What makes a good contract?

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We enter into contracts everyday. Many of them are verbal contracts. When you agree to meet somebody for coffee, you are entering into a verbal contract.

Formal contracts are written agreements signed by both parties. When you buy a house or lease an apartment, you enter into a formal contract and if you don't comply with the terms of the contract, the counterparty can use the full force of the law to make you uphold your end of the deal. 

Remember when Elon Musk acquired Twitter (n/k/a “X.com”) in 2022? Musk already owned about 9.0% of Twitter when he offered to buy the rest of the publicly held shares for a total deal value of $44 billion. The Twitter board accepted the offer and now a binding contract was in place, subject to a few months of waiting for perfunctory shareholder and regulatory approvals.

Shortly after the deal was signed, Musk triggered a clause that is in almost every acquisition contract known as the “Material Adverse Event.” The MAE is exactly what it sounds like: if there is a material adverse event between the signing and closing of the deal, the buyer can walk away.

For example, if a company lost a customer that represented a large portion of its revenues, the buyer could point to the MAE and claim, “Hey, the business we are actually acquiring is in much worse condition than what we signed up for, so we are out.”

Most of the time, a buyer threatening to use the MAE does so to pressure the seller to lower the price or make other terms more favorable to the buyer. Musk pointed to the MAE and claimed Twitter had millions of accounts that were really just bots, and not people. He was unsuccessful and the court forced him to close the deal.

In most acquisition transactions there is a period ranging from a few weeks to several months between signing the binding deal and closing the deal. This is the time when necessary regulatory and other approvals are accomplished and when the seller sweats a lot.

Buyer: You represented that the Canadian division was growing, the latest numbers show it shrinking, what are we going to do about this?

Seller: Well, since we told all the other buyers to go home and we are stuck with you, I guess we can knock the price down by 10%, I hope that’s enough.

So, how do we construct a good contract where there is some balance of power and one side cannot take advantage of the other side?

My favorite example of a balanced contract involves the search operation for flight MH 370, the Malaysia Airliner that disappeared on March 8, 2014 into the ocean somewhere between Malaysia and China. 

To recap, a Boeing 777 with 239 passengers and crew departed from Malaysia en route to China and lost contact with civilian air traffic control about an hour into its flight. Military radar, however, tracked the flight for another hour, recording a flight pattern that took it well off its originally intended course. The plane vanished into the ocean and only a few scraps of the aircraft were ever found, despite one of the most comprehensive and expensive searches in aviation and maritime history.

This brings us to the present-day contract between the government of Malaysia and underwater robotics company, Ocean Infinity, based in Austin Texas. The families of those lost on MH 370 have not let up on the pressure to find answers to this mystery. (The volume and complexity of theories around the vanishing of the flight are staggering, but the families of survivors just want some sort of closure.) 

Technically, the agreement between the government and Ocean Infinity is not yet finalized, but is expected to be completed in the next 90 days.

Ocean Infinity will be paid $70 million if it finds wreckage from MH 370. But, what if the search goes on for the agreed upon 18 months and nothing is found? Ocean Infinity gets paid $0.

Check out Ocean Infinity’s website and you can get a feel for the dollars it will be investing in the search and see the scale of some of its other projects. The company seems well-suited for a big risk, big reward contract like the deal with Malaysia. Industry experts estimate Ocean Infinity will spend between $10 million and $30 million to conduct the search. 

If you are interested in the mystery of flight MH 370, please take the poll below. I will store the results and publish a post at the conclusion of the Ocean Infinity search.

Key Takeaways

• Avoid one-sided contracts, even if you have the leverage. These agreements generally end poorly.

• At-risk deals are good if you have the resources and have done the research like Ocean Infinity. Else, they are a fool’s errand.

• If you have a balanced contract, add in extra bonuses that benefit both sides if things go really well. This is common in construction: If the bridge is completed ahead of schedule, bonus payments are made to the construction company and the local government has a bridge in use sooner than planned. Both sides win.

Things I think about

The first fatality in a powered aircraft was in 1908, when Orville Wright crashed into an observer from the U.S. Army. (This was about five years after the famous first flight of the Wright Brothers at Kitty Hawk, NC.)

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