Value Creation Through Trades

 

There are two concepts in negotiation which separate the beginners from the professionals.  One is value claiming – seeking to take a bigger share of a fixed pie.  The other is value creation – seeking to co-operate with the other party in increasing the pie.


Ben Killerby

 

Value claiming happens in both distributive negotiations and integrative negotiations.  Value creation, on the other hand, really only happens in integrative negotiations.

 

  • Value creation” is creating a gain for one or more parties in a negotiation by co-operating and sharing information.

 

Value creation happens in the context of one party offering something of lesser value to itself as a trade for something that it views as higher value from the other party. Value creation is a way out of win-lose negotiations and can be use even when there is otherwise no zone of possible agreement (“ZOPA”).   The essence of value creation is to trade something else at your disposal for what you want from the other side.

 

 

For example, to increase the valuation of your business prior to a capital raising or a sale, you might seek to reduce your input costs from your suppliers.  If you want to buy 10,000 units a month at no more than $5 (your reservation price) , but your supplier is firm on selling 10,000 units at not less that $6 (the supplier’s reservation price), then in a distributive negotiation, there is no ZOPA.  But before you walk away, try creating value through trades.  Ask the supplier if they would sell 120,000 units at $5.  If the answer is yes, then ask if you put in an order now for $120,000:

 

  • Would they stagger delivery over 12 months at 10,000 units a month?
  • Would they offer interest free terms?
  • Would they offer staggered payments?
  • Are there any other customers of the supplier that would do a joint order with you using some or all of these options?

 

By asking for information at all stages about the issues affecting the supplier, you might find that short runs of 10,000 units cost the supplier more because of the set-up costs.  The longer the run, the lower the unit cost to the supplier and the more the supplier can afford to lower the price whilst still maintaining its margin.  Finding value creating options can save your business millions over the years and position it for a successful fundraising or sale.  Some value creating techniques are:

 

  • Reducing the initial  payment on placement of order
  • Increasing the scope of the warranty
  • Increasing the length of the warranty
  • Knowing the supplier’s cost of goods and talk frankly about margins
  • Entering into a long term supply agreement in return for a lower price
  • Offering to be a reference customer so that the supplier can use you to get further customers.

 

Most value creation comes from information you have about the other side.  It is extraordinary how easy it is to get this information.  For example, before going into the negotiation with the supplier, ask the supplier for a list of reference clients that already buy this product.  Then simply pick up the phone and call these other clients.  More often than not, after a few introductory questions on service, deliveries, quality etc., simply ask them how much they pay for  a run of 10,000.  Then ask how much they think the supplier might give up for early payment or longer contracts.  Unless these customers are your mortal enemies, they often give all sorts of information over the phone that you can then take into negotiations.

 

 

Value creation through trades is possible not only with information, but with the ability to put yourself in the shoes of the other side.  If you imagine the average supplier, for example, their concern is mostly about getting paid.  Therefore, develop some possible trades that are at little cost to you, but  of enormous importance to them:

 

  • One trump card is to offer a bank guarantee in return for a lower price.  Yes, a bank guarantee lowers your  overall borrowing capacity by the amount of the guarantee, but it is an extremely powerful weapon in securing a lower price
  • You can also offer to pay the insurance premium on the supplier insuring your debt if that makes sense when the lower unit price far outweighs the insurance premium on the debt insurance.

 

Information about the other side yields all sorts of possibilities in terms of doing a deal at a lower price:

 

  • If you knew that they had old stock that that they needed to clear, could you live with that older stock in return for a lower price?
  • If they are running at 45% capacity and your order will bring it up to 85%, will they do it for a lower price to you and not to the customers buying the 45%?
  • If it is the end of the month, do they need to fill a sales quota, even if it is at a lower price?

 

Sources of Value Creation

 

In my view, value creation comes about by arbitraging the differences between the parties.  There are four sources of value creation that you should look for in each negotiation:

 

  • Differences between the parties
  • Non competitive similarities
  • Different economies of scale
  • Opportunities for reducing transaction costs and dampening economic opportunism. [1]

 

Differences between the Parties

 

Finding differences between the parties is more important than finding common ground.  Common ground cannot be arbitraged, but differences can. There are five commonly accepted forms of difference [2]:

 

  • Different Resources: If each party has a pre-existing resource, they might simply swap the resource that they view as lower value of the resource of the other side that they consider higher value.  This might come about  when a start-up retail venture trades interior design for shares in the start-up.
  • Different relative valuations: If each party has a different idea of the value of their resources, then it is easier to trade one viewed as low valuation for one of higher valuation.  The interior designer may do the job in downtime when there is no other work and might yearn to have equity instead of payment by the hour.  The start-up may welcome the opportunity to conserve cash.
  • Different forecasts of future events: A seller of a business usually has a more optimistic view of the future than does the buyer.  This can often lead to the parties walking away from a prospective deal, unless an earn-out mechanism is found whereby the seller is rewarded if the business performs well, and the buyer  does not have to pay more if it does not.
  • Different risk profiles: A supplier might be confident that its products will not fail in the first three years, but a buyer might be very concerned about the effect of product failure on the rest of its business.  Here a deal can be done by shifting the risk from the worried buyer to the confident seller where the seller does not believe that anything will fail, but the buyer now has this worry taken away and is prepared now to do the deal.
  • Different time preferences: There are usually two time preferences in simple negotiations – when the agreed event will occur and when it will be paid for.  These can be adjusted as simple trades to create value.  The buyer may want the delivery early, in which case the supplier could charge a premium.  Alternatively, the buyer may agree to staggered deliveries over time if that suited the supplier’s production schedule.  Alternatively again, pricing may change depending on whether the goods are paid for on 30, 45, or 60 days.

 

Non-Competitive Similarities

 

A non-competitive similarity is one where the parties do not compete.  That is, one person’s gain does not mean the other person’s loss. [2]  This can be found in a shared desire by the parties to have a cordial relationship that is productive and remains so in the future.  The relationship between an entrepreneur and a prospective VC is like this – they will have to work together for a number of years, so they might as well keep it civil.  The sale of a business where the vendor will have no further involvement does not have the same imperative.

 

 

Economies of Scale and Scope

 

Two smaller competitors can form an alliance whereby they combine production into one bigger plant.  The savings on administrative overheads, rent, insurance and related matters usually work out at around $500,000 per $4m in turnover.  Such economies of scale are a quick source of creating value.  Another source is economies of scope – where the same resources are used to create different products.

 

 

Opportunities for Reducing Transaction Costs and Dampening Economic Opportunism

 

A final way of creating value through trades is trading information and conducting negotiations in such a way as to reduce the time and cost of coming to an agreement.

 


Conclusion

 

The term “win-win” is bandied around a lot – and probably without regard as to how wins are achieved.  There are a number of steps in value creation, however, that can be followed in most negotiations to achieve a better outcome. Most of these steps focus on the differences between the parties.  In this sense, the differences between the parties are much more important than the similarities.

 

 

 

[1] Mnookin, R.H., Strategic Barriers to Dispute Resolution 8 Harv. Negot. L. Rev., 1

 

[2] Mnookin, R.H., Peppet, S.R., Tullemello, A.S., Beyond Winning Harvard University Press p. 16

 

[3] Ibid., p 17

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