Contingent Contracts: a Valuable Tool When Negotiating Agreements
When you are negotiating an agreement, there are all sorts of ways contract discussions can break down. Often when negotiations become difficult, a contingent contract is a compromise that can lead to a mutually beneficial resolution.
What Is a Contingent Contract?
A contingent contract is an agreement in which the parties to the contract agree to different obligations depending on a future event. A common example is a non-discretionary performance bonus for an employee or manager. A simple provision awarding a non-discretionary bonus might look something like:
If Company Sells X number of units or more of Product Y in 2014, Employee will receive an additional $100,000 in compensation, payable on March 1st, 2015.
In this example, the Company agrees to provide the Employee with additional compensation depending on a future event: namely, the sales of the product the employee is working on.
A convertible note is another example of a contingent contract, one that is ubiquitous in the startup realm. A convertible note converts debt to equity upon a future event–usually a priced equity investment round. The purpose of the convertible note is to delay the pricing until more information is available about the value of the startup. (If you’re interested in learning more about convertible notes, you can read my post explaining why I don’t always think a convertible note is a good idea for startups.)
What Are the Benefits of a Contingent Contract?
One of the major challenges facing negotiators is identifying the information the other party possesses. For example, if you’re looking to sell real estate,
- and you know that the real estate would be worth more if it was zoned commercially,
- but you don’t know if it will be zoned commercially any time soon,
- and you don’t know if the other party knows if the property will be zoned commercially any time soon,
you could add a provision to the sales agreement that requires an additional payment from the purchaser if the property is used for commercial development within the next five years. If the purchaser isn’t planning on using the property for commercial development, they probably wouldn’t have cause to object. However, if the purchaser knows that local officials will change the zoning in the near future, they might be more hesitant to agree, as they’d likely want to try to capture as much of that additional value for themselves as possible. From this example, you can see that contingent contracts can be a powerful tool for acquiring information about the knowledge of the other party and for obtaining additional value from agreements.
You can use contingent contracts to diagnose deceit.
This is another type of information asymmetry discussion; if you are unsure about whether or not the party you’re negotiating with is being truthful, you can ask them to put their money where their mouth is. If you are entering into a manufacturing agreement and the manufacturer is promising a delivery date of June 1st, and you’re doubting whether they can complete the manufacturing of your product by that date, you can suggest a contingency that reduces the payment owed to the manufacturer if they fail to deliver by June 1st. If they are confident in their ability to deliver in a timely fashion, they won’t likely object too strenuously. However, you might find that they are adamant that they will not agree to such a provision, in which case you shouldn’t expect them to deliver your product by June 1st. By suggesting contingent contracts to ferret out deceitful statements you can acquire valuable information in a productive and less confrontational manner. Asking for a reduction in payment obligations is much less confrontational than asking if they’re lying about their ability to deliver by June 1st.
By providing an extra payment if some goal is reached, you can incentivize your employees or contractors to reach important goals for your business. Athletes’ contracts often include performance bonuses. A real life example:
In 2006 the Giants signed pitcher Barry Zito to a six year contract with an optional seventh year. If Zito pitched 200 innings in 2013 he would be guaranteed $18 million in 2014.
Zito didn’t end up pitching 200 innings last season, and thankfully the Giants don’t have to pay him $18 million this year (I’m a Giants fan who’s appreciative of Zito’s efforts, but didn’t always enjoy watching him pitch).
You can use contingent contracts to align interests.
This also dovetails with the previous benefit. Employees and contractors generally have an incentive to “shirk their duties” or “be lazy” in more colloquial terms. If you are paying an employee (or an attorney) by the hour there is an inherent incentive to work at a plodding pace? Why overexert yourself if you’re going to get compensated the same regardless of your efficiency? Of course, this is a short-sighted view for an employee or an attorney to take, but it is a real problem. How can you overcome an employee’s incentive to shirk their duties? You can give them a performance incentive like the one Barry Zito received or like the one the employee would have received in the first example if X units of Product Y were sold. By awarding the employee for reaching a goal that furthers the company’s interests, you can align the company’s and the employee’s interests, and reduce the employee’s incentive to shirk.
You can use contingent contracts to turn differences of opinion into mutual value.
Differences of opinion are often a source of contention in contract negotiations. For example a consulting firm might think that it can increase net income for a business by $1,000,000 in the next two years. But the company hiring the consulting firm might only think the consulting firm could increase the company’s net income by $100,000 during that time. This fundamental disagreement could derail a negotiation for pricing the consulting firm’s services. However, the company and the consulting firm could agree that the consulting firm will be compensated by 25% of the increase in net income for the business in excess of $100,000 during the next two years. This would address the company’s concern about the value they would receive from the consulting firm’s services, it would encourage the consulting firm to work hard to meet the company’s goals, and it would reward the consulting firm only for meeting those goals.
This is similar to the differences of opinion issue, but individuals and companies have a tendency to overvalue their own products or services. Something’s always a little bit cooler, if you’re the one that built it. This inherent bias can throw a wrench in negotiations. You can use a contingent contract to test the strength of these biases and protect your interests against these biases by again asking the party you’re negotiating with to back up their claims with financial incentives. If you’re negotiating with a company licensing their product and they’re promising the product will result in $10 million in sales, make a portion of their fees based on reaching this sales milestone–let them assume the risk that their view is biased.
You can use contingent contracts to reduce risk.
A contract is essentially a careful allocation of risk. A thoughtfully drafted contract should address who bears the risk of the product or service underperforming, being delivered late, etc. Frequently the purchaser assumes this risk and takes a larger share of the upside in the event the product or service outperforms estimates. By utilizing a contingent contract, the seller and the purchaser can share the risk and the upside.
Why Aren’t Contingent Contracts Used All the Time?
Negotiators don’t always know that contingent contracts are an option.
Sometimes contingent contracts are overlooked simply because they’re not tremendously common. In many types of agreements standard terms get recycled and negotiators forget to pursue other options.
Contingent contracts require continuing interaction.
If you’re dealing with a party you’re not very fond of, a contingent contract might not be the best option. Once the event that determines the outcome of the contingent contract has been resolved, the parties will have to reconvene to settle the contract. Sometimes this requires only a nominal event like in the case of Barry Zito, where the target wasn’t reached and the Giants didn’t have to pay him for reaching the milestone. But in other scenarios a more impactful event may be triggered. For example, in the case that Zito had pitched 200 innings, the Giants would have had to keep him for another year at the cost of $18 million.
Contingent contracts can lead to enforceability issues.
There are two primary issues to be concerned about with regarding enforcement of contingent contracts (in addition to the usual concerns about the enforceability of contracts in general):
- The contingent event described needs to be described with sufficient precision. You don’t want to be litigating whether or not the contingent event occurred.
- If you’re contracting to have someone pay you at a future date, provided that a future event occurs, you need to be sure they have money to pay you. One potential solution to this issue is to require a payment be made into an escrow account. Another would be to purchase a financial loss contingency insurance contract.
Contingent contracts can lead to additional transaction costs.
Drafting a contingent contract can be more complicated (but is not necessarily more complicated) than drafting a contract without contingencies. Additionally with a contingent contract you might have the extra step of collecting or issuing an additional payment. And in a worst case scenario, you’re in court litigating whether or not the contingent event occurred. All of these possibilities can add transaction costs that eat into the potential value captured from a contingent contract.
Contingent contracts may be more uncertain.
Contingent contracts might have more uncertainty than other contracts. One way of looking at a contingent contract is viewing it as a bet on the future. That future event is uncertain, and thus the parties to a contingent contract have to deal with this uncertainty. However, once you’ve completed the purchase of a product or service using a contract without contingencies, the uncertainty isn’t necessarily removed entirely as you’ll still have to be concerned about the quality of the product or service you’ve purchased. Indeed, well-drafted contingent contracts can actually reduce uncertainty by reducing and efficiently allocating risk.
If you’d like to know more about contingent contracts or if you are interested in contract negotiation services, you can email us at email@example.com or call us at (206) 745-5229.