Perverse incentives can be created through mistakes in the contracting phase. Lopsided terms, intended to empower the client, ironically weaken the value of the relationship and condemn it to eventual non-renewal. Similarly, strong arm vendor management tactics can backfire by sabotaging delivery. It may be in the vendor’s best interest to hold-back and under-deliver.

These perverse incentives can be frustrating. Clients and vendors both feel like their hands are tied and any effort to fix the problem would be sending good money after bad. Co-investment is impossible, though both parties would benefit from a deeper commitment.

Informativeness Principle

Oliver Hart and Bengt Holmström were awarded a Nobel Prize in 2016 for their related work. Holmström’s Informativeness Principle states that contracts should link agent’s pay to performative-relevant information. Hart explored decision making authority when the future was unknown. They point out together that incentives must be aligned when ownership has imperfect knowledge of an agent’s activities.

A technology managed services vendor, for example, works as an agent in the client’s environment. The client has imperfect information about the vendor’s delivery and limited ability to make decisions to deal with changing conditions. Creating the right balance of power and accountability by aligning incentives should be a priority.

Honest conversations about incentives is the first step to preventing or correcting the problem. Vendors are stakeholders in client success, just as clients are stakeholders in vendor success.  Leaning in to help the other side is often the financially responsible thing to do. Here are a few examples of perverse incentives and ideas for aligning them.

Unprofitable Deals

Hard negotiations to find the vendor’s lowest possible price can create a perverse incentive when it comes time to deliver against that agreement. While the client is looking for great value, the vendor is trying to lower costs to improve low or negative profitability.

Vendors use profitability to incentivize their teams, invest in products, invest in the relationship, and fix minor issues. In an effort to make bad deals profitable, or at least minimize losses, vendors often assign junior consultants, hold-back investment, nickel and dime the customer, and cut corners. Quality of service inevitably declines. You get what you pay for.

Clients should be wary of over-eager vendors who will agree to any price just to win the business. Clients should ensure their vendors are profitable by asking a few questions before contracting. Is this deal profitable enough, that you’ll continue to invest in our relationship? Do you have the profitability needed to cover continuous improvement? Will you still be profitable if inflation increases by X%?

Vendor Lock-In + Limited Growth

Clients may have limited ability to replace a vendor for contractual and non-contractual reasons. A unique skillset or knowledge of the environment may make the vendor irreplaceable. Switching costs like migration fees or risk may be too great, or there may be a political impediment.

Locked-in vendors who have limited ability to grow the account by selling additional services have a perverse incentive to minimize investment. Their service quality hovers just above the point at which replacement is viable, maximizing immediate returns for the sake of the long-term relationship. This may not be a conscious, malicious choice, but rather just the consequence of juggling multiple clients with multiple demands on their time.

Avoid vendor lock-in by making good architectural decisions to maintain low switching costs. Avoid black box services where the vendor controls the data, systems, and processes with little transparency and accountability. Include continuous improvement and gain share language in your contracts to keep vendors engaged.

Defense of the Status Quo

Technology is continually evolving and improving. Once manual tasks are now automated or obsolete. This evolution lowers the cost and risk of maintaining systems, but it also creates a problem for vendors who were hired to perform work that is no longer useful.

Vendors who maintain the status quo may defend their source of revenue by hiding technological changes, talking down their impact and usefulness, or simply ignoring them until the client forces the conversation. They have a perverse incentive to use old technology that is not in the best interest of the client.

Vendor defense of the status quo is often shortsighted as changes in technology and business needs can create as much opportunity as was destroyed. Vendors who deliver business value first should be rewarded with opportunities to lead exploration of new technologies. If co-investment in these technologies lowers costs, the gain should be shared by client and vendor alike.

Termination for Convenience

Contractual language intended to create flexibility and give the client the upper hand can create a perverse incentive for the supplier to minimize investment. In an HRB Article from 2019, A New Approach to Contracts, the authors quote a supplier CFO who puts it succinctly. 

“A 60-day termination for convenience translates to a 60-day contract,” one CFO at a supplier told us. “It would be against our fiduciary responsibility to our shareholders to invest in any program for a client with a 60-day termination clause that required longer than two months to generate a return.”

HBR: A New Approach to Contracts

Some managed services contracts create a backdoor termination for convenience by allowing the client to decrease the quantity of units managed without penalty. The possibility of losing revenue with little notice creates substantial risk and a perverse incentive to minimize investment for the vendor.

Fixed Bid Projects

Vendors may contract to deliver a project for a fixed fee instead of charging for actual effort through time and materials. At face value, this approach lowers client risk and incentivizes the vendor to quickly deliver the project. In practice, however, it creates a perverse incentive to trade quality for efficiency.

Fixed bid projects create risk for the vendor as project overruns erode their margins. Vendors overprice fixed fee engagements to control this risk. A vendor must know they will be profitable, even if the project can is canceled before completion. Expect to overpay on any fixed bid project.

Other Legal Terms

There are a number of legal terms that can create perverse incentives for vendors.

• Performance penalties – Vendors hedge against the possibility of paying a performance penalty by increasing margin. Performance penalties are paid, as a kind of insurance, by the client.
• Non-solicitation of employees – Vendors are unlikely to assign their best employees to a client if there is a possibility the client may recruit them. Strong non-solicitation language protects both the client and the vendor.
• Limiting vendor risk – Vendors look to control their risk by limiting costs of litigation and damages.  Rarely should a vendor accept lopsided warranty, indemnification, or other legal terms that unbalance the risk / reward equation.

Eliminating Perverse Incentives

Efforts to align client and vendor incentives through changes in contract terms, vendor management approaches, and relationships are in the best interest of both parties. Strong vendor relationships create substantially more business value than transactional relationships in which the client is simply trying to get the most for their money, and the vendor is trying to minimize the cost of delivery.

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