Incentive and Skin in the Game

Downside - Share of the Harm - Compensation - Ownership - Long Term

Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about building successful startups.

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Charlie Munger once said: "Show me the incentives, and I will show you the outcome." I'm amazed by the power of incentives and the negative consequences created by the absence of skin in the game. Incentives matter a lot, and yet it's tough to design a sound incentive system. Here is a funny anecdote: in colonial India, a bounty was offered to eliminate cobras. People bred cobras to claim more bounties and released all their snakes when the prize was abandoned. Overall, the cobra population grew more with the bounty program.

A proper incentive system creates skin-in-the-game. This latter concept means sharing a portion of the harm. Most incentives offer a benefit from the upside and no suffering from the downside. The code of Hammurabi, the oldest legal text, was written around 1755 BC and included excellent examples of skin in the game. For instance, this following rule: "If a builder builds a house and the house collapses and causes the death of the owner of the house—the builder shall be put to death." What a charming way to align the incentive of the owner and the architect! 

Not having skin in the game means that people are separated from the consequences of their actions. It creates an asymmetry of risk in which someone benefits from the upside, and others suffer from the downside. Wall Street is an excellent example of that. Fund managers invest other people's money without putting a significant part of their cash on the line. As a result, they benefit from the upside of generous compensation and never suffer the downside. Their incentive is thus to take on risky trades, grow their asset under management, reap hefty fees versus creating long-term gains for their investors. The corporate world isn't immune from such behaviors too. 

In the corporate world, long-term incentive plans are designed around stock compensation. I insist on the word compensation because too many people believe that stock options are free. In accounting terms, it's not even an expense taken in the calculation of earnings. There is no free lunch in this world. If 10% of the company's stocks are granted through stock options, the cost is at least 10% of the current market capitalization. 

Another misconception about stock options is that supposedly managers have the same alignments as investors. It's not true because most stock options are granted freely. People don't put their money on the line. When you place your capital at stake, you share a portion of the downside. You also bear the cost of capital as you could have invested elsewhere. Quoting Warren Buffet: "Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all."

It's tough to design a sound incentive system because every system can be gamed. For instance, managers can be tempted to reinvest all earnings, regardless of the returns on reinvested capital, to grow the company's valuation and thus the value of their stocks. The manager can also skip dividends and opt for expensive share buybacks to pump the stock price to the detriment of long-term shareholders. Another unfortunate consequence could be that managers authorize only short-term investments to pump the stock price and then dump their shares, jeopardizing the company's future. Let's try to find a sound incentive plan for our two examples, the fund manager and the business manager.  

Regarding the fund manager, I like Warren Buffet's partnership compensation plan: no management fees, 4% return guaranteed to shareholders paid by Buffet himself in case of any shortfall, and any returns above 4% are shared equally between Buffet and the investors. Even more impressive, the obligation to pay back losses was unlimited. If Warren had blown up, he would have bankrupt himself - clearly an inspiration from the Hammurabi code. The cherry on the cake: all his friends and family invested a lot of money in the partnership. 

Regarding the business manager, I will follow Berkshire Hathaway, Fairfax, or Markel's incentive plan. Managers should have a significant portion of their net worth in the company. Moreover, these shares should be bought, not given. Quoting Markel's CEO: "Stock ownership is also a very important component of our compensation philosophy. Many companies believe stock options achieve this ownership mentality. We disagree. We do not use options as part of our ownership programs. We believe purchasing, paying for, and assuming the downside risk are all integral components of stock ownership" and Warren Buffet: "alignment means being a partner in both directions, not just on the upside. Many "alignment" plans flunk this basic test, being artful forms of "heads I win, tails you lose."

I want to highlight a caveat regarding putting money at stake. It works if it is a significant portion of one's net worth. Say the manager or investor has a $25m net worth, putting $300k on the line is only 1.2% of their net worth. One can ask to put $15m, but the company must be big enough to accommodate such investment. Regarding rich people, I would recommend putting on the line the two most valuable things in life: time and reputation. Time spent can't be recovered, and reputation lost might take decades to be retrieved. 

I want to exemplify here that a sound incentive system is more about sharing the downside than the upside. Benefiting from a significant gain is essential but less than the feeling that someday one might contribute to the loss. It leads to prudent behavior and long-term thinking. I'm leaving the conclusion to the great Charlie Munger: "I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. Never a year passes that I don't get some surprise that pushes my limit a little farther." So don't mess up with the incentive system! 

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