September 1, 2020

You Have to Have Skin in the Game

Periodically I receive inquiries from people in the startup community who are exploring an idea or want an estimate on how expensive this particular idea may be to implement - as is common in the entrepreneurial community I’m happy to pay it forward (because I received help like this when I was just getting started too) and review a pitch deck, specification, or business plan and offer my advice if the person is someone I’ve interacted with online, in-person, or is referred through someone else I know.

Most of these pitches are doomed from the start. It’s not because the idea is terrible (although many often are) or because there’s some impassable barrier to market entry. It’s because the founder has insufficient skin in the game and thus, they’re not going to behave successfully. Why is that?

Skin the Game

Incentives Matter

Imagine three founders who set out to create a startup company together:

  1. Founder A - will go broke if the company isn’t able to make enough money to pay his salary within 6 months;
  2. Founder B - has enough in savings to go without compensation for up to 18 months; and
  3. Founder C - has another full-time job but is willing to contribute work on nights and weekends.

Which founder is going to:

  1. Work as fast as possible to deliver revenue-generating results?
  2. Eagerly begin contacting and recruiting potential customers?
  3. Design a system to iterate as fast as possible in order to achieve business sustainability?

Founder A, obviously - for the simple reason that he has the most exposure to the consequences of the company’s decisions. If the company fails to achieve break-even, he’s going to lose all of his savings and be left with nothing. Founder B will be out 6 months’ worth of savings - some skin in the game, but not a catastrophic loss.

Founder C will probably drop out of the startup altogether because the company’s success or failure is immaterial - Founder C has very little financial exposure to any amount of downside and very little to gain from the startup achieving break-even success. The startup would have to be an overnight success in order for Founder C to join the company full-time.

Most people who send me pitches are Founder C - people who think they have a great idea but aren’t willing to risk very much themselves to realize it. Therefore, their hope is that their idea is so good that someone with a skill they require would be willing to take on most of the delivery and implementation risk in exchange for worthless equity. In practice, this almost never works because ideas are intrinsically worthless - only through their implementation can value be realized.

Skin in the game means having a personal stake in the desired outcome - exposure to both the upside and the downside. This exposure creates very different behavior on behalf of the actors in a given economic, financial, business, technical, or really any kind of decision making. Actors who have sufficiently high amounts of skin in the game are strongly incentivized to behave in a way that is more likely to create positive outcomes and avoid negative ones.

Aligned Incentives

Say you have a friend who strongly recommends purchasing Tesla stock and thinks it’s going to be worth 10x its current value in two years - would it make a difference to you if:

  1. The purchaser agrees to buy in at the same time and dollar amount as you;
  2. The purchaser holds a large Tesla position that is already very profitable; or
  3. The purchaser holds no Tesla at all and no future plans to do so.

This information should influence your decision. Position 1 has the greatest skin in the game - they’re exposed the same amount of entry point and time risk as you. Position 2 has some risk, but they’re already sitting on a large and profitable position - if Tesla doesn’t make a significant upwards move from its current price then this person has no downside. Position 3 has zero skin in the game - your friend’s recommendation is useless in this scenario as they don’t believe in their own advice strongly enough to take it themselves.

But it’s not just financial decisions that require skin the game - the same can be said for technical and product decisions too.

Imagine if a technology company created a cloud service that it did not use itself for any production services - what kind of experience would you have? Well, this was exactly what Windows Azure was like inside Microsoft circa 2010 - product groups like Bing, Xbox Services, Office 365, and others didn’t build any of their products directly on top of the consumer-facing version of Windows Azure and as a result - Azure was largely unusable up until about 2014-2015.

Compare this approach to Amazon’s early mandate that 100% of its internal services would communicate with eachother strictly through APIs, a practice which ultimately bred the practices and patterns that would lead to the creation of Amazon Web Services - the first product that really delivered “cloud computing” as we know it. AWS was built to run Amazon.com first and turned into a customer-facing product second. Amazon had a significant amount of skin in the game with AWS - which is why it was revolutionary and successful, whereas Azure stagnated for over five years until new leadership changed the model for how Azure would be developed and used internally.

Skin in the game significantly changes the behavior of the actors involved because it alters their incentives; those incentives can be to mitigate risk, financial rewards, market leadership, or even to achieve a self-sustaining small business. You simply can’t trust actors who don’t have any skin in the game to overcome the hurdles of thankless drudgery, risk, or uncertainty that stand between coasting by and achievement - they’re not sufficiently exposed to upside or downside to make it.

Discussion, links, and tweets

I'm the CTO and founder of Petabridge, where I'm making distributed programming for .NET developers easy by working on Akka.NET, Phobos, and more..