Risk Sharing - Upside and Downsides
How should risk sharing be balanced between positive and negative incentives?
In a service provider context, there is neither full control over the final outcome nor full economic benefit from its achievement. That’s why it’s called risk “sharing”.
Incentives for the service provider to achieve mutually agreed objectives need to not only reflect the reality that either party (or both) may fall short on its responsibilities, but also that it may be difficult, even impossible, to apportion responsibility after the outcome is known.
This is why penalties in risk sharing frameworks ultimately make such frameworks worse than no risk sharing at all. A company that feels it could be subject to penalties for outcomes beyond its 100% direct control feels compelled to lace the contract with qualifiers and disclaimers that effectively void any future potential of a penalty being applied. The service provider feels defensive from the outset, since people and companies tend to focus more on avoiding losses than maximizing potential gains when confronted with both potential outcomes.
WHAT TO DO?
Consider “upside-only” incentives. A bonus is earned if the timeline is achieved early. X% of unused units can be billed if the total deliverable beats quality standards. Etc., etc.
What’s in it for the buyer?
Many buyers intuitively understand that positive incentives are far more motivating than penalties.
If price competitiveness is a concern, simultaneously apply a discount and position the upside incentive as a way to earn back all or part of the discount upon achieving an excellent outcome.
Limit- even eliminate- the typical list of legal qualifiers and disclaimers that apply. These typically only serve to protect against incurring penalties anyways.
A contract with a competitive price and positive incentives sets the stage for better outcomes and relationships.