Steven Kury: Interactive Media Development, Business Analyltics and Strategy

Risk vs. Reward, Part II: Speculative Pricing

Have you ever had a client ask you to accept less than full payment for a project because he couldn’t afford to pay for your fees and, if you cut him a break “this time,” he’ll keep you in mind for future projects that he is “lining up?”  Or, he needs a proof of concept/ability to showcase to potential clients so that he can land them in the future?  He can only afford to pay you a small percentage of what your time is worth at the outset, but if his clients buy into it, it could turn into an untold amount of work for you.

If no one has asked anything like this of you yet, don’t worry, it will happen.  I guarantee it.  The question is, how do you price a project in this sort of arrangement and negotiate the “what if” aspects of it.  This is generically referred to as “speculative pricing,” and I will share with you some insight into how to do it.

As I mentioned in my first article about risk and reward, they must always be linked.  The more risk you accept, the more reward you are entitled to.  The problem with the aforementioned situations is that many clients would have you accept the risk, by doing the time involved work, with no linkage to appropriate reward.  If the deal works out, you are not tied into the reward.  If it doesn't, you take the fall.

There are two key questions that you need answers to in these situations, “what is the likelihood that the gamble will pay off, and what is the expected reward?”  Let’s start by considering a simple slot machine.  This slot machine accepts bets of a quarter with a payoff of $2.00 that happens 10% of the time.  So, each time you drop $0.25 in the slot and pull the lever, there is a one in ten chance that you will receive the $2.00 reward.

At first, it sounds pretty cool.  “Yeah, sure, I’ll drop in a quarter and try for the $2.00.”  If you just want to give it a shot with one quarter as you walk past the machine for fun, no problem.  However, if playing slots is your investment strategy, it is a guaranteed losing proposition.  Think about it for a minute.  On average, you would have to place ten bets to win the payoff.  That means that, on average, you will have to pay $2.50 in order to win $2.00.  Every time that you win, you will have lost 50 cents.  The more that you play the machine, the more you will continue to lose over time.  (This is how casinos profit from slot machines.)

If you do a project for less than full price for clients on speculation that doing so will lead to significant future projects, the financial value that you expect to receive from them must be the speculated sum multiplied by at least the number that is the chance that they will come through.  Otherwise, it is not worth it.

More concisely, if you conclude that the chance of a future project coming through for you is one in X, and you are discounting Y dollars off of the current one, the value to you of the future project should be at least X times Y dollars.

For instance, consider this example based on my experience.  Suppose a creative director wants you to develop a prototype for a product promotional game for him to present to a prospective client, as a proof of ability in order to induce his client to hire him to produce one for them.  If it is a $10,000 game for you, he might propose that you do it for $2,500 payment now and the opportunity to develop the future games that he wants his client to contract him to produce.  You would be speculating $7,500 in this deal.  If you decide that the chance of him actually talking his client into hiring him to produce a game for them is one in five, you would need your client to contract you to develop at least $37,500 in games for it to be economically worthwhile.

Let’s modify this example.  Suppose that your client has 5 potential clients that might hire him to produce a game for them, and the chance of him talking any one of them into do so is still one in five.  Hence, you are confident that one of them will come through.  In this case, you might need your client, the creative director, to engage you to develop at least $15,000 in games for the deal to be worthwhile to you.  If you don’t think that he can do that, don’t take the deal.

If you get nothing else from this article, remember this: the payoff must be more than the speculated sum.  Don’t speculate $7,500 on a current project if you expect to receive only a $7,500 deal later, if it comes through.  An even bet is pointless.

Be careful though.  Clients can be very smooth in selling you on this.  Any deal that they are “working on” is far from a done one, and they know that.  If they are so sure that it is going to happen, ask them to include it in the contract.  If they get shaky when you ask for specifics of the future deal and won’t tie it into the contract for the current project, you know that the likelihood of it coming through is not good.  You need some way of qualifying the likelihood of the future project coming through so that you can gauge it.

Corporations work with this principle in different ways.  For example, there are technology companies that will drop some amount of seed money, perhaps $100,000, on a number of technology research and development groups, perhaps ten, for each to develop a prototype of a “blue sky” idea that they have.  The corporation expects that it might able to develop one of these prototypes to a point that it can be brought to market.  The payoff for it so vastly exceeds the $1,000,000 that it invested in this seeding process that it is simply not a concern for them.

Ultimately, you want your clients to call you back to do the second project because you delivered a solid value in the first one.  By solid value I mean consistent communications, accountability, and a quality work product. (That is respectable, but simply working for cut rate prices is not.) Don’t lose sight of the value of your work to them, and make sure that you get your fair share of the pie if it comes through.

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Steven Kury, MBA, is an interactive media developer and producer.  Over the past 12 years he has contributed to several rich Internet application (RIA) systems, as well as a breadth of marketing communications solutions.  Contact him at steve@steve-kury.biz or (717) 350-6781 to discuss what he can contribute to your project.