Thursday, September 22, 2011

How does your Reservation Value relate to your BATNA?

Your reservation value is the lowest value you will accept in a deal.   It goes by many names -- your bottom line, your walkaway point, but whatever you call it it is the worst possible deal you would be willing to accept.  We always hope to do better than our reservation values, but it's important to know what yours is, both to avoid accepting a deal you shouldn't have and as a reference point for how much a current deal is worth to you.

If you read a typical textbook on negotiation, you might think that the question of how reservation value  relates to BATNA is trivial.  Most books define Reservation Value in terms of the value of one's BATNA and assume that they are equal.  This makes sense -- as long as the deal is better than your BATNA you'd rather take it than walk away; if it's of equal value then you're indifferent and if it's worse than you'd rather follow your BATNA than take the deal.

For example, imagine you're selling a used car and your BATNA is to sell to someone who has offered you $6,000 in cash.  Your BATNA is therefore worth $6,000 and any deal worth less than that will be refused. If you had a deal for $6,100 and were sure you couldn't increase it, you'd take the deal.  Right?

I'm not so sure.  I think there are good reasons to set your reservation price at a premium to your BATNA, coming from such diverse fields as psychology and poker.

Pot Odds

Experienced poker players will make bets they expect to lose because of "pot odds".  If the cost of losing is small relative to the gain of winning, the expected return can be positive even if the most likely outcome is a loss.

Suppose we're playing no-limit poker and I'm down to my last $1,000.  There's $10,000 in the pot and it's raised $1,000 to me.  Based on my read of my opponent I think I'm an underdog, with only a 25% chance to win.  Even though I expect to lose, I should call assuming my decision is based purely on maximizing my expected return on this hand.  The math works as follows:

Fold: 100% chance of having $1,000.

Call: 25% chance of having $12,000 ($10,000 plus $1,000 bet plus $1,000 call) and 75% chance of having $0 which is a weighted average return of $4,000.

Since the payoff was much larger than the investment the expected return on calling was positive even though I expect to lose three times out of four.

One professional negotiator I know defines reservation price as "the lowest price you'd accept if you were positive you couldn't get more" but this assumes knowledge we almost never have -- that the other person really won't do any better than their "final" offer.

In our car example, suppose you refuse the $6,100 offer and say you want $7,000.  What might happen?  It's possible that the other party will say, "Sorry, $6,100 really is the best I can do."  They might groan and say, "I can do $6,300 but that's really it."  Or they might actually value the car at $8,500 and accept your price.  Since $6,100 is really only worth $100 to you (relative to your alternative offer), it's quite likely that you have a positive return on holding out for more, even if you think it's likely that $6,100 really is the buyer's top price.

A final consideration is that refusing someone's final offer isn't always irrevocable.  If you say "no" to $6,100 and the buyer walks away you can often (not always) call back and say you've changed your mind.

Underestimation of your BATNA

I find people frequently underestimate the value of their BATNA -- in particular the potential to improve it.  Is your BATNA regarding the used car really $6,000?  That's an offer you have, but it might be negotiable.  You might also find another buyer.  We tend to focus on the most tangible aspects of our BATNA, which can lead us to undervalue it.  Of course, in theory this means we may need to improve the evaluation of our BATNAs rather than that our reservation price should be set higher, but in practice it speaks to holding out for more.


Many negotiations you undertake are semi-public -- people you'll negotiate with in the future (including those you're negotiating with now!) will have some awareness of the results.  Given that, it's worth thinking about the reputation you'd like to craft and then weighing that in to the decisions you make.  An ideal reputation would include integrity and an ability and willingness to create value but I think it should also include being someone who expects significant value out of a deal and will walk away if that proves impossible to achieve.  This may shield you from wasting time on deals that don't offer you much and it encourages your counterparts to adopt a value-creation posture rather than trying to squeeze you.

Cognitive bias

There are at least two types of common cognitive bias that make a no-gain reservation value dangerous: small pie bias and focal point bias.

Small pie bias is pretty straightforward -- people tend to underestimate the size of the pie, which can lead to missed opportunities to grow it and to accepting too small a piece.  Focal point bias refers to research showing that in stressful, complex situations (e.g. negotiations) people tend to gravitate mentally to whatever focal point is the most significant to them.

Combined, these factors can easily lead us to think that our reservation value is the value to think about and that any gain above that is a win -- a prescription for leaving a lot of value on the table.

One strategy for fighting this is to set an aspirational target and try to focus on that, keeping the reservation value in your back pocket to be looked at only if the negotiation goes more poorly than expected.  This approach has some validity but I think it's risky for all but the most experienced negotiators.  Moreover, if you come to believe you've misunderstood the ZOPA and are faced with a deal that is better than your BATNA but worse than the reservation value you've set there's nothing stopping you from taking a step back, re-examining the new information you've received, and adjusting your numbers accordingly.

Putting it all together

Let's look at an example.  You've been tasked with buying the patent rights for a piece of technology that's worth $10 million more to your company than your best alternative.  Based on a classic BATNA analysis, you'd set your reservation price at $10 million.  Your company, however, is the only natural buyer for the technology and you're fairly confident from your analysis that the patent isn't worth anything to its owners and that the best rival offer they're likely to get (from a company in a different business) is in the $3-4 million range and probably less.

There are a lot of away-from-the-table steps you'd take if this was a real situation, but to keep it simple let's assume that they have an unknown but firm offer and are negotiating with you to see whether your company gets the patent.

Suppose they say, "We have a very good offer from (the firm you expected would pay at most $3-4 million), but we know this technology is very valuable to your firm.  We'll sell it to you for $15 million."

You take this in stride as an anchoring tactic, state clearly that they have substantially overestimated how much the patent is worth, and make a counter-offer of $2 million.  There is some back-and-forth but abruptly they say, "Our absolute final offer is $9.7 million.  If you won't pay that, we'll have to go with the other company."

You tell them you'll consider their offer, cautioning them that it's high, and go back to your desk.  You revisit your analysis with your team and bring in an outside expert for a fresh view.  You still can't believe that it's worth more than $4 million to the other company.  But what if it is?  You don't want to throw away money, even if it's "only" $300K.

In this situation, there are some compelling reasons not to accept their "final" offer.

First, let's be pessimistic and assume there's only a 20% chance that they're bluffing -- but that if they're bluffing you'll be in the driver's seat and can reasonably expect to pay $5 million.  That's an expected return of $1 million relative to your BATNA, which is greater than the $300K on offer.

Second, if your analysis is correct and the ZOPA is $6 million or $7 million in size, neither your firm nor your own career benefits from capturing so small a piece of it.

Next, is your BATNA really to do without the technology?  If the firm that buys it is in a different business you may be able to license the technology from them.

This is, of course, simplified.  You have a range of tactics available to gain information...but at some point in a negotiation you can be presented with a "final" offer that doesn't make sense given everything you can learn but that is slightly better than your BATNA.  Theory says you should take it -- I hope I've provided some reasons to question theory on this point.

Wednesday, September 14, 2011

Own Your Mistakes

I started this blog while at an executive negotiation class at Harvard Business School.  It was a fantastic opportunity to negotiate with professional investors from around the world, and I take real pleasure in the fact that in all of my negotiations I reached agreements that created the maximum value possible (in one case my group was the only one that did) and captured significantly more of that value than average.

All of them but one, that is.  In one simulation, I failed to reach a deal at all.

The negotiation involved three entrepreneurs who had formed a very loose ownership agreement when they started a new venture.  A few months in, one of the founders (me, in the exercise) concluded that he was working harder and contributing more that was reflected in the original agreement and that this should be reflected with a higher share of equity.  He initiated a renegotiation, sending a proposal to his co-founders which formed the starting point of the exercise.

Our discussion didn't go well.  One of the other co-founders was keen to make a deal but the other wasn't.  He made demands that we couldn't meet, said things that were frankly insulting (always interesting in a simulation!) and ignored our responses.  As an example, one of the topics for discussion was his salary (the other co-founders were working just for equity) and neither of us could agree to anything above $110K as we didn't think the venture's cash flows could handle it.  Even after we'd made that clear he was proposing deals in which he got paid $150K.

Near the end of the exercise it looked like we might be able to reach a deal, but at the last moment he said he couldn't agree to what was on the table and we "agreed to disagree".  Upon returning to the class

My initial reaction was to blame our difficult partner.  This was reinforced as we learned more about the other roles and it became clear that salary -- what he had made the largest demands about -- was actually his least important interest and he'd failed even to bring up his most important one.  Small wonder we couldn't create enough value to reach agreement when a key player was giving poor information.

Unfortunately, life is rarely so simple.  Negotiations is a complicated endeavor and one where we rarely, if ever, get a precise read on how well we did.  For this reason it is vital that we review our negotiations candidly, gathering new information if possible and evaluate our performance as objectively as possible.  Most of all, we have to own our mistakes.  That's why I always review and analyze my negotiations to see what went well and, in particular, what I should have done differently.

In this case I did at least a few things wrong.  Foremost, I was in too aggressive a mindset.  This exercise, the second in the class, came immediately after a review of a solo exercise in which I had paid $70K for an asset on which the median purchase price was over $200K.  Our negotiation had been discussed in class and I judged (correctly) that in the next exercise my counterparts were going to be aggressive in order to avoid a similar result against "the tough negotiator".

Because I was gearing up for a fight, I didn't put as much thought as I normally would into understanding where my counterparts were coming from, something that is key to successful negotiation.  Afterwards I would blame our difficult partner for not raising his key issue but normally I would have figured it out ahead of time and been able to raise it myself.

In negotiations it is generally preferable to take an aikido approach.  If someone is being aggressive, don't meet that aggression head-on.  Doing so makes irrational escalation more likely and makes it harder  to work together to create value.  Instead, disarm him with a lateral move.  In this case if I'd put myself in his position I would have realized that he was feeling like an employee rather than a partner and that "my" initial proposal emphasized that.

Imagine that you're feeling unappreciated and are gearing up for a tough negotiation against a hard-nosed bargainer.  Imagine that he begins by saying that he tried looking at the situation from your side and realized that if he was in your position he would feel taken for granted.  He wants to start the discussion by asking if that's the case for you, apologizing for it, and then asking what factors are most important to making you feel good going forward?

Another mistake I made was in my orientation to any final deal.  As we discussed here, the value you capture in negotiations that involve ongoing relationships are a combination of the tangible factors covered in the deal itself and the intangible consequences of how your counterparts behave in the future based on their own sense of the deal.

In this exercise, three entrepreneurs were agreeing on principles of fairness and value distribution...but what value was being distributed?  The equity of the company!  This is far from a fixed pie; if we reached a deal but ended up not wanting to work together, we'd each end up owning a slice of nothing.  Even in a class exercise this should have affected my approach.

One of the most common forms of human bias is thinking we've performed better than we have.  A famous example is car drivers.  In one survey, motorists were asked to rate their own driving skill on a scale of 1 to 5 as well as the average skill of other drivers.  Other drivers came in at 2.7, while drivers rated themselves 3.9.  Unfortunately, this self-delusion can be extremely costly when it prevents us from improving.  A tough self-assessment in which we explicitly look for our own errors is one tool to help us resist it.

Thursday, September 8, 2011

Adding Issues to Create Value

As we’ve discussed in prior posts, one of the most straightforward and effective ways to create value in a negotiation is to identify and implement value-creating trades.  If getting your way on an issue is worth a million dollars to you while getting my way is worth half a million to me, then my goal shouldn’t be to get “my way” but rather to let you get your way…in exchange for more than half a million dollars in value.

In some deals this is relatively easy.  The discussions begin with a variety of interests identified, the parties are sophisticated enough to be able to evaluate trade-offs efficiently and discussions move effectively towards the value-maximizing configuration of terms.

Frequently, however, life isn’t so simple.  Today’s post looks at introducing issues to a single-issue negotiation using a real-world negotiation I’ve just begun with a software developer.

Some years ago I published a card game called The Battle for Hill 218.  It’s fun, quick and deep and has been my most successful single product (still selling quite well today).  A few different players have asked me to consider making a version for the iPhone or iPad and recently one of them introduced me to a developer who was interested in creating an iOS version on a revenue share basis (i.e. instead of me paying for his time, he’d be paid out of a share of sales for the app).

The developer’s initial offer was a 70/30 revenue split in his favor.  Alternately, I could pay him a flat fee which would be somewhere in the $10K to $20K range.

If the revenue split is all we’re negotiating there’s not much we can do to create value in the deal.  Naturally there’s some value in each of us being happy with our agreement and being motivated to promote the app, but for the most part we’d be haggling on price and trying to capture as much of the ZOPA as possible.  If there’s only one issue, there’s no room for value-creating trades. 

Price, however, is rarely the only important issue worth discussing and in this case there are a number of other possibilities worth considering besides the split of sales.

Price of the app.  Even if we agree on what price will maximize revenue of the iOS version of Hill 218, either of us might want to set a lower price in order to attract more users to the app.  The developer might like wider exposure of his work and to be able to say (to other potential clients) that he produced an app that a lot of people downloaded.  More concretely, I have a monetary incentive to maximize users (especially new users) since I’m still selling the physical game.  I’m convinced that offering a free Java version of Hill 218 played an important role in sales of the physical game, and having an iOS version is likely to lead to more sales as well.

Let’s assume for illustration purposes that his ideal price is $3.99 and mine is $1.99.  Our next task is to determine how strongly we prefer those prices, as well as how we feel about prices in between.  If a price of $1.99 is worth $5,000 more to me than $3.99 and is worth $3,000 less to him, then pricing the app at $1.99 creates $2,000 in value between us.  Put another way, I can give up over $3,000 in value from app revenues (which makes him better off) and as long as I give up less than $5,000 I’m better off as well.

Marketing budget.  Presumably we can increase sales somewhat by advertising, but I get a double benefit since advertising should boost sales of the physical game as well.  To keep things simple, let’s assume that we each think that each dollar (up to $1,000) of advertising would lead to only eighty cents in additional app revenue (forty cents to him and forty to me if we’re splitting things evenly) and that I also think it will be worth forty cents in additional revenue from physical sales.  The total value of advertising is $1.20 per dollar, so it’s clearly attractive.  If, however, we don’t negotiate advertising then it won’t happen; he gets only forty cents on the dollar and I get eighty (forty from the app and forty from the physical game).  Neither of us gets enough to justify doing it alone.  If, however, the developer “pays” me more than twenty cents and less than forty cents for each dollar of advertising I do, we’re both better off.  (Payment could be done directly (i.e. we share the actual ad expense) or indirectly (i.e. factored into the terms of the deal).

Split based on results.  Hill 218 is a new game for the developer.  He’s played it online and likes it, but he’s naturally cautious about how much it will sell.  I’m more optimistic, given its sales numbers and how popular the Java app has been.

This difference will naturally factor into our discussion over what a split should be.  He’ll point to the number of game apps that sell less than a thousand copies and argue that he’s unlikely to make a normal developer fee even with 70%.  I’ll talk about how many unique players the Java version has, how the physical game has nearly sold out its second print run and the posts on BoardGameGeek asking for an iOS version.

The key to moving that discussion past arguments for value capture is to recognize that different expectations create room for a compensation split that both parties prefer to any flat fee they might agree.

To keep things simple, let’s assume a price of $3.99 (before Apple’s 30% commission) and volume forecasts as follows:

Developer’s Guess
Chad’s Guess
Total Sales (unit)
Total Revenue ($)
Each party’s share

(Total sales is calculated by multiplying each percentage estimate by that amount of sales, i.e. the Developer’s total sales is 70% of 1,000 plus 15% of 4,000 plus 15% of 10,000.)  N.B. These are not my assumptions and I have no idea what assumptions the developer may have -- I put them up here purely for the sake of discussion!

The developer’s average estimate puts total dollar sales at less than $10K and he thinks there’s a 70% chance that sales will only be about 1,000 units, or less than $3,000.    I think sales will be nearly $20K and my most likely scenario is a “hit” with 10K unit sales and about $28,000 for us to split.

Given this variance, the last thing we should try to do is agree a single fixed split.  That’s could break the deal altogether and is likely to lead to resentment down the road when one of us turns out to be right.  If I persuade the developer to take 50% and he ends up getting paid $1,400 it’s a turkey for him; similarly if sales are close to $30,000 and he got 70% of it I’d wish I’d never agreed to a revenue share deal.

A simple alternative is a split that changes as sales grow.  Suppose the developer gets 100% of the first 1,000 sales, 75% of the next 1,000 and 25% of sales beyond that.  The developer would expect to receive $4,480 (on average), an increase of 15%, and his risk is much lower.  If he’s right that the most likely outcome is only 1,000 units at least he gets 100% of the sales.  I also expect to receive about 16% more this way, albeit with a higher risk of getting nothing.

Some would argue against calling this value creation since eventually one of us will be proved wrong.  Both parties might like this deal better up front but in the future one will be better off and one worse off by exactly the same amount.  I would counter with two points.  First, being able to “bet” according to one’s beliefs is generally regarded as valuable.  Investors buy and sell stocks, companies invest in markets and technologies, collectors buy stamps, coins and other items based in part on their estimation of what the future will bring.  Enabling two parties to act according to their expectations of the future is a valid goal of negotiation.

More fundamentally, while one of us will be worse off we’re more likely to be satisfied with the variable commission because the result will be much closer to what we would have agreed if we knew the sales up front.  If unit sales are just 1,000 I won’t feel bad that the developer gets all the revenue…and if I expected sales to be that modest I would view the app as a nice promotional item rather than a source of revenue.  Similarly, if app sales are 10,000 units can the developer really feel badly about only getting around $10K?  Not only do sales of that level imply that the game (my contribution) was highly valuable, but if we knew that sales would be that high I could contract to have the app done by a professional firm for that amount.

How to Introduce Issues

Introducing issues is generally trivial with experienced, sophisticated negotiators.  They’re eager to include as many important issues as possible for the same reason you are – they know that’s a powerful way to maximize the deal’s final value.  The challenge arises when your counterpart doesn’t have this perspective.  He may see an attempt to introduce issues as some sort of gamesmanship or a waste of time.  Perhaps worse, he may see it as a request by you that merits a reciprocal concession – that is, your effort to introduce value creation may be met by a value capture effort by the other side.

I’ve found the best approach is to be up front and open about why you want to add issues and then to share at least top-level thoughts about where your interests lie (and where you think your counterpart’s may lie) on each topic.  For example, here’s an excerpt from the email I sent to the developer on the subject:

If we can put haggling aside for a moment, however, I'd like to make sure that whatever agreement we reach is as valuable to us in total as possible.  As you may guess from my signature, I'm a negotiations geek in addition to being a game geek.  This doesn't mean that I'm a particularly hardball negotiator but rather that I'd like us to make sure that we aren't forgetting any "levers" in our agreement that might make the final deal more valuable to each of us.  In addition to royalty split, I can think of some other terms we should discuss and I'll share my thoughts about my own interests on them.

I start off by establishing this as separate from haggling over price.  This helps avoid the “OK, we can discuss these things but you’ll have to do better on price” trap and makes it clear that adding issues is a mutual and collaborative process of value creation.  I finish by offering my thoughts, which then invites him to reciprocate with his.

Value Creation in Parallel with Value Capture

A key consideration through all this is that adding issues (along with other value-creation techniques) don’t replace value capture efforts.  They happen in parallel.  While raising other issues with the developer, I also expressed my view that his initial offer of a 70/30 split was too high.  I’m also addressing his implicit anchor and working on my BATNA by getting quotes from iOS development firms for a cash-only development deal.  Although I want my counterpart to be happy with our final deal, emphasizing value creation in no way means that I have to give anything away.  It just means that when we finally split up the figurative pile of money on the table, we’ve got as big a pile as possible.