If negotiations are games of information, then surely information is a precious resource -- to be shared only with the expectation of getting something equally valuable in return? Not necessarily. Consider the results of an (informal) study with a Harvard MBA class. Students were paired off to play one of two roles in a complex negotiation (let's call them buyer and seller just to keep it simple). Each was provided with confidential information about how they valued a range of potential options and also what their reservation value was.
Half of the buyers were, unbeknownst to the sellers, given the seller's confidential information. Not only did they know exactly how much the sellers cared about each issue on the table, they also knew exactly what the seller's BATNA and reservation price was.
As the professor expected, the buyers in possession of confidential information did much better than the buyers without it -- but the sellers paired with those buyers also did better than the sellers whose secret information was actually secret!
The dominant factor, as it turned out, was not superior ability to claim value but to create it. The pairings where the buyers had perfect information were much more effective at identifying value-creating tradeoffs. The overall result was that even though the advantaged buyers had a clear edge in value capture they were dividing a much larger pie, so their counterparts did well by comparison.
I've seen this same effect in real-world negotiations. Opportunities to create value are easily missed because a reasonable (but false) assumption by one side isn't given voice and thus isn't corrected. Great negotiators know that failing to find and realize value-creation opportunities is no different than throwing money in the paper shredder.
Sharing information should be strategic. You should use it to build trust, to gain information in return and to help control the framing of the negotiation. But don't hoard it. In a healthy negotiation, sharing information can easily result in gains for both sides.
Wednesday, June 29, 2011
Sunday, June 26, 2011
Lessons from a Busted Auction
In 2003 the transit authority of the state of Massachusetts (the MTA) announced that it would sell, by sealed bid auction, a ninety-acre plot of land in Allston. The land had some significant "development issues" (being occupied at the time by CSX rail yards) but more importantly it bordered Harvard University on one end and Boston University on the other. Both schools had deep pockets, a long term need to expand, and a serious shortage of available real estate opportunities.
An article in the Boston Globe cited an internal MTA paper's estimate that Harvard would pay approximately $150 million for the land, a figure an insider to the school's decision team told me was "disturbingly accurate." Harvard had paid a similar price for a plot of land three years earlier that was much less encumbered but also only half the size.
Harvard did buy the land, but at half the expected price -- just $75 million. What happened?
Before looking at what went wrong, let's revisit one of the two key differences between a negotiation and an auction: price pressure on buyers. In a negotiation, that pressure comes from the seller, e.g. through an opening offer and statements about what prices are or aren't acceptable. For example, if the MTA were negotiating with Harvard directly it might have opened with a request for $200 million and perhaps had a reservation price of $120 million. Where the price ended up would depend on how the across-the-table discussions went.
In an auction the source of price pressure is from the same side of the table, i.e. rival bidders. The MTA didn't make an opening offer or hire a team of negotiators to push Harvard towards a higher price. Instead, it looked to Boston University to accomplish that goal on its behalf by being a rival bidder for the property.
The most obvious problem with this negotiation is that there were only two credible bidders. Moreover, the two bidders were far from equal. BU's endowment was less than one billion dollars; the Harvard University endowment was over twenty billion. BU was also somewhat less constrained in terms of growth; more small plots of land were available to it along its southern border. For these reasons it was clear that Harvard's ability and willingness to pay were both significantly higher than BU's.
The Harvard decision team created a sub-group assigned to put themselves into Boston University's position and try to determine what their rival might bid. That team came back with a best guess of $60 million, but with the caveat that the range of possible bids was huge -- from no bid at all to over $100 million.
Some people on the Harvard team still favored a large bid. One person told Harvard's president something along the lines of, "No one will remember who overpaid for this land but everyone will remember who secured the university's future growth for a century."
There was one more piece to the analysis. The Harvard team recognized that their chance to get the land didn't end with the auction. If they bid low and BU won the property they could then negotiate with BU to purchase some or all of the land. Thus, a low bid didn't mean "save money" or "lose the property" it most likely meant "save money" or "pay a full price to BU".
Harvard submitted a bid of $75 million and BU declined to bid. Quite likely the BU team concluded that they were unlikely to prevail and thus chose not to come in second. I suspect that Harvard wouldn't have bid much less than $75 million even if they knew BU wasn't going to bid as any further reduction in price would increase the political risk of the sale being blocked. (At it happens there were a number of statements of outrage at the low price and the Massachusetts rail authority threatened to seize some of the land through eminent domain.)
An effective auction can enable a seller to realize a better price than might be possible from negotiation, but a busted auction can be a disaster. Since the power of an auction comes from same-side-of-the-table pressure, a would-be seller should needs to ask whether the available bidders will provide that pressure. In this case, with just two bidders and a clear difference in need and resources between them, sufficient pressure didn't exist. Boston University didn't force Harvard University to bid anything like the value it placed on the property. A one-on-one negotiation between the MTA and Harvard would likely have resulted in a substantially higher price.
Another lesson to draw from this case is that Harvard didn't limit their thinking to the auction itself. By thinking through their options in the event that they lost the initial auction they realized that the risk of a low bid was lower than it might seem. Understanding your BATNA is just as important in an auction as in a negotiation.
An article in the Boston Globe cited an internal MTA paper's estimate that Harvard would pay approximately $150 million for the land, a figure an insider to the school's decision team told me was "disturbingly accurate." Harvard had paid a similar price for a plot of land three years earlier that was much less encumbered but also only half the size.
Harvard did buy the land, but at half the expected price -- just $75 million. What happened?
Before looking at what went wrong, let's revisit one of the two key differences between a negotiation and an auction: price pressure on buyers. In a negotiation, that pressure comes from the seller, e.g. through an opening offer and statements about what prices are or aren't acceptable. For example, if the MTA were negotiating with Harvard directly it might have opened with a request for $200 million and perhaps had a reservation price of $120 million. Where the price ended up would depend on how the across-the-table discussions went.
In an auction the source of price pressure is from the same side of the table, i.e. rival bidders. The MTA didn't make an opening offer or hire a team of negotiators to push Harvard towards a higher price. Instead, it looked to Boston University to accomplish that goal on its behalf by being a rival bidder for the property.
The most obvious problem with this negotiation is that there were only two credible bidders. Moreover, the two bidders were far from equal. BU's endowment was less than one billion dollars; the Harvard University endowment was over twenty billion. BU was also somewhat less constrained in terms of growth; more small plots of land were available to it along its southern border. For these reasons it was clear that Harvard's ability and willingness to pay were both significantly higher than BU's.
The Harvard decision team created a sub-group assigned to put themselves into Boston University's position and try to determine what their rival might bid. That team came back with a best guess of $60 million, but with the caveat that the range of possible bids was huge -- from no bid at all to over $100 million.
Some people on the Harvard team still favored a large bid. One person told Harvard's president something along the lines of, "No one will remember who overpaid for this land but everyone will remember who secured the university's future growth for a century."
There was one more piece to the analysis. The Harvard team recognized that their chance to get the land didn't end with the auction. If they bid low and BU won the property they could then negotiate with BU to purchase some or all of the land. Thus, a low bid didn't mean "save money" or "lose the property" it most likely meant "save money" or "pay a full price to BU".
Harvard submitted a bid of $75 million and BU declined to bid. Quite likely the BU team concluded that they were unlikely to prevail and thus chose not to come in second. I suspect that Harvard wouldn't have bid much less than $75 million even if they knew BU wasn't going to bid as any further reduction in price would increase the political risk of the sale being blocked. (At it happens there were a number of statements of outrage at the low price and the Massachusetts rail authority threatened to seize some of the land through eminent domain.)
An effective auction can enable a seller to realize a better price than might be possible from negotiation, but a busted auction can be a disaster. Since the power of an auction comes from same-side-of-the-table pressure, a would-be seller should needs to ask whether the available bidders will provide that pressure. In this case, with just two bidders and a clear difference in need and resources between them, sufficient pressure didn't exist. Boston University didn't force Harvard University to bid anything like the value it placed on the property. A one-on-one negotiation between the MTA and Harvard would likely have resulted in a substantially higher price.
Another lesson to draw from this case is that Harvard didn't limit their thinking to the auction itself. By thinking through their options in the event that they lost the initial auction they realized that the risk of a low bid was lower than it might seem. Understanding your BATNA is just as important in an auction as in a negotiation.
Thursday, June 23, 2011
Auction Lessons from Storage Wars
After yesterday's post about American Pickers
, I couldn't resist taking a look at another reality show, Storage Wars
. Where American Pickers is about negotiation, Storage Wars is about a very unusual type of auction. Just as American Pickers has a lot to teach us about negotiation, a look at why the Storage War auction works offers some useful insights to anyone thinking of holding or entering an auction.
A lot of people store extra belongings in rented storage spaces. If they don't pay their monthly fees the storage company is eventually allowed to take possession of the goods. They naturally want to sell the goods for as much as possible but they also want to sell quickly so they can rent out the units again.
The value of what's in the units can vary tremendously. One unit might have nothing but clothing and some old furniture while another could hold a valuable collection (in the handful of episodes my wife and I have watched we've seen coins, baseball cards, tens of thousands of dollars worth of newspapers reporting the death of Elvis and one buyer reflecting on the time he bought a comic book collection worth hundreds of thousands of dollars). Thus, a given unit could be worth anything from "less than it costs to haul it out and look through it" to six figures.
As a buyer of an item that could be worth almost anything from $0 to $100,000+ you'd naturally want to be able to invest some time in figuring out what the actual value was. And surely as the seller you'd want to give buyer's this opportunity so that when you have a unit worth $100,000 it doesn't go for a few hundred bucks.
But no. The rules of Storage War auctions are that potential bidders get just five minutes to look at a unit and they must do so from outside the unit. No boxes are opened, no clues are given -- the only opportunity the buyer's have to learn about the unit is a brief look from outside.
Moreover, this isn't a whacky auction created for TV drama. It's the way these auctions were done long before someone decided to film a subset of bidders and create a reality TV show. Is the industry in the hands of an insane person or is their logic to this counter-intuitive system?
The most obvious advantage of the Storage Wars auction system is that it's fast. Five minutes to look, about the same to bid, the winner puts a lock on the door and it's off to the next unit. This lets the storage company auction off all delinquent units in a single day, reducing not only their costs but the time commitment of the buyers.
That's not enough, though. As the show highlights, these companies regularly sell units for a tiny fraction of what they're worth. So why not spend the extra money and give the buyers time to come through the units?
When you're setting the rules for an auction (or any kind of deal where you're the process setter), it's important to think dynamically from the perspective of the process takers. Let's think forward to what an auction might look like with better information and then consider how a rational buyer might react.
Better information seems great from a buyer's perspective...but not if everyone has access to it. In one episode, a nearly-empty unit held a vintage mannequin with a phone built into it. To me, and to most of the bidders, it wasn't anything special but one person knew it was valuable. He bought the unit for $250 and sold the mannequin to a dealer for $2,000. If there was plenty of time, the other bidders could have taken a picture and emailed it to an appraiser.
An auction with full information thus offers a much lower opportunity for profit for expert buyers, who are the ones that will reliably come out to bid on units. The restriction on information is actually a benefit to core buyers and helps to maintain a strong base of buyers. What seems like a cost-saving tool for the seller is actually a conscious transfer of some value to buyers to maximize the likelihood that the auctions will be successful.
Having a strong base of buyers is critical to the sellers due to the nature of auctions. In a negotiation the price pressure comes from the opposite side of the table -- i.e. the buyer tries to push the seller's price down and the seller pushes the buyer's price up. In an auction the pressure on buyers comes from the same side of the table -- if it's worth $250 to you and $240 to me, my desire to push it will force you to pay $240 for it.
If you have a small number of bidders (and what counts as small depends on the circumstances), you lose that pressure and suddenly prices can be quite low. At best you'll have sales where only one player puts a high value on an item; at worst you'll see collusion (explicit or implicit) between the buyers. A "busted" auction can be disastrous.
A few lessons to take away for anyone thinking of holding an auction or an auction-like sale:
, I couldn't resist taking a look at another reality show, Storage Wars. Where American Pickers is about negotiation, Storage Wars is about a very unusual type of auction. Just as American Pickers has a lot to teach us about negotiation, a look at why the Storage War auction works offers some useful insights to anyone thinking of holding or entering an auction.A lot of people store extra belongings in rented storage spaces. If they don't pay their monthly fees the storage company is eventually allowed to take possession of the goods. They naturally want to sell the goods for as much as possible but they also want to sell quickly so they can rent out the units again.
The value of what's in the units can vary tremendously. One unit might have nothing but clothing and some old furniture while another could hold a valuable collection (in the handful of episodes my wife and I have watched we've seen coins, baseball cards, tens of thousands of dollars worth of newspapers reporting the death of Elvis and one buyer reflecting on the time he bought a comic book collection worth hundreds of thousands of dollars). Thus, a given unit could be worth anything from "less than it costs to haul it out and look through it" to six figures.
As a buyer of an item that could be worth almost anything from $0 to $100,000+ you'd naturally want to be able to invest some time in figuring out what the actual value was. And surely as the seller you'd want to give buyer's this opportunity so that when you have a unit worth $100,000 it doesn't go for a few hundred bucks.
But no. The rules of Storage War auctions are that potential bidders get just five minutes to look at a unit and they must do so from outside the unit. No boxes are opened, no clues are given -- the only opportunity the buyer's have to learn about the unit is a brief look from outside.
Moreover, this isn't a whacky auction created for TV drama. It's the way these auctions were done long before someone decided to film a subset of bidders and create a reality TV show. Is the industry in the hands of an insane person or is their logic to this counter-intuitive system?
The most obvious advantage of the Storage Wars auction system is that it's fast. Five minutes to look, about the same to bid, the winner puts a lock on the door and it's off to the next unit. This lets the storage company auction off all delinquent units in a single day, reducing not only their costs but the time commitment of the buyers.
That's not enough, though. As the show highlights, these companies regularly sell units for a tiny fraction of what they're worth. So why not spend the extra money and give the buyers time to come through the units?
When you're setting the rules for an auction (or any kind of deal where you're the process setter), it's important to think dynamically from the perspective of the process takers. Let's think forward to what an auction might look like with better information and then consider how a rational buyer might react.
Better information seems great from a buyer's perspective...but not if everyone has access to it. In one episode, a nearly-empty unit held a vintage mannequin with a phone built into it. To me, and to most of the bidders, it wasn't anything special but one person knew it was valuable. He bought the unit for $250 and sold the mannequin to a dealer for $2,000. If there was plenty of time, the other bidders could have taken a picture and emailed it to an appraiser.
An auction with full information thus offers a much lower opportunity for profit for expert buyers, who are the ones that will reliably come out to bid on units. The restriction on information is actually a benefit to core buyers and helps to maintain a strong base of buyers. What seems like a cost-saving tool for the seller is actually a conscious transfer of some value to buyers to maximize the likelihood that the auctions will be successful.
Having a strong base of buyers is critical to the sellers due to the nature of auctions. In a negotiation the price pressure comes from the opposite side of the table -- i.e. the buyer tries to push the seller's price down and the seller pushes the buyer's price up. In an auction the pressure on buyers comes from the same side of the table -- if it's worth $250 to you and $240 to me, my desire to push it will force you to pay $240 for it.
If you have a small number of bidders (and what counts as small depends on the circumstances), you lose that pressure and suddenly prices can be quite low. At best you'll have sales where only one player puts a high value on an item; at worst you'll see collusion (explicit or implicit) between the buyers. A "busted" auction can be disastrous.
A few lessons to take away for anyone thinking of holding an auction or an auction-like sale:
- Think about your process choice from the perspective of would-be buyers. There are a lot of choices with auction structure, but don't just think about how a given structure suits your needs. Is it sufficiently attractive to the bidders you most want?
- Have you got the right bidders? Thinking back to the mannequin example, the sellers lost several hundred dollars in value because only one bidder knew what it was worth. That's going to be unavoidable in a storage unit auction, but the success of an auction depends on having bidders who place a high valuation on what's being sold.
There's also good lessons for anyone thinking about participating in an auction: ask yourself, "What is my edge?" The successful bidders in Storage Wars have two important advantages over a random person. First, each has considerable experience -- meaning they can more accurately estimate the value of a unit. Second, each has established sales channels for what they get. Two run thrift stores (and buy specifically for what they can sell in their stores) and the other two have networks of collectors they work with. This means they can price units more accurately and that a given unit will be more valuable to them than to an average bidder. If you don't have an edge, you're set to lose money.
(In this post I've assumed that auctions are one seller (the process giver) and multiple buyers (the process takers). In practice, some auctions involve multiple sellers (e.g. if a procurement department holds an auction to supply a company with a good or service) and many deals are neither pure negotiation nor pure auction but rather negotiauctions (to borrow a phrase from one of my professors). We'll talk more about those in coming days.)
Tuesday, June 21, 2011
Negotiation Lessons from American Pickers
One of my guilty pleasures is American Pickers, a show where two guys (Mike Wolf and Frank Fritz) drive around the country "picking" through people's barns and basements for junk that is actually valuable. It's arguably "just another reality show" and is sometimes over-scripted, but it's a lot of fun. Mike, Frank and Danielle Colby (their gal Friday) are an engaging team, the people they encounter are by turns eccentric and charming and you get to play along in the hunt without long hours on the road or climbing through junk-filled barns in ninety degree heat.
Of course, what I really like about it is that it's a show about negotiation.
The core of each episode is Mike and Frank buying things they hope to sell later at a profit. Oil cans, old advertising signs, saddles, samurai swords, pinball machines, vintage clothing, furniture, bicycles, cars...as the opening credits say, they'll buy "anything we think we can make a buck on." I don't think either guy is a big theory geek but unsurprisingly they are good at negotiating and a lot of good rules for negotiators are illustrated by the show. I'm going to break these down into three categories: setup & preparation, process and tactics.
Setup and Preparation
One of the biggest mistakes many people make is assuming that negotiation is what you do when you're at the table. Most negotiations are won (or lost) before the parties even sit down; a successful negotiator always seeks to prepare and to create an advantageous setup. Let's look at what Mike and Frank have as a result of their setup and preparation:
Process
Process, or how you go about a negotiation, is another key to success. Process is often the key determinant of how happy your counterparts are as well as how able you are to turn your preparation and tactics into successful outcomes.
Tactics
Not all of these tools are appropriate to every negotiation, of course. The main point is that Frank and Mike have a set of tools that work very effectively for them. They create an advantageous context for their negotiations, follow a very healthy process and have a set of useful tactics to close deals at a good price and with both parties satisfied.
More on Bundling
I think Frank's bundling tactic is a special case solution to an emotional block. Let's look back at our example, where Mike is at $200 on an item and the seller is firm at $250. There is another item that the seller has asked $75 for. It's possible that Mike could bargain the second item down to $50, but by no means guaranteed. The seller might easily insist on $60. Somehow, however, Mike is able to get both items for $250 by combining them. What is happening?
People don't like to lose in negotiations and they particularly don't like to be pushed around. If someone makes an opening offer of $300 it can be emotionally difficult to come down to $200 even if their BATNA is $180. They may be afraid of being a sucker (e.g. if the buyer's BATNA is really $320) or they may be embarrassed about asking for $300 if they were actually willing to sell for $200. It may be as simple as seeing their final offer of $250 as winning and anything else as losing...even as they think, "I'd really hate to lose this sale."
By bundling, Frank gives them an out. They're getting their price (I think he always has the bundle come out at or slightly above the price they wanted for the larger item) in exchange for throwing in a little extra. That feels like a shared win, even if from the numbers alone Frank is getting his price.
This general idea has lots of applications. If the seller of an asset needs to get a particular price it may be better to let them have their price but get financing terms that reduce the net present value to what you're willing to pay. If a company has strict rules about salary it may be better to negotiate for other items of value, such as a bonus, budget for training or an extra week of vacation. The key point is that if the other party has locked in to a particular "headline" number you may be able to sell them victory on that number in exchange for things you value more.
, a show where two guys (Mike Wolf and Frank Fritz) drive around the country "picking" through people's barns and basements for junk that is actually valuable. It's arguably "just another reality show" and is sometimes over-scripted, but it's a lot of fun. Mike, Frank and Danielle Colby (their gal Friday) are an engaging team, the people they encounter are by turns eccentric and charming and you get to play along in the hunt without long hours on the road or climbing through junk-filled barns in ninety degree heat.Of course, what I really like about it is that it's a show about negotiation.
The core of each episode is Mike and Frank buying things they hope to sell later at a profit. Oil cans, old advertising signs, saddles, samurai swords, pinball machines, vintage clothing, furniture, bicycles, cars...as the opening credits say, they'll buy "anything we think we can make a buck on." I don't think either guy is a big theory geek but unsurprisingly they are good at negotiating and a lot of good rules for negotiators are illustrated by the show. I'm going to break these down into three categories: setup & preparation, process and tactics.
Setup and Preparation
One of the biggest mistakes many people make is assuming that negotiation is what you do when you're at the table. Most negotiations are won (or lost) before the parties even sit down; a successful negotiator always seeks to prepare and to create an advantageous setup. Let's look at what Mike and Frank have as a result of their setup and preparation:
- No competition. Getting a good price is often a lot harder in an auction than in a negotiation. By coming to people's houses and driving off when the pick is over, Mike and Frank avoid facing a seller who says, "Thanks for pointing out all the things I have that may be worth something. I'll get them appraised (or send photos of them to other potential buyers) and get back to you."
- Superior knowledge. The pickers have impressive knowledge about a wide range of items, including their history and, most importantly, their market value. This means that they typically know what they're willing to pay, which enables them to make more effective offers and to close deals quickly.
- Strategic buyer advantage. It's quite common for the pickers to know exactly who they're going to sell an item to, or at least to have a rolodex of potential buyers. If someone is willing to sell an old sign for $200 there's a big difference between knowing you can sell it for $400 that day and being pretty sure you can sell it for over $250 eventually.
- Knowing the seller. When Danielle phones in a tip, Mike and Frank want to know everything about the seller, not just what he or she has. Why are they selling? How did they build their collection?
Process
Process, or how you go about a negotiation, is another key to success. Process is often the key determinant of how happy your counterparts are as well as how able you are to turn your preparation and tactics into successful outcomes.
- Positive relationship. First contact is often from Danielle, who is as charming as she is quirky. Mike and Frank then take the time to get to know the people they're buying from and demonstrate a clear interest in and appreciation for their story. "Two guys in a van want to buy stuff so they can sell it for a profit" could so easily turn into an adversarial battle; Mike and Frank turn it into a fun experience that everyone feels good about. After a pick, the sellers share their experience and it is almost always positive. Moreover, avid collectors often express satisfaction that Mike and Frank will find a new home for their prized items with someone who will enjoy it as much as they have. That's not the sort of thing people usually say about middle-men!
- Questions. The guys ask a ton of questions -- about the sellers, about the items they're looking at, etc. This strengthens the rapport, helps them conform or correct their expectations and helps identify good items to buy.
- Action. The guys don't get bogged down on any item. They see something, negotiate a purchase (or fail to) and move on. Sometimes they come back, but they don't spend more than a few minutes negotiating on most items. In particular, they don't haggle over every offer -- about half the time they accept the price the seller asks and their own opening offers are high enough that sellers often accept them. They also prioritize "breaking the ice" early by buying something. This keeps the tone of the pick transactional; the assumption is that new items will be purchased (rather than held on to by the seller for sentimental reasons) and that deals will be struck quickly.
Tactics
- Mix of first offers. Mike and Frank vary whether they make an opening offer or ask the seller for one. There's a lot of research and a variety of opinions on whether to make the first offer or wait for one, but (recognizing that I can't read minds even in person, let alone over the TV) I think Mike and Frank are following some good principles. They are most likely to ask for a price when the item's value is unclear (especially if it's unclear to the seller!) and more likely to offer one when they suspect that the seller's initial offer will be high.
- Ready counter-offer. When a seller does make an initial offer, the guys will either accept it or make a counter-offer pretty quickly.
- Reasonable offers. The guys rarely fish with offers that are way below their willingness to pay. If they offer $40 on something it's likely that their walkaway isn't North of $60 and sometimes it's $45. Sometimes an aggressive opening offer is correct, but in the context of a pick it could be costly. Suppose the owner happens to know that they'd offered $40 on something with a retail value of $500. Not only would they not get that item (which they might have gotten at a wholesale price if they'd offered) but the seller might call off the rest of the pick.
- Bundling. Frank, in particular, loves to bundle -- that is, to make an offer for more than one item at a time. He does this quite often when he and the seller aren't able to come together on price, and it's amazingly effective. A typical example might have him willing to pay at most $200 for an item where the seller is firm at $250. Mike then takes another item that the seller has asked $75 for and offers $250 for both -- and the seller frequently agrees! We'll talk more about this later.
- Cash on hand. A lot of the sellers on American Pickers aren't highly motivated to sell, and the guys rarely know whether a pick is going to be full of $40 purchases or have a $7,000 car. Mike and Frank make sure they have plenty of cash with them, both so they can present an unsure seller with a real offer and so they don't miss out on opportunities due to lack of resources.
Not all of these tools are appropriate to every negotiation, of course. The main point is that Frank and Mike have a set of tools that work very effectively for them. They create an advantageous context for their negotiations, follow a very healthy process and have a set of useful tactics to close deals at a good price and with both parties satisfied.
More on Bundling
I think Frank's bundling tactic is a special case solution to an emotional block. Let's look back at our example, where Mike is at $200 on an item and the seller is firm at $250. There is another item that the seller has asked $75 for. It's possible that Mike could bargain the second item down to $50, but by no means guaranteed. The seller might easily insist on $60. Somehow, however, Mike is able to get both items for $250 by combining them. What is happening?
People don't like to lose in negotiations and they particularly don't like to be pushed around. If someone makes an opening offer of $300 it can be emotionally difficult to come down to $200 even if their BATNA is $180. They may be afraid of being a sucker (e.g. if the buyer's BATNA is really $320) or they may be embarrassed about asking for $300 if they were actually willing to sell for $200. It may be as simple as seeing their final offer of $250 as winning and anything else as losing...even as they think, "I'd really hate to lose this sale."
By bundling, Frank gives them an out. They're getting their price (I think he always has the bundle come out at or slightly above the price they wanted for the larger item) in exchange for throwing in a little extra. That feels like a shared win, even if from the numbers alone Frank is getting his price.
This general idea has lots of applications. If the seller of an asset needs to get a particular price it may be better to let them have their price but get financing terms that reduce the net present value to what you're willing to pay. If a company has strict rules about salary it may be better to negotiate for other items of value, such as a bonus, budget for training or an extra week of vacation. The key point is that if the other party has locked in to a particular "headline" number you may be able to sell them victory on that number in exchange for things you value more.
Thursday, June 16, 2011
A "Hidden" Source of Value Creation, Part 2
In my last post we challenged the theoretical assumption that single-issue negotiations necessarily involve a fixed pie, such that the negotiator's only task is to claim as much value as possible. After looking at examples of price negotiations where a highly "successful" value claim led to disaster and giving away more than was necessary led to a great result we reached the conclusion that in many negotiations the value we receive depends on how the other party views the resulting deal.
Ultimately this is because relationships are much broader than contracts or agreements. People who are happy with an arrangement and who believe they have been treated honestly and fairly will generally outperform in their promised duties than people who are indifferent or unhappy or who believe they were treated poorly.
Today I want to look at the practical side of this. How do we negotiate so as to benefit from satisfied counterparts without overpaying?
Step one: Evaluate the importance of their satisfaction
We already discussed a simple asset sale with no follow-up business, such as a typical house purchase. In those cases you're pretty close to zero-sum, although even then there are reputation considerations. Act ethically and within the law, but otherwise you want to pay as little (or sell for as much) as possible.
At the other extreme are negotiations with family and coworkers where your relationship is more important than any single issue you're likely to negotiate. Someone once wrote that if you ever win an argument with your spouse you should apologize immediately; this is not a relationship where you want to defeat the other person (unless you're both game players). Not only do you want a healthy relationship for very pragmatic reasons but you also (hopefully!) care a great deal about their happiness for its own sake.
Most negotiations fall somewhere on the continuum between these extremes and you can get a pretty good sense of where a particular one lies by asking yourself some questions, like:
Ultimately this is because relationships are much broader than contracts or agreements. People who are happy with an arrangement and who believe they have been treated honestly and fairly will generally outperform in their promised duties than people who are indifferent or unhappy or who believe they were treated poorly.
Today I want to look at the practical side of this. How do we negotiate so as to benefit from satisfied counterparts without overpaying?
Step one: Evaluate the importance of their satisfaction
We already discussed a simple asset sale with no follow-up business, such as a typical house purchase. In those cases you're pretty close to zero-sum, although even then there are reputation considerations. Act ethically and within the law, but otherwise you want to pay as little (or sell for as much) as possible.
At the other extreme are negotiations with family and coworkers where your relationship is more important than any single issue you're likely to negotiate. Someone once wrote that if you ever win an argument with your spouse you should apologize immediately; this is not a relationship where you want to defeat the other person (unless you're both game players). Not only do you want a healthy relationship for very pragmatic reasons but you also (hopefully!) care a great deal about their happiness for its own sake.
Most negotiations fall somewhere on the continuum between these extremes and you can get a pretty good sense of where a particular one lies by asking yourself some questions, like:
- How might the other party behave differently in the future if they are happy or unhappy about this deal and/or our relationship?
- Do I expect to do business with them again? If so, how will this deal affect prospects for future collaboration?
- Is the other party likely to be an important source of word-of-mouth? How is my reputation going to be affected by their perception of our negotiation?
- How important are all these factors? Remember the example of my lead creative agency for a EUR60 million marketing budget. With all the constraints we faced, shaving $100K off their fee wasn't nearly as important as being one of their favorite clients. A similar improvement in the speed and reliability of office supply delivery might not be nearly so valuable.
Once you have an idea of the benefits of happy counterparts you're ready to plan your negotiation accordingly.
Step two: Plan to make them happy
Just as you plan and prepare carefully for other aspects of a negotiation, you should think about what is likely to make your counterparts happy with the deal -- both at closing and over the course of the relationship.
It's tempting to see this in terms of simple generosity, i.e. letting them have a larger piece of the pie than you could get away with, but this is at best an oversimplification and in some cases counterproductive.
First of all, process is often at least as important as outcomes. If you listen carefully, take the other party's interests into account, treat them honestly and work collaboratively towards value creation (all things you should do even if you didn't care about their satisfaction!) you're a long way towards them feeling good.
It's also not always the case that more money leads to more satisfaction. Consider a negotiation in which you're selling a business you helped found to a larger company in your industry. Your reservation price is $3.5 million and based on your research you estimate their reservation price as $5 million. Having read this blog post you decide to keep the whole ZOPA in play with an opening offer of $5.2 million.
The negotiators for the buyers blanch and explain that that's really too high a price. They counter with $4.1 million and you're glad to see that they're already above your reservation price. After some more discussion you shake hands on a price of $4.6 million. You've gained $1.1 million in value and you suspect that you've captured more than half of the value in the ZOPA. You're feeling good.
Now imagine that instead they did a double-take at your opening offer and said, "Five point two million? Done!" Then, beaming, they stand up to shake hands and say they'll have the contract delivered to you in the morning.
You're better off in scenario two, but most of us are likely to feel better in scenario one because clearly in scenario two we sold for less than we had to. By the same token, you can often negotiate hard and claim most of the value and shake hands with a satisfied counterpart.
An anecdote from my recent HBS negotiations class illustrates this point well...as well as two important pitfalls. Our first negotiation simulation involved a book deal, with one person playing the role of the author's agent and the other a senior editor of an interested publisher. In studying the case I correctly guessed that the initial interest the author had received from other publishers had fallen away and that the author's agent was in a weak position. Most likely he only had to secure a large enough advance to make his client feel the project was worthwhile. Thus, even though we were very eager to get the book deal and I was authorized to make an advance of up to $350,000 I opened with a very aggressive offer of $37,000, just over 10% of what I was actually willing to pay. The agent countered with an offer of $100,000 and we ended up settling on an advance of $75,000 which was $25,000 above his reservation price and $275,000 below mine.
As class resumed, Prof. Bazerman asked for a show of hands as to who felt they got a good deal? Nearly every hand went up, including my counterpart's. I'd captured almost all of the value on the table but from his perspective things had gone quite well. He'd fought off an unacceptable opening offer and secured 50% more than what his client was willing to accept.
And now the pitfalls. Once the results went up and it became clear not only that I'd been willing to pay almost ten times my opening offer but that most other pairs had settled on a price closer to $300K, my counterpart naturally felt less good about the result. Had ours been an real-world negotiation that might easily have translated into bad blood. (Whether the cost of that would have outweighed the money saved is a business judgment you'll have to make in each case.)
Your counterpart may not know your reservation price during the negotiation, but it's important to ask what information he or she is likely to gain later. In the 1930s, the Institute for Advanced Studies recruited Albert Einstein to come work with them in Princeton, NJ. When asked how much salary he would require, Einstein answered $3,000 "unless you think I can get by with less." The IAS "countered" with an offer of $15,000.
This wasn't necessarily generosity on the part of the IAS! They simply recognized that Einstein had no knowledge of the salary he and his peers commanded in that context but that he would certainly learn it over time. Better to start him off with an appropriate salary and build trust in the relationship than to save a few thousand dollars and erode that trust or lose the relationship altogether.
Pitfall number two could have come into play if I'd badly underestimated his reservation price. What if his client had told him only to make a deal at $250,000? That would imply a ZOPA of $250K to $350K and $100,000 of value to be had...but it would be a lot harder to reach a deal in that ZOPA without my counterpart concluding that I'd blatantly lowballed him.
What counts as a successful deal varies tremendously based on the nature of the negotiation. If you're negotiation a service contract from a vendor with essentially one offering it may be enough to be slightly more profitable than their normal contract. If you're negotiating with your spouse it may be that the only thing that ultimately matters is listening well and showing care and respect. As with so many other aspects of negotiation, put yourselves in their position and think about what would make you happy.
Step three: Explore and ask
You've done your homework and you've identified a good path to your counterpart's satisfaction. Just as you ask questions to test other assumptions you should test this one as well. Ask them to tell you, without giving away specifics, what metrics they use to evaluate the success of a deal? Not only will this help you ensure that they're happy with the end result, it can be a useful part of learning their priorities for more traditional value-creating tradeoffs.
Finally, in cases where you're explicitly looking to give your counterpart a larger-than-necessary share of the pie because of the value you expect to get back as a result it can be worth saying so. After settling on price with the partner at Mother, I had a quiet conversation with him about the upcoming year's work. I explained that I was glad he was happy with the price we'd agreed and that I'd set out to make sure our contract offered his agency a good margin, but that in return I was counting on them delivering things that a contract couldn't cover -- the sorts of intangibles that a "best client" gets. Too few people are as straightforward in their dealings (especially when they are doing something unusual, like looking out for their counterpart's interests as an end in and of itself), and I find it's rewarding far more often than not.
Wednesday, June 15, 2011
A "Hidden" Source of Value Creation
In this post we looked at one of the core methods of value creation in negotiation: trading off multiple issues, sometimes called logrolling. By identifying the relative value each party assigns to the various components of the negotiation, good negotiators can "sell" the things they value less than their counterparts for improvements in price, to "purchase" concessions they value more than their counterparts or both.
Reading books on negotiation could easily lead you to conclude that multiple issues are not merely helpful for value creation but essential to it -- that a single-issue negotiation (e.g. price) is purely distributive, or win-lose. Whatever you gain must come at the expense of the other party(ies).
Many analyses take it as given that if only one issue is being negotiated there is no real scope for value creation (and thus negotiators are urged to find creative ways to add issues or to meet the other's needs).
Consider the following:
Or, from a more technical book:
But is this really correct? If you're negotiating a single issue, like price, is the pie really fixed such that your only consideration is how to get the biggest piece for yourself? Often the answer is no.
If you're negotiating a simple asset sale (or purchase) you may not care whether your counterpart got a good deal. Your ideal (having maximized the size of the pie, of course) would be to capture nearly all of the value, leaving the other party with something only slightly better than his or her BATNA. If, however, you have any sort of ongoing relationship that may be far from ideal. In those cases, your value from a deal is partially contingent on the value received by the other parties.
In Negotiation Genius, Malhotra and Bazerman give the example of "Sharon and Mark," a couple that wanted to build their dream house. Having taken a negotiations course they held an auction for the project, with eight different contractors bidding. The winning contractor was 10% below the runner-up and Sharon and Mark suspected that he was probably desperate for business. They pushed for a further price cut and got a further 3% reduction. From a price perspective they had done a fantastic job.
You can probably guess what came next. Having been pushed hard, the contractor saw the relationship as adversarial and once the project was underway he had no interest in working with them as partners. Change orders received very high prices and when the project fell behind schedule the contractor simply blamed subcontractor problems, which the couple discovered their contract didn't cover.
When the project was complete, the problems didn't end. The couple found several major problems with the work and chasing the contractor to repair things was anything but easy. In one angry exchange he said, "I know I'm obligated to fix the cracks in the drywall, but I'm not obligated to do it at your convenience."
It could be that this contractor would always be difficult to work with -- that his strategy was to bid low and then hit hard on changes. (It's unsurprising that contractors often give way on price before they have the project but not once they do, since there is a massive shift in the parties' respective BATNAs once work has begun.) It could be that he regularly saves money by doing second-rate work and then delays fixing it. But it's also likely that his willingness to work together with Sharon and Mark was destroyed by them when they set out to capture every dollar of value in the deal.
Several years ago I ran the Product Marketing department for a start-up within Siemens Mobile. With a marketing budget of EUR60 million ($86 million), one of my key partnerships was the advertising agency that would be our overall creative lead. We visited leading agencies throughout Europe and invited two finalists to give a pitch presentation. One of them, Mother, was the clear winner -- so much so that halfway through their presentation our CEO leaned over and joked, "Don't tell them they've won yet."
The negotiation (held before Mother knew they'd won) must have been a nightmare for the Siemens purchasing rep who thought that the only thing that mattered was price. She wanted to squeeze them as hard as possible and if they said no we could always use the other agency. When I explained to her that I wanted the contract to give them a good margin she seemed to think I was either insane or bad at math. At one point she reminded me that their fee was coming out of my budget so every dollar we saved was another dollar I could spend elsewhere.
In the end, Mother got a price they were happy with...and I got an agency that consistently did whatever they could to exceed my expectations, both because we were a profitable client and because we'd established a relationship of partners rather than merely vendor-client. Even without any unforeseen events this would likely have been worth more than the Euros we might have squeezed out of them, but how many relationships don't encounter unforeseen events? (As it happened there was a significant unforeseen event almost immediately that could easily have cost a lot of time and money but which was instead solved with a couple of phone calls and at no financial cost.)
So here we have two real-world examples of price negotiations. In one case the buyers squeezed hard and claimed nearly all of the value, with terrible results. In the other the buyer negotiated with the goal of making the deal profitable to the seller, with good results. What's going on?
I think the theorists are falling into two common traps -- one they know a lot about and one that academics in general are often vulnerable to. The first trap is the fixed-pie bias -- a common human tendency to think that a given negotiation is over a limited amount of value and to underestimate the potential to increase (or, sadly, reduce) the amount being divided. Like many biases, knowing about it doesn't necessarily free one from it.
The second trap is the beauty of math. Theorists (myself included) tend to love math and in particular the power and beauty of a mathematical model that illuminates important real-world concepts. A single-issue negotiation is so elegantly represented by a ZOPA created by two BATNAs, as is value creation by trading off differently-valued issues. A model can be extremely useful but we have to remember that it's just a model, and its underlying assumptions may not be correct in the real world.
In the real world, what you buy is often not fixed. Two "identical" service contracts aren't identical if one client is top priority while the other one's requests are put off as long as the contract allows. Two "identical" purchases aren't identical if the seller makes a note to tell one buyer (but not the other) the next time he has something interesting to sell. Two "identical" employee hires aren't identical if one employee feels like a partner and the other is looking for the exit.
Most of us know this intuitively. We've been on both ends of agreements (business or personal) where the actual value delivered varied based on how the parties felt under the terms. The practical question, of course, is how to turn this intuitive knowledge into better negotiation work.
I'll try to provide an answer in my next post.
Reading books on negotiation could easily lead you to conclude that multiple issues are not merely helpful for value creation but essential to it -- that a single-issue negotiation (e.g. price) is purely distributive, or win-lose. Whatever you gain must come at the expense of the other party(ies).
Many analyses take it as given that if only one issue is being negotiated there is no real scope for value creation (and thus negotiators are urged to find creative ways to add issues or to meet the other's needs).
Consider the following:
Sometimes negotiation is about only one issue...such negotiations are typically zero-sum in nature: one party can gain only at the expense of the other (assuming they reach agreement). Such negotiations are said to have a "fixed pie" of value or resources: the only thing negotiators can do is slice up the pie and try to get a big piece of it.
- Malhotra and Bazerman, Negotiation Genius
Or, from a more technical book:
By distributive we mean negotiations...concerned with the division of a single good. ... Distributive negotiation is about getting a bigger piece for oneself.
- Howard Raiffa, Negotiation Analysis
But is this really correct? If you're negotiating a single issue, like price, is the pie really fixed such that your only consideration is how to get the biggest piece for yourself? Often the answer is no.
If you're negotiating a simple asset sale (or purchase) you may not care whether your counterpart got a good deal. Your ideal (having maximized the size of the pie, of course) would be to capture nearly all of the value, leaving the other party with something only slightly better than his or her BATNA. If, however, you have any sort of ongoing relationship that may be far from ideal. In those cases, your value from a deal is partially contingent on the value received by the other parties.
In Negotiation Genius, Malhotra and Bazerman give the example of "Sharon and Mark," a couple that wanted to build their dream house. Having taken a negotiations course they held an auction for the project, with eight different contractors bidding. The winning contractor was 10% below the runner-up and Sharon and Mark suspected that he was probably desperate for business. They pushed for a further price cut and got a further 3% reduction. From a price perspective they had done a fantastic job.
You can probably guess what came next. Having been pushed hard, the contractor saw the relationship as adversarial and once the project was underway he had no interest in working with them as partners. Change orders received very high prices and when the project fell behind schedule the contractor simply blamed subcontractor problems, which the couple discovered their contract didn't cover.
When the project was complete, the problems didn't end. The couple found several major problems with the work and chasing the contractor to repair things was anything but easy. In one angry exchange he said, "I know I'm obligated to fix the cracks in the drywall, but I'm not obligated to do it at your convenience."
It could be that this contractor would always be difficult to work with -- that his strategy was to bid low and then hit hard on changes. (It's unsurprising that contractors often give way on price before they have the project but not once they do, since there is a massive shift in the parties' respective BATNAs once work has begun.) It could be that he regularly saves money by doing second-rate work and then delays fixing it. But it's also likely that his willingness to work together with Sharon and Mark was destroyed by them when they set out to capture every dollar of value in the deal.
Several years ago I ran the Product Marketing department for a start-up within Siemens Mobile. With a marketing budget of EUR60 million ($86 million), one of my key partnerships was the advertising agency that would be our overall creative lead. We visited leading agencies throughout Europe and invited two finalists to give a pitch presentation. One of them, Mother, was the clear winner -- so much so that halfway through their presentation our CEO leaned over and joked, "Don't tell them they've won yet."
The negotiation (held before Mother knew they'd won) must have been a nightmare for the Siemens purchasing rep who thought that the only thing that mattered was price. She wanted to squeeze them as hard as possible and if they said no we could always use the other agency. When I explained to her that I wanted the contract to give them a good margin she seemed to think I was either insane or bad at math. At one point she reminded me that their fee was coming out of my budget so every dollar we saved was another dollar I could spend elsewhere.
In the end, Mother got a price they were happy with...and I got an agency that consistently did whatever they could to exceed my expectations, both because we were a profitable client and because we'd established a relationship of partners rather than merely vendor-client. Even without any unforeseen events this would likely have been worth more than the Euros we might have squeezed out of them, but how many relationships don't encounter unforeseen events? (As it happened there was a significant unforeseen event almost immediately that could easily have cost a lot of time and money but which was instead solved with a couple of phone calls and at no financial cost.)
So here we have two real-world examples of price negotiations. In one case the buyers squeezed hard and claimed nearly all of the value, with terrible results. In the other the buyer negotiated with the goal of making the deal profitable to the seller, with good results. What's going on?
I think the theorists are falling into two common traps -- one they know a lot about and one that academics in general are often vulnerable to. The first trap is the fixed-pie bias -- a common human tendency to think that a given negotiation is over a limited amount of value and to underestimate the potential to increase (or, sadly, reduce) the amount being divided. Like many biases, knowing about it doesn't necessarily free one from it.
The second trap is the beauty of math. Theorists (myself included) tend to love math and in particular the power and beauty of a mathematical model that illuminates important real-world concepts. A single-issue negotiation is so elegantly represented by a ZOPA created by two BATNAs, as is value creation by trading off differently-valued issues. A model can be extremely useful but we have to remember that it's just a model, and its underlying assumptions may not be correct in the real world.
In the real world, what you buy is often not fixed. Two "identical" service contracts aren't identical if one client is top priority while the other one's requests are put off as long as the contract allows. Two "identical" purchases aren't identical if the seller makes a note to tell one buyer (but not the other) the next time he has something interesting to sell. Two "identical" employee hires aren't identical if one employee feels like a partner and the other is looking for the exit.
Most of us know this intuitively. We've been on both ends of agreements (business or personal) where the actual value delivered varied based on how the parties felt under the terms. The practical question, of course, is how to turn this intuitive knowledge into better negotiation work.
I'll try to provide an answer in my next post.
Friday, June 3, 2011
Agree on the Decision Principles Early
My family just bought a puppy.
My daughters are both crazy about dogs, something they may have inherited from me. When Morgan, our youngest, was not quite two, my wife Trish ended the constant requests with a promise: we would get a dog when Morgan turned five. Both girls accepted this and have been talking about it regularly ever since.
With Morgan's fifth birthday approaching we had to get serious. Jade has a slight allergy and Trish's key interests were "not too big" and "no shedding". After some research we decided that a mix of poodle and cocker spaniel (known as a cockapoo) was our ideal dog and we identified a good breeder within driving distance. Trish and I went out to meet the breeder and then brought the girls to pick out their new puppy.
There were two dogs available when we went out. Within minutes it was clear to me that one of them was the right choice. He was energetic and affectionate and spent the whole visit going from person to person, getting attention, licking hands and then going to the next person.
It was also clear that we might have a problem on our hands.
The other puppy was very shy and quiet. He didn't seem to want much attention and didn't go to any of us. He was, however, born on March 11, which happens to be Jade's birthday. Jade had picked him up and was holding him in her lap and was quietly falling in love with him. I didn't think he was the right choice, but it looked like Jade might be heartbroken if we didn't pick him.
Then Jade gave a wistful smile and said, "I love this one. But I think that one loves our whole family. He's the one we should take home."
What happened?
For years we've been talking with the girls about getting a dog and we've told them over and over that the most important rule for getting a dog is to let the dog pick you. At bedtime I would tell the story of how I got my first puppy because out of the whole litter he was the one who walked right over to me. They both agreed on how we would pick out our dog long before we actually met any puppies.
As time got closer, Jade and Morgan began imagining their dog. Morgan has a brown stuffed dog that she sleeps with and announced that she wanted a brown dog. That worked for Jade, too. Sometimes they wanted a boy and sometimes a girl. Trish and I knew that the puppies we were going to see were both black males. We went back to our rule and we also had the girls list everything they wanted in a puppy. Once they had that list (which we made sure included "loves us" and "friendly and playful") we asked them which ones were really important. They quickly agreed that color, sex and whatever else was secondary. We would let the puppy pick us so that we got one who loves us and is friendly and playful.
Without that background I'm pretty sure Jade would have wanted the puppy who shared her birthday. I'm sure it would also have been a fine dog, but I'm very glad Jade was committed to the idea that the puppy chooses us; it got us a fantastic dog, and without any heartbreak, tantrums or fights between the sisters. (Morgan wanted the one we chose from the start.)
This story illustrates an important process step for negotiations. It is often much easier to reach consensus on details of a negotiation if the parties first agree on the principles that will be used to decide. The agreement should be as specific as possible; if, for example, you want to use a principle of fairness you should define what fairness means and get consensus. If you don't you may find yourself disagreeing over what's fair, with each party honestly believing in a definition of fairness that favors them.
In this blog post I discussed the problem of fairness and discussed a negotiation simulation I did at Harvard. Let's look at it in more detail here and see how important it was that we agreed on decision principles up front. In the case two subsidiaries of an industrial conglomerate (probably based on General Electric) had to negotiate how to share a new magnet technology. One subsidiary (mine, in the exercise) had developed the technology for its own use as a component in devices it manufactured. It owned the product and could manufacture it for its own use but by the rules of the company only the other subsidiary (that produced industrial magnets) was allowed to sell it. Since the market potential was much larger than the value of using it solely as a component, we needed to make a deal.
In addition to royalties (i.e. how much the magnet subsidiary would pay us) we had a huge range of options about exclusivity, both in terms of length and whether exclusivity was total, limited to other sister companies or limited to our product line. It was clear that finding the "right" exclusivity terms was key to maximizing the value of the deal -- as we discussed here the key goal is to create the biggest pile of money possible, rather than to "win" exclusivity terms that were more favorable to us but which cost the other side more than we gained.
This exercise came at a point in the course where trust among the participants was high and where we all shared an understanding of the importance of value maximization. As a result, both three-person teams in our simulation independently decided to suggest a "full disclosure" approach. By fully sharing the relative cost/benefit of each of the possible exclusivity terms we would identify the best possible deal and then split the value.
Before we got started, however, I wanted to make sure we agreed on what defined the value of the deal, i.e. what exactly we would be dividing.
Let's use the "pile of money on a table" analogy. Suppose that, by cooperating, you and another person are able to create a pile of $1,000 on a table to divide. Is it fair to divide it evenly so each of you takes home $500? What if the table started off with $300 of your money and $100 of the other person's money so that $600 was added? If you split the whole pile you gain $200 (the difference between $500 and $300) and the other person gains $400. If you split the money that was added you each gain $300 over where you started; you take $600 in total and the other person takes $400.
Before we began the analysis I said we thought that the value to be divided evenly should be the value created by the deal, rather than the total value of the deal. (In the table example this is the $600 rather than the full $1,000.) Thus, once we maximized the size of the pie we would subtract the value we each began the negotiation with (i.e. our BATNAs) to determine how much had been created. Then we would structure the deal so that we each improved on our BATNA by half of the value.
After some discussion, mostly to clarify that everyone understood, the other team agreed to that principle. With full disclosure of information we quickly figured out that the best deal was worth a total of $150 million. Our BATNA (the value of producing the magnet solely as a component) was $50 million. Their BATNA (do nothing, since we retained the product) was $0, so the value created by the deal was $100 million ($150 - $50 - $0). They paid us a royalty that brought our total value to $100 million and theirs to $50 million so each of us was $50 million better off than our BATNA. We all left happy.
Now let's imagine how things might have gone if we hadn't agreed on exactly what was being split. We'd have arrived at the $150 million total value and someone from the magnet subsidiary would have said, "OK, so now we just work out the royalty we pay you so that each of us gets $75 million in value." We reply that the deal only created $100 million in value so the correct split is $100 million to us and $50 million to them, since they came in with nothing and we came in with $50 million.
That discussion would be likely to produce two bad (for us) results: less money (unless we were very persuasive we would almost certainly have to meet in the middle) and frustration and lost trust on both sides. Instead we got full value out of the deal and everyone involved felt they'd gotten a good deal.
It's important to note that this isn't just about everyone leaving the table happy or reducing the risk that negotiations break down and a value-creating deal is lost. Taking the initiative on decision principles can be an important part of controlling how a negotiation is framed and thus capturing the most value possible. I do think that the method we chose is "correct" but it was also favorable to us compared to splitting the entire value of the deal.
When we returned to compare results it quickly became apparent that many groups had looked at how to divide the value far differently than we had. For some groups it seemed that "my" subsidiary had created $50 million and the other subsidiary was now creating $100 million more so they should get the larger share of the pie! Most groups in fact reached a deal that gave more than half of the total value to the magnet subsidiary; our team got the highest score for our subsidiary, averaging perhaps $30 million more than our counterparts.
Thus, what seemed like a small detail was arguably the cornerstone of a very successful negotiation. It streamlined agreement on the final details, avoided potentially costly and trust-eroding arguments and positioned us to capture far more value than we might otherwise have.
Obviously a real negotiation over $150 million would involve lawyers and contracts rather than a simple discussion and calculating and verifying deal values becomes very complex. The fundamental point, however, remains valid. It's much easier to reach agreement if all parties have a shared understanding of the decision principles when negotiations start...whether you're negotiating a business deal or picking out a puppy. And thinking about those principles ahead of time so you can shape them can be instrumental in getting the result you want.
My daughters are both crazy about dogs, something they may have inherited from me. When Morgan, our youngest, was not quite two, my wife Trish ended the constant requests with a promise: we would get a dog when Morgan turned five. Both girls accepted this and have been talking about it regularly ever since.
With Morgan's fifth birthday approaching we had to get serious. Jade has a slight allergy and Trish's key interests were "not too big" and "no shedding". After some research we decided that a mix of poodle and cocker spaniel (known as a cockapoo) was our ideal dog and we identified a good breeder within driving distance. Trish and I went out to meet the breeder and then brought the girls to pick out their new puppy.
There were two dogs available when we went out. Within minutes it was clear to me that one of them was the right choice. He was energetic and affectionate and spent the whole visit going from person to person, getting attention, licking hands and then going to the next person.
It was also clear that we might have a problem on our hands.
The other puppy was very shy and quiet. He didn't seem to want much attention and didn't go to any of us. He was, however, born on March 11, which happens to be Jade's birthday. Jade had picked him up and was holding him in her lap and was quietly falling in love with him. I didn't think he was the right choice, but it looked like Jade might be heartbroken if we didn't pick him.
Then Jade gave a wistful smile and said, "I love this one. But I think that one loves our whole family. He's the one we should take home."
What happened?
For years we've been talking with the girls about getting a dog and we've told them over and over that the most important rule for getting a dog is to let the dog pick you. At bedtime I would tell the story of how I got my first puppy because out of the whole litter he was the one who walked right over to me. They both agreed on how we would pick out our dog long before we actually met any puppies.
As time got closer, Jade and Morgan began imagining their dog. Morgan has a brown stuffed dog that she sleeps with and announced that she wanted a brown dog. That worked for Jade, too. Sometimes they wanted a boy and sometimes a girl. Trish and I knew that the puppies we were going to see were both black males. We went back to our rule and we also had the girls list everything they wanted in a puppy. Once they had that list (which we made sure included "loves us" and "friendly and playful") we asked them which ones were really important. They quickly agreed that color, sex and whatever else was secondary. We would let the puppy pick us so that we got one who loves us and is friendly and playful.
Without that background I'm pretty sure Jade would have wanted the puppy who shared her birthday. I'm sure it would also have been a fine dog, but I'm very glad Jade was committed to the idea that the puppy chooses us; it got us a fantastic dog, and without any heartbreak, tantrums or fights between the sisters. (Morgan wanted the one we chose from the start.)
This story illustrates an important process step for negotiations. It is often much easier to reach consensus on details of a negotiation if the parties first agree on the principles that will be used to decide. The agreement should be as specific as possible; if, for example, you want to use a principle of fairness you should define what fairness means and get consensus. If you don't you may find yourself disagreeing over what's fair, with each party honestly believing in a definition of fairness that favors them.
In this blog post I discussed the problem of fairness and discussed a negotiation simulation I did at Harvard. Let's look at it in more detail here and see how important it was that we agreed on decision principles up front. In the case two subsidiaries of an industrial conglomerate (probably based on General Electric) had to negotiate how to share a new magnet technology. One subsidiary (mine, in the exercise) had developed the technology for its own use as a component in devices it manufactured. It owned the product and could manufacture it for its own use but by the rules of the company only the other subsidiary (that produced industrial magnets) was allowed to sell it. Since the market potential was much larger than the value of using it solely as a component, we needed to make a deal.
In addition to royalties (i.e. how much the magnet subsidiary would pay us) we had a huge range of options about exclusivity, both in terms of length and whether exclusivity was total, limited to other sister companies or limited to our product line. It was clear that finding the "right" exclusivity terms was key to maximizing the value of the deal -- as we discussed here the key goal is to create the biggest pile of money possible, rather than to "win" exclusivity terms that were more favorable to us but which cost the other side more than we gained.
This exercise came at a point in the course where trust among the participants was high and where we all shared an understanding of the importance of value maximization. As a result, both three-person teams in our simulation independently decided to suggest a "full disclosure" approach. By fully sharing the relative cost/benefit of each of the possible exclusivity terms we would identify the best possible deal and then split the value.
Before we got started, however, I wanted to make sure we agreed on what defined the value of the deal, i.e. what exactly we would be dividing.
Let's use the "pile of money on a table" analogy. Suppose that, by cooperating, you and another person are able to create a pile of $1,000 on a table to divide. Is it fair to divide it evenly so each of you takes home $500? What if the table started off with $300 of your money and $100 of the other person's money so that $600 was added? If you split the whole pile you gain $200 (the difference between $500 and $300) and the other person gains $400. If you split the money that was added you each gain $300 over where you started; you take $600 in total and the other person takes $400.
Before we began the analysis I said we thought that the value to be divided evenly should be the value created by the deal, rather than the total value of the deal. (In the table example this is the $600 rather than the full $1,000.) Thus, once we maximized the size of the pie we would subtract the value we each began the negotiation with (i.e. our BATNAs) to determine how much had been created. Then we would structure the deal so that we each improved on our BATNA by half of the value.
After some discussion, mostly to clarify that everyone understood, the other team agreed to that principle. With full disclosure of information we quickly figured out that the best deal was worth a total of $150 million. Our BATNA (the value of producing the magnet solely as a component) was $50 million. Their BATNA (do nothing, since we retained the product) was $0, so the value created by the deal was $100 million ($150 - $50 - $0). They paid us a royalty that brought our total value to $100 million and theirs to $50 million so each of us was $50 million better off than our BATNA. We all left happy.
Now let's imagine how things might have gone if we hadn't agreed on exactly what was being split. We'd have arrived at the $150 million total value and someone from the magnet subsidiary would have said, "OK, so now we just work out the royalty we pay you so that each of us gets $75 million in value." We reply that the deal only created $100 million in value so the correct split is $100 million to us and $50 million to them, since they came in with nothing and we came in with $50 million.
That discussion would be likely to produce two bad (for us) results: less money (unless we were very persuasive we would almost certainly have to meet in the middle) and frustration and lost trust on both sides. Instead we got full value out of the deal and everyone involved felt they'd gotten a good deal.
It's important to note that this isn't just about everyone leaving the table happy or reducing the risk that negotiations break down and a value-creating deal is lost. Taking the initiative on decision principles can be an important part of controlling how a negotiation is framed and thus capturing the most value possible. I do think that the method we chose is "correct" but it was also favorable to us compared to splitting the entire value of the deal.
When we returned to compare results it quickly became apparent that many groups had looked at how to divide the value far differently than we had. For some groups it seemed that "my" subsidiary had created $50 million and the other subsidiary was now creating $100 million more so they should get the larger share of the pie! Most groups in fact reached a deal that gave more than half of the total value to the magnet subsidiary; our team got the highest score for our subsidiary, averaging perhaps $30 million more than our counterparts.
Thus, what seemed like a small detail was arguably the cornerstone of a very successful negotiation. It streamlined agreement on the final details, avoided potentially costly and trust-eroding arguments and positioned us to capture far more value than we might otherwise have.
Obviously a real negotiation over $150 million would involve lawyers and contracts rather than a simple discussion and calculating and verifying deal values becomes very complex. The fundamental point, however, remains valid. It's much easier to reach agreement if all parties have a shared understanding of the decision principles when negotiations start...whether you're negotiating a business deal or picking out a puppy. And thinking about those principles ahead of time so you can shape them can be instrumental in getting the result you want.
Wednesday, June 1, 2011
Why is the "Win-Win" approach so popular?
Scenario one:
You're entering a contract negotiation. It's a one-time deal and you don't even like the people you're negotiating with, so all you want is to get the most value you possibly can out of the contract, which currently is open with respect to price and some term provisions. In your preparations for the deal you've noted one provision in particular is worth $300,000 to your firm if you can get option A instead of B. Having done your homework you're pretty sure the other side wants option B and that it's worth $450,000 to them.
What does your perfect deal look like?
Scenario two:
You're meeting with a potential customer for your product. You don't like the buyer and for whatever reason know your firm will never do business with them again, so all you care about is maximizing your profit on the sale. The product in question costs you $300,000 to make and from your research you're pretty sure that it's worth about $450,000 to them.
If the meeting goes well, will you sell it to them?
Most people consider the question in scenario two to be a no-brainer. You obviously want to sell the product and the only question is how close to $450,000 you can set the price. A lot of those people will envision the perfect deal in scenario one as having option A (the one that is worth $350K to their firm). On a fundamental level, however, these are identical questions. In both cases you have something that is worth $300,000 to you and 50% more to someone else and the question is who, ideally, should own it at the end of your discussion. The difference is that in negotiations we think in terms of winning, which translates to getting our way and avoiding anything that imposes costs on us. Business, on the other hand, is all about selling things that cost us less than they're worth to someone else; no one thinks they got beaten because someone bought their product.
Let's assume you got a deal with option A. You and your counterparts are a combined $150,000 poorer than you should be. For any possible deal with option A, you can make deals with option B that make each party better off.
Let's say the total value of the deal to you (with option A) is $1 million better than your BATNA. Since you did such a good job and captured most of the value, the other side is only $400,000 better than their BATNA. Now let's change the deal so that you get $375,000 more but they "win" on the provision and get option B. Now the deal is worth $1,075,000 to you and $475,000 to them. You didn't lose on the clause -- you sold it to them for more than it cost you to give it up.
The Win-Win approach to negotiations is popular for the same reason that businesses like to sell things. If something is worth more to you than it is to me, you should end up with it. If it's mine, I should sell it to you. If it's yours, you should not sell it to me. If it's part of a negotiation, it should end up going your way. The key point is that you aren't giving it away; you're selling it for a gain. You're making a concession in exchange for another concession that is worth more to you than what you gave up.
Most negotiations are about more than just price. They include payment terms, guarantees, exclusivity periods, options to share upside, protection against downside, how disputes will be resolved, etc., etc. Many of these issues are quite important to one or more parties but they are rarely equally important. The win-win approach enables the parties to discover where things are valued differently and for the parties who value something the most to buy it from their counterparts. This increases the value of the deal, often resulting in greater gains than could be accomplished by value capture alone.
One of my professors put it like this. If you're negotiating with someone over how to divide a pile of money on a table would you rather that the table had one million dollars on it or ten million? Good negotiators want the amount of money on the table to be as big as possible. They certainly don't abandon value capture (and, indeed, there's no need to) but they know that it's a lot more fun to divide ten million dollars than one million.
We'll look at how to identify win-win opportunities and how not to sacrifice your value capture position in later posts...but for now, go back to scenario one. Are you excited about "losing" your preferred option? You should be.
You're entering a contract negotiation. It's a one-time deal and you don't even like the people you're negotiating with, so all you want is to get the most value you possibly can out of the contract, which currently is open with respect to price and some term provisions. In your preparations for the deal you've noted one provision in particular is worth $300,000 to your firm if you can get option A instead of B. Having done your homework you're pretty sure the other side wants option B and that it's worth $450,000 to them.
What does your perfect deal look like?
Scenario two:
You're meeting with a potential customer for your product. You don't like the buyer and for whatever reason know your firm will never do business with them again, so all you care about is maximizing your profit on the sale. The product in question costs you $300,000 to make and from your research you're pretty sure that it's worth about $450,000 to them.
If the meeting goes well, will you sell it to them?
Most people consider the question in scenario two to be a no-brainer. You obviously want to sell the product and the only question is how close to $450,000 you can set the price. A lot of those people will envision the perfect deal in scenario one as having option A (the one that is worth $350K to their firm). On a fundamental level, however, these are identical questions. In both cases you have something that is worth $300,000 to you and 50% more to someone else and the question is who, ideally, should own it at the end of your discussion. The difference is that in negotiations we think in terms of winning, which translates to getting our way and avoiding anything that imposes costs on us. Business, on the other hand, is all about selling things that cost us less than they're worth to someone else; no one thinks they got beaten because someone bought their product.
Let's assume you got a deal with option A. You and your counterparts are a combined $150,000 poorer than you should be. For any possible deal with option A, you can make deals with option B that make each party better off.
Let's say the total value of the deal to you (with option A) is $1 million better than your BATNA. Since you did such a good job and captured most of the value, the other side is only $400,000 better than their BATNA. Now let's change the deal so that you get $375,000 more but they "win" on the provision and get option B. Now the deal is worth $1,075,000 to you and $475,000 to them. You didn't lose on the clause -- you sold it to them for more than it cost you to give it up.
The Win-Win approach to negotiations is popular for the same reason that businesses like to sell things. If something is worth more to you than it is to me, you should end up with it. If it's mine, I should sell it to you. If it's yours, you should not sell it to me. If it's part of a negotiation, it should end up going your way. The key point is that you aren't giving it away; you're selling it for a gain. You're making a concession in exchange for another concession that is worth more to you than what you gave up.
Most negotiations are about more than just price. They include payment terms, guarantees, exclusivity periods, options to share upside, protection against downside, how disputes will be resolved, etc., etc. Many of these issues are quite important to one or more parties but they are rarely equally important. The win-win approach enables the parties to discover where things are valued differently and for the parties who value something the most to buy it from their counterparts. This increases the value of the deal, often resulting in greater gains than could be accomplished by value capture alone.
One of my professors put it like this. If you're negotiating with someone over how to divide a pile of money on a table would you rather that the table had one million dollars on it or ten million? Good negotiators want the amount of money on the table to be as big as possible. They certainly don't abandon value capture (and, indeed, there's no need to) but they know that it's a lot more fun to divide ten million dollars than one million.
We'll look at how to identify win-win opportunities and how not to sacrifice your value capture position in later posts...but for now, go back to scenario one. Are you excited about "losing" your preferred option? You should be.
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