I Shiver When I Hear “Skin in the Game”
by Donald Kennedy
The realized outcome is not always in line with the intent
I forget how many decades ago it became popular to talk about motivating people or organizations by letting them have ‘skin in the game.’ As with many high level principles, it is easy to present the idea in a way that appears to make a lot of sense. The basic concept is that a person will try harder to achieve a goal if they get to share the benefits of success and, likewise, suffer personally when the result fails to meet expectations. Because it sounds good, the policy is often adopted in negotiations with individuals as well as in contractual negotiations. But as with all things dealing with human behaviors, the realized outcomes are not always in line with the intent.
What if you own a hockey team
If you own a professional hockey team, you want to win games. Games are won by scoring more goals than the opposing team. One policy that would give players skin in the game would be to pay them $50,000 for every goal. A 50 goal scorer could make $2.5 million dollars. The unintended consequence of such a move might motivate a player to become what is sometimes called a “garbage man,” a player that parks themselves in front of the net waiting for a puck to come along to shoot into the net. This also means the player is not ready to go on defense if the opponents get possession. When all the players want to score as many goals as possible, as motivated by the financial benefit of doing so, no one is left to play defense. Since the overarching goal is to win games, the lack of a strong defense will result in a lot of goals scored against your team, and probably a failure to achieve the real desired outcome of wins.
The average CEO spends around 3 years in that job. I recall a few decades ago, a CEO in a tower near my home mentioned how his salary was $500k a year, whereas his friends at similar companies were making double his pay. During this time, the investment community looked at their professional management teams and decided (to use a term that simplifies the complex process) that by basing CEO pay on share performance, the CEOs would have skin in the game and therefore be better motivated to assure solid financial performance for the firm. Awarding stock options became a very common practice in CEO remuneration. The CEO is thus rewarded when the share price rises higher than some specified value. This is seen as giving them the desired skin in the game. The current successor of the CEO I mentioned above currently makes a bit more in salary than the predecessor, but the profits from personal stock options exceed $10 million a year. Shareholders sometimes say that this benefits them more than $10 million so the CEO pay is worth it, but yet again there are complications with outcomes.
With the increase in incentives for CEOs came a shift in what corporations do with their profits. Fifty years ago, the profits were normally distributed as dividends. Since 1997 however, more profits have been spent on share buybacks than dividends. Buying stocks creates a short term boost to share prices allowing anyone with stock options to preferentially benefit over the common shareholder. CEOs are also incentivized to look at the short-term performance (a 3 year tenure) and may forgo long term benefits (maintenance budget cuts, for example) in favor of short term gain.
My Personal Experience with Construction Companies
Not too long ago, I worked for a construction company that engaged in a $100 million project. The organization that hired us insisted on payment terms that gave us skin in the game. This owner established high and low financial targets on a cost reimbursable contract - giving us, the contractor, the opportunity to benefit significantly from saving money and penalized us for exceeding the targets. Given the information provided, it appeared we had the potential to make more than we could have under a typical lump sum tendering process. The dangling of the incentives and the threat of awarding to another contractor, plus the need for us to have any work to keep the lights on motivated us to sign the deal. As the project progressed, many new
situations developed that greatly hindered our ability to stay on budget. One example is the discovery of underground infrastructure, known to the owner at the time of signing, including some municipal sewer lines and utility corridors. The owner’s argument against allowing us some slack on the targets was that these were in the public record and therefore should have been considered in our base price. As the project progressed, it was clear that the owner had seen an opportunity to pass the risk on budget to the contractor by urging them (us) to have skin in the game.
The management world is full of examples of systems set up with good intentions that ultimately lead to the rewarding of behaviors that actually work against the intent. Many of my ASEM conference papers include examples of this. Management is complex and takes work to develop winning strategies.
About the Author
Dr. Donald Kennedy, Ph.D.,P.Eng.,IntPE,CPEM,FASEM is a regular contributor to the ASEM Practice Periodical. He has celebrated more than 1 year in the manufacturing business following a lengthy, but turbulent, career in heavy industrial operations and construction.