Weekly Thoughts: Legal Documents
Here is a topic that caught our eye this week:
We recently stumbled across Berkshire Hathaway’s 1967 purchase agreement for National Indemnity Company, Berkshire’s oldest operating subsidiary. While this document is a standalone piece of business history, for us, the most interesting part was its length (two pages) and its language (simple). Our interest in the Berkshire document stems from the fact that, as we progress with our venture to build a portfolio of cash generative small operating businesses, we struggle with how to responsibly use legal documents in a way that does not derail negotiations.
In a space where handshake deals are commonplace, we have found that many small business owners simply find the length, complexity, and detail of “boilerplate” M&A legal documents unnerving. Moreover, we often find ourselves wondering why, despite our intention to produce simple, middle-of-the-road agreements, our documents always seem to end up as jargon filled tomes. This is not a problem specific only to us, as the template purchase agreement for a search fund acquisition, as provided by Stanford University, is 40 pages long. If Warren Buffet can buy a company with a two page document, why do we need a 40+ page document?
During our more cynical moments, we share the sentiment of Bram Cohen, the inventor of BitTorrent, who tweeted “Lawyers are like phone companies. Their bread and butter is in tricking you into racking up minutes.” Despite any individual lawyers’ best intentions, the reality is that over the past half-century, the billable hour has become central to how value is measured in the legal profession. For instance, from a business profitability standpoint, law firms focus on optimizing two key metrics – realization rates and leverage ratios – both of which are based on maximizing billable hours. For those unfamiliar, the “realization rate” measures the fees collected relative to the amount quoted (with the goal of having a rate at or above 100% of the quoted amount) and the “leverage ratio” measures the number of associates (lower hourly rate) relative to the number of partners (higher hourly rate). As Laura Empson described in Managing the Modern Law Firm: New Challenges, New Perspectives, lawyers are keenly aware that “each billable hour increases their short-term compensation and long-term partnership status within their firms.”
When faced with pages of incomprehensive deal documents and astronomical legal bills, it’s tempting to think our struggle with legal documents is driven by greedy lawyers who purposefully produce unnecessarily complicated documents in an effort to inflate billable hours. That said, while the billable hour paradigm does create certain incentive structures, we learned this week it’s not the only factor at play.
Long and Complex
Fees aside, our main issue with legal documents is that they tend to be unnecessarily long and littered with jargon that makes it very difficult for non-practitioners to understand. While thankfully our team has one member who can “read legal,” the rest of us need sentence by sentence translation to understand the implications set forth in our documents. As such, we completely empathize with the frustration sellers experience when they receive our draft purchase agreements, which despite being a reflection of verbal discussions, tend to have so much legalese that they create an immediate negative response. Peter Tiersma’s 1999 book, Legal Language, explains further:
“Anyone who has ever seen a legal document realizes that it differs dramatically from everyday speech. In fact, some people have argued that lawyers actually speak a separate language. It is true that at one time, English lawyers did literally have their own language: Law French… Still, in some ways lawyers do still speak a foreign tongue, or at least, a type of language that is quite unfamiliar to the general public. Law students refer to it as ‘talking like a lawyer’. They work hard to acquire this lingo in law school. We will see that talking like a lawyer requires using long, complex and redundant sentences, conjoined phrases, impersonal constructions and arcane words or phrases like the document aforesaid, witnesseth, or to wit.”
It’s important for us to remember that legalese is still a form of professional jargon and individuals with no financial background may find our internal discussions about “EBITDA,” “EV,” and “COCR” equally confusing. That said, the use of jargon in the legal profession has more negative externalities as lay people must rely on legal work product to facilitate everyday transactions. The fact that we must use an almost separate language to communicate to a broader scope of stakeholders creates frictions that can cause confusion, invoke fear, and lead to mistrust.
The question is, why does the use of this language persist, despite the fact that pretty much everybody agrees that nobody understands legal documents? It turns out these trends may persist because lawyers are actually trying to increase work efficiency and reduce risk levels. For example, from a pure production standpoint, it is actually more efficient for lawyers to recycle template contracts than it is for them to create custom documents. In her book, Why Contracts Are Written in Legalese, Claire Hill explains that since “drafting and negotiating complex business contracts is difficult,” lawyers use something called the “form” which is basically a contract the lawyer has used in previous, similar transactions. Hill explains the efficiency outcomes related to the use of form, noting that a “new product, custom-crafted for the client from a form, can be produced quickly, and at far lower cost than a product crafted from scratch. The form design enables the product to be produced by lower-paid, less-senior and less-experienced lawyers. Given the complex nature of the task, and the quick turnaround time typically required, even the most experienced lawyer would have difficulty remembering every step and detail; the form is a useful reminder.”
The use of forms leverages contract terms that have been tested over long periods of time thereby increasing reliability of the terms and reducing risk that certain terms may be misunderstood. In their 2012 book, The Three and a Half Minute Transaction: Boilerplate and the Limits of Contract Design, Mitu Gulati and Robert E. Scott explain how forms become ingrained in the legal process over time:
“Thanks to repeated use, the terms are better understood and flaws and uncertainties get worked out. Terms that survive this quasi-Darwinian trial and error evolutionary process become mature terms whose risks and performance characteristics are well-known and understood. Thus, market players and courts develop an understanding and confidence in the ‘reliability’ of these terms. The high level of understanding then reduces the risk of erroneous interpretation, particularly an erroneous interpretation by a court. In a sense these terms are ‘battle tested.’”
Paradoxically, while the use of forms may be more efficient from a work production standpoint, they also create longer documents with more legalese, because they are, by design, a reflection of a wide range of previously vetted language and terms. Furthermore, lawyers have less appetite to stray from the use of forms than some more entrepreneurially minded individuals might like because the billable hour caps the amount of upside associated with any given transaction (i.e., lawyers don’t get equity). This asymmetry means a lawyer’s primary role is to ensure their documents limit potential downside with less regard paid to things like deal complexity, timeline, or counterparty fatigue. This dynamic is what can earn lawyers a reputation as “deal killers.” Hill explains further:
“If many lawyers overestimate the probability of bad events, they might practice law defensively, doing mostly that which they can defend. They therefore should favor relying on the form, which someone, and indeed, many people, some of who are quite senior, has vetted, rather than relying on themselves, whom no one has vetted. They also should favor fewer changes in the aggregate, and less changes that are structural. But they also may be willing to make benign additions….with little regard to the ever increasing size and unwieldiness of the contract.”
In the context of downside protection then, these documents are long and complicated because they are specifically designed to leverage the knowledge of multiple lawyers and the experience of previous transaction terms, rather than creating documents based on the knowledge of a single lawyer and the terms of a single transaction. Similar to the sentiment shared by French philosopher Blaise Pascal that he “would have written a shorter letter, but did not have the time,” in the context of billable hours, our lawyers may actually be doing us a favor by using long form contracts rather than creating a new document, even if that new document could be shorter and simpler.
After researching the subject, we now have a better grasp of the dynamics pulling the legal profession to create long, complicated documents and can understand that documents of this type, at their core, are in our interest. However, the reality is that an agreement that is comprehensive and efficient from a legal standpoint may not be the best way to work with sellers to execute deals in the small business space. We believe our biggest edge as a potential buyer of companies is that we are willing to spend the time to meet sellers on their terms, listen to their thoughts and concerns, and build the trust necessary to execute a successful transition. In the vast majority of cases, owners we meet have a “handshake” business mentality, and fundamentally believe their word is their bond. When we agree to general terms in that context, and then present an overwhelmingly long legal document later that stipulates all the ways one party may or may not take advantage of the other, a lot of the trust we work so hard to build evaporates. Seth Godin explains the contract versus handshake mindset:
“If you lease a car, borrow money for school or engage in some other complex transaction, there’s a contract to sign. It’s filled with rules and obligations, and the profit-maximizing finance organization does everything it can to do as little as it can (and make you responsible for as much as it can). This sort of contract has evolved into a battle, an effort to get something now and deliver as little as possible later. Loopholes and fine print are there for a reason, and it’s not to make you happy. Contracts like this are about the past. ‘We agreed on this, go read your copy, we don’t care so much that you’re annoyed, goodbye.’
“A handshake deal, on the other hand, is about the future. Either side can claim loopholes or wriggle out of a commitment, but the consequence is clear—if you disappoint us, we won’t be back for more. The participant in a handshake deal is investing in the future, doing more now in exchange for the benefits that trust and delight and consistency bring going forward.”
We completely understand Godin’s point because whether an owner remains with the company post-transaction or not, we understand that we are in the business of creating partnerships with sellers to ensure smooth transitions. We want to rely on prior owners to continue to run day to day operations, share wisdom, or provide valuable introductions. However, we also believe that we simply cannot responsibly execute multi-million dollar transactions based on handshakes, and still need some form of legal framework for our deals. We feel fortunate that we are able to partner with service providers who understand our desire for balance. While we have yet to crack the code regarding the trade-off between prudent legal protection and preserving trust, gaining a better understanding of the dynamics driving complex legal documents is a positive first step in rectifying the tension and working towards a solution that works for both Chenmark and its business partners.
Have a great week,
Your Chenmark Capital Team