Partnerships and alliances create value by leveraging the complementary capabilities of two (or more) parties. Often, these relationships are governed by contracts. Many of the innovative products we enjoy today have been brought to us by partnerships rather than a single firm. In highly uncertain entrepreneurial environments, partnerships can also enable firms to share risks and invest in a greater number of more daring projects.

Despite the upsides of partnerships, one needs to be aware of the pitfalls. Research studying how contracts can address those pitfalls has led to multiple nobel prizes. Broadly, these works address both the uncertainty involved in multi-party interactions and an array of information problems that may arise.

In this article, we describe some of these information problems. In subsequent articles, we will discuss how companies can address them, have addressed them, and what has happened when the problems were not appropriately addressed.

So, what are these information problems?

Asymmetric Information

When one party has private information, or is better informed than the other about one aspect of their interaction, it can use this information to its advantage. Such hidden information is termed private information. Relationships are often hindered by the presence of private information, which may lead to the collapse of negotiations, destroying value for all parties involved.

Moral Hazard

Moral hazard involves hidden action rather than hidden information. Some actions (such as how much effort they put into a task) are either not observable to the other party. Actions can also be difficult to verify. In either case, these actions cannot be directly and meaningfully written into a contract.

Holdup Problem

When one party needs to make upstream investments in relationship-specific assets, while the other party makes downstream decisions, the latter cannot credibly commit to reimburse the former for their investment. The former rightfully worries about being held up in this way and either does not make any investment or underinvests. This results in below-par performance.

Risk Preferences

Two parties may have different preferences with respect to risk. It can be expected that smaller firms, that cannot spread the risk they face across many projects, will behave in a risk-averse manner. In contrast, larger firms that can spread risks across many projects can be risk-neutral.

Contracts written between two parties have the potential to alleviate or exacerbate these problems. In subsequent posts, we will discuss how you can address them in your partnerships.

The above findings are robust across sectors but the specific circumstances of a given firm or sector will warrant specific analysis. For insights curated to your unique circumstances, to make use of predictive models, for collaboration opportunities, and speaking arrangements, please reach out through the contact form.