To ensure it remains a top priority for us, we delve deeper into what this means and how we can continue to implement it.

Simply put, it is very important that, as commercial lawyers, we adopt a commercial mindset in such contexts, as it helps us to stay in touch with the overall transaction and what is at stake, keeps costs in perspective, and really brings to light what the risks are and how to mitigate them, as well as highlighting the truly crucial aspects.

Similarly, we often find that our clients are engaged in commercial negotiations with other parties where lawyers are not necessarily involved; here, it can be very important for them to maintain a legal mindset while having these discussions, as they can otherwise find themselves at a commercial disadvantage.

In this article, I therefore want to explore the topic of how lawyers should use a commercial mindset in legal negotiations on behalf of their clients and, vice versa, how clients should keep in mind important legal aspects when conducting commercial negotiations. I will examine both sides of this coin in the context of M&A transactions and fundraising.

Defining a commercial mindset

When it comes to the work performed by us commercial lawyers, what does it actually mean to have a commercial mindset?

In essence, it means ensuring that you are always bearing in mind the overall transaction and the key drivers for doing it. When you look at the legal provisions and negotiations through this lens and keep the overarching context and bigger picture in mind, it helps you to focus on the things that matter the most and ensures that you do not end up missing the wood for the trees.

As a result, it also means that you are not arguing about each point and are able to keep costs and timings more efficient, something clients appreciate for obvious reasons.

Test case for applying the commercial mindset: negotiating the warranty package

Having defined what a commercial mindset is, let us now look at how to apply this in the context of the legal negotiations involved in M&A and fundraising transactions.

Here, one area that is often the subject of intensive negotiation is the set of warranties, indemnities, disclosures and limitations governing the respective transaction. These all represent tools for allocating and mitigating risk and must be negotiated with the client’s best commercial interests front of mind, which will vary depending on whether they are the buyer, the seller, founder or an investor.

Warranties and indemnities are often provided by the seller in a sale transaction, and by the company and founders in an investment transaction. Essentially, these are statements or confirmations about various matters related to the target company and the business being sold or invested in.

The idea is that if these statements are wrong, then the buyer would have a claim against the seller or the company or founders for loss incurred or as reimbursement. As a seller or founder, you would want this list to be as small as possible; and as a buyer or investor, you would want it to be as long as possible.

This has led to the development of ‘seller/founder-friendly’ and ‘buyer/investor-friendly’ versions of a warranty package, and their usage will depend on who is preparing the first draft. Examples of issues that come up include whether a statement should be given ‘to the best of the seller’s/founder’s knowledge’; qualified by ‘materiality’; if it should be limited by time; or if a simple widget business should come with a full suite of IP warranties.

Now, it’s not uncommon to see lawyers spending disproportionate amounts of time (and clients’ money) arguing over what could in fact be fairly minor issues. This is why it’s so important to review the wording and guide clients to take a view in light of the overall risk in the context of the business being sold or invested in, the timings involved, as well as what can be practically and efficiently achieved within the desired deal timetable.

A very useful assessment tool: the risk matrix

This is where a so-called risk matrix comes in useful, as it allows you to weigh up the probability that the respective danger that you have identified will become reality, versus the potential consequences if this were to happen.

When using such a matrix, the X axis represents the probability of something happening, while the Y axis denotes the severity of the consequences. You can then assess each issue and decide which quadrant it falls into: low probability and minor consequences; low probability and major consequences; high probability and minor consequences; or high probability and major consequences.

As soon as you start thinking about the open issues in the context of the risk matrix, the core focus for the negotiations and potential practical solutions come to light – for example, in the context of warranties, if there are certain issues with a company’s historic legal documents, assessing the risk against the risk matrix could help parties decide the best approach (e.g. if it’s something they could live with, request/offer a price chip or cover by limiting their liability).

The best risk mitigation tools when drafting commercially informed warranties

Once you have made your assessment using the risk matrix, you can then decide which of the available risk-mitigation tools to apply in order to achieve the best outcome for your client when negotiating their warranty terms. These tools include the following:

●       Limitations on liability – in any M&A or investment transaction, the seller/founders/company takes on the risk of warranties going wrong, and therefore being potentially liable to pay. Without a limitation, this is a very uncertain and open-ended situation. It is therefore common for the seller or company’s lawyer to put in place a limitation on warranties. There are standard amounts (e.g. purchase price) according to the sector and nature of the transaction, but this can be negotiated

●       Disclosures – these are a way of mitigating the risks on the seller or founder side by disclosing things that may go against the wording of the warranties. However, the real point of the disclosure exercise is to give assurances to the buyers or investors that the sellers/founders have properly gone through the statements and ensured that, if there do happen to be any skeletons lurking in the closet, these are evicted from their hiding place before the buyers complete the purchase or investors make the investment

●       Indemnities – under UK law and practice, these exist to cover known risks; for example, if a company has carried out some actions in the past which is likely to result in a government authority issuing a fine in future. It is an event that hasn't happened yet, but there is an increased risk that it could occur (high probability and high consequence quadrant of the risk matrix). With the correct indemnities in place, if it does happen, the buyer is then reimbursed for the full amount

●       Limitations on indemnities – these usually sit outside the standard warranty limitations. Such limitations are sometimes unlimited, but more often limited by an amount that is the maximum likely sum (worst-case scenario), with the potential addition of a ‘buffer’ sum. Again, this is often debated over during negotiations; however, by referring to our risk matrix, we are often able to help our clients 'take a view' one way or the other

The other side of the coin: maintaining a legal mindset in commercial negotiations

Having looked at the importance for lawyers of maintaining a commercial mindset in legal negotiations, let us now turn our attention to the inverse situation and examine the key legal aspects that laypersons need to bear in mind in commercial negotiations.

Specifically, I want to highlight some of the potential legal pitfalls that companies face when they have secured investment and are about to enter into term sheets or documentation to set out the commercial deal.

Early funding rounds can be a very exciting time for startups and other fledgling businesses. And when there is an investment deal to be done, all the parties are understandably very keen to put ink to paper and get everything formalised.

However, in this scenario, it is especially important to maintain a legal mindset during the term-sheet negotiations, which are often conducted by the principals themselves.

Here are five key points to bear in mind:

●       Non-binding nature of term sheets: as the name implies, a term sheet sets out all the important terms of the investment; however, it is a non-binding document (in most parts) that often gives the false assurance that the commercial aspects can be nailed down without thinking about the legal aspects, which can be sorted out between the lawyers at a later stage

However, legal and commercial aspects in a transaction are acutely interlinked. Therefore, the term sheet is really crucial in forming the framework for the definitive legal documents. The clearer and more robust the agreed term sheet is, the more efficient the process of drafting and negotiating the legal documents becomes.

Furthermore, even though most parts of a term sheet are non-binding, parties are likely to be held to the positions taken during the term sheet negotiation stage.

●       Think about words that are not on the page: it’s important to think about what is missing from the term sheet. What could be debated endlessly at a later stage?

Warranties are one example: it is usual to see term sheets saying that the legal documents will have ‘customary’ warranties. It is better to refer to something specific, such as the BVCA documents, or set out a list of the areas that the warranties will and will not cover.

For example, should they cover just title and capacity, or also employment, IP, environment, etc? Will there be warranty and indemnity insurance?

●       Hope for the best but plan for the worst: whilst the intention is that things will go well, applying a legal mindset means that you have to think of what could go wrong (worst-case scenario analysis)

You may have a falling-out with the founder if you are the investor, or with a shareholder if you are the business owner. Would you want the shareholders/founders/employees to lose their shares in certain situations? It may be important to ensure that your co-founders are appropriately restricted from anti-competitive behaviour.

It is important to mentally war-game scenarios that you could potentially find yourself in, even if it is not the immediate situation.

●       Protect yourself: think about the ways in which you can protect your interests. As an investor, when you think about your returns on your investment, consider whether there are ways in which these could be taken away (future rounds with preferences granted)? As a founder, are there enough protections against your own dilution?

To ensure that no key issues fall through the gaps, it may be worth going through the headline issues usually covered in full legal documents to make sure there is basic agreement on the crucial ones.

●       Know that clarity is king: thinking like a lawyer also means making sure things are as clear as possible, so that all parties are on the same page

One example is price: when entering into an investment term sheet, it is important to be clear about whether the price is calculated based a pre-money or post-money valuation.

The capitalisation tables used as part of term sheet discussions should also be clear around the shareholding position (both actual and on a ‘fully diluted basis’).

Seemingly minor terminology differences can mean that the parties understand materially different things from the same words, which can lead to confusion and endless debates.

Key takeaways

As we have seen, it is important that commercial lawyers don’t lose sight of the wood for the trees during any legal negotiations. Instead of majoring in the minor, a much more fruitful approach is to take a step back, adopt a commercial mindset and focus specifically on the greatest risks inherent to the specific transaction, which can then be mitigated.

For their part, clients involved in commercial negotiations without the assistance of a lawyer must make sure they are aware of the key legal aspects to avoid putting themselves at a disadvantage. However, sooner or later they are likely to consult a lawyer in order to formalise the deal, and it is as well to have sound legal advice from the outset to avoid any potential pitfalls.