Incentives & We
It is not often one reads a book that is great. I had the time to finally get around to reading Do Androids Dream of Electric Sheep by Philip K Dick. A large amount of the book is on what incentivizes one to do their job. The book focuses on Rick Deckard in a post-apocalyptic world where most humans have mostly immigrated to other planets from earth, and most animals, plants and insects have been killed off. There are so few animals that owning one is considered a sign of prestige. Infact, due to how prestigious it is people will often own fake animals; like our Rick who owns an electric sheep. Rick hunts human-like robots for money, and he dreams of using that money to buy a living animal. His incentive to do his job is the status that money can bring.
Anyone who reads, or listens to Charlie Munger knows that he always focuses on incentives: show me the incentives and I will show you the outcome. If someone does x, what makes it in their interest to do so? Thinking philosophically, one could always point to the fact that we live in a Society of Control. As Gilles Deleuze would say we are controlled (incentivized) by non-stop observation, judgement and examination of society and/or the State. This though does feels incomplete. Rene Girad would say that we desire what others desire through the process of Mimetic Theory. Munger would tell us to use multiple models in analysing behaviour.
We
It seems everyone is talking about the We Company, how it is a failure of corporate governance, and how it is a bad investment for retail shareholders. What I think is more interesting is: how did we get here? What are the incentives that make an IPO this derided?
Obviously, we got here as the We Company needs money for growth, and for early VC backers to exit. But I want to focus on the founder and CEO, Adam Neumann and how he treats the company, and what it all means.
Greed is good.
— Gordon Gekko (Wall St, 1987)
The abstraction we call the corporation may well be one of the smartest imagined realities humans have ever made. The ability to create an entity out of thin air, and imbue it with its' own person-hood has made the modern world possible. Society allows the corporation to own and control property and thus individuals (shareholders) can pass off risk. Individuals do not need to risk their own bankruptcy, they can risk a non-entities, an imagined entities, bankruptcy. In many cases, owners of these entities are absent from the running of a business and they need managers for it.
That is a big issue though, between those that manage these entities and the owners who are invested in the company. How do the groups align incentive if management want a salary, prestige (status), and other benefits, and shareholders want a high ROIC? Even if there is no risk due to the debts being owned by the company not investors, they do not want a loss in their sunk cost of their own investment. Thus there are systems in place to keep shareholders and management interests aligned.
It's very, very important to create human systems that are hard to cheat. Otherwise, you're ruining civilisation because these big incentives will create incentive-caused bias and people will rationalise that bad behaviour is ok.
Since the 1990's giving management equity has been the usual way to align interests, in fact there is even a Dummies article about it! Nowadays more and more start-ups are taking a lot of money and diluting the founders share of equity but through preference shares and different classes of shares they are retaining voting control of the company. Management may own less equity than other shareholders and be able to out vote them in meetings. This can be perverse if you have bad acting management.
Let's bring this all back to We Company.
Adam Neumann holds a lot of his wealth in We Company (about 30% of We’s equity), and in theory equity in a company can often thought of as a call option on the capital structure in incredibly levered companies. Neumann should in theory, have a lot of upside and limited downside, hence the creation of a company in the first place.
Once a founder has a company and is raising money, a founder generally should be incentivized to do what is best for the company. Especially as their ownership share gets more and more diluted by different funding rounds. As this happens hopefully their remaining equity is more valuable though. Now one should be paid for the work they do, especially if it creates wealth for the shareholders. And Adam does not draw a salary from We but gets paid through the loans from We, taking out loans from banks based on his equity in We, and through the valuation of We itself increasing.
This does not mean Adam has not acted in bad faith as management to other shareholders. By using $700m from We's backers to buy buildings that We leases and making it pay for a new trademark (he was paid in equity for this), giving family members jobs there, and the whole weird corporate structure shows that basic governance is lacking. Adam is acting like bad management. He knew that We would want the trademark he himself held, yet he sold it from himself to the company, giving money from shareholders to himself.
Further, the incentive to sell down his own holding ahead of the IPO is an awful sign. Why? Probably as he does not much believe in the companies prospects. And truthfully, why should he? The duration mismatch on assets to liabilities is huge. He is very obviously maximising his gains at the expense to others as he rightly should as an individual, but as a manager he probably should not do so as it decreases shareholders wealth due to negative perceptions.
Adam recently turned around and gave back the equity he got for the trademark (I started writing this post two weeks ago before I got too busy to finish this.) What is the incentive for this one may ask? It is all about making Adam money (again). If the negative perception of the IPO makes the listing valuation less, by holding the new piece of equity for the trademark, Adam takes a large loss on his remaining equity. The observation, judgement and examination by the wider investor community forced him to give it back.
What does this add up to: Adam is obviously extremely interested in enriching himself and probably not about trying to match asset and liability duration even as doing so would maximise shareholder value (will that raise consciousness though?) If we really want to see Adam caring about his company and other shareholders he should remove the classes of shares and have one class. One vote for one share, see how he acts then if he can be voted out of his management position.
One last thought
In October of last year pension funds and asset managers wanted exchanges to limit how long a public company could stay listed with dual class shares for governance reasons.The reason that individually they could not just refuse to include stocks with dual class in their funds themselves and called for regulation was that they needed their competition to exclude them too. If they did not, and the competition performed well (funds with dual listings) vs their fund (funds without dual listings) that would put their funds at risk of redemptions. This is emblematic of how powerful incentives can be. All needed to change or none would be able to. Causing an incentive to all complain together but not change their investment mandates individually.