I’ve opined quite a bit on the VC-funded ecosystem (“VC-istan”) and put forward the hypothesis that we’d be much better served by a fleet of 50,000 so-called “lifestyle businesses” than 500 red-ocean, get-big-or-die future corporate megaliths. It’s not that I dislike VCs. I have no issue with them, as people. However, I think that centralized power is generally undesirable. The information-theoretic incompetence of central authority is why command economies don’t work. The current system for financing high-risk technology businesses is out of whack. There are a small number of investors, and they all know each other, and the career matrix of their industry requires them to collude rather than compete. It’s not that they’re explicitly price fixing, but that their careers rise and fall on access to black-albatross deals (black swans are not big enough) that come once in a decade, so they optimize for social access rather than economic efficiency. They compare notes in a way that is almost certainly illegal, but it’s hard to hate them for doing so if one understands their career concerns.
VCs also exist in a framework where making quick returns is more important than building great companies, which favors aggressive-growth businesses bent on upsetting established players in winner-take-all markets (or, more often, threatening to upset those established behemoths and getting acquired in a panic) but overlooks concepts that might be “niche” today but that will build out the future. What we have is a system that overlooks a massive space, favors large companies with horrible management structures, and worst of all, keeps a large amount of capital out of the human creative process.
VC overlooks a massive space
Creativity doesn’t come from large organizations. It comes from people. Large companies can encourage creativity by providing resources and autonomy and, then, getting out of peoples’ way. Or, they can stifle it, via subordination and corrupt, creaky permission systems. Most go toward the latter. If your business truly requires creativity, your only option is to set up an R&D environment that trusts people with their own time. Provide direction, keep incentives aligned, and keep them on-task enough that their work benefits the company. Then get the hell out of their way. Goldman Sachs did this with their “core strategies” division, giving a set of software engineers and quantitative analysts (“quants”) a level of autonomy that was unheard-of by Wall Street standards, especially then. This generated a technical infrastructure far superior to what its competitors had, and they’re still catching up. It’s due to core strats that Goldman didn’t melt down during the Crisis of 2008 as other banks did; because of the software they built, Goldman could assess its financial risk on a firm-wide basis and hedge.
If you want creativity, put your most talented in an R&D center and let them get to work. The researchers are trusted, implicitly, with their own time, and the executive’s role is to be a filter, deciding when creative assets are “ready for prime time” and when they need more refinement. Typical, risk-reductive management will destroy their creativity and you’ll get nothing.
Self-organizing and generally small teams are, in general, where creativity will come from. It doesn’t require a corporate megalith. You’ll get your best performance from small groups of people who picked each other (rather than being glued together by a manager saying, “be a Team, now!”) and who are deeply invested in trying out a new idea. This can happen inside a large corporation, but it’s atypical. We’re going to need a lot of small organizations if we’re serious about building the future.
The future’s not going to be built by well-connected, materially ambitious, and usually already independently wealthy “credible founders” trying to build 750-person companies, get their pictures on the cover of Forbes, and sell to Yahoo for the GDP of a small island nation. Those people have made their beds and are half asleep. Those “founders” are well-connected early retirees playing startup. They aren’t interesting. Don’t waste a minute thinking about them. Rather, the future’s going to be built by the rebellious sorts of people that VCs wouldn’t even touch, because they carry mediocre paper (note to all: “we don’t invest in ideas, but in people” means “we invest in resumes“).
I don’t think that most venture capitalists can detect the people who are capable of building the future. I don’t even think I can do it well on a person-by-person basis, and I’m one of the smartest fuckers out there, so I know that they can’t. It’s just naturally very hard to predict, for highly convex creative endeavors, who and what will succeed and what will not. That’s why you need a fleet. A fleet is more than a portfolio. Portfolios are manageable; that’s even a title and job description: portfolio manager. With a fleet of 50,000 “lifestyle” businesses, there’s no central authority that will be able to manage it. The solution will be to fund creativity on a broad-based scale and passively enjoy the rewards. The moral problem, here, is that we need a structure that guarantees that investors participate in rewards. That’s actually a hard one to solve. I’ll get back to that.
VC favors fast-growing companies with horrible management and culture
In truth, venture capitalists don’t care about corporate culture. It’s not that they’re bad people; of course, most of them aren’t. It’s just not their job to babysit. Ideally, they want to hand a wad of cash over to those they fund, and get a much larger wad of cash back. They’ll only intervene if the macroscopic performance of the company falters (and if the cause of macro-scale failure is microscopic cultural corruption, it’s far too late; just shoot the fucking thing in the head and liquidiate). Founders are implicitly trusted to deal with the internal, cultural issues, unless the company starts to fail in a macroscopically visible way.
Fast growth is what often ruins the culture. Consider Valve’s self-executive open allocation, for an example of what is good. This is a great way of doing things, but it actually makes it very hard to hire “credible” executives. If you make employee autonomy an inflexible pillar of your company, you can’t hire entitled, semi-retired executives who want the fall-back of authority as opposed to genuine leadership. Employee autonomy isn’t usually eaten by messianic founders. That can happen, but more often it’s sold off to parasitic executive implants. Often, the founders don’t even have a choice. One of the perks of being a venture capitalist is the ability to give executive sinecures and portfolio companies to your underachieving drinking buddies from business school.
A company that wants to have a culture worth caring about is going to have to put the brakes on the malignant sorts of growth, in order to prevent the culture from being sold off entirely in a managerial hiring frenzy. It will even have to give low-level employees some veto power over executive hires, which is not that radical because proper management works for the managed (as well as for investors; interests shouldn’t oppose). It will need to seriously consider an Employee Bill of Rights. It will be able to grow fast (possibly 20 to 30 percent per year, and at twice that rate in early stages) by normal-people standards, but not at the “rocket fueled” rate expected by typical VCs.
VC excludes a large pool of capital
Right now, a middle-class family has two main options regarding direct financial investment in capitalistic activity. One is to buy debt, and the other is to buy stocks, both cases, in large and established companies. Regulations exist to keep their “dumb money” out of the small, much riskier endeavors like new businesses such as VC-istan corporations and lifestyle businesses. Now, I fully agree that a retired widow shouldn’t be putting her $400,000 life savings in one lifestyle startup. It’s too risky. She should have the option of putting that money into lifestyle startups, plural, in some broad-based way that protects her from the swings of any one company, but allows her to participate financially in human creativity, which can be expected to deliver better average returns than established, rent-seeking corporations with no interest in inventing the future.
What is a “lifestyle business”?
I don’t think “lifestyle businesses” deserve their negative reputation. Who says that it can’t become a more ambitious project over time? Nintendo was founded in the 1880s– as a playing-card company. It wasn’t founded with the intention of creating the dominant gaming console 100 years later. To me, “lifestyle” simply means that the founder intends to be with the company for a long time, and would rather grow at a modest (10-30% per year) rate than keep doubling up to appease investors hell-bent on a quick exit. What’s wrong with that? To be blunt, I think it’s a luxury of the already-loaded to consider something growing at 2% per month “mediocre”.
When founders expect to be with a company for 20 years, they’re going to take the long-term cultural issues seriously. They won’t bring in the human garbage that rapid-growing startups often hire when their investors say, “It’s time to hire real executives”, because they don’t want to subject themselves and their employees to atrocious middle management. A founder who can’t say, “that’s our acquirer’s problem”, is going to think differently.
I see lifestyle businesses as an increasingly tenable alternative to the get-big-or-die gambits. Why increasingly tenable? The global economy now grows at 5% and that’s accelerating. (Developed-world economies are stagnating, however; nation-states are becoming obsolete and that, temporarily during this period of adjustment, hurts those of us under the auspices of highly successful nation-states.) Prevailing poverty is turning over to prevailing prosperity. This won’t happen overnight; it’ll be 100 years before the tyranny of geography is over, and there some utterly dire ecological problems we need to solve along the way. However, it doesn’t need to happen overnight. A business thrives if it turns less into more, and with “the pie” growing annually at 5%, that’s a fortunate and “un-level” playing field. The zero-sum, Malthusian mentality of a 10,000-year agrarian era with almost no growth is obsolete. Winner-take-all, “red ocean” markets still exist, but those tend toward natural monopoly, which leads to commoditization and regulatory interference. They’re not that interesting anymore. In the seven minutes that it takes the average adult to read one of my blog posts, the world will become over $1 billion wealthier. In a few minutes, progressive, positive-sum interactions between people just generated enough wealth to make 1,000 people millionaires.
What this means is that dominate-or-die will no longer be the prevailing business reality. Yes, growth will still be required, but it will be increasingly possible to grow (explore, improve, profit) without domination.
However, economic growth is not “magic”. It happens, minute by minute, as people discover better ways of doing things. It’s the process of “mining chaos” that I’ve discussed earlier. It’s impossible to measure, but I would be surprised if I haven’t added $1 million to the economy over the past year, by helping the most talented people better understand the market and allocate their assets more efficiently. (My estimate of my impact is $2.4 million.) Growth happens because people (for a variety of reasons, some altruistic and some selfish) go out and do things. They take a “why not” approach, not a “why me” approach. The vast, vast majority of them were not drinking buddies with venture capitalists at Harvard Business School and, therefore, they cannot access traditional funding for these red-ocean gambits designed to be “X killers”, where X is some powerful corporate behemoth that the VC hopes will not just be typically inefficient and (as corporations generally are) reduced to 10% of its strength, but so inefficient that it can’t fight back with even 1 percent of its strength.
The financial problem
There’s a deep economic problem with the funding of lifestyle businesses, however, and here it is. Many economists will argue that “profits shouldn’t exist”. What does this mean? No economist would seriously argue that they do not exist, or that there aren’t good logical reasons for them to exist, rooted in imperfect information and the fuzzy question of where the line between labor and profit (for small businesses, managed by their owners) lives. Just as financial arbitrage is possible for people with superior technical infrastructure (competitive advantage) it is possible for a firm to make a profit based on its advantages. What these economists mean is that in an ordered, fair, and stable world, no one would be able to sell something for a price higher than the sum value of the capital, materials, and labor required to make it. Profit comes from the same place as economic growth, from which things that aren’t “supposed to exist” emerge: chaos.
One important distinction that average people often fail to make about “greedy corporations” is that profit is not the corporate economy’s true evil. If a large company is making “too much profit” off of its customers, there’s usually an appropriate response: buy stock. Rather, the robbery takes the form of executive markup. Being extremely technical on terminology, even CEOs are “labor”. Almost every large company has been hijacked by an entrenched, entitled caste of useless parasites whose compensation is justified by social access and failures of self-regulation (i.e. corruption in wage setting) instead of a fair market value for the work. In fact, if corporate executives had full authority to set compensation, there would never be such a thing as profit. They’d take it all for themselves, and owners would get shafted just like employees do. Corporate boards are supposed to step in and prevent this, but the “country club” mentality is so severe among that set that this self-policing is effectively a joke. They all go to the same parties and sit on each others’ boards. No, there isn’t one capital-C Conspiracy “to rule them all”, but there’s enough upper-class collusion to keep anyone else from getting a fair shake. Not wanting to lose executives’ jobs in a shareholder revolt, companies will allow just enough profit to appease equity owners, but deploy it in a different way. They have replaced dividends with “buybacks” that enable next year’s gigantic executive stock grants, nominally tied to “performance”.
These phenomena are important for analysis to show that one can’t reflexively or implicitly trust labor, insofar as even the looting executive sleazebags who periodically ruin the economy are, technically speaking, still “labor”. There’s a natural conflict of interest. Profit is return on capital, and labor would prefer increases in baseline compensation. Labor that controls its own compensation is especially dangerous.
This brings us directly to the moral problem of business finance, and separability of risk. A substantial number of people would be more productive and effective as key operators in small businesses (if they could raise money) than as subordinates in large companies. The problem is one of trust. If there’s a passive financial backer, and a working entrepreneur with no “money in the show”, then the latter holds all the operational power. Once the check clears, very little explicitly prevents the newly-crowned executive from defection. Banks require personal liability on loans, in order to keep people honest. Venture capitalists, having an in-crowd that compares notes to an extent that’s almost certainly illegal, can use its reputation economy as a cudgel. Entrepreneurs are terrified of the barbaric violation that will be inflicted on their reputations if they even hint at defection. (This keeps founders honest, but it also allows extortive terms like multiple liquidation preferences and participating preferred, which would never exist if founders could decline term sheets without reputation risk.)
The problem here is that there’s an underserved valley of business concepts. What’s the actual failure rate of businesses? No one really knows, because the terms are somewhat subjective, but the most credible estimates seem to refute the claim that “90% of new businesses die in 5 years”. It seems that about 40-50 percent of companies given full-time investment will survive 5 years, with much of that failure in the first year, and higher per-year survival rates as time goes on. Think of that as a 15% per year rate of job loss, which is worse job security than typical corporate employment (~4% per year) or incumbent politicians (~2% per year). It’s risky, but not as horrible as it’s made out to be, and would be tolerable if such job loss weren’t packaged with personal financial risk. Moreover, not all businesses that are closed were money-losers in the first place. A large number of them made money, but at low margins that were not enough to justify the managerial labor (from the owner, usually) required. They “failed” when for accounting for the owner’s opportunity cost, but not always objectively. What I mean to say is that the gargantuan failure rate of VC-istan is not the norm across all of small business.
Let’s consider the spectrum of business possibilities by survival rate. VCs want to fund the 0-20% category that, if they succeed, will deliver massive returns. They’re only concerned with expected value. For bank loans that require personal liability, it’s just not wise (and probably impossible to get funding) for anything riskier than 80%. So banks can cover that 80-100% range where, even if the business is closed, the loan will probably be mostly repaid. Technology lifestyle companies live in that 20-80% range that is, right now, completely unfundable. There is too much risk in this “no-man’s land” for bank loans, but almost no chance of them being billion-dollar concerns in less than 15 years, but there’s no good reason why they can’t be a profitable avenue for investment.
The issue is one of structure and incentives. Good-faith business failure is OK, so long as the successes cancel out the failures. No investor should risk her entire life savings on one lifestyle business, but investment into the class of them, in a broad-based way, should be possible. Making that possible is a valid (and, likely, profitable) business goal. That’s not what we’re worried about. A 20-80 percent chance of failure isn’t a catastrophic problem in a portfolio of businesses, seeing as the successes among these “lifestyle companies” will be substantial: not the 1000x returns that the VCs seek, but plenty of 5x and 20x hits. The issue that must be addressed is “moral hazard”. How do we guard against bad-faith business failure, or against managerial looting of what should be profit?
How does a passive investor of a lifestyle business demand profit, when their executives would always favor personal compensation? Bank loans compensate by refusing to take equity and requiring personal liability on debt– meaning that good-faith business failure is punished as well; there is no discrimination in that– while VCs take control of businesses, and have a perverse and probably illegal reputation economy (that also punishes good-faith business failure). Yet, while it’s conceivable how one might fund a fleet of 50,000 lifestyle businesses, it’s a harder problem of how to keep them all of their founders honest. It will require equity financing, because there’s too much risk in them for debt. Yet there will too many of them to manage with a feudalistic, VC-istan reputation system. So what’s the answer?
Solve It!
It’s easier to solve two problems at once than one in isolation.
Reiner Knizia, world-famous board game designer, once said that it’s a lot easier to fix two design problems at once than a single issue. Chances are, the design’s position in the state space is already a local maximum, so changing one thing is likely to degrade fitness, while changing multiple might improve it. Here, I’m going to argue that solving cultural problems and the “moral hazard” issue of the lifestyle business aren’t separate issues, but actually two facets of the same problem.
First, let’s get back to financial theory. People with capital to put at risk are owners, and employees implement their financial strategies in exchange for stability. There’s a risk transfer here, and it seems symbiotic, but with the potential for adversity. It’s the classic “principal-agent problem“. How do the owners know that their employees won’t rob them blind? In a small business managed by the owner, that’s relatively straightforward, but often, owners are unable to execute their interests by dictation and need to hire a special kind of labor, management. Managers are especially dangerous, because their job (traditionally) is to enforce the owners’ interests while remaining indifferent to those of employees (including their own). People who will take (and enjoy) such a job are generally not the nicest people.
Ownership, here, pertains more to financial risk than to paper. When a bank writes a loan, the bank is in the ownership position (even if it is a debt-holder rather than in equity) and the business owner is a manager– until the debt is repaid. Once management comes into the mix, there are three tiers. It gets messier, morally speaking. Managers end up with information advantages over employees and owners both, and will sometimes exploit the other two sets of people. As soon as managers are being hired, the relationship between owners and employees becomes one where defection is possible and distrust is common.
The MacLeod process starts when a subset of managers becomes a fourth tier of proto-executives (MacLeod Sociopaths). These are the ones who turn their information advantages into overwhelming personal yield. If they’re smart about it, they won’t rob the company explicitly, but use their information advantages and control to make themselves look like high performers, increasing their relative position. Those who fail to do so end up, socially and financially, in the lower Clueless tier. Thus, a MacLeod degeneracy can be viewed as a process in which a subset of managers use their extreme advantages of information to conspire against the workers (who suffer a degraded work culture) and the owners (who are loaded with externalized downside risk they are rarely even aware of) as well as against any managers (proto-Clueless) who cannot or do not participate.
Lifestyle businesses keep the three parties (financial owners, management, and employees) in alignment on culture. In fact, a primary motivation for a manager of a lifestyle business is building a desirable culture, since she intends to work at that company for a long time. That’s not an investor-facing issue, but it’s of interest to investors as well. For long-term organizational health, culture becomes important. I discussed, previously, why a good corporate culture is expensive in the short term. It’s cheap in the long run– for everyone involved.
Where there is the potential for disalignment is on wages, and that’s where “profits shouldn’t exist” comes in. Managers and employees both want to push compensation up (until there are no profits) so investors would lose if that were taken to its logical extreme. That’s the fundamental fear one would have when investing in a lifestyle business– what if these people take the money and throw a huge party, leaving their backers out? In order to keep the arrangement fair to equity-holding investors, they need to have some authority over compensation. However, for most industries, investors are not authorities on what fair compensation is. That is something I intend to address.
VC-istan’s solution is for managers (especially founders) and investors to collude. Investors are not shafted by their hired small-business managers (founders) because they are in on the whole mess together. Culture and career development are thrown by the wayside as they work, together, to drive for rapid high valuation (stability optional) and acquisition. Workers get the shaft: bullshit token ownership in a world where hours are long, business models are unproven, firing is fast and usually without severance, and management is almost always incomptent. VC-istan solves one problem, by defusing the potential for managerial abuse of investors (who take an active role in directing the company). However, workers (investors of time) get screwed.
Notice, above, what I said about employees, especially in new and unproven businesses. They’re investors of time. This isn’t just a metaphor, but an actuality. This is one of the reasons that I think VC-istan is fundamentally careerist and mediocre. Typical employees such as software engineers are not treated with the respect that would be accorded to investors, but seen as third-class citizens. A VC-istan engineer typically faces an employment contract where he vests no equity if he is terminated before the end of the first year. It’s not uncommon for engineers to be fired (“cliffed out”) at 364 days. If you “cliff out” an investor, you go to jail and, when you get out, you never raise a dime again. Yet cliffing-out of employees (for bullshit “performance” reasons that are thinly-veiled extortion– a threat to the employee’s reputation if he fights back) is a VC-istan institution.
If employees are investors (again, of time) then there is a common interest between the two parties, both of whom are often excluded by a conspiratorial set of morally bankrupt executives. That’s interesting! Perhaps the moral hazard of funding lifestyle businesses and the cultural desires of employees are facets of the same problem. I believe that they are. Both low-level employees and investors have an interest in guarding themselves against managerial malefaction.
The typical business is extremely opaque with information, with every piece of it guarded as if it were a competitive advantage. Thus, employees have no idea whether they’re being fairly compensated, and investors rarely know if the business is well-managed. Investors and employees almost never talk to each other; it would be treated as inappropriate, and insubordinate, for an employee to even dream of initiating such interaction. (The firm’s executives would fire that employee for jumping rank.) So if investors find out that a company’s badly run, it’s almost always too late for them to fix it. Talented employees have already quit, external relationships are beyond damaged, and the criminals have already cashed themselves out.
Investors fear that management and employees will collude on compensation, effectively overcharging the company’s ownership for their services. One solution is for investors (as seen in typical corporations) is to set tight limits on compensation and risk allocation. Then, managers and employees compete with each other and, more interesting, managers compete with other managers. You get a MacLeod hierarchy quickly out of that; the managers who can hide risk (“heads, I win; tails, you lose”) and make themselves look like indispensable high performers become executives (Sociopaths). The other solution is for investors and business managers (or founders) to create a tightly-controlled reputation economy that aligns their incentives, but abuses employees. That’s VC-istan, and it only works when you have a pool of Clueless young talent and the means of convincing them they’re on a path to extraordinary compensation. That’s not sustainable, because the lie will eventually see daylight, and talented people will stop taking terrible offers from bad startups. In any case, it doesn’t seem like there’s a good resolution in any of this muck to investor/employee (especially investor/manager) competition.
So, look again at the common MacLeod pattern. A subset of the management tier finds ways to transfer and hide risk. As important work becomes increasingly convex, it will be correspondingly difficult for anyone to prevent this (e.g. by contractual provision). Fighting against this behavior through normal means won’t work. The source of the problem must be addressed. In this case, it’s information asymmetry. A small set of managers can conspire against employees and investors (and other less-aware, Clueless, managers) because they hold the critical information. When abuse of information can’t be prevented (as it can’t, in a convex world) the alternative is transparency: democratize it. Investors and employees win. Sociopathic executives lose. Hey, that sounds like a fair trade!
The solution is to be transparent about both culture and compensation. Employees should know whether they’re getting a fair deal, investors should know what they’re paying for work. Cultural expectations should be explicit and spelled out in an “Employee Bill of Rights” over which employees, managers, and investors all have a say. Financial and strategic matters can come down to the traditional vote-per-dollar shareholder system. Everything cultural (e.g. closed or open allocation) needs to be on a one-person, one-vote system.
Details of how to make that work could stand to be fleshed out, and those would merit an essay of their own, but here’s a set of thoughts I had. It’s fundamentally hard to define what the “fair” value of anything is, which is one of the reasons why transparency is so important, but external market salaries are pretty easy to discover. That gives a reasonable starting point.
If I were running a technology company, everyone would get the market rate, plus 20%, based on objective job description, for salary. I would be upfront with investors about this. Yes, I am “overpaying” engineers, so I can be selective. I want this to be a destination company right now, and not hire cheaply to get a job done and then have to fire people when I decide to upgrade my quality bar. We are paying now for quality. That salary number would be published internally to employees and investors. Oh, there’s one other rule. There’d be only three levels of software engineer: Apprentice, Engineer, and Mentor/Fellow (equal; one for teaching and one for research). The Mentor/Fellow level would be maximum salary in the company. No one would get more in base salary. Not even me, and certainly not some damn non-technical executive. That’s to keep such people from robbing investors (and employees).
This is not hippy-dippy egalitarianism. It’s not altruism either. I’d be doing all this for purely selfish reasons: building a great company and getting rich, all without robbing people because, well, I don’t like doing bad things.
This company would be intended for slow growth (10-30% per year) and hire only the best technological talent. Now, when you employ 20-50 people (mostly software engineers) and pay them market-plus-20%, something funny happens. Mature technical enterprises can easily break $1 million per employee. That is, you generate a lot of profit. So, there’s a question of how to share it. Obviously, investors must get some. Employees should get some, too.
I’d favor profit sharing over equity, because I don’t think it’s good for a company to have hundreds of “owners”, many of whom are no longer part of it, and I don’t think the bullshit “partnership” of a 0.03% slice in an 50-person company is going to fool anyone for much longer. Also, we’re talking about lifestyle businesses which, while they might be sold at some time, are not intended specifically for that purpose. “Liquidity” might never happen. Let’s stop betting our lives on such things. Most employees would not have equity. They wouldn’t need to worry about options exercise or 83(b) election or liquidation preferences. Instead, they’d get considerable profit shares. Here’s a model for how that would work. About 20 percent of profit gets invested back into the business, no matter what, unless there’s a conscious decision to reduce cash holdings (and pay dividends) at business maturity. Thirty-five percent goes to equity-holders, who decide whether to reinvest it or take a dividend, and 45 percent is paid in compensation to employees.
I don’t know that 45 percent is exact right amount to give to employees, but it’s that neighborhood (35 to 65%). The intuition behind it is as follows. High-end investment vehicles (e.g. hedge funds, venture capital) charge a baseline management fee of 2%, plus and 20% of profits (“2-and-20″). That’s what wealthy investors have to pay to participate in the above-normal returns of these funds, and they’re happy to do it. The elite quant funds (who can reliably deliver double-digit returns) charge more: as high as 5-and-44. I’d be charging no ongoing “management fee” (once capital is raised) but investing a high share of the proceeds into employee morale. Effectively, the model here is “0-and-45″ for access to elite technological talent (as opposed to 2-and-20 for access to elite financial strategies). I don’t know what the exact right number is, but I think 45 is in the neighborhood.
Employee profit-sharing would be in proportion to “points”. Here are the rules of profit points:
- Profit points are compensation, not equity. You keep them as long as you work for the company. If you leave before an annual payout, you get a pro-rated share on payout date. (It’s not like banking where leaving before “bonus day” means you get nothing.)
- Each employee has at least 1.0, with the intention of keeping the average at 1.5-1.75 (and never more than 2.0) per head. Meaning: no one has less than half an average slice.
- The total number of points is published, and if anyone holds more than 3.0 points, that person’s amount is public within the company. Except in extreme crisis (read: desperate CxO search) no one is hired with more than 3.0, or raised to that point in the first year. Meaning: anyone with a large slice better be deserving, because it’s public information, and that may only occur after one year of work, so employees aren’t hoodwinked by executive implants who start on top.
- Anyone with managerial authority (should such an institution become necessary) has his or her share published automatically. Meaning: management is there to benefit investors and employees, and they have the right to know exactly what they’re paying for the service.
- Profit points should not, in general, be allocated faster than profits can increase. Meaning: business risk might reduce the value of profit points, but dilution shouldn’t. Your share as a percentage of the whole may go down; the expected value should be going up.
The reason I call these “points” instead of “shares” is because they need not be disbursed in whole numbers– an employee might have 1.5 profit points– and also to distinguish them from investor shares, which deserve to be separate (investors shouldn’t be diluted by employee hiring).
One other thing I would consider allowing, for very senior hires who might not be able to accept market-plus-20%– for example, you can’t raise a family in New York on 1.2 times the typical software engineer salary– would be zero-interest advances against profit points. The existence and structure of the program would be public; that someone is using it would be private. The purpose of this is to accommodate “HR expedient” hiring of people at compensation levels greater than what is fair (based on others’ compensation). Yes, it’s allowed to happen as a temporary measure, but the “advance” model keeps it from becoming perpetual inequality.
What’s above, I think, is a principled rubric for allowing some opacity (in fact, a lot of it, because a healthy software company would generate $50-250k+ per profit point under this model) in the pursuit of “HR expediency”, but keeping abuses from getting out of hand. If someone’s getting 10 times more than a colleague, the whole company will know and have a right to an opinion (possibly, including the right to vote on such things, just as investors would have) about it.
How transparency Solves It
Ultimately, the principal-agent problem that currently blocks the financing of lifestyle businesses is that investors (who do not know enough about technology to evaluate decisions being made) don’t know if they’re getting screwed on compensation, because they don’t know what market salaries are. No one wants to fund such a business, out of the fear the a CEO will give himself and his employees high salaries, blowing up what could be a successful business by taking such pay, thereby stealing from investors. VC-istan solves this by having investors explicitly manage compensation, often to an overbearing degree. (VC: “You can’t pay an engineer $160,000! That’s too much for just a programmer!”) That kind of micromanagement doesn’t scale to a fleet of 50,000 lifestyle businesses. Compensation needs to be simple, obviously fair, and accessible to investors. My model is one in which, unless there is profit returned to investors, founders earn no more than senior engineers.
What’s also being thwarted, under this model, is self-perpetuating salary inequality. Since outsized salary takes the form of advances against profit points (that would only be extended if it’s likely that they’d be repaid) people who require high compensation (and are afforded it, for HR-expedient reasons) would not have be able to leverage their salaries into persistent, across-the-board improvements (in “performance” bonuses, calculated as a percentage, and in raises). The existing system is good for people who can negotiate amid opacity, because they tack market conditions (getting pay improvements when the market’s strong, negotiating for more autonomy when it’s weak) and move themselves forward via calculated job-hopping, but it’s not the best for the world.
I haven’t said much about how this solves cultural problems. Obviously, there’s no guarantee that it would. Those things come down to more than money alone. However, I believe I’ve made a start on it. Incentives are not the only thing that matters, and financial incentives are not the only kind of them, but there’s a start, here. If everyone at a specific job description is earning the same salary, and bonuses are based on (fairly allocated) profit points, then the incentive structure seems better. The employee’s question then isn’t, “How do I get a $10,000 raise?” (usual answer: get an offer elsewhere) but “How do I improve the company so my profit points are worth $10,000 more?”
VC-istan startups rarely deliver raises and their equity compensation is, for the most part, pathetic. A software engineer joining a 50-person company is lucky to get 0.04%. What that means is that his financial incentive isn’t to improve the company’s value, because the difference between delivering average and “10X” work for a year, on a 0.04% slice, won’t even pay his Starbucks budget. Rather, his incentive is to become an executive and get a real slice. If you don’t see how this is a recipe for an engineer-hostile, fucked-up culture, you don’t understand technology.
My system wouldn’t entitle an engineer to that token ownership, but it would allow a much greater non-owning participation and that, for such a minority share, is preferable. With the numbers above, the least-compensated engineer of the 50-person startup would be entitled to 0.45% of the annual revenue, not 0.01% per year (minus a bunch of wonky VC robberies like “participating preferred”, over which the employee has no control) of some highly unknown (median: zero) value at “liquidity” in the future.
This “uncanny valley” of trivial ownership is, in my opinion, worse than the total (and mutually understood) non-ownership of an employee in a traditional corporation. The non-owning corporate employee has no expectation of getting a ten-fold increase in “equity” because he has none (unless it’s a publicly-traded company and he bought stock on the market). He’s just there to trade labor for money at an agreed-upon and well-known rate. If he’s playing for comfort and stability (MacLeod Loser) he’ll be happy with a 4% raise each year, to account for costs of living. If he’s going for rapid career growth and personal yield (MacLeod Sociopath) he’ll probably “job hop” if he’s not on track for 15%-per-year. But it’s obvious who the players are and what they want. There’s no “You’ll get rich on this!” mythology devised to turn the MacLeod Losers into Clueless. VC-istan, on the other hand, is all about cutthroat social climbing. Engineers want to become executives and get real equity slices (although they seem to harbor a delusion that they’ll still be able to code, and use their control of the division of labor to give themselves the best projects, in such positions… instead of having their lives eaten by useless meetings, which is what actually happens when they become executives). Executives without investor contact want to become executives with investor contact, so they can break off and be founders next year. Founders want to be “angel investors” (read: rich, but still considered important by smart people). It’s a world powered by the young and the Clueless– Clueless who are trying to be Sociopaths, and often very bad at it.
Transparency on all fairness issues (compensation, employee autonomy, cultural guarantees) is the antidote to Cluelessness. If there’s no Cluelessness, then there aren’t “Clueful” sociopaths robbing investors and exploiting employees. Then the goal isn’t to “become an executive” but actually to fulfill a role well and make the company great. Imagine that! It’s not a magical antidote that will cure all forms of cultural malfeasance. I don’t think it can be expected to solve all problems, but it starts the conversation.