Back of the Napkin #8: Incentives Rule Everything Around Me

“Never, ever, think about something else when you should be thinking about the power of incentives.” — Charlie Munger ^[1]

Sports are full of apparent conundrums that seem to happen all the time: Why would the owner of an NFL team want their team to lose? Why would a team trade a player with better stats for someone worse? Why do teams go for points that have no material impact on the game?

Sometimes the answer is that they’re irrational. But sometimes it’s not because they’re crazy, but because everyone’s incentives aren’t aligned.

Players, coaches, and GMs of sports teams technically work for (literally) the same team, but their incentives aren’t all the same. Players and coaches are trying to hold down a job, and winning is the best way to do that. But GMs and owners are tasked with building towards long-term franchise success – sure, they’d love to win every game along the way, but if they have to sacrifice some games (or seasons), that’s part of the game.

In an example from last year, with the Houston Texans already out of the playoffs, the team stood to gain nothing from a win, while a loss would guarantee them 1st overall pick in next year’s draft. Instead, they won the game after a last-second touchdown and two point conversion, ensuring they would only draft 2nd, and head coach Lovie Smith was promptly fired.^[2]

The front office and ownership wanted a loss, but players are there to win (with coaches telling them to play for “your name and your tape”).^[3] And so due to misaligned incentives, we get what looks like a clown world situation.

In an even more black and white example of misaligned incentives, here’s a case where Iowa’s offensive coordinator’s contract was literally tied to an incentive to go for meaningless points:

Why would Iowa go for such meaningless points? Again, the game was completely over; most coaches would chose to kneel the ball and run out the clock for both sportsmanship purposes and to avoid the risk of a player getting injured on a throwaway play (football is a violent game; it’s absolutely not unheard of for players to get injured on meaningless plays. [...]

It turns out that Iowa’s offensive coordinator has an unusual incentive clause in his contract that says the team must average 25 points per game (and win 7 games) or else his contract will terminate. That clause has proven somewhat controversial, but it’s yet another reminder: incentives drive outcomes, and poorly structured incentives can lead to a lot of suboptimal decision making.^[4]

A lot of what we have been discussing so far in this series has been personal — what is your edge, how to spend your time, how can you avoid adverse selection. But what makes a multiplayer game (and most games that matter are multiplayer) are other people, and other people have all sorts of incentives that are different from our own.

Back to the interview with Giffon, who is talking about misaligned incentives between founders and investors when things aren’t going well:

There are exceptions. There are a handful of really great VCs, which is both economically and morally the right thing to do. But for the most part, a VC has no good reason to tell you to shut down because they're in the outlier business. And a founder is going to just -- first of all, just be terrified of telling their investors that...

Patrick: [00:09:42] They failed.

Jeremy: [00:09:43] Well, not even that they failed, that's the crazy thing about these. Maybe you have $10 million a year of revenue, but you're only going to grow 60% this year. And you raised...

Patrick: [00:09:52] Somehow that's bad.

Jeremy: [00:09:53] Yes, because you raised it $300 million or something and you're going, "Oh, man, am I going to have to do a down round, if I do a down round, then I'm really going to get drowned out on the pref stack. I'm never going to make a dollar here, it's going to be another five years." But you don't want to go to your Board and say, "I want to give up on this company. I just realized I'm never going to make a dollar from it." And your Board doesn't want to come to you and say that because then there's this bogeyman story of, "My VC told me to give up."

You can imagine a situation where a founder has raised money from a VC, but things aren’t going so well lately. The company might be making money, but maybe growth has slowed, or macro conditions have changed. (Say, maybe interest rates have gone up and the hurdle of speculative investments that pay off in the far future has gone up. Sound familiar?) In this case, even though the company makes money, it is going to have problems raising the next round at a higher valuation — maybe they even have to do a dreaded down round at a lower valuation. The founders are losing morale, and if they do a down round, they’ll be signing up for another five years of work, with questionable upside.

But the incentives for the VC are not always aligned.

Venture is an outlier business. They don’t care if you have a mildly profitable business — they are interested in zero or hero plays. Getting a 2x return doesn’t matter.5 And VCs are also playing a repeated reputation game, so also don’t want to run the risk of telling you to shut down because it may look to outsiders like they don’t believe in their investments.

And so they urge you onwards. Because of incentives.

The takeaway here is that when thinking about complex situations it is useful to pay less attention to what people say, and instead to look at what their incentives are. People aren’t perfectly rational, but they are motivated by incentives (poorly designed or otherwise). If you can identify them out you can better understand why people make the decisions they make.

What looks like strange behavior may just be people each acting according to their own incentives.

Which we would do too.