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What should be humanity’s top priority?
I saw a quora article by this title back in February. In it, there were various suggestions split into two main camps: either social or technological. I think humanity’s top priority is probably the intersection of the two.
Specifically, humanity’s top priority is almost certainly is the predictive ability of economics, and thereby, the application of science to government.
Many ideas were suggested in the quora article, including space colonies. How can we know which is best? Economics should come to the rescue, but it’s the “dismal science.” We cannot predict with any repeatable certainty which actions will lead to “improvement.” To make matters worse, there is serious disagreement over what to improve. Should we minimize the maximum unhappiness? Should we maximize average happiness? Should we do whatever it takes to propagate our genome, our ideas, or our individual freedoms? Should we all just seek inner enlightenment, as one person suggested?
The truth is we have only a vague idea. Our limited history gives us incomplete empirical data, very little of which was designed for statistical analysis or recorded in adequate detail. Our theories can explain some concepts and some trends very well, but when it comes to Trump’s election or ISIS we are easily blind-sided. And unlike our endeavors in the similarly complex medical sciences, we have no economic “clinical trials.” There is almost no deliberate experimentation in government or society. There is little candor in evaluating the results of what little we try.
I suspect that we will be able to decide the next “top priority” — and eliminate political divisiveness in the process — if we can first beef up economics. There are two components to this: economic “clinical trials” and better predictive modeling.
Imagine you could take a proposed law and run it forward 100 years in a simulator. What does that do to the target objective? What externalities do we see? Does the simulation suggest a refinement or an altogether different approach?
Meanwhile, for things that are harder to predict, can we voluntarily enlist 100,000 people in an economic trial? One group is a control, the other group lives under slightly different circumstances.
With either approach, there are daunting implementation details to be worked out. Modeling is sharply limited by our understanding of human behavior and our computational inability to simulate anything as complex as a society. And economic trials are going to be befuddled by selection bias, and double-blind issues, and all the ethical questions delineating the degree to which we experiment on ourselves.
But in principle, this is the approach. We have used it with astonishing success in mechanical engineering, which is the application of science to solving hard physical problems. We should apply similar methods to social engineering. Politics as a method leaves me feeling misdirected, to say the least.
My hope is that we can — with modeling and economic trials — expand the scientific method to the work of government. Rallied around an objective reality, anything will be possible. Divided along untestable ideological lines, we can only hope to muddle our way forward.
So science in government first. Space colonies later, if that’s what makes sense.
How Should Cofounders Split Equity? A Cofounder Vesting Riddle
Here’s a cofounder riddle:
Cofounders A and B start a company around A’s idea. There are 10 million shares authorized. A gets 2 million unrestricted for the “idea.” A and B each get 4 million subject to vesting.
Due to unforeseen circumstances, A immediately quits. A’s unvested shares return to the company. B presses forward alone and vests all 4 million shares. The company succeeds without further investment.
At liquidation, A has 2 million of the 6 million outstanding. B has 4 million. A gets 2 million divided by 6 million = 33% of the proceeds. A’s idea premium was lofted from the 20% agreed-upon to 33%. B feels snookered.
What could A and B have agreed to on “day one” so that A would have ended up with just the 20% idea premium?
I posted this to the MIT Venture Mentoring Services forum. Here’s a summary of what was proposed by others:
- A, the departing founder, could be
- subjected to steeper vesting
- given a contractual claim or special class of shares, instead of common, that convert to 20% of the liquidation proceeds
- B, the remaining founder, could be
- granted additional stock or options
- signed onto a “bear hug” right of first refusal to purchase cofounder shares
- given a loan from the company to purchase cofounder shares
- Or we could do one of the following:
- forget idea premiums;
- accept ownership changes as a risk in starting up;
- forget the whole “riddle” as an impossible problem.
The type of solution we’re looking for is:
- Not predictive: we shouldn’t have to know whether A will actually quit;
- Prescriptive: if A does quit, or participates less fully than B desired, there is no disagreement on how A or B should be penalized/compensated;
- Smooth: the spectrum of A’s non-participation and B’s compensation, from “A quit” to “A is fully engaged,” should have no step changes;
- Tax-free: founders can still declare an 83(b) election to pay relatively zero tax on their founder stock; and
- Cash-free: founders should not have to come up with lots of money to maintain an agreement made early.
Many of the ideas above have either tax or cash consequences, or are not smooth, or are predictive.
The “bear hug” concept combined with an idea sent to me privately, issuing warrants that expire as the co-founder’s stock vests, seems to me to be an implementable solution with few tax or cashflow consequences. So that’s what I’ve been working on this week.
I will report back and/or blog about it if we produce anything interesting. Certainly the name of this scheme would be, “a completely warranted bear hug.” Stay tuned.
Montien Thai Restaurant Pricing Practices
Last night I ate at Montien, a Thai restaurant in Boston. The food was good, as usual. When we got the check, I noticed one entrée was $2 more than the menu list price (about 10%). I didn’t think much of it. It seemed pretty normal that a printed menu might have fallen out of date.
The waitress came by to get my credit card.
She said, “Oh, would you like to pay cash to save 10%?”
I said, “What?”
She said, “See, you can pay cash and save 10%.”
She pointed to a line on the check that said something like, “Sign here to agree to pay cash and save 10%.”
I signed. She handed the credit card back, took the check, and said she’d be right back. She came back with a new check with a 10% lower total cost.
I looked at one appetizer and saw that it had also been billed at a price higher than the menu. About 10% higher. As a matter of interest, so had everything else. I was now paying what I had expected to pay, based on the menu list prices.
I put three twenties into the check fold. The waitress picked it up and came back with change. We didn’t have any singles, which would have been necessary to leave a normal amount of tip, so I flagged her down again. She broke my five into ones. We left the tip and left the restaurant.
A Questionable Pricing Practice
Shouldn’t the menu have had an asterisk somewhere saying, “List prices are for cash”? Maybe it did.
Either way, you can’t list the price of a Chili-Chili Duck as $20.95, then charge me for $22.95, and tell me I’m getting a discount by paying cash. I’m really being charged more for using a credit card.
Does a 10% surcharge make sense? Here are the costs for a $50 dinner for two:
| Customer Pays with Credit Card | Customer Pays with Cash | |
|---|---|---|
| Credit card processing fee | $1.50 to $2.50 | n/a |
| Waitstaff time (1 min ea. visit to table; $10/hr wage) | $0.33 | $0.66 |
| Processing cost | $1.83 to $2.83 | $0.66 |
| Customer Surcharge | ($5) | ($0) |
| Loss (Gain) from Processing | ($3.17 to $2.18) | $0.66 |
Under the surcharge scheme, the restaurant makes additional money every time someone pays with credit card. But they have their waitstaff making as many as two extra trips to the table, plus they have back room expenses associated with counting, safeguarding, and depositing all that cash.
Nevermind all that, I felt deceived. As I said above, it was presented to me as a discount, but I was observant enough to see that it wasn’t. I probably won’t go back. The extra $2 to $3 they got from me may be the last of it.
It’ll depend on how much I want that Chili-Chili Duck.
The Greatest Stock Option Plan You’ll Probably Never See
If you’re running a company — a real one or a startup — you’ll want to remember the story of Fred Futile, CEO of Stagnant, Inc.
The compensation committee of Stagnant, Inc. saw fit to award Fred stock options equal to 1% of the shares then outstanding. This was intended to give Fred an owner-like interest in the business and incentivize him to increase the value of the company. Stagnant was at the time earning $1 billion each year on $10 billion of equity. There were 100 million shares outstanding, so earnings per share were $10. The company traded at a price to earnings of 10, so the option price was set at fair market value, $100 per share. Here’s a table summarizing the vital statistics:
Now Fred did an ingenious thing. Rather than work hard to change Stagnant into something more than the marginally billion-dollar business that it was, he used the year’s earnings to repurchase shares. Look what happened:
The one billion dollars of earnings bought ten million shares at $100/share. Assume the company traded constantly at a P/E of 10 and you can see the trick: just by withholding money from shareholders, Fred was able to put his options in the money and make himself $11 million. He didn’t have to improve the business at all. And if that doesn’t surprise you, look at this: if in Year 2, instead of holding constant, earnings had actually declined by 5% due to Fred’s negligent management, Fred would still have been in the money on his options:
Fred was gaming the system then, to be sure, so let’s look at what would have happened if he had tried to reinvest the earnings into some seemingly worthwhile project that earned 5%. We’ll add one row at the bottom for “return on equity”. We started with $10 billion in equity, and then Fred will reinvest $1 billion at 5%.
Do you see how the return on equity decreased? Fred’s seemingly worthwhile project gave his investors a worse return on investment than if he had done nothing at all. And oh, Fred is still making millions on his option plan.
The lesson here is that Fred’s option plan is flawed. It’s okay to want to incentivize Fred with options, because as CEO he does have an impact on the overall success of the business. But his options should have a cost of capital or time factor. This way, it’s clear to Fred that if he can’t use company earnings to match the current return on equity, he should pay the money out to shareholders. Take a look at this new and improved option plan where Fred’s strike price increases at 11% each year:
Now if he tries his repurchase scheme, he doesn’t get rewarded (at least, not as much; I left off some pennies and he’s still technically in the money here).
The same is true (even more true) if he tries his unsuccessful project:
Option plans with hurdle rates should be used for every CEO or other executive that insists on option plans. This much better aligns his or her incentives with those of the investors, and comes as close as you can get to having them just buy in to a large amount of stock, which would be best of all.
The inspiration for this article, including Fred Futile and Stagnant, Inc., is owed to Warren Buffett and his annual Letter to Shareholders, 2005 (click here to read and search for “Futile”).
A Modern Marvel: The Funnel
Let me tell you why this $1.19 funnel that I purchased from AutoZone should astonish you. Behind it lies not only a secret about consumer product pricing but also an amazing but true fact about manufacturing.
First, the secret: a consumer product is typically priced at two to five times what it costs to make. Does that mean that most of every sale is profit? No, most of it goes to getting the product to where you’re going to buy it. Here are some real numbers from a project I’ve worked on:
The “Gross Margin” would be profit except that’s the money used to keep the central office running. Administrators were getting paid to keep everything running smoothly, and so was the landlord and also the power company keeping the lights on. Actual profit was far less than that 9%.
Now for the amazing part. Let’s apply the 37% that is “given to manufacturer” to the funnel. It works out to be $0.44. It costs forty-four cents to make this funnel. But it’s not only to make this funnel, it’s also to make the plastic. Imagine you were working at a funnel factory for $8/hr, minimum wage in Massachusetts. Forty-four cents represents 3 minutes of your time. But you’re not really in a funnel factory, so think about this: if I pulled out a stopwatch and I said “Go!” and gave you 3 minutes to make some plastic and press it into the shape of this funnel, could you do it? Three hours? Three days? Three weeks? Three months? Give me three years and I’d probably have a pretty good frankenfunnel, with the price tag printed up all nice, but it still wouldn’t be as good as this. And I’ll have spent a lot more than $0.44.
That’s the amazing but true reality of the world we live in, where you can go from “nothing!” to having a nice funnel in three minutes. And you just have to walk down the street to AutoZone to pick it up.
What the Market Thinks about North Korea
Is South Korea going to be attacked? Well, we can get a sense for market opinion by analogy with World War II.
Back in 2004, Financial History Review published an article correlating market events with World War II events. In particular, they looked at the prices of Nazi German bonds and Belgian bonds. Below is an example of Belgian bonds traded in Zurich. Before the invasion, starting in about 1936-37, the market slowly started demanding lower and lower prices (higher and higher yields) for taking the risk of buying bonds from Belgium. When Poland was invaded in 1939, Belgian bond prices dropped sharply. When Belgium itself was invaded, trading was briefly suspended (break in data), but then resumed at far lower prices (higher yields):
You can read the full article here.
So what’s going on with South Korea’s borrowing? Are investors demanding a high risk premium for buying South Korean debt? The answer is basically “no.” Here’s a graph of yield for South Korean bonds (you’ll have to mentally invert it to compare it to the graph above, which shows prices):
Over the last two years, buyers of South Korean bonds have been accepting lower and lower yields (higher and higher prices). There’s a slight uptick at the very end there, but overall, investors in aggregate seem to be saying that South Korea will be just fine.
But it’s hard to say, especially with menacing North Korean displays like this.
Financial Figuring for Landlords: Real Estate Moats
A moat was a medieval form of security. Just pull up the drawbridge and watch as your enemies fail to get across the water, or if they do, to scale the wall of your castle. Although physical moats have no place in modern real estate (can you imagine the lawsuits?), an “economic moat” is Warren Buffett’s choice metaphor for what makes a business resistant to competition. Real estate as a business has a few good economic moats.
First of all, it’s very expensive for a tenant to change their real estate provider. This is called “high switching costs.” Think about the search for a new apartment, giving notice, cleaning and repairing the apartment to get a security deposit returned, moving all that stuff, and unpacking it all on the other side. This could take days, and if some of the security deposit is withheld or a moving company is hired, it could cost hundreds of dollars on top of that. This means that a rational consumer of rental housing will grudgingly accept any rent increase below their moving costs. That’s good for your business.
The second moat is the potential to be the low cost provider. A lot of real estate businesses are run suboptimally. They’re saddled with high debt, old equipment, and bad rental agreements. A business run with reasonable debt, reliable equipment, and good tenants (or else, good conflict negotiation mechanisms) can operate at a lower price than average. This helps you get the best tenants and keep them, translating into lower turnover and lower vacancies, both good for business.
The third moat can be location. Although I poo-poo’d it in my last column, saying that price mattered most of all, location can be a valuable intangible asset. You might reasonably pay more to acquire a property on a public transportation route, for instance, because it makes your property more desirable to prospective tenants. Once you have it, this kind of benefit is hard for competitors to replicate.
So the next time you think your rents are a bit low, or you paid too much for a property in a prime location, remember that these moats may be contributing to your economic success. On the other hand, a little rent raise probably wouldn’t hurt, either.
What if you change your mind halfway through a negotiation?
Inconsistent decision making sometimes leads to a crummy result. Here’s a thought-provoking, quantifiable example from real life.
Two of us were preparing to drive from Boston to New York City. We both wanted to go there, and if we didn’t drive together we would have gone separately. We could take his car, a mid-size sedan that gets so-so mileage, or mine, a compact sedan that gets good mileage.
There’s this system we use to determine who takes on the burden of driving without switching up, without putting a driver in an unfamiliar car. (I have to explain it quickly here with a single paragraph and a table, and then I can give you today’s story.) One person drives the whole way, and the other pays a set rate per mile. Any gas, tolls, or tickets paid have to be covered by that set rate. The payer pays on only half the miles, because if we weren’t doing this complicated auction we’d be splitting costs. This also prevents the suboptimal result that we don’t carpool. The table below shows a 100 mile trip, where Person A will drive. His car will incur costs of $50.
Person B pays A half the costs at $0.60/mi, or $30. Person A’s “hassle premium” is therefore $5 ($5 saved over a 50-50 split of costs, where each pays $25).
Whatever profit may be left over for the driver is compensation for their labor. If the rate doesn’t cover half of the baseline expenses ($gas/mile plus depreciation) then the driver is paying more than half and doing all the work besides. So there’s a floor below which a potential driver shouldn’t bid.
Here’s how it worked last time:
He said, “I’ll drive for half the costs at 80 cents per mile.”
That meant, if I agreed, then he’d do all the driving and I’d pay him 80 cents per mile, times all the miles there and back, divided by two (like the table above).
I generally don’t choose to drive in New York if someone else will do it, but I didn’t want to pay 80 cents per mile to get there. So I said, “78 cents.” (There’s a rule that you can only bid in increments of two cents.) I add, “Remember that your car has GPS in case we get lost.” What I’m doing here is bidding his price down while encouraging him to bid again. He could accept my bid, in which case I’d be stuck with driving. But if he wants GPS, he’ll bid lower.
It works. He wants GPS for the drive, so he says, “76 cents.” I’ve saved myself four cents per mile.
I think the price is still too high, though, so I say, “74. Remember your car also has an audio input, so we can listen to podcasts.”
He says, “72.”
We continue like this for a bit. I’m successful at driving down the price of his driving to 64 cents per mile. Then suddenly I think to myself that maybe driving isn’t so bad, and I could use the lunch money. So I change my mind and the kinds of things I’m saying.
I say, “You know, it’s a bit of a hassle to drive around in the city. Sometimes drivers really cut you off. I’ll drive for 62.” Now I’m sincere.
He sees the change that has come over me and knows that I’m bidding now because I actually want to drive, not because I want to lower the price of his driving. And he knows that my floor is lower than his. In this situation, he can bid us all the way down to his floor and, if I really want to drive, the auction will stop when I bid just below his floor and he accepts.
This is just what happened. It was facilitated by more unhelpful commentary from me, in which I reminded him how awful it would be for him to drive. We settled at my driving for half the costs at 48 cents per mile.
The last time we held an auction to New York, the driver didn’t say anything manipulative to let on his true intentions and got $0.58/mile, over 20% more than what I had just won.
So The Moral Is
Before you enter a negotiation, know what you’re aiming for. And don’t try to game it, because in some circumstances, it just drives your price to the floor.
Miracle on 1st Street SE
Imagine that you are the proud manager of the only company that provides food to the people who live in a large area around your plant. Your CFO comes to you for the quarterly update and for the first time in a long time it’s good news. He shows you the graph below:
“We haven’t made money in ten years. If we do nothing, we’ll be on forecast 1, still losing money, but the bleeding is slowing down. We’re going to get through it. We’re lucky that the cost savings and price increases we put in place over the last ten years have set us on that path, because sales and operations are demanding even lower prices and bigger budgets. If we were going to give them what they wanted, we’d be on forecast 2 and still hemorrhaging cash.”
You think about it for a second and ask your CFO, “What does our balance sheet look like?”
He pulls out a copy of the balance sheet and hands it across your desk:
“Oh, hmm, ” you say. “I see our shareholders are in the red by about $15 trillion. God love ’em, they do support us. Let’s give sales and operations what they’re asking for.”
Your CFO should be shocked, but by now he’s totally resigned to your insane management of the company. “Okay,” he says, “I’ll call up our overseas competitors and get additional funds.”
You reassure your CFO, saying, “Don’t worry, they know we’re the only company providing food here. If they need us to pay off the debt, they’ll let us know, and we’ll just raise prices. Our customers will have to pay it. But let’s try to avoid that, okay? Also, call some emergency meetings with sales and operations. Make them work through the holidays to make sure we get onto forecast 2.”
You might think you’d be insane to run a company this way, but oddly enough, this is exactly what we’re doing to ourselves in the United States. See, for instance,
