Kyle Hulten recently wrote on the iVLG blog about the value of contingent contracts when negotiating agreements. It’s a great read and below I’ve highlighted some of the key takeaway points from Kyle’s article.
What is a contingent contract?
You probably guessed it. A contingent contract is a contract that includes contingencies, i.e. future events that may occur and change the terms of the agreement. Some of the most well-known contingent contracts are in professional sports. Athletes often receive additional money if they achieve certain goals. Another common example is in the employer-employee context. You may hire an employee and incentivize that employee to work hard by providing a non-discretionary bonus if the employee performs beyond a certain target, e.g. if employee sells more 100 cars, then the employee will receive the bonus.
The benefits of contingent contracts
Contingent contracts can address information asymmetries during negotiations. I know, it sounds complicated, but it’s not. Basically, one party may have access to more information than the other, and using contingent contracts can help balance this asymmetry of information and add value to your agreement. For example, if you’re contracting for real estate and the price will depend on zoning regulations, you may negotiate for a contingent contract that will result in a different price depending on changes to zoning regulations.
Diagnosing deceit. Let’s say you hire a contractor to install a new door at your business and he agrees to complete the work by next Friday. In fact, the independent contractor knows that he probably won’t finish it by next Friday, but he hasn’t made you aware of this. To avoid getting burned by the contractor’s delay, you can use a contingent contract to provide for a reduced payment if the door isn’t installed by the deadline (next Friday).
Motivating performance. As I mentioned above, contingent contracts are often used to incentivize employees and contractors to work harder or perform tasks more efficiently. By offering additional compensation for reaching certain milestones, you can motivate your workforce to maximize efforts. For example, the Seahawks often offer contingent contracts to their players to motivate those players to perform at a certain level in order to receive additional cash bonuses.
Reducing your risks. A carefully drafted contingent contract can address the risks of late delivery or lower-than-expected quality products or services. Often the purchaser assumes the risk in these situation and takes a larger share of the upside if the product or service outperforms expectations. A contingent contract can allocate the share of risk (and upside) evenly between the seller and purchaser.
Why aren’t contingent contracts more common?
Most of the reasons include the uncertainty of entering into a contract where the terms may change depending on specific events that occur. Each party is betting on the future under these contracts. There are also additional transaction costs associated with contingent contracts. There may be an extra step of collecting or issuing additional payment if a certain event occurs. Contingent contracts also require a continuing interaction between the two parties. This may be nominal–e.g. you’re require to issue a check to an employee that reaches a performance target–or it may be more impactful. For example, you may be required to lock your business into a longer term contract if a certain event occurs. If you’re not particularly fond of the party you’re contracting with, a contingent contract may not be the best option.
To learn more about additional benefits and drawbacks of working with contingent contracts, check out Kyle’s full post here.
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