EntrepreneursVenture Capital

Principles of fairness

By March 3, 2008 5 Comments

You know that feeling when you’d almost rather take nothing than accept an insulting low offer?

It isn’t a rational position, but the there are principles of fairness at stake, and if the sacrifice isn’t too high you might just make a stand.

Well, it turns out these feelings are entirely natural.  Even monkeys have them, or at least similar ones – see papers by Brosnan and de Waal.

It turns out these feelings are important to the effective functioning of society overall.  Here is for why, as ever with a focus on venture capital.

Economists have an experiment they call the ‘Ultimatum Game‘ which shows that under these circumstances people don’t act as rational self maximising agents.  From Wikipedia:

The ultimatum game is an experimental economics game in which two players interact anonymously and only once. The first player proposes how to divide a sum of money between themselves, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal. Since the game is played only once, and anonymously, reciprocation is not an issue.

And from Wisdom of Crowds describing the results when the sum of money in question is $10:

If both players are rational, the proposer will keep $9 for himself and offer the responder $1, and the responder will take it.  After all, whatever the offer, the responder should accept it, since if he accepts he gets some money and if he rejects, he gets none.  A rational proposer will realise this and therefore make a lowball offer.In practice though, this rarely happens.  Instead, lowball offers – anything below $2 – are routinely rejected.  Think for a moment about what this means.  People would rather have nothing than let their ‘partners’ walk away with too much of the loot.  They will give up free money to punish what they perceive as greedy or selfish behaviour.  And the interesting thing is that the proposers anticipate this – presumably because they know they would act the same way if they were in the responders shoes.  As a result the proposers don’t make many low offers in the first place.  The most common offer in the ultimatum game, in fact, is $5.

These issues come up frequently in venture capital.

In down round situations it is common not to dilute the suffering shareholders as much as you might be able to get away with – partly out of a desire to treat people fairly, and partly for fear of provoking an irrational reaction that stymies the deal.

Similarly in ratchet or milestone situations it is typical to look past the documentation to the spirit of what was agreed.  This often involves one party not maximising their position.

Negotiations at bonus time are another example.

To the extent we do them, we do these things in the first instance because we are nice people with integrity.  But if we look beyond that and ask ‘why is it that management of these situations is (usually) entrusted to people with integrity?’ then I think it comes down to trust.

These are almost never truly one-off events, they happen in a system with actors that will probably come into contact with each other again, at least indirectly.  We all know that if everybody aggressively self maximised all the time the startup ecosystem would be nothing like what it is today – hence we have to be able to trust that people will play the game and won’t try to free-ride.

As individuals and companies trust and reputation are intertwined – our reputations come from people’s ability to trust us.  Moreover, this issue is becoming more and more important as the economy becomes more networked and relstionship based  In this regard it is interesting to note the difference between Microsoft and Google as leaders of the last and current generation respectively.

Surowiecki would describe all these situations as co-operation problems.  For the system to deliver the best result individual agents need to take account of each other and not short-term maximise in every situation.  As he describes it complex norms based on the underlying principle of fairness emerge.  These principles govern how we behave and as individuals the system is so important to us that we are prepared to make personal sacrifices to punish people who break the rules.

And what is really incredible is that most of this happens in the subconscious, at an emotional level.