Betting On Wifes Virtue

Betting On Wifes Virtue

Business communication

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Betting on the Future: The Virtues of Contingent Contracts

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Betting on the Future: The Virtues of Contingent Contracts

by

Max H. Bazerman
and
James J. Gillespie

by

Max H. Bazerman
and
James J. Gillespie

A version of this article appeared in the September–October 1999 issue of Harvard Business Review .
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or related topics
Negotiation strategies and Decision making and problem solving

Max H. Bazerman is the Jesse Isidor Straus Professor of Business Administration at Harvard Business School and the author (with Don A. Moore) of Decision Leadership: Empowering Others to Make Better Choices (Yale University Press, 2022) and Better, Not Perfect: A Realist’s Guide to Maximum Sustainable Goodness (Harper Business, 2020).

James J. Gillespie is a lecturer and doctoral student at Kellogg.

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Copyright © 2022 Harvard Business School Publishing. All rights reserved. Harvard Business Publishing is an affiliate of Harvard Business School.
A television production company was recently trying to sell the syndication rights for a popular sitcom to an independent station in one of the three largest U.S. broadcast markets. Both parties were eager to close the deal, but they had very different expectations about the program’s ratings. The producer was confident that the sitcom would grab at least a 9 % share of the audience in its early-evening time slot. The station felt the show wouldn’t garner more than a 7 % share. Because each share point was worth about $ 1 million in advertising revenue, the difference in expectations translated into very different ideas about what the rights to the show were worth. After many heated debates, the negotiations broke down. The producer forfeited the market, and the television station bought a less attractive program to fill out its schedule.
The negotiation dynamic that played out between the producer and the station occurs frequently in business. Two parties with common interests fail to reach an agreement—about a sale, a merger, a technology transfer—because they have different expectations about the future. They are both so confident in their prediction, or so suspicious of the other side’s forecast, that they refuse to compromise. As the negotiations progress, the difference of opinion comes to dominate the discussions and the common interests recede from view.
Such impasses are hard to break through. Fortunately, though, they can often be avoided altogether by using a straightforward but frequently overlooked type of agreement called a contingent contract . A contingent contract’s terms are not finalized until the uncertain event in question—the contingency—actually takes place. If the television producer and the station, for example, had used a contingent contract, the program license fee would not have been fixed at the time the agreement was signed. Instead, it would have varied depending on the program’s actual ratings. With a contingent contract, differences of opinion about future events don’t have to be bridged; they become the core of the agreement. Companies bet on the future rather than argue about it.
Differences of opinion about future events don’t have to be bridged; they become the core of the contingent contract.
In some areas of business—compensation, for example—contingent contracts are common. When a CEO agrees to tie her pay to her company’s stock price, she’s entering into a contingent contract. When an actor takes points in a movie in return for a lower up-front payment, he’s agreeing to a contingent contract. But in many business negotiations, contingent contracts are either ignored or rejected out of hand. Why? There are three reasons. First, many negotiators are simply unaware of the possibility of using contingent contracts. Second, contingent contracts are often seen as a form of gambling—something that just shouldn’t be done in business. Third, most companies lack a systematic way of thinking about the formulation of such contracts. Our goal in this article is to raise managers’ awareness of contingent contracts, showing that such agreements are both appropriate and beneficial in many kinds of business negotiations.
It used to be assumed that differences were always a source of contention in negotiations, limiting the parties’ ability to reach an agreement. But in recent years, negotiation scholars have shown that differences are often constructive. They provide the basis for tradeoffs that can pave the way to mutually beneficial agreements. When the differences have to do with uncertain future events that are critically important to both parties, however, trade-offs become very difficult to make. By making the differences the basis for a bet that offers potential gains to both parties, contingent contracts enable negotiators to avoid long, costly, and often futile arguments. Negotiators are able to focus on their real mutual interests, not on their speculative disagreements.
Consider how a contingent contract might have changed the course of one of the century’s most famous (and fruitless) antitrust cases. In 1969, the U.S. Department of Justice filed suit against IBM, alleging monopolistic behavior. More than a decade later, the case was still bogged down in litigation. Some 65 million pages of documents had been produced, and each side had spent millions of dollars in legal expenses. The DOJ finally dropped the case in 1982, when it was clear that IBM’s once-dominant share of the computer market was eroding rapidly.
During the case’s 13 years, IBM and the DOJ had essentially been arguing over differences in expectations. IBM assumed that its market share would decrease in coming years as competition in the lucrative computer market increased. The DOJ assumed that IBM, as a monopolist, would hold its dominant market share for the foreseeable future. Because neither felt the other’s view was valid, neither would compromise.
A contingent contract would have been an efficient and rational way to settle this dispute. IBM and the government might have agreed, for example, that if by 1975 IBM still held at least 70 % of the market—its share in 1969—it would pay a set fine and divest itself of certain businesses. If, however, its market share had dropped to 50 % or lower, the government would not pursue antitrust actions. If its share fell somewhere between 50 % and 70 % , another contingency plan would be executed.

Constructing such a contract would not have been easy. There were, after all, an infinite number of feasible permutations, and many details would have had to have been hammered out. But it would have been far more rational—and far cheaper—to have lawyers from both sides devote a few weeks to arguing over how to structure a contingent contract than it was for them to spend years filing motions, taking depositions, and reviewing documents. We would suggest, parenthetically, that a similar course might have been taken in the dispute between Microsoft and the U.S. government.
For another example of how contingent contracts can create value from differences, consider the predicament faced recently by a prestigious management consulting firm. A large conglomerate had hired the firm to help turn around a struggling division. After completing its analysis, the consultancy was convinced that the division’s problems could be solved, and it created a detailed turnaround plan. At just that point, the client received a $ 100 million offer for the division—an offer it saw as highly attractive given the division’s existing problems. The consulting firm argued strenuously that if the client followed the recommended turnaround plan, the division could be sold for approximately $ 200 million within two years. But the client, more than a little suspicious that what the consulting firm really wanted was another two years of fat fees, viewed the rosy projection with skepticism. It didn’t believe the division’s value would go up by more than a few million dollars—an amount that would have been offset by the additional consulting fees—and it accepted the offer on the table.
The consulting firm might have had better luck if it had offered a contingent contract. It could, for example, have proposed to charge no fees for its work if the client agreed to pay the consultancy 25 % of any amount over $ 100 million that it received when it sold the division in two years. Such a proposal would likely have convinced the client that the consultants had confidence in their turnaround plan and were bargaining in good faith, thus removing an important obstacle to agreement. The consulting firm didn’t even consider such a proposal because, as one of its partners said afterward, “We don’t do things like that.” But if the firm knew its advice was sound, it would have stood to make a considerable sum of money with the contingent contract—both for itself and for its client.
Companies can come to very different conclusions about many kinds of future events, from prices and interest rates to market shares and competitors’ moves. Whenever such a difference exists, there’s an opportunity to craft a contingent contract that both sides believe to be in their best interests.
It’s well known that negotiators are subject to various biases that can distort their positions and their decisions. Many companies make big investments in training to try to eradicate or at least temper these biases. But by their nature the biases are difficult to root out—they’re embedded in the way the human mind works. Contingent contracts offer a different approach to solving the bias problem. By enabling each side to bet on its bias, the contracts remove the biases as sources of contention and ultimately have the effect of canceling them out altogether.
Consider, for example, one of the most common biases affecting negotiators: overconfidence. Companies, like individuals, tend to have an irrational degree of confidence in their own abilities and, as a result, they tend to overestimate the likelihood of achieving positive outcomes. In a contingent contract, each side translates its overconfident assumptions into a wager on the future. The outcome of the wager tends to fall between the two extreme positions, creating a rational result without requiring either party to sacrifice its firmly held bias.
To see how this works, imagine that two companies, one based in the United States and the other in Europe, are discussing the establishment of a joint venture to market each other’s product. The U.S. firm is confident it will be able to sell $ 50 million of the European product in the first year, but the European firm thinks that estimate is much too optimistic. Similarly, the U.S. company is skeptical of the European firm’s forecast that it will sell $ 50 million of the U.S. product. Rather than argue about the different forecasts, the parties can take advantage of each other’s confidence (or overconfidence) by crafting a contingent contract under which each side’s percentage of ownership in the venture hinges on the actual first year sales. If both hit their targets—or if both miss them by equal amounts—they’ll each own half the venture. But if one side misses its target by more than the other, it will forfeit equity to its partner. The rewards, in other words, are based on actual performance, not on biased predictions. And because each side believes its sales forecast to be rational, both will view the contingent contract as attractive.
Another bias common in negotiations is egocentrism, which occurs when negotiators hold self-serving perceptions about the fairness of their position. Here, too, contingent contracts can defuse the tension and create a rational outcome. Imagine two big technology firms, TechNorth and TechSouth. Although they have had a history of productive collaboration, they are now engaged in an acrimonious dispute over who owns the patent rights on a potentially lucrative new technology. The egocentric bias causes each company to believe its position is the fair and right one, reducing the likelihood that either will compromise.

Cases like this, which happen all the time in business, often end up in court, leading to big costs, long delays, and enormous ill will. A better strategy for TechNorth and TechSouth would be to agree to an independent arbitrator who would review the evidence and reach a binding decision about the patent’s ownership. Arbitration is a form of contingent contract in which the arbitrator’s decision serves as the contingency. Presented with the option of arbitration, each side’s egocentrism leads it to assume that the case will be resolved in its favor. While arbitration has many parallels to the court system, it allows each party to believe that its fairness concerns have been addressed while avoiding the costs and delays of litigation.
In effect, contingent contracts allow negotiators to be flexible without feeling that they’ve compromised.
Contingent contracts counter biases by, in essence, indulging them. They establish two contrasting future scenarios, each reflecting one party’s biases. Because each side anticipates that its scenario will be the one that plays out, each has a strong incentive to accept the contract. In effect, contingent contracts allow negotiators to be flexible without feeling that they’ve compromised.
Many negotiations are characterized by asymmetric information: one side knows more than the other does. In acquisition talks, for example, the target company typically knows more about its business and its value than the prospective buyer does. This asymmetry puts the acquirer at a disadvantage, raising the odds that it will bid too much for the company or that, fearful of being cheated, it will walk away from a good deal.
Contingent contracts are a simple way to level the playing field. Let’s say, for example, that you, the CEO of Big Co., are interested in buying the small but growing family-owned company, Little Co. Your number crunchers have come up with a range of possible values for Little Co., but you don’t know its true worth. Rather than risk making an overgenerous bid—one that may guarantee that the acquisition never generates real returns—you formulate a contingent contract. You offer to pay Little Co.’s owners a baseline amount, at the low end of the projected range of values, and then set up a sliding scale of additional payments based on the company’s post-acquisition performance or on a postacquisition audit by neutral financial analysts. The contingent contract allows the sale to go forward but delays the determination of final terms until after you have had a chance to run the company and inspect the books from an insider’s perspective—until, in other words, the information has become symmetrical.
Information asymmetry commonly exists within companies as well. Consider the hypothetical company El-Tek. 1 El-Tek’s Audio Division owns a magnetic technology that can be more effectively commercialized by its Magnets Division. The two highly decentralized divisions are in the process of negotiating the terms of the technology’s transfer. The Magnets Division, armed with deep information about the market, expects the technology to earn annual profits of between $ 14 million and $ 15 million. The Audio Division, enamored of the technology but lacking information about the magnets market, thinks the profit potential is much higher—upwards of $ 40 million. The Magnets Division discloses its information to the Audio Division, but Audio’s managers suspect that their colleagues have skewed the data. The negotiations devolve into long arguments over the projections, and the transfer is delayed—to the detriment of the corporation as a whole.
El-Tek could have avoided the dispute by encouraging the divisions to bet on the outcome. Rather than trying to convince the suspicious Audio managers that their profit forecasts were irrational, the Magnets Division could have offered to pay a reasonable sum for the technology, with the following kicker: Audio would be credited with half of any annual profits earned above $ 25 million. If the Audio group believed its own forecasts, it would see the offer as fair and accept it. The contingent contract would have removed the barrier of information asymmetry.
What makes information asymmetry so discomforting to companies is that it raises the possibility of deceit. Indeed, the fear of deceit can be a major impediment to all sorts of business agreements. Contingent contracts are a powerful means of uncovering deceit and neutralizing its consequences.
Contingent contracts can uncover deceit and neutralize its consequences.
Consider the case of a major U.S. clothing company that had contracted to buy a large quantity of sweaters for the upcoming fall season from an overseas manufacturer. The agreement stipulated that the manufacturer was responsible for paying shipping costs. Soon after the contract was signed, the U.S. government announced an embargo on a fabric used in the sweaters. The buyer became very worried that the cargo ship scheduled to carry the sweaters would not arrive before the embargo date. The manufacturer, for its part, insisted that the shipment would arrive in time.

Unconvinced, the buyer suggested that the cargo be sent by air—a quicker but much more expensive option. The manufacturer declined to pay the extra cost, assuring the buyer that it had nothing to fear. Increasingly suspicious of the manufacturer’s unwaveringly confident pronouncements, the buyer proposed a contingent contract. The manufacturer would ship the sweaters by air, thus ensuring their arrival before the embargo deadline. The companies would then track the progress of the ship scheduled to carry the sweaters. If the ship arrived in the U.S. port before the deadline, the buyer would pay the entire airfreight cost. If it arrived late, the manuf
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