Try a Contingent Contract if You Can’t Agree on What Will Happen

Negotiators often reach impasse because of their different predictions of how the future will unfold. By negotiating a contingent contract, they can eliminate the need to reconcile those differences.

By on / Dealmaking

contingent contract

In negotiation, all the goodwill, trust, and cooperation you create can seem useless if you and your negotiating counterpart disagree about how future events may play out. In such cases, a contingent contract can be a highly useful, though widely overlooked, tool for creating value in negotiation.

Imagine, for example, the following negotiations:

  • A home remodeler insists that his team can finish a potential customer’s room addition in two months, but the customer fears he’s being too ambitious or possibly lying.
  • A town manager is negotiating for a new fuel-oil contract with a vendor and is concerned about unforeseen increases in the price of the oil, which could hit citizens hard.
  • A teenager insists she can earn enough money babysitting to reimburse her parents for the monthly payments on a new phone, but her parents aren’t so certain.

In situations such as these, contract terms would seem to depend on one or both parties making a risky compromise based on its predictions about how the future will unfold. When assessing how to close a deal in such situations, negotiators would be wise to consider negotiating a contingent contract.

What is a Contingent Contract?

Contingent contracts are “If this happens, then we do this or that” promises that parties add to their negotiated contract to reduce their risk in the face of uncertainty about the future, writes Massachusetts Institute of Technology professor Lawrence Susskind in his book Good for You, Great for Me: Finding the Trading Zone and Winning at Win-Win Negotiation.

In virtually any negotiation, parties must make forecasts and assumptions about the future, notes Susskind. Will materials arrive on time for the contractor to meet his deadlines? Will fuel-oil prices remain stable or rise suddenly? Will the teenager find as many babysitting jobs as she anticipates?

In terms of deal design, a contingent contract often creates incentives for compliance and/or penalties for noncompliance, according to Susskind, but also can take the form of insurance, bonds, and other tools designed to reduce risk. For example:

  • The homeowners might propose to pay the contractor a 5% bonus for on-time completion, on top of his negotiated fee, but charge him a 5% penalty for any delays.
  • The town manager could ask the fuel-oil vendor to provide a guaranteed annual price-increase cap of 10% in exchange for negotiated delivery dates and amounts as spelled out in the contract.
  • The parents could tell their teen that if she is unable to meet her monthly phone payments by babysitting, she will have to work at the family’s small business to make up the difference.

In each of these cases, the party being offered the contingent contract should be happy to take the bet (or negotiate it slightly) if his or her promises have been truthful.

How can you make a contingent contract part of your negotiation behavior? First, outline the scenario that each party imagines will happen in the future. Second, negotiate expectations and requirements for each of these visions of the future. Third, put both of these scenarios in your contract.

Advantages of Contingent Contracts

In addition to spreading risk and surfacing deceptive claims, contingent contracts have numerous other benefits for negotiators, according to Susskind:

  • A contingent contract eliminates the need to come to agreement. By allowing parties to bet on their predictions, a contingent contract enables parties to “live with” their differences.
  • A contingent contract makes commitments self-enforcing by eliminating the need to reconvene or renegotiate when a surprise crops up.
  • A contingent contract heads off litigation by reducing the likelihood that conflict will arise over surprising events and by spelling out exactly what will happen if a conflict emerges.

Contingent contracts are a great way of creating value in negotiation, but they need to be considered and crafted with care, due to potential pitfalls, notes Harvard Business School and Harvard Law School professor Guhan Subramanian. For example, a homeowner who is skeptical that a contractor will meet his stipulated deadlines could turn out to be misinformed and end up overpaying for the project, via a bonus. For this reason, before negotiating a contingent contract, be sure to consider that the other party may have access to information that you lack.

Have you ever negotiated a contingent contract (whether you called it that or not)?

Comments

One Response to “Try a Contingent Contract if You Can’t Agree on What Will Happen”

  • Christ Z.

    Excellent points in this article!
    When we needed to add a room addition to our home for our soon-to-be-born child, I negotiated a completion date (one month before our child’s birth date).
    For every day late, the contractor was penalized $250 a day. The human factor of sympathizing with a pregnant wife combined with the penalty is a great combo. In addition, we had exact plans for the builder and independent inspection for objective determination of what “completion of the project” means.
    I would like to hear from the author about how contingent contracts “play out” when dealing with owners selling their business to Private Equity Groups (or any professional investors). Many times owners want a higher valuation than the traditional multiples in the industry. And the owner feels the business is stronger and more growth orientated than outside folks. But the owner is reluctant to sign a contingency purchase agreement.

    Reply

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