Monday, January 31, 2011

Net Present Value (NPV) and Discounted Cash Flow

To be a negotiator there are times when you need to understand certain financial concepts and Net Present Value and Discounted Cash Flow is one of those concepts negotiators should know.

Net Present Value looks at what a future cost is worth in today’s dollars. Discounted Cash Flow looks at how much of an investment would need to be made today to make a payment or investment in the future. Net Present Value takes into account the fact that the other party will have the benefit of using the money in the interim and getting the compounding effect on that, making it worth less to you (as you aren’t getting the compounding effect of the money). Discounted Cash Flow takes into account the fact that you will have the benefit of the investment and would be earning a return and get the benefit of compounding in the interim so the amount you need to invest today to make a payment in the future is less than the payment amount.

The NPV is calculated by dividing 1 by (1 plus the interest rate) N  where n equals the number of years. For example if you had a value of money of 12%, and the agreement was to pay you $1.00 three years from now, the NPV calculation would be:
                 1                         1                            1                         1
NPV  --------------  or   ----------------   or    ------------------      or    -----------   =  $.7117                     
            (1 + rate)n         (1 + .12)3             1.12 x 1.12 x 1.12       1.4049

This means that a commitment to pay you $1.00 three years in the future is equivalent to you having $.71 today. From a discounted cash flow perspective it would mean that for you to have that $1.00 three years in the future, you would need to invest $.71 today.

Net Present Value or Discounted Cash Flow deal with the concept of time value of money. That’s important to Procurement as throughout a contract there are promises to make payments, hold inventories, and pay damages, all which may have a time value impact. For example, if you were purchasing a major piece of equipment there can be a significant difference in the NPV based upon the payment schedule. Sometimes the issue of time value of money exists in the subtleties of the language used or the changes Suppliers try to negotiate. For example compare the same commitment, but with one word inserted:
            “Supplier will pay all damages awarded.” 

What’s the difference?  The difference is when you will get paid. In the first, once damages are awarded the Supplier must pay. In the second, payment will occur at some point in the distant future after the Supplier no longer has any possible appeals so the award is final. You will still get paid a dollar, but on a net present value basis you will get less.  Using a 12% value of money, here’s what they would be worth depending on timing:

Time to get paid
Current value of that payment commitment
1 year
2 years
3 years
4 years
5 years
6 years
8 years
10 years

So in the change of the language example, changing it from damages awarded to damages finally awarded would mean that the Supplier would not have to pay you until the award is final, meaning that they exhausted all means of appeal. If that took 8 years to happen, from a Net Present Value perspective it would mean that commitment to pay is really paying you the equivalent of 40% of what it would be worth if they paid you today. Sure if the award was $100,000 you would still be paid $100,000. The difference in value is because they are holding the money not you, so they would be getting the compounding effect of the investment on that money. 

Another way to look at it is from a discounted cash flow perspective, all they would need to invest today to pay you the $100,000 in 8 years if they had a 12% return on their money is $40,000.

Another way to look at it is if they paid you the $100,000 today and you were able to get a 12% simple return on your money here’s what it would be worth to you during the same period.
Day 1
End of 1st year
End of 2nd year
End of 3rd year
End of 4th year
End of 5th year
End of 6th year
End of 7th year
End of 8th year

So that one additional word in the commitment could cost you $147,598. That’s the  difference between being paid $100,000 at the end of the eighth year by the Supplier when the award was final versus having $247,596 because you were paid immediately and had the compounding effect on your money.

Non-Compete Provisions

In some Procurement situations there may be a need to make sure that the Supplier is not selling competing products. Most of the time it’s because the Buyer has committed to make significant investments in the creation of a new product or service. It could also involve the Buyer making certain volume commitments to the Supplier or the Buyer entering into a form of requirements contract where the Buyer is limited to only purchase from the Supplier. 

In the first case the Buyer wants the non-compete provision so they have a better assurance that they will get the return on the investment they made. In volume purchase situations the Buyer wants to be assured that the Supplier will not be taking actions that would prevent the Buyer from purchasing those committed volumes and winding up either having to purchase items they can’t sell, or pay termination charges on the items they don’t take delivery on. In a requirements situation the Buyer would not want to be limited to only being able to purchase from the Supplier while the Supplier is competing with them or creating other relationships that could impact the Buyer’s ability to make the sale. 

Agreements not to compete can be done by either a separate non-compete agreement between the parties or by the addition of a non-compete section where there is a “covenant not to compete”. A covenant is a formal commitment to do or not do something.

Most covenants to not compete will normally answer the following basic questions:
  • Who is agreeing?
  • What is the scope of the commitment?
  • The description of what is being restricted.
  • The term of the restriction.
  • The geographical scope of the restriction.

Here’s a simple example
Covenant Not To Compete.
Supplier hereby covenants and agrees that it shall not, directly or indirectly, either on its own or through an agent, joint venture, affiliate, or independent contractor, sell, lease or otherwise distribute the Ajax Product (Part number #______  or any product that contains the functionality and performance set forth below to parties other than Buyer. This covenant shall remain in effect for the term of this agreement and shall apply worldwide.
        Description of Product:
        Restricted functionality and performance

 In the example:
  • Who is agreeing: The Supplier
  • The scope of the commitment: The Supplier shall not, directly or indirectly, either on its own or through an agent, joint venture, affiliate, or independent contractor,  sell, lease or otherwise distribute the Ajax Product (Part number #______  or any product that contains the functionality and performance set forth below to parties other than Buyer
  • The description or scope of the restriction: It would exclude both the named product any other products that had the functionality and performance that was described
  • The term of the restriction.  For the term of the Agreement with Buyer
  • The geographical scope of the restriction: Worldwide

In the example I used functionality and performance as measures as a Supplier could easily come out with a slightly different product and by including both functionality and performance you could control the extent the Supplier may be able to use the technology. For example, you may not be concerned if substantial functionality wasn’t included or if the performance of the product was significantly less so that it didn’t compete on a price performance basis with the Product you are buying.

If you needed a covenant not to compete in an agreement, there are several additional changes that you would want to make to your agreement. The first is you would want the right of injunctive relief to enforce the covenant. Injunctive relief would allow you to seek a court ordered injunction to prevent the Supplier from further violating the covenant. The second thing is you would also want to modify your limitation of liability provision so the damages you could collect from the breach of the covenant would include lost revenue and profits as those would be the primary damages you would have from the breach of the covenant.

One last comment. Non-compete provisions are a form of a restraint of trade. If the circumstances would make sense for a non-compete provision, you should review it with your law department to ensure that the covenant would not be in violation of anti-trust laws and that it would be enforceable.

Opportunity Costs

In negotiations you mostly focus on direct and indirect costs associated with the Supplier relationship. In motivation behind the negotiation, you may also have opportunity costs that may drive the behavior of the Supplier or Buyer. For example, a common tactic in product development and sales is to be the first one out with a Product or Service so that you become designed into your customer’s product or solution so that it becomes difficult or costly to switch to another Supplier. In that situation the opportunity cost that drives their behavior is all the residual and annuity business they would get once they are selected.  If they don’t close the contract, they don’t just lose that sale, they also lose any residual or annuity sales that would flow from that.  It doesn’t hurt to remind a Supplier of that during the negotiation.

There can also be opportunity cost that you can use in negotiation of the renewal of service contracts. For example, I once negotiated a renewal bonus if we were to renew a major service agreement. The rationale that we used in negotiating the bonus was that if we walked away and went with a new supplier, the Supplier would have significant expense in bringing in new business to replace us, so if we saved them that cost we should get a benefit from that renewal.

Another form of opportunity cost to a Supplier can be in simply having your company as a customer.  There are two types of potential value involved. One is in what they can learn from you if they do business with you. The other is the value of your name or brand in the marketplace in their selling to other customers.  Being able to list certain companies as your customer can be like having the “Good Housekeeping Seal of Approval”.  Potential customers view Suppliers that have prestige customers different than ones that don’t, and that provides substantial marketing advantage to a Supplier.  If they don’t get your business or lose you as a Customer, that’s an opportunity cost to them.

In preparing for a negotiation one of the things you should always check is recent business news about the Supplier such as recent announcements, awards, cancellations, claims etc. That type of information can help identify their need for your business.

Buyer’s can have opportunity cost which also can motivate their behavior and it’s important in dealings and conversations with the Supplier to not disclose the facts behind such opportunity costs. For example a Buyer could need the Supplier’s product to do the same thing as the Supplier (such as try to be first to market with Buyer’s product so they can lock in their own customers in and get the same benefits of being designed in to a solution). Buyers can also have opportunity cost in terms of costs they accrue waiting for work to be done. I once had to negotiate a contract to fit out a Computer Store that we were locating on Wall Street. In that case the opportunity cost was the substantial rent that we had to pay each month until we could use the space.  The longer it took to negotiate the agreement the longer we would have to pay rent without using the space.

Buyers may also have opportunity cost tied the profit they can make once the work is complete. I once negotiated for the construction of a plant in Hong Kong and the Vice President who had control over the future plant made it very clear to me that he wanted the agreement closed as quickly as possible and he want the work done as fast as possible, but still pay a competitive price. It wasn’t until later that I found out the reason was that once completed, the operation would make enough profit in six months to pay for the entire building and all the equipment in it. That’s a real potential opportunity cost if there were delays.