Something I’ve been thinking about a lot recently is what is the best way for ecom business owners to incentivize the CEOs / general managers (GMs) of their businesses.

At Agora we’re acquiring DTC ecom businesses. It would be impossible for my co-founders and I to run all of the business ourselves, so this question is directly relevant. But it’s not something I feel like we’ve totally nailed.

This would be easier if we acquired minority stakes. If the operators still own a majority of the business, they’re pretty incentivized to manage it efficiently. But we usually buy 100%.

One obvious answer is to pay GMs, in addition to a base salary, a percentage of profit (net income) bonus. This is what we’re optimizing for. But this has several problems:

Problem 1: Ecom businesses can often maximize short term profit by starving the business of investment. For example, turning ads way down or doing no new product launches will likely improve profit in the immediate term.

A GM planning to stay at a business for many years probably wouldn’t do this because one could starve the business of investment for perhaps a year or two before it’s reflected in the numbers. But a GM that’s considering leaving in a year might. Or a GM that’s just trying to hit their bonus and not thinking about the downstream consequences.

The principal-agent problem here is real: the owner wants steady, long-term profit while the GM is motivated to maximize short-term profit. How can we know unless we’re running the business?

Problem 2: The businesses already have meaningful net income when we acquire them, so we’d be giving GM’s relatively large payments even if the business is flat.

So maybe we should pay GM’s only a percentage of net income growth each year?

The issue with this is ecom businesses are incredibly volatile and sometimes it’s actually a win to keep profit flat (e.g., year after iOS14). Should the GM get no bonus in that world? Also, what about when it’s 6 months into the year and net income is trending below last year and so it’s very unlikely GM’s will make any bonus. The GM’s then have no incentive to make sure they’re only 10% down vs. 50% down. That seems like a huge problem.

Problem 3: Sophisticated GM’s can boost net income in a way that’s detrimental to a business.

For example, a GM could make the decision to purchase a ton of inventory and ensure the business is never out of stock on any product ever. Every dollar of revenue lost to out-of-stock is a dollar the GM doesn’t collect a net income bonus on. But is this optimal? Probably not; in most cases excess inventory will end up being sold at a discount or written off years later and until then the inventory is a massive cash drag on the business. But GMs have a strong incentive to do this.

The above are just the problems with net income-based incentives. There are different but comparable problems with growth-based, cash flow-based, or combo-based incentives.

This is genuinely a puzzle. What do you think the best incentive approach is?