The Winner’s Curse: When to Make the First Offer in Negotiations

A winner's curse negotiation - when winning at the bargaining table feels like losing

By on / Dealmaking

winner's curse

In a winner’s curse negotiation scenario, the winner may often find herself on the losing end of the deal. Ever win something you wanted, then realize too late you got a raw deal? Here’s how to recognize when backing away is your best bet in a negotiation.

Imagine that while exploring an outdoor bazaar in a foreign country, you see a beautiful rug that would look perfect in your home. While you’ve purchased a rug or two in your life, you’re far from an expert. Thinking on your feet, you guess the rug is worth about $5,000. You decide to make a bid, but a low one. You engage the merchant in some pleasantries and then make an offer of $1,000. She quickly accepts, and the transaction is complete.

How do you feel as you walk away? Pleased with your purchase – which was, after all, far cheaper than you expected – or uneasy about it?


Discover how to boost your power at the bargaining table in this FREE special report, Dealmaking: Secrets of Successful Dealmaking in Business Negotiations,
from Harvard Law School.


Most negotiators who put themselves in this negotiation scenario feel uneasy, sensing that the rug is not as good as they thought it was before agreeing to the price. The winner’s curse describes a common paradox in negotiations: winning something you wanted, then realizing that the other side’s acceptance tells you some disappointing news about what you just bought (see also, information asymmetry in negotiations).

Tackling a problem from the business world can help resolve the internal dilemma that surrounds the winner’s curse. Read the following hypothetical scenario drawn from negotiation examples in real life and decide what your answer would be (for more in-depth information on the winner’s curse, see also Definition of the Winner’s Curse in Negotiation).

Acquiring a Company

In this negotiation role play simulation exercise, you represent Company A (the acquirer), which is thinking about acquiring Company T (the target) by means of a tender offer. You plan to tender in cash for 100% of Company T’s shares but are unsure how high a price to offer.

The main complication is this: The value of Company T – indeed, the company’s viability – depends directly on the outcome of a major oil exploration project it is currently undertaking. If the project fails, the company will be worth nothing under current management – $0 per share. But if the project succeeds, the value of the company under current management could be as high as $100 per share. All share values between $0 and $100 are considered equally likely.

By all estimates, whatever the ultimate value under current management, Company T will be worth 50% more under the management of Company A.

If the project fails, Company T will be worth $0 per share under either management.

If the project generates a $50 per share value under current management, Company T will be worth $75 per share under Company A. A $100 per share value under Company T implies a $150 per share value under Company A, and so on.

The board of directors of Company A has asked you to determine the price it should offer for Company T’s shares.

This offer must be made now, before the outcome of the drilling project is known.

Company T has made it clear it that it wants to be acquired by Company A, provided the price is profitable and that it is uninterested in taking bids from other companies.

You expect Company T to delay a decision on your bid until the results of the project are in, then accept or reject your offer before the news reaches the press.

In other words, you won’t know the results of the exploration project when you submit your offer, but Company T will know the results when deciding whether or not to accept it. Company T is expected to accept any offer by Company A that exceeds the value of the company under current management.

As the representative of Company A, you are considering offers ranging from $0 per share (tantamount to making no offer at all) to $150 per share.

What price per share would you tender for Company T’s stock?

A Question of Logic

This negotiation problem has been presented to MBA students, auditing partners, investments bankers, and CEOs. Most people tender an offer that falls somewhere between $50 and $75 per share. Why? The acquirer knows that the company’s value under current management falls somewhere between $0 and $100 per share, with all values equally likely.

Since the firm is expected to be worth 50% more under the acquirer’s management than under current ownership, it appears to make sense for Company A to make an offer.

Many people argue that, on average, the firm will be worth $50 per share to the target and $75 per share to the acquirer. Consequently, any transaction in this range will, on average, be profitable to both parties.

This explanation is dead wrong. Don’t believe it?

Consider the logic behind deciding whether to make an offer of $60 per share.

Negotiation Examples from a Winner’s Curse Negotiation – Making an Offer

If I offer $60 per share, the offer will be accepted 60% of the time – whenever the firm is worth between $0 and $60 per share to Company T. Since all values between $0 and $60 are equally likely, the firm will, on average, be worth $30 per share to Company A, resulting in a loss of $15 per share ($45 to $60). Consequently, a $60 per share offer is unwise.

A bit of analysis shows that this reasoning applies to any positive offer. On average, Company A acquires a company worth 25% less than the price offered and accepted. For any offer, Company T will be worth anywhere from $0 to the amount offered, with all values equally likely. Thus, on average, Company T will be worth half the value of the offer to the target. Even when the 50% premium is factored in, the expected value of the firm to the target is still 75% of the value offered.

The inevitable conclusion? All Company A’s offers are more likely to lose money than to make money. The only good bet is zero dollars, or no bid at all (for related information, see also The First Offer Dilemma in Negotiations and Dealmaking Strategies – Haggling: When to Make the First Offer).

 


Discover how to boost your power at the bargaining table in this FREE special report, Dealmaking: Secrets of Successful Dealmaking in Business Negotiations,
from Harvard Law School.


Adapted from “The Winner’s Curse” by Max H. Bazerman for the 2004 Negotiation newsletter.

Originally published 2013.

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