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The Math of Success Fees: A Calculator for Rational Decisions

14/04/2018

Success fees are increasingly popular. However, they are often set too low by vendors. This calculator allows you to set the success fee at an appropriate level based on expected value and risk aversion.

The bottom line: the expected value of a success-fee project must always be higher than the fee under a no-risk arrangement.

The basic concept of expected value (EV) is at the core of the calculation. EV = the sum of all possible values, each multiplied by the probability of its occurrence. Your expected value before risk aversion (EV1) of base and success fee should equal the fee you would receive under a traditional no-risk arrangement (EV0).

In addition, you are risk averse. Since you are not certain if the success fee will materialize, you need a risk premium. This gives a final expected value EV2 (>EV1).

The calculator assumes you know the the probability of success, and the risk aversion premium you require. With these known, you can run different scenarios for the mix of base fee and success fee.

Remember: EV2>EV1; EV1=EV0

This exact calculator is what we use when we determine our own success fees.