The Do's and Don'ts of Deal Making and Contract Management

I had an opportunity to sit in on the second day of the Sourcing Industry Group meeting in Orlando today.  Ed Hansen from the law firm of Morgan Lewis presented on the essentials of writing a good contract.  Good is a difficult word here, but it is important to think through how contracts operate in the “complex” world.  This was truly one of the best presentations I’ve seen on how to write effective contracts and make good deals that drive mutual benefit.

Ed began by pointing out that the definition of successful contracts has nothing to do with “never having to work it again”. It is not a weapon to battle the other side – and not just something that legal should haggle with every time. But contract management is about getting the ROI that you negotiated, and ensuring that it is driven by a common sense approach.

An important caveat is to differentiate contracting in terms of commodity vs. complexity deals.

A commodity is something you can completely describe in a contract.  The specifications are right and supplier agnostic.  Price and value is generally a linear relationship.

Complexity occurs when parties are very interdependent, and neither party can be truly successful without the input, support, and cooperation of the other. The price/value relationship may not be inverse.

It is much more difficult to write a contract for a complex deal.  Economic rents are often involved, and there can be different facets of the deal.  For example, software license usually is not considered complex sourcing – but the systems integration work most certainly is.  The people skills can be critical in systems integration, as driving change is a non-linear activity that may not be easily quantified into a price.  Think about using a fixed price deal on an ERP implementation system where there are so many unknowns and requirements.  Talk about complexity!

Ed went through his list of “pet peeves” when it comes to ineffective contract management terms and phrases. He emphasized how important it was to avoid the use of nominalization, the passive voice, and a pompous voice.

For example, one might have a simple statement of working stating that “The supplier will drink a glass of water” or even better, state a specific outcomes (“I will do what is required to remain hydrated, including drinking water, Gatorade, or another beverage.”).  Examples of poor contract language include the following:

• “After they agree on the timing, the supplier will drink a glass of water.”
• “He shall partake in the drinking of water from a glass.”
• “I will fill a glass with water and raise it to my lips. For the avoidance of doubt, I will not pour the water on my head, or use it to wash my hands.”
• “I will grab a glass, fill the glass, raise it to my face, open my mouth, and pour the contents of the glass into my mouth.”

A supplier will prefer this last statement – but it could mean they are drinking bleach!  In fact, the supplier may not know they are expected to stay hydrated!  The important part here is that clear contract language provides transparency. When you do contracts with clear language, you reduce the level of stress and the more likely you are to get good results.

Simple language also helps to make the contract easier to read and understand.  If the lawyer is the only one who can understand a contract, then it’s poorly drafted. A lawyer doesn’t have better reading comprehension than a business professional. If reasonable people can differ, they will. Anything that requires “mutual agreement” means that the other party has a veto…so you have to try not to agree to agree. If substitutions are allowed – what are they. The operational element you are hiding, will come back to hide you later.

It is important to have a good limitation of liability clause, that is determined by market conditions. You need to have an emphasis on execution, not just terms. You need to look at the overall investment, including up front costs, soft costs, etc. to maximize return on investment. Limitation of liability clauses are invoked in less than ½ % of all contractual deals…. but this doesn’t mean you shouldn’t have one!   If you don’t pay attention to your fee schedule, then you are making a big mistake.

A good contracting process should avoid the RFP prisoner’s dilemma. The idea is that the other party shouldn’t be able to rip you off on cost, but if you make price important upfront, you will not see the solution-ing capabilities of the supplier. You may get a good cost, but if the project is 200% over budget, then where is the savings?   The worst you can do in a complex deal is eliminate the right supplier for the deal. To try to force a bad supplier into a good deal, or vice versa, is not a good idea, as you may not be able to enforce it.  Contracts are based on relationships, but relationships based on contracts tend to fail. If you have a good relationship and you contract for what you want – and try to build the relationship after you have signed – it is a recipe for failure.

Looking forward to more insights tomorrow!