Legal professionals are well-versed in identifying risk and estimating its potential impact on their organization’s financial and reputational standings. But your risk-averse nature and seemingly obsessive knack for risk mitigation can sometimes turn you into bottlenecks in contractual processes.
You may get too cautious about unfamiliar business opportunities, spend too long reviewing legal documents, or even advise business teams against closing deals that might have been profitable for the organization.
To strike a balance between the need for risk mitigation and the imperative to support business growth, you must take a more holistic and purpose-driven approach, viewing risk through a whole new pair of lenses.
This is where the idea of risk likelihood comes into play. For a more nuanced and informed decision-making process around contractual risk, you must start asking questions beyond the nature of risk and its potential impact, paying more attention to its probability of happening.
With this approach, they will be able to not just identify risks but also get better at prioritizing the ones that really matter.
"To me, a risk only matters if it's material. If it's immaterial, I don't care about it. If it's likely to occur, but it's not very costly, I probably don't care. If it's unlikely to occur, but man, if that meteor hit the earth today, it would be bad — I also don't care. It's just not likely to happen."
~ Jonathan Franz, Head of Legal at Crunchbase
Navigating Economic Turbulence and Thriving in Chaos
The role of risk in commercial contracts
“It’s difficult to be part of any business and not hear about “risk.” It’s everywhere. Risk is the new black. It’s on the lips of every CEO, CFO, and board member, as it should be. And, anything that is important to the board and the C-Suite, is important to the legal department.”
~ Sterling Miller, CEO and Senior Counsel, Hilgers Graben PLLC
Ten Things: Spotting, Analyzing And Managing “Risk”
Contract risk refers to the possibility of adverse outcomes, losses, or disputes arising during the execution of a contractual agreement between businesses or commercial entities.
In commercial contracts, risks can take a wide variety of forms, including:
- Operational risk: Risks related to the day-to-day operations of the business, such as supply chain disruptions, equipment failures, or changes in market conditions.
- Financial risk: Potential for financial losses, such as payment defaults, exchange rate fluctuations, or changes in interest rates.
- Legal risk: The possibility of disputes, regulatory changes, or legal actions that could affect the contract's enforceability.
- Reputational risk: Possibility of damage to a party's reputation due to actions or events related to the contract.
- Environmental and social risk: Risks related to environmental compliance, sustainability practices, or social responsibility.
It is important to understand that risk plays a significant role in business and remains an inherent part of the entrepreneurial landscape. While negativity is naturally associated with risk, it does have positive attributes to its existence.
For instance, a business exploring new markets faces multiple risks that could, upon materialization, result in financial and reputational losses. But on the flip side, the business’s willingness to strategically take on these risks empowers it to conquer untapped markets, gain competitive advantage, and achieve higher revenue growth.
“When we think of “risk” we tend to think only of bad things. Yet, not all risk is negative. Avoiding all risk is not the way to run a successful business, sports team, legal department, research facility, military, or pretty much any organization you can name. Taking risks is important to the success of any endeavor.”
~ Sterling Miller, CEO and Senior Counsel, Hilgers Graben PLLC
Ten Things: Spotting, Analyzing And Managing “Risk”
It is also true that not all risks are worth taking. Thus, it becomes the legal counsel’s responsibility to carefully assess and prioritize them.
Also read: Legal Risk Management—From the Playbook of 11 GCs & Leaders
Will the meteor hit? Understanding risk likelihood
“Often because of their years of reading about worst possible outcomes and risk-adverse nature, they tend to evaluate (and exaggerate) risk based on the worst happening. But is that outcome a likely or probable one?”
~ Sheikh Shaghaf, Vice President and Assistant General Counsel at Informa
Exploring risk likelihood in commercial contracts
In-house legal professionals have a strong suit for identifying risk and estimating its impact. However, they often base these estimates on worst-case scenarios.
But, regardless of how monumental the risk appears to be, it can only be either of two things: material or immaterial. In the words of Jonathan Franz, risk is only material if it meets two criteria:
- Its potential impact is costly (with respect to the organization’s tolerance)
- It is likely to happen
Many in-house counsel base their decisions on the first point. But if the risk is not likely to happen, then it is to be considered immaterial and shouldn’t hold significant weight in the decision-making process.
Now the question becomes: how do you assess risk likelihood in commercial contracts?
Also read: Effective Contract Risk Management—Top Tips & Strategies
Best practices to assess risk likelihood in commercial contracts
“It’s prudent to consider the worst-case scenario, of course, but to be meaningful that must be done in the context of risk likelihood.”
~ Sheikh Shaghaf, Vice President and Assistant General Counsel at Informa
Exploring risk likelihood in commercial contracts
Evaluating risk likelihood requires careful assessment of multiple factors related to the risks in consideration. This can be approached quantitatively using mathematical methods like probability distributions, regression analysis, and Monte Carlo Simulations.
However, most legal professionals focus on the qualitative approach, relying on expert insights, historical performance data, market research, and industry statistics. This approach is more common in commercial contracts because such contracts often have multifaceted risks and require quicker decision-making.
Also read: Contract Risk Assessment Checklist—A Guide to Future-Proofing Your Agreements
Below is a more detailed explanation of how to qualitatively assess risks in commercial contracts.
#1 Compare similar contracts
This approach provides insights into the likelihood of risks materializing based on data from risk occurrences in similar contracts.
Here, you make a collection of past contracts related to the deal in consideration and identify recurring issues that materialized during the execution of these contracts. For instance, if contracts of similar nature are consistently subject to cost overruns, data breaches, and delivery delays, then there’s a considerable likelihood that such risks will materialize in your contracts.
#2 Evaluate performance-related risks
You may also assess your counterparty’s historical performance for risks related to delivery and compliance. For instance, does the counterparty have a track record of maintaining compliance with relevant laws, how often does the counterparty get involved in legal claims, and how has the counterparty handled such situations?
If your counterparty has a track record of getting into compliance issues or disputes over delivery and quality standards, you could say that the likelihood of such risks occurring will be high.
#3 Gather expert insights
You can reach out to legal experts who have experience dealing with such contracts. Find out the exact risks they had to deal with when managing similar contracts for their clients and organizations and take note of the ones that occur the most.
The most reoccurring risks detailed by these experts will have a higher likelihood of occurring in your contracts.
#4 Assess current market conditions
To evaluate the likelihood of specific risks, you should also consider the prevailing market conditions and how they could impact the risks associated with your commercial contracts.
An increase in competition, changes in industry regulations, volatility of consumer behavior, and more can significantly increase the likelihood of revenue losses, supply chain issues, compliance challenges, etc.
Why in-house counsel must prioritize risk likelihood in commercial contracts
It is true that not all risks are created equal. However, the probability of a risk materializing is just as significant as its potential impact.
Risk likelihood is a crucial but often overlooked aspect of risk assessment in business contracts. But in this section, we will explore the various reasons legal counsel must recognize it as a driving factor for effective risk management and decision-making.
#1 Resource allocation
By focusing on risks with a higher likelihood of occurrence, legal teams can ensure that their time, budget, and efforts are dedicated to addressing the most pressing issues. This reduces unnecessary costs and ensures the organization's resources are used efficiently.
#2 Proactive risk management
Understanding the likelihood of various risks enables in-house counsel to be proactive in their risk management efforts. They can take steps to prevent or minimize the impact of foreseeable risks before they materialize, reducing the company's potential legal and financial risk exposure.
Also, prioritizing risks based on likelihood allows in-house counsel to develop a risk management strategy that addresses the most immediate and impactful threats first. This approach ensures that critical risks are not overlooked in favor of “potentially severe risks” that are significantly less likely to occur.
#3 Strategic decision-making
By gaining a holistic view of all risks associated with a specific contract, in-house counsel can make crucial contributions to strategic decision-making processes. They’re able to sufficiently advise stakeholders on the feasibility of pursuing specific business initiatives based on the nature of associated risks, their likelihood of occurrence, and their potential impact on their organization.
“Different leaders will have different views on how to determine risk, and understanding that risk tolerance is super important to your success. If you work for a growing company, for example, your general counsel and your business leaders may be more open to taking on more calculated risks. Your job is often explaining legal risk in a digestible way to ensure that the business is aware of what could happen and what the consequences of certain decisions may be.”
~ Katayoon Tayebi, Associate General Counsel, FIGS
Accelerating Your Career as In-house Counsel
#4 Legal preparedness
Prioritizing risk likelihood ensures that legal teams are prepared to respond effectively in case of disputes or contractual breaches. By anticipating potential risks, in-house counsel can develop contingency plans, assemble necessary documentation, and establish internal processes for dealing with various legal issues, thereby reducing the organization's exposure to liability.
Assessing the value of risk in commercial contracts
Estimating the value of risk in commercial contracts is crucial in managing business relationships and ensuring that potential liabilities are adequately accounted for. This is done by considering the probability of the risk alongside its impact on contracting parties.
Let's consider a hypothetical example involving a software development contract to demonstrate how this can be done.
Company A (your employer) is entering into a contract with Company B, a software development firm, to create a software application that they intend to roll out in the next twelve months. The contract specifies the scope of work, deliverables, timelines, and payment terms. As the in-house counsel at Company A, you want to assess the potential risks associated with this project.
Here’s how you can approach this task:
#1 Identify the associated risks
Risks associated with this kind of contract typically include:
- Technical risks: The project may face challenges implementing complex features or integrating with other systems.
- Timeline risks: Delays in development could impact project deadlines and lead to disrupt plans for testing and launching.
- Financial risks: Overruns in development costs or disputes over payment terms may arise.
- Legal risks: This includes potential intellectual property disputes, non-compliance with licensing agreements, or breaches of confidentiality.
- Market risks: This includes changes in market conditions that may affect the demand for the software.
#2 Assess probability and impact
For each identified risk, assess its probability of occurrence and potential impact on the project.
Use a scale, such as low, medium, or high, to categorize probability and impact. Alternatively, you can assign arbitrary numerical values like 1 (for low), 2 (for medium), and 3 (for high).
You can determine the risk probability and impact using a variety of approaches, such as comparing similar contracts, analyzing past performances, inquiring from other experts, and assessing current market conditions.
Below is a possible conclusion:
#3 Define the total risk value
Having categorized the risks based on probability and impact, you can combine figures from probability and impact to get the total value for each risk. In this case, we arrive at the following:
#4 Prioritize the risks
In this case, Market Risk has the highest risk value, followed by Technical, Legal, Timeline, and Financial risks, respectively.
With this information, you can now weigh the feasibility of carrying on with the contract. Assuming it’s feasible to keep the contract going, you can devise the right mitigation strategies, propose indemnification terms, and negotiate liability limits and dispute resolution clauses to ensure that the interests of your organization are sufficiently represented.
Wrapping up
A holistic, result-driven approach to contract risk management in modern business calls for the prioritization of risk likelihood in parallel to risk impact. Not only does it enable legal counsel to effectively identify and prioritize risks, it also ensures they allocate resources efficiently, adapt to changing circumstances, and ultimately help their organizations make the right business decisions.
Take advantage of SpotDraft’s robust contract management capabilities to streamline every aspect of your commercial contracts, spot risks with AI, and safely drive your organization closer to its goals.
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