Saturday, August 25, 2012

Kickstarter and Deal Design

One of my favorite web startups is crowd-funding leader Kickstarter.  The core idea is pretty simple.  You have a project and need funding.  Kickstarter provides a platform for you to promote your project to people who might be interesting in providing part of that funding, either because they love the idea or because of tangible rewards you offer.  (Many Kickstarter projects are funded with what amount to pre-orders of the game, book, film, art, etc.)  If you get funded, Kickstarter collects a commission.

This is a pretty straightforward value proposition.  Kickstarter can be thought of as an intermediary, a virtual place for people who are interested in cool projects to meet with people who have cool projects and need money.  There are all sorts of interesting facets to this site but I want to focus on what we can learn about deal design -- and not just for people on Kickstarter itself.

A key part of a Kickstarter deal is that the project owner specifies a minimum amount they need to raise and all pledges are conditional on that target being met.  If it's going to cost you $10,000 to do your project you can set that as your target.  If your combined sponsor pledges are $10,000 or less then the sponsors are charged and your project goes ahead.  If the pledges are less than $10,000 then the project doesn't go ahead.  (Of course, you're not required to set your target at the cost of doing the project.  More on that later.)

This simple facet offers some substantial benefits.  Most obviously, it reduces risk.  Instead of  investing money up front and hoping to recoup that investment, the seller can pre-sell her project.  Risk is reduced for the buyer, too -- if he sees a project he likes he can make a pledge and then continue to learn about it, potentially increasing (or retracting) his pledge.

A more subtle benefit is the interaction it enables between seller and buyers.  Because a project's sponsorship period lasts for a period of weeks, the seller gets an excellent opportunity to connect with buyers and to customize her offering to their wants.  A conventional product launch requires much more time before feedback from early adopters can be incorporated.  A Kickstarter deal is more like a software project with beta testers providing immediate feedback before the "real" launch.

Third, a Kickstarter approach enables potential customers to see other potential customers.  This can offer psychological benefits for the seller (it's well-documented that people are more apt to buy something that they believe is popular) but in some cases the visibility of other customers creates tangible value in and of itself.

Let's take a step back from the website to see how this approach can be applied elsewhere.  Sadly the deal I'm going to discuss was not successful, but a "Kickstarter" approach increased my chances of success from zero to something reasonable and kept my personal risk very low.

Some years ago I thought it could be very interesting to help young job seekers understand potential career paths.  My concept was to do in-depth video interviews with people at different points along a particular path, exploring the measures of success, the rewards and challenges and how they changed as someone advanced within the company or field.

After consulting with a number of people in the recruiting field I concluded that charging users was a non-starter and that hoping for sufficient ad revenues was dubious and highly risky -- but that companies that recruited a lot of people out of school might pay to be part of the service.  These firms spend millions on recruiting and getting the right people is very important for them.

I refined my pitch and got a meeting with senior recruiting partners at McKinsey and Boston Consulting Group.  I didn't ask them to sign up but rather to explore the concept with me.  They connected me with the right people at Bain Consulting.  Having those three firms interested in the project made it easy to have the right conversations with other leading consulting firms.

During those discussions I got very useful feedback on what each firm wanted.  Each agreed that they wanted a service that included only the best firms their peers.  A small boutique firm could be acceptable if it had an excellent reputation but they didn't want to be alongside second-tier firms.  (This would extend to other fields as well.)  Other wants were varied.  One firm really valued the ability to connect with top students at smaller colleges or graduate programs; another had a laser focus on a very small number of schools and only wanted to increase their presence at those schools.  The service morphed considerably from what I'd first envisioned, becoming potentially more valuable to my clients.

In the end, the project didn't go ahead.  The legal and marketing departments of the firms each wanted a level of control over content that I thought would undermine the project (the recruiters agreed with me) and one of the key firms decided not to go forward.  This was a disappointment, obviously but the approach had made success possible...and all I lost was my time.

In thinking about whether and how to apply a Kickstarter structure to negotiations, consider the following questions:

1. How useful will it be to get indications of interest from potential counterparties?  Are people more likely to be interested if they see that their peers (or rivals) are interested?
2. How valuable do you think feedback will be and how can you set things up to get the most useful feedback?
3. How do you close the deal?

The last question is important, because it's very easy for a Kickstarter-style conversation to keep moving forward but never cross the finish line.  Kickstarter deals with this in the most obvious way; it has a deadline.  Unsurprisingly, projects tend to get most of their pledges shortly after launch and right as the project closes.  Think about how you can convert interest into closure.

Kickstarter within a Kickstarter?

I'm going to end with an anecdote that I think illustrates not only the power of the Kickstarter approach but more generally how useful it can be to think openly about deal design and negotiation.

I was working with a client on raising equity investment for a start-up business.  He had a good team and an exciting initial product that had the potential to be a home run success but also entailed considerable risk.  He had found a group of angel investors that were ready to put up the seed money, but only at a valuation he couldn't accept.  He needed a way to increase the perceived value of the deal.

We discussed Kickstarter and unsurprisingly he was already planning to use it in his launch.  The snag was that Kickstarter alone was unlikely to meet his full funding needs, creating a risk that even a successful Kickstarter launch (say, one that raised a third of what he needed) would create fundraising problems because he would need to raise the rest of the money quickly enough to continue product development aggressively.

My suggestion was to pitch an investment agreement that would be contingent on the Kickstarter launch hitting an ambitious target.  That is, the investors would agree to a more favorable valuation (i.e. get a smaller piece of the company) but their investment commitment would be contingent on a Kickstarter result that would merit that higher valuation.  (Contingent agreements like this are often a good solution to different expectations about the future, e.g. how successful a product or company will be.)

Again, this approach does not have to involve Kickstarter itself.  Imagine a start-up that has received interest from a VC firm and from a few potential big clients.  The VCs are reluctant to invest until the firm has at least one large client but the clients don't want to commit to a service from an unfunded startup.  A contingent agreement might be a natural solution; if the clients know that the VC is in if they are, the deal is much more attractive.  (In practice, of course, VCs will often take the initiative in making this happen.)

Sunday, August 12, 2012

Breaking the Rules

One of my most consistent pieces of advice to negotiators is to break the rules.  By this I don't mean the rules of law or of ethics, but rather the self-imposed rules we're often unaware of that limit our choices.  George Perkins refused to think only about the terrible BATNA facing Teddy Roosevelt's campaign and as a result got paid rather than paying out a fortune.  Pat Toomey tried to gain leverage in negotiating the debt ceiling with Obama by changing the no-deal outcome so that it became a credible threat.  Not every move succeeds, but many of the most successful examples of value creation and of value capture involve one or both parties going past the conventional approach.

A reader of the blog sent me the following clip, which absolutely made my day.  It's a perfect example of breaking the rules.  The clip shows the finale of a UK game show called Golden Balls.  During the show the players accumulate money in a jackpot and then in the final round they are presented with a Prisoner's Dilemma.  Each must secretly choose either "Steal" or "Split".  If both choose Split they split the jackpot.  If one chooses Split and the other chooses Steal then he takes the whole jackpot.  If both choose Steal, they get nothing.  Before they decide they get 30 seconds to talk about what they're going to do.

Let's break down what happened.

First, let's review the incentive problem that a Prisoner's Dilemma creates.  Imagine that you're one of the players and you know the other person is going to choose Split.  You can then either choose Steal (and get the whole thing) or Split (and get half).  You're better off choosing Steal.  Now imagine you know he's going to choose Steal.  You get nothing either way.  Thus, Steal can be better than Split but Split can never be better than Steal.  In game theory terms, Steal dominates Split.

Given this, the normal play is to spend thirty seconds persuading the other person to choose Split, presumably with the promise that you're going to choose it yourself.  Each player will pledge to "do the right thing" and then worry that the other one will choose Steal -- and, of course, some of them will choose Steal themselves.

In this case, however, the gentleman on the right broke the rules.  He declared that he was going to choose Steal but promised that if the other player chose Split he would split the money with him after the show.

His move is based on two key insights.  First, the show doesn't have to be the endpoint of the game.  The whole gambit only becomes possible with the recognition that even if the show awards all the money to one player, the players could have a separate agreement to split it.

The second insight is that this particular Prisoner's Dilemma can be broken.  A typical Prisoner's Dilemma requires both players to choose the "cooperate" option (in this case, Split) in order to gain the best combined outcome.  In Golden Balls, however, it only requires one person choosing Split for the full jackpot to be awarded.  This, combined with the ability to offer an after-the-show promise, allowed him to reverse the game theory implication for his opponent.

Imagine you're the player on the left.  You believe that the other player is going to choose Steal.  That leaves you with two choices -- Steal (and get nothing) or Split (and hope that he's honest and will divide the money with you).  Unless you're really angry with the strong-arm tactics or really want to avoid being suckered when he says, "Thanks for choosing Split but I have no intention of sharing the money with you," your best choice is to choose Split.  Instead of the Dilemma pushing you towards a "defect" option, it now pushes you to cooperate.

That leaves one small problem.  People aren't always rational, especially under pressure.  There has to be a non-zero chance that the player on the left will choose Steal either out of anger or confusion or simply because he really doesn't want to be suckered.  Our hero solves this problem by choosing Split in the end!  If his gambit succeeds then the players split the money (which was his intention anyway) but if it doesn't then the other player might decide that he had good intentions all along and agree to split the money as they'd both said they wanted to do.

In my experience, opportunities to break the rules aren't rare -- they are the rule rather than the exception.  The more we can free ourselves of artificial constraints, the more likely we are to find win-win opportunities (or ways to capture value) that would otherwise have gone unnoticed.

Friday, August 10, 2012

Deconstructing an Offer

Today we step out of theory for a bit and look at a very mundane negotiation; the type each of us faces regularly at home and at work.  Hopefully it will be useful for your own negotiations but naturally I'm going to try tying it to a larger theoretical idea.

Part of the renovations of the school next door to my home included putting up a new fence along the abutting side of my property.  At the start of the project there were two fences there; an old chain-link fence on the school side of the line and a wooden one on ours.  The renovation called for the school to replace the chain-link fence with a new cedar fence.

Our fence is both old and, to use a technical term, cheap.  It was already in rough shape and it sustained some damage during the project.  There was an obvious win-win opportunity here; rather than ask the town to fix the damage to our fence we asked them to remove that section entirely so that when the project is complete there is only one fence -- the new wooden one.

As the date of the fence work approached, my wife and I decided we should also look at replacing our fence that ran along the back of our yard to match the new fence along the side.  This also seemed like a natural win-win since the additional cost for the fencing company to add in another section of the same fence they were installing for the school would be significantly lower than for a new job.  (Their crew and equipment would already be here, and they might get a further volume discount on the fence itself.)

As I contacted the fence company, I knew I was missing some potentially important information.  I knew what the new fence looked like and what it was made of, but I didn't know the wholesale cost or the specific product information that would let me get a bid from another fence company.  I wasn't too worried about that, however, since this was easily findable information (and the fencing company would know that).

I would never begin a large negotiation without having that homework in place but for something relatively small it can make sense to move forward and only spend time getting information if it proves necessary.  As with anything, the benefits have to be weighed against the costs.

The initial quote from the fencer was significantly higher than I'd anticipated.  Without having done my homework I was now in that uncomfortable position of wanting to negotiate them down in price while not knowing what would be a realistic counter-offer.

A useful technique in this situation is simply to ask the other party to explain their offer, providing some context as to why it seems high but not making a counter-offer of your own yet.  I told the company that I'd expected a fairly low cost for the this fence given that they would already have their crew and equipment on site and asked them to break their quote down, including detailing the cost of the fence materials (to them) and labor.

This sort of framing is useful in multiple respects.  First, it sets the other party's expectations that this is a competitive negotiation without becoming hostile or aggressive.  Second, by breaking down their bid into material cost, labor and profit it becomes very hard for the vendor to keep their bid inflated.  Any fence company can confirm their wholesale cost (so it's both fruitless and dangerous for them to lie about it) and labor is also hard to fudge.  Thus, when they come back to me they either need a rationale for the original bid (assuming I wasn't just underestimating the fence cost) or they need to come down in price before I even make a counter-offer.

In this case they did both.  The owner explained that because the school project was a public-sector job they had to pay "prevailing union wages" but that she was willing to come down 10% on the price of the job.  Now I was 99% sure that nothing prevented them from having their crew do a separate job right next to the school job and pay them normal rates (even assuming they actually had to pay higher rates for the fence along the school property line) but I didn't want to accuse her of lying.  So how do we get them to lower their bid further?

If a counterpart is telling you something that you think isn't true in order to justify a higher price, see if you can find a decision that makes sense if they're telling the truth but that they would want to prevent if they aren't.  In this case, I answered that I'd assumed that already being on-site would make the job cheaper for them.  If, in fact, it was making it more expensive then instead of having them do the extra fence we would just wait.  I asked her to give me a quote for doing the work at a later date and said that with the time pressure off we could see how we liked the new fence installed and whether we wanted to replace it after all.  We could also get a couple of other quotes before moving ahead.

If, in fact, they had to pay higher labor costs because of the proximity to the school project then this was the rational response on my end.  If, however, they can pay their normal wage rates it's a terrible outcome for them.  They risk not getting the job at all and if they do get it their costs would be higher.  Rather than accusing anyone of lying I created a situation where if they were lying they would correct the lie themselves.

It seems that my initial assumptions were correct; the fence company could indeed pay normal labor rates for the work on our fence and since they were already there they could take a lower margin on the additional work than would normally make sense.  They called back and said they had "figured out a way" that they could handle the wage issue by making it a separate job and their offer now came in at just over half the original quote.  Calls to two other fencing companies confirmed that this bid was more than competitive; no one else would match it.  One guy even said, "At that price I wouldn't make enough money to cover the cost of coming out there."