Contracts: Defining Future Negotiations

Contracts are necessary to doing business but surprisingly many people miss a central point about them: they define the starting point for future negotiations. Where you actually wind up as an outcome depends on both the contract and external factors that determine your bargaining power. Let me illustrate what I mean by that by looking at a rental contract (lease) for an office.

Suppose you have signed a three year office lease and two years into it you have to leave. The lease says that you owe one more year of rent. But how much you actually have to pay depends on a number of factors. For instance, if you have a right to sublet in the lease and it is a hot real estate market in which you are paying a below market rent you might be able to just get the landlord to release you from the lease for a couple of months rent. If your lease does not give you the right to sublet and the market is down then the landlord is in a much better negotiating position and you might wind up having to pay for most of  year. The difference in bargaining outcomes is explained by the combination of the contract features (length of rental, sublet or not) and the external factors (strength of market) that combine to define the “threat point” or “disagreement point” — what you could reasonably expect to get if the negotiation breaks down and the contract has to be court enforced.

Voting agreements in venture deals are just another type of contract so as you take financing you want to think about the future negotiations that might arise. For instance, if you are selling the company it is a very different situation if the voting agreement lets you drag smaller holders into a deal or requires their approval. In the latter case every small holder effectively has some (limited) veto power over the deal happening. The “threat” of that veto power can be used in a negotiation to extract additional economics for the holder. Similarly if all Series of Preferred shares vote as one class and no investor has a majority then no single investor can block a deal. Conversely if you have voting by Series, then usually the investor who led that Series controls it and now you have many potential blockers to a transaction.

So when you are negotiating the terms of a rental contract or the terms of an investment or any other contract for that matter, always keep in mind that what you are doing is defining the starting positions for future negotiations. And very often you should be willing to trade off price for a better future bargaining position (an office lease with the right to sublet but a somewhat higher square footage price, a voting agreement with a drag and everyone voting as one class but a slightly worse price per share). Because the future is highly unpredictable these improved bargaining positions often turn out to be highly valuable.

Posted: 26th June 2013Comments
Tags:  startups law

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