One of my favourite quotes when talking about fairness of commercial arrangements comes from a US friend of mine which goes:

“. . . the only fair I have seen is the one that comes to town twice a year.”

While I do enjoy the humour of this statement, unfortunately, it is an all too common feeling towards Performance Based Contracts (PBCs); that they are riskier than conventional contracts due to their very nature (i.e. performance based). However, the focus should be on whether this risk is real, or whether it perceived due to an emotional response from being performance managed.

In my observation most practitioners focus what consequences can be applied due to a failure to perform (e.g. reduction in profit, no additional contract extensions, etc.) rather than what consequences are likely to be applied. In many cases practitioners over-estimate the risk (noting that risk is defined as a combination of likelihood and consequence) by focusing on the consequences deterministically (that is, that they will occur during the term of the contract) not probabilistically (that is, what is the chance of this event occurring during the term of the contract). This risk averse behaviour can be a significant cost driver and can damage commercial relationships before they have even began.

So what do we do? Firstly, we need to acknowledge that the aim of a highly successful PBC is to pay the seller 100% of contract price since this would mean that the buyer has received 100% of their required outcomes; a win-win for both parties. However, this also means that for most PBCs the contract outcomes need to be achievable by the seller and not a stretch goal or target. That said, there are forms of incentivised contracts that can be used in this case which I will talk about in a future post. Secondly, that a failure by the seller to deliver 100% of the buyers required outcomes has consequences, and that these consequences may escalate as less of the buyers outcomes are delivered. And finally, we need to understand what is the likelihood of the specific consequence occurring to determine the real risk to both buyer and seller. Some of my colleagues and I call this last step consequence analysis and will part of a future post.

So in summary, to avoid “performance anxiety” both the buyer and seller needs to understand the probabilistic risk of non-performance and not simply assume that all consequences are going to occur equally, or even at all.  However, if either the buyer or seller truly believes that all consequences are likely, then I’d suggest it is a bad deal for both parties.

I would be interested in others observations and opinions.