Charlie Munger’s quote, “Show me the incentives — and I’ll show you the outcome,” encapsulates the essence of inculcating the growth mindset within the organizational DNA.
Many times businesses fail or are unable to reach their maximum potential as they are busy chasing sub-optimum metrics. Particularly in case of start-ups the North Star Metric happens to be Valuation.
Let’s explore the ideology behind the reward metrics and why misalignments in this metric can contribute to business failures, highlighting the principal-agent problem.
Principal — Agent Conflict
The principal represents the shareholders or investors, while the agent represents the employees or founders of the business.
The conflict arises when the agents’ interests diverge from those of the principals, leading to inefficiencies and suboptimal decisions.
The incentive system is like a video game designed to reward long-term thinking and combat fatigue.
Warren Buffett and Charlie Munger famously emphasized the significance of incentives in driving outcomes. They understood that the principal-agent problem lies at the heart of many organizational challenges.
Buffett & Munger looked to create an incentive model so that every agent in the business was rewarded for thinking like the principal. If incentives are not aligned with the overall goals of the business, the results can be counterproductive. This is where the concept of inversion becomes crucial.
Incentive schemes must be designed intelligently to avoid magnifying the principal-agent problem.
Inversion
“You get what you reward for. If you have a dumb incentive, you get dumb outcomes” — Charlie Munger.
Having a bad incentive scheme is worse than having no incentive scheme.
Consider the case of FedEx, which initially paid employees by the hour, leading to a lack of urgency and poor service delivery.
This example underscores Munger’s point about the impact of incentives on outcomes.
At companies like GEICO, they focused on just two variables: new business (measured by the number of policies) and profit growth. This simplicity ensured that every employee could understand and align with the company’s objectives.
Businesses can learn from global examples like GEICO and FedEx and tailor their incentive structures accordingly.
Pairing Metrics
Another strategy to address the principal-agent problem is pairing metrics. If founders / employees are solely incentivized based on new business, they might pursue growth without considering long-term profitability. Conversely, a focus solely on profitability could lead to short-term gains at the expense of sustainable growth.
By combining growth-related metrics with profitability measures, founders and employees are encouraged to pursue sustainable growth strategies.
This alignment ensures that short-term gains do not come at the expense of long-term viability. Balancing these metrics aligns employee goals with shareholder interests, fostering a healthier organizational environment.
Indian startups have had instances where misaligned incentives have led to challenges. For instance, consider a startup that focuses excessively on rapid customer acquisition without considering long-term profitability. In such cases, the founders might prioritize short-term growth metrics to impress investors, leading to unsustainable business practices.
The alignment of incentives creates a win-win scenario. When founders, employees, and investors are aligned on common goals and incentives, it creates a collaborative environment where everyone works towards collective success. This alignment minimizes conflicts of interest and promotes cohesive decision-making across the organization.
Behind the scenes, there’s a complicated interaction of incentives and motivations that can either propel a business forward or lead it astray.
In one of the cases, the sales team at a SaaS company was being incentivised for the monthly sales, this led to the teams under — selling the product. The teams offered up to 80% discount with a consideration that they could increase the no. of clients by 5x at the price point and achieve similar sales.
This strategy led to increase in cost for the company as more users led to increased support & cloud cost.
Further, this also hampered the reputation of the brand as discounting by such high margins diminished the perceived value of the product and the discrepancy of price across customers led to diminished trust.
As a result, 2 years into the business the growth plateaued.
During a visit to the company’s HQ, the founder addressed the concern of plateaued growth to the Auxano team.
Auxano delved deeper — interacted with the sales team, customers, and identified the underlying issue and addressed the same for the management by implementing a relevant set of KPIs to monitor the issue.
As a result, the ARPU in the following month increased by 80%, leading to better unit economics and healthier bottom line.
Takeaway
In conclusion, by aligning incentives with long-term sustainability, value creation and addressing the principal-agent conflict, businesses can navigate challenges, mitigate risks, foster innovation, attract talent and build resilient, growth-oriented cultures.
Author:
Karan Gupta
