Incentives

I've been pondering incentives & penalties recently, and how they can influence people's behaviours, probably because of books I've been reading on Economics / Game theory and also events over the summer with my business buddy.

As I've said earlier, I am an equal partner in a business with my business buddy, and over the last 6-9 months, not much has happened. To some degree we haven't moved forward that much. That isn't strictly true, as we did have a major rethink in May about our product range & strategy, but essentially we're still where we were in January in that we have a web site set up, ready for trading.

Over the summer, I could have easily intervened in the inertia and made something happen, as is very much in my personality. However, I chose not to. I did what I perceived what I thought was a fair amount of work and no more. But why stop at that?

I felt that any work I did beyond my "fair share" would not reward me beyond my 50% of the share capital. I felt that my partner would be "unfairly" rewarded for my extra work, as he was focussed on something else, of far more importance and he had admitted he hadn't given the fair level of input to the project.

But perhaps that is not logical. Currently I am earning zero dividends from that share capital because there are zero sales because the outstanding work has to be completed. If I had made the interventions, then I would have at least a chance of earning something. So therefore I could justify my intervention.

However, I think, on balance I did the right thing. Simply put, it is impossible to have an exact "fair share" of the workload between two parties, and I accept that. Also, it would have set a precedent which I would not be happy or willing to live up to in the future - my business buddy can clearly see the impact that he has in the business and also that I have in the business.

So what's my solution on how to solve this problem in the future? It comes down to having a fair and transparent guideline for the share capital. The premise of 50:50 share capital is intact, but it slides depending upon how much time and how many of the actions are put into the business.

This is how it could work in practice...

All parties agree a nominal value for the business... perhaps its £1,000, with the share of the value of the business being determined by who does what, on the basis of time. Basically the longer it takes to do, the more shares you get. It could be engineered to ensure a 50:50 split, if the time taken was equally split.

We need to make sure that there is no "inflation" in the complexity of the tasks being set. For example, it might only take me 30 minutes to upload 10 products onto a web page, but if I was being devious I might claim that it will take me 2 hours. That would be "cheating" so I could quadruple my share capital. But there's also the view that I can do things quicker than the other party and vice versa. So how do we get round the problem of inflation and efficiency?

My way round this is for the tasks not to have any owners at first, and each party individually estimates the amount of time it would take to complete the task. The parties then combine their times for each task and take the lowest time for that task as the "currency" for that task (remember the more time spent on the work = greater share capital).

The parties then bid for ownership of that task, with every bid reducing the estimate of time for that task (i.e. reducing the share capital value of that task), therefore driving down the cost until it becomes optimally efficient (why would I bid for something that would take longer than I thought it would!). If nobody "bids" for ownership of that task then the party who estimated the shortest time for that task ends up owning that task. This reduces the risk that parties will under call the time it to do a task that they don't know how to do but spoil if for the expert in that field.

As an example, say the action is to develop a web page. Now I might not know anything about web page development (which isn't far from the truth!). But my partner does know about web page development. Now if I was being devious I could undervalue this task by estimating a significantly lower value, so that my partner ends up with lower capital. But by making the lowest estimate the winner, it means I would be shooting myself in the foot because I would then have to learn web development thus spending valuable time that I could spend on other tasks where I could be more efficient with my time and therefore earn more capital.

So by now, we know how long all the actions should take and the corresponding level of capital each action offers, and we should also have bided on each action ensuring a "fair" split of capital. Now, we introduce an incentive to finish the task on time by having a deadline. If the deadline on that action is missed, then both parties have an equal chance to complete the action and increase their share capital.

One last thing to introduce would be a floor level of shares for an individual to ensure that if an unforeseen event comes up meaning that one of the parties can't complete their tasks, then they are not wholly penalised and end up with zero.

This only really works if there is trust & respect for each party. If you don't have that level of trust you shouldn't get into business with each other! If you don't respect the other party then you probably don't need them, so why get involved with them in the first place???

Bearing in mind trust & respect, interestingly in Tim Harford's book "The Logic of Life", he quotes the authors of Freakonomics arguing over the split of any future revenues before they started to write it. They both dug their heels on demanding a 60:40 split of the revenues, but each party had wrongly assumed that the other one had wanted the 60, when actually they thought their own contribution was worth 40. It was only after they both realised their mistakes that the agreed to do the book. That's an interesting view in how to run a partnership - only enter into ones where you are valued more than you value yourself!

Another interesting dilemma on incentives is with a friend who recently offered me a "cut" of any business I bring him. Nothing wrong in that, but it doesn't feel right with me nor does it actually incentivise me to send him work. I think it's something to do with the fact that the cut is not worth my reputation in sending him the work and also something about "karma". I feel it would be bad karma only to pass on work for the basis of a cut and not on the quality of the work itself. Perhaps that's the actual point... I really don't know how good he actually is and until that I won't recommend him, no matter how much of a cut he gives me!