Tom Matthews
In today’s competitive business landscape, incentives play a significant role in the success or failure of a company. Aligning incentives to business outcomes is at the core of what we do at Pemba as successful growth investors.
The importance of incentives?
“The rabbit runs faster than the fox, because the rabbit is running for his life while the fox is only running for his dinner.” — Richard Dawkins
Incentives matter a lot. Incentives drive human behaviour. Understanding incentives is the key to understanding people. Conversely, failing to recognise the importance of incentives often leads us to make major errors.
As Charlie Munger, legendary investor, vice chairman of Berkshire Hathaway and Warren Buffett’s long-time friend and business partner said:
“Never, ever, think about something else when you should be thinking about the power of incentives.”
“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.”
How best to set incentives?
One of the most critical aspects of incentives is aligning them with desired business outcomes. For example, if a company wants to promote profitable growth and long term appreciation in shareholder value, it might reward increases in annual revenue and gross margin equally with tied equity awards to the achievement of increases in economic profit (profit after a capital charge).
Similarly, if a company is looking to foster collaboration and growth, it might set performance metrics that require collaboration across teams and departments. For example, a company might set a goal of increasing client retention rates by 10% over the next year. To achieve this goal, the sales team might need to work closely with the customer service team to identify areas for improvement and address customer concerns. By tying bonuses to achieving this goal, both teams are incentivised to work together and share knowledge.
How we think about the superpower of incentives at Pemba
Pemba is a leading investor in high-growth, entrepreneurial businesses. We assist entrepreneurs in scaling their businesses and reaching the next level of success. Beyond providing capital, we accelerate and de-risk their path to the summit.
At Pemba we believe that whilst capital is crucial, talent and people are the key drivers of successful businesses.
We prioritise retaining and motivating these key people by offering incentivisation mechanisms, often equity participation, to ensure their interests align with the company’s long-term success. We look to bring these key individuals into the equity structure and support their transition from employees to equity owners.
No one-size-fits-all solution
By aligning incentives with desired business outcomes, we financially align and motivate the key employees to achieve the high priority strategic goals, and create a culture of high-performance.
However, it is essential to understand that incentives are not a one-size-fits-all solution. The type of incentive that works for one company may not work for another. It is crucial to tailor incentives to suit the specific needs and goals of the company.
Incentive-caused bias in decision-making
Incentives can also lead to bias in decision-making. At Pemba, we pay particular attention to incentives, monetary or otherwise, particularly as people will usually navigate the shortest path to achieving the incentive.
For instance, if a sales representative is rewarded based on the number of products they sell, they may push customers to purchase products they don’t need or oversell products to meet their targets. In such cases, incentives can harm customer relationships, the company’s reputation, and therefore be detrimental to long-term shareholder value.
It is essential to create incentives that do not lead to bias, encourage positive behaviour, and long-term value creation. For example, a company can create incentives that reward employees for providing excellent customer service or for coming up with innovative solutions to problems.
Closing remarks
In conclusion, incentives are a powerful tool in business and investing. When used correctly, they can motivate employees to achieve their goals, create a positive work environment, and drive business success. However, it is crucial to align incentives with desired business outcomes, avoid bias in decision-making, and tailor incentives to suit the specific needs and goals of the company.
If you would like to hear some of the ways that we use incentives to drive positive business outcomes across Pemba’s partner companies, then please email me at tomm@pemba.com.au and I’ll be happy to discuss further.
