Fractured Atlas
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This is an archived post from our old blog. It's here for the sake of posterity (and to keep the search engines happy). Our new blog can be found at http://blog.fracturedatlas.org.

Risk, Reward, and the Agency Problem

I've often argued that the traditional non-profit model discourages necessary risk-taking.  It does this for a few reasons:

1) Employees can't own stock, so they don't benefit from financial success.  Yet they're still vulnerable to financial failures (i.e. they can lose their jobs or suffer career setbacks).  To a lesser extent, the same is true for non-profit Board members.  When someone's got no stake in the upside but is still exposed on the downside, the rational response is extreme conservatism.

2) The culture of the non-profit sector is such that managers go to absurd, herculean efforts to avoid admitting failure, mostly in an effort not to embarrass themselves in front of funders.

3) Non-profit organizations are chronically under-capitalized.  By failing to build reserves or hoard surpluses, we end up in a situation where each budget is a tightrope.  A single serious misstep is enough to pose an existential threat to the organization.

So, if the non-profit sector is going to get more comfortable with risk, it needs to start acting more like the for-profit sector, right?  It's true that for-profit businesses rarely experience any of these problems.  Unfortunately, they tend to swing too far in the exact opposite direction.

Unless you've been living in a cave (yes, your art studio counts), you're aware of what's going on with the financial markets.  Huge, venerable institutions are collapsing (Lehman Brothers), teetering on the brink getting bailed out by taxpayers (AIG), or being sold for a fraction of their recent valuations (Merrill Lynch).  A significant contributing factor to this mess is the fact that free-market capitalism - for which I am generally a sincere cheerleader - actually encourages excessive risk-taking.  The reasons for this are a mirror image of those I listed above:

1) Companies "incentivize" their employees by granting stock options.  The nature of an options contract is that it magnifies the gains from a stock's upward movement but becomes worthless long before the stock itself does.  Here's how it works:

Let's say your company's stock is at 100 and you've got an option to buy stock at 105.  Until that stock reaches 105, your option isn't worth much.  When the stock hits 106, it's worth roughly $1/share.  At 115, it's worth $10/share.  Etc.  Now, imagine you've got to choose whether or not to take on a risky project with a 50/50 chance of success.  If it succeeds, your company's stock will go to 110.  If it fails, your company's stock will go to 60.  If you're a shareholder, this is a terrible deal: heads you win $10, tails you lose $40.  But for the employee holding the options contract, it's a golden opportunity: heads you win $5, tails you lose $0.

This is obviously a greatly simplified example, but you get the point.  Options grants encourage employees to take big risks that aren't necessarily in the best interests of the company's shareholders.

2) Executives of publicly traded companies are equally eager to avoid admitting failure, but it has the opposite effect as in the non-profit sector.  For a publicly traded company, the critical time not to screw up is in your quarterly earnings report.  Wall St. is ruthlessly impatient.  The markets rarely are willing to wait for long-term investments to pay off.  Rather, they focus almost exclusively on a) earnings per share in the last three months and b) predicted earnings per share in the next three months.  Miss your estimate and your stock price gets clobbered.  Beat your estimate and it soars.  This pressurized environment acts as an amplifier for the misaligned incentives in point #1.

3) The sophisticated capital markets that large corporations can access mean that companies can tap essentially unlimited resources.  This was a huge part of the problems we're seeing in the current crisis.  Companies like Lehman and Merrill were leveraged up the wazoo, effectively investing $30-40 of borrowed money for each $1 of collateral assets.  As long as those investments keep going up, profits are multiplied many times over.  But as soon as they start to fall, the proverbial house of cards collapses.  Under-capitalization is obviously a factor here, but in a very different form than afflicts the non-profit sector.

In both cases, the essential dysfunction comes down to what's known as the "agency problem". The term refers to a category of conflicts of interest that arise between management and other stakeholders.  These conflicts most often occur when incentives are misaligned or when management has access to information that isn't available to shareholders, Board members, creditors, etc.

The main mechanism for addressing these problems in the for-profit world is government regulation.  We're going to hear a lot about this over the coming weeks, as the feds debate what kinds of new rules need to be imposed on Wall Street.  In theory, such regulations are designed to mitigate the agency problem and protect shareholders, customers, etc. from excessive risk.

There's no such easy solution on the non-profit side.  You can't force non-profit managers to acquire stiffer backbones by government fiat.  However, you can tap into our tendency to dance shamelessly to the tune of our funders.  Any meaningful shift in the non-profit sector's culture of risk must therefore begin with a shift in strategy from our leading philanthropists.

I was at an event a few years ago with a bunch of peers from the arts service community, including Ben Cameron, who was then head of Theatre Communications Group but is now the Program Director for the Arts at the Doris Duke Charitable Foundation.  Ben observed that, for the most part, arts funders were acting like consumers rather than investors.  His point was that most funders focused on short-term, narrowly defined, project-based support, instead of identifying important organizations doing exciting work and providing the financial resources for them to leverage their native strengths over the long-term.

If our biggest foundations could break the habit of cautiously supporting tiny, specific aspects of an organization's activities and begin ensuring sufficient capitalization and providing multi-year general operating support, we'd go a long way towards fixing at least 2 of the problems I identified at the beginning of this post.  (The good news is that I'm starting to see a few moves in this direction, but that's a subject for another post...)

The issue of incentivizing employees and Board members by ensuring that they benefit when the organization thrives is a lot trickier.  IRS rules prevent "private inurement" from contributions given to a 501(c)(3), so any kind of explicit sharing of a revenue surplus would be illegal.  At Fractured Atlas we've tried to work around that limitation by awarding annual performance-based group bonuses that, while meager by Wall Street standards, are meatier than at any other small non-profit I know.

Bonuses help, but they're not a panacea.  That's partly because non-profit employees tend to be motivated by largely non-financial factors (e.g. belief in the organization's mission, aesthetic appreciation of its work, etc.).  Harnessing those passions in a way that encourages responsible risk-taking is difficult but potentially powerful.

Measurement is one tool.  To the extent that you can quantify "mission return on investment" (whatever that means) and make that transparent throughout the organization, people become more likely to appreciate the "upside" of a given project or decision.

Culture remains the most important factor, though.  We need to constantly remind each other that it's okay to fail.  In fact, if you've never suffered a complete, humiliating, public failure, then you're probably not trying hard enough.  Time to grow some cojones and take a chance.