One of the benefits of being a corporate lawyer is the opportunity to participate in a variety of interesting deals. In these, you encounter a motley crew of characters. You witness a range of negotiating styles and tactics, and learn which are effective and which are not. You see some ventures succeed and many others fail.
In the great theatre of the deal, there are rare moments in which something may not feel right to the lawyer or the client about a proposed business transaction or partner. The thing amiss may only be verifiable by circumstantial evidence. To paraphrase the Delaware Chancery Court, it may be that the circumstances surrounding the person or transaction stink bad enough that they simply do not pass the “smell test“.
Questions may arise following diligence on the target (which should minimally include Google and litigation searches), from a person’s conduct in negotiation or from other third party sources. There will not typically be any proverbial smoking gun, so your judgment and careful diligence will be your guiding light.
In my years as a deal lawyer, the appearance of any of these nine elements (not in any order of priority) has been a fairly reliable harbinger of difficulty, dishonesty or even fraud in proposed business deals. If any of these elements arise in your dealings, you should consider diving deeper into diligence to determine if there is genuine cause for concern or possibly re-negotiate or abandon the deal altogether.
- The demanding long-winded negotiator of trivial things. Excessive demands for non-substantive or patently unreasonable changes to the initial non-binding deal document, such as the term sheet or letter of intent, may foreshadow protracted and possibly agonizing negotiation of the definitive agreements and a challenging ongoing business relationship. If the demands are coupled with the party’s long-winded or repetitive arguments why he is right and you are wrong (or other ridiculous anectdotes), they may suggest personality issues. In my experience, character defects are not easily remedied and often worsen with time. The unreasonable negotiator should distinguished from the tough savvy negotiator, who requests substantive deal points but is often reasonable and a good business partner after the deal is papered.
- The deal requires urgent participation and won’t be available after “X” occurs. This is the classic illusion of scarcity tactic. If your prospective business partner claims that if you fail to act now, (i) a large investment from Mrs. “Y” will soon be received and the price of the investment will increase or (ii) the deal will not be available for “Z” reason, the claim may be a red herring and should be carefully scrutinized. Fictional future money is sometimes characterized as coming from abroad or from some well-known person with whom the partner purports to have a close relationship.
- The secrets that cannot be revealed. If the target’s founder or your prospective partner is unwilling to reveal certain fundamental aspects of the business or how it expects to make money, the company may not have a business plan. You have a right to know the company’s business model and growth strategy, with the understanding that the model will likely evolve over time. In one startup deal I reviewed for a client, the founder made repeated excuses why he could not provide information about critical company inventions and provisional patent applications. Later diligence revealed that the company had no inventions and its business plan was impracticable. After spending the other investors’ money, the founder abandoned the company and the U.S. This is akin to Bernie Madoff’s “black box” investment strategy that was “so good” that it could not be understood or replicated by any reputable investor.
- The anonymous “big money” partner. Any person who must remain anonymous is often a red flag, particularly if this mystery man is a primary financing source. A client once instructed me to prepare the draft documents for a “big investment by a Chinese investor who needs to remain anonymous.” A third party had informed the client that the Chinese wanted this, that, and the other, and I prepared several draft iterations at the client’s request. The Chinese investment never materialized and the client wasted money on legal fees. Some celebrities and others have genuine reasons to protect their privacy, but if you are doing a deal with someone (including a celebrity), you have a right to know their identity and to size them up. Always insist upon lifting the veil of anyone who says they must remain anonymous.
- The shell company spider web. Domestic and offshore entities are often formed to execute lawful business strategies, including liability and tax mitigation, particularly for companies with substantial non-U.S. source income. But as the Panama Papers confirmed, offshore shells with limited assets may also be created for tax evasion and other corrupt purposes. Before doing any deal with a company that owns or operates affiliates, especially offshore shell entities, you should fully understand the organization chart and confirm that each entity exists for lawful and legitimate purposes.
- The paperless office. It is fine if your partner keeps a clean desk and operates in the cloud, but a lack of paperwork memorializing a business’s structure, assets and operations is almost invariably a red flag. You should have access to reasonable diligence paperwork and you should be able to freely ask questions and to have them answered.
- No skin in the game. If the deal does not require your business partner to put money or something else of value into the deal, your interests may be de-aligned from the beginning. In the startup context, this could be the situation where a founder’s shares are fully vested from day one and he has no invested capital or other hook to prevent him from walking away when the going gets tough or he receives a better offer. In a joint venture, it could be the ability of a party to enrich himself at the expense of the venture. De-alignment can usually be remedied by careful drafting of the legal incentives in the deal documents.
- The promise of abnormally high or guaranteed returns. This trick is as old as prostitution: returns above market rates or guaranteed returns on invested capital are often signs of a Ponzi scheme, where the prompter lures you to invest to pay his prior investors rather than to make bona fide investments with you money. You should always determine the source of returns and whether that source is capable of generating the projected payout. Most financial projections are exactly that, and vary dramatically from actual results. There is no such thing as a guaranteed return.
- It sounds too good to be true. This is a corollary of abnormally high returns. As the adage goes, if what you are to receive in exchange for your participation sounds too good to be true, then it probably is. In most of these cases, you should run away from these deal absent a reasonable and verifiable justification for its sweetness.