Value Creation for Companies by Lawyers
According to Michael E. Porter, “Every firm is a collection of activities that are performed to design, produce, market, deliver, and support its product” (value activities). These consume resources and are linked together in processes. The value activities can be presented as a value chain that is divided into the so-called primary activities and support activities. Primary activities provide a direct value-adding contribution to the creation of a product or service. Primaryactivities are internal logistics, production, external logistics, marketing & sales and service. Support activities are those which are necessary for the performance of primary activities. These include corporate infrastructure, human resource management, technology development and procurement. Value added by the enterprise is thus the difference between the services provided by the enterprise and the inputs used by the enterprise. Value is the amount that a buyer is willing to pay for the product or service provided by the company. Margin is generally defined as the difference between total value and the collective cost of performing the value activities (costs).
From these remarks alone, it is easy to see how difficult it is to determine a “measurable” and verifiable contribution to value creation in the work of lawyers for a company. In contrast, it seems much simpler to assign lawyers a measurable share of the overhead costs “without measurable value” which they have incurred. The difficulty of determining the contribution to value creation exists even though none of the primary or secondary activities of the company mentioned above can ultimately take place in a “lawless” environment. In the area of compliance, the awareness of the legal relevance within the value chain has already gained ground due to the threat of liability risks. If, however, the entire value chain of companies is covered by law in the form of legal and/or contractual rules, whether directly or indirectly, the law also has a positive or negative effect on them and the associated value creation, and not only from the point of view of preventive risk management in the area of compliance and corporate governance. The same therefore also applies to lawyers and their work for the company. The questions that follow are, on the one hand, whether and how this contribution can be measured and, on the other, whether this effect should be deliberately controlled or unknowingly accepted.
From the perspective of the economic analysis of law, the central task of law is to introduce and enforce rights of action under the primary goal of “efficiency”.
Law as a “bundle of rights of action” and “means of allocating and controlling risks“
The economic analysis of law reveals two basic ideas that are suitable for better understanding the significance of law in the value chain and for providing initial indications of the measurability of legal activity in the creation of value. The following comments refer to the negotiation and agreement of an exchange of services for products or services (transaction).
From the perspective of the economic analysis of law, the central task of law is to introduce and enforce rights of action under the primary goal of “efficiency”. Rights of action regulate competing interests in the use of resources. If no conflict is present, the law is also intended to increase the coordination efficiency of market participants. The idea of rights of action is to understand goods and services as a bundle of rights and, consequently, to qualify the exchange of these as an exchange of “bundles of rights” between the parties involved. Essential parts of such a bundle of rights are, for example, the right of use, the right of sale, the right to appropriate the success or the right to change. The holder of these rights must be protected against interference by others, i.e. he is entitled to defensive rights. On the other hand, in exercising his rights, he must not infringe the rights of others. In contrast to the mere technical marking of goods, “bundle of rights” thus indicate the possible uses of resources in a concrete legal system. The value of a good is therefore not only determined by its substance and technical possibilities of use, but also by its endowment with “rights of action“. The market value of a “right of action” will increase in line with its exclusivity. If the exclusivity of a right of action is restricted by the rights of third parties or by law, its value will correspondingly decrease.
According to the economic analysis of the law, a “complete contract” exists if the contracting parties have agreed on the allocation of all risks associated with the performance of the contract before the contract is concluded. In order to achieve this objective, they would have to discuss every eventuality, assign the resulting risk to a contracting party and agree on the performance to be assumed by the risk-bearer in the event of the occurrence of the risk and the consideration to be received in return for the assumption of the risk. For each risk assumed, the transferee will demand an additional premium for his services, which at least reflects the expected value of these risks (amount of damage, influenceability of the risk, probability of occurrence, insurability).
It should also be borne in mind that the behavior of a party can be controlled via the legal consequences and the economic risk of a breach of contract.
From the perspective of the economic analysis of the law, for reasons of efficiency, the party that can avoid, insure or otherwise manage the risk with the least effort should assume the risk in order to avoid cost inefficiencies that have a negative impact on pricing. The distribution of risks through the respective contract design therefore influences the value of the item or service. It should also be borne in mind that the behaviour of a party can be controlled by the legal consequences and the economic risk of a breach of contract. The transaction costs associated with the conclusion of a “complete contract“, in terms of obtaining the necessary information, negotiating the contract, implementing and monitoring it and making any necessary adjustments, are by their very nature very high. It is also unlikely to be possible to cover all eventualities. In practice, the “complete contract” is therefore generally an exception. A further value-generating factor is the enforceability of the agreed rights and the associated costs, such as those involved in agreeing the applicable law, the place of jurisdiction and the court order.
In conclusion, the following legal factors play a role in determining the value of a “transaction” and may also influence each other:
- The nature and scope of the legal options for action and their exclusivity associated with the product or service offered
- the contractual allocation of risks and their assessment,
- possible increase in coordination efficiency,
- The nature and extent of transaction costs, including costs for the enforcement of rights, and their distribution
The influencing factors mentioned above can be applied to the assessment of the complete value chain and the underlying exchange ratios.
Example: supply chain management
In essence, a supply chain is made up of autonomous actors who are basically striving to maximize their own profit. Supply chain management aims to increase customer benefit (effectiveness) and to improve the cost-benefit ratio (efficiency) throughout the system. The subject matters and conditions which ultimately regulate the legal relationships between the parties involved at the various exchange levels are very diverse due to the complexity of the various performance relationships and interests. Contractual regulations have a considerable coordinating function with regard to the different interests, but also with regard to the clear distribution of responsibilities and the standardisation of “communication“. By reducing the transaction costs of the various exchange stages by standardizing and coordinating all exchange relationships (e.g. warranty and service) with each other, the profit of the entire supply chain can be increased.
Warranty risks are part of the imputed costs.
A central area of regulation is the fair distribution of costs, risks and profit under “efficiency aspects“. This concerns in particular the question of warranty. Warranty risks are part of the imputed costs. The question of the legal distribution of these risks or the legal protection of the enforcement of claims is thus one of the influencing factors in the value creation of the company. When distributing the risks under “efficiency aspects“, the following questions, among others, can be asked in order to avoid the price premiums or discounts associated with the assumption of risk and to enable an efficient distribution of the risks:
- Who can best avoid the specific risk, i.e. who can best control the risk, whereby the risk avoidance costs must be lower than the expected value of the risk?
- If the risk is insurable, who can insure the risk at the lowest cost?
It cannot be denied that the protection of investments in the field of research & development by patent rights provides significant added value to the underlying inventions. This is especially true as it allows further rights of action to be assigned to the invention, especially in the form of exclusive rights of use. Otherwise, there is a risk not only of losing the investment, but also of losing potential profits. However, a corresponding value assessment can be made for each “legal position” of the company, which is why the creation of “efficient legal positions“, especially for trade relationships, is just as important for a company’s legal activity as the avoidance of unwanted risks
About the author
Publication: E-Book „GmbH-Geschäftsführer 2019“
Publication date: 13. März 2019
Publisher: EUROFORUM Deutschland GmbH