Episode 56: Wasted equity. THE fix for broken incentives

One of the most persistent belief systems in modern business, is that by giving someone equity they automatically increase their contribution and engagement. Why is it that this is just not the lived reality more often than not?! Using vivid examples — from dental practice partnerships to office managers gaming bonus systems — I expose the structural and psychological flaws that cause incentive systems to fail, revealing what THE critical missing ingredient is. Whether you're handing out equity to retain a star performer or offering bonuses to hit overhead targets, this episode will fundamentally upgrade how you design deals and incentivize the people around you.

Transcript

Speaker 4 0:01

Welcome to The Sovereign Guide. I'm your host, Alistair McDonald. Let's get started.

Speaker 0:27

Why do incentives break down? Why do we create an incentive deal for an employee to get a certain project complete or give equity to a potential owner? Any number of these things assured that they're gonna help us out, but they just don't work. I was listening to a Silicon Valley guru the other day talking about incentives and equity and partnerships and so forth. And in his dialogue he mentioned, uh, he said a simple line. He said, talking about aligning incentives. And he said, so if I have a business and I give you equity in that business, we have aligned incentives. And so therefore we are going to be dot, dot, dot and continued on with his, you know, kind of story about why equity and ownership in a business is critical to incentivize people. And so, and I just had to stop right there because these types of assumptions are so embedded into our language that we take them for granted. Give somebody a bit of equity and you know, in his example, give equity and they'll, they'll immediately show up as an owner. Why is it that this just does not happen predictably? I mean, how many people do you know? How many times have you created an incentive, or particularly around equity given or sold equity to somebody? Sure. That because you own it and you are heavily incentivized toward doing the work, staying long nights, late nights, and long weekends and so forth, that they will do that automatically themselves, and yet they don't. What's going on? What's broken here? What I'm gonna share with you is what I believe to be the critical unlock. Of why, where, and how incentive systems fail to work, whether it is an employee or a partner, or anybody along the value chain. This, this one key piece is critical. Let's imagine for a moment that I own a dental practice and I want you as this wonderful associate. To join me as a partner, I've decided that you are perfect because you are a great producing dentist. The patients love you. You've been working here for a year. Everybody knows, likes and trusts you. You're doing good clinical work. You're produce at a high level. I like you, et cetera, et cetera. All of these qualifications I am sure will do one of two things. Either make you a great partner or make you a great partner for someone else, and I don't want to lose you, so I will give you or offer you equity to stop you from leaving. This is strangely common. Why do I say strangely common? Because if you think this through this fear of scarcity, the fear of loss, you realize just how intellectually bankrupt and energetically maladaptive it is if you are thinking about giving or selling equity to somebody so that they don't leave. If that is your primary concern, I want to point out by way of a ridiculous example, just how Ill conceived that is. Now, again, I understand we're all afraid of losing high performing team members. I get it. I have the same concerns myself, but I'm worried about you leaving because it would have a negative impact on the business. Okay. That's the core premise. It is not enthusiasm for your remarkable entrepreneurial skills. It is a fear and aversion to your leaving and devaluing the business. That's what I'm trying to avoid. Join me for a thought experiment. Imagine that you go out on a date, that's a first date. You've never met this person before. And, uh, by any measure they seem to be an otherwise good fit. You sit down having a drink at the bar and this person sitting next to you is hitting all the right notes. Everything about them just seems just right. They're interesting and funny and smart and worldly, and they're interested in you, which is typically the thing that makes us think people are wonderful if they are interested in us. And as you sit there about 20, 30 minutes into the date, you say, that's it. I don't wanna lose this person. I think they are the one. And so you stand up and say, excuse me, You get down on one knee and say, listen, I know we've just met. But I'm gonna go ahead and I brought this ring and I would like to get engaged. I'd like us to get married. Um, I realize we don't know each other really. And, uh, you've got these qualities that I see, but then a bunch of them that I don't yet know. But we'll work that out. Let's go ahead and get married. Let's get you outta the dating pool. Get you locked in and we'll, it'll be wonderful. We'll just get to know each other in the future, whether you are a man who does this to a woman or a woman who did it to a man or a woman to a woman, or a man to a man. Ask yourself what that would look and feel like. That would feel like I've just bumped into Jeffrey Dharma or Hannibal Lecter and they are trying to imprison me in a relationship that I don't even understand the future of. They should run screaming, and if anyone did it to you, you should do the same thing. But it's, this is exactly what practice owners are doing every day. By giving away equity, whether they sell it or not, they are moving an otherwise valuable asset, made valuable by the stewardship of its owner into the hands of an unqualified, untested, unknown person who is going to maintain that value. No, they are not. Take a look at any company that changes ownership and watch what happens to the quality of its products and its inherent value. Not all owners are created equal. So I have to deviate into that little kind of wrinkle in our narrative here because if you are approaching. Equity ownership and spreading out equity with individuals because you're afraid of losing them, because that will impair the value of the business. You will inherently and implicitly devalue the business anyway. Not only have you disempowered yourself, if you have high standards, it will have taken high standards to create an exceptional business. You have undermined all of the work you've done to create an particularly special, valuable, and unusual business. And now you've given that equity stewardship over it, influence over its future to somebody that is, as I say, untested, unknown, unqualified, and it will inherently achieve exactly the thing that you wanted to avoid in the first place. Let's go back to our original story. I've decided that for all of these wonderful reasons, I think you should be an equity owner, so. I am gonna offer you 50% of my $2 million dental practice. And uh, you're gonna do a couple of things. Either you can go to the bank and borrow a million dollars, which is great 'cause now this checks the box for our Silicon Valley guru that I was referencing because you've got that beautiful phrase, skin in the game. You got skin in the game. That million dollar debt, man, that's really gonna motivate you. It is, it is. That's the first option. The second is not to worry. Uh oh. It turns out you can't borrow a million because you've got half a million in student loans from qualifying a dental school, so, okay. Sorry about that. No issue. We'll just go ahead and I'll lend it to you out of the practice by basically withholding eight or five or 10% of your paycheck every month. No problem. Let's hit pause there for a moment and realize what value I'm actually contributing to the business versus what it is that you want done. What you want done is help growing the business. That's the point of it. The whole point of it is to grow the business's value over time. That's why I am offering this and I'm trying to avoid the anti-growth problem of your departure. It's all trending, it's all tracking. It makes sense, but ask yourself what these two profiles are actually incentivizing. By encouraging you to go to the bank and borrow that million dollars, or me saying, I'm just gonna withhold whatever it is. Out of your monthly production, what have I really incentivized you to do to do more clinical dentistry? How does that help my business grow significantly? It'll improve top line marginally, but would it be worth a marginal net increase to the business' monthly cash flow? for the price of a 50% loss of equity and control. The answer is no. Mathematically no. I have incentivized you to prioritize yourself. Why? Well, 'cause you've got a thousand dollars a a month bill owed to the bank. That's a thousand dollars hole in your paycheck. You're gonna set about filling that a thousand dollars hole again. Will there be an impact on the business? Yeah, there will. On its profitability. Marginally. Is it worth giving up 50%? No. Again, mathematically, no. By the way, you'll see here that these threats, that the risks here are true to both parties, meaning this is what I refer to as a truth that travels this reality is going to go with that associate wherever they go to become an owner just as much as it exists here. Likewise, the challenges that I face, I will continue to face. These are truths that travel, meaning it's not specific to this particular person. Even if we pursued that, we would find ourself where exactly, where 90% of the people, you know, in business partnerships. What do you think of your new partner? Oh, a really great guy. Doesn't really do anything. How do you feel about the contribution between you? Oh, I've, I've always done everything, so I just keep doing it. The resentment that grows between Jack and Jill, because she's the one who's there nights and weekends and so forth, why would he, why is he not showing up like this? Why does this break down? There are a couple of examples and reasons for why this can break down, and they are what I'm referring to at the infrastructure level and the individual level. At the infrastructure level I have by offering you 50% of my practice overlooked a major statistical problem, that there is a very low likelihood that you are actually business owner material, not just is there a low chance, there is actually statistically a one in 10 chance that you have what it takes to build and run a business. How can I say that with such conviction? One out of 10, the Bureau of Labor Statistics in the United States tells us that of the American workforce, 100% of the American workforce, 90% are employees. One in 10 working adults in the United States are actual entrepreneurs and business owners. Out of the gates, I've got a numbers problem. There is a low probability that you actually have in you. What I assume you will suddenly by magic get purely because you now have equity. That's the first structural problem. The second is we are describing a scenario where I have immature business. This is not a scratch start business where the two of us are in it from day zero. bloodying our knees and skinning our elbows as we work to make something from nothing. This is a mature business. That's why there's actual equity in it. Well, given that it's a mature business, in this example, I'm gonna say I've been a business for 10 years. I have every job assigned to somebody on the team. Every job, role, task, et cetera, is being satisfied by somebody equally. One would hope everybody in this dental practice is working hard to achieve their specific tasks every day. Why is this relevant? Will you join me with a 50% equity position incentivized as you are to pay off your note as quickly as possible to improve your quarterly cash flow? What incentives do you have to step out of that channel of clinical production and contribute on the professional side of the business? I separate. These two rolls out there is what contribution is made on the clinical side, actual revenue, and on the professional side, everything from marketing, advertising, legal and ethical compliance, attorneys, contracts, labor laws, hr, reputation management, websites, on and on and on. Physical infrastructure, utilities, supplies, you know, the list. That list is a mountain compared to what is asked of them. That list is huge, and we are asking them now to create room in their life to stack those responsibilities on top of their shoulders while simultaneously trying to cover the note that they have every month. You are unlikely to do that. You also have no incentive to do it because it's already being done by people who just do that stuff. Those are the things they're good at. I also need to be smart and come to terms with the fact that any of these jobs that you did, let's say for example, you, uh, took over marketing because your nephew knows Facebook ads, and so therefore you are perfect to do all of our marketing. Never done it untested. Never really qualified, but my goodness, is this a common one? Why would I. Take you away from revenue generating work to reroute you into revenue supportive work, which is what most of management is. It is not revenue additive. It is merely revenue protected, not just that. But if you are this wonderful studly great doctor that I've been drawn to offer equity to in the first place, I'm gonna be taking you away doing let's say, a million dollars in revenue to the practice every year. And I'm gonna reroute all of your contribution to take over a role that I can hire away for $55,000 a year. We've just gone from a beautiful, profitable practice to a completely asymmetrically skewed value creation between two partners and a business that has now fallen in revenue by 50%. This doesn't make any sense, And it should be really obvious to us, but we overlook it. Even if I say I'm gonna take 20% of your working hours and direct it toward this, well, we can tell exactly what that'll cost. That will cost us $200,000 in revenue every year. So even if you were to pay me as your partner, that $55,000. It's now costing the business two hundred and fifty, two hundred fifty $5,000. You get the point. We've gotta pay attention to this. If this person that you are offering equity to is in a revenue generating role, you need to come up with a better plan. These are the examples of the structural problems. I have no incentive either monetarily or energetically to step in and take tasks on and responsibilities that are other people's right now, and there's a one in 10 chance that I'm even likely to do so in the first place. So let's get to the individual level. We spoke earlier about this same scenario. If you go to the bank or what have you, we know that there is an inherent distortion there, skewing your contribution back toward self preservation. Again, to pay down your note, because I've incentivized you with something the wrong way. There is another reason why this particular incentive doesn't foster or engender the type of thing we expect. Equity has a value in the future that is invisible to me in any shape, way, or form except sacrifice now. So not only am I going to forego a thousand dollars a month for the note that I'm going to need to pay, but I will not feel or see any benefit until that notice paid off in 10 years. There's another critical piece about equity that it appears only those who have it know equity has value in only two ways and for only two reasons. You either sell to extract it and turn it into cash, or you borrow against it as collateral. Now if you've just borrowed a million to buy it, you don't have collateral to then use it to borrow again. That's a complete wash, so that's not gonna work. There goes 50% of the benefit, and equally, how can I extract the value of a business that is not for sale? I won't feel it. In my lived experience, all I'm going to feel is the heightened sense of obligation about how to run this business with an unqualified mind while I'm using the example of equity. The real core point is why is it and where is it that incentives break down and don't actually work? So we've identified a couple of things. What equity really is, it's actually nothing. You only feel it in the future if and when we sell or borrow against it, that on the way there, I'm only going to feel a sacrifice for no visible measurable gain and that there is a one in 10 chance I'm even going to do it. And if I get that chance and even less it. Probability that I'm actually gonna do it because I would need to take roles and responsibility of other people's shoulders that they're already being compensated for in their jobs. If we look back at the nature of an incentive system, what is it supposed to do? It is supposed to trigger change, change. You are working here in this dental practice of mine, and I am considering you as an equity partner for the same reasons that I support and built it in the first place. I am oriented and orienting toward growth in the information theory of capital. One of the core principles is this, all growth is learning. This is a critical piece. All growth is learning. Every relationship, every mind, every body, every society, every economy, every legal system, anything on earth requires. If it's aspiring toward growth needs learning, that's what creates true capital. It's worth remembering that this is a capitalist system. And the origin of capital is from the Greek kaput, the head. We need to get smarter if we're gonna grow. And that's the initiative behind my bringing you in as a partner. And that's what I'm trying to incentivize. I'm trying to incentivize change. I wanted to fuel initiative and drive. I wanted to get and generate new, better, different outcomes from you by different and better behaviors and actions. That's what I need from you. I need you to learn so that you can grow, and when you grow, we grow this business. That's the whole point. I have fought blood, sweat, and tears for the last 10 years to get this practice to where it is today. I paid a huge price in time, money, mental health, physical wellbeing, stress debt, note payments, time away from the family. I have paid a major price for my learning. Learning comes at a cost. And so if you are going to, in this case, if I am going to unleash an incentive system that allows you the opportunity to become an equity holder, then it follows that this thing I have is valuable. And if it's valuable, it's going to cost you even more to buy it, to earn it, to grow into it than it is currently costing me. What I mean is that the price of that growth and effort to learn and work and sweat and labor must be born by the recipient. If I am giving that to you, I am equally giving you the invoice for its. I'm giving you the chance, but I'm also giving you the bill. This is what it's gonna take, and it will take long, hard hours, and so on and so forth. It's gonna take a lot less hours, a lot less blood, sweat, and tears with me than it did cost me, because I'm gonna make it easy for you. That's what a good partner does. They make it easy for others to grow. They make it easy for them to learn faster, full-time, and grow the business by growing themselves. So it follows that in order for this to be meaningful and actually work, the price of that growth must be carried by you, not me, and not this business, and certainly not this team. It also needs to be equal to or greater than the price I am currently paying as the current owner. Oh, that might seem unreasonable. No, this is a truth that travels. You have to earn valuable things. You can go down the road to the practice owner that wants to give equity away and get to ask yourself right away. How valuable is it if it's being given away. Valuable things are hard to get, and this is one of them. After all, if it wasn't hard and made valuable by that difficulty, by that aspiration and work ethic, why would you partner with me and why would I partner with you? Stepping back from the ownership equity example. Coming to the core principle of why, where, and how incentives break down. We can use a different example with a team member. Let's say that you are my office manager and I am going to help. I'm going to enlist your help with this project. And this project is about getting a certain overhead down, a certain overhead. Let's say that it is in. Supplies. Supplies are at 8% and I want to get them down to five. I come to you and I say, great. As my office manager, we've got this project. I would like you to get this 8% cost down to 5% and I will pay you two of those percent, one of those 3% savings. This sounds like a standard incentive system. Makes perfect sense. Okay, but let's follow this one through. In the same way we walk through with the associate being incentivized by equity, I say to you, Hey Jack, Jill, please run with us. You take this, you know, 8%, run it down to five. You can pocket two. I'll keep one. I'll be stoked. You're still saving me money. Or we'll split it 50 50 or you get one and I keep two. Doesn't matter. Let's move on. You say, great, you set off. Bust your hump, work it out. Solve the problem. By learning, by growing. And you come back in 30, 60 days and you say, Hey boss, I've done it. Look here, 8% is now five. I've saved you 30,000 bucks. Wonderful. Here's your 10 or 15,000. Perfect. And we move. Yeah, just like we followed the incentives of the associate orienting their energies and efforts toward more production because they have to pay their bill, they wanna pay that note off, they wanna make more money every month. We can see immediately why this incentive is distorted as well. Ask yourself what you're gonna do. If you were that office manager, you're gonna go back to work. And you are going to let that overhead metastasize back to 8% over the next month or two. Of course you are. Why? Because you are going to hold off. You're going to literally be compensated when you know that I'm gonna come back to you and say, Hey, that overhead's got up there again. Could you please? Now at eight and a half, could you get it back down to five? Same deal stands. Sure I can do that. Absolutely. And once again, I do my job and get given a bolus of cash. Once again, an otherwise airtight appearing incentive system is broken, just the same as it is broken with the associate who prioritizes their own income or doesn't wanna make a sacrifice for the benefit they're already getting for free. What's missing here, friends, this is the unlock, the whole point of cleaning up this overhead. The whole point of bringing you in as an associate was growth. It is to grow this ecosystem, this organization that we're all a part of. What does that tell us? It tells us that something has to learn. In order for an incentive to truly not just be overpaying somebody for what is really just their job. You've done this before. I've done it. Hey, it'd be great if you could. Uh, they are being incentivized to do their job. That's called a paycheck. But when we create this opportunity for an extra bonus or some other incentive simply to do your job, you are rewarding people to not do it, but sporadically get a fat check for actually doing what you've been paying them for the whole time on top of their paycheck. Why is it that in the case of the overhead management scenario, we have created a disincentive? Because even though you went away. To learn how to fix this. You grew, you solved it. You came back. You looked like the warrior, prince or princess. I am so excited. I gave you a check. Doesn't this show that it worked? No. No. Because you grew, but the system didn't. What good is it for you to have improved, to have learn, expanded and grown in your contribution if it stays with you? How is the enterprise itself growing? How is the enterprise learning to fix this? You can see immediately what the solution is. We go back in time. This time I'm wiser. Hey, we've got this 8% bill. I'd like to get it to five. Okay. Got it. Look, it's part of your job anyway, so if you don't do it, you're gonna get fired. That's an, that's an option too. I mean, if this is part of their role and they're not doing it, we should hardly give people a reward for actually doing a job they're already being paid for. But let's pretend that it wasn't part of your job. It wasn't anyone's job. It was mine, and I didn't do it. I said, listen, this is what we're gonna do. I want you to get this 8% down to five. And to the extent that you can do so, and it is sustainably sticking at five, I will give you one of those percent every quarter. The difference is immediate and obvious. The former example rewards me to not grow the system. The latter rewards me to grow the system and maintain it. to grow something new that wasn't previously there. A protocol process, system plan, what have you, to install it and to see to it that it is predictably functioning and profitable in the doing of. Incentives are always and only effective if they induce growth by learning or force growth by learning. If your incentive systems do not have an induction to growth by learning, then they must have a force that insists on it. What does that mean to use our associate equity partner? We could come up with any number of combinations that force it. I will, for example, give you the list of the top 10 things that I hate doing on the professional side, that you are now taking complete responsibility for If you can do these 10 things with measurable outcomes predictably. Every quarter, your equity remains valuable, meaning whatever distributions you might get as a 50% owner, you will get, but if you don't, you will get nothing. This is a, it's an example of something that incentivizes or forces growth by learning. To the extent that these tasks are not done. Again, I'm going to force it. Then you will forego 5% of your equity every quarter until you've righted this aspect of the ship. Now you might say, that's unbelievable. I would never do that to somebody. Nobody did that to me. Yes, they did, but it wasn't a person. It was a thing called the marketplace. One of the biggest misconceptions about business is individuals feeling like they are the ones who decide. How things go. They are the ones who decide the prices they can charge or what they can pay. People they don't. This is the United States of America. It is a capitalist system, which means it is a meritocracy. You absolutely effectively lost 5% a quarter when you didn't take care of those things yourself. It's just nobody took it away from you. It just became worthless, which meant the value was lost, which means effectively it was taken away from you. Isn't it true that you, as the business owner, had periods of time where you made no money at all? I mean, I would hope that you've had this experience. I found it to be one of the most mentally sharpening experiences you can ask for much like experiences with being broke. I wish them for everybody. That's what happened to you when you did a poor job any particular quarter or month. There was no money for you either, and consequently, the enterprise value of your business fell by that amount as well. So yes, this is exactly the world as we know it. The idea that your practice should protect a partner from the real world is a fool's errand. It is insulting to you and to them. It suggests that you are actually capable of protecting others from that which nobody protects you and or it suggests that they are really wonderful but incapable and I must protect them. You are insulting the capabilities of somebody that you purport to be admiring of. It doesn't make sense. Check your incentive systems. Audit them for that one piece growth. If it is not a project or a task, or a role or a challenge that induces growth for the organization, starting with the person, it is not an incentive. It is. A paycheck that Friends is the great unlock Every incentive system that you've built that broke down was because it was overlooking the critical piece of growth by learning, and it fails to either induce that growth or enforce that growth. You fix your incentive systems. With that modest, easy repair and everything changes. I wish you all the best.

Speaker 3 34:28

That's it for this episode. Thanks for being here. Hey, there's only two things that you have in your life. Your time and your attention that you've given both to me for these few minutes of today means everything. Cheers.