One of the most powerful tools in the entrepreneurial management tool kit is the Deal. A deal is simply an allocation of cash and risk. Deals are everywhere. There are deals with investors, partners, employees, customers, the government, and suppliers. Deals can create value, destroy value, or transfer value.
There are very simple set of questions to understand deal terms. Here they are:
- Who gets what amount of cash at what time?
- How is risk allocated?
- What are the incentives of all parties to the deal now and what will they be for reasonable scenarios in the future?
- Who will be attracted by the deal?
- What can be inferred from how people respond to the terms of a particular deal?
- What are the future consequences (at all levels) of current decisions?
To see how these questions provide insight, let’s consider a deal with a lawyer. How do lawyers get paid? Who bears risk in the relationship? What are the incentives? Typically, lawyers get paid by the hour. In many situations, they get paid the same whether or not they win a court case or whether or not the work they do is great. Lawyers therefore have an incentive to maximize the hours they work. As one observer said, “It’s not whether you win or lose, but how long you play the game.”
It’s certainly possible to design different incentive systems for lawyers and for activities like lawsuits. Some lawyers work on a contingency basis, sharing in the proceeds from a successful court case and paying most of the costs of suing. That is a different system and it will be more attractive to some lawyers than to others. Also, there are limits on the perverse incentives for lawyers to maximize hours because they do operate in a competitive system that controls bad behavior and rewards more effective and efficient lawyers and firms. Your lawyer is generally not the only lawyer in town. So, if you hire a lawyer – or any service provider for that matter – make sure you understand that person’s incentives.
As another example, consider the residential real estate business. Historically, brokerage firms hired multiple agents and paid them a share – typically 30-50% – of the commissions they generated. The brokerage firm paid expenses, including overhead, listing fees, and advertising. Then, in the 1970s, a firm called Re/Max offered a very different deal. Brokers paid Re/Max a fixed monthly fee to affiliate, but the brokers paid their own expenses. In return, they received 95% of the commissions. They also had more flexibility in setting the commission rate they charged buyers and sellers. Re/Max made money by selling franchises, getting franchise fees, and by taking a small percentage of real estate commissions. That’s a different risk-reward sharing scheme.
Re/Max’s deal appealed to the best brokers who were confident in their work. They received higher pay from Re/Max than from traditional brokerage firms. The risk of this deal for the broker is that they don’t sell as many houses as expected, and thus can’t cover their expenses. Brokers who were less experienced, less skilled, worked fewer hours, or were risk-averse stuck with the lower risk model. They were willing to give up some upside to avoid the downside.
As the best brokers went to Re/Max, they gained market share at the expense of the other firms. They grew rapidly. They worked hard to create a global brand identity and to help brokers succeed. After a difficult initial period, Re/Max took off in the US and abroad. By 2016, the company had 112,000 agents and had participated in over 1 million residential transactions. Re/Max made money by selling franchises, getting franchise fees, and by taking a small percentage of real estate commissions. The company had profit margins of over 50% and a market capitalization of $1 billion.
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Resources of these articles are: Harvard Business School