Monday, December 9, 2019

Find the problem before you own it

All of these companies could have benefitted from the advice of Chapter 19, "Anticipate adverse selection."  
  • in 2016, Marriott acquired Starwood for $13.6 billion, unaware that Starwood's reservation system had been attacked which exposed personal data of nearly 500 million of its customers.
  • In 2017, Verizon discounted its original $4.8 billion purchase price of Yahoo by $350 million after it learned--post­ acquisition--of the latter's data breach exposures. 
  •  In 2016, Abbott announced the acquisition of St. Jude Medical, a medical device manufacturer based in Minnesota, only to learn of a hacking risk in 500,000 of St. Jude's pacemakers a year later in 2017. Abbott ending up recalling the devices.    
BOTTOM LINE:  when purchasing an item of unknown value (you don't know whether a target acquisition has hidden liability associated with data breaches), anticipate that the target may have better information than the acquirer which would make the target more likely to sell because the target knows it is not worth what the acquirer has offered.  Acquirers should "find the problem before they own it." (HBR Article)

Evidence that acquirers are anticipating adverse selection:  After the EU adopted stricter liability associated with data breachers in the form of GDPR, venture capitalists were less likely to invest in startups or and a number of deals fell apart:
  • One study estimated that venture capital invested in EU startups fell by as much as 50 percent due to GDPR implementation. (NBER)
  • “55% of respondents said they had worked on deals that fell apart because of concerns about a target company’s data protection policies and compliance with GDPR” (WSJ)
HT:  Danny Sokol & MarginalRevolution.com

Tuesday, December 3, 2019

Paying People to Lie: The Truth about Corporate Budgeting

Michael Jensen's timeless classic is available here.  In it he describes how stock market analysts set earnings expectations for a company's stock.  Since the CEO is paid in stock options which will decline in value if earnings fall short of analysts' expectations, the CEO wants to ensure that each division makes enough money to meet analysts' expectations.  In consultation with division managers, she turns analysts' earnings expectations into performance metrics, with each division manager's bonus tied to meeting her division's share of company earnings. 

With these incentives, each division manager has an incentive to understate (or lie about) how much her division can earn.  As a results, the negotiated division budgets need not reflect what managers actually know.   Important decisions are then made based on based on budgets constructed from lies.

Fortunately, there is an easy fix:

 [by]...changing the way organizations pay people. In particular to stop this highly counterproductive behavior we must stop using budgets or targets in the compensation formulas and promotion systems for employees and managers. This means taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile of each employee and manager. Such purely linear compensation formulas provide no incentives to lie, or to withhold and distort information, or to game the system.


With a linear compensation scheme, there is no incentive to understate how much a division will earn.  And with better information, better decisions are made:

I believe that solving the problems could easily result in large productivity and value increases - sometimes as much as 50 to 100% improvements in productivity.

Sunday, December 1, 2019

Sales "bunching" and high-powered commission rates

Ian Larkin studies the use of "high powered" quarterly sales commissions, used by virtually every firm that sells software. A typical incentive compensation scheme (as a function of sales) is highly convex: a sales person earns 2% if she sells $100,000 worth of software; 5% if $500,000; 8% if $1,000,000, ..., up to 25% if $8,000,000.

Ian finds that these high-powered (convex) compensation schedules give sales people an incentive to "bunch" sales into the same quarter. Just as convex production costs can be reduced by "smoothing", i.e., holding inventories to buffer sales shocks, so too can convex commissions be increased by "bunching" sales into the same quarter, the opposite of "smoothing."

Using proprietary data from a large vendor he finds that 75% of sales are occur on the last day of the quarter; and 5% of sales occur on the first day of the quarter, as sales people give discounts to customers to accelerate or delay purchases. These discounts cost the firm about 7% of revenue, which is about the same amount that it pays out in sales commissions.

The 7% revenue loss suggests that there is a way to make both firm and its salespeople better off: adopt linear commission schemes to eliminate the incentive to "bunch," and split the 7% savings between the firm and its sales people in the form of higher commission rates.

When asked why they use these costly incentive compensation schemes, managers say only that they need them to retain their "superstar" sales people. But surely there is a better way to retain superstars, isn't there? As always, I would like to hear from readers on whether they think this would work.