03 Mar 2003  Research & Ideas

The Ingredients of a Deal Disaster

A deal can unravel quickly if it doesn’t embody the mutual understanding—the social contract—behind the words on paper. The risk factors surrounding negotiation are detailed in this Harvard Business Review excerpt, co-authored by HBS professor James K. Sebenius.

 

Experienced negotiators are generally comfortable working out the terms of an economic contract: They bargain for the best price, haggle over equity splits, and iron out detailed exit clauses. But these same seasoned professionals often spend so much time hammering out the letter of the deal that they pay little attention to the social contract, or the spirit of the deal. So while the parties agree to the same terms on paper, they may actually have very different expectations about how the agreement will work in practice. Without their arriving at a true meeting of the minds, the deal they've signed may sour.

Risk factors

The most common causes of social contract problems are lack of awareness and benign neglect. The parties involved inevitably form expectations about how the deal will be carried out, whether they discuss them or not. Even if initially compatible, those expectations can silently shift in response to actions taken, even though no overt negotiation takes place. Of course, if costly misunderstandings are to be avoided, it's normally in the parties' best interests to make their expectations explicit and negotiable. And red flags should go up when especially challenging conditions, such as the following, are present:

When cultures clash. Negotiators from diverse organizational, professional, or national cultures often bring clashing assumptions to the table. As Ming-Jer Chen, the former director of Wharton's Global Chinese Business Initiative, explains in Inside Chinese Business, "The Chinese perceive contracts as too rigid to take new circumstances into account. Hence, there is no stigma to changing the terms of an agreement after it has been signed." That approach often frustrates businesspeople who assume a signed contract is a done deal and a complete, fixed description of each side's obligations.

Not all breaches need be fatal; how they are handled can strengthen or rupture the social contract.
—Ron S. Fortgang, David A. Lax, and James K. Sebenius

Consider how cultural expectations damaged relationships at NCR Japan. While the company was U.S.-owned, it had a history of stable lifetime employment and a union that enjoyed close relations with management. However, when the plant's first U.S. manager instigated downsizing to enhance returns—even though the plant was profitable—employees resisted this perceived violation of the underlying social contract. A second union was quickly organized, and it took a far more adversarial approach, demanding higher wages and insisting on job guarantees. Local suppliers saw the company as untrustworthy and refused to do business with it. A full decade after the plant manager was ousted, the second union remained in power, and the supplier boycott continued.

This example underscores not only the risk of underestimating differences between cultures but also the strength of the backlash to perceived breaches of a social contract. It's important to note here that not all breaches need be fatal; how they are handled can strengthen or rupture the social contract. If a breach is inadvertent, for example, managers normally should acknowledge it and reassure the other side that the "violation" was unintentional, not exploitative. Indeed, sincere efforts to rebuild confidence can often buttress the existing social contract.

When the wrong minds meet. Sometimes problems arise not because of cultural differences but instead because the right people are not involved in negotiations. For example, when two CEOs negotiate a strategic partnership—say between a retailer and a supplier—they may stress the importance of many dimensions of cooperation, the mutual need for service and quality, and the long-term time horizon of the joint effort. Yet the retail buyer, for instance—mainly compensated on the basis of quarterly numbers—refers to "our strategic partnership" primarily to beat price reductions out of the supplier. This problem will persist unless senior retail executives work to reset employees' expectations and incentives at the working level when they forge what they see as a strategic alliance.

There are other, less obvious, ways that key parties are inadvertently omitted from social contract negotiations. For example, in 1988, Komatsu, Japan's leader in earth-moving construction equipment, and U.S. conglomerate Dresser Industries combined their North American engineering, manufacturing, and marketing efforts to attain what they called a "mountain of treasure." Dresser sought Komatsu's design technology and a cash infusion for plant modernization and capital expenditures. Komatsu hoped to become a successful global player, so it wanted better North American market penetration. While preserving parallel brands and distributorships, Komatsu and Dresser created a fifty-fifty joint venture (Komatsu Dresser Corporation, or KDC), merging manufacturing, engineering, and finance operations. The joint venture maintained equal management representation on the six-person oversight committee and agreed to a $200 million investment. Beyond the economic terms of the companies' arrangement, they aimed to foster a strong social contract between their management teams.

Yet the implementation of their arrangement strained the emerging deal, and the separate distributors, who never subscribed to the new expectations, began competing for sales. Tensions escalated: Komatsu saw Dresser as backward and unresponsive; Dresser complained of learning about key Komatsu decisions after the fact. As the situation worsened, executives from both companies clamped down on communications, which prevented dealers from getting vital information about their counterpart's inventory levels and warranty coverage, further exacerbating the conflict.

Neither side did its due diligence on their mutual perceptions of the real underlying social contract.
—Ron S. Fortgang, David A. Lax, and James K. Sebenius

Despite the efforts of industrial consultants and a last-minute plan to swap employees between the two companies, the dealer conflicts intensified, KDC market share declined sharply, losses mounted, 2,000 jobs were cut, and ultimately, the venture was dissolved. Subject to more than the usual cross-cultural hazards, KDC suffered: It failed to ensure that potentially influential parties bought into the new social contract.

When third parties drive the deal. Failure also happens when one team, such as the business development unit, uses a heavily price-driven process to negotiate an alliance or acquisition. Once the parties agree to the terms, the team "throws it over the fence" to operational management, which is stuck with the unenviable job of forging a strong, positive social contract after the fact. Jerry Kaplan, Go Technologies' founder, was especially critical of the negotiation process IBM used when it invested in Go. As Kaplan explains in Startup, "Rather than empowering the responsible party to make the deal, IBM assigns a professional negotiator, who knows or cares little for the substance of the agreement but has absolute authority." With a process like that, the right minds have little chance of truly meeting on the underlying social contract. It's almost always best to get the managers who must make the deal work involved in the negotiating process, where they can begin to forge a positive social contract.

In some cases, investment bankers or other dealmakers with a powerful interest in making a transaction happen—for better or worse—can divert the principals' attention from possibly fatal differences in their views of the underlying social contract. For example, Matsushita Electric's primary rationale for paying $6.59 billion for MCA—owner of movie studios, record companies, and theme parks—was to ensure a steady flow of creative software for its global hardware businesses. Senior MCA management agreed to the acquisition, expecting the new, cash-rich Japanese parent to provide capital for acquiring more record companies, a television network, and so on, all of which were vital to helping the combined companies compete with rivals such as Disney and Cap Cities/ABC.

To get the deal done, however, Michael Ovitz, talent agent turned unorthodox corporate matchmaker, kept the parties mostly apart during the process, managing expectations separately on each side and building momentum until the deal was virtually closed. Neither side did its due diligence on their mutual perceptions of the real underlying social contract—partly because of the cultural chasms dividing old-line industrial Japan, creative Hollywood, and the New York financial community, but largely due to the deal-driving third party (Ovitz). As a result, each side had an optimistic but badly distorted view of the other's real intentions, leading to post-deal friction and the sale of MCA a few years later to Seagram, at a substantial loss to Matsushita both in financial terms (roughly $1.64 billion) and in prestige.

When too few parties are involved in the deal. Even a tightly aligned social and economic contract can be vulnerable if the expectations and agreements that underlie it are shared by only a select few. Senior partners in consulting firms, for instance, often depend primarily on their relationships with CEOs in their client companies. But if the CEO leaves, the consulting firm may lose the account. Consciously creating a wider web of involvements and dependencies throughout the firm would result in a more sustainable relationship—and greater commitment to implementation of agreed-upon recommendations—even when fewer participants could complete the consulting projects more efficiently.

Ron S. Fortgang, David A. Lax, and James K. Sebenius are principals of Lax Sebenius, a negotiation-strategy consulting firm in Concord, Massachusetts.

Excerpted with permission from "Negotiating the Spirit of the Deal," Harvard Business Review, Vol. 81, No. 2, February 2003.

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Conducting an Audit: Sample Questions

Discussing expectations before you sign a deal can greatly increase the odds of its success. To help you get that conversation started, here are some sample questions about the letter and spirit of your deal.

Sample Questions

Underlying Social Contract

Real nature and purpose of the agreement
Do you envision a discrete transaction or a partnership? A merger of equals or something quite different? Are you building an institution for the long term or making a financial investment with a nearer horizon? What is the driving culture (operational, for example, or research oriented)?

Scope and duration
Is your agreement focused on a discrete, short-term task, or is it open-ended? Is it a likely prelude to a larger or different arrangement? What kinds of actions, even outside the bounds of the deal, do you expect to be told about? And about which do you expect some say?

Ongoing Social Contract

Consultation
How fully, formally, and frequently do you expect to consult with the other side? How extensively will you and your partner share or protect information?

Decision making
Beyond the formal governance mechanisms, by what process do you want to discuss and make decisions: by consensus or majority? Informally or formally? Who will be involved?

Dispute resolutionIn the case of conflict, what approach do you expect to use: informal discussion, mediation, binding arbitration, court? What if disagreement persists?

Reevaluation and renegotiation
How will you handle unexpected challenges (such as changing economics or competitive dynamics)? What should trigger reevaluation or renegotiation, and what should you and your partner expect from each other in such a case?

Meeting of the Minds and Fit Alignment

Do the economic and social contracts reinforce each other? If they don't, what should you and your partner do to align them?

Shared perceptions
All things considered, what's your view of the social and economic contracts? What do others in your organization think? What is the other side's view, and does it mesh with yours? How do you know? How can you and your partner ensure that you have a real meeting of the minds on your perceptions? If you discover divergent perceptions, how should you resolve them?

Excerpted with permission from "Negotiating the Spirit of the Deal," Harvard Business Review, Vol. 81, No. 2, February 2003.