On Incentive Alignment and Sleeping Well

It turns out, when you start thinking about creating a new business, there is no shortage of ways to evaluate your opportunity set:  competing frameworks online, business gurus offering advice, twitterati celebrating the next new new thing.  It can be overwhelming.

For what it is worth, rubric that resonates best with me is from Seth Godin, distilled to:

• What are you willing to invest (time, reputation, emotional bandwidth, capital)?
• Who do you want your customer to be? (you will fail if you don’t have empathy for customer)
• What experience do you want?  (pay dues for big outcome, enjoy the ride, etc)
  

These questions shape my thinking. They are actionable and universal.

Let me offer another tool.  How aligned are stakeholder interests in this business model?

Every company will have different stakeholders - investors, customers, and employees are the three most common, though you could add the environment, society at large and others.  What I mean by aligned incentives is: would each one of those three groups choose to act in the best interest of the others even if no one is observing them?  That is, with perfect information, do they see it in their best interest to perform a task, do a job, etc that rewards them while at a minimum not harming the other two groups.

Aligned incentives mean everyone is inherently driven toward an optimal outcome for all other parties in the long term. How can these get out of line? Let’s use a few examples:

Online commerce companies use GMV (gross marketplace volume) as a key metric. If you are earning a % fee on every transaction, then monitoring and optimizing for more transactions is a sensible objective.  This could work well selling Pez dispensers or books - fixed products with clear attributes -  and ratings systems to record and display the reputation of sellers in the market.

However, when the online product moves to a loan, as it did when the first Fintech lenders launched (LendingClub, Prosper, SoFi, Affirm, etc), the incentive puts some segment of customers against the company itself.  

Lending marketplaces that have a recurring, relentless incentive to grow volume operate with an inherent tension between the well-being of their customers (investors in the loans in this case) and themselves (meeting the monthly/quarterly/annual loan growth target).  It is inescapable.  Inevitably, the pressure to grow pushes up against the quality bar of the financial product promised to investors, pushing the management further out on the risk curve.  While traditional banks and other lenders have a similar tension in theory, they are not venture backed, a model of financing that focuses heavily on growth.  

Misaligned incentives occur in many other business models as well. Spotify pays music rights holders each time a song is streamed on their service, a rate that differs depending on the stature (and leverage) of the artist, yet their revenues come from flat monthly fees from their customers.  Therefore, their long-term incentive is to maximize retention of the customers while trying to get them to listen to the least valuable songs less often.  Managing the P/L of the business, when it is at scale, will require leaders to constantly trade-off shareholder value with customer delight, even if on the margin.  Should the next ‘randomly’ selected song be a Taylor Swift song ($$) or an unknown artist not yet known (and not yet represented by high powered agents and lawyers)?  

To be clear, all businesses at some point in time face misaligned incentives between their customers and shareholders. Something as simple as a pricing decision shows the conflict - a higher price of the product is better for shareholders, worse for customers.  And, many very large and successful companies have thrived despite deeply entrenched these incentive challenges (Facebook as one prominent example).

But, it seems to me some business models are set up from the start for more tension and conflict.  I often thought about the newspaper test when leading my company - if the action I am taking now was on the front page of every newspaper tomorrow, would I be ok with that?  It is a simplifying tool in the daily fog of too many decisions.  

Incentive alignment is a meta newspaper test for the business model itself. If customers, shareholders and employees all have perfect information about the profit drivers, short and long-term incentives and tensions in the business, would they all be comfortable?  

I can think of no more important question to the long term happiness of the founder and CEO.  If you don’t get that right, while the business may still be successful, you are setting yourself up for countless sleepless nights holding a tremendous ethical weight on your shoulders.