Working out the details of a real options framework

Draft of 2009.08.28 ☛ 2015.06.15

May include: ideasworklife&c.

Suppose a prospective client approaches you to do work for hire. In many contracts for technical work, there will also be a requisite nondisclosure agreement (NDA), which may be unilateral or bilateral, but which in either case specifies that you (the contractor) will keep secret certain information regarding the client and contract.

Lacking such a nondisclosure agreement, it’s commonly understood that you could whenever you wish disclose whatever information you like about the name of the client, the nature of the work proposed or done, or even trade secrets you learned in the course of the conversation. Depending on the character and values of the client, one or more of those facts will probably be subject to nondisclosure clauses in the contract they want you to sign. And those clauses may (if you’re not thoughtful or careful) have no expiration date.

I’m thinking of one former client—a large Midwestern corn hybridizer—who made us sign an indefinite nondisclosure agreement that promised we would never state the name of the company. That’s it; just the name.

At any rate, let’s look for a moment at what you’re signing.

As we understand the law, until you sign that contract you possess the option to disclose whatever you want, at any time you want. Within certain extreme limits (libel, slander, state secrets, and so forth).

Let’s give you the benefit of the doubt as a contractor, and assume you’re not interested in revealing the pre-existing trade secrets of your client. Let’s just say you shouldn’t ever do that, and that they have a clear right to keep you from doing that before any are revealed to you, and that therefore the deal is broken if you demand the ability to tell anybody anything.

But common nondisclosure language also covers the broad range of knowledge and information that arise during the course of the project: not just the stuff you make together, but the name of the client, the terms of the contract, the outcome of the project… all kinds of new information that many clients would like to keep you from passing along.

What is the value of that option to speak about your collaboration with one another? Financially, I mean?

Well, the value to you might be substantial, especially in the current business culture: Assuming you’re a consultant, contractor, advisor, or other nonemployer firm, the relative marketing value of adding this information to your public portfolio of work may be huge, depending on the nature of the client and work. If you had completed contract work without the burden of the NDA, you would have the option to brag about the name of the client, the nature of the work, the details of the tools and cunning solutions you brought to bear, the amount you were paid… all inarguably useful information to trot out the next time you’re speaking with a similar client.

Lacking the ability to share any of that information, as an individual contractor or consultant, you have inarguably limited your ability to market yourself. Who did you work with? Can’t say. What did you do? Can’t say…. And (again, give the current business culture) that marketing value is not diminished even if the project was a total technical failure. So from the side of the consultant, it’s clear the ability to promote one’s own expertise has positive value.

Now suppose you do sign an NDA that restricts your ability to pass along this information for one year. In real options terms, it seems that you’re postponing the exercise of your implicit right to market your business. In exchange for compensation, of course: the payment you receive from the client, and whatever general knowledge and experience might be accrued during the course of the project.

So at this point it seems that the amount you should charge the client just to sign an NDA depends on the expected loss of revenue you will experience from limitations of your ability to market your work. If we pare away the decision to work on the project together, we cannot get looped into ridiculous conundrums like, “Well, if you don’t sign the NDA we aren’t going to have a contract.” The value of the NDA is not the value of the entire contract; the work you do for the client is what causes them to pay you.

The NDA’s value must be separable.

But there’s where I get hung up, somehow, so I keep mulling it over looking for a way to model the transaction that captures the risks and benefits of disclosure and nondisclosure so they can be made more explicit. Maybe because in this combined deal (contract-plus-NDA) there is also a set of complex options being created, sold and exercised by the client, I admit I get tied up.

I’m encouraged, though. Consider that a well-formed contract for work is above all an aid to the planning processes for both participants, in that it reduces the uncertainty regarding possible outcomes. As a contracted worker, you have more assurance of income in the near future; as a contracted client, you have more assurance that the project will proceed, and you have a better handle on the costs.

Still, the value of nondisclosure within one of these contracts feels complicated, though not necessarily from the standpoint of the contractor. What are the sources of value and uncertainty on the client’s side of this planning process?

Surely the client believes that by engaging you and applying your expertise and effort there will be positive business value compared to what they would achieve without your participation. Or perhaps your presence reduces the risk of failure by a detectable amount. In any case, let’s limit the scope of the analysis by assuming there is a clear-cut case in terms of risk and return for them to engage you.

But they clearly also believe—whether or not it’s true—that public disclosure of certain information will put them at a competitive disadvantage. As if you didn’t know it already, this is the assumption I’m most prone to challenge. It’s clearly the reason current practice so often makes nondisclosure a dealbreaker: it’s common knowledge that the revelation of trade secrets is expensive.

Now I confess there is a tendency among those of us who have been entrepreneurs or analysts or modelers or IT professionals or experts of any sort who type and draw on whiteboards a lot to imagine that the sort of trade secrets that a client might want to protect are the same kind of simple innovation that we create almost every day: better software, working analytics, cunning and insightful reports, graphic designs, improvements in institutional structure. Insights, call ‘em.

These “secrets” are the kind of thing we joke about around here by saying (quite accurately), “A good idea is born worth minus $25000.” Because ideas are cheap to formulate, but each one has real costs to implement. Over the course of a decade one inevitably hears the same idea pitched a dozen times in whispered tones as if it were made of gold: a real estate aggregator, a stock prediction system, a social site for book lovers, a killer app on the iPhone….

These are, in my experience, the most common kind of client projects: the sort any moderately smart professor or middle-manager or graduate student stumbles across in the course of their “real work”, sees unbounded upside potential of, and (without exploring the practicalities) pursues optimistically. And thus tends inevitably to overvalue.

In the case of such trivial secrets, let’s assume that the client’s model of the risks from disclosure of their “secret” greatly overestimates the chances or the losses, or both. Your model, or perhaps “the market’s” model, would produce a much lower risk for the client, and therefore a lower price for [non]disclosure.

But as an expert contributing skills to completing the project, the ability to promote the sort of work you are brought in to do is no less valuable to you—independent of its validity as a “secret”. You write, you type, you answer questions, you contribute insights whether they are building a hugely innovative first-mover, or a bog-standard also-ran.

So it strikes me that the problem in these cases lies with the quality of the client’s models of their intellectual property and competitive landscape. They overestimate the recoverable value (or underestimate risks) associated with the project, and as a result the realizable long-term value to them of keeping the secret appears to be greater than the immediate value to you—and to them—of promoting the work.

Because we shouldn’t disregard a qualitatively different model of the contract: Suppose instead of being client and customer you are partners, and you are faced with the decision whether to promote your project or keep it secret together. There is marketing value to both of you, but also risk from competition to both of you upon disclosure. And disclosure is irreversible, don’t forget.

So from a real options perspective if you can postpone the decision to disclose until the benefits of promotion definitely outweigh the risks of competition, you both win. Whether you’re partners, or consultant and client.

Hopefully you can see the same real options structure I do. At some point, if they’re paying attention, the client will eventually improve their model of the real value of their “secret information.” We just don’t know when that will be, externalities and uncertainties of life being what they are.

So suppose you enter into a suite of simple options contracts regarding disclosure in which (a) you cede your right to disclose the information for a fixed length of time (say a year) in exchange for a certain sum of money to offset your lost marketing value; (b) your client is granted an option to renew that contract for another year at its end; and (c) your client is granted an option to abandon the entire nondisclosure structure (including scheduled payments) at any time. They should exercise this option, obviously, when they’re out of the money: when the costs they will be paying in future outweigh the realizable benefits given new information.

What is the price for nondisclosure, here? It can be estimated as the loss of revenue you as contractor will experience from failure to market yourself. If your client receives new information at any time that reduces the perceived value of secrecy to the point it no longer seems to be worth paying you for it, they can abandon the agreement and your right to irreversibly disclose the information reverts to you. If at the end of a contract period they still perceive positive value in secrecy, they may renew (perhaps at a new price).

Now it’s been pointed out to me that there’s more than just this sort of “naive secrecy” I’ve sketched. While it’s common in startups and small businesses, a larger or more capable client probably has better models of the risks and values of disclosure. If nothing else, larger firms are more likely to be aware of real competitive landscapes and best practices, and tend to outsource development as opposed to research projects.

The secrets in these cases are not so much innovations as they are well-defined functional practices and information that’s been tried and tested. In many cases there are smart accounting models of exactly how much they’re worth.

But I don’t see how this negatively affects the calculation of the cost of secrecy. Indeed, it should improve matters and simplify for all involved if the components of the contract regarding secrecy are separate from those regarding work-for-hire. Give the customer the benefit of the doubt here, and assume we’re now at the opposite extreme from “naive secrecy”: now the least accurate predictive model is probably the contractor’s, in that it overestimates the value of marketing (disclosure).

What we do in this situation? I’m not sure.

And uncertainty is the key: that’s what real options pricing is all about. So maybe (after I think about it for a while) we can work the rest of the model out, and maybe slap some probabilities and prices on there.

In general, here’s where I feel like I am: The presence or absence of an NDA clause in a contract should not materially affect the expected cost of the actual work performed, and therefore it can be separated away from the work-for-hire clauses. Further, the matter of disclosure of pre-existing trade secrets (in either direction) is not what I’m thinking about here, and that should be separated as well; I’m talking about novel information material to one particular project, ranging from the existence of the project, to statements of the goals of the project, to descriptions of the particular techniques applied, to news of the eventual outcome.

This information would be of value to the contractor (and arguably the client, but we’ll ignore that) for marketing purposes, who therefore expects a financial advantage when it is disclosed. But the information is also (arguably) of value to competitors of the client, who therefore expects a financial cost should it be disclosed.

There is uncertainty associated with all these valuations, and with the probabilities of the events occurring. How do we model that in such a way as to make it simpler to separate agreements for work from agreements regarding nondisclosure?

It’s simple refactoring, really: The modules have very different functions, and yet they’re too often interconnected.