Friday, May 27, 2011

Breaking the Negotiator's Dilemma

In 1992, David Lax and Jim Sebenius (who I was lucky enough to have as a professor) noted that the classic Prisoner's Dilemma has a natural application for negotiation work.

For anyone not familiar with Prisoner's Dilemma, it's a concept from game theory about how people can be trapped in situations where rational behavior leads to bad outcomes.  The simplest form of the dilemma involves two suspects in a major crime who have been arrested and are being questioned.  The police have enough evidence to convict them for a minor crime but offer each one a degree of leniency if he will confess to the larger crime and implicate their partner.

If neither suspect confesses, each gets 1 year in jail for the minor crime.  If both confess, they each get eight years.  If one confesses and the other doesn't, the one who confessed gets off clean while his partner goes to jail for twelve years.

The worst combined outcome for the suspects is if both confess -- they serve a combined sixteen years.  The best combined outcome is if neither confesses -- they serve a combined two years.  The dilemma's fame derives from the fact that the rational decision for each prisoner is to confess, leading to the worst outcome.  The problem is that whatever one prisoner does, the other is better off confessing.  If the first prisoner doesn't confess then the second must choose between a year in jail and walking out a free man.  If the first prisoner does confess than the second must choose between eight years and twelve.  In each case he gets a lower sentence by confessing, meaning that confessing is a dominant strategy.  Since the same calculus applies to both prisoners, the rational outcome is also the worst.

A lot has been written about various Prisoner's Dilemmas, both theoretical and in real-world applications.  In general we speak of decisions to cooperate or defect, where a choice to cooperate improves the combined result and a choice to defect maximizes the individual result at the expense of the other player(s). In negotiation the tension arises over whether one should seek to create value or to claim it.

Creating value requires sharing information.  In particular, it means being open and clear about which elements of a potential deal are relatively more valuable and by how much.  For example, let's assume that a supplier and a customer are negotiating a parts deal.  In addition to price, they are discussing the length of the contract and volume minimums.  At the moment the deal that's on the table is a two-year contract with a minimum annual commitment of two hundred units.

The supplier wants a longer commitment from the buyer with large volume minimums; the buyer wants a shorter commitment and low minimums.  But it's likely that they don't value them equally.  It may be, for example, that each party would be happier with a one-year contract with a three hundred unit minimum.  The more openly both parties share their interests the more likely they are to find this sort of value-creating trade.

Capturing value, however, often requires holding back information.  Let's say you're the customer and the minimum commitment isn't a problem -- you know you're going to buy more than double the current minimum.  If the supplier indicates that she'd like a higher minimum your value capture instinct will be to suggest that this is possible but a very painful concession that will have to be made up for with a price decrease or some other substantial concession on the supplier's part.

If one party is completely open and the other isn't, they will probably find many of the value-creating opportunities, but the less open party will capture most of that created value.

In the classic PD formula, "create value" is cooperate, while "capture value" is defect.  Each party is individually better off emphasizing value capture, regardless of what the other party chooses.  Unfortunately, this leads to the worst aggregate outcome -- both parties emphasize capture and leave money on the table -- in some cases, more money is left on the table than was captured.

So how do we, as negotiators avoid this trap?  It's not enough to read Getting to Yes and committing to focusing on value creation; we need to maximize the chance that our counterparts will as well.

The simplest and probably most reliable way to solve a prisoner's dilemma is with iteration.  If two parties are playing a single round of a PD "game" then, as we noted above, "defect" is the dominant strategy.  (By dominant we mean that it defeats all other strategies in all circumstances.)  But what if we are going to play hundreds or thousands of rounds and our behavior can be tracked from round to round?

A little over thirty years ago, political scientist Robert Axelrod held two "tournaments" to test various strategies for a iterative (i.e. repeating) prisoner's dilemma.  Entrants defined the rules by which their agents (essentially computer programs) would operate, and each agent would play multiple rounds against each other agent.  The rules could not take advantage of knowing that a given round was "final", so the effect of repeated rounds was always present.

The winning strategy was a very simple one: tit for tat.  A tit for tat approach involves cooperating on the initial round and then choosing whatever the other party chose for all subsequent rounds.  If you cooperate with tit for tat, it keeps cooperating back.  If you defect, it defects but if you return to cooperation it does as well.  It retaliates but is quick to forgive.

A tit for tat strategy will still lose, very slightly, to a defect strategy because the defect strategy scores big in round one and then every other round is a tie.  But in a world with lots of different strategies, including some that seek mutual cooperation, it is extremely effective.  Two tit for tat agents meeting will cooperate in every round, maximizing their total benefit.

Tit for tat (and similar approaches) are even more effective with people because we can signal our intentions with words as well as actions.  If you know your counterpart will cooperate as long as you do but will retaliate if you defect, your dominant strategy is to cooperate (assuming you have enough future negotiations to come).

So far, so good -- but how do we make our negotiations iterative?  Fortunately there are some practical steps we can take.

1. Form long-term relationships, especially in areas where value creating opportunities are likely to be substantial.

If you're choosing vendors for your business, think about the scope for value creation that will exist.  For office supplies that potential may be low, so whoever provides what you need at the best price is likely the best choice.  But the more complex the interaction and the more variability (number of terms, potential to meet needs with different products/services) involved in your purchases, the more value creation is likely to dominate value capture as a source of good deals.  In those cases it's worth investing in a partnership where your vendor sees each deal as a step towards a dozen more.  (Unfortunately, many companies use long term relationships solely for gaining leverage for capturing value -- the most successful ones use it to create a pattern of value creation.)

2. Build your negotiation brand/reputation.

If you're known in your industry as someone who will share information openly and look for win-win solutions but who will retaliate (proportionately) against someone who tries to use that against you, many negotiating partners will choose to cooperate with you. In some cases it will be because that's enough to make it the correct strategy; in others it will be because that's the way they prefer to do business (they emphasize capture only because they assume the other side is doing the same).

3. Make this negotiation iterative.

Even if you're only negotiating a single deal and it's with someone who doesn't know your reputation (or you haven't built one yet!) you can create iteration within a single deal provided there are enough issues for it to be worth the effort.  You don't have to share all of your information at once or none at all.  Instead, lead off by saying something like, "With so many factors to consider in this deal it seems clear to me that we can find some great win-win opportunities if we're able to discuss our interests openly.  At the same time, I recognize that this can be difficult so I'd like to start by telling you about some of our key issues.  Then you can do the same, and we can build on that."  Each party can then share

4. Be willing to walk away from deals that are slightly better than your BATNA.

Guhan Subramanian noted that a key assumption of the Negotiator's Dilemma is that people will accept any deal that is better than their no-deal alternative.  If, however, people will walk away from deals unless they create substantial value it becomes more attractive for each party to emphasize value creation.  "Cooperate" can easily become an optimal strategy.  Subramanian points out that in the private equity world, this is already the case -- the big private equity firms have high value thresholds for the deals they do, which leads to more value creation behavior in negotiations.

This plays into the value of your reputation as a negotiator.  If you're willing to walk away from small gains (especially in cases where you have reason to suspect that the pie is at least potentially large) and your counterparts know it, they take a much bigger risk emphasizing value capture and counting on you to provide the information necessary for creation.

Monday, May 23, 2011

Negotiating with a bad BATNA

It's wonderful to have a strong BATNA.  Knowing you have a great walk-away option takes all the stress out of negotiating and puts you in the driver's seat both for process and value creation.  When your BATNA is strong you can often have the negotiation go the way you would like, capture most of the created value and have the other parties thank you for it at the end.

But what about when your BATNA is terrible?  What if you need a deal and the alternative is unacceptable?  Under these circumstances it's easy to feel helpless and to set a goal of just getting something rather than nothing.  Often, however, a bad BATNA doesn't have to mean a bad deal.  Here are some tangible steps you can take to get good results from a bad BATNA:

1. Focus on the other side's BATNA.

Negotiators love a story out of Teddy Roosevelt's presidential campaign.  Shortly before embarking on a whistle-stop train trip, the campaign discovered a serious problem.  They had printed three million copies of a pamphlet with Roosevelt's picture and speech only to realize that they had not secured permission from Moffet Studios, the holder of the copyright on the picture.  Some quick research showed that if they went ahead and distributed the pamphlets they could be liable for $1 in damages per picture.  Some more research revealed that Moffet was very focused on money and would be unlikely to show much sympathy to their predicament.

The campaign had a horrible BATNA -- neither destroying the pamphlets nor risking scandal and millions in liability were acceptable.  Campaign manager George Perkins contacted Moffet with the following cable:

We are planning to distribute millions of pamphlets with Roosevelt’s picture on the cover. It will be great publicity for the studio whose photograph we use. How much will you pay us to use yours? Respond immediately.
Moffet replied that although he'd never done something like that before he'd be willing to pay $250.

If Perkins had thought only of his own BATNA he might have approached Moffet with an appeal for fairness and ended up paying a fortune.  Recognizing that Moffet didn't actually know his BATNA was so bad let him frame the negotiation so it was about Moffet's BATNA (forego the publicity) which wasn't good either.  Note that by ending with, "Respond immediately" he emphasized that Moffet was at risk for losing the deal and didn't give him time to make phone calls and perhaps find out that the pamphlets were already printed.

It's a fun story but not really that unusual.  Just because you don't have good alternatives to a deal doesn't mean the other party does.  If they don't know what your BATNA is and you know (or can reasonably guess) theirs you may be able to control the negotiation and arise at a good result.

2. Improve your BATNA.

Your BATNA generally isn't fixed.  Change it!  If you're negotiating price with the only vendor who can supply your needs, try to develop an alternative supplier.  If you only have one offer for your house, see if you can postpone negotiations and secure another bidder.  Not only is an improved BATNA useful, but if the other parties can see that your BATNA has improved (and may continue to improve) they may see you in a stronger position.

You can also improve the other parties' perception of your BATNA.  In his (excellent) book, Negotiauctions, Guhan Subramanian relates a case of the sale of a business which was off to a bad start.  In was was intended to be an auction, only one qualified party had shown interest.  The investment bankers continued as though all was well and informed the potential buyer that due diligence would be conducted over a weekend, with bids to be submitted at the end.  The buyer requested the Saturday morning "slot" and was told it was already taken.  The next two slots requested were also taken.  When the buyer came in on Sunday morning they found the garbage cans were overflowing with containers of Chinese takeout.  All this gave the impression that the seller's BATNA was another bidder which led to the buyer bidding based on a full valuation.

This example skates close to the law and in my opinion goes beyond what is ethical.  I offer it here not as a blueprint but to illustrate the principle -- even the perception that your BATNA is strong can be very valuable in a negotiation.

I applied these two principles in a more mundane fashion when negotiating insurance reimbursement increases on behalf of a healthcare provider.  The provider's balance sheet wasn't strong enough to afford a loss in business, so our BATNA was very weak.  Nonetheless, we were able to show that our insurance partners had a lot to lose as well if we didn't agree on a deal as we were the low cost provider.  I also played up the Board of Director's and CEO's insistence that rates had to improve to suggest that we were ready to go to our BATNA if necessary.  This played a key role in keeping the discussions about how large an increase was acceptable rather than on whether they had to offer an increase at all.  (This was at a time when rate increases were generally very hard to get and decreases were being pushed on many providers.)

As these negotiations were going I also discussed with the Board and CEO the constraints the organization's weak balance sheet placed on their ability to push for rate increases -- in short, that the balance sheet was hurting profitability.  The organization agreed to slow down on growth in order to strengthen the balance sheet so that future negotiations would be less vulnerable.

3. Focus on creating value.

Imagine that instead of a real-world deal you are negotiating over how to split $10,000 that is sitting on a table.  If you can't make a deal you get nothing but your counterpart gets $9,900 -- and she knows it.  This is the essence of a bad deal; you can hope to get $50 out of the deal and perhaps more if the other party feels generous but essentially you're negotiating over $100 and the rest is already hers.

What would happen if you could magically increase the amount of money sitting on the table to $15,000?  Now things aren't so bad; your BATNA is still weak and you're still going to get much less than half of the money but now she really wants to make a deal.  By increasing the size of the pie you've dramatically improved your prospects.

This approach can be particularly effective if the value creation comes in the form of something that costs the other side nothing but is valuable to you.  Suppose you are seeking secretarial work with a firm that provides software training?  Instead of trying to negotiate a higher salary you might ask to be able to join training classes that aren't full.  The cost to the firm of letting you sit in an otherwise empty seat is near-zero but could be valuable to you.

Value creation is something you should prioritize in all negotiations, but normally it must be balanced with value capture.  When your BATNA is weak (and the other party knows it) value capture is often impractical until new value has been created, so the balance (and prioritization) shifts.

4. Focus on the relationship.

You may have no leverage on this deal, but that doesn't mean you have no leverage at all.  If the current deal is part of a relationship (or if the other party would like it to be) then they have a vested interest in you being happy with the result.  Even if there's no particular relationship an appeal to fairness or reputation can help.

Harvard's PON (Project on Negotiation) newsletter offered a good example.  A homeowner had gotten some work done on his house that required the contractor to develop some custom moulding.  A year or so later he wanted a bit more work done but quickly realized he was in a tough negotiating position.  His contractor was the only one who had the moulding, which meant that any other contractor would be prohibitively expensive.  Indeed, the initial estimate was very high relative to the scope of work and normal negotiation methods only reduced the price marginally.  Ultimately the homeowner acknowledged the tough position but pointed out that he was both a past and potential future customer and that he needed the contractor to be fair with him now.

5. Don't negotiate!

Sometimes it's an error to try to negotiate, at least in the classic sense.  Suppose you're applying for a job out of college or grad school.  It's quite likely that your employer knows that they're either your only or your clearly preferred position, especially since you're unlikely to lie about it.  Rather than try to haggle you may be better off asking for fair treatment -- perhaps a salary review after six months (so you can show how well you're performing) or for the employer to do a salary comparison if you think the offer is a bit low.

Taking a step back, what really matters in your new job?  Wrangling an extra 3% on your starting salary, or having your new boss see you as an excited new member of his or her team?

In other cases it may just not be worth negotiating if your BATNA is weak.  Negotiation can carry costs, in time, in resources and sometimes in goodwill.   You should always weigh those costs against the potential benefits.  If you don't stand to gain much you may be better off not negotiating and moving on to the next opportunity.

Wednesday, May 11, 2011

Microsoft and Skype: why Microsoft might have chosen to overpay

One of the big business stories of the moment is the acquisition of Skype by Microsoft for $8.5 billion.  Skype had been planning an IPO which was expected to raise around half that much when Microsoft came in with an unsolicited bid.  Many analysts have panned the acquisition, with a principal complaint being that Microsoft paid too much.

I can think of three reasons why Microsoft may have made such a large bid -- one optimistic, one pessimistic and one tactical.

On the optimistic side, Skype may be worth more to Microsoft.  Microsoft has a very strong position in the business software market but lacks an application that people want to use every day at home.  Skype is that product and moreover Microsoft may be able to leverage their strength in the business market by selling an upgraded Skype service for business users that can be integrated into their other Microsoft products.  Lots of other synergies have been offered as well, e.g. Xbox and Windows Phone integration. So maybe Skype is really worth $8.5 billion or even more?

That's not a very satisfying explanation.  If something is worth $8.5 billion to your company but only $5 billion to anyone else, the answer isn't to bid $8.5 billion but to bid just over $5 billion and capture the rest of that value for yourself.  At worst you have to pay a premium, but not like this.

This brings us to the pessimistic reason.  In addition to the value Skype offers to whichever company acquired it, there is also the loss of value to that company's competitors.  If an asset offers a significant competitive advantage and ends up in auction it can actually be rational to pay far more than it's worth.

Let's use a simple illustration.  A market is divided evenly between two major companies, each with 50%.  The companies are offered the chance to bid for a new technology that offers enough of a competitive advantage for the owner to capture 10% of the market from the other.  If 10% of the market is worth $5 billion (we'll keep it simple and not try to adjust for scale, costs of downsizing, etc.) where is bidding likely to end?

Not at $5 billion.  At that price the winner of the auction is break-even (they've paid $5 billion for $5 billion in value) but the loser is down $5 billion because they're losing market share.  They'd much rather pay $6 billion (losing a net $1 billion in value) but that's not high enough either -- the first company would rather pay $7 billion than lose the auction (losing $2 billion is better than losing $5 billion).  In fact, the rational point for bidding to end is at $10 billion -- twice the value the technology provides.

In situations like this, the ideal outcome for the potential bidders is for the auction not to start -- in this case for neither Microsoft or Google (or anyone else) to make a bid, with Skype left independent.   That may have seemed unsustainable to Microsoft, however.  If they concluded that Skype would eventually end up being acquired and that the dynamic we just discussed would mean the price would be too high, the next step is deciding how to minimize the damage.  This means buying Skype for less than it would go for in a full-out auction.

This brings us to the final reason -- the tactical one.  Let's assume for the moment that Skype is "really" worth more like $7 billion to Microsoft but that in order to keep it out of Google's hands they would be willing to pay up to $10 billion.  They know if they make a $6 billion or even $7 billion bid there's a real risk of a bidding war.  What else might they try?

My guess is when the dust settles we'll learn that Microsoft engaged in a "shut down move" to close off the auction before it started.  A simplified version of this would be, "We're offering $8.5 billion but you have an hour to decide.  If any of you leave this room or make a phone call the deal is off and we will not bid again."  The key is to take the possibility of a competitive auction off the table by saying Microsoft won't bid in an auction.

If this threat is credible then Skype's owners have to choose between $8.5 billion and trying to get more through negotiation rather than auction.  A bidding war might have raised more but negotiating with Google when Skype's BATNA is $4-5 billion through an IPO is almost certain to raise less.  Microsoft would still be paying a premium* but much less than might have been paid in an auction.

* To be clear, I have no basis for evaluating the "pure" value of Skype to Microsoft.  It could be that Skype is worth $10 billion or that Microsoft's management thinks it is.  The point I want to make is that even if Skype is worth less than $8.5 billion it might have been rational for Microsoft to pay what it did.

Tuesday, May 3, 2011

How aggressive should your opening offer be?

Suppose you're involved in a price negotiation as the seller and you've decided to make the first offer.  How high should it be?

Students of negotiation psychology will point to the power of anchoring and a fair amount of research that shows that aggressive opening offers tend to lead to better final agreements.  Clearly, however, there are limits -- if your offer is too aggressive you risk angering the other party or being seen as unserious.

I saw this first-hand when I was asked by a healthcare provider to negotiate reimbursement rates with their insurance partners.  They'd previously retained a different consultant whose negotiating strategy seemed to be, "Ask for the moon and then try to settle for the sky."  In an environment where many providers were being forced to accept lower reimbursement rates, she was asking for massive increases (over 50% in some cases).  When I took over I found that many of the insurance representatives were angry and confused, and were doubtful that we were negotiating in good faith or that we understood their reality.

On the other hand, too low an opening offer risks leaving money on the table.  If the ZOPA is from $100 to $200 and you (the seller) open with $180, you've given up 20% of the ZOPA before we even get started.

In their book Negotiation Genius, my HBS professors Max Bazerman and Deepak Malhotra propose a useful rule of thumb for targeting your opening offer.  Assuming you've done your homework and have a good idea of what their reservation value is, your opening offer should be slightly more aggressive than that.  In other words, if you think the highest price the buyer might pay is $200 you might open as the seller with $210.  An opening like this is likely to seem reasonable, albeit demanding, and your counterpart is then in the position of negotiating you down in order to get you into the ZOPA.

Bazerman and Malhotra offer another rule for your opening offer.  It should never be so high that you can't finish the sentence, "I think $X is fair, because..."  Providing a reason for your offer greatly reduces the risk that the other party will see it in a negative light and has the added benefit of combining your anchor with favorable framing.

Going back to our healthcare provider, I approached their insurance partners with rate increase proposals that were high but that came with a profitability analysis.  We showed that the provider (a non-profit) was losing money while the insurance companies were saving a great deal since for many of the procedures the alternative provider was a hospital -- which was much more expensive.

By showing that they were capturing the lion's share of the value created by the relationship we made our demands much more reasonable and our threat to walk away (i.e. to terminate the contract) much more credible.  We also focused the discussion on the benefit the insurance companies were receiving (rather than the general state of the healthcare market or the fact that other providers were seeing rate decreases).  As long as that was the topic it was impossible for the insurance companies to argue that a rate increase wasn't appropriate.

The end result was significant increases from all the major private insurers and a net result that far exceeded the organization's target.

This analysis assumes a reasonably high level of uncertainty about information.  The more the two parties know, the more cautious you should be about a really aggressive offer.  To take an extreme example, suppose the ZOPA is $100 to $200, both parties know it and know that the other knows it.  In that case, an offer of $210 by the seller isn't going to be well-received.  There's no "because" that justifies an offer you know full well the other party can't accept.

Another thing to consider is the relationship effect.  If you're buying a car from a stranger you may not care much whether they think you worked them over afterwards, but if you're negotiating with one of your firm's strategic partners or one of your top clients that's very different.  That doesn't mean you can't try to capture a large piece of the pie, but make sure you're considering value in the fullest sense, rather than just the cash on the table in this particular deal.

Finally, you need to think about the nature of the deal itself.  If it's a clean sale, then today's price may be all that matters.  If what you're negotiating is the division of rewards from a collaboration, that's a very different matter.  Smart negotiators sometimes meet a generous offer with a counter-offer that is more favorable to the other party because they realize that the first offer won't be sustainable over time.  (A simple example is an American university that asked a famous European scientists how much he'd require as salary if he became a professor.  His offer was significantly lower than the going rate for prominent professors so they countered with more than double what he'd asked for.  If they'd accepted his low rate he would soon have learned that he was underpaid and might have left even if they'd belatedly made up the difference.  By treating him well, they helped ensure a good relationship.)  Before you make your offer, ask yourself how you'd feel on the receiving end knowing what you know.  If it would offend you, it might offend the person you're making it to.