Metamorphosis Inc.
Turning a business lawyer into a strategic business lawyer
By Eran Kahana
Ever heard a client complain to you about lawyers, as if you could single-handedly fix the profession? If you haven't, it's probably just a matter of a few more hours before you do.
From the perspective and experience of a business lawyer who has heard his fair share of jurisphobic monologues bemoaning how we don't understand or else needlessly complicate business deals, sometimes just plain kill them, and (lest we forget) charge too much, I can share with you that at least in my experience these tantrums are based on flimsy anecdotal evidence.
But when you are faced with this situation, maybe only the clinically insane among us would take on the client and argue the point. There is simply no way to win this argument as much as there is no way any single lawyer can cure the mythological "evils" of the profession or outlaw lawyer jokes (except, of course, for the good ones).
This discussion proposes one possible method by which we can use that critique to effect a modest change in how we approach our work. It is not meant to placate the irritated as much as it is meant to genuinely add an important dimension to the practice of business law.
Effecting this change is as simple to conceptualize as it is complex to execute. Conceptually, it is inspired by some of Harvard Business School Professor Georges Doriot's work in the 1930s.
Doriot's thesis called for creating a "value-added" investor. It meant creating a new breed of investor, one who combined the skills of a business strategist, policy maker and investment manager into a single function. The result of this experiment became known as the venture capitalist: The single most important source of capital for start-ups and emerging companies.
Using a similar approach, this proposal prescribes creating a new, "value-added" lawyer. It's achieved by combining the skills of a legal analyst with that of a business strategist. This new "creature" can be referred to as a strategic business lawyer (SBL), a term that without further elaboration would no doubt be nauseatingly obscure.
So let's get right down to the definition: First, the SBL is much more than an auditory and visually aesthetic title. It's properly assigned to a lawyer who proves he/she can provide an intelligent distillation of alternatives, guidance, forecasting and planning at various strata within the context of legal and business considerations, while at the same time maintaining focus and purpose on refining the quality of legal services provided.
Providing this level of business law services requires knowledge of various business concepts. But at the same time it does not require the SBL to be an expert in all or have an in-depth understanding in any particular topic. After attaining a broad base, each SBL can develop specific strengths in a particular topic (or topics), such as finance.
For the purposes of illustrating the knowledge and function of the SBL, this discussion will focus on business facets related to business-plan and accounting-ratio analysis. Even though these are but a sampling of what could be discussed, they represent two critical topics (tools) that the SBL uses.
First, the SBL routinely requests the latest copy of the client's business plan. The goal here is analysis of the business opportunity; a thorough but selective vacuuming-like process of critical information. Once completed, it provides the SBL with an enhanced understanding of the client's business. For instance, what the company sells, how it sells it, what the expected market share is for the product or service, who are the members in the management team, what are their backgrounds, successes, failures; who is the competition, etc.
The management team's composition is critical and is always one of the sections in the business plan the SBL pays careful attention to. Here the SBL is guided by the virtually indisputable fact that venture capitalists invest not so much in products as they do in the people that bring them to market.
According to famed venture capitalist Arthur Rock (widely regarded as the "dean" of American venture capital and credited with coining the term "venture capitalist"), he would rather invest in a Class A team developing and selling a Class B product than the reverse. Therefore, the caliber of the senior executives in the company is directly proportional to its prospects for attracting investment and its prospects for success.
One excellent illustration of this principle at work is the $18 million (first round) venture financing raised by peer-to-peer (P2P) company Kontiki. The primary attraction behind this company, according to Venture Reporter, is the caliber of its management team (curiously, its business model is actually problematic from an investment point of view because it is fraught with problems and uncertainties).
The company is headed by Marc Andreessen, Netscape and Loudcloud founder; Mike Horner, known for his efforts on behalf of the Netcenter portal, which turned Netscape into an attractive acquisition target for AOL; and Jim Barksdale, former CEO of Netscape. These are the names that can secure a post-Internet bubble burst, first round "fortune" of $18 million. This is no small feat, especially for a company that is not part of the trendy, "red hot" life sciences sector.
Sure, Kontiki is an easy example. In all likelihood the existence of management "brand names" will be the exception, rather than the norm. So unless the SBL is personally familiar with the company's founders and their strengths, he/she will have to rely on several short paragraphs outlining each executive's business experience for this critical information.
Unfortunately, on occasion they contain borderline, self-glorifying accounts of the specific individual's achievements, which in certain respects can act like static electricity, negatively affecting the reader's "reception" of information. The key, therefore, to traversing this is to focus and gauge competency based on relevant experience.
It's a process that frames the SBL's analysis within the framework of "How is each of these executive's experience relevant to the opportunity at hand?" If the experience appears irrelevant (for example, former stellar CFO of a drug company is hired as CEO of an Internet service provider) the company's value is detrimentally affected. It will most likely have problems attracting venture capital investment and may be less attractive as a client to the firm.
It is at this point that the SBL can continue or decline representation. If the decision is to continue, then he/she will suggest assistance in locating a competent CEO and take other steps to help ensure that the management team is up to par.
From focus on the management team we now turn to another critical section in the business plan: The business model. The SBL's analysis examines the selected model, be it a business-to-consumer (B2C), business-to-business (B2B), or P2P model. Being in tune with the latest sector trends knowing, what's hot, what's not; what gets funded, what not, kicks in and starts painting the client's prospects for success.
For instance, the SBL knows that the lion's share of battered, investment-starved, and extinguished dot-coms (with the rare exception of companies like Priceline.com, eBay and Kontiki) are businesses modeled on B2C and P2P platforms. In contrast, B2Bs, such as eConnections, have fared better (as of this writing).
We now turn our attention to the second business facet in our discussion: These metrics (tools of measurement), known as accounting ratios, are a means by which the SBL can gain a better understanding of a company's financial picture. It's important to pause here for a moment just to emphasize a fact that is hardly disputable: Finances are the lifeblood of any company. Without money, there is no company. Therefore - at the very least - a rudimentary understanding of the following accounting concepts is not only helpful, but arguably highly worthy of consideration.
Let's take a look at how they are used. The methodology of working with accounting ratios is similar to that of working with a relational database; the independent significance of the financial statement's numbers is limited in the same sense that datum plugged in rows and columns of tables has relatively little independent meaning. In both cases substantive value is extracted from formulating mathematical relationships (or queries) and then analyzing the results.
Accounting ratios are also highly customizable and can be used to measure just about anything in a company's financial statement. Once the required ratio is obtained, the SBL can distill from it certain information that is relevant to the transaction and devise intelligent (that is, logical) alternative strategies for action. For instance, within the context of mergers and acquisitions, they can provide the SBL with valuable information that can help guide negotiating strategy to the client/acquirer's advantage.
Four particular ratios will serve to illustrate this point. The first is the venerable profit to earnings (P/E), the second is the return on equity (ROE) ratio, the third and finally fourth are the current and debt ratios, respectively.
First, the P/E ratio. This is useful for measuring the value, for example, of an acquisition target's stock. A P/E is derived from dividing the current market price per share by the per share earnings, which is the company's after-tax profit divided by the number of outstanding shares.
But this gets more interesting. Somewhat complicating the SBL's work is his/her awareness of the growing trend of companies across the board to manipulate their P/E ratios. In fact, this practice has become so pervasive that financial commentators (such as those interviewed in the Wall Street Journal) don't miss a chance to throw in that P/E ratios aren't what they used to be, some even going as far as claiming they are worthless because the companies are managing, versus objectively reporting, their earnings.
How are P/E ratios modified? A company, for instance, can inflate earnings per share through taking "special charges" (or "one-time charges") against earnings, or delaying large expenditures. The SBL knows these tactics serve to guide investor/analyst inquiry away from large expenditures that the company subjectively deems "unusual" and unrepresentative of its routine operations. What this amounts to is manicuring the stock price to appear more reasonable, when in fact it may really be overpriced.
The key here, as with other metrics, is the analysis. The SBL plugs numbers into a simple spreadsheet in order to initiate the examination of whether the company is reporting or subjectively managing/manipulating earnings.
He/she starts with the numbers the company is reporting, without jumping to conclusions. To illustrate this, let's assume Acme Coyote Products Inc., (Acme) a high-tech manufacturer of laser-guided missiles, has the following balance sheet: Gross earnings of $200 million; $55 million in operating expenses; a $100 million one-time charge for advertising and pension payments; and $14.4 million in taxes. Acme also has 10 million shares outstanding and a market price of $85 per share.
OK. Now the SBL rolls up his/her sleeves and jumps into action. (Sincere apologies for those who are plagued by "numbers nausea.")
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Using these figures, the SBL's spreadsheet yields a P/E ratio of 8.6. Analyzing this number suggests at least two things: First, from a general perspective, this particular P/E is much lower than the historical average of 14.5 and current industry average of 22. This then translates into the realization that the company's share prices are an excellent bargain. But why? (Lawyers are very good, or at least should be, at asking "why" about almost anything.)
In the process of searching for this answer, the second issue pops up: examination of earnings. How were "earnings," the denominator in the fraction, calculated? Plugging the $100 million one-time charge back into the earnings report changes the P/E from 8.6 to 27.77.
Now wait a minute! That is a very different number. Not only is it considerably higher, but it's also higher than the historical and current average figures. What conclusion is warranted? Could it be that Acme's earnings-manicure session was deliberately aimed to avoid the appearance of an overpriced stock that could lead to a sell off and further value erosion?
What does all this mean? If the value is indeed eroded, how does Acme look to outside investors? Is it a bargain, or is it something to steer clear from? From the law firm's perspective, is it a client the firm should represent? Will it be able to pay its bills, short or long term?
P/E distortions are also caused by other borderline deceptive pro forma methods to calculate and report earnings, which are not recognized by general accepted accounting principles (GAAP). This means consistency and predictability are not part of the earnings disclosure process and suggests that every deal will require even more extensive scrutiny.
It should be emphasized (for those yearning to sue someone) that pro forma accounting methods are not illegal; at least not yet. Until stricter standards are imposed, corporate executives will continue engaging in "creative" accounting practices that serve only the company's interest. At the same time, and focusing on the bright side, SBLs will continue having a field day dissecting these transactions and analyzing them within the legal framework for their client's benefit.
Now remember, the "S" in the SBL stands for "strategic." Strategy is a key element in all of this. Knowing how to navigate through this accounting labyrinth and distill from it valuable information enables the SBL to launch his/her problem-solving, business-savvy character traits into action and formulate strategy.
Instead of dealing with "problems," the SBL, by his/her nature, turns them into opportunities. Specifically, having distilled this information imbues the SBL with a strong negotiating position where the client/acquirer (who is the SBL's client) now has the opportunity to present several counter proposals based on the target's pro forma earnings report.
Take for instance selecting a strategy of demanding a uniform definition of "earnings," which is designed to lower the acquisition price. Alternatively, the SBL and client/acquirer can strategize on whether these one-time charges could also be deemed legitimate from the client/acquirer's perspective. If they are, no harm done; and even if they're not, negotiations can still continue and there is no reason to kill the deal unless the client/acquirer makes that decision.
The purpose for using P/Es is that the SBL leverages them to take on a role greater than (and yet consistent with) that of a lawyer. This knowledge and analysis does not hamper the ability to practice law. On the contrary, it offers an excellent magnifying glass with which to analyze a deal and effectively consult and strategize with the client.
The other accounting metric is ROE. This is a profitability ratio. It examines the relationship between net income and owner's equity. To calculate ROE, the SBL takes the company's net income/total assets x total assets/owner's equity. (Assets are defined as the sum of liabilities plus owner's equity.)
Suppose the client has $10 million in net income at the end of Fiscal 2000 and the owner's equity equals $12.5 million. Its current ROE ratio is calculated as $10 million /$12.5 million = 80 percent, which is not, for argument purposes, considered a high value in this industry sector.
In order to position the company more attractively, the SBL knows this can be achieved by reducing the owner's equity. This can be done in the following manner: The client takes the $10 million it made in 2000 out of the company and pays it back to itself as dividends. It then obtains a bank loan to finance its future cash needs. The result is a balance sheet that reflects a long-term debt balance of $10 million (the loan from the bank) and the owner's equity is reduced by the retained earnings of $10 million to $2.5 million ($12.5 million - $10 million). All of this results in an ROE ratio increase from 80 percent to 400 percent (10 million/2.5 million).
At this point you may be asking "Why in the world do these accounting acrobatics result in a better position for the client?" Good question. The answer is that it's because companies are valued based on this ratio. The Forbes' Annual Report of American Industry ranks companies with greater ROEs higher than many of their more profitable counterparts simply because of their financing choices.
Knowing how this process works and its significance enables the SBL to analyze a transaction from his/her client/acquirer's point of view. It could be the case that, while the target is waving its new and improved ROE around, it's really nothing more than an illusion. This is because, for example, its higher debt load is now unserviceable. That presents a big problem, or as it is known in the SBL world, "opportunity." Does the cash flow issue translate into a deal breaker? Perhaps, but not necessarily.
Remember, the SBL's mission is consistently to search for solutions, distill information and plan ahead. In this case, this and other similar information siphoned off the target's financial statements serves to position the SBL's client/acquirer in a better negotiating stance.
If the target is playing tough on the terms because of its "amazing" ROE, the SBL can call its bluff by pointing out that it really doesn't mean much when it is having a hard time paying its bills. Once deflated, this could mean more attractive terms for the client, assuming of course the client decides it still makes sense to proceed.
How did the SBL find out the target's debt in the previous example was unserviceable? This particular nugget was gleaned from using the current ratio (CR), which measures liquidity. CR takes the current assets and divides them by current liabilities. If the ratio is larger than 1, it's a good sign. Additionally, the larger the number to the right of the decimal point, the more capable the target is of paying its bills.
Even more telling is the debt ratio (long-term debt divided by liabilities plus owner's equity). If the target's debt ratio is greater than 50 percent, the target is in a precarious cash flow position, which increases the risk to the client/acquirer and to the firm representing it (remember we need to get paid for our services). But once again it is important to reiterate that nearly any increase in risk can also present opportunities. The key for the SBL is developing the awareness to recognize them and formulate appropriate legal strategies for dealing with them.
Now you may be asking, "Did the client's financial advisers disappear? Why aren't they taking care of all this?" The answer is that these advisers, if they existed in the first place, did not disappear. They still have their traditional role to play. And in that respect, the SBL is not "taking care" of these issues in the financial sense, but using the information that can be distilled from them for the sole purpose of increasing the caliber of legal services being provided.
So how does one begin the journey of becoming an SBL? The first step is to identify which business skills are lacking or need to be reinforced. If you don't know what "what you don't know," then the first step is to read, read and read. Every day and as much as possible. Additionally, if it's affordable and practical, take general course work or seminars (some of which qualify for CLE credit) offered at universities with business and MBA programs.
Books such as The Ten Day MBA, and others can help bolster your understanding of key business concepts at a fraction of the cost of getting an MBA. Newspapers and magazines such as the Wall Street Journal, Investors Business Daily, Business Week, The Economist and the Harvard Business Review are also important for building your business knowledge database.
Finally, although by no means the least important, is hands-on experience. Any business lawyer who has founded or materially participated in building a business will already have good working knowledge of at least one of the concepts discussed here. Learning the rest should be much easier. So, if you have time to volunteer your legal services at a start-up with a strong management team, you may get the opportunity to gain exposure to many of the important business skills mentioned here.
After all this, will the criticism cease? No. But instead of seeing this as a problem, we can seize it as an opportunity to listen to our clients and distill from them valuable information about how we approach our work. In the process we may find that we gain important insight into what fuels and lubricates the world of business and work to use this knowledge to enhance what we do. We will continue to work as we have been trained and we will continue to be mindful of the importance of maintaining focus. At the same time we will also focus on listening and doing something to respond to their needs.
Maybe Professor Doriot's "experiment" was not only important in creating what we know today as the venture capitalist. Maybe its other significance is that it offers a template with which we can test new models for doing business. If we succeed with an SBL initiative, at least our clients may be satisfied that we not only appear but actually are more "business-friendly." Perhaps this will serve to ultimately diminish the tinged perceptions of our role as business lawyers and spare us from future jurisphobic tirades. At least for a few moments.
Kahana is a sole practitioner, senior partner and general counsel with ViAtlantic LLC, in Minneapolis. His e-mail is eran@mchsi.com.
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