Do the transaction costs of allocating intellectual property rights in collaborative R&D influence merger and acquisition strategy? When it is difficult to write intellectual property agreements, does it makes sense for managers to turn to a merger or acquisition as the solution? The answers have consequences for how business strategy and legal strategy interact.
What Are Transaction Costs?
Transaction costs are costs incurred in participating in economic exchanges through the market, as opposed to doing an activity within a single firm. An example of a transaction costs is negotiating and writing a contract to allocate intellectual property rights of a R&D collaboration between two companies. See Ronald Coase’s classic 1937 paper The Nature of the Firm for the original statement of transaction cost analysis. (Note that Coase did not use the term transaction costs. Oliver Williamson, the 2009 Nobel Co-Laureate in Economics, first used that term.)
Case Study: The Transaction Costs of Allocating Intellectual Property Rights In The Roche And Genentech Merger
In March 2009, Roche completed its acquisition of Genentech by purchasing the remaining 44% of Genentech stock it did not own. Among other things, the merger will facilitate collaboration between Roche and Genentech in developing personalized medicine. Roche is a leader in diagnostics — technologies doctors use to determine which patients will respond well to which drugs. Genentech pioneered diagnostics with Herceptin, a breast cancer drug that contains a genetic test to identify suitable patients for the treatment.
This excerpt from a Business Week article summarizes the management benefits of eliminating the transaction costs of allocating intellectual property rights:
When they were separate, Genentech and Roche rarely tried to co-develop diagnostics, because it took too long to work out patent rights and other legal logistics. “Now there’s no intellectual-property discussion, there’s no negotiation—we’re the same!” Scheller says. “You wouldn’t believe how much easier it is.”
Three points regarding intellectual property and merger strategy immediately come out.
- The transaction costs associated with dividing intellectual property rights deterred collaborative work between the companies.
- The acquisition eliminated the transaction costs, thereby facilitating collaboration.
- The merger aligned incentives for collaboration and innovation.
Discussion
The article raises questions about the relationship between the transaction costs of intellectual property agreements and merger and acquisition strategy. Two questions deserve further analysis:
1. What causes transaction cost failures in the intellectual property context?
2. When does transaction cost failure influence merger and acquisition strategy?
The takeaway is that the economic analysis of intellectual property agreements informs important business activities, including collaboration, innovation, management, and mergers and acquisitions. Using transaction cost analysis to analyze intellectual property agreements and business activities is a prime example of how Legally Informed Strategy adds value to clients. By understanding how transaction costs connect to a company’s activities, business intellectual property attorneys can write contracts that better meet their clients’ priorities.
Business lawyers often argue that involving a lawyer early on in a transaction is cheaper than fixing a problem later. Clients sometimes want to negotiate a deal on their own and then have a lawyer write it up. The concern might be cost or the attorney’s grasp of the business issues. Further, an attorney who understands how legal strategy fits into your business strategy can provide Legally Informed Strategy, thereby adding value to the transaction.
The Benefit Of Having Legal Advice Early On
In a recent blog post, John L. Watkins, Esq. of Chorey, Taylor & Feil, APC in Atlanta presents a persuasive argument for getting a business lawyer on board at the beginning of the transaction. The problem with waiting far into the deal is that the client may have to remodel or completely tear down what has been negotiated. The process of legal remodeling or tearing down a document can be costlier and riskier than getting legal advice early on.
As to cost, Mr. Watkins notes: “the irony is that involving a lawyer from the beginning and doing the transaction correctly will probably be no more expensive than either a last minute tear down or a remodeling project.”
Mr. Watkins summarizes the legal reasons for getting a lawyer’s advice at the beginning of the negotiations:
Business lawyers are used optimally when they are involved early in the process, and certainly before the key terms are struck. Lawyers can provide valuable input on how the transaction might best be structured. Lawyers can also identify key terms and conditions that should be included to protect the client’s interests. Lawyers can also advise the client on whether terms proposed by the other side are carry unanticipated risks.
Discussion
Bringing in an attorney early on a business transaction usually results in a better outcome for the client. Yet, part of the reason why clients sometimes minimize the lawyer’s role is the belief that the attorney does not adequately understand the business implications.
A business lawyer who understands how the deal fits into the client’s strategy, the competitive environment, and how the client creates and captures value can add value by providing Legally Informed Strategy.
This discussion raises the question: How can attorneys add value to business transactions? We would love to hear your thoughts.
NOTE: DYP Advisors, Inc. has no business relationship with John Watkins or Chorey, Taylor & Feil, APC.
Source: AP Photos
Do more lawyers mean lower wages for lawyers? The legal blogosphere has been abuzz since Mark Greenbaum argued in the Los Angeles Times that too many new lawyers drives down lawyers’ wages. However, Mr. Greenbaum’s argument is based on misunderstandings of competition in the legal industry.
To summarize, Mr. Greenbaum contends that there are too many new lawyers and that the job market cannot support them. Instead of allowing new law schools to flood the market with more lawyers, thereby driving down wages, the American Bar Association should be stripped of its accreditation power because of irreconcilable conflicts of interest.
“No More Room At The Bench”
In arguing for a slowdown in number of new lawyers, Mr. Greenbaum asserts:
“There is a finite number of jobs for lawyers, and this continual flood of graduates only suppresses wages.”
In support of his position, Mr. Greenbaum reasons:
“From 2004 through 2008, the field grew less than 1% per year on average, going from 735,000 people making a living as attorneys to just 760,000, with the Bureau of Labor Statistics postulating that the field will grow at the same rate through 2016. Taking into account retirements, deaths and that the bureau’s data is pre-recession, the number of new positions is likely to be fewer than 30,000 per year. That is far fewer than what’s needed to accommodate the 45,000 juris doctors graduating from U.S. law schools each year.”
Analysis: Why More Lawyers Do Not Mean Lower Wages
Both prongs of Mr. Greenbaum’s analysis rest on misconceptions and misplaced assumptions.
Mr. Greenbaum’s statement about the connection between new lawyers and wages is overly simplistic. First, he apparently assumes that lawyers are employed by law firms, companies, or the government. This ignores solos. Solos create their own opportunities. Second, Big Law is not cutting back salaries because there are more new lawyers. The correction in salaries is due to client pressure on law firms to reduce fees, the economic downturn, and misplaced hiring and management policies. Third, Mr. Greenbaum assumes that income levels could not be maintained with more lawyers. Yet, Mr. Greenbaum presents no evidence that lawyers’ wages have declined as the number of lawyers has increased. The claim that lawyers’ salaries have decreased conflicts with the perception that lawyers cost too much and make high salaries.
More importantly, whether more lawyers pushes down income turns on three factors:
- Demand for legal services
- The intensity and character of competition
- External forces affecting competition in the legal industry
Mr. Greenbaum should have said that when the number of lawyers increases faster than the demand for legal services, fees will face downward pressure because of increased competition. As the supply of lawyers increases relative to demand, competition increases. And Mr. Greenbaum says nothing about the demand for legal services. The economic downturn — not an influx of new lawyers — reduced the legal budgets of companies.
Price competition has increased over the past two years, but not because of a flood of new lawyers. Separately, the commoditization and automation of certain practice areas is intensifying price based competition.
Moreover, Mr. Greenbaum’s analysis of the demographic data is incomplete. If there is demand for only 30,000 (or any other number of) new lawyers every year, then supply does not outstrip demand. When supply and demand are in relative balance, an increase in the number of lawyers will not drive down wages because competitive intensity does not increase.
The crucial point is that even if lawyers’ wages have decreased, it is not because there are more lawyers. Other factors have had a much bigger effect on incomes than the supply of lawyers.
Conclusion
Many lawyers are uncertain about how to react to the changing competitive landscape of the legal profession. Crafting good solutions to the legal profession’s problem requires a solid understanding of that landscape. If lawyers have difficulty understanding what is happening in their own profession, how can they understand their clients’ businesses?
NOTE: This blog post is based on a discussion that fellow blog contributor Soyeun Choi and I had about Mr. Greenbaum’s essay.
The Securities and Exchange Commission’s (SEC) new disclosure rules mandate disclosure of material adverse risks created by compensation policies. A prominent corporate attorney’s recent analysis of compensation program design and risk focuses on process, but completely ignores reputation risk.
Reputation risk based on the amount of compensation, regardless of adherence to established procedures, is “reasonably likely” to create risk that is likely to have a material adverse effect on the company. Therefore, boards of directors must consider reputation risk created by compensation packages.
Do Boards of Directors Knowingly Approve Risky Compensation Programs?
Edward Greene, partner at Cleary Gottlieb Steen & Hamilton LLP, states:
We are skeptical that any compensation committee knowingly approves compensation programs and arrangements that place the company at material risk, and insofar as the standard imports a “risk factor”-type threshold, we question whether it will elicit meaningful disclosure.
(emphasis added)
The assertion that compensation committees of boards do not “knowingly” approve compensation programs that create risk is based on a narrow view of what constitutes material risk. To summarize, Mr. Greene argues that the compensation committee should make sure that compensation and performance are rationally related, and that engaging in a process-based review of compensation and risk adequately balances risk and reward in disclosure decisions.
Large Compensation Packages Create Reputation Risk
But does completing such a review reasonably ensure that risks surrounding compensation programs have not been knowingly approved?
No, because a process-focused review of compensation program fails to account for adverse public reaction to compensation packages. Banks like Goldman Sachs, JP Morgan Chase, and Bank of New York Mellon are concerned about the reputation risk they will have to deal with after handing out large bonuses for 2009. The looming question is: How large should bonuses be?
Banks are worried about public backlash, government investigations, and heightened regulatory scrutiny over bonuses. In 2009, New York Attorney General Andrew Cuomo asked banks to provide details about executive compensation. Great Britain has imposed a special tax on bankers’ bonuses, and Ohio Congressman Dennis Kucinich is drafting legislation to do the same.
Jon Reed, former Citigroup chairman, cautions that large huge bonuses will make it difficult for the industry to improve its reputation and regain the public’s trust:
“There is nothing I’ve seen that gives me the slightest feeling that these people have learned anything from the crisis,” Mr. Reed said. “They just don’t get it. They are off in a different world.”
Managing and Optimizing Reputation Risk As A Material Risk
This raises the question: Is reputation risk a material risk? Although reputation may not directly impact the bottom line, there are indirect costs in the form of reputation, trust, and regulation. In this sense, reputation risk is concrete and must be managed.
Even better, directors can optimize reputation risk by addressing public concerns about hefty compensation packages. In this context, risk optimization involves going beyond process compliance and taking steps to deal with compensation amounts.
Some banks are taking the cue and attempting to optimize risk around compensation. Goldman Sachs reduced the percentage of revenue earmarked for compensation from 50% to 48%, and JP Morgan’s investment bank decreased the percentage from 40% to 37%. And Goldman Sachs may broaden a program under which top executives must contribute a percentage of their income to charity.
Conclusion
Whether a company should disclose reputation risk created by compensation programs depends on its industry and exposure to public scrutiny and regulation. Regardless of SEC disclosure requirements, boards of directors need to keep reputation risk on their radar screens because reputation is difficult to burnish once it is injured.
