Tuesday, June 28, 2005

Signaling vs. Motivating

The end of the semester is always a crazy time. The last couple of weeks have been no exception, as I've had final projects and finals, and plenty of papers to grade. However, in the midst of all this chaos, several of my friends and I were able to get together for a wonderful evening of dinner and discussion about the book "Coopetition". We were also fortunate enough to have one of the authors, Adam Brandenburger, join us for the evening. I've had the pleasure of working as the Professor's teaching assistant, and can say that he is easily one of the nicest and most intelligent people I've ever met.

Our group was comprised of several part-time students like myself, so we were able to discuss the concepts of the book as it related to our various industries and areas of expertise, and we had a number of very stimulating exchanges. I hope to talk more about some of these in the future, but I'm still working my way through most of them.

For those who are not familiar with the book, "Coopetition" discusses the concept of the value net, explaining how various players interact with one another, including a new (at the time) type of player - the complementor. It then moves on to discuss the application of game theory to business strategy, presenting a framework of PARTS (Players, Added Value, Rules, Tactics, and Scope). One exchange that I found particularly interesting came up when we were discussing the "Tactics" section. As an example, the authors describe their thoughts on how to negotiate on their own book deal, and the conflicting interests that shaped their position. On one hand, they wished to signal their confidence in their book idea. To signal this, they considered taking a higher royalty with a low guaranteed advance. However, they also wanted to make sure their publisher was committed to the book as well, so it would be motivated to properly market the book. As such, they felt a large advance and a smaller royalty would better align their interests with the publisher.

This seems to be a similar to the conundrum faced by most VCs and entrepreneurs when settling on terms. Entrepreneurs need to signal their confidence in their plans, and VCs have to protect their investments - both of these lead to terms such as liquidation preferences. However, these protections, by their nature, affect the motivations of both the VC and the entrepreneur. An extreme example of this is a contingent valuation, where the entrepreneur and VC agree on an initially high valuation, with penalty clauses that allow the VC to acquire more of the company if certain benchmarks (like sales or profits) are not met. Agreeing to such a deal is often a sign of an entrepreneur who is sure that he/she can meet their rosy projections. However, in a perverse twist, the VC now has a financial motivation to delay the success of the company for a time, to get more of the company.

Now this is a greatly simplified example that ignores the fact that VC that actually did exhibit this sort of behavior would soon have no deals at all. But there should be a way to remove even this level of conflict, so that both interests of signaling and motivation can be addressed. One possible example? An escrow of the "contingent shares", which does not transfer to the partner in case the numbers are not met, but are only released if the entrepreneur agrees that the VC made all reasonable attempts to assist in making those numbers. If the two parties cannot agree, the shares would revert to a neutral third party (perhaps some sort of charity). In this way, the entrepreneur does get the incentive to project reasonably, since he/she loses part of the company if they don't hit their projections, but the VC has all incentives to "sandbag" removed. In this way, the conflict - between the desire to signal your confidence and to properly motivate your partner - is removed.