Tuesday, October 25, 2011

Courting bad behavior

The other night I was watching Storage Wars and saw an unhappy but predictable bit of value destruction play out.

For those not familiar with the show, kudos on having better taste than I do the basic setup is as follows.  Property that has been in private storage gets auctioned off when the owners fail to pay rent on their unit.  Storage Wars focuses on four men who try to make a living bidding on the contents of the units.  The bidding is complicated by the fact that the storage managers only open the front door to the unit; bidders can't go inside or open boxes, so they have to garner what information they can from a very limited viewing.

In this episode, nine lots from a single owner were being auctioned.  The most experienced bidder (Dave, nicknamed "The Mogul" on the show) looked in the first unit and realized that the semi-random pieces of metal it contained were part of an expensive stage lighting system.  He guessed (correctly) that the other units each contained part of the overall system; the whole was worth much more than the sum of the parts.

Dave decided to try to buy all nine units up for auction.  Most likely he reasoned that if no one else realized what was in them they wouldn't see the value and he could outbid them and still make money.  Moreover, if someone did realize what was in them, then once he bought the first unit he'd still have an advantage, since he could complete the system while a rival bidder's best hope would be to get part of it.

The snag in his plan soon became apparent.  One other bidder, Darrell, understood what was going on and waited until Dave had invested a lot of money buying several lots.  He then began to bid aggressively, starting with a lot he suspected had a particularly key component -- the control system.  Dave, likely realizing that if he forced the issue on this lot he'd have to keep doing so on the rest, let the lot go after the bidding had gone high enough.

After the dust settled, it seemed that Darrell's gambit had worked.  He did indeed have a central component to the system.  He'd bought it for around $1200 and it would cost Dave $5,000 to replace.  He offered to sell it to Dave for $3,000.

Dave refused, saying, "I'd rather die than see you make a buck."  Instead, Dave sold what he bought as scrap metal, letting him make a profit albeit a much smaller one than he could have made.  A lot of value was destroyed.

So what happened?

First, a disclaimer.  Storage Wars is a TV show.  The incentives are almost certainly distorted by the fact that the players are paid and drama is encouraged.  That aside, this sort of dynamic plays out in competitive negotiations so let's treat it as real and unscripted.

The math on Darrell's gambit was flawed in one key respect -- it looked at this deal in isolation.  He was correct in assuming that he could force Dave to let him have one of the units (in order to prevent this, Dave would have had to pay a premium for every single unit remaining), but his assumption that Dave would then buy that unit back from him only makes sense if this is the only time these two are competing.  Since Dave knew there would be plenty of other opportunities for Darrell (and others) to try to hold him up in the future it could be rational for him to take a loss today in order to signal that he would retaliate against anyone trying to do so.

Darrell also magnified the likelihood that Dave would fight back by trumpeting what he was doing during the auction.  He crowed about how he'd blocked Dave's plan and was going to make Dave pay him.  Not only might this have made Dave angry it increased the signal value (or cost) of Dave's decision.  If he paid Darrell then all the other bidders would have been on the lookout for a chance to do something similar.

Darrell's chance of success would have been much higher if he took a different approach.  He should have bid on that unit without giving any indication that he knew what Dave was up to, instead indicating that he thought he saw something collectible in it.  Then, when the dust settled, he could have approached Dave and said, "That unit I bought had a control panel that's a key component to the system you put together from the other units.  It retails for five grand, but I wasn't buying it to screw you so I'll sell it to you for three."  Dave might still have refused, but he would have had better incentive to negotiate.  Instead, Darrell took completely unnecessary effort to make Dave angry and to create incentives for Dave to refuse to deal with him.

Yesterday I was in a meeting for a multi-party negotiation that has become quite contentious.  One of the parties accused another party of lying on a key issue for a period of several months.  I think the first party had some grounds for complaint and even for suspicion but it's very rare that calling someone a liar is constructive.  In this case it was particularly self-destructive because the latter party has nearly all of the power in the negotiation.  They'd like to reach a mutually-acceptable agreement but if none can be reached they are in a position to go ahead with what they want.  Calling them liars encourages them to be defensive about legitimate complaints and encourages them to shut off potentially constructive paths to dialogue.

In each case, the lesson is largely the same.  Negotiators need to think about how counterparts will react to their words and actions.  If you've pulled off a maneuver that benefits you at someone else's expense, the last thing you want to do is trumpet it!  If you want to voice criticism of the other party's behavior, think carefully about how you express it.  There's a big difference between, "There have been some important pieces of information that weren't communicated clearly; how can we improve this going forward?" and "You've been hiding information you knew we needed."

Negotiation is about getting other parties to do things that are in your interest.  Like a doctor's first rule is to do no harm, a negotiator's first rule should be never to cause others to act against our interests.

Tuesday, October 18, 2011

Leverage from Being Small

It seems absurd to think that being a relatively small client gives you leverage but in many cases it does -- provided what you want is reasonably easy to grant.  Companies generally develop a low cost approach to managing small clients.  The person (or service department) managing your account likely has a large number of similar clients -- more than they can possibly spend much time with.  The model works because most of your peers don't ask for service and (in many cases) because the customer service reps are empowered to meet small requests quickly so that the client is retained and expense is kept low.

This comes up quite often in personal business, such as banking, cable, etc.  You may not be able to avoid paying standard fees at your bank, but if you incur a one-time fee you can often negotiate it away just by asking.  Similarly, if there are two cable providers in your area and the one you don't use is offering a sweet deal, you can likely get your own provider to match it or to provide you with something similar.  Your leverage comes from providing the company with a choice -- make you happy at little cost or risk you switching to the competition.  Not only don't they want you to switch, they don't want to invest a lot of expensive staff time retaining you.  (In these negotiations it helps if you say that you're considering switching as a result of whatever it is you're not happy about or whatever special the other company is offering.  Agents sometimes only have the ability to grant your request if you indicate that you might switch.)

This type of leverage isn't limited to getting six months free HBO.  Consider my negotiation on behalf of a small healthcare non-profit we discussed under Negotiating with a bad BATNA.  My client represented well under 1% of revenue for Blue Cross Blue Shield of Massachusetts.  I wasn't even negotiating with the decision-maker there, but rather with two of his subordinates.  So how could my (implicit) threat to end our contract with them have any leverage at all?

Consider the situation the Vice President in charge of reimbursement was in.  He was engaged in a massive struggle with Massachusetts hospitals to halt and even reverse the long trend of rate increases.  He didn't want to lose small partners like us, particularly if we were profitable partners, but he also didn't want to spend any bandwidth on us.  My goal, therefore, had to be to make sure that when our case got to him (and we were asking too much to think it wouldn't), two things would be apparent:

  1. Giving us what we wanted was strongly preferable to losing us.
  2. Losing us was a real possibility if he said no.
  3. Trying to keep us while giving us less than what we wanted would be costly, in his time.

I didn't just make sure that his subordinates understood that using us was saving them money.  I prepared a powerpoint slide (designed so that they could go over it with their VP) that showed how much we were saving them and then compared that with operating losses our organization was incurring.  The message was clear -- we weren't just asking for money, we needed it to make our business sustainable.

Next, I provided a strong narrative for my counterparts to use in selling the increase.  Internal negotiations amongst the various people in an organization are critical, so I helped my counterparts with their task of selling the increase to senior management.

BCBS came back with an offer of 3%.  This was better than most providers were getting that year (most hospitals were having rate reductions) but we turned it down and said that we felt we needed to escalate to the VP.

(As a side note, I'd been very open with my BCBS counterparts both about what we needed and my awareness of their constraints, so that when I escalated it was expected and came across as a natural next step in the process rather than me going over their heads.  Now they were in a key way my allies -- an escalation like this is much better for them if it goes quickly and seems justified, so from their perspective it would be much worse if the VP turned us down than if he concludes that this is a worthy exception.  In the former case he's doing their jobs; in the latter they did their job correctly and now he's doing his.)

I revised the powerpoint presentation with feedback from my BCBS counterparts and they presented it to the VP, along with a list of reasons (ranging from financial to our non-profit status and work with poor communities) why we should be an exception to BCBS's determination not to give out rate increases that year.  They came back with a substantial increase, no doubt in large part because the VP saw that as a better option than continuing to negotiate or risking losing us as a partner.

Being small often means that your counterpart doesn't need you it also means that granting you what you're asking for probably doesn't cost them very much.  If you can frame the choice so that it feels reasonable and present your counterpart with the ability to make you happy quickly and easily, there's a good chance that doing so will be their best option.

Thursday, October 13, 2011

NBA Lockout: a mechanism for avoiding value destruction in disputes

The recently-announced NBA labor dispute will eliminate at least the first two weeks of the season.  On the face of it, such disputes should be rare.  The total pie (i.e. gross profits to be shared) is huge, both parties have expert negotiators to represent them and both parties incur substantial costs when they are not able to reach agreement. Today's post will look at how disputes of this kind arise generally (and not just in sports) and how they are made more likely by the structure of payments typical in sports.  Finally we'll look at a mechanism that could reduce the risk of destructive escalation going forward.

Let's start with a basic problem that arises when two parties must agree how to divide a large pile of money.  This seems like a wonderful "problem" to have, but it's surprisingly easy for it to go wrong.  To see why, let's play a game called "Ultimatum."

There is $1,000,000 on the table.  You get to propose a split.  I can then either accept the split, in which case the money is divided as you proposed, or I can decline it, in which case neither of us gets anything.  This structure puts you into a very powerful position.  If, for example, you propose that you get $900,000 and I get $100,000 (a very slanted split) my choice is between $100,000 and spite.  Unless I'm a very spiteful person, I'm going to take the $100,000.  If you know I really need cash you could propose a split of $990,000 to you and $10,000 to me, capturing 99% of the value on the table by leveraging your position.

Now imagine a more "normal" negotiation over how to split a million dollars.  We'll call this game, Even Steven.  We have an hour to negotiate; if we haven't struck a deal by then neither of us gets anything.  Neither of us has any advantage; if you suggest a split that favors you I can say "no" without losing anything.  Most likely (and this is supported by practical experience and academic studies) we'll end up splitting the pie evenly and each taking home $500,000.

Now, if you're choosing between a game where you win $900,000 and one where you win $500,000, which would you rather play?  Most of us would rather play Ultimatum, which is where commitment dynamic into play.

Suppose we're playing Even Steven and you come up with a way to convince me that you'll refuse any deal that doesn't give you at least $900,000.  Perhaps you sign a contract binding you to lose $1,000,000 if you agree to any worse deal.  Perhaps you have a reputation for doing anything to keep your word and you swear on your honor that you don't take a penny less.  Whatever the specifics, if you can make a credible commitment to take nothing unless you get $X, then you've changed the game from Even Steven to Ultimatum with you in the driver's seat.

The same dynamic happens in real-world negotiations.  When the pile of money to be divided is big or the consequences of failing to reach agreement are disastrous there is an incentive to claim a big share of the pie by committing yourself to an aggressive bottom line.  We saw this play out in the recent debt ceiling negotiations -- Republicans made very public commitments not to accept any tax increases precisely because saying it privately wouldn't have committed them.  That put Obama and the Democrats in a position where if they insisted on tax increases they risked finding out that they were playing Ultimatum rather than Even Steven.

Even if you don't have a mechanism to create commitment, you can try to play Ultimatum by appearing committed.  Using this approach, a negotiator stakes out a very aggressive position and either sticks to it or makes tiny concessions (which is generally a signal that someone is near their bottom line).  "OK, you won't accept me getting $900,000 to your $100,000?  I can go $880,000 to $120,000."  If both parties do this, of course, the negotiation can quickly break down into acrimony -- neither side trusts the other, the parties are far from agreement, and progress looks remote.

Things get worse when we add ego (and I think it's fair to say that professional athletes and the owners of NBA teams all have healthy egos) and different senses of what's fair to the mix.  If it's possible for people to fail to divide a pile of money on the table (and it most certainly is), imagine how much harder it gets if each person think that they deserve 70% of that pile.  People commonly overestimate their contribution to any shared effort; it's safe to assume that the players and team owners have very different views of how much each of them "ought" to get from the revenues generated by the NBA enterprise.

All that would be bad enough, but sports leagues often add one more structural problem to the mix. Players typically earn salaries that are paid throughout the season, while owners earn a relatively high percentage of their income during post-season television.  This means that each side has a window in time where the pain of a fight is greater for the other side than for themselves.  For this reason, lockouts are more likely to happen at the start of the season (more painful to players) and strikes more likely later in the season.

Two Different Types of Value Destruction

If labor and management, players and owners or whatever parties share in creating a pool of value cannot agree on how to divide it, they typically stop creating that value -- temporarily.  Strike, lockout, "taking a break" in the relationship, the basic dynamic is the same.  Each side stops receiving its current share of value creation until the dispute is resolved.

While in some sense any value destruction is unfortunate, a good case can be made that at least some of it is necessary, too.  If the current division of value favors one party over the other, that party may need leverage to bring the other party to the negotiating table.  Even in the game Even Steven it's useful to have a deadline, since otherwise negotiations could drag on indefinitely.

It's worth distinguishing, however, between two different forms of value destruction.  The first is having to forego current value that would have been created if no dispute takes place.  In a strike/lockout, for example, workers don't get paid* and owners don't get the profits the business would normally earn.  Ideally agreements would be resolved before a strike is necessary but having that stick available is healthy and probably unavoidable.

Another source of value destruction is damage done to the enterprise itself by the strike.  If a company loses key customers permanently because a strike disrupted its service to them, then when labor and management agree on how to divide the pie they are sharing a smaller pie -- potentially much smaller.  As Hall of Fame goalie Ken Dryden put it (discussing the 2004-5 NHL strike), "You never want to give a fan a chance to find out whether it was passion or habit."  If fans get turned off watching players and owners (each group being far richer than the typical fan), future revenues can be significantly damaged.

A Mechanism to Reduce Value Destruction

So now we have a conflict.  The ability to inflict economic pain is a useful tool, without which a division that favors one side may be impossible to resolve because that side won't come to the table.  At the same time, both sides have an incentive to limit the pain to lost revenues during the negotiation itself rather than killing the golden goose.

In theory, this can be avoided by replacing an actual strike with an artificial one.  Players and owners contractually would commit to pay money into a pool in the event that they are unable to agree on contract terms -- with the payments designed to simulate the revenues that would have been lost in the event of a strike.  Instead of an actual strike/lockout, however, play continues -- and fans, instead of being disappointed and potentially putting their entertainment loyalty elsewhere, get to watch the teams they love compete.  Best of all, instead of the losses being "real" losses they could be donated to charity.  Imagine the positive press if as a result of a contract disagreement the NBA were announcing that it would be donating a large sum of money to improve inner-city parks or to provide sports equipment to low-income public schools...instead of canceling games.

Such a solution would be unusual, but far from impossible to implement.  A trusted third party (e.g. McKinsey & Co.) could be brought in to do the analysis on how much each side would pay and to provide a mechanism for re-evaluating the system as revenues change in future years.  All it would really take is a willingness to adopt an unusual agreement on how to resolve future disagreements.  The end result would be superior for all parties -- owners, players and fans.

* Workers typically get paid by their union, but not at full wages and in any case this is money come out of their collective pockets rather than from the company.