Dear Negotiation Coach: “Bad acts” and better contracts.

Q: I work for an international nonprofit that tries to eliminate “bad acts” around the world—not illegal activities, but ones that we consider unethical. We are currently negotiating with a U.S. business owner who is engaged in these bad acts. His business is generating losses, so we are trying to buy him out and put him out of business. Our due diligence shows that he has a commitment to pay $275,000 per year for the next six years on his lease. Our board has authorized us to pay him up to $2.1 million to cover his lease commitment and then some, so there should be room to bargain here. He turned down our first offer of $687,000. What should our next step be?

A: With your offer of $687,000, you have launched a price negotiation, and if you continue along these lines, you and the business owner likely will settle for an amount greater than $687,000 and less than $2.1 million.

A natural “focal point” for this negotiation would be $1.65 million, since it’s the number that would make him whole on his lease commitment. But let’s reexamine your assumptions about what would happen next. If the landlord can readily find a new tenant, the business owner would likely negotiate to get out of his lease commitment for much less than $1.65 million. This would leave him with a windfall in his negotiation with you—an outcome that may not square with your commitment to not reward “bad acts.”

You might anticipate this risk by having a “clawback” provision in your agreement with the business owner: For example, you would get back 50% of any money that he saves in a renegotiated lease commitment with the landlord. But this approach has at least two problems. First, it assumes that the “bad actor” will truthfully report to you what he has renegotiated with the landlord and then actually make the required payment to you. What if the bad actor and the landlord collude to avoid the clawback provision in your contract? Second, and perhaps more important, this provision would reduce the business owner’s incentive to renegotiate the lease terms in the first place.

The better approach, in my opinion, would be a different kind of deal structure. Instead of negotiating a price deal, negotiate a deal in which the tenant simply assigns the lease to you—in essence, sublets it—and walks away from the business. You now have every incentive to renegotiate the terms of the lease commitment with the landlord. In the worst case, you pay $1.65 million over six years, which is better than a single payment today in terms of cash flow.

Stepping back, your question raises the interesting issue of “incentive-compatible” contract design—that is, making sure that parties’ incentives are aligned in a way that leads to long-term value creation. Sophisticated dealmakers are constantly looking to structure deals in ways that minimize such contractual problems as moral hazard (as in your case), adverse selection, information asymmetries, and asset specificity. Just as negotiators can leave value on the table by not identifying win-win opportunities for trade, these problems, if unaddressed, act as a tax on the transaction that reduces overall value. In your situation, reassignment of the lease is likely a better way to maximize incentives than a flat payment.

Guhan Subramanian
Joseph Flom Professor of Law & Business, Harvard Law School
Douglas Weaver Professor of Business Law, Harvard Business School
Academic Editor, Negotiation
Author, Dealmaking: The New Strategy of Negotiauctions (W. W. Norton, 2011)