Fixed Bid Projects and Naked Call Options
Part of my role at Magenic for the Chicago office is that I am the person who writes the proposal, facilitates getting an estimate from our technical people, and negotiates with clients to determine how the project will be structured. Frequently, we come upon requests from clients that they would like us to bid on the work with a fixed price rather than a time and materials quote that is "open ended".
Of course, having been on the other side of the table in my career, as a buyer of technology services from firms like ours, I completely understand where the impulse comes from. You worry about cost overruns, about a vendor coming in and under-performing while you continue to pay the bill. Indeed, especially when you have real P&L responsibility, it is a scary thought - like getting in a taxi and asking a driver whom you may or may not trust to take you to some ambiguous location that you have only the faintest idea of where it is. Especially knowing that the way they make your budget is that they give you X certain dollars to accomplish Y.
I like analogies to financial services terms because, at least, there is some math that backs them up and allows you to price risks, such as using the Black-Scholes model for option pricing. So here goes. When a client finds they need a software solution, in financial services terms, they are “short” the solution. That is, they have a need, which requires them to go the market and purchase it, just like someone who is “short” a stock has a requirement to go onto the open market and purchase said stock. The same would be true if you are without a house, and needed to buy one, you are considered "short" housing. Generally, it means that you will benefit if the price of housing falls, but you will suffer if the price of housing rises.
There are two ways that the organization that is “short” a software solution can go about purchasing it. One is to simply buy the solution (aka a T&E project) – over the course of a year, which will expose them to market risk (price of solution could rise, just like the price of a share does) - or, in the alternative, they can purchase a “call option” to purchase the solution at a fixed price, which means that they pay a premium for the option, just like you would if you purchase an option to buy a stock at a given price one year out. The premium can often be substantial – even in the world of stock options, where “at the money” options (i.e. option to purchase at today’s price) one year out often sell at 20% or more of the value of the stock itself.
As a solution provider, we are either net sellers of “solutions” – i.e. going short people that we have in inventory – in the case of a T&E project, or we are writers of call options on people in the case of fixed bid projects. In other words, the appropriate term for what we do when we write fixed bid proposals is called “writing naked call options”. This link provides a good explanation of the risks involved with writing naked calls.
How does this relate to clients? Well, it is sobering to realize that when your vendor is writing fixed bid proposals, they are doing the consulting version of writing naked calls. They get a "risk premium" for writing it, with the underlying knowledge that we are taking a huge risk that has undefined boundaries - especially if there is any ambiguity at all in the body of the requirements. All other things being equal, it is much more cost effective to develop a trusted relationship with a partner where you get consistent delivery of software, than to pay the risk premium that all firms that have any premise of surviving in the long term will charge for a fixed bid project.
At Magenic, not only do we have multiple levels of oversight for all fixed bid projects, but we also dictate that we do the project management (to further manage the risk), and as well, agree to a change order process that assures that additional work that is outside the defined scope is separately paid for. So we engage in some traditional risk mitigation that helps us manage the downside risks when we do fixed bid projects.
However, it is all for naught if we write a fixed bid, allow our sponsor to go to a finance committee and get a budget number on the basis of that number, and then have to "change order" them to death, which over the long term can break down the trust between client and vendor, absent expectations from the start that the number should be more flexible (which of course begs the question, why fixed bid then?). While it protects us from the worst consequences of the naked call, it does not protect our sponsor, who often deals with a body that is not going to be interested in how we get to a result, only in the result itself, and the short term bottom line impact of getting there. Therefore, even in a case where our own risk mitigation is perfect, there is a great deal of residual risk left over when we do fixed bid projects.
So, what to do about this? Well, as with all things in life where nuance is required, it depends. Having worked at a major accounting firm myself, I understand the market realities that demand service providers that are willing write call options and "insure" against requirements change. That said, living in the world of technology, I understand that opportunities emerge during the entire course of the project, especially in requirements and envisioning phases. Thus, you have to ask yourself as a buyer what is more important - price certainty or agility? Or a mix of the two that moves to a higher degree of price certainty after a shorter "agile" period that at least gets a good set of requirements. Or better yet - though certainly not always viable, the ability to have some flexibility in the annual budget cycle when opportunities arise so you can prioritize throughout the year as opportunities emerge - i.e. the ability to six months into the year to pull from one project into another if one area looks promising and perhaps another less so.
Regardless, it is important to understand that there is not a company on Earth in the technology services business - at least one you want to deal with (aka one that has financial viability) - that will trade risk for nothing. Price certainty for a good that isn't defined to exact specifications is always going to come at a cost, and while that is sometimes required, having a constructive and trusting relationship with your provider that has transparency about cost, opportunity, and risk on an ongoing basis will save you money and, frankly, lead to greater project success.