Good contracts make good business relationships

Akin to the adage that “good fences make good neighbors” so do good contracts make good business relationships. Contracts are the foundation of a strong business relationship between buyers and sellers, principals and agents, and partners; therefore, contracting should be part of the business relationship process from beginning to end. Good contracts align interests, incent proper behaviors, establish rights and responsibilities, and form the basis to allocate value and risk.

Risk cannot be ignored

Bigger risks do not always equal bigger rewards; however, value can often be extracted from risks in a relationship. The essence of risk is uncertainty, leading to potential positive and negative impacts. However, to extract value from risks, risks must be properly identified, understood, analyzed, treated, and allocated. The result is that risks can be used as an important lever to achieve a win-win business relationship.

Furthermore, not addressing or ignoring risks does not make them go away; it just means risks are being taken on without understanding them – a dangerous approach. Of course, companies usually don’t make policies to ignore significant risks; however, it often happens because risks are either not recognized or there is a belief that if something is uncertain it cannot be addressed. Risks are, by definition, uncertain.  But they cannot be ignored.

”Open up” negotiations for value

Too many negotiations are one dimensional; they focus on buying or selling one narrowly defined product or service at a price. This approach inherently leads to price based negotiations that are win-lose by nature. The problem is that by focusing on the one element of the offering that is always valued the same by both parties (i.e. price) one party’s gain is another party’s loss. A better approach is to “open up” the negotiations using a multi-dimensional approach that establishes a clear linkage between multiple product or service offerings at different prices. Negotiations are then focused on understanding what and how different elements drive different values and risks for each party.   After the important elements of the contract offering are identified, a win-win business relationship can be formed by trading values and risks of these elements between the parties in a guided and deliberate negotiation process.

Quantify value for more informed decisions

Business decisions are driven by the bottom-line.  How the contractual relationships support the bottom-line can and should be quantified before making a decision.  Whether on the buy or sell side, significant economic improvement, or impairment is often the result of good or bad contracts.  A financial engineering approach can be used to analyze contracts. The approach leads to unmasking hidden options and potential risks which can be leveraged to further increase benefits derived from the business relationship.  A formal contract structuring and valuation process will help the business make more informed decisions and create a portfolio of higher performing contracts.

In summary

  • The elements that create a good business relationship can and should be “hard-wired” into contracts
  • The essence of risk is uncertainty; it is inherent in every business relationship
  • Risk can drive value and should be formally identified, valued, treated, and optimally shared among parties
  • A multi-dimensional approach to negotiating drives value discovery and achieves better results and reveals win-win solutions
  • The bottom-line impact of a contractual relationship can and should be holistically quantified