Monday, March 23, 2009

The “Hidden” Cost of Doing Business: Enforcement; and Three Suggestions

Any business transaction has several stages.  First is the prep stage in which the parties get ready to do a deal, learn what each other has to offer, and whether there is a mutual benefit.  Second, there is the deal making where the parties agree to actual terms of the transaction.  Third is performance. 

Hopefully, everything stops there. 

However, when performance goes wrong, there is the fourth, often overlooked, stage: Enforcement.

Enforcement Generally

OLYMPUS DIGITAL CAMERA         Enforcement in transactions is the process of making the other party do what they promised, pay what they owe, or hold up their end of the bargain.  What many clients fail to realize, is that there is a cost for enforcing an agreement, even when all the facts and circumstances seem to be in their favor.  If a party is not willing to do their part voluntarily, there is going to be a cost to forcing them to do their part or letting them out of their obligations. 

These costs include things like hiring an attorney, hiring a replacement, renegotiations, sending correspondence, making phone calls, filing a lawsuit, actually obtaining a judgment from a court, getting an injunction, or making the legal efforts to collect money damages from any source where the money might be.

As a result, failing to take the potential cost of enforcement into account at the beginning of a deal is bad business. 

Why “Hidden”?

In short, if one has to pay more than the up front price to get a good or service, the extra costs are often considered to be “hidden”.  The problem with hidden costs is that, if known, they would change the purchase decision process. 

Usually, the evaluation of whether the price of a good or service Face and hands (small) is acceptable is generally made by considering the value of what one is going to get in relation to other options.  That determination is subjective and depends on expectations.  When factors are missed because of deception or a lack of foresight, the potential benefit of the bargain is undermined.

There can be a lot of costs lumped into “hidden” costs.  For example, the cost of a car is not simply the sticker price.  There is insurance, negotiation costs, delivery costs, repair and maintenance and so on.  Each of these costs can be viewed as an independent and individual transaction, or as the overall price of the car.

The cost to enforce a transaction is one of these potential additional costs.

Finding Hidden Costs

Sometimes the hidden costs do not matter.  In a minor transaction for a stick of bubble gum, it is simply not worth the effort.  Nobody should spend a dollar chasing 25 cents.

On the other hand, if one is going to invest $1,000,000 for an anticipated future return, they should take significant steps to avoid, and account for, all costs.

And sometimes only some effort is required to address obvious risks.  When one buys an item off of Craig’s List, one generally ought to deal locally in order to see the merchandise and test it before giving the seller the money.  If a seller refuses to do this, it is a clear sign that the hidden costs may be high and the transaction should not take place.

Enforcement is a risk that can be great in some situations, and minor in other situations.  The expense should be adjusted accordingly.  But it should never be ignored.

Some Suggestions for Taking the Cost of Enforcement into Account

Here are just a few basic suggestions.

First, adjust the price you are willing to pay up front.  For example, pay less if there is a risk that you will not get the benefit of the bargain, or charge more up front if they are unlikely to perform later. 

Second, create a contract with terms that will help with enforcement.  For example, include an attorneys fee provision so you can recover the costs of paying an attorney to seek enforcement.  Another possibility is to make payment terms in the contract that allow you to pay as the party performs, or withhold money if performance is unsatisfactory.  And yet another option is to determine how and when conflicts will be resolved whether in court, at mediation, or in arbitration.

Third, get sufficient security or collateral for the transaction.  When banks do a loan for property, they get the property as collateral so they can foreclose on property if the borrower is unable to pay.  Similarly, consider obtaining rights to an asset or something of value from which you can recover if the other side fails to perform. 

Conclusion

At the beginning of a deal, the potential costs of enforcement can seem remote and unlikely.  Nobody wants to assume, or suggest, that they cannot trust the person with whom they are working.  Often we rely on a presumption that the other party has an incentive to perform in order to maintain their reputation, obtain repeat business, or keep integrity within a community.  However, incentives change, and it is appropriate to test these presumptions and make sure we are wise with our resources.

When addressed appropriately, the parties can do themselves a great service by taking the time to consider the enforcement costs as a means of facilitating the transaction, the relationships, and being wise stewards of resources.