Risk tolerance and the consulting man

When negotiating a contract, there are many factors to consider as you wind your way to a working agreement.  Some of these factors are quantifiable, like duration or rate, but others, like trust, are harder to pin down.  Signing a contract with a new client is a process of weighing all those factors, finding some quantifiable measure of risk inherent in the contract, and deciding what your tolerance for that risk will be.  There are a number of forms of risk to consider too: financial, reputational, and even physical.  We recently went through the process of negotiating a contract with a client who questioned our standard contract on the payment schedule terms (and good for them!), so we were forced to sit down, evaluate the financial risk quantitatively and negotiate with the client to bring the payment schedule into line with our tolerance.  This is the story of that journey.

What is risk

In this case, the risk was one of exposure:  the entirety of the contract would be worked prior to the first invoice being due for payment.  The risks we negotiated were many:

  1. the risk that negotiating would hurt our reputation; hardball can sometimes get you into hot water, we needed to negotiate a contract out of the client’s norm without alienating them
  2. the risk that key resources would be tied to a contract that wouldn’t cover their costs at the expense of other contracts; when you are signing a contract for a single individual, but there is no commitment to number of hours to be worked, you have to be careful you cover your costs.
  3. the risk we wouldn’t get paid; we have no history with this client so the fact that they would pay at the end of the day was entirely predicated on trust In the case of the first, we had to rely on our business experience and a cool head to work through that one.  The first inclination is to say “our contract is non-negotiable” and walk from the contract.  This isn’t a good way to do business development and neither does it fit well with our corporate culture.  While a bit pithy to say, we believe strongly in our culture and to deviate from that wouldn’t be worth it in the long run.  On the other hand, to give in at the first pressure sets an example with your client that doesn’t bode well for a long, mutually beneficial relationship.  The balance of polite, but strong insistence on staying within your tolerances with the flexibility to meet your clients needs was key.

In the case of the second, this initial contract was intended to test the water for both parties.   They needed some reassurances that we could deliver, we needed some history of having our invoices paid and of being given the space and the tools to do our job.  Signing a contract always takes a resource out of play, but its particularly challenging when that resource has standing roles within the organization that continue to need to be met.  At this point, the risk is mitigated by the possible reward: this client seems to be exactly the clientel that we are looking to attract with the likely hood of long-term, stable work.

The third case, the financial constraints were the most challenging.  We weren’t prepared to assume all the financial risk, but it was hard to quantify what the risk was in order to define which flavour of contract would suit our client and still meet our tolerances.

Risk tolerance

This contract was to be a “feeling each other out” contract for 34 days.  It wasn’t a signed minimum 3 month term, it was an ad-hoc, hourly contract to offer services while a direction was solidified.  One of the risks in a contract like this is that you have a resource engaged full time with a client but because of the ad-hoc nature of the contract, the billable hours aren’t full time.  We have a standard method for dealing with that kind of situation which is essentially to charge a premium for the hourly rate to cover the possible losses.  Thankfully, in this case, the client was perfectly amenable to that arrangement.  Whew - one risk taken care of.

The second risk was entirely related to the billing cycle.  In a very typical IT contract, billing is monthly, with net 30 days to pay.  This means that you work for a month, and by the time the client is required to pay their first month’s invoice, you’ve worked a second month.  In the case of this contract, the entire contract would have been worked before the client would be in default.  No early warning, no early termination clauses, no safety net.  It made us nervous.  Our standard contract requires a retainer be paid at the begining of the contract which is credited to the invoice once the payment history has been established.  The client in this case wasn’t inclined to pay an advance, and this was the negotiation point.  So we had to find a quantifiable measure of the risk involved in a contract, especially one this short, based on the billing cycle.  The measure we came up with was maximum contract exposure over the total value of the contract.

For illustrative purposes, lets assume that a year is 240 working days and that months are 22 working days.  For clarity, lets define exposure as the number of days worked, invoiced or not, that are unpaid on the billing due date.  Perhaps an example:

Contract A specifies that the client will be billed at the end of the month for all hours worked in that month and the client has 30 days to pay (net 30 days).  If the contract is for the entire year, the total value of the contract is 240 days.  Given the billing cycle, the total exposure is the first month’s invoiced days and the second month’s un-invoiced days for a total of 44 days.  Our risk in this contract is defined, as a percentage, as 44/240= ~18%.  We’ll use that as a benchmark. In the case of the contract we were negotiating, the client wanted monthly billing with net 30 days, but the contract was only for 34 days.  By that measure the total value of the contract was 34 days.  The total exposure was … 34 days, or a risk measure of 100%.  When using 18% as a benchmark, carrying 100% of the risk with a client we didn’t know didn’t sit well.

In order to negotiate, we had to come up with some alternatives and define their measure:

  • A monthly billing, net 30 days in a 34 day contract amounts to 34 days exposure over 34 days = 100%
  • A 2 week billing, net 30 days in a 34 day contract amounts to 32 days exposure over 34 days = ~90%

  • A 10 day pre-payment, but monthly billing, net 30 days (original contract) amounts to 25 days over 34 days = ~75%
  • A 2 week billling, net 10 days in 34 day contract amounts to 20 days exposure over 34 days = ~60%
  • A 2 week billing, net 5 days in a 34 day contract (new proposal) amounts to 15 days exposure over 34 days = ~45%

  • A monthly billling, net 30 days in a 1 year contract amounts to 44 days exposure over 240 days = ~18% We quickly came to understand that our risk tolerance was pretty much anywhere under 90%, in which case, we had 3 options to bring to the table.

Why extended contracts help

So, astute reader, you might be asking “doesn’t this problem exist even in longer term contracts?”  Yes, there is still exposure in long term contracts.  The 18% quoted above shows that, but there are two things working for you in longer term contract.  First, there’s work to do after the first billing cycle, so you have the option to withold services until invoices are paid.  Second, there’s a 30 day termination clause which allows you to get paid for the last month you won’t be working to cover the first month you worked without getting paid.  If you take that into consideration in your risk calculation, on that benchmark 1 year contract, it brings your exposure down to 22 days, or 9%.  If you can get a 1-month retainer or monthly pre-payment, it reduces the risk to almost nil.  Generally we don’t consider that in the calculation, though, because often the only way to get paid for a 30 day termination clause without working it is litigation.

In the end, flexibility

So in the end, what did we learn on this journey?  We learned that flexibility it key.  Our standard contract didn’t work for our client.  Their’s didn’t work for us.  We set forth a number of versions of contracts, defined what the risk quotient was for us, and indicated what our risk tolerance was.  They have the option of choosing a payment method from those options, providing a different method that we could evaluate using the same criteria, or not entering into the contract.  The calculation, however, removes the emotional aspect from the negotiation and allows us to compare apples to apples.


Jon Holt

A coach, an entrepreneur, and a no-bull advisor in growing small businesses through the use of practical strategy, light-weight governance and sitting back and thinking about running your business, regardless of what you do.

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