Dealmaking: The New Strategy of Negotiauctions

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3 Sentence Summary

Dealmaking dives into the theory of both negotiations and auction sales, and then presents a third hybrid theory that is a combination of the two (hence the subtitle). Subramanian writes from an academic’s perspective, but he doesn’t fail to provide plenty of helpful examples and case studies along the way. Recommended as a how-to guide for anyone involved in the sale of high-value assets, this book is a fun read for those who have a deeper appreciation for deal-making strategy than most.

5 Key Takeaways

1. Use anchoring and your understanding of the zone of possible agreement (ZOPA) to decide when to make a first offer during a negotiation.
2. Auction when you have a large number of potential buyers, the asset for sale is well specified, or speed and process transparency are important.
3. Negotiate when bidders are well known, when the potential for value creation is high, when the working relationship is important, or when the seller has a low risk tolerance.
4. You can avoid the winner’s curse by reflecting on all the costs and benefits of winning or losing the auction when calculating your reservation value.
5. Negotiauctions are common in complex dealmaking situations. Use setup moves, rearranging moves, and shut-down moves to change the game for your advantage.

Dealmaking Summary

Introduction

• The difference between a negotiation, auction, and negotiauction is the source of competitive pressure.

Preparing to Negotiate

• The first step in preparing for any negotiation is to think carefully about the parties involved and their interests.
• BATNA = Best Alternative to a Negotiated Agreement
• BATNA = What do you do if you don’t reach a deal?
• You need to think multiple steps ahead.
• Keep asking yourself, “And then what would happen?”
• Reservation Value = Your walk-away number
• Your reservation value should reflect your BATNA
• ZOPA = Zone of Possible Agreement
• Can you reach an agreement given each party’s BATNA and reservation value?
• Remember that individuals negotiate deals. It’s critical to understand the incentives of the individuals who are doing the negotiating.
• How are they compensated?
• How long have they worked for the company?
• What are their long term aspirations?

At The Table

Anchoring

• Anchoring works by influencing your perceptions of where the ZOPA lies.
• Anchoring is a reason for making the first offer, because you can potentially influence the other party.
• But it only works when the other side is uncertain about where the ZOPA is.

Risks of Making the First Offer

1. Anchoring too aggressively. If you make a first offer way outside of the ZOPA, you may have to make large concessions to reach a deal or walk away even though a ZOPA exists.
2. Anchoring too conservatively. You unknowingly give away a big chunk of the ZOPA on your first move.

First Offer Guidelines

• Consider making the first offer when you have a pretty good sense of where the ZOPA is in order to anchor the negotiation in your favor.
• If you don’t know the ZOPA, hang back and let the other side make a first offer, or make a soft anchor, e.g. “We’re thinking about something in the ballpark of $30.”
• When you don’t know the ZOPA, but your opponent does, resist their attempt to anchor you.
• Default to a first offer that is more aggressive than your instincts might lead you to make. What is the highest number than I can justify?

Counteroffers

• Use the midpoint rule to your advantage. Think about where you want to end up, and start with a counteroffer that gets you to that number as a midpoint.

Value-Creating Moves

• Differences in expectations about the future often create value in negotiations.
• Contingency contracts have three major benefits:
  1. They align incentives
  2. They allow the parties to diagnose the honesty of the other side
  3. They enable the parties to share the risk

When to Auction, When to Negotiate

• An auction is a mechanism in which the seller is a passive participant after the process has been set, and the primary source of competitive pressure arises from competition among buyers.
• A negotiation is a mechanism in which the primary source of competitive pressure arises in across-the-table dynamics between buyer and seller.

Auction vs. Negotiate: 4 Factors to Consider

1. Profile of potential bidders
2. Asset characteristics
3. Your profile as the seller
4. Contextual factors

1. Profile of Potential Bidders

Number of bidders

• An auction becomes more appropriate as the number of serious potential buyers increases.
• Most efficient number is considered between 5-8 bidders.
• There are costs and risks associated with managing the complexity of too many bidders.

Certainty About Who the Bidders Are

• Negotiate if there are only a few qualified buyers.
• Auction if you don’t know who the high-value buyer is, and it would take a lot of time and effort to find out.

Buyers’ incentives to participate

• Bidders are generally wary about participating in auctions.
• When the bidder’s BATNAs are good, you may need to negotiate privately to get them to come to the table.
• Some bidders might not participate in auctions because other bidders can get a free ride off their expertise. In which case, a sealed-bid auction may be appropriate.

Distribution of Valuations

• You may want to negotiate privately if the top two valuations are far apart. There’s potential for leaving a lot of value on the table by holding an auction.
• The predicted outcome in an auction is the second-highest valuation, plus a little bit.

2. Asset Characteristics

Ability to Specify The Asset

• All else equal, the more you are able to specify what you want, the more likely it is that an auction will be a better option than a negotiation.
• Buying commodities are a good example of an appropriate thing to auction.
• Even clearly defined services can be auctioned like commodities effectively. But you risk losing out on potential win-wins that might have come up during a negotiation.

Potential For Value Creation

• Auctions boil everything down to price.
• Negotiations open things up for value-creation.
• If there is possibility for win-win moves, it is better to negotiate with one or more potential counterparties than to hold an auction.

Importance of Relationship

• Negotiations are best when relationships, service, and/or deal execution are important aspects of what is being bought or sold.
• Negotiations leave room for more favorable resolution of potential problems down the road.
• Auctions signal that the buyer is indifferent among suppliers, other than the price received.

3. Seller’s Profile

Importance of Speed

• Auctions are a much faster process than negotiations.
• If there is a specific window of opportunity to sell, or the asset is deteriorating as time passes, auctions are preferable.

Tolerance for Risk

• Auctions are faster and riskier. They sometimes “bust,” in which nobody shows up; or, even worse, only one bidder shows up.
• Negotiations are safer bets. They allow you to test the water as you make your way to a better outcome.

4. Contextual Factors

Need for Secrecy

• Broad-based processes like auctions are difficult to keep secret.
• Negotiations are much more private.
• A frequent concern during M&A deals is to broaden the search process in the sale of a company for fear that the employees will find out, start looking for new jobs, and the value of the company drops.

Importance of Transparency

• Transparency = The appearance of a level playing field among bidders.
• Auctions are a more transparent process than private negotiations.

Choosing The Right Kind of Auction

Open Outcry or Sealed Bid? 4 Factors to Consider

• Open outcry auction = Bidders know the high bid at all times, and have the option of beating it.
• Sealed bid auction = Bidders submit written bids and do not know what others bid, or (often) how many bidders there are, before the winner is revealed.

1. The number of potential bidders
2. The degree to which bidders’ valuations are “affiliated”
3. The degree of bidder risk aversion
4. The need to deter collusion among bidders

Number of Potential Bidders

• The minimum number of initial bidders in an open-outcry auction is five or six
• Less than five bidders and better to conduct sealed auction where a lack of transparency means bidders may bid against themselves.
• A sealed bid auction can create the perception of competition even when there isn’t.

Affiliation of Bidder Signals

• Open outcry is better for the seller when bidders’ valuation should be influenced by others’ bid.

Bidder Risk Aversion

• When bidders exhibit risk aversion, use a sealed-bid auction.
• Risk averse bidders in a sealed-bid auction will shade their bid less, benefiting the seller.

Bidder Collusion

• If bidder collusion is suspected, choose a sealed-bid auction.

Open Outcry Design Choices

• English auction = Typical auction style. Price starts low and bidders increase the price until there is only one bidder remaining.
• Minimum bid increment. Auctioneers usually start at half of the minimum selling price to get a lot of people interested, then couple it with a high increment at the start. The minimum bid increment decreases as the price increases.
• Dutch auction = Price starts high and comes down until a buyer is willing to pay.
• Dutch auction style is much faster than English auction style. Think the sale of flowers in the Netherlands.
• Japanese auction = Same as English auction except all bidders must acknowledge their willingness to buy at the current price. Failure to do so means that you drop out of contention. Not common, but faster than English auction.

Sealed Bid Design Choices

• First price sealed bid = High bidder pays their price.
• Second price sealed bid = High bidder pays the second highest bid.
• Second price can be advantageous because it is the optimal strategy for all bidders to bid their full reservation value.
• Second price auctions are rare in practice, probably because most bidders will still shade their bids, despite the optimal strategy to do otherwise.
• Second price auctions are also rare if there are negotiations that will happen after the auction. In which case the bidder doesn’t want to reveal their true valuation.
• Make sure participants know the “finish line,” otherwise they may hold back and artificially extend the process.
• Think about what incentives you are creating when setting the rules of the game.

Playing The Game As Process Taker

Overcoming the Winner’s Curse

• Winner’s curse = The feeling that you overpaid simply because you were the highest bidder.
• Reflect on all the costs and benefits of winning or losing the auction in calculating your reservation value.
• Costs often include much more than price. Could be your reputation, or competitive advantage in the marketplace.
• All-pay auctions = Event where all bidders must pay something, regardless if they win or lose.
• The only scenario that matters is the one where you win. Think to yourself, “Am I comfortable paying this price, even if it turns out that I over-paid?”
• Only when you have an information edge or private value in the asset, will you be able to safely bid higher than others and avoid the winner’s curse.

Bidding in Sealed Bid Situations

• The key is to bid high enough to win, but low enough that you preserve as much profit as possible from the deal.

Maximum Bid of Others (MBOO)

1. Determine how your chances of winning increase with your bid (draw the graph)

2. Choose the bid that maximize your expected profit = Probability x Profit

Bidding in Open-Outcry Situations

• Continue bidding up to your full reservation value.
• Whenever common value plays a role, bidders should rationally “update” their reservation value during the course of the bidding. E.g. the layman bidder taking cues from an expert with insider knowledge.
• Three factors that fuel “competitive arousal:” intense rivalry among bidders, time pressure, and the presence of an audience.
• Avoid this by:
• Writing down your reservation value
• Ask yourself, “What do I know now that I didn’t know at the beginning of the auction?” If you don’t know anything new, then you should drop out of the auction.

An Introduction to Negotiauctions

• Negotiauction = A dealmaking situation in which competitive pressure is coming from both across-the-table competition and same-side-of-the-table competition.

Common Features of Negotiauctions

1. Several (but not too many) potential buyers. Usually between three and ten.
2. Asymmetric information. The seller typically knows more about the structure of the situation than the buyers.
3. Ambiguity around traditional process setter and process taker roles. The process itself is up for grabs. Roles are highly malleable and control over deal process can shift over time.
4. One-one-one meetings than resemble standard negotiations. The seller’s BATNA is fluid, not static, because it involves the prospect of negotiations with known, unknown, or potential competitors on the same side of the table as the buyer.
5. One or more rounds of bidding and other forms of direct competition among potential buyers in ways that resemble auctions.

3 General Lessons for How to Play Effectively in Negotiauction Situations

1. Look forward and reason back to learn from the moves of others.
2. As the process setter, use the BASC framework to determine how to apply competitive pressure. Simultaneously leverage same-side-of table and across-the-table leverage.
3. As the process taker, change the game to your advantage through setup, rearranging, and shut-down moves.

Setup Moves

• Your entry in a negotiauction can have value. When it does, don’t give it away for free; instead, extract concessions for it.
• “Pay me to play.” When your participation in the seller’s process turns it from a negotiation into a an auction, extract process concessions in exchange for your entry.
• Setup moves must be accepted by the process setter. It will succeed only if it is better than the process setter’s perceived BATNA.
• A setup move can shape the game to your advantage.
• A setup move can protect you against entanglement in a negotiauction where you can’t possibly win.

Rearranging Moves

• Reconfigure the assets or the parties, or both, in ways that create additional value in the deal.
• Can be made at the outset or after the negotiauction is under way.
• Rearranging moves can give you more firepower than you would have otherwise.
• In general, the party that initiates the rearranging move will capture most of the value that arises as a result.

Shut-Down Moves

• A shut-down move is one that prematurely cuts off same-side-of-the-table competition.
• Shut-down moves work only when they are better than the process setter’s perceived BATNA.
• The shut-down move itself must be choreographed properly to influence the seller’s perception of its BATNA.
• Any shut-down move must be coupled with a credible threat that weakens the perceived BATNA and therefore increases the likelihood that the move will be accepted.
• They do not need to be absolute. They can also be a matter of degree. You can dampen the same-side-of-the-table competition, even if you can’t shut it down completely.

Legal Constraints in Negotiauctions

Using Fictitious Bidders

• Courts usually side with the buyers when sellers use fictitious bidders to induce higher bids.

Bidding Through Others

• Using an agent to bid on your behalf is a legal tactic used to avoid less informed bidders from riding off your expertise or insider knowledge.
• Avoid situations where sellers would charge higher prices if they know the buyer’s identity.
• But buyers can’t hide behind an agent to buy something that they couldn’t have bought legally on their own.

Bidder Collusion

• Collusion is permissible under the Sherman Act if the agreement promotes (rather than hinders) competition or efficiency in the marketplace.

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