26 February 2013

When Corporations Get Smart Enough to Become Venture Capitalists (or How to Make Employees Very Happy)

Daniel Kahneman is the only psychology professor to have won a Nobel Prize in Economics. His studies on how people value things are one of the reasons. They suggest something counter-intuitive about the design of incentives.

In the study, Kahneman ran a few scenarios with coffee mugs from a person’s alma mater. In one scenario he gave people the mug and let them “take ownership” before offering to buy it back from them. In the other study, he let people with money buy the mug that was not yet in their possession. On the surface, you’d think that they would value the mug the same way in both instances, but they didn’t. He had to pay, on average, $7 and some change to buy the mugs back from people. By contrast, he had to sell the mug for about $3 and change to get them to buy. Kahneman’s conclusion was that people put a higher price on loss than they do gain. It is more painful to lose what you have than never get something comparable. He had to pay people twice as much to give up their mugs as they thought they were worth when they simply bought them.

And this makes sense. You might feel the pang of a relationship that fails to materialize but that is nowhere near as devastating as a divorce. Not getting the job is rarely as painful as getting laid off. Loss is painful and we put a premium on avoiding the loss of valuable things.

This is one reason that Warren Buffet is worth so much. He sells insurance. People pay to avoid loss.
I think that this explains one reason that corporations have the opportunity to profit from entrepreneurship more than venture capitalists, investment bankers, or traditional investors.

The prime candidates for entrepreneurial ventures are actually people in their 30s and 40s. Their startups are less likely to fail and reasonably so. They’ve got experience. They know processes and products and people. But they have one major disadvantage in comparison to the twenty-something crowd: they have so much to lose.

Imagine a 40 year old who has been in the industry – any industry – long enough to have a potentially lucrative idea. He knows a cheaper way to make an old product or has an idea for an innovative new idea or how to tap an untapped market. He also knows that executing this idea will require capital. And leaving his job. And working at risk for at least 6 months – more often about 3 to 7 years. It’s not hard to imagine that at 40, he’s been married for 10 or 12 years. His children are 9 and 7 and he has a small amount saved for their college. He is 8 years into his 30 year mortgage. He is 10 years into his job and now gets 4 weeks of vacation and is fully vested in the 401(k), which is just starting to seem sizeable – but still not enough for retirement. The man has a lot to lose. And if Kahneman’s studies are correct, he puts more weight on the value of that potential loss than he does the potential gain from his entrepreneurial venture.

The twenty-five year old, by contrast, has almost nothing to lose and for this reason alone might be the better candidate for entrepreneurship.

If Kahneman’s studies are right, our 40 year old values what he has now vs. what he could have about twice as much as he should. The emotional cost of losing what he has – waking up at 47 with no 401(k), no business, no money for college for the 16 and 14 year olds, no equity in a home – is so much greater than the emotional boost from gaining what he doesn’t have – waking up at 47 to a net worth of $5 million and prospects of doubling that every 2 to 5 years. His preference for the second scenario is not as great as his desire to avoid the first.

This suggests that corporations have a great deal to make by offering entrepreneurial opportunities to their employees. Countless employees who could be great entrepreneurs shy away from the prospect because they have something to lose. What a corporation would have to offer as a percentage of returns would be less – perhaps considerably less – than what a venture capitalist or traditional banker would have to offer. A successful venture could return considerably more to the corporation than it might to the venture capitalists.

Regular readers of this blog or readers of my book know that I think one of the big shifts that will occur during the next ten to twenty years is the re-definition of employee to something more entrepreneurial. This matter of valuing loss more than gain is just one of the reasons why I believe that. 

It’s time to give employees the chance to make more money than they ever could in any position but a C – CEO, CFO, CTO – position, but still less than they could if they were traditional entrepreneurs. Given how much of a higher price we place on loss than gain, there’s a huge difference through which you could drive a whole business. Or two. And a way to make both employees and stockholders much happier. 

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