Contracting mistake #7: Bad incentives

“Never, ever, think about something else when you should be thinking about the power of incentives.”

Charlie Munger

Throughout this series of mistakes, I’ve touched on incentives driving suboptimal outcomes. I believe the impact is so profound, I’m dedicating the final mistake to bad incentives.

Calling out these incentives makes some uncomfortable. This is understandable - no one wants to feel susceptible to outside influences. But even if you are not affected, are you sure that no one else is?

So what impact can bad incentives have on contracting?

  • If people are afraid of later finger pointing, they will try to ensure that the contract covers every possible issue as strongly as possible and will not send out reasonable terms.
  • If people are rewarded for taking more time, they will not focus on getting rid of obstacles that drag out the contracting process.
  • If people are valued for their knowledge or fear they will be redundant without it, they will not proactively share their knowledge with others.
  • If people are incentivised to just get the deal done, they will be prone to signing anything and try to sidestep stages in the process.
  • If people are incentivised to protect against risks in their specialist area at all cost, they will impose ridiculous long-winded requirements on the negotiation team.
  • If people are worried that a change will remove the need for their role, they will fight that change.
  • If people are rewarded based on measurements, they will game the metrics.

The problem is not just that people respond to incentives, but that different people in your organisation have conflicting incentives and that individual incentives can undermine desirable outcomes for the business as a whole.

Reality is complicated. Your organisation needs contracts to be signed quickly, but it also mustn’t give the farm away. Your organisation needs to comply with laws, but there are other issues that are more fundamental to the deal working. Your organisation needs to have confidence that the agreement will be followed, but the risk balance must work for the other side too.

We need “and” thinking, not “or” thinking; we need to find a way of balancing competing issues; and we need to reflect the balance in how individuals are incentivised.

For starters, perhaps stop giving final decision-making powers to people who can't see the whole picture?

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