Remaking market making

There are some who believe that the rise of new, low-cost electronic securities trading should have killed market making and brokerage—the obscure tasks of executing securities trades for customers and matching buy and sell orders, whether on the floor of the New York Stock Exchange or on some trader’s desk deep inside an investment bank. Indeed, commissions have been slashed and bid-ask spreads have fallen; revenue from trading activities has been volatile. Furthermore, the industry has been tarred by trading scandals that have ranged from price-fixing among NASDAQ market makers to the rogue trader who brought down the 232-year-old Barings Bank.
The conventional wisdom is thus that investment banks and securities firms should abandon securities trading and stick to more attractive activities, such as managing assets and originating securities. Investors have hopped on this bandwagon, penalizing banks that earn substantial trading revenue with low price-to-earnings ratios (Exhibit 1).

But is market making and brokerage really such a bad business? Our analysis shows that, despite the gloom-and-doom prognosis, its economics are healthy. The old business model, which relied on manual, ticket-based trading and on fat commissions and spreads, will no longer work. But market making can still be attractive for players that use technology to automate the trading process and gain scale. All banks, whether they choose to compete fully or not, should decide how to position themselves.

Market making revisited

Despite all the bad press, the economics of market making and brokerage compare well with those of other core banking activities, such as underwriting securities and managing assets. Over the past 20 years, trading revenue has grown just as fast as other sources of bank income and been only a bit more volatile (Exhibit 2). And despite declining margins, trading revenue has grown even faster in recent years because of the global boom in securities trading. From 1995 to 1999, market making and brokerage revenue grew at an 18 percent clip annually, slightly faster than the overall average revenue for the whole securities industry. At the same time, the trading of securities accounted for more than half of the total revenue growth for some of the largest securities firms (Exhibit 3).

On the whole, margins in market making and brokerage can be just as attractive as margins in other banking activities. Some banks are realizing a return on equity of well over 20 percent from making markets for traditional cash equities, while margins for more innovative products (such as derivatives) or for the provision of trade-related services can top 40 percent. Compare this with the 10 to 30 percent earned in underwriting and asset management.
Historically, trading volumes surged every time the structure and efficiency of markets improved—for example, the 1986 "Big Bang" reforms at the London Stock Exchange and the 1997 order-handling rules in the United States. So the prospects are good: forthcoming regulatory changes—such as the introduction of single stock futures in both the United Kingdom and the United States—will stimulate the trading of securities by increasing the market’s efficiency and give market makers more flexibility, thereby improving their margins.
In the United States, NASDAQ’s SuperMontage will increase the market’s transparency by introducing a quasi-central limit order book in over-the-counter (OTC) stocks. (The SuperMontage will display three levels of orders or quotes on individual stocks rather than just the best bid and offer, so participants will be able to get a better sense of the depth of prices of and interest in a particular security.) The repeal of the NYSE’s Rule 390 will authorize the off-exchange trading of all listed stocks, thus boosting the market’s efficiency and allowing market makers to match orders internally and to capture both sides of the spread. Decimalization, which was recently introduced on the NYSE and is now being launched in OTC stocks, should also stimulate demand because spreads will narrow, thereby reducing the cost to trade.
In Europe, the changes will be even more far-reaching. The existence of more than 20 separate International Settlement Depositories makes clearing and settlement for intra-European trades three times more costly than they are for US ones. The implementation of a proposal to establish two main clearinghouses would eventually reduce much of that cost and stimulate cross-border trading, but even without this change, the trading of securities is booming among retail and institutional investors alike. European retail investors are diversifying their portfolios of bonds and local equities, taking advantage of new higher-yielding securities and cross-border opportunities. Institutional investors, overly concentrated in local securities, are also diversifying. As a result, from 1996 to 1999 the compound annual growth rate for the trading of European equities (31 percent) outstripped that of the United States (25 percent). We expect this trend to continue.
Meanwhile, the businesses that were supposed to save investment banks—M&A and equity origination—are becoming less attractive. They enjoyed record years in 1999 and 2000, but the sharp devaluation of technology stocks, the downturn in global equities markets, and the slowdown of many economies will all have their effect. In the United States, the telecom and technology sectors accounted for nearly 60 percent of investment-banking activity last year; this level is already falling off as investors question the growth trajectories of these businesses and as companies restructure their balance sheets.

A factory, not a fashion show

Far from killing the business of market making and brokerage, technology will actually save it

If market making and brokerage is an attractive business, why do so many industry players disparage it? The main reason is confusion about the role of technology. Far from killing the business, technology will actually save it. Sure, commissions and spreads are falling, and this trend won’t be reversed. The old people-intensive business model, for the most part, no longer holds. Huge parts of the business—trading in bonds, cash equities, and standardized derivatives—are becoming commoditized. Winning in this environment will require banks to reach unprecedented scale, and a handful of them will take the lion’s share of the profits. But emerging technologies will make competing in this new environment profitable for the eventual winners, allowing them to increase—dramatically—the volume of trades they can process while lowering their costs and increasing their profitability. The leading players will recognize that technology is an advantage, not a threat.
New systems can automate everything from front-end order capture to back-office clearing and settlement. At the front end, new services now enable both institutional and retail investors to enter their trades directly into their brokers’ systems or electronic communications networks (also known as alternative trading systems). Firms process far more trades, and both costs and errors are lower. Bloomberg, Bridge Information Systems, ITG, and Reuters offer such services, and most investors now have electronic-data-interchange links to their brokers.
Technology is also revolutionizing the post-trade process, reducing per-ticket clearing and settlement expenses. Cross-border European trades cost an estimated €28 ($24.90) to settle, compared with only €1 or €2 for settlements executed with more highly automated systems. To automate the back office, financial institutions should look at custodian and clearing banks. State Street, for example, has invested $250 million to $300 million annually in technology for the past five years and can now offer inexpensive back-office services to other firms. Financial institutions must keep an eye on these players, since they are now creeping into the execution of trades.

New systems allow trading firms to match trades internally, thereby capturing the entire spread between the bid and offer price

Paradoxically, technology can also increase margins per trade and improve the ability to manage the execution of block trading. New systems allow trading firms to match trades internally, thus capturing the full spread between the bid and offer price and avoiding exchange fees, though internalization can boost profits only for institutions with enough volume to ensure a high internal matching rate. New order-management software can automatically break up and manage large trades to minimize their impact on market prices, thereby giving the customer a better price and boosting margins in the process. This is particularly useful in portfolio reallocations, which entail the trading of large blocks of many different securities.
Newer technology can also give market makers and brokers a better understanding of their customer base. Banks and securities firms that have always won business by building personal relationships with a few big investors can now use software to determine the profitability and appropriate service levels for a much larger number of accounts. Another new technology will permit trading units to change their service model away from primarily "push" (deluging portfolio managers with the latest research) and more toward "pull," which allows investors to access research selectively and analysts to aggregate and tailor information easily. Multex.com, for example, gives investors access to research from most major institutions. Consortia such as Securities.Hub are making it possible for investors to access, in a single place, the initial-public-offering calendars, research, and other services of leading firms. All of these efforts increase margins per account and may boost trading volumes as well.

Getting to scale

Investing in these new technologies obviously raises the fixed costs of any trading business. Scale, which makes the business more attractive in several other ways, will therefore be needed. Besides lowering the marginal cost per trade, a greater volume of orders cuts volatility and risk. With a larger order flow, an institution can match more of its trades internally, thereby putting up less capital in each transaction and holding a smaller inventory of securities. As a result, there is a clear negative correlation between trading revenue and the value at risk (VAR) relative to trading volume (Exhibit 4).¹ Merrill Lynch and Morgan Stanley Dean Witter, for example, have a much lower VAR relative to their trading revenue than do firms that have smaller order flows. Bigger companies will find trading to be a more stable and profitable business.

In capturing additional order flow, players will also benefit from diversification. Institutional orders from mutual-fund managers, pension funds, and insurance companies are important because of those orders’ size and overall share of the market. But many institutional-investor segments trade infrequently and tend to base their buy and hold activities on fundamental portfolio decisions. Hedge funds are usually more active traders, with average turnover rates that are three or more times the size of their assets, so their order flow can provide valuable real-time information on market conditions. And banks can’t ignore retail customers: smaller trades are easier to execute and more richly priced. Furthermore, small orders (a proxy for retail trades) now represent around 70 percent of all trades executed in OTC stocks, up from 57 percent in 1994. Orders from outside the United States will also be important given the rapid growth of global securities trading.
Increasingly, winning businesses will need to provide services beyond trade execution. Some investment banks, for example, now offer prime brokerage services—all of the back-office and financing services that support a trade—to hedge funds and other players.
A faster way of capturing extra order flow, following the lead of wholesale trading houses in the OTC market such as Knight Trading Group and Spear, Leeds & Kellogg, is to purchase order flow from smaller broker-dealers. Because wholesalers process a large volume of trades, they can often act as the counterparty on both sides of a trade, thus boosting margins. Investment banks have recently bought several of these wholesalers: Goldman Sachs purchased Benjamin Jacobson & Sons and Spear, Leeds & Kellogg, while Merrill Lynch purchased Herzog Heine Geduld. But perhaps this model has been too successful, for few independent wholesalers are now left; Knight is the most important of them.
Acquiring customers in Europe is going to be more difficult for US banks, since European retail investors naturally turn to local institutions, and European bank acquisitions are complicated by large branch networks and strong labor unions. A more promising strategy is to capture order flow through another channel. Morgan Stanley and OM Gruppen, for example, launched Jiway, an exchange where retail investors trade the top European stocks (more than 400 of them at present). Goldman Sachs launched PrimeAccess, a service that provides international-trade execution, research, and some IPO allocations to on-line brokers (mostly in Europe), including Direct Anlage Bank and Banca Popolare di Verona. Merrill Lynch and Credit Suisse First Boston (CSFB) are launching similar services; to this end, CSFB built an alliance with Postbank’s on-line broker, Easytrade, in Germany.

A role for proprietary trading

Many banks abandoned the trading of securities because it has been associated, wrongly, with the scandals of so-called proprietary trading. In the second half of the 1990s, banks often put their own capital at risk to make speculative macroeconomic bets—for example, bets on the direction of interest rates or currency movements. Not surprisingly, the returns were highly volatile, and the shareholders and managers of these banks were sometimes caught off guard.
Such trading has received a huge amount of well-deserved bad press. These activities are essentially no different from what hedge funds do, but while George Soros’s investors are prepared, at least in theory, to stomach huge losses as well as gains, shareholders of blue-chip banks are not.² In recent years such opportunities have been more limited, and the resulting risk of these trades is better left to hedge funds, whose investors can diversify their own portfolios appropriately.
Most major banks have now scaled down these speculative activities, but taking principal positions is a necessary—and potentially lucrative—part of market making. The difference is that such positions are closely related to customer business, not speculative bets. In making markets or executing a large client trade, a bank must often take on some or most of the position for a period and stands to gain (or lose) from price movements during that time. In fixed-income businesses, trading gains (or losses) from this kind of activity can overwhelm spread or commission revenues. Naturally, banks also gain valuable information about market sentiment from market making. They can, and should, exploit this information to manage their inventory of securities efficiently and (if risk limits are observed) to gain from taking principal positions for the bank’s account.³

The sweet spots

Other parts of the trading business will continue to earn higher margins as well. One task that will never be fully automated is block trading, or executing the huge trades that would move prices too much if put into the market all at once. Traditionally, "upstairs" traders break these trades into smaller ones and work them over several days to obtain the best overall price for the customer. Electronic-trading algorithms are replacing some of this activity; trades of 100,000 (or even a million) shares may soon be executed electronically.4
Even so, the average size of block trades is increasing in parallel. Last year, J. P. Morgan executed a $1.9 billion trade; other trades too were reported to involve more than $1 billion. Given this trend, upstairs trading will always be needed. What will change is the definition of a block trade; in other words, the size of trades defined as block trades will increase.
Margins also remain substantial in more complex derivatives and bundled products. There has been tremendous growth, for example, in derivatives that allow would-be IPO millionaires to realize their assets before they exercise their options. Other opportunities exist for structuring intergenerational wealth transfers and for taking short positions on market movements for large investors. In fixed income, demand for credit derivatives is likely to continue growing despite recent hiccups. Bundled products, such as portfolio reallocation, index trading, and arbitrage, are attractive as well.

The low-margin commodity side of market making and brokerage will eventually look quite different from the higher-margin trading side

Over time, the low-margin commodity side of the trading business and the higher-margin areas will look very different. The former will be ruled by programmers developing new trading algorithms; the latter will remain labor-intensive and high touch. For those higher-margin areas, investments in talent will be of critical importance. Still, there will be important synergies between the two sides of the business. Proprietary trading, for instance, will depend on information that is derived from the flow of customer orders. With a strong flow, a trading firm can reduce its inventory and net more trades internally. We therefore expect the leading players to develop strong capabilities in both the automated, volume-driven business and the high-touch areas.

Only a few players will win

With the price of new technologies likely to be several hundred million dollars a year, competing in this new environment will hardly be cheap

With the price of new technologies and talent likely to be several hundred million dollars a year, competing in this new environment certainly will not be cheap. Some players are already investing heavily, and this seems to be paying off: investors report that the biggest spenders on all forms of information technology have lower trading costs than do their more frugal counterparts.
How should banks react? Different, and difficult, choices will have to be made. Institutions with a strong share of trading volume should move full-speed ahead. Given the scale and speed needed to win, Mergers and acquisitions are the most promising way to obtain new technology and order flow quickly; relying on organic growth will be difficult. A global presence is a necessity, since much of the growth will take place outside the United States, and some new technologies—and institutional learning—can be leveraged globally.5
To gain a foothold in other countries, joint ventures may offer an alternative. In Europe, for example, the prevalence of universal banking means that a pure-play acquisition is tough, and an acquisition of a universal bank would bring in several business lines that are much less attractive. At the same time, the biggest players can’t afford to ignore the talent needed for the high-margin parts of the business. Technology, scale, and skills will differentiate the best from the rest.
Yet the game isn’t over for smaller and more regionally oriented institutions. Smaller banks have a good position to make great outsourcing deals with larger players that want to gain order flow. Besides getting paid for order flow, smaller institutions might gain access, for example, to the larger bank’s research and IPO calendar. In Europe, several smaller or more retail-focused players have partnered with large trading houses to offer customers more cheaply executed trades, a broad array of research, and access to European and US securities. In addition, smaller firms can make markets in niche securities for which skill is more important than scale. The regional bank WestLB, for instance, may be able to compete successfully in making markets for some German derivatives.
Trading is being redefined by technology and is creating terrific opportunities for a host of banks. It is clearly time for another look.

About the Authors

Jonathan Davidson is a principal in McKinsey’s Toronto office; Léo Grépin is a consultant in the Montréal office; Charlotte Hogg is a principal in the Washington, DC, office.

McKinsey on Finance on iPad

Using your sales force to jump-start growth

There’s no escaping the impact of the sales force on your company’s growth trajectory. This is the frontline group best placed to gain an intimate understanding of existing customers, to observe the forces at work in an industry, and to identify potential new business. During the past year, we interviewed about 100 sales executives around the world, across a range of industries, to identify the critical elements that distinguish true sales leaders from also-rans. This article highlights four intriguing ideas the executives described for leveraging the sales force to jump-start growth. Together, these suggestions offer practical insights for sales groups, as well as a starting point for discussions among CEOs and other senior managers hoping to get more from sales and marketing investments.

Look over the horizon

The sudden arrival of a truly disruptive technology—one that upends markets in ways few anticipate—presents obvious challenges to industry incumbents. Yet it’s also a huge growth opportunity. One supplier of parts to high-tech manufacturers has created a team of “speculative market analysts” to better identify the emergence of disruptive technologies and to predict their business implications. The team helps the company to position itself as a supplier that’s ahead of the curve and to enjoy superior sales growth while competitors scramble to catch up.
The full-time team cuts across all business units and draws on a variety of internal and external sources: the sales force provides insights into the technology initiatives of the company’s customers while continually pressing them for feedback about its shortcomings and the efforts of competitors. In addition, the team closely scrutinizes all reports from competitors and customers—easier said than done, given the sheer volume of market information emanating from countries such as China. It even fosters close ties with venture capital firms and provides up-and-coming companies with funding and “sweat equity” to convert innovative concepts into realities. Together, these efforts have helped the company’s sales force to get ahead of recent major disruptive trends, including the boom in tablet devices and e-readers, as well as the growing fields of LED lighting and solar technology. What’s more, the team’s efforts are generating an estimated annual return on investment that exceeds 12 percent.

Hunt and farm

It’s easy for organizations to fall into the habit of seeking sales growth only through existing customers. Even though the sales force is typically best placed to find and approach potential clients, individual reps may shun the uncomfortable task of cold-calling in favor of selling to customers they know well. Yet there’s only so much each customer can buy, so finding new business is critical for growth.
One large distributor of auto parts tried tackling this problem by separating these activities. Its sales leader designated some reps as “hunters,” who focused exclusively on finding new prospects, while “farmer” reps concentrated on existing customers. The model succeeded initially but later foundered as hunters became discouraged by the time and effort required for their relatively scant wins, as well as the perception that they were second-class citizens compared with farmers.
As attrition rates among hunter reps grew, the sales leader changed tack. To demonstrate the importance of finding new customers, he designated one day a month as a “hunting day,” when all reps would exclusively chase new prospects. The rest of the time, they could focus largely on existing customers. The result was astounding: in a single day, the company signed up as many new customers as it normally did in two months. Setting aside one day a month for hunting new business is now an ingrained part of the company’s sales practices.

Motivate with more than money

The basic remuneration model for sales reps is simple: a base salary offers security; commissions and bonuses provide incentives to perform. Most companies work endlessly to optimize the balance. Yet what if money isn’t the thing that actually matters most? One financial-services company tried all manner of compensation plans before determining that while carrots and sticks did influence the sales performance of its financial advisers and sales managers, the results were short-lived.
As the company explored alternatives, its sales leader observed something important: the most successful advisers often spoke passionately about the sense of fulfillment that came from helping clients realize their dreams. Fundamentally, that was why these men and women had become financial advisers. The realization that money was just one of the factors driving performance prompted the sales leader to work with managers and individual advisers to develop specific goals that would help the advisers feel they had genuinely helped customers. Maybe it was prioritizing quality over quantity by working more intensely with fewer clients. Perhaps advisers needed a wider range of financial products to ensure that they had all possible options to meet their clients’ investment goals. At the same time, the company identified and laid out steps for overcoming potential bottlenecks, such as a lack of coaching, training, financial-management tools, or appropriate products.
The company knows that money remains critical to its sales team but now recognizes the benefits of identifying other, deeper motivations. The attrition rate among financial advisers has fallen sharply, and they not only have become more successful at winning business but also have found that clients are entrusting more of their wealth with the company. These goals have been met with no increase in the compensation of advisers.

Boost sales without slashing prices

Companies experiencing flat or declining sales often elect to cut prices to spur demand. Yet sometimes, averages lie: a decline across a market doesn’t mean that all market segments are weakening. A North American logistics company learned this lesson the hard way when it empowered sales reps to lower prices to meet management’s goal of boosting volumes. Because the price guidelines were set without taking into account the competitive dynamics of each specific market segment, only some reps recouped the cost of the price cuts with higher volumes. The company’s overall competitive position deteriorated.
Top management decided to recalibrate its approach. The characteristics of each of the company’s various market segments varied wildly. Some were growing fast in the wake of continuing property construction, population influxes, and investment; others were flat-lining. The sales reps got new price and volume targets based on each segment’s characteristics. These targets incorporated metrics such as the economic growth rate in geographies where particular industries were heavy users of the company’s services, the strength of the company’s operational assets relative to those of its competitors, and whether the company was losing or gaining customers at accelerating or decelerating rates.
This granular view of each sales territory led to new sales approaches. In higher-growth markets with limited competition, sales reps aggressively sought new business and raised prices where possible. In declining markets with stiffer competition, reps were authorized to cut prices to prevent customers from defecting. This market-by-market roadmap allowed the company not only to reverse several years of declining market share but also to secure an overall average price increase of 3 percent.

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https://www.mckinseyquarterly.com/Marketing/Sales_Distribution/Using_your_sales_force_to_jump-start_growth_2781

Leader Fatigue: Making the Difficult Choice to Move On

Late last week when Cathleen Black resigned after just three months as New York City's schools Chancellor, many influential New Yorkers decided that the way to analyze the event was as evidence of their mayor's stumbling. That's quite a turn of interpretation for a man who, for several years, seemed to be able to do no wrong. Not that long ago, Michael Bloomberg was being talked about widely as a post-partisan presidential possibility. The fact that the bloom is now off the rose, and constituents are said to be tiring of him, offers an important lesson in power for all of us.
Let's start by observing the obvious: that anyone who wields great power is bound to rub some people the wrong way, and those disaffected people accumulate over time. They also tend to have longer memories. As Dan Julius, a senior academic administrator now in the University of Alaska system told me years ago, "the things you did that upset people and create enmity live on much longer than what you did that people liked and created supporters." Thus, the goodwill Bloomberg earned during the successful tenure of former schools chancellor Joel Klein, and for the many things he has done to make New York more economically vibrant and livable, is rapidly degrading. People are already forgetting how he took on budget problems inherited from his predecessor, Rudy Giuliani, and helped the city successfully live within its means. Accomplishments seem to have a shorter half-life — at least in people's memories — than animosities.
This is one reason that leaders need to be "repotted" after a long tenure, believed Ernie Arbuckle, the Stanford Business School dean who did much to put the school on its successful trajectory. He noted that it becomes harder to get things done as resentments build and people get tired of you. Arbuckle stayed as dean for 10 years, then left to become chairman of the board of Wells Fargo for ten years, and after that, chairman of Saga Foods, also for ten years. (It will not surprise you to hear that he thought the right moment to "repot" was after ten years.) But he didn't see it as only a problem of perception. He also thought that, after a while in a given position, one's ability to see new challenges and opportunities clearly diminishes.
The problem is that most people, having attained a position of power, are reluctant to leave it and venture into new territory. Often, having racked up accomplishments and seen them celebrated, they are fired up by the possibility that, with a little more time, they could do more. In some cases, they cling to office because their age suggests they will not go on to scale any greater heights. Yale professor Jeffrey Sonnenfeld described this phenomenon in his decades-old book, The Hero's Farewell. In it Sonnenfeld noted that while some aging CEOs exited gracefully while they still enjoyed wide acclaim, many hung on too long, reluctant to face their own mortality. There was William Paley, the titan of CBS, who challenged his biographer by asking just why he had to die. And there was Armand Hammer, CEO of Occidental Petroleum, who put in place a long-term incentive plan for himself with a ten-year payout horizon — when he was in his 90s. Few executives or political leaders are as wise as UCLA's legendary basketball coach, John Wooden, who retired after winning his tenth championship — quitting while he was on top.
My wife has a phrase, "leave before the party's over," which contains much wisdom about the importance of leaving positions before our charms have faded, and about the discipline required to do so. By overstaying, leaders place themselves in situations where they become less effective, tarnish their legacies, and are therefore less able to move on to a new position of power. As Bloomberg's third term wears on, and wears thin, CEOs and other leaders would do well to heed its lessons.

Why Most Product Launches Fail

As partners in a firm that specializes in product launches, we regularly get calls from entrepreneurs and brand managers seeking help with their “revolutionary” products. After listening politely, we ask about the research supporting their claims. The classic response? “We haven’t done the research yet, but we know anecdotally that it works and is totally safe.” We’ve been fielding these calls for so long that we can often tell from one conversation whether the launch will succeed.

Most won’t. According to a leading market research firm, about 75% of consumer packaged goods and retail products fail to earn even $7.5 million during their first year. This is in part because of the intransigence of consumer shopping habits. The consultant Jack Trout has found that American families, on average, repeatedly buy the same 150 items, which constitute as much as 85% of their household needs; it’s hard to get something new on the radar. Even P&G routinely whiffs with product rollouts. Less than 3% of new consumer packaged goods exceed first-year sales of $50 million—considered the benchmark of a highly successful launch. And products that start out strong may have trouble sustaining success: We looked at more than 70 top products in the Most Memorable New Product Launch survey (which we help conduct) for the years 2002 through 2008. A dozen of them are already off the market.

Numerous factors can cause new products to fail. (See the sidebar “40 Ways to Crash a Product Launch.”) The biggest problem we’ve encountered is lack of preparation: Companies are so focused on designing and manufacturing new products that they postpone the hard work of getting ready to market them until too late in the game. Here are five other frequent, and frequently fatal, flaws.

Flaw 1: The company can’t support fast growth.

The Lesson: Have a plan to ramp up quickly if the product takes off.

Mosquito Magnet

In 2000 we worked with American Biophysics on the launch of its Mosquito Magnet, which uses carbon dioxide to lure mosquitoes into a trap. The timing was perfect: The West Nile virus scare had elevated mosquitoes from irritating nuisances to life-threatening disease carriers.
Mosquito Magnet quickly became one of the top-selling products in the Frontgate catalog and at Home Depot. But American Biophysics proved more adept at killing mosquitoes than at running a fast-growing consumer products company. When it expanded manufacturing from its low-volume Rhode Island facility to a mass-production plant in China, quality dropped. Consumers became angry, and a product that was saving lives almost went off the market. American Biophysics, which had once had $70 million in annual revenue, was sold to Woodstream for the bargain-basement price of $6 million. Mosquito Magnet is making money for Woodstream today, but the shareholders who originally funded the device have little to show for its belated success.

Flaw 2: The product falls short of claims and gets bashed.

The Lesson: Delay your launch until the product is really ready.

Microsoft Windows Vista

In 2007, when Microsoft launched Windows Vista, the media and the public had high expectations. So did the company, which allotted $500 million for marketing and predicted that 50% of users would run the premium edition within two years. But the software had so many compatibility and performance problems that even Microsoft’s most loyal customers revolted. Vista flopped, and Apple lampooned it in an ad campaign (“I’m a Mac”), causing many consumers to believe that Vista had even more problems than it did.

If Vista were launched today, the outcome might be even worse, owing to the rising popularity of Twitter and YouTube and the prevalence of Facebook “hate” pages. As social media and user-generated reviews proliferate, the power of negative feedback will only increase—making it even more imperative that products be ready before they hit the market.

Flaw 3: The new item exists in “product limbo.”

The Lesson: Test the product to make sure its differences will sway buyers.

Coca-Cola C2

For its biggest launch since Diet Coke, Coca-Cola identified a new market: 20- to 40-year-old men who liked the taste of Coke (but not its calories and carbs) and liked the no-calorie aspect of Diet Coke (but not its taste or feminine image). C2, which had half the calories and carbs and all the taste of original Coke, was introduced in 2004 with a $50 million advertising campaign.
However, the budget couldn’t overcome the fact that C2’s benefits weren’t distinctive enough. Men rejected the hybrid drink; they wanted full flavor with no calories or carbs, not half the calories and carbs. And the low-carb trend turned out to be short-lived. (Positioning a product to leverage a fad is a common mistake.)
Why didn’t these issues come up before the launch? Sometimes market research is skewed by asking the wrong questions or rendered useless by failing to look objectively at the results. New products can take on a life of their own within an organization, becoming so hyped that there’s no turning back. Coca-Cola’s management ultimately deemed C2 a failure. Worldwide case volume for all three drinks grew by only 2% in 2004 (and growth in North America was flat), suggesting that C2’s few sales came mostly at the expense of Coke and Diet Coke. The company learned from its mistake, though: A year later it launched Coke Zero, a no-calorie, full-flavor product that can be found on shelves—and in men’s hands—today.

Flaw 4: The product defines a new category and requires substantial consumer education—but doesn’t get it.

The Lesson: If consumers can’t quickly grasp how to use your product, it’s toast.

Febreze Scentstories

In 2004 P&G launched a scent “player” that looked like a CD player and emitted scents (contained on $5.99 discs with names like “Relaxing in the Hammock”) every 30 minutes. The company hired the singer Shania Twain for its launch commercials. This confused consumers, many of whom thought the device involved both music and scents, and the ambiguity caused Scentstories to fail.
When a product is truly revolutionary, celebrity spokespeople may do more harm than good. A strong educational campaign may be a better way to go. The product’s features provide the messages to build brand voice, aided by research and development teams, outside experts, and consumers who’ve tested and love the product.

Flaw 5: The product is revolutionary, but there’s no market for it.

The Lesson: Don’t gloss over the basic questions “Who will buy this and at what price?”

Segway

The buzz spiraled out of control when news of a secret new product code-named Ginger and created by the renowned inventor Dean Kamen leaked to the press nearly 12 months before the product’s release. Kamen, it was said, was coming up with nothing less than an alternative to the automobile. When investors and the public learned that the invention was actually a technologically advanced motorized scooter, they were dumbfounded. Ads showing riders who looked like circus performers perching on weird-looking chariots didn’t help, nor did the price tag—$5,000. Instead of selling 10,000 machines a week, as Kamen had predicted, the Segway sold about 24,000 in its first five years. Now it sells for far less to police forces, urban tour guides, and warehouse companies, not the general public. If there was ever a product to disprove the axiom “If you build it, they will come,” it’s the Segway.

 

Some of these problems are more fixable than others. Flaws 1 and 2 are largely matters of timing: If the launches of Mosquito Magnet and Microsoft Vista had been postponed, the manufacturing and quality problems might have been resolved. Even though companies may be wedded to long-established or seasonal launch dates, they would do well to delay if waiting might increase the odds of success. Flaws 3, 4, and 5 are trickier, because they relate more directly to the product itself. Managers must learn to engage the brand team and marketing, sales, advertising, public relations, and web professionals early on, thus gaining valuable feedback that can help steer a launch or, if necessary, abort it. Hearing opposing opinions can be painful—but not as painful as launching a product that’s not right for the market or has no market at all.

http://hbr.org/2011/04/why-most-product-launches-fail/ar/3

Incentive or Gift? How Perception of Employee Stock Options Affects Performance

The basic theory of why companies issue stock options to their employees is fairly simple: The more that a firm's stock price increases, the greater the profit from exercising those options, creating what employers hope is a valuable incentive that will motivate employees to focus on making the company more successful and more profitable.
But new Wharton research shows that managers may not view stock options as an incentive at all. In a paper titled, "Stock Option Exercise and Gift Exchange Relationships: Evidence for a Large U.S. Company," management professor Peter Cappelli and Martin J. Conyon, a senior fellow at Wharton's Center for Human Resources, found the practice impacted employee performance after workers earned a sizable payoff from exercising their stock options. Even then, the employees viewed the options not as an incentive, but as a gift they felt compelled to repay by working harder.
"The reciprocity effect we found is really bigger than the incentive effect," Cappelli says. "We found that when the company does well and the share price goes up and people make more money, their performance in the next period goes up as well. The story reminds us that the workplace is a psychological place and a social place, as well."
Indeed, the patterns uncovered by Cappelli and Conyon might cause companies to reconsider the ways that stock options are used. As outlined by the paper, the stock option arguably functions more as a lottery, with those employees who were lucky to sell their shares at exactly the right time delivering the expected better performance, while others do not.
"The story is not that people work harder to make the share price go up," Cappelli noted. "It is that if the share price goes up and people make money, they feel an obligation to work harder. That's a bit of a surprise."
The Impulse to Give Back
Boosting the research effort was a large amount of data provided by a major American public corporation. The firm granted stock options to the 4,500 employees -- primarily store managers -- based solely on their level within the company hierarchy, as opposed to job performance. Because these lower-level managers were largely responsible only for the sales performance in individual stores, there was little chance that their day-to-day work would actually directly influence share price, or that the manager would perceive such an impact.
The issue is significant because over the last two decades, American firms have both greatly increased use of a stock option plan as a form of employee compensation, and broadened the class of eligible employees to include more than just the most elite executives. According to the National Center for Employee Ownership, only one million U.S. employees held stock options in 1990. That figure has since skyrocketed to nine million workers now participating in roughly 30,000 different plans.
Despite the wide number of stock option plans, the philosophy behind each of these programs is essentially the same. The company grants employees the option to sell a set number of company shares when the price of the stock goes above a fixed level within a fixed period of time. Of course, the higher the stock price, the greater a profit an employee sees -- either on paper or in cash if he or she immediately sells those shares. Thus, leadership at firms offering this benefit expect it to result in better employee performance, or creative ideas to boost profits and sales in ways that would have a positive effect on the stock.
Past studies have shown some positive effects from stock option programs -- particularly when it comes to retaining employees in a more competitive labor market. But experts have long questioned the options' role as a workplace incentive, since the connection between any individual's job performance and the company's share price is highly abstract, as opposed to a manager's bonus for meeting a specific sales or cost-cutting goal. "Think about how hard an individual manager would have to work to drive the share price of their company up," Cappelli points out. "There is so little connection between your efforts and share prices."
Cappelli and Conyon's hypothesis was based upon the notion that the gains from stock options are not necessarily expected, and therefore act as more of a gift from the employer than as an incentive. To test this theory, they first examined decades of research into how gifts affect human behavior.
Anthropologists studying Stone Age cultures, or more modern but primitive social structures in remote areas, have found examples of a so-called "gift economy," in which an abundance of food or other material is shared, causing recipients to feel a moral obligation to give back. Other studies demonstrate that this basic tendency of human nature extends into more advanced and sophisticated social settings, and that the impulse toward "reciprocity" often becomes a moral imperative, even with no express obligation to offer something in return.
To fully demonstrate their hypothesis, the researchers hoped to show that the larger the perceived gift, the greater the subsequent improvement in employee performance. Cappelli says the data made available by the unnamed company afforded a unique opportunity to examine the links between exercising stock options and worker performance. The firm evaluates its managers on a numerical scale every year, he notes, looking at both objective performance outcomes such as store sales, as well as subjective evaluations. These worker ratings could then be plotted against financial data from the exercise of the stock options.
According to Cappelli, earlier academic exercises that looked at the impact of gift exchanges on worker performance are mainly based on laboratory experiments of contrived circumstances. "This is not an experiment," he says of the data supplied by the company. "This is the real workplace."
It All Comes Down to Price
One of the most critical variables was showing that the size of the stock profits realized by the managers was essentially the result of good luck in when they decided to sell, and not an indicator of either inside company knowledge or a special knack for timing the stock market. "Even top executives don't do better than the average investor in making these selling decisions," Cappelli states, noting that the majority of the employees in the study were store managers, not experienced stock traders. "Markets are pretty unpredictable, and there's strong evidence that they don't do well in timing the market."
Despite the unpredictable nature of the market, the researchers also found -- based on this study and earlier efforts -- that employees who profited handsomely from exercising their stock options appear to give a lot of the credit to the positive attributes of the company. "The reason why it is sensible to think that employees would attribute at least some of the value of the profit from options as coming from the employer is precisely because that is how employers represent it," the researchers write in the paper. "They go to considerable lengths to persuade shareholders that improvements in share prices are attributable to the actions of the firm."
In order to effectively gauge the impact of profits from the exercise of the stock options, Cappelli and Conyon took into account a number of other variables, including differences in pay and bonuses; the employees' ages and health, and the number of shares that each continued to hold in his or her account after selling. They also looked at the relationship between the gains from stock options and the incidence of being dismissed by the company for poor performance.
The researchers found that a doubling of the profits from a sale of options resulted in a 1.3% increase in performance appraisal scores and a 1.1% decrease in performance-related dismissals -- numbers that were statistically significant and meaningful in the broader context of the company data. According to Cappelli and Conyon, the data suggests that a company would have to increase the number of options awarded to employees by sevenfold to achieve the same impact on worker performance as a doubling of the profits from options.
"This shows that we're not strictly economic in our relationships," Cappelli says. "The proof of that is these folks who feel that they have been given a gift that they didn't expect for their performance. There is nothing that requires them to reciprocate by performing better, but they do anyway." Indeed, the research suggests that the improved performance after a profitable exercise of stock options typically lasts for a year or longer.
But the findings also raise questions for the many firms that offer stock options as a benefit, since the research shows that the impact on employee performance really depends on the price at which employees sell their shares, which changes in ways that are essentially unpredictable -- and mostly out of the control of company leadership.
"If I'm running a company, and I'm looking at this and we decide that we want to give everybody a stock option, I would start to question that a little," Cappelli notes. He and Conyon also suggest avenues for future research, including an examination of the effect that selling just before share prices reach a high has on employee performance. "It would also be interesting to see whether these gift exchange effects exist, or perhaps vary, across other aspects of job performance, such as cooperative behaviors or good citizen behavior that is harder to observe," they write.
Ironically, the main lesson for top executives from the research may be for companies to continue emphasizing the importance of keeping share price as high as possible -- a focus that has drawn criticism for its effect on other areas of doing business, such as taking on too much risk or engaging in short-term leadership initiatives. "Here's a reminder," says Cappelli, "that what really matters is what happens with share prices."
 http://knowledge.wharton.upenn.edu/article.cfm?articleid=2749

Inflation? What is inflation? What the heck is it?

If you are interested in economics, you may realize that three most important figures are employment rate, interest rate and inflation rate. Frankly, I see these rates every single day, especially inflation one. More terrible, newspapers keep bombing us with fear and greed about inflation. I do not believe so. I just read a very good comprehensive article about inflation. I would like to put it into my blog for further reference. Inflation is not as fearful as we, normal people, have thought.

In a high-profile research paper titled "Understanding the Evolving Inflation Process," published recently, a group of private-sector and academic economists have endorsed the Fed's policy of price stability and transparency as an important tool in keeping inflation at bay.[1]
Economists have however, warned the Fed not to rely too much on inflationary expectations as the main tool for controlling inflation. The writers of the paper maintain that their research shows that inflationary expectations actually don't cause inflation, but that things are the other way around.
The heart of their analysis is a modified Phillips Curve equation, which is labeled the New Keynesian Phillips Curve (NKPC). What drives the inflationary process in this way of thinking is expected inflation, past inflation, the real output gap and some disturbances, i.e., irregular events. In this way of thinking an increase in the output gap — i.e. a relative increase in actual output versus potential output — gives rise to inflationary pressures.
Using the NKPC and two other equations that deal with the output gap and interest rate determination, the researchers have made an attempt to explain the reason behind the great inflation between the mid-1960s and the late 1970s. The economists have also produced an explanation for the fall in the pace of inflation since the early 1980s. The reason for the great inflation, according to the paper, is the lack of willingness on behalf of Fed officials back then to stick to the goal of keeping prices stable. While the reason for moderate inflation since the 1980s, according to these economists, is central bankers commitment to price stability.
Despite the use of sophisticated mathematical and statistical techniques, the research paper never gets to the heart of the phenomenon of inflation. Also, the paper deals with the description of price changes without acknowledging any role that money might have had in these changes. The entire framework is based on a dubious modified Phillips curve and a black-box, time-series analysis. Whilst the research paper mentions extensively the word "inflation," it never even attempts to define this term. The lack of a clear identification of what inflation is all about casts doubt on various conclusions that the writers of this paper have reached. Covering undefined terms with mathematical dressing cannot make the analysis more meaningful if the object of the analysis is not clearly identified.
Defining inflation
The subject matter of inflation is the debasement of money. For instance, historically inflation originated when a ruler would force the citizens to give him all the gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return to the citizens diluted gold coins. On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins for his own use. (He could now divert real resources to himself). In short, what was now passing as a pure gold coin was in fact a diluted gold coin. The expansion in the diluted coins that masquerade as pure gold coins is what inflation is all about. As a result of inflation, the ruler could engage in an exchange of nothing for something.
Under the gold standard, the technique of abusing the medium of the exchange became much more advanced through the issuance of paper money unbacked by gold. Inflation therefore means here an increase in the amount of paper receipts that are not backed by gold yet masquerade as true representatives of money proper, gold. Again the holder of unbacked money can now engage in an exchange of nothing for something.
In the modern world the money proper is no longer gold but rather paper money hence inflation in this case is purely the increase in the stock of paper money. Please note we don't say as monetarists are saying that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.
Once it is established that the subject matter of inflation is the expansion of the money stock, we can attempt to ascertain whether the Fed is an inflation fighter.
Monetary inflation and prices
Most economists and commentators define inflation as a general rise in prices, which is summarized by the so-called consumer price index (CPI). While a general rise in prices may be associated with inflation, it is however not inflation. What is the price of a good? It is the amount of money asked per unit of a good. (Observe that without money one cannot even begin to discuss what prices are.)
Now, if for a given stock of goods an increase in the money supply occurs, this would mean that more money is going to be exchanged for a given stock of goods. Obviously then the purchasing power of money is going to fall, i.e., the prices of goods are going to increase (more money per unit of a good). In short, in this case inflation is associated with the general increase in prices.
But now consider the following case: the rate of growth in money is in line with the rate of growth in goods. Consequently, there is no change in prices of goods. Do we have inflation here or don't we?
For most economists, if an increase in the money supply is exactly matched by the increase in the production of goods, then this is fine, since no increase in general prices has taken place and therefore no inflation has emerged. We suggest that this way of thinking is false since inflation has taken place, i.e., the money supply has increased. This increase cannot be undone by the corresponding increase in the production of goods and services.
For instance, once a king has created more diluted gold coins that masquerade as pure gold coins he be able to exchange nothing for something irrespective of the rate of growth of the production of goods. In short, regardless of what the production of goods is doing, the king is now engaging in an exchange of nothing for something, i.e., diverting resources to himself by paying nothing in return. The same logic can be applied to money paper inflation. The exchange of nothing for something that the expansion of money sets in motion cannot be undone by the increase in the production of goods. The increase in money supply — i.e., the increase in inflation — is going to set in motion all the negative side effects that money printing does, including the menace of the boom-bust cycle, regardless of the increase in the production of goods.
For mainstream economists, an increase in economic activity is almost always seen as a trigger for a general rise in prices, which they erroneously label inflation. But why should an increase in the production of goods lead to a general increase in prices? If the money stock stays intact, then we will have here a situation of less money per unit of a good — a fall in prices. This conclusion is not affected even if the so-called economy operates very close to "potential output" (another dubious term used by mainstream economists). Only if the pace of money expansion surpasses the pace of increase in the production of goods will we have a general increase in prices. Note that this increase is only on account of the inflation of money and not on account of the increase in the production of goods.
Another popular explanation for a general rise in prices is the increase in wages once the economy is close to the potential output. If the amount of money remains unchanged then it is not possible to raise all the prices of goods and wages. So again the trigger for a general rise in prices has to be monetary expansion.
Having established that inflation means monetary expansion, we suggest that the key factor behind the acceleration in prices in the period of mid '60s to late '70s is  the strong monetary expansion in that period.
In relation to its 12-month moving average, our measure of money AMS followed an exponential path (see chart). For instance, in August 1969 the differential between the AMS and its 12-mma stood at negative 0.5 against positive differential of 21 in December 1979. It is therefore not a big surprise that the gap between the CPI and its 12-month moving average jumped to 4 by December 1979 from 0.9 in August 1969 (see chart).
In contrast, since 1980 monetary expansion has not been as aggressive relative to its 12-month moving average. In relation to its 12-month moving average, AMS has been trend-less (see chart). So it is not surprising that the CPI in relation to its 12-month moving average has also been trend-less (see chart). The introduction of new technology has probably given a boost to the production of goods, which in turn has contributed to the lowering of the general increase in prices. Another positive is the strong increase in the supply of goods from various economies such as the former Soviet block and China.
Contrary to popular thinking, the Fed's preoccupation with price stability, by keeping the rate increases in the CPI at a particular acceptable range, can actually generate nasty surprises. For instance, as a result of strong monetary expansion and a correspondingly strong increase in the production of goods, prices remain stable. Notwithstanding this stability, various nasty side effects that emanate from monetary expansion are likely to emerge. Hence we suggest that Fed policy makers should pay close attention to the sources of monetary inflation rather than focusing on the symptoms of inflation.

$29

On this Rothbard wrote,

The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the Great Depression caught them completely unaware.[2]

Similarly Mises explained in his essay "Inflation: An Unworkable Fiscal Policy,"

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term "inflation" to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. …  As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.[3]

But if the Fed were to acknowledge that inflation is actually printing money, then it would mean that the US central bank is not an inflation fighter but is itself the key source of inflation. After all, without the Fed's monetary expansion, the whole machinery of inflation would have fallen apart.

http://mises.org/daily/2525

You’ve Passed the Interview. Now Give Us a Presentation.

This interview with Chris Cunningham, co-founder and C.E.O. of Appssavvy, a social media-focused marketing firm, was conducted and condensed by Adam Bryant. (The New York Times has an ownership stake in Appssavvy of less than 5 percent.) 

Q. Do you remember the first time you were somebody’s boss? 
A. It was when I started a magazine in North Carolina called the Vagabond. And the vision was to enable business travelers and families to discover restaurants, hotels and golf courses in 50 top cities. It is the same theory that I believe in today with Appssavvy, which is to be really clear about the vision and how you’re going to get there, and tell people how their involvement will be meaningful. The more you can make people feel that they have a hand at the wheel, that they’re driving something, the more that they’ll participate and own it like you own it. 
 From my experience, if you have an army of people who believe as passionately about the goal and the vision, you’re going to find a lot more success than by using the theory of command and demand. 
Q. And what were some early leadership lessons?
A. I was born in Finland. My grandfather started a paper company in Finland, and I had experience in high school as an intern selling paper products internationally from a desk outside of Helsinki. And I didn’t really know what I was doing other than having a phone and a piece of paper and some sort of concept of the products. But learning how to sell internationally gave me confidence to do things at an early age. 
You also learn through sports — and I was a sports junkie, from hockey to football to lacrosse — what you have in your gut, in your heart, and you learn about your ability to get people to listen. Most of the time, people will listen to you not just because of the direction you set, but also because of the follow-through and the execution. 
Q. How do you hire?
A. We look for people who really want the job. And that sounds really simple to say, but some of the most important people in the organization who shine and are really transformative people were the ones who were almost jumping out of the chair, saying: “I have to be here. I’ve been studying this company. This is all I’ve ever wanted. And if I’m not here, I’m not going to be happy.” Those individuals took that extra step as well to follow through after the interview. We watch how quickly the person follows through, and how much thought they put into how they want to contribute. But how badly do they want the job — I can’t stress that piece enough. 
Their résumé, I believe, is one of the least-valuable components of an interview. For me, primarily it sits on the desk as a reference point, and to potentially make that person feel comfortable that I’m a professional C.E.O. But the truth is, I’m not interested in the résumé. I’m more interested in understanding the time that the person took in understanding our business, product and the industry landscape. 
I spend a lot of time asking about the challenges people have faced in prior work environments, and how they would behave or react in an unfamiliar situation where they might not be too comfortable. The people who are able to respond quite quickly and have very short, concise answers to how they would overcome a problematic situation typically are the ones who seem to possess leadership skills. You have to ensure that you’re not just hiring a person because you have an opening, but you want people who possess leadership qualities so that they could replace the person who’s hiring them. 
Q. Can you elaborate on this quality of facing down challenges?
A. I ask them to recall real examples. It can potentially expose something that we believe is very important, which is problem-solving. Great leaders can take the initiative and solve problems on their own. So we ask: Were you in a challenging predicament, and faced with a scenario that you were not used to? What did you do? Who do you reach out to? How did you go about handling this? How would you follow through on it?
Some of the biggest misses, I think, come from people not following through. A great idea or solution is only as strong as the follow-through. Nothing will potentially frustrate me more than if there’s no action item. If you follow through, that is a tremendous asset that a lot of individuals don’t necessarily possess. 
Q. What else is unusual about your hiring process?

 A. Every job candidate must present to five to seven people as the final step before we hire them. We will give them a real-life example from our company and ask them to make a presentation. That is literally where you can just make or break it, and find out if they’re an all-star or whether you just avoided making a bad hire. If someone can come up with a great idea for the proposal and present it without becoming nervous or uncomfortable, and hold their own in the Q.& A., you have a slam dunk.
Those presentations are an extra layer of protection. The process gives us the confidence that this person actually understands the market, and it also makes us feel confident that the training wheels won’t be on for that long. Because in a small start-up company, there isn’t a lot of time for training. There isn’t a handbook sitting on the coffee table. There isn’t somebody who’s going to be your mentor. 
Q. What else is important in the culture you’re creating?
 A. I think another important component is treating people well, making them feel that they’re cared for, they’re looked after — good days and bad days — and that the door’s always open. There’s so much more, I think, that most companies probably don’t get out of their people because they just go to work for a paycheck, and they look at the clock, 9 to 5. People want to feel like they’re part of building something. So you treat people well, and make sure that they fundamentally understand that you do care about them as people. And you do what you say. I often hear stories from people in interviews where they’ll say, “Well, I was promised this, but I didn’t get it.”
So if you do everything you say you were going to do, then you’ve just cemented additional trust, which means you’re going to find another 25 percent or so of work ethic and commitment that most organizations don’t have. You can’t extract that 25 percent through command or demand or force or threats or anything else. The only way you can extract that 100 percent threshold or even 110 percent — with somebody wanting to work on a weekend or wanting to get in early, whatever the case may be — it’s because of those commitments and promises, and the follow-through that they’ve experienced, and that their peers experienced. If you don’t have that, then you’re only going to get 75 percent of that employee. That follow-through and that commitment is absolutely critical. If you don’t do it, there could be a potential domino effect. 
Q. You’ve talked a lot about the importance of follow-through. Is that because people promised things to you that they didn’t deliver on?
A. Yes, I’ve had a few experiences where there were big promises made, and there was just an overwhelming amount of commitment that I personally made, and an overwhelming amount of sacrifice. And the leadership did not follow through on their promise. That was a big never-do-what-that-guy-did lesson. That left a very bad taste in my mouth, and one where I think I learned a lot of the things that you don’t want to do. So you don’t overcommit, you don’t overextend, and the commitments that you do make, you actually follow through on.
Q. In reading some materials about you, it said one of your favorite expressions is “crush.”
 A. I started saying “crush” three years ago — it’s just a word that I’ve used. We’re going to crush it. We’re going to crush it this year. There aren’t that many words that I think sort of embody the sense of confidence, that we’re going to go for it. And people want to hear that. I think part of leadership is saying, “I’m going to go into battle with you.” For whatever reason, crush just feels like the essence of what we’re going to do. We’re going to crush the competition. The next thing you know, you hear another person saying crush. And then they’ll sign off “crush” on e-mail. And then you go into a meeting and three people will be talking about crushing it. It’s literally part of our culture right now. It’s funny how this one word has literally just carried through everything we do. People want that level of energy. 
Q. What would you tell other entrepreneurs about building a culture early on?
 A. It’s important to celebrate every minor accomplishment. When we got a couple, three chairs in a shared office space, that was a moment to open some beer. And the first check is on the wall. Make sure that you recognize the early accomplishments, because it’s very easy to work for eight months straight and wonder why you’re working on Saturdays and Sundays. Whatever your metric is — traffic, or revenue, or whatever — celebrate those things, because those actually kind of help you stay alive and survive. And it could be the smallest win, but celebrate those wins, and celebrate them often. 
Q. What advice would you give to business school students?
 A. The biggest piece of advice I could give a business school student is that if you want something, tell them that you want it. There was one guy I interviewed — he works at the company now — but he was really soft-spoken. I said after the interview, “Let’s go get a beer.” And we were sitting there, and I said: “Dude, do you want this job? What’s wrong with you?” He said, “What do you mean, what’s wrong with me?” I said, “You’re giving me nothing.” 
Q. Obviously he said something that won you over, since you hired him.
A. He said, “I really want to be here.” Some people just need that pinch. They need to be sparked. Not everyone’s going to jump up out of their chair and say “I want the job, this is my job, and no one else should have this job.” But sometimes there are ones who you really like, and there’s something about this individual that makes you feel they can be instrumental in growing the business, and it’s important to give them a nudge.  

The Problem with Financial Incentives -- and What to Do About It

Bonuses and stock options often improve performance. But they can also lead to unethical behavior, fuel turnover and foster envy and discontent. In this opinion piece, Wharton management professors Adam Grant and Jitendra Singh argue that it is time to cut back on money as a chief motivational force in business. Instead, they say, employers should pay greater attention to intrinsic motivation. That means designing jobs that provide opportunities to make choices, develop skills, do work that matters and build meaningful interpersonal connections.
Enron. Tyco. WorldCom. The financial crisis. As corporate scandals and ethical fiascoes shatter the American economy, it is time to take a step back and reflect. What do these disasters have in common? We believe that excessive reliance on financial incentives is a key culprit.
Starting in the mid to late 1970s and 1980s, the view emerged in management thinking that the primary role of corporate leadership was to maximize the interests of shareholders. In time, this view came to be known as financialization, and maximizing shareholder value became the reigning mantra. Over time, the belief became almost axiomatic; questioning it was tantamount to heresy in many schools of thought.
This broader perspective translated at lower levels of organizations into an emphasis on rewarding employees with financial incentives contingent upon performance. The thinking seemed to be: Get the incentives right, and people will be motivated to perform better, resulting in better performance for the firm. Researchers Brian Hall of Harvard Business School and Kevin Murphy of the University of Southern California found that less than 10% of total executive compensation at publicly held firms was contingent on stock prices in the early 1990s, but by 2003 that share had ballooned to almost 70%. And despite the bad press and public uproar that big payouts generated in the wake of the financial crisis -- when critics pointed out that many top executives had been heavily rewarded for short-term performances that ultimately proved disastrous -- the system marches on. CEO bonuses at 50 big U.S. companies rose more than 30% last year, a gain not seen since before the recession, The Wall Street Journal reported in mid-March.
To be clear, we are not suggesting that companies abandon financial incentives. Indeed, there is a wealth of evidence that these incentives can motivate higher levels of performance and productivity. To assess results across multiple studies, researchers have used a technique called meta-analysis. As Sara Rynes of the University of Iowa and her colleagues summarize, on average, individual financial incentives increase employee performance and productivity by 42% to 49%.
But these gains come at a cost. Our concern is about the unintended consequences of financial incentives. What do they mean for unethical behavior, jealousy and turnover, and intrinsic interest in the work? And what measures can be taken to lessen their negative impact?
Three Important Risks
Several years ago, Green Giant, a unit of General Mills, had a problem at one of its plants: Frozen peas were being packaged with insect parts. Hoping to improve product quality and cleanliness, managers designed an incentive scheme in which employees received a bonus for finding insect parts. Employees responded by bringing insect parts from home, planting them in frozen pea packages and then "finding" them to earn the bonus.
This is a relatively benign example, but it points to a serious problem. Incentives can enhance performance, but they don't guarantee that employees will earn them by following the most moral or ethical paths. Research by Wharton management professor Maurice Schweitzer and colleagues demonstrates that when people are rewarded for goal achievement, they are more likely to engage in unethical behavior, such as cheating by overstating their performance. This is especially likely when employees fall just short of their goals. Harvard Business School's Michael Jensen has gone so far as to propose that cheating to earn bonuses -- such as by shipping unfinished products or cooking the books to exceed analysts' expectations -- has become the norm at many companies.
When strong financial incentives are in place, many employees will cross ethical boundaries to earn them, convincing themselves that the ends justify the means. When we value a reward, we often choose the shortest, easiest path to attaining it -- and then persuade ourselves that we did no wrong. This tendency to rationalize our own behavior is so pervasive that psychologists Carol Tavris and Elliot Aronson recently published a book called Mistakes Were Made (but not by me) to explain how we justify harmful decisions and unethical acts.
In addition to encouraging bad behavior, financial incentives carry the cost of creating pay inequality, which can fuel turnover and harm performance. When financial rewards are based on performance, managers and employees doing the same jobs receive different levels of compensation. Numerous studies have shown that people judge the fairness of their pay not in absolute terms, but rather in terms of how it compares with the pay earned by peers. As a result, pay inequality can lead to frustration, jealousy, envy, disappointment and resentment. This is because compensation does not only enable us to support ourselves and our families; it is also a signal of our value and status in an organization. At Google in 2004, Larry Page and Sergey Brin created Founders' Awards to give multimillion-dollar stock grants to employees who made major contributions. The goal was to attract, reward and retain key employees, but blogger Greg Linden reports that the grants "backfired because those who didn't get them felt overlooked."
This claim is supported by rigorous evidence. Notre Dame's Matt Bloom has shown that companies with higher pay inequality suffer from greater manager and employee turnover. He also finds that major league baseball teams with larger gaps between the highest-paid and lowest-paid players lose more games; they score fewer runs and let in more runs than teams with more compressed pay distributions. The benefits to the high performers are seemingly outweighed by the costs to the low performers, who apparently feel unfairly treated and reduce their effort as a result.
Similarly, Phyllis Siegel at Rutgers and Donald Hambrick at Penn State have shown that high-technology firms with greater pay inequality in their top management teams have lower average market-to-book value and shareholder returns. The researchers explain: "Although a pay scheme that rewards individuals based on their respective values to the firm does not seem unhealthy on the surface, it can potentially generate negative effects on collaboration, as executives engage in invidious comparisons with each other."
Other studies have shown that executives are more likely to leave companies with high pay inequality. The bottom line here is that financial incentives, by definition, create inequalities in pay that often undermine performance, collaboration and retention.
A third risk of financial incentives lies in reducing intrinsic motivation. In the 1970s, Stanford's Mark Lepper and colleagues designed a study in which participants were invited to play games for fun. The researchers then began providing rewards for success. When they took away the rewards, participants stopped playing. What started as a fun game became work when performance was rewarded. This is known as the overjustification effect: Our intrinsic interest in a task can be overshadowed by a strong incentive, which convinces us that we are working for the incentive. Numerous studies spearheaded by University of Rochester psychologists Edward Deci and Richard Ryan have shown that rewards often undermine our intrinsic motivation to work on interesting, challenging tasks -- especially when they are announced in advance or delivered in a controlling manner.
Autonomy, Mastery and Purpose
So, the good results generated by financial incentives need to be weighed against the bad: encouraging unethical behavior; creating pay inequality that reduces performance and increases turnover; and decreasing intrinsic interest in the work. To limit the negative effects, we recommend that financial incentives should be (a) used primarily for tasks that are uninteresting to most employees, (b) delivered in small sizes so that they do not undermine intrinsic motivation and (c) supplemented with major initiatives to support intrinsic motivation.
Stanford's Chip Heath has shown that managers tend to have a strong bias in favor of extrinsic incentives: They rely too heavily on financial rewards, underestimating the importance of intrinsic motivation. In Drive: The Surprising Truth About What Motivates Us, Daniel Pink summarizes a rich body of evidence that intrinsic motivation is often supported by three key factors: autonomy, mastery and purpose. High effort and performance often result from designing jobs to provide freedom of choice, the chance to develop one's skills and expertise and the opportunity to do work that matters. Evidence also supports the importance of a fourth factor: a sense of connection with other people.
Autonomy involves freedom of choice in what to do, when to do it, where to do it and how to do it. Extensive research has shown that when individuals and teams are given autonomy, they experience greater responsibility for their work, invest more time and energy in it, develop more efficient and innovative processes for completing it and ultimately produce higher quality and quantity. For example, in a study at a printing company, Michigan State's Fred Morgeson and colleagues found that when teams lacked clear feedback and information systems, giving them autonomy led them to expend more effort, use more skills and spend more time solving problems. Numerous other studies have shown that allowing employees to exercise choices about goals, tasks, work schedules and work methods can increase their motivation and performance.
Mastery involves the chance to develop specialized knowledge, skills and expertise. Research shows that when employees are given opportunities for mastery, they naturally pursue opportunities to learn and contribute. For instance, research by the University of Sheffield's Toby Wall and colleagues documented the benefits of giving operators of manufacturing equipment the chance to develop the skills to repair machines, rather than waiting for engineers, programmers and supervisors to fix them. The operators took advantage of this opportunity for mastery to create strategies for reducing machine downtime, and worked to learn how to prevent problems in the future. As a result, they were able to complete repairs more quickly and reduce the overall number of repairs.
Purpose involves the experience of contributing to a meaningful effort or cause. Adam Grant (one of the authors of this piece) has shown that when employees meet even a single client, customer or end user who benefits from their work, they gain a clearer understanding of the purpose of their jobs, which motivates them to work harder and smarter. For example, when university fundraisers met a single scholarship student who benefited from the money that they raised, the number of calls they made per hour more than doubled and their weekly revenue jumped by 500%. And when radiologists saw a photo of the patient whose X-ray they were evaluating, they felt more empathy, worked harder and achieved greater diagnostic accuracy. In The India Way, Wharton management professors Peter Cappelli, Harbir Singh, Jitendra Singh (one author of this piece) and Michael Useem observe that Indian companies have found success in motivating employees by cultivating a strong sense of purpose and mission. As Adam Smith, the father of economics, wrote in A Theory of Moral Sentiments: "How selfish soever man may be supposed there are evidently some principles in his nature which interest him in the fortunes of others, and render their happiness necessary to him, although he derives nothing from it except the pleasure of seeing it."
Connection involves a sense of community, belongingness and being valued by others. Although financial incentives can support connection for star performers, they often impede it for the rest of the organization by creating pay inequality. Studies consistently show that the strongest driver of turnover is not pay, but rather the quality of an employee's relationships with supervisors, co-workers and customers. In a meta-analysis led by Rodger Griffeth of Georgia State University, the quality of relationships with their direct bosses explained more than twice as much variance in employees' decisions to quit as did their objective pay levels or satisfaction with their pay. Even a small but genuine gesture of thanks can help employees feel valued. In a study conducted with Francesca Gino of Harvard Business School, Adam Grant found that the effort of call center employees increased by 51% during the week after an external manager paid them a single visit to express appreciation for their work. In short, relationships matter for retention and motivation.
Finding the Right Context
Researchers Amy Mickel of California State University, Sacramento, and Lisa Barron of the University of California, Irvine, have argued that managers should think more carefully about the symbolic power of financial incentives: who distributes them, why they are distributed, where they are distributed and to whom they are distributed.
When incentives are given by high-status leaders, employees may see them as more meaningful. For example, blogger Greg Linden notes that "Google rarely gives Founders' Awards now, preferring to dole out smaller executive awards, often augmented by in-person visits by Page and Brin." When incentives are awarded in public, they confer greater status but also make inequality more salient. Carefully designing financial incentive programs to carry symbolic meaning can be an important route to enhancing their effectiveness and reducing their adverse consequences.
So what does the overall picture look like? We believe that financial incentives have an important role to play in employee motivation, but the reality of human motivation is more complex than the simpler vision built into the financialization model. Excessive reliance on financial incentives can lead to unintended consequences that sometimes defeat the very goals they are designed to achieve. We feel that it is also important, for instance, to create cultural contexts that help shape norms, values and beliefs specifying guidelines for inappropriate actions, regardless of financial incentives.
Perhaps such an approach would have saved the school board members in Kenosha, Wis., from losing a large chunk of their teachers' retirement plan in risky investments called Collateralized Debt Obligations (CDOs). These investments should never have been sold to them. Although the financial incentives for all the actors in the decision chain were well aligned, what was apparently missing was the necessary ethical restraint.