Aligning incentives

Well, 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. And never a year passes but I get some surprise that pushes my limit a little farther.

Charlie Munger (source)

Can you think of someone you considered kind, smart, trustworthy or hardworking who suddenly did something that went completely against the high regard in which you had been holding them?

Were you disappointed? Or even shocked? How could they suddenly behave so foolishly, dishonestly, lazily or maniacally?

In my experience running a business, the answer is not that they are a bad person, rather it’s that their incentives are not aligned with yours. They either lack the motivation to take the action you are expecting, or there is some other source of motivation that is causing them to move in a different direction.

Growing up, we are led to believe that there is justice in the world, good guys win and that what people say is what they do. This is also the mindset that I like to assume when working with others; it’s a handy mental shortcut that works wonderfully when our incentives happen to be aligned. Some of my best relationships are with people that I just gel with and never consciously think about what is driving them. But it’s not smart to assume that it will always be like that.

Two case studies: What happens when incentives are not aligned

There have been events in my life when incentives were quite tragically misaligned. While I believe that in none of those cases the other party had evil intentions, the fact that we were fundamentally not on the same page caused substantial friction. Here are two examples:

  1. I was once managing a software agency business with another co-founder. Within a year after starting, it turned out that we had totally different mid- to long-term visions: I was interested in prototyping validating product ideas and using the business to sponsor our internal R&D. I couldn’t wait to get on with exploring all the different product ideas in my head. On the other hand, my co-founder was chiefly interested in growing the agency business. They only paid lip service to the product vision but eventually spent their time and energy pursuing agency work. For this and a few other reasons we eventually decided to split.

    In this situation, I had failed to understand what really drove and excited them, what kind of goal and reward motivated them to behave in this way and not another – in other words, that they were intrinsically incentivised to work on different things to ones I was. In retrospect, there were clear signals that should have made me think twice before starting a presumably temporary agency business.
  2. At one time I agreed to a software contract having only a rough description of the work to be delivered. After signing, the client suddenly gave me a significantly more detailed list of what he wants built, which had several times the complexity of what I thought was reasonable to assume. Imagine budgeting 3 months for a project, and finding out soon after signing the contract that 9 months will be needed.

    While our instinct often is to assume malice on their part, I believe this is better explained by lack of thoughtfulness (see Hanlon’s razor). From their perspective, they were very passionate about their app, having personally invested what to them was a lot of money and time into planning and researching the idea. Perhaps, they were also unaware of the realities of software development: what takes a business-minded person or a designer precisely 0.2 seconds to imagine, may take days or weeks to build.

    But it goes without saying that the scope of a project needs to be fixed so that the price and timeline to be realistic. The incentive misalignment resulting from the different ways in which we pictured the scope of the contract made the following months difficult for both of us. My motivations were to deliver on a feature set as fast as possible and carry on finding new clients or pursuing personal projects, whereas they wanted all of their newly communicated details done to perfection. What ensued was lots of bargaining over details, what goes “in” and what doesn’t, all of which felt wasted and unproductive. In the end, I ended up doing much more work than I had budgeted for, while the client still probably got less done than they had imagined they would get.

What went wrong

In my first example, I failed to appreciate what kind of business my ex-cofounder wanted and how that difference would manifest long-term. I failed to understand both their financial aspirations, and how low their level of intrinsic drive was for building products.

In my second example, the client had a great amount of passion for the project, but little experience creating software products and a fairly limited budget. Thinking about it now, it would have been better for him to have found a technical cofounder that was equally passionate about their vision, and wouldn’t be influenced by competing pressures from other clients and personal projects. Additionally, equity or profit sharing would have been a more appropriate form of compensation in that relationship.

Based on these, and other lessons I’ve drawn from my experience I became more attuned to how incentives are aligned or could be aligned. It has now become a prominent mental model that I use on a frequent basis.

How to align incentives

In a nutshell, figure out:

  1. What does the other party really want?
  2. Is the agreement in front of us therefore destined for success or failure?

In life and business, you want to play long term games with long term people. Do you know what drives the other person? What are their actual long term goals, ambitions and fears? What are they expecting of you?

Once you’ve understood the long term motivations, consider this: are the terms of your deal in harmony or in conflict with them? What are the main risks? Are there any alternatives that either of you will be more attracted towards?

Can this be learned viscerally?

The ability to detect and understand the motivations of others is in my opinion the most important skill in business and relationships.

It is unfortunately not natural to many, myself included. Within most education systems, we are trained to copy from the whiteboard, to the notebook, to the exam sheet. But that’s not how the world works; our systems and organisations are build by people, for the benefit of (some?) people. An ambitious person wanting to make a substantial impact must therefore understand various possible incentive structures when planning any initiative of importance.

The way I came to truly understand the importance of incentive alignment was through experience. Over the years, I stumbled across various resources that elegantly communicated the concept, but it was only experience that made me start to follow it in deeds rather than just words.

I’d be interested in finding a good method of effectively teaching a concept like this, but that is perhaps a topic for another time.