In this negotiation, Hasan's lawyer had an interesting idea, make the pie larger by giving Hasan the entire 100 million bonus. Yes, I know there's an issue of incentives, but let's focus for a moment on seeing just how large we can make the pie. By giving Hasan the entire bonus, the lawyer is taking advantage of the difference in beliefs about the likelihood of FDA approval. She's using the beets versus broccoli principle. Since the bonus is worth more than Hasan, give all the bonus to him. This makes for a really big pie. Since Hasan is getting the entire bonus, it's only his perspective on the bonus that matters. The $100 million bonus is worth $60 million to Hasan, and that also means the pie is $60 million. Let's confirm this, on his own, Hasan would take the deal from Zam's for $20 million. On its own, Zincit wouldn't have a drug to sell, so its profits will be 0. Combined no deal is worth $20 million, but what if they agree to a deal? How much benefit can they get by working together? Under the big bonus deal, Hasan will get some upfront payment, we'll call that X, plus a $100 million bonus. While Zincit will make $20 million minus the upfront payment of X to Hasan. If we add up those benefits they come to a $120 million if the drug is approved by the FDA, and $20 million if it isn't. If we subtract the combined $20 million benefits to Zincit and Hasan when there's no deal, we can see the pie is just a $100 million bonus that goes to Hasan if the drug is approved. because Hasan believes there's a 60% chance of approval. This bonus is worth $60 million to him, and that's the pie. Before going further, what was the pie when Hasan got a $20 million up front payment, and the two parties split the bonus $50 million, $50 million? The pie was $35 million. Thus, giving all the bonus to Hasan increases the pie from $35 million to $60 million. Now let's turn to how we should split this giant pie. Since the pie is $60 million, an even split means that both sides expect to end up $30 million ahead. But how do we make that happen? Let's start with the case where Hasan has a $20 million upfront payment. In that case, Hasan gets the entire pie of $60 million, and Zincit gets zip. Splitting the pie means that each party should expect to get $30 million. Since we can't change the bonus levels, we'll have to adjust the amounts Zincit pays Hassan up front. Specifically, Zincit has to reduce its upfront payment by $30 million compared to what Hasan would get in a Zams deal. That means Hasan would get minus $10 million as an upfront payment, and how would that work you might ask? Hasan would pay Zincit $10 million up front for the right to get a $100 million bonus if the drug is approved. Zincit will make $30 million no matter what happens, and that $30 million is half the pie. The gain to Hasan over the Zam's deal is also $30 million. He'll be down $30 million if there's no approval but the expected bonus is worth $60 million to him for a net of 30. I imagine some of you are thinking that's crazy. Why would Hasan ever pay Zincit? The answer is that this is the only way to get FDA approval. Hasan should be willing to help cover their upfront costs in return for an opportunity to get a higher royalty. Indeed, I had a similar opportunity with my first book contract. Instead of getting an advance and the standard 15% royalty, I decided to take no advance, and cover all the production and overhead costs, in return for a 30% royalty. Yes, the publisher would make less per copy, but this eliminated all their downside risk. The publisher was game, but my co-author was not, so we didn't do it. The book, thinking strategically, ended up selling several hundred thousand copies, so it was a big missed opportunity. In retrospect, what I should have done is cover my co-authors cost share in return for his upside. That is, instead of the two of us splitting the upfront costs and the 30% royalty, I would have paid all the upfront costs and in return receive all the extra royalty. Lesson learned. Of course, there are limits to this approach. I still wanted the publisher to have skin in the game. If the royalty rate were pushed too close to all its profits, then the publisher wouldn't have any incentive to promote the book. The same issue arises in the Zincit case. If Hasan gets a 100 million bonus, then Zincit has no incentive to get FDA approval. Yes, they're contractually bound to apply for approval. But it's always better to have your interests aligned than count on a contract. A second issue is that one side may be capital constraint. In the case of the book contract, paying the upfront costs would not have been that expensive. But Hasan probably doesn't have 10 million lying around to invest in the project. It's possible he could afford to take nothing upfront. Or perhaps he could afford to pay 250,000. You can't get the other side to pay you more upfront than what they have. A third issue to consider is risk. If Hasan pays $10 million up front, assuming he has that amount, then he's bearing all the risk. Zincit ends up 30 million ahead no matter what happens, while Hassan is either 30 million down or 70 million ahead, which is a 100 million swing. That's a whole lot of risk for Hasan to bear. The cost of accepting this risk should be taken into account when calculating the pie. We haven't done so. But that's another good reason not to go all the way to the 100 million bonus extreme. At the same time, that doesn't mean we should split the 100 million bonus 50/50. Perhaps Hassan should get $80 million and Zincit 20. That leaves some incentives for Zincit while lowering the risk to Hasan. There's one more point I want to make. In the previous video, Hasan's lawyer pulled a fast one. She proposed they go from a deal where Zincit pays 20 million up front plus a 50 million bonus, to one where Zincit pays 15 million upfront plus a 100 million bonus. As she rightly pointed out, from the perspective of Zincit, the two deals have the exact same expected value to Zincit. Under the original deal, Zincit has a 10% chance of being $50 million ahead, which is worth $5 million. Under the new deal, Zincit ends up $5 million ahead no matter what happens. Thus, the two options are equally good to them. But look at the new deal through Hasan's eyes. The gain to Hasan over the Zum's deal is now $55 million. His upfront payment is down $5 million compared to Zum's, but he has an expected bonus worth $60 million. Compared to Zincit's measly $5 million, Hasan is getting way more than half the pie. What Hasan's lawyer did was pretty clever. She increased the pie by $25 million by going all the way to a $100 million bonus. And then, came up with a payment scheme that gave all the extra gains to Hasan. This is a sweet deal for Hasan and not so sweet for Zincit. For Hasan, this was a smart way to ask for more than half the pie. Zincit was focused on the deal from its side and didn't consider or ask for the extra gains going to Hasan. It's great when the other side finds ways to expand the pie, but be sure you share in those gains. So here are our three lessons. First, go to extremes. In this case, it means giving Hasan a 100 million bonus. Second, don't ignore incentives and risk sharing. An 80 million bonus is close to the extreme while still leaving incentives for both sides. And third, don't forget to split the pie. To do so, one side may have to cover startup costs, or give the other side money upfront.
