with the laws of

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the State of California, the separate existence of Subsidiary shall cease and it shall be merged into Target. The date on which the Merger is effected shall be known as the “Closing Date”.

D. The laws which are to govern the Surviving Corporation are the laws of the State of California. The Articles of Incorporation of Target as in effect on the Closing Date (unless otherwise set forth in the Agreement of Merger) shall be the Articles of Incorporation of the Surviving Corporation from and after the Closing, subject always to the right of the Surviving Corporation to amend its Articles of Incorporation in accordance with the laws of the State of California.

E. The Bylaws of Target in effect immediately prior to the Closing Date shall be and remain the Bylaws of the Surviving Corporation until the same shall be altered, amended or repealed as provided therein or as provided by law.

F. The directors and officers of Target on the Closing Date shall be the directors and officers of the Surviving Corporation immediately following the Merger.

G. On, or prior to, the Closing Date, Acquiring will issue and deliver the Merger Shares to Subsidiary to be delivered to Shareholder upon surrender by the Shareholder to Acquiring of the certificates theretofore representing all of the outstanding shares of the common stock of Target.

H. At the Closing, all of the common stock of Subsidiary shall be converted as a result of the Merger into 100 shares of Target common stock.

I. In the event that, subsequent to the date of this Agreement but prior to the Closing, the outstanding shares of Acquiring Common Stock shall have been, without consideration, increased, decreased, changed into or exchanged for a different number or kind of shares of securities through reorganization, recapitalization, reclassification, stock dividend, stock split, reverse stock split, or other like changes in Acquiring’s capitalization, then an appropriate and proportionate adjustment shall be made in the number and kind of shares to be issued to the Shareholder on the Closing Date and to be placed in escrow by the Shareholder.

III. WARRANTIES, REPRESENTATIONS, AND AGREEMENTS OF THE SHAREHOLDER AND TARGET

A. Target and the Shareholder jointly and severally represent, warrant and agree as follows:

(1) Target is a corporation duly organized, validly existing and in good standing under the laws of the State of California, with the power to own its property, to carry on its business as now being conducted, and to enter into and carry out the terms of this Agreement.

(2) Target is not qualified to do business as a foreign corporation in any jurisdiction; and neither the character of the properties owned and leased by Target, nor the

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nature of the business conducted by Target makes qualification as a foreign corporation in any other jurisdiction necessary.

(3) The Shareholder is the lawful owner of, and has good and marketable title to, all of the outstanding capital stock of Target, free and clear of any mortgages, pledges, claims, liens, charges or encumbrances, or other rights in third persons to purchase any shares thereof.

(4) The authorized capital stock of Target consists of shares of common stock, $1 par value, of which shares are issued and outstanding, and no shares are held as treasury stock. All of the issued and outstanding shares of Target have been duly authorized and validly issued and are fully paid and non-assessable. There are no outstanding options, warrants, rights, calls, commitments, conversion rights, plans or other agreements of any character providing for the purchase of any authorized but unissued shares of the capital stock of Target. Prior to the Closing, Target will not issue any capital stock or authorize any increase in the number of shares of its authorized capital stock or issue any options, warrants, calls, commitments or rights to subscribe for or purchase any of its securities. Copies of the Articles of Incorporation, Bylaws and all minutes of Target are contained in the minute books of Target and such minute books and all stock books of Target will be delivered to Acquiring at the Closing.

(5) Each balance sheet delivered to Acquiring pursuant to this Agreement shall reflect all claims, debts or liabilities of Target which should be reflected thereon in accordance with generally accepted accounting principles. Without the prior written consent of Acquiring other than in the ordinary course of business or as otherwise permitted herein, Target will not incur, prior to the Closing, and indebtedness for money borrowed or incur any liabilities.

(6) All of Target’s inventories, except for quantities deemed not to be material, of finished foods, work in progress, raw materials and supplies are current, usable and merchantable and are not excessive or out of balance, and are in the physical possession of Target and will be valued on the Balance Sheet and all financial statements furnished to Acquiring pursuant to this Agreement at the lower-of-cost-or-market (cost being computed on a “First-in, First-out” basis).

(7) Since November 30, 19 , Target has not issued, or declared or paid any dividend on, or declared or made any distribution on, or authorized the creation or issuance of, or effected any split-up or any recapitalization of any of its capital stock of any class, or directly or indirectly, redeemed, purchased or otherwise acquired any of its outstanding stock or authorized or made any change in its Articles of Incorporation or agreed to take any such action and, prior to the Closing, Target will take no such action.

(8) Target has filed all requisite Federal income, payroll and excise tax returns and all appropriate state and local income, sales, payroll, personal property and franchise tax returns required to be filed by it and has paid all taxes and assessments (including interest or penalties) owed by it to the extent that such taxes and assessments are due. To the extent any

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subsequent tax liabilities have accrued but have not become payable, the full amounts thereof have been reflected as liabilities on the books and in the financial statements of Target as of the date of their accrual. In addition, Target has paid all taxes which would not require the filing of returns and which are required to be paid and which otherwise would be delinquent.

(9) Target does not own any real property. Except as noted in Schedule A [Schedules have been omitted. [Ed.]]. Target has good and marketable title to all of its personal property, free and clear of all encumbrances, liens and charges of every kind and character. None of the personal property of Target is subject (i) to a contract for sale, except inventory to be sold in the ordinary course of business, or (ii) to mortgages, pledges, liens, encumbrances, security interests or charges of any kind of character except as herein disclosed or as set forth in Schedule A. Except as set forth on Schedule A, all buildings, structures, appurtenances, machinery and equipment owned or leased by Target are in good operating condition and in a state of good maintenance and repair, ordinary wear and tear excepted. There is no real or personal property currently used in the Operations which is not either leased or owned by Target, and all property owned or leased by Target is in its possession.

(10) Set forth in Schedule B hereto is a list of all leases under which Target holds any real or personal property. Each lease set forth in such schedule is in full force and effect, all rents and additional rents due to date on each such lease have been paid; in each case the lessee has been in peaceable possession since the commencement of the original term of such lease and neither Target nor, to the best of its knowledge, any lessor is in default thereunder; no waiver, indulgence or postponement of the lessee’s obligations thereunder has been granted by the lessor; or of the lessor’s obligations by lessee and there exists no event, occurrence, condition or act which, with the giving of notice, and lapse of time or the happening of any further event or condition would become a default by the lessee (or to the best of Target’s knowledge any lessor) under any such lease. Target has not violated any of the terms of conditions under any such lease and all of the covenants to be performed by the lessee and lessor under each such lease have been fully performed.

(11) Set forth on Schedule C hereto is a true and correct list of all obligations for indebtedness and all obligations not incurred in the ordinary course of business stating the origin of the obligation, amount owed and the terms of payment.

(12) Set forth on Schedule D hereto is a true and correct list of all policies of insurance on which Target is named as the insured party, including the amounts thereof, in force as at the date hereof, and such policies are in full force and effect. Target will continue to maintain the coverage afforded by such policies in full force and effect up to and including the Closing Date.

(13) Set forth on Schedule E is a true and correct listing of all trade secrets, technical information, patents, patent rights, applications for patents, trademarks, trade names, copyrights, processes or formulae owned, possessed, licensed or used by Target in its business. Except as set forth in such schedule, none of the trademarks or trade names have been registered in, filed in, or issued by any governmental office. Except as noted on such schedule, to the best of Shareholder’s and Target’s knowledge, no such trademark or trade name infringes on others.

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Except as noted on such schedule, no such trademark or trade name is licensed by Target to, or used by Target, pursuant to a license from any other person, firm or corporation in the United State or elsewhere. Except as set forth in Schedule E, Target has full right, title and ownership to its corporate name and to any and all other names under which it does business. Target possesses valid rights to use all trademarks, trade names, and licenses now used or necessary to conduct its business as presently being conducted.

(14) Except as set forth in Schedule F hereto, there are no actions, suits or proceedings which have been served on Target or to Target’s knowledge, threatened against or which affect Target, at law or in equity, by or before any Federal, state or municipal court or other governmental department, commission, board, bureau, agency or instrumentality. Target is not subject to any material liability by reason of a violation of any order, rule, or regulation of any Federal, state, municipal or other governmental agency, department, commission, bureau, board or instrumentality to which it is subject. To the best information and belief of the Shareholder, there exists no event, condition or other circumstance (relating particularly to the business of Target as contrasted with matters relating to its industry or of a regional, national or international character) which immediately or with a lapse of time will materially adversely affect the business of Target as presently conducted.

(15) Except as set forth in Schedule G hereto, Target does not have any collective bargaining agreements with employees, employment agreements, compensation plans, employees’ pension or retirement plans or pension trust, employees’ profit sharing or bonus or stock purchase plans or any other similar agreements or plans (formal or informal). To the knowledge of Target and Shareholder, no party is in violation of any of the provisions of such agreements or plans. Target has not has any work stoppage due to concerted action by any of its employees and to the best of its knowledge none is threatened or contemplated. Between the date hereof and the Closing, Target will not, without written consent of Acquiring, except in the ordinary course of business and consistent with prior practices, make or agree to make any increase in the rate of wages, salaries, bonuses, or other remuneration of any employee or employees, or become a party to any employment contract or arrangement with any of its officers or employees, or become a party to any contract or arrangement with any officers or employees providing for bonuses or profit sharing payments, severance pay or retirement benefits.

(16) Set forth in Schedule H hereto is a true and correct list of all outstanding contracts, agreements or understanding to which Target is a party, except (i) those referred to elsewhere in this Section II, (ii) any contract, agreement or understanding involving an aggregate expenditure of less than $5,000 and (iii) purchase commitments for Target inventory which Target expects to sell within 30 days of receipt in the ordinary course of business. Neither Target nor to the best of its knowledge any other party to any such contract, agreement or understanding is in default under the terms of any such contract, agreement or understanding. Between the date hereof and the Closing, Target will not, without the written consent of Acquiring, make any changes or modifications in any such contracts, agreements or understanding, which result in an increase of Target’s obligations by more than $2,000 for each

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such agreement or surrender any rights thereunder, or make any further additions to its property or further purchases of equipment except such changes or modifications, each in an amount less than $5,000, as are in the ordinary course of business or are necessary or appropriate to maintain its properties and equipment and except for the replacement of any trucks as are necessary or appropriate. Target is not a party to any continuing contract for the future purchase of materials, supplies or equipment in excess of the requirements for its business as now being conducted. Neither Target nor the Shareholder is subject to, or is a party to, any mortgage, lien, lease, agreement, contract, instrument, order, judgment or degree or any other restriction of any kind or character which would prevent the continued operation of the business of Target after the Closing on substantially the same basis as theretofore operated.

(17) Neither Target nor the Shareholder is subject to any order, judgment or decree with respect to Target’s business or any of Target’s assets or property, or to any charter, bylaw, mortgage, lease, agreement, instrument, order, judgment or decree which would prevent the consummation of any of the transactions contemplated hereunder, or compliance by Target or the Shareholder with the terms, conditions and provisions hereof.

(18) All outstanding accounts receivable (trade or other) of Target as will be set forth in the Balance Sheet and in Target’s books and records, and in any other financial statements prepared by Target pursuant to the terms of this Agreement will be collectible, except to the extent of the reasonable reserve for bad debts to be set forth on said Balance Sheet, books and records, or other financial statements.

(19) Since December 31, 19 , the business, properties, or condition, financial or otherwise, of Target has not been materially adversely affected in any way as a result of any legislative or regulatory change, revocation of any license or right to do business, fire, explosion, accident, casualty, labor trouble, flood, drought, riot, storm, condemnation, or act of God or other public force or otherwise (whether or not covered by insurance).

(20) The copies of all leases, instruments, agreements or other documents that have been or will be delivered to Acquiring or Subsidiary pursuant to the terms of this Agreement are and will be complete and correct as of the date delivered and as of the Closing Except as set forth in Schedule I,* the execution and delivery of this Agreement and the other agreements which are to be executed pursuant to this Agreement (all such agreements, including this Agreement, are sometimes collectively referred to as the “Executed Agreements”), and the performance of the obligations thereunder do not on the date hereof and will not hereafter violate any of the terms of provisions of any leases, instruments, agreements or other documents to which Target is a party and none require the consent of any third party to the transactions contemplated hereby.

(21) Target has maintained its books of account in accordance with generally accepted accounting principles applied on a consistent basis.

(22) In the negotiations leading up to the transactions contemplated by this Agreement, neither the Shareholder nor Target has retained or utilized the services of any broker or finder.**Schedule I has been omitted. [Ed.].

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(23) During the period from the date hereof to and including the Closing, Target will conduct its business solely in the usual and ordinary manner and will refrain from any transaction not in the ordinary course of business or except as otherwise permitted herein unless the prior written consent of Acquiring to such transaction has been obtained.

(24) All actions and proceedings required by law to be taken either by Target or the Shareholder at or prior to the Closing in connection with the Executed Agreements and the transactions provided for therein shall be duly and validly taken on or prior to the Closing.

(25) To the knowledge of the Shareholder, no information necessary to make any of the representations and warranties herein contained not materially misleading has been withheld from or has not been disclosed to, Acquiring.

(26) The only officers and directors of Target are:

Name Position

President and Director

Vice President, Secretary and Director

Vice President, Sales

Treasurer and Director

Assistant Secretary and Director

Director

(27) Target will give Acquiring written notice of all meetings (or actions in writing without a meeting) of Target’s Board of Directors and/or its shareholder held (or taken) prior to the Closing at least ten days prior to such meeting (or the taking of actions without a meeting). The notice herein provided shall disclose the purpose of the meeting or the proposed action in writing without a meeting. Acquiring may at its discretion waive the ten days’ notice requirement of this subsection. Target shall allow a representative of Acquiring to attend, as an observer, any meeting of its Board of Directors or of its shareholders. Promptly after preparation of the minutes for any of the above-described meetings or actions, Target shall cause a copy of such minutes to be forwarded to Acquiring.

(28) Target does not have any subsidiaries or affiliates or own any interest in any other business, corporation, joint venture, partnership or proprietorship.

B. The Shareholder covenants, warrants and represents both as of the date hereof and as of the Closing Date as follows:

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(1) That, except as required in connection with his employment by Target, he will not disclose or use at any time any secret, confidential or proprietary information or knowledge pertaining to the business affairs of Target.

(2) That he has no claim against Target except for current salary, and claims disclosed in Schedule J attached hereto.

(3) That he has full power, right and authority to enter into this Agreement and agrees to vote his shares of Target common stock in favor of the transactions contemplated by this Agreement.

(4) Shareholder recognizes that among the intangible assets of Target is its goodwill. Until the Closing, Shareholder will utilize his best efforts to keep Target’s business intact, to keep available to the Surviving Corporation the services of Target’s present officers and employees, and to preserve for the Surviving Corporation the goodwill of Target’s suppliers and customers and the goodwill of others with whom Target has business relations. Shareholder agrees that, for a period of three (3) years following the Closing Date, he will not, without the written consent of Acquiring or as an employee of Target, on his own behalf or as a partner, officer, executive, employee, agent consultant, director, trustee, or shareholder (except as a shareholder of not more than 5% of the outstanding securities of a publicly held corporation) carry on a business of the type conducted by Target on the Closing Date or engage in any business which would be competitive with such business within any county in any state in which Target has carried on its business and so long as Target continues a like business therein.

IV. WARRANTIES, REPRESENTATIONS, AND AGREEMENTS OF ACQUIRING

Acquiring represents, warrants and agrees as follows:

A. Acquiring is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware and has the corporate power to own its property and to carry on its business as now being conducted by it.

B. As of November 30, 19 , the authorized capital stock of Acquiring consisted of shares of Common Stock, par value $1 per share, and shares of Preferred Stock, par value $1 per share.

C. The Merger Shares when issued and delivered pursuant to this Agreement will be duly authorized, validly issued, fully paid and nonassessable Common Stock of Acquiring listed on the American Stock Exchange (or listed subject to notice of issuance), free and clear of all preemptive rights, and other claims, liens or encumbrances whatsoever.

D. All actions and proceedings required by law to be taken by Acquiring and Subsidiary at or prior to the Closing Date in connection with the Executed Agreements and the transactions provided for therein shall have been duly and validly taken on or prior to the Closing Date.

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E. Acquiring’s Board of Directors has approved the transactions contemplated by this Agreement.

F. Acquiring shall apply for a tax ruling at its expense that no gain will be realized as a result of the Merger or as a result of the release of shares from the escrow referred to in Article II.

G. In the event the Merger is not consummated, all written information furnished to Acquiring or its representatives with respect to Target shall be returned to Target, and Acquiring shall keep confidential all non-public information obtained pursuant to the terms of this Agreement.

H. (1) Acquiring will at any time or times during the three years immediately following the Closing Date, upon the written request of the Shareholder and at his expense, file as soon as practicable a Registration Statement pursuant to the Securities Act of 1933 (the “Act”), and all requisite registrations or qualifications under any state securities laws, covering the sale by such Shareholder of all or part of the Acquiring Common Stock to be issued to him hereunder (and any additional shares distributed thereon in any stock dividend or stock split), and shall use its best efforts to have such Registration Statement made effective in order to permit a sale of such Common Stock upon terms of an offering to be supplied to Acquiring in writing. The Shareholder shall promptly pay and reimburse Target for all costs and expenses (or, if any other shareholder of Acquiring shall join in such registration as provided in subsection (3) below, each “selling shareholder” participating in such registration shall pay and reimburse Acquiring for his proportionate share of all costs and expenses) related to such registration (including legal, accounting and printing expenses), without regard to whether the Registration Statement is made effective or the proposed sale of Acquiring Common Stock is carried out.

(2) Acquiring agrees to notify the Shareholder in writing prior to the filing of any Registration Statement (including any Registration Statement filed pursuant to the provisions of subsection H(1)) during the three years immediately following the Closing Date. If so requested by the Shareholder without ten (10) days after receipt of such notice as aforesaid, Acquiring shall include in such registration all or such part of the shares of Target Common Stock received by the Shareholder hereunder as the Shareholder may request.

(3)(a) The covenants and obligations of Acquiring under subsections H(1) and/or H(2) are subject to the following conditions:

(i) Acquiring shall not be required to file more than one Registration Statement during any period of twelve consecutive calendar months.

(ii) The Shareholder shall deliver to Acquiring a statement in writing that he bona fide intends to sell the shares of Common Stock which he proposes to include in Registration Statement.

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(iii) The Shareholder shall cooperate with Acquiring in the preparation of the Registration Statement to the extent required to furnish information concerning the Shareholder therein.

(iv) With respect to any Registration Statement relating to any shares of Common Stock of the Shareholder, the Shareholder will indemnify Acquiring and each person, if any, who controls Acquiring within the meaning of the Act, in writing, in form and substance acceptable to counsel for Acquiring, against all expenses, claims, damages or liabilities to which Acquiring may become subject, under the Act or otherwise, insofar as such expenses, claims, damages or liabilities arise out of or are based upon any untrue statement or alleged untrue statement of any material fact contained in any Preliminary Prospectus, the Registration Statement, the final Prospectus or any amendment or supplement thereto, or arise out of or are based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, in each case to the extent, but not only to the extent, that such untrue statement or alleged untrue statement or omission or alleged omission was made therein in reliance upon and in conformity with written information furnished to Acquiring by the Shareholder expressly for use in the preparation thereof.

(v) With respect to any Registration Statement relating to any shares of Common Stock of Shareholder, Acquiring will indemnify the Shareholder, each Underwriter of the shares of the Shareholder, and each person, if any, who controls the Shareholder or any such Underwriter within the meaning of the Act, in writing, in form and substance acceptable to counsel for Target, the Shareholder and such Underwriters, against all expenses, claims, damages or liabilities to which the Shareholder, any such Underwriter, or any such controlling person may become subject, under the act or otherwise, insofar as such expenses, claims, damages or liabilities arise out of or are based upon any untrue statement or alleged untrue statement of any material fact contained in any Preliminary Prospectus, the Registration Statement, the final Prospectus or any amendment or supplement thereto, or arise out of or are based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading; provided, however, that (X) Acquiring shall not be liable to the Shareholder (or any controlling person of the Shareholder) in any such case to the extent that such expenses, claims damages or liabilities arise out of or are based upon any untrue statement or alleged untrue statement or omission or alleged omission made therein in reliance upon and in conformity with written information furnished to Acquiring by such Shareholder expressly for use in the preparation thereof, and (Y) Acquiring shall not be liable to any Underwriter (or any controlling person of such Underwriter) in any such case to the extent that such expenses, claims, damages or liabilities arise out of or are based upon any untrue statement or omission or alleged omission made therein in reliance upon and in conformity with written information furnished to Acquiring by such Underwriter expressly for use in the preparation thereof.

Any such Underwriter, as a condition to obtaining the indemnity agreement referred to in this subparagraph (v), shall be required to indemnify Acquiring on the same terms as provided in the previous subparagraph (iv) in the case of the Shareholder in respect of the written

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information furnished by such Underwriter which is referred to in clause (Y) of the preceding paragraph.

(b) The covenants and obligations of Acquiring under subsection H(2) are subject to the following conditions:

(i) Acquiring shall not be required to include any of the Common Stock if, by reason of such inclusion, Acquiring shall be required to prepare and file a Registration Statement on a form other than that which Acquiring otherwise would use.

(ii) Acquiring shall not be required to include any Common Stock in such Registration Statement if any managing underwriter with respect to the Common Stock then being offered by Acquiring shall in good faith object to the inclusion therein of the Common Stock of the Shareholder.

(iii) The Shareholder shall offer and sell his Common Stock pursuant to such Registration Statement and the Prospectus forming a part thereof upon such terms and conditions and at such times as shall be agreed upon and consented to by any managing underwriter with respect to the Common Stock offered by Acquiring pursuant to such Registration Statement.

(iv) In the event that by reason of such inclusion of the Common Stock of the Shareholder in any Registration Statement the effective date of such Registration Statement is unduly delayed, Acquiring may thereupon amend any such Registration Statement and remove therefrom any of the Common Stock owned by the Shareholder previously included therein.

(v) Without regard to whether the Registration Statement relating to the proposed sale of any Common Stock of Acquiring is made effective or the proposed sale of such Common Stock is carried out: (x) if the Shareholder shall propose to sell Common Stock received by the Shareholder hereunder in conjunction with the proposed sale of Common Stock by Acquiring, then Acquiring shall pay the Shareholder’s portion of the fees and expenses in connection with such Registration Statement, including without limitation, legal, accounting, and printing fees and expenses; except that the Shareholder shall pay his pro rata portion of the registration fees under the Act and the state securities laws, all of the underwriting discounts and commission with respect to the Common Stock of the Shareholder included in the Registration Statement, and all of the fees and expenses of counsel to the Shareholder, (y) if the Shareholder shall propose to sell any Common Stock of Acquiring received by the Shareholder hereunder in conjunction with the sale of such Common Stock by any other shareholder of Acquiring, each selling shareholder shall pay his proportionate share of all costs and expenses related to such registration (including legal, accounting and printing expenses), each such shareholder paying a percentage of such costs and expenses equal to the percentage of such shareholder’s interest in the net proceeds of the sale of all of the Common Stock which are offered for sale in such registration.

V. AGREEMENTS AND INDEMNIFICATION

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Target, and the Shareholder, jointly and individually, agree as follows:

A. The Shareholder agrees that, notwithstanding any investigation of the business and assets of Target made by or on behalf of Acquiring prior to the Closing, he will indemnify and hold harmless Target and Shareholder from and against any “Loss,” which with respect to Target and Shareholder shall mean any claims, liabilities, losses, costs or damages, net of any taxes and future tax benefits or other recoverable sums, and actual expenses (including without limitation reasonable counsel fees incurred in litigation or otherwise) arising out of or sustained by Target or Shareholder directly or indirectly due to (i) breach of any warranty, representation or agreement of Target or Shareholder contained in this Agreement, or in any Certificate, Schedule, Exhibit, Appendix or writing attached hereto or required by this Agreement, or (ii) any liability, debts, claim, tax penalty, or loss of Target arising out of any transaction prior to the Closing Date which was required to be disclosed and was not fully disclosed pursuant to this Agreement, or (iii) any cost or expense which may be incurred by Target or Shareholder in curing any breach of warranty contained in the Executed Agreements.

B. The Shareholder and Target agree that (i) any expense incurred, settlement made or judgment paid by Acquiring or Target after December 31, 19 which arose out of any action or inaction prior to January 1, 19 (including those which are described in Exhibit F hereto) or which occurred at any time on or after January 1, 19 and prior to the Closing (x) as to which it is probable that a claim will be asserted and (y) which was not disclosed to Acquiring as required by Sections VI.B shall be a “Loss” as to which Target is indemnified under Section V.A. above; and (ii) any expense incurred, settlement made or judgment paid by Target or Acquiring after December 31, 19 which arose out of any action or inaction of Target which occurred after December 31, 19 shall not be a “Loss” as to which Acquiring is indemnified under Section V.A. above, unless such action or inaction occurred prior to the Closing Date, it is probable that a claim will be asserted with respect thereto, and Target has failed to disclose the facts surrounding such an event to Acquiring by the Closing Date.

C. In the event a claim is made against Target or Subsidiary in respect of which they are (or either of them is) indemnified hereunder, Target or Subsidiary shall notify of the Shareholder of such claim. In case any action is brought against Target, Subsidiary or Acquiring and Acquiring shall notify the Shareholder of the commencement thereof, the Shareholder shall assume the defense thereof with counsel satisfactory to Acquiring. Acquiring shall have the right to employ separate counsel in any such action and participate in the defense thereof but the fees and expenses of such counsel shall be at the expense of Acquiring unless the Shareholder has authorized the employment of such counsel. The Shareholder shall have the right to settle any such action or judgment based on any such action and in such event the Shareholder shall pay the amount of such settlement. If the Shareholder shall fail to promptly defend such action, Acquiring may do so with attorneys of its own selection and the Shareholder shall be responsible and pay any settlement or judgment effected by Acquiring and attorneys’ fees. Notwithstanding anything contained herein to the contrary, the Shareholder shall not be required to pay the first $25,000 of Losses (as defined in this Article V.).

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VI. CONDITIONS TO ACQUIRING'S AND SUBSIDIARY'S OBLIGATION TO CLOSE

The obligations of Acquiring and Subsidiary to consummate the transactions herein contemplated shall be subject to the fulfillment on or prior to the Closing Date of the following:

A. (1) Target must have: (i) realized pretax earnings (after elimination of non-operating gains and losses) or at least the lesser of 2.2% of net sales or $220,000 in the six-month period preceding July 1, 19 ; or (ii) not incurred a loss in the first quarter of 19 and realized pretax earnings (after elimination of non-operating gains and losses) of at least the lesser of 2.2% of net sales or $220,000 in the six-month period preceding September 30, 19 ; or (iii) realized pretax earnings (after elimination of non-operating gains and losses) of 1% of net sales in calendar year 19 ; and have informed Acquiring in writing at least two weeks prior to the end of each of the above-referenced periods during which Target believes that it might satisfy the pretax earnings condition referred to above as to such period and given written notice to Acquiring of having met one of the earnings goals outlined in this Section VI.A.(1) within thirty (30) days of having first reached one of such goals (which notice hereby agrees to give).

(2) Notice from Target (for purposes of this Section VI.A.) shall include a balance sheet and statement of earnings of Target, which Acquiring, at its election may have audited by a firm of independent certified accountants in the same manner and subject to the same requirements as provided in Section I hereof. In the event Acquiring should desire to perform an audit, the conclusions of the firm of certified public accountants selected by Acquiring to perform such audit as to whether the conditions set forth in this Section VI.A. have first been met shall be conclusive and binding on the parties hereto. Provided that the conditions set forth in Sections VI and VII are met or waived, the Closing shall occur upon 72 hours notice from Target to Acquiring, but no later than ninety (90) days after receipt by Target of notice from Acquiring that the conditions of this Section VI.A. have been met, or thirty (30) days from the delivery to Target and Acquiring of the above-referenced audity, whichever shall occur first.

(3) Notwithstanding the foregoing, in the event of Shareholder’s death or permanent disability, the Closing will occur no later than one hundred twenty (120) days after receipt by Acquiring of notice of such death or evidence reasonably satisfactory to Acquiring of such permanent disability.

B. Contemporaneously with giving notice to Acquiring, Target shall have provided Acquiring with revised Schedules dated as of the last day of the applicable period referred to in Section VI.A.(1) hereof (the “Revised Schedules”), with material changes through such date duly noted, and the Revised Schedules shall not contain any disclosures which would constitute a violation of this Agreement unless any such disclosures have been approved in writing by Acquiring.

C. Acquiring shall have received from , counsel for Target and the Shareholder, a favorable opinion, dated the Closing Date, to the effect that (i) Target is a

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corporation duly organized and existing in good standing under the laws of the State of California; (ii) Target has the corporate power to carry on its business as then being conducted and, to the knowledge of such counsel, is not required to be qualified as a foreign corporation in any jurisdiction in which the character of the properties owned and/or leased by it or the nature of the business conducted by it makes such qualification necessary; (iii) the authorized and outstanding capital stock of Target is as represented in this Agreement, and all the issued shares have been duly and validly authorized and issued and are fully paid and non-assessable; (iv) neither the execution of this Agreement nor the consummation of the transactions contemplated herein will conflict with any provision of the Articles of Incorporation or Bylaws of Target or to the best of such counsel’s knowledge (after having made due investigation with respect thereto), conflict with or result in a breach of any indenture, mortgage, deed of trust or other agreement to which Target or Shareholder is a party and which violation would have a material adverse effect on Target; (v) to the knowledge of such counsel (after having made due investigation with regard thereto), there are no outstanding options or agreements on the part of Target or the Shareholder to issue or sell any capital stock of Target; (vi) this Agreement, the Merger Agreement, the Escrow Agreement and the Employment Agreement have been duly executed and delivered to the extent required by Target and the Shareholder and, assuming valid execution by Target and Subsidiary, each of this Agreement, the Merger Agreement and the Employment Agreement is the legal, valid and binding obligation of Target and the Shareholder to the extent executed by it or him and all corporate action required pursuant to the terms of this Agreement has been taken; (vii) to the knowledge of such counsel, Target is not engaged in or threatened with any legal action or other proceeding, except such legal actions or proceedings as are disclosed on the Revised Schedules, nor has Target been charged with any presently pending violation of any Federal, state or local laws or administrative regulation, which would materially adversely affect the financial condition, business, operations, prospects, properties, or assets of Target; (viii) no stock transfer taxes are applicable to the transactions provided herein; (ix) all other actions and proceedings required by law, or any of the Executed Agreements, to be taken by Target or the Shareholder at or prior to the Closing Date in connection with the Executed Agreements and the transactions provided for therein have been duly and validly taken: (x) upon filing the Merger Agreement with the California Secretary of State, the Merger will be effective under and in compliance with the laws of the State of California: and (xi) as to such other matters incident to the transactions contemplated hereby as Acquiring may reasonably request at or prior to Closing.

D. No action or proceeding before a court or any other governmental agency or body shall have been instituted or threatened to restrain or prohibit the Merger contemplated hereby.

E. The representations and warranties of Target and the Shareholder (and any written statement, certificate or schedule furnished pursuant to or in connection with this Agreement) shall have been correct when made and the information contained in the Revised Schedules shall be true on and as of the Closing Date with the same effect as though all such information had been given to Acquiring on and as of such date and each and all of the actions of Shareholder and to be performed on or before the Closing Date pursuant to the terms hereof shall have been duly performed; and the Shareholder and Target shall have provided Acquiring with a certificate to that effect.

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F. The Shareholder shall have entered into an Employment Agreement with Target in substantially the form attached hereto as Appendix B and executed an investment letter in substantially the form attached hereto as Appendix C.

G. Target and the owner of the building currently leased by Target in , California shall have entered into a lease in substantially the form of the existing lease covering that property, except that: (i) the original term shall end five years after the Closing Date; (ii) Lessee shall have a five year option to renew at same basic rent; and (iii) Lessee shall, if Lessor desires to sell the premises, have the option to purchase the premises for $1.2 million. Lessor shall give Lessee written notice of such desire and Lessee shall have 15 days to exercise the option and an additional 30 days to consummate the transaction and to pay the purchase price.

H. All consents, if any, to the consummation of the transactions contemplated herein required in order to prevent a breach of or a default under the terms of any agreement to which Target or the Shareholder is a party or is bound shall have been obtained.

I. The parties shall have complied with all Federal and state securities laws applicable to the transactions contemplated by this Agreement.

J. The Shareholder shall have executed on the Closing Data a general release of all claims which such Shareholder may have to the date thereof against Target, Subsidiary and Acquiring, except claims for current salary, and rights and claims under this Agreement, the Employment Agreement, the lease referred to in Section VI.G., and claims disclosed to Acquiring prior to the Closing Date and consented to in writing by Acquiring.

K. Acquiring shall have received on the Closing Date certificates of good standing, qualification and tax certificates from the State of California.

L. Acquiring shall have received on the Closing Date certificates representing all the issued and outstanding shares and all treasury shares of Target.

M. Acquiring shall have received on the Closing Date the corporate minute books, seals and stock transfer books of Target and its predecessors (if any) certified by the corporate secretary of Target (in form and substance acceptable to Acquiring) as complete, true and correct.

N. Acquiring shall have received at the Closing copies of minutes of meetings of the shareholders and the Board of Directors of Target, certified by the corporate secretary of Target, unanimously approving and authorizing the Merger and the other transactions contemplated by this Agreement.

VII. CONDITIONS TO TARGET’S OBLIGATIONS TO CLOSE

The obligation of the Shareholder and Target to consummate the transactions herein contemplated shall be subject to the fulfillment on or prior to the Closing of the following conditions:

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A. The Shareholder shall have received from , counsel for Acquiring, a favorable opinion, dated the Closing Date, in form and substance satisfactory to Target, the Shareholder and their counsel, to the effect that (i) Acquiring is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware and it has the corporate power to own its property and to carry on its business as it is now being conducted; (ii) Subsidiary is a corporation duly organized, validly existing and in good standing under the laws of the State of California; (iii) the shares of Acquiring Common Stock to be issued and delivered to the Shareholder pursuant to this Agreement have been duly and validly authorized and issued and upon consummation of the transactions contemplated herein will be fully paid and non-assessable; (iv) this Agreement and the transactions contemplated herein have been duly authorized by the Board of Directors of Acquiring and Subsidiary and, assuming valid execution by the Shareholder and Target, this Agreement is a valid and binding obligation of Acquiring and Subsidiary in accordance with its terms; (v) the Merger Shares have been listed, or approved for listing subject to official notice of issuance, on the American Stock Exchange; and (vi) the issuance of the Merger Shares is exempt from registration under the Act pursuant to Section 4(2) thereof.

B. The representations and warranties made by Acquiring herein shall have been correct when made, and shall be deemed to have been repeated at the Closing Date and shall be true and correct as of such date.

C. No action or proceeding before a court or any other governmental agency or body shall have been instituted or threatened by an agency of the United States Government to restrain or prohibit the Merger contemplated hereby.

D. Shareholder shall have received a favorable tax ruling covering the matters referred to in Section IV.F.

E. The parties shall have complied with all Federal and state securities laws applicable to the transactions contemplated by this Agreement.

F. The Book Value Per Share of Acquiring Common Stock (determined in the same manner as set forth in Section I.C., but using updated information) as of the end of Acquiring’s most recent financial quarter prior to the Closing Date shall not be less than Acquiring’s Book Value Per Share on December 31, 19 .

VIII. CLOSING

The Closing shall be held on the Closing Date at the Office of Acquiring or its counsel. At the Closing, Acquiring, Target and Subsidiary shall consummate the Merger contemplated by this Agreement by filing an Agreement of Merger complying with the laws of the State of California relating to the merger of domestic corporations. At the Closing the Shareholder shall receive the Acquiring Shares to which he is entitled pursuant to Section II. hereof.

IX. TERMINATION

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This Agreement may be terminated and abandoned prior to the Closing Date:

A. By mutual written consent of Acquiring, Target and the Shareholder.

B. By Acquiring if, by the Closing Date, the conditions set forth in Sections V and VI hereof shall not have been met or waived.

C. By Target or the Shareholder if, by the Closing Date, the conditions set forth in Sections V and VII hereof shall not have been met or waived.

D. By any party hereto if the Closing Date contemplated herein shall not have occurred on or before March 1, 19 .

X. ADDITIONAL REPRESENTATIONS OF SHAREHOLDER

The Shareholder hereby acknowledges:

A. That in his opinion he has such knowledge and experience in financial and business matters, and particularly the business conducted by Acquiring, that he is capable of evaluating the risks of the investment in Acquiring Common Stock contemplated by this Agreement.

B. That he is able to bear the economic risk of the investment in Acquiring Common Stock contemplated by this Agreement.

C. That the Merger Shares which Shareholder may receive are for his own account and not on behalf of other persons;

D. That Acquiring has furnished to Shareholder a copy of its annual report for the fiscal year ended , 19 on Form 10-K, its quarterly report for the quarter ended , 19 on Form 10-Q, its proxy statement dated , 19 , all as filed with the Securities and Exchange Commission, and its 19 Annual Report to Stockholders and a description of Acquiring Common Stock. Acquiring has made available, and does hereby agree to continue to make available, any additional information which the Shareholder may wish to obtain to the extent Acquiring possesses such information or can acquire it without unreasonable effort or expense necessary to verify the accuracy of any information contained in the above-referenced documents and descriptions.

E. That he has been informed that he must continue to bear the economic risk of the investment in Acquiring Common Stock contemplated herein for an indefinite period because the Merger Shares will not have been registered under the Securities Act of 1933 and therefore will be subject to the restrictions set forth in subsection F below and cannot be sold unless they are subsequently registered under the Securities Act of 1933 or an exemption from such registration is available.

F. That the certificates representing the Merger Shares will contain a legend stating that the Acquiring Common Stock has not been registered under the Securities Act of 1933 and

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cannot be sold absent registration under such Act or an exemption therefrom and that stop transfer instructions will be given to the transfer agent for Acquiring prohibiting such transfer agent from transferring the Acquiring Common Stock without compliance with the provisions of the Securities Act of 1933.

G. That he will be required as a condition to receiving his Acquiring Common Stock at the Closing (and thereafter) to execute an investment letter in the form of the letter attached hereto as Appendix C.

XI. NOTICES

Any notices or communication required or permitted hereunder shall be sufficiently given if sent by first class mail, postage prepaid, and if to the Target or the Shareholder addressed to: , California with a copy to , Attention: . If to Acquiring or Subsidiary addressed to it at , marked for the attention of , with a copy thereof to , Attention: .

XII. HEIRS, LEGAL REPRESENTATIVES AND ASSIGNS

This Agreement and the rights of the parties hereunder may not be assigned and shall be binding upon and shall inure to the benefit of the parties hereto and their heirs, legal representatives and successors.

XIII. ENTIRE AGREEMENT

This Agreement and the Schedules, Exhibits and Appendices attached hereto and to be attached hereto, and the documents delivered pursuant hereto constitute the entire agreement and understanding between Acquiring, Subsidiary, Target and the Shareholder and supersede any prior agreement and understanding relating to the subject matter of this Agreement. No change, amendment, termination or attempted waiver of any of the provisions hereof shall be binding on Acquiring, Subsidiary, Target or Shareholder unless in writing and signed by the President or other senior officer of Acquiring, Subsidiary, or Target, as the case may be, and if such change affects the Shareholder, then if signed by the Shareholder. Unless specifically otherwise herein provided or agreed to by Acquiring, Subsidiary, Target and the Shareholder in writing, no modification waiver, termination, rescission, discharge or cancellation of this Agreement shall affect the right of Acquiring, Subsidiary, Target or the Shareholder to enforce any claim whether or not liquidated, which accrued prior to the date of such modification waiver, termination, rescission, discharge or cancellation of this Agreement, and no waiver of any provision or of any default under this Agreement shall affect the rights of Acquiring, Subsidiary, Target or the Shareholder thereafter to enforce said provision or to exercise any right or remedy in the event of any other default, whether or not similar.

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XIV. COUNTERPARTS

This Agreement may be executed simultaneously in two or more counterparts, each of which shall be deemed an original and all of which together shall constitute but one and the same instrument.

XV. EXPENSES

Whether or not the transactions herein contemplated shall be consummated, Acquiring, Subsidiary, and the Shareholder will each pay their own fees, expenses and disbursements and their counsels in connection with the subject matter of this Agreement or any of the Executed Agreements and any amendments thereto and all other costs and expenses incurred by it or him in performing and complying with all conditions to be performed by it or him under this Agreement or any of the Executed Agreements. Target will pay the fees, expenses and disbursements incurred by it and its counsel in connection with the subject of this Agreement or any of the Executed Agreements and any amendments thereto and all other costs and expenses incurred by it in performing and complying with all conditions to be performed by it under this Agreement, and any of the Executed Agreements.

XVI. FURTHER ASSURANCES

Upon reasonable request from time to time, the Shareholder shall execute and deliver all reasonably required documents and do all other acts which may be reasonably requested by Acquiring to implement and carry out the terms and conditions of the transaction contemplated by this Agreement, all such actions to be performed without further consideration, but at the expense of Acquiring, unless arising out of the default of the Shareholder. Except as prohibited by law, the Shareholder shall be required to furnish evidence against himself.

XVII. MISCELLANEOUS

A. Any party hereto may waive any provision contained in this Agreement for its benefit and such waiver shall not affect any of the other provisions hereof.

B. The singular shall include the plural and the plural shall include the singular; any gender shall include all other genders--all as the meaning and context of this Agreement shall require.

C. This Agreement shall be governed and regulated and the rights and liabilities of all parties hereto shall be construed in accordance with the laws of the State of California.

IN WITNESS WHEREOF, the undersigned parties have set their hands and seals as of the day and year first above written.

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APPENDIX A.

ESCROW AGREEMENT

AGREEMENT made as of this day of , 19 , by and among (“ ”), , a California resident (“Shareholder”), and (“Depository”) hereinafter referred to as “ESCROW AGREEMENT”.

PRELIMINARY STATEMENT

Acquiring Corp. (“Acquiring”) and the Shareholder have entered into a Plan of Reorganization for the conversion of all of the issued and outstanding shares of Target Corp., a California corporation (“Target”) into shares of Acquiring’s common stock, par value $1 (“Acquiring Common Stock”), dated , 19 (the “Acquisition Agreement”), which Acquisition Agreement is incorporated herein by reference and made a part hereof. The parties have agreed that Shareholder will deposit certain of the Acquiring Common Stock received pursuant to the Acquisition Agreement (the “Merger Shares”) in escrow in accordance with the provisions of Section II of the Acquisition Agreement.

NOW THEREFORE, in consideration of the mutual covenants, representations and promises of the parties of this Escrow Agreement, the parties hereto agree as follows:

1. DEPOSIT OF SHARES. Shareholder will deliver to the Depository that portion of the Merger Shares referred to in Section II.B. of the Acquisition Agreement (i.e., 15,000 shares) at the time and place of Closing (as defined in the Acquisition Agreement).

Such shares as are delivered to Depository (the “Escrow Shares”) shall be held and distributed by Depository as provided herein and in Section II of the Acquisition Agreement. The Escrow Shares will have attached thereto a stock power duly executed in blank by Shareholder, with signature guaranteed by a bank or trust company having an office or correspondent in New York City or by a broker or by a firm of brokers having membership in the New York Stock Exchange, in proper form to permit the transfer of the Shares represented thereby on the books of Acquiring.

The Escrow Shares shall continue to be registered in the name of Shareholder unless they are transferred to in accordance with the terms of this Escrow Agreement.

For purposes of this Escrow Agreement:

(a) “Year One” is the four fiscal quarters of 19 ending on . The “Base Year” is the twelve full months immediately preceding Year One. “Year Two” is the first four fiscal quarters of 19 following Year One. “Year Three” is the first four fiscal quarters of 19 following Year Two.

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(b) The “Target Operations” are the business operations which constituted Target immediately prior to the Closing.

(c) “Pretax Earnings” are the pretax earnings of the Operations after elimination of all non-operating gains and losses, as computed by the public accounting firm which is the public accounting firm of at the time of such computation (the “Accounts”). “Net Sales” are the net sales of the Operations (as determined by the Accountants) for the time period in question. Acquiring, Shareholder and Depository hereby agree that, for purposes of this Escrow Agreement, determinations of Net Sales and Pretax Earnings, as computed by the Accountants, shall be final and binding.

2. THE TERM OF THE ESCROW. The Depository (or its nominee) agrees to accept delivery of the certificates representing the Escrow Shares subject to the provisions of this Escrow Agreement, and to hold and distribute said shares during the period of this Escrow Agreement, all as herein provided.

3. DELIVERY AND DISTRIBUTION OF ESCROW SHARES. Within sixty days from the end of each Year (Year One, Year Two or Year Three), as appropriate, the Accountants shall compute and deliver to the Shareholder, Acquiring and to the Depository, a statement showing the Net Sales and the Pretax Earnings of the Operations for such Year. Within thirty days from the date of the receipt of such statements from the Accountants, the Depository shall distribute and deliver to Shareholder the number of Escrow Shares (if any) to which Shareholder may be entitled pursuant to this Escrow Agreement, and upon termination of this Escrow Agreement, the Depository shall distribute all of the Escrow Shares remaining in escrow and deliver same to Shareholder or Acquiring all in accordance with the following provisions:

(a) If during Year One the Target Operations shall experience Net Sales equal to or in excess of 115% of those experienced by the Target Operations in the Base Year and have Pretax Earnings equal to or in excess of 3.4% of such Net Sales, then 5,000 of the Escrow Shares shall be delivered to Shareholder.

(b) If during Year Two the Target Operations experience Net Sales equal to or in excess of 132% of those experienced by the Operations in the Base Year, and have Pretax Earnings equal to or in excess of 4.2% of such Net Sales, then 5,000 of the Escrow Shares shall be delivered to Shareholder.

(c) If during Year Three the Target Operations experience Net Sales equal to or in excess of 152% of those experienced by the Target Operations in the Base Year, and have Pretax Earnings equal to or in excess of 4.8% of such Net Sales, then 5,000 of the Escrow Shares shall be delivered to Shareholder.

(d) Notwithstanding Sections 3(a) through 3(c) above, in the event that any Escrow Shares remain in escrow after the end of Year Three, all remaining Escrow Shares shall be delivered to the Shareholder if the Target Operations shall experience Net Sales in Year Three equal to or in excess of 152% of those experienced by the Target Operations in the Base Year,

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and the aggregate Pretax Earnings of the Target Operations in the Years One, Two and Three shall equal or exceed the sum of (i) 3.4% of Year One’s Net Sales (ii) 4.2% of Year Two’s Net Sales, and (iii) 4.8% of Year Three’s Net Sales. Those Escrow Shares which are not released from escrow and delivered to Shareholder pursuant to Sections 3(a) through 3(d) shall be returned to Acquiring 42 months following the Closing.

4. DIVIDENDS AND OTHER DISTRIBUTIONS: VOTING. Shareholder shall be entitled to retain all dividends, whether in cash, shares or other securities or property paid or distributed on or in respect of the Escrow Shares other than dividends payable in Common Stock. Shareholder agrees to deliver to Depository to be held in escrow subject to the term of this Escrow Agreement, all dividends in Acquiring Common Stock and all Acquiring Common Stock issued as a result of a stock split, together with stock powers duly executed in blank by Shareholder, with signature guaranteed by a bank or trust company having an office or correspondent in New York City or by a broker or by a firm of brokers having membership in the New York Stock Exchange, in proper form to permit the transfer of the Shares represented thereby on the books of Acquiring. All such shares shall be distributed by Depository in the same manner as the Escrow Shares in respect of which it was issued.

5. FEES AND EXPENSES. Acquiring shall bear and pay all expenses and charges of the Depository incurred in connection with this Escrow Agreement upon demand by the Depository.

6. LIMITATION OF DEPOSITORY’S LIABILITY. The Depository shall incur no liability in respect of any action taken or suffered by it in reliance upon any notice, direction, instruction, consent, statement or other paper or document believed by it to be genuine and duly authorized, nor for anything except its own willful misconduct or gross negligence. The Depository shall not be responsible for the validity or sufficiency of any shares or other securities which may be delivered to it hereunder. In all questions arising under this Escrow Agreement, the Depository may rely on the advice of counsel, and for anything done, omitted or suffered in good faith by the Depository shall not be liable to anyone.

Without limiting the generality of foregoing provisions, the Depository shall be entitled to completely rely on the statements delivered to it by the Accountants and/or on the certification and direction of the President or any Vice-President of Acquiring, and shall not be liable for any error, misstatement, misinformation or misdirection in the Statements of the Accountants or the certification or direction of the President of any Vice-President of Acquiring.

7. NOTICES. All notices, instructions and other communications required or permitted to be given hereunder or necessary or convenient in connection herewith shall be in writing and shall be deemed to have been duly given if delivered personally or mailed first-class, postage prepaid, registered or certified mail, as follows:

If to the Depository:

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If to Shareholder:

If to :

With copy to:

or to such other addresses as the Depository, Shareholder or shall designate in writing delivered to each other.

8. GENERAL. This Agreement shall be governed by and construed in accordance with the laws of the State of and shall be binding upon and inure to the benefit of the parties hereto and their respective heirs, executors, administrators or other legal representatives, and their respective successors.

9. ADDITIONAL DOCUMENTS. Acquiring and the Shareholder agree to execute all other documents reasonably required by the Depository, in keeping with the meaning and intent of this Escrow Agreement and the Acquisition Agreement.

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Deals Problem Set # 3

Derivatives


I. 1Basic Concepts, Forward Contracts and Swaps

1. What is a derivative?

2. What is the difference between a “long” and “short” position?

3. What is a forward?

4. Suppose the price of gold is $300 per ounce. In January 2012, Debbie enters into the following contract. She agrees that in two years (i.e., January 2014), she will buy from Larry one ounce of gold. When she receives the gold, in January 2014, she will pay $330.

A. Who is “long” under this contract? Who is “short”?

B. If the price of gold in January 2014 is $400 per ounce, what are Debbie’s economic consequences from entering into this contract? What are Larry’s consequences? (For simplicity’s sake, assume Larry did not own the gold upon entering into this contract; instead, he buys it in January 2014, in order to deliver it to Debbie.)

C. What if, instead, the price of gold in January 2014 is $150?

D. What would it mean for the parties to “cash settle” this contract? How is that different from “physical settlement”?

5. What is “leverage”? Which is a more “leveraged” investment – buying the stock today, or entering into a forward contract to buy it at a fixed price in the future?

6. What is a futures contract?

7. What is a swap? Are they “cash settled” or “physically settled”? Are they settled all at once or periodically?

8. Suppose Debbie and Larry want to change the above arrangement in two respects. First, Larry will not make physical delivery of the gold. Second, Debbie and Larry will not wait the whole two years (i.e., until January 2014) to settle up their bet on the price of gold. Instead, they want to make two one-year bets. Suggest a derivative they can use to achieve this goal.

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II. 1Options

1. When an ounce of Gold is trading at $300, Debbie pays Larry $10 for an option to buy gold from him at $315, at any time in the next year.

A. What is Debbie’s option called? Is Debbie’s option American or European style? What is Larry’s position called? What is the term for the payment he receives?

B. What is the economic result for Debbie and Larry if Gold is trading at $400 in one year? At $200? How would your answer change if, instead of buying an option, Debbie had entered into a forward contract to buy an ounce of gold from Larry at $315 in one year?

2. Assume that Larry believes the price of gold is going to decline below its current $300 level. What option should he buy from Debbie (assuming she is willing to sell it)?

3. Assume that Debbie wants to enter into a forward contract to buy 1 ounce of Gold from Larry for $315 in one year. Instead of using a forward contract, can she achieve the same economic result with one or more option transactions? In other words, how can you synthesize a forward contract with options?

4. Rank from most leveraged to least leveraged: a direct investment in gold, a forward contract to buy gold, and a call option to buy gold.

5. Assume that Debbie believes the price of gold will rise from $300 to $315 – but will go no higher. She wants to make a profit on this prediction, but she wants to minimize her risk of being wrong, and she wants to put down as little money as possible. How can she do it?

6. When the price of gold is $300, Larry will charge Debbie $10 for an option to buy gold at $315 at any time in the next year. Will he increase or decrease the price, if the option changes as follows? Why?

A. Debbie is allowed to use the option at any time in the next three years.

B. The price of gold falls to $299. Will the price of the option change by more or less than a dollar? Alternatively, what if the price rises to $301?

7. Debbie and Mimi have different predictions about the price of gold in one year. Debbie believes there is a 50% chance that Gold will trade at $400, and a 50% chance that it will trade at $200. In contrast, Mimi believes there is a 50% chance that Gold will trade at $500 and a 50% chance that gold will trade at $100. Who will be willing to pay more for gold today – or would they both pay the same price? Who would be willing to pay more for a call option to buy gold at $300 – or would they both pay the same price?

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III. 1Options as Compensation

1. You are considering buying stock in either Autoco or Carco. They make similar products (automobiles) and are otherwise similar, except for this difference: The executives in Autoco all own stock in Autoco, but the executives in Carco do not own stock in Carco. Why might this difference be significant?

2. You are the chief executive officer (“CEO”) of Bigco. You are thinking about buying a corporate jet. The business of the company does not require it, but you think “I’m the boss, I deserve it.” The jet costs the company $10 million, and you will derive pleasure worth 1% of that, or $100,000.

A. Will shareholders want you to buy the jet? If not, what steps can they take to stop you?

B. If you are not a shareholder, will you want to buy the jet?

C. If you own 2% of the company’s outstanding stock, will you want to buy the jet?

D. If you own options on 2% of the company’s outstanding stock, will you want to buy the jet?

3. You are the chief executive officer of Bigco. You have worked there your entire career, and you are well respected in the business world for your successes. As a result, you constantly receive other offers to work elsewhere, but you have turned them down. One of your advisors brings you the following proposal. If you invest all of Bigco’s assets in a new technology (the “Venture”), it could pay off very well. Specifically, there is a 50% chance that the company’s stock price will go from its current level of $100 to $500. On the other hand, if Venture does not succeed, the company will become bankrupt (so the stock will drop from 100 to 0).

A. Will your shareholders want you to invest in Venture?

B. Why might the investment in Venture seem less attractive to you than to shareholders?

C. Will the investment in Venture seem more attractive to you if you hold stock in Bigco?

D. Will the investment in Venture seem more attractive to you if you hold options in Bigco?

4. Assume that the stock of Company is currently trading at $1,800. Assume also that the S&P 500 Stock Index is trading at $1,800. Which of the following options is more likely to motivate an executive to work hard? An option to buy a share, at any time in the next

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10 years, for $1800 (“Conventional Option”)? Or an option to buy a share, at any time in the next ten years, for the value of the S&P 500 Stock Index on the date of the purchase (“Indexed Option”)?

IV. Business Hedging

11. What is the difference between hedging and speculation?

2. Issuer, a corporation, needs to borrow money for two years. If it issued a typical fixed rate debt instrument, Issuer would pay a coupon of 6% every year. Instead, Issuer offers something a bit fancier, which costs $100. The size of the coupon will depend on the level of hurricane damage in Fort Lauderdale, Florida during that year. If the dollar value of the hurricane damage (as measured by a federal agency) is less than $1 billion, the Issuer pays $12. But if the dollar value of the hurricane exceeds $1 billion, the Issuer pays no coupon for that year. Either way, the investor is guaranteed to receive her $100 principal at maturity.

A. Why might an investor want to buy this kind of bond?

B. Why might an issuer want to raise money with this bond, instead of a more traditional one? Do you expect that this bond would be an especially attractive source of funding for issuers in a particular business?

3. Jane makes fine jewelry for sale over the Internet. Her father taught her the trade, and her “value added” is that of an artist. She has an eye for beauty, and can turn molten metal into works of art. But Jane has never liked the business world and, in particular, she has no idea which way the price of gold will go. Her problem is that gold and other precious metals are essential ingredients, and they make her profit margin hard to predict. What should Jane do?

4. Oilco has a new well that its geologists believe is very promising. If Oilco invests $900,000 now, it will be able to bring 1 million barrels of oil to market in one year – something that would be profitable at today’s $1 per barrel price of oil. Yet Oilco is worried that the price of oil might decline below $1. Indeed, Oilco is considering abandoning the project as too risky, given the volatility in the spot oil markets. Suggest various solutions to this problem.

5. You are a diversified shareholder of Oilco, which is a public company. Why might you oppose the use of derivatives by management to hedge the above risk? Why might you favor such hedging?

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Problem Set #4:

Tax Planning and Regulation


I. An Introduction to Tax Planning

1. Assume that interest rates are 10%. What is it worth if someone lends you $100 for a year and charges you no interest?

2. If you have to pay someone $100 in one year, and interest rates are 10%, how much do you have to set aside now in order to pay $100 in one year? This amount is called the “present value” of your obligation.

3. Assume interest rates are 10%, and that you owe $100 of tax this year. If you are able to pay the tax next year instead (and don’t have to pay any interest in putting off your tax), do you save any money by delaying the tax? If so, how much?

4. True or false: By delaying (or “deferring”) your tax, you reduce its present value.

5. To see an example of basic tax planning, you will need to know the following four rules:

a. If you make money on a derivative, you have to pay tax on the amount of your profit. Let’s assume you make $1000 and the tax rate is 40%. You keep $600 and the government receives $400.

b. If you lose money on a derivative, you can use the loss to reduce your tax bill. This means the government will also lose money when you lose money. If you lose $1000 and the tax rate is 40%, you lose $600 and the government loses $400 (because you pay $400 less in taxes).

c. Assume that you don’t have to pay tax (and cannot claim a loss) until you settle the derivative. That can happen when the derivative reaches its “maturity date (so that it is scheduled to expire), or it can happen you can choose to settle it early.

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d. Finally, assume that you compute how much tax you owe every year. Money you earn before midnight on December 31 is taxed this year, while money earned after midnight is taxed next year.

6. Ellen earns $100,000 each year in her job and pays a 40% tax on what she earns, so that she ends up keeping only $60,000. She would like to keep more of her money. So she tries the following tax planning strategy, which is called a “straddle.” She enters into a forward contract to buy an amount of gold on January 1, 2014 for $100,000 (“the long forward”). At the same time, she enters into a forward contract to sell exactly the same amount of gold on January 1 for $100,000 (“the short forward”).

a. Can she make any money on these contracts? For example, let’s say gold is worth $120,000 on January 1, 2014. How much money does she earn on the long? How much does she lose on the short? What is the effect of the two together?

b. Let’s say gold is worth $70,000 on January 1, 2014. How much money does she lose on the long forward? How much does she earn on the short forward? What is the effect of the two together?

c. Assume that gold prices are $120,000 at 11:50pm on December 31, 2013, so Ellen cancels her short contract, and pays $20,000 to settle it a day early (on December 31). Then at 12:01am on January 1, 2014, she cancels the long contract, receiving $20,000. When you look at both the long and the short forwards combined, how much money has she earned or lost?

d. Remember that Ellen can subtract her losses from her taxable income. In 2013, she earned $100,000 in her job, but lost $20,000 in cancelling her short forward (a day early on December 31). What is her taxable income? If she pays a 40% tax, how much tax does she owe? If instead she earned $100,000 and had no losses on derivatives, how much would her taxable income be and how much tax would she pay? How much (if any) tax does she save in 2013 by entering into this straddle?

e. Ellen again earns $100,000 in her job in 2014. In addition, she receives $20,000 in settling her long forward. What’s her total taxable income? What’s her total tax?

f. What was the effect of this tax planning strategy? Why is it valuable to Ellen?

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g. By the way, the U.S. tax system now has a rule, called “the straddle rules,” that denies people the tax benefit they used to claim from doing this sort of transaction. But the basic idea of accelerating losses and deferring gains remains an important tax planning goal.

V. Regulation: Third Party Effects, Public Opinion and the Case Study of Shale Oil and Gas

1. What is hydraulic fracturing?

2. What effect has hydraulic fracturing had on oil and natural gas production in the United States?

3. What are the economic benefits of this activity?

4. What are the geopolitical effects of this activity on the United States? On Israel? (By the way, do you know if there is any shale oil or gas in Israel?)

5. What are the effects of shale oil and gas on air pollution and on climate change?

6. What are the effects of shale oil and gas on the development of wind, solar, and other sources of alternative energy?

7. What are the effects on local communities?

8. Is fracturing feasible in places that have shortages of water?

9. In what ways can fracturing fluid contaminate drinking water?

10. In what ways can methane contaminate drinking water?

11. If you knew that the only way to attain the economic and geopolitical benefits of shale oil and gas was to allow drinking water to be contaminated, would you allow shale oil and gas drilling?

12. If you owned a shale oil and gas drilling company, would it affect your business if one of your competitors had a highly publicized accident that contaminated drinking water?

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13. If you owned a shale oil and gas drilling company, in what circumstances could you use contracts to deal with the risks of water contamination? When are contracts ineffective?

14. If you owned a shale oil and gas drilling company, why might you worry that regulation would add to the costs of your business, and thus reduce your profits?

15. If you owned a shale oil and gas drilling company, why might you worry that a lack of regulation could add to the costs of your business, and thus reduce your profits?

16. What are the following regulatory approaches, and what are their costs and benefits:

a. a moratorium

b. best practices regulation

c. liability

d. disclosure

17. Which of these approaches do you favor? If you owned a shale oil and gas company, would your answer change?

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