Contracts are not an insurance policy

Posted by Kathleen Fasanella on Apr 2, 2009 at 4:10 pm / Intellectual Property, Slavery or Bravery / Trackback

As I said yesterday, many people think that contracts with their partners such as NDAs, production, licensing and the like are effective ways to control the costs of transactions in the event relationships go awry. They are not. Contracts subvert relationships; contracts are actually the antithesis of trust.

The biggest problem with contracts is that people think those are an insurance policy for their business with the potential of recovering full compensation for their losses. Society worships the myth of David beating Goliath; but are you willing to risk the success of your venture on a piece of paper? Someone linked to this article (a very good read) in the forum today:

…suppose you manage to distill your world down to just ten company killers and you think you’ve eliminated 90% of the risk in each category:

There’s a 90% chance that you’ve identified a genuine market need;

There’s a 90% chance that your addressable market is as big as you think it is;

There’s a 90% chance that you can actually implement your innovation;

There’s a 90% chance that you can sell it for more than it costs you to make it;

There’s a 90% chance that you have assembled the right management team to do the job;

There’s a 90% chance that you manage to stay one step ahead of the competition;

There’s a 90% chance that you don’t get sued into bankruptcy;

There’s a 90% chance that you won’t get buried in regulatory red tape;

There’s a 90% chance that you don’t run out of money; and

There’s a 90% chance that nothing else goes wrong.

…the probability of surviving all ten risk factors (making a technical assumption that the ten risk factors are statistically independent of each other) is:

90% × 90% × 90% × 90% × 90% × 90% × 90% × 90% × 90% × 90% = 35%

In summary, even if you have a contract, all of these factors will play into determining whether you win in business. In short, a contract will never be an insurance policy.

I’ve made no secret that I think contracts between two business entities are pretty close to worthless. Having grounds for a lawsuit doesn’t mean you can exact justice. Forget finding an attorney to take it on contingency, too much can go wrong. The only kind of contracts I think are useful are those closer to a work agreement that itemize the duties, responsibilities and expectations of both parties in a relationship. You’d be surprised how often this goes unsaid. Another contract in the same category are sales agreements. In some states, sales agreements are required by law as a condition of representation (not that a contract will cover you if the deal goes south as many will attest).

A blog I’m liking very much lately says contracts are a transaction cost:

What do work-for-hire contracts, email disclaimers and spam have in common? They are all getting ubiquitous, annoying—and ineffective… Costs of production go down with scale. Transaction costs, however, go up. Often exponentially.

The more commercial contracts, the more detailed the lawyers will want to make those contracts. The more fragmented the bits of sample music are, the more detailed must the IP contracts become to cover all eventualities.

The old response to risk was to create tighter contracts. But as the world becomes more complex, the ever-fertile legal mind will find more and more risk to be mitigated—and will unfortunately default to the only thing it knows—more and more complex contracts.

A recent book, Life without Lawyers provides more fodder. Don’t get the idea I don’t like lawyers, I actually do but if someone needs me to sign a contract to work with them, I know they’re likely to be the sort of person I’d need a contract with to cover myself and even after everything I know, I can’t begin to imagine the level of complexity needed to cover every eventuality. More importantly, I don’t want the drain of potentially needing to sue someone. No deal is worth it so it’s easy to say no. It doesn’t even hurt to say no. Every time someone whips out a contract, I feel a tremendous surge of relief. I feel like I’ve dodged a bullet because I’ve found that if someone needs a contract to keep you honest, it’s because a contract is needed to keep them honest. The intangible costs of these contracts is more than I’m willing to pay. Perhaps worst, being asked to sign a contract puts one in a defensive position. It presumes one will act unethically unless cross checked with a contract. Why do business with someone who backs you into a corner from the get go? That’s not a relationship, it’s a threat.

I didn’t intend to descend into a rant; the point is contracts are a cost that squeeze someone you should be developing a relationship with. Arguably, contracts cost more than they’re worth particularly if you think they’re an insurance policy. This next bit is somewhat off topic but speaks to the whole issue of trust and building relationships. Namely, don’t squeeze too hard.

I have never understood how people don’t hesitate to try to cut their suppliers and service providers too close to the bone over pricing. It’s like a game, competitive negotiation is fun for them. Particularly now, it’s kind of insulting when someone attempts to use leverage of a bad economy to demand (!) a lower price. This presumes they’re the only one feeling any pain (narcissistic focus) and two, that it’s within their rights to demand your pain (power play). If your supplier hasn’t increased prices it’s not because they haven’t needed to; they’re working with lower margins to remain competitive themselves. But most of all, when buyers demand discounts, they do it to increase their advantage over their own competitors, expecting a supplier to provide the advantage when increasing their operations efficiencies is the better strategy and less punitive. Forcing suppliers into a corner will backfire. Either they’ll go under or the competitive advantage you’ve come to rely on -off their backs- will disappear at the first opportunity. Resentments linger. It’s better to get ideas from your suppliers on how to lower costs. You stand more to gain if you expose your frailties. Trust builds in a climate of long term commitments when you make sacrifices of your own.