Finance And Law: Risks And Financing Transactions
Lawyers can serve their clients better if they have a strong grasp on the financial side of commercial transactions.
Finding financing is a critical element in many business transactions today, from the sale of a firm to the spin-off of a division to even just growing a business. Many attorneys specialize in the area of commercial law focused on just these kinds of events. The reality is that in these kinds of transactions though, business people and attorneys often speak different languages. While business people are primarily focused on issues like valuation and future cash flows, attorneys tend to think in terms of risk mitigation and regulatory compliance. That dichotomy in mindsets is natural given the functions both groups serve, yet lawyers can still serve their clients better if they have a strong grasp on the financial side of commercial transactions.
Business valuation is a complex procedure, but one that has been well studied and established by financial economists. In its simplest form, valuation involves forecasting future cash flows and then combining those future cash flows through a process known as a discounted cash flow model or DCF. That process is used by everyone from Wall Street analysts to small one-person valuation shops. When future cash flows are difficult to determine, tools like Monte Carlo analysis and options valuation formulas need to be applied. Again, the techniques are well established here, but the process for applying those techniques can be complex.
More importantly for attorneys, while the process of valuing a business may be well established, there are a number of key risks regarding valuation that should be addressed in any funding transaction. Chief among these are risks around cost of capital estimation, risks around cash flow forecasting, and risks around unexpected events. As attorneys are often being asked to advise clients on the risks of a transaction, understanding each of these areas is a great way for attorneys to add value for clients. Attorneys working on financing transactions need to take action to address all three of these primary risk areas.
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Cost of capital estimation risks involve the costs firms face to raise capital in equity or debt markets. Commercial transactions often involve such capital raising efforts. Due diligence around cost of capital estimation requires studying comparable interest rates being applied in the market to similar firms and then making adjustments for the case in question. Attorneys can add value for clients by advising them on (1) costs they may face based on past transactions the attorney has completed, and (2) how the client can gain certainty around future cost of capital (such as through bilateral swap arrangements on loans, or the issue of convertible debt at specified terms).
Due diligence for businesspeople around cash flow forecasting requires performing sensitivity analysis to stress test cash flow assumptions. While this type of sensitivity analysis is outside the area of the typical attorney’s expertise, attorneys can aid their clients by helping them to understand options and choices if realized cash flows do not meet expectations. For instance, attorneys can help business clients to negotiate limited guarantees on capital raising and real estate transactions, and especially to help clients avoid giving personal guarantees regarding business debts. Attorneys can also help by ensuring that any covenants and or requirements that the business adhere to are as flexible as possible especially in the event of adverse business conditions.
Finally, risk mitigation via evaluating tail-risk events is also a critical issue for attorneys to advise clients on. Due diligence around this is generally best done with a Monte Carlo simulation. Again, that type of analysis is often best done by an economist or investment banker, but that does not mean attorneys do not have a critical role to play. Tail-risk events are often areas where business people are blissfully unaware of the consequences or have not thought through the issue at all. Attorneys can use their past experience to help clients understand the reality of such risks, and then find options to mitigate those risks, including negotiated risk sharing with transaction counterparties.
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Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at [email protected].
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