Tuesday, 19 May 2009

Game Theory and Software Business Partnerships

A recent discussion on game theory and sequential games triggered this article.

Managing partnerships with multiple players in an organization is a challenge, regardless of the economic situation. However, a down economy imposes specific strains on partnerships as organizations become even more focused on short term objectives. Projects that were in the process of getting into a growth trajectory are in danger of being pared back or terminated as the organization goes into survival mode. In addition, companies are subjected to disruptive events such as layoffs, which rob an alliance of the relationships that have been built over long periods. 

What can a partner manager do to ensure that their organization does not make an investment that is suddenly rendered useless as a result of a cancelled agreement? Game theory has something to teach us here.

As business partnerships are legally constituted and involve multiple interactions, their equilibrium state can be modelled as cooperative sequential games. However, if either or both partners become aware that the relationship is about to end, i.e. that the next game could be the last, they revert to looking after their own needs, resulting in a suboptimal outcome for one or both parties. What can a manager do to prevent this situation occurring? The answer is to engineer a contract that encourages ongoing cooperation and penalizes (premature) termination.

Some options:

1.     Deferred payment: In a deferred payment situation, one of the partners is a manufacturer or vendor, and the other a reseller. The reseller collects a fee immediately and is paid a deferred incentive. The incentive can be paid over multiple years and made contingent on a minimum number of sales per year. It can also be increased for each period where the vendor outperforms. If the relationship terminates prematurely, the deferred amount can be withheld. The net effect is that a successful reseller that brings in multiple deals, will have an increasing incentive to continue the relationship.

2.     Options: Options can be given over a period of years and programmed to vest only if the partner is meeting a baseline. Options can be more powerful than revenue as they give the reseller a stake in the overall business success of the vendor, without the risk of a merger. The risk of vendor underperformance remains however. A famous case is that of the early advertising deal between Google and AOL, which worked out extremely well for AOL, and was also the deal that ‘made’ Google.

3.     Sharing board members: A famous example is that of HP and Cisco sharing board members. Carly Fiorina, then CEO of HP, was a Cisco board and during her tenure, HP emphasized Cisco’s products over it own. Weaker commitments can be made using shared non-executive directors.

4.     Vendor Lead Program: A strong lead generation program by the vendor can ensure that the relationship is two-way. Apportioning high quality leads to resellers that deliver the most sales is a great quid pro quo and can be a powerful motivation for them to stay in the relationship. This is especially useful if the reseller has multiple offerings as each new customer has a value over and above that of the immediate (vendor) deal. In these types of programs, it is important to track lead conversions and review the program with executive sponsors.

5.     Joint marketing program: The vendor and the reseller agree to run marketing awareness activities on an ongoing basis. This could include marketing events such as customer workshops, with incentives for meeting targets on customer attendance. This is a variant on the vendor lead program.

6.     Shared employees/infrastructure: Vendors can offer to sponsor employees dedicated to their products at the reseller premises. Employees are jointly recruited and trained and their remuneration is shared. Having made an investment, neither party is likely to want to prematurely terminate the relationship. This can be repeated with infrastructure, for example a testing facility, which is specific to the vendor.

The litmus test for any partnership is value creation. The above measures are not substitutes for this. However, in a partner situation with multiple priorities and limited resources, a calendar of ongoing revenue and defined activities will win out over short-term expediency. 

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