Thursday, March 11, 2010

Compensation is hard, let's go shopping!

Whenever you hear about a spate of acquisitions by big companies of innovative small companies, there's always a temptation to point fingers and laugh at how the behemoth can't innovate any more. Of course, that's a myth, as How the Mighty Fall shows: most big companies are quite innovative (especially in capital intensive industries), and failures of large successful firms aren't usually caused by too little innovation. The problem usually has to do with incentives.

With the cost of starting a startup decreasing by the year, it is far easier for entrepreneurial employees to leave big companies and start their own thing than to push through the bureaucracy at a large company to launch their product. Part of it is because large companies have a lot to protect (compare YouTube's early days with Google video's early days, and you'll see that the innovation differences had very little to do with technology), and the other part is that a large company like Microsoft cannot launch a product without it having to scale immediately, while a small unknown startup has the luxury of making mistakes and trying several ideas out in order to find one that gains traction.

But what about incentives? Leaving aside the fact that it's very difficult to use compensation to reward creative problem solving, it turns out that it's very difficult to reward entrepreneurial activity in a large firm. You might think that you could for instance, offer an entrepreneur a higher risk/reward ratio by asking him (and possibly his team as well) to risk a portion of the salary in order to potentially receive startup-like rewards. Now, you can't offer everyone this, or you'll discover that everyone who's part of your existing fast growing revenue engine will take the deal and get out-sized rewards without actually taking any risks. The problem lies in that any project/employee who has strong enough connections to get this offer, by their very nature also has the political capital to negotiate their own goals and metrics by which they can get that out-sized rewards. This leads to extremely negative incentives, like launching a product while knowing you can't possibly scale to meet demand, or launching a product missing a critical feature that would have been needed to drive adoption in order to meet an artificial, pre-negotiated deadline. In fact, this problem is so endemic that even for external-acquisitions, earn-outs are being abandoned because of the costs and undesirable side-effects associated with them.

Ok, pre-negotiated goals don't work. How about post-facto awards? Since those aren't expected, you won't have negative incentives, and people would stay on if they believe in their projects, right? It turns out that people are actually pretty good at figuring out that a project is successful or going to be successful. Someone I know was on a project that obviously had great trajectory, and he was amazingly unhappy about large groups of senior engineers and managers suddenly descending on his (previously under-the-radar) project trying to take credit for a piece of it in order to get an out-sized award. The resulting feeding frenzy isn't good for morale, and obviously leads to entrepreneurs thinking that starting their own companies just isn't that bad an idea after all. Worse, after you hand out that out-sized awards, everybody now has an incentive to leave that project in order to find the next big thing so they can repeat the process. Of course, not rewarding such successful projects doesn't work either, since you then risk losing valuable employees to other companies.

If you ask me, there's no real easy solution to any of these problems. You'd have to have an amazing top-level manager, who is so aware of everything that happens at every level of the company to be able to avoid all of the pitfalls I detailed above, which doesn't even scratch the surface of the fundamental problems in compensation. This is one reason why when faced with these issues, many top-level executives just throw up their hands and say, "Compensation is hard, let's go shopping for acquisitions instead!"
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