Drop Anchor or Anchors Aweigh? Making the First Offer In Negotiations

Negotiation Strategies: Tips for Establishing Connection and Optimizing Results

Series: Part 3

Years ago, my wife and I took a trip to Mexico. The worker in me was ready to kick back and put down a tequila or two. But my inner negotiator was anxious to test his skills at a Mexican mercado (market). Who would win the test of wills between the novice American buyer and savvy Mexican seller? Would I squeeze him or her down to a substantial price discount and walk away triumphant? Or would my Mexican friend finagle more money out of me than even they expected?

The big day arrived, and I found myself in a busy mercado. I had not asked the hotel concierge about the pricing customs of local merchants in advance. Why should I? I knew how to handle myself. Before I knew it, I was eye-to-eye with a worthy opponent, bidding on a large colorful vase. The sticker price was 1000 pesos (about $50 US), but I knew I could do better. I decided to dive in with an initial “blind” offer of 700 pesos, about $34 US. After a little give and take, I walked away with a beautiful vase for about $40 US (a 20% discount), feeling quite good about myself.

That was until later that day, when I heard someone ask the concierge how much of a discount merchants typically accept at the mercado – the very question I had deemed unnecessary. The concierge said that merchants substantially overprice their goods, and usually accept between a 60-70% discount. Translation: Had I done my research and convinced the merchant to make the first offer, I could have gotten that beautiful vase for about $15 to $20 US, over 50% less than my $40 killer deal.

Time for a margarita.

Lesson 1: To Decide Whether to Make the First Offer, Don’t Just “See How It Goes1”

Deciding who should initiate the bidding is a critical decision. In any negotiation, never decide whether to make the first offer on the fly, like I did at the mercado. While you may be impressed with your negotiation skills and have your bottom-line number clearly in sight, you are flying blind if you decide to “see how it goes” without first answering a few questions. Like any other element of preparation, you must do your homework and consider the strategic advantages and disadvantages of you or your counterparty making the first offer before you walk into the room.

Lesson 2: Anchoring and the Zone of Possible Agreement

Before delving into how and when to make the first offer, two concepts are critical to our analysis: “anchoring” and the “zone of possible agreement.”

According to experts at the Harvard Negotiation Project, anchoring, “[a] well-known cognitive bias in negotiation, …is the tendency to give too much weight to the first number put on the table and then inadequately adjust from that starting point.”2 Even if the first offer is a bit outside3 the expected bargaining range, studies have shown that its anchoring effect will pull the value of the parties’ subsequent analyses, counteroffers, and final settlement terms towards it.4 Just like a ship is held in place by the taut line of a dropped anchor, the “tug” of the first offer will influence the amount of subsequent offers and final settlement terms.

The zone of possible agreement, “ZOPA,” is “the range in a negotiation in which two or more parties can find common ground. Here, the parties can work toward a common goal and reach a potential agreement that incorporates at least some of the other’s ideas.“5 It basically describes the range of options that should be acceptable to both sides, “where the respective minimum targets of the parties overlap.”6

Both concepts must be considered when you decide whether and when to make the first offer. Let’s return to our discussion.

Lesson 3: Never Assume that You Should NEVER Make the First Offer

While this may be the traditional view, it is not always correct.7 As discussed in more detail below, there are times – especially when you have a better sense of the ZOPA than your adversary – when you can use the first offer to put yourself in optimal position to influence the discussions and ultimate settlement terms. Let’s suppose that a cedant knows from experience that a reasonable settlement of their $200,000 bill should be in the $150,000 to $175,000 ZOPA range, but the reinsurer has never before handled this type of claim. Because the cedant has a better sense for their ZOPA than the reinsurer, it can comfortably start the negotiation with an anchoring first offer of $180,000. This signals to the reinsurer (who is trying to determine a ZOPA for this new claim) that the cedant is bullish about the merits of its position and allows the cedant to drop a strong anchor to pull the ultimate settlement well within its $150,000 to $175,000 range.

But suppose the opposite is true – the reinsurer has extensive experience adjusting and settling these types of claims, but this is a first-time billing by the cedant. And suppose further that the reinsurer sets a ZOPA in the $135,000 to $170,000 range, but the cedant cannot estimate its or the reinsurer’s ZOPA without more information. If you are the cedant, you should let the reinsurer start the bidding. Why? Because where the reinsurer starts will give you a sense for how bullish the reinsurer is about its position and reveal a number at or close to the lower end of its settlement range. Also, the cedant risks leaving money on the table in the final settlement if it makes a blind first offer. For example, what if the cedant with no firm ZOPA opens the bidding with a $160,000 demand (a 20% discount) just to see how it goes? No matter where the claim settles, the cedant has already left $10,000 on the table since it unknowingly underbid the $170,000 high end of the reinsurer’s ZOPA.

To recap: the concepts of anchoring and ZOPA inform your decision of whether and when to make the first offer. If you know your ZOPA and can estimate the other party’s ZOPA, you can confidently determine where to make an anchoring first offer strong enough to pull the final settlement terms into the overlap between your and your counterparty’s ZOPA. If you don’t know your and the other party’s ZOPA, let the other party make the first offer and gather more information before entering the bidding.

In interest-based negotiations, the objective is to reach a value within the overlap between each party’s estimate of the ZOPA.

Lesson 4: How to Decide Who Makes the First Offer?

In general, the decision whether to make the first offer should be based on two factors:

Your knowledge of the ZOPA, and
Your assessment of the other side’s knowledge of the ZOPA.

Imagine that a ceding company has a $400,000 claim against a reinsurer. While officially seeking the entire balance, the cedant has sufficient information to privately analyze the merits of its position and set its ZOPA between $300,000 and $375,000. In other words, after carefully reviewing the facts and assessing the impact of any applicable arbitration or litigation outcome, course of dealing between the parties, and customs and practices in the industry, the cedant would be comfortable accepting between a 6.25% ($375,000) and 25% ($300,000) discount.

In contrast, suppose the reinsurer has access to and analyzes the same information, but estimates that its ZOPA is between $250,000 and $315,000, a 37.5% to 11.25% discount. Finally, assume that the parties were both able to make these ZOPA estimates because they have negotiated and settled similar claims in the past and are well aware of the factual and substantive bases for their respective positions.

Given the parties’ history of settling similar claims and shared knowledge of the salient elements of this claim, any attempt to anchor settlement discussions with first offers outside of their expected ZOPA ranges will have little impact. If the cedant insists that it will accept nothing below $395,000 ($20,000 above its $375,000 upper ZOPA limit) or the reinsurer counters that it will pay nothing above $150,000 ($100,000 below its $250,000 lower ZOPA limit), neither party will give credibility to or sense any “pull” from the other’s offer since it deviates substantially from their prior experience and current expectations. Under these circumstances, the parties’ ZOPA estimates overlap between the cedant’s lowest acceptable settlement of $300,000 and the reinsurer’s highest acceptable payment of $315,000. Thus, a settlement should be possible in the $300,000 to $315,000 range.

The circumstances are different where you believe that the other party knows more than you about the possible ZOPA (like the seller of the vase at the mercado). Without garnering more information about the claim (like I failed to do), it will be hard to set a proper first offer and anchor effectively. Under the circumstances, it makes more sense to let your opponent make the first offer, which you can compare with your uninformed bottom line to begin to estimate the possibility of a deal. Had I forced the Mexican seller at the mercado to make the first offer (he had more knowledge than me about his ZOPA), he might have pleasantly surprised me with a larger discount than I expected and ultimately accepted a price below the $40 US that I paid.

If neither side has sufficient experience or information to estimate a potential ZOPA, you may be able to effectively drop an anchor and pull the “double-blind” negotiations towards your range. But be careful. The problem is that, without having sufficient information to estimate a realistic, reasonable ZOPA, you risk being too concessionary or demanding. The “cost vs benefit” of holding or making the first offer in this position is aptly demonstrated by the true story of Thomas Edison’s Ticker Tape patent. Edison invented and patented the ticker tape machine when he was a young, 22-year-old telegrapher. He was negotiating to sell the machine to a more senior and experienced executive. Since this was a brand-new invention, neither party could set a ZOPA based upon personal or market experience. Edison considered asking $3,500 ($87,500 in today’s dollars) for the machine, but hesitated, since he had no college degree and had never before sold an invention. Instead of making a blind first offer, he asked the executive what he would pay for it and received a surprisingly generous $40,000 offer (close to $1M in today’s dollars), which Edison immediately accepted.

The lessons are simple: Where neither party knows its ZOPA, beware of going first. And, if you know a great deal about the claim under discussion, you can make an aggressive first offer with confidence and expect that your offer will anchor the discussion to your advantage.

Lesson 5: Advantages of Making the First Offer

Once you decide to make the first offer, consider these factors:

Sending A Message: Making the first offer “drops an anchor” that communicates an aggressive opinion of your relative bargaining strength and expected settlement range. For example, if your counterparty is seeking $1M, and you offer $200,000, they know that you don’t give their position much value. And notwithstanding their protest that your starting point is unreasonable, it will pull their counteroffers and any ultimate settlement lower and closer to your acceptable settlement range. If you wait and allow the other party to drop anchor first, their first offer could have the opposite effect, pulling subsequent financial negotiations away from your desired settlement range.

Getting Information and Accelerating Discussions: Negotiators can also use the first offer to obtain information (from your counterparty’s reaction), especially when neither party can fully estimate a proper best alternative to a negotiated agreement (‘BATNA’)8 or ZOPA. For example, what if the parties’ dispute concerns an issue of first impression, they are adversaries in a recently started arbitration or lawsuit, and want to settle early, before investing time and expense in formal discovery (or before damaging evidence gets produced to the other side)? Here, the parties can’t estimate a proper settlement range for two reasons: a third-party tribunal has not yet decided the novel issue and they haven’t shared enough evidence in discovery to knowingly evaluate the merits. Since getting information and shutting down the case quickly are priorities, party A could put aside the risks noted above and float a low first offer just to see the scope and content of party B’s response. In response, party B might present a surprisingly low counteroffer, low enough for party A to seriously consider. Or party B might not counter, instead sending a detailed response, outlining the substantive bases for their position (and a stinging objection to party A’s ‘insulting’ offer). In the former case, party A learns that the parties’ blind case evaluations are closer than expected. In the latter, party A gets an idea of party B’s formal position on the merits, which might enlighten or embolden it, and which party A can challenge point-by-point in its reply.

Including Key Terms in a Settlement Agreement: The first offer doesn’t always have to be financial to be beneficial. If you and your counterparty reach a settlement in principle, you could offer to draft the settlement agreement to ensure that certain provisions are included. For example, you may want to insert (a) a provision setting the law of your state as the governing law of the contract, (b) indemnification provisions (if necessary), or (c) a longer time period between the parties’ execution of the agreement and your payment of the agreed balance. Offering to draft the settlement agreement lets you insert the terms you want, making it harder for the other side to exclude them than it would be if you wanted to include them.

Conclusion

Deciding whether to make the first offer is a critical element of pre-negotiation preparations. Both parties must carefully assess the relative strengths of their positions, knowledge of a proper ZOPA, and risk of anchoring in the wrong place. Carefully assessing the points in this article will lower the risks and raise the rewards of making or taking the first offer.

Key components of this article are from Latz, Gaining the Edge, Negotiating to Get What You Want (2004), pages 151 to 169.
Deal Making and the Anchoring Effect in Negotiations The anchoring effect in negotiations: what to know about when to show your interests at the bargaining table, by Program On Negotiation, Harvard Law School, Staff January 31, 2022/Deal Making, https://www.pon.harvard.edu/tag/dealmaking/.
If the first offer is unreasonably below or above the expected bargaining range, it loses its anchoring effect and is rejected.
What is Anchoring in Negotiation? Learn how to defuse the anchoring bias and make smart first offers. By Katie Shonk – December 20, 2021 / Negotiation Skills.
Understanding ZOPA: The Zone Of Possible Agreement, by Marcela Marino – September 14, 2017/Harvard Business School – Business Insights.
Wikipedia, https://en.wikipedia.org/wiki/Zone_of_possible_agreement.
“Traditionally, negotiation experts advise us to sit tight and wait for the other side to float the first number…[because]… the other party’s offer may shed light on his goals and alternatives and better equip you to meet them. Yet more recent negotiation research on the anchoring effect has added nuance to the conventional wisdom about when to make the first offer in a negotiation.” Negotiation Advice: When to Make the First Offer in Negotiation, Use this Negotiation Advice So You Know the Anchoring Effect Can Steer Deal making in the Right Direction, By Katie Shonk – March 29th, 2022 / Negotiation Skills.
BATNA is the best course of action you have if negotiation hits an impasse. Evaluating your BATNA is necessary for you to establish the bottom line at which you will reject an offer. BATNA Basics: Boost Your Power At The Bargaining Table, Management Report, Program on Negotiation, Harvard Law School, 2012.