Is there such a thing as too much incentive for an entrepreneur?

December 13, 2013

incentivesWhen we’ve written on the subject of board performance, we’ve emphasized that private company boards often have greater chemistry and transparency because the incentives of the entrepreneur and investors are more easily and perfectly aligned than in public companies.

Here’s how we put it in 2010 in Communicating good news and bad:

In our experience, the relationship between entrepreneur and venture partner in private companies is more cooperative, longer-term, and (mercifully) not subject to the quarterly reporting pressures of public companies.  Moreover, venture investors have real “skin in the game” and have the same incentive as the entrepreneur to understand the nuances of the business and focus on long term value creation.  As a result, the communication of good news and bad tends to be more forthright and in real-time, enabling partners (assuming they are good partners!) to understand intuitively the right kind of counsel and support to offer during both the good times and during the inevitable challenges of building a business.

Not too long ago we came across a great piece at HBR Blog Network on the importance of aligned incentives.  In There Is Such a Thing as Too Much Incentive for Entrepreneurs, N. Taylor Thompson makes the case that there are instances in which  an entrepreneur ought to “take some money off the table”:  when lack of diversification in his wealth creates a difference in economic incentive between himself and his investors.  If all his money is tied up in the startup, it could (quite reasonably) cause him to “prioritize exit probability above expected value because of diminishing marginal utility and loss-aversion.”

In other words, if all his money is in the company he founded, but it’s just one of several investments for the venture firm, the pressures and logic of decision-making within the partnership can be different.

From the HBR piece:

Behavioral economist Dan Ariely has conducted a set of experiments to gauge the relationships between economic incentives and performance. In one experiment, he offered participants payments for pressing alternating keys on a keyboard; in another, he offered payment for math problems – and, in both he varied the incentive so that participants could earn either up to $30 or up to $300. For key-pressing, stronger incentives led to better performance. For math problems, incentives decreased performance.

Ariely’s interpretation is that simple tasks requiring no cognitive engagement respond as expected to increased incentives, while cognitively complex tasks peak and then show decreasing performance, as increasing incentive distracts from cognitive performance…

Taking a small amount of money off the table aligns incentives much better to focus on making a big, world-changing impact. And diversifying also can remove the performance-destroying stress that comes with overly strong incentives.

To be clear, aligning incentives remains critical to startup success; my argument is simply that a modicum of diversification helps both entrepreneurs and investors. Taking money off the table isn’t about getting rich, it’s about freeing entrepreneurs to focus on doing something great – not just good enough.

While we (also quite reasonably) prefer to have our capital directed toward growing the business, we understand there are times it makes sense to achieve partial liquidity for founders who want to continue building the business but would also like to realize a portion of the value they have created to date.

On a related note:  buying out a minority or absentee partner’s interest can also often better align incentives and remove a barrier to rapid growth.

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