The Risky Hire

It’s no secret that unemployment is close to 10% now. If you run a business and are hiring or if you are looking for a job here is an interesting way to view it. From a book written by Professor Edward Lazear, Stanford, and Professor Michael Gibbs, University of Chicago, comes a notion of the “risky hire”.

When the word “risky” is used in finance and economics it doesn’t mean going to Vegas and putting it all on red. It does mean that there is more variance in whatever you are describing as risky.

Suppose you ran a business and needed to hire a person. You interviewed two people, Jimmy and Johnny. Both seemed pretty nice. Had a nice suit on, with decent resumes. However, there was a big difference between Jimmy and Johnny. Jimmy had a little experience in your business. In college, he interned at a similar business. On the other hand, Johnny had no experience. But Johnny seemed to have some intangible qualities that you really liked and thought might make him a star person for your business.

Lets assume some numbers to quantify the decision. You aren’t going to hire this person on “gut feel” alone are you?! Assume that Jimmy was going to make you 200k per year. But Johnny is different. There is a 50% chance that he’d make you $500,000 per year. But, there is also a 50% chance that Johnny becomes a 100k a year loser for the business-a lemon.

Here is how the math looks:

Expected output of Jimmy=1×200,000=200,000

Expected output of Johnny=.5(500,000)-.5(100,000)=200,000

But, lets look at something else. How about profits? That’s what businesses are really interested in. Profit looks really different for Johnny and Jimmy. Assume we pay each of them $100,000 per year for up to ten years. Also assume that after the first year, the business will have a really good idea of how productive they will be. If Johnny hits a homer his first year, the business keeps him. If not, the business lets him go. Johnny can start looking for jobs.

Profit for Jimmy=$200,000-$100,000=$100,000×10=$1,000,000. Not bad.

Profit for Johnny=.5x$4,000,000-.5x$200,000=$1,900,000! The business makes 900k more by taking a risk and hiring Johnny! (The business will fire Johnny after one year if he is not working out) This personnel manager looks like a hero!

Hiring Johnny is like a real call option for the business, with a one year expiration. The business gets the upside of it works out-and loses a little if it doesn’t. There is limited downside risk.

Professor Mike Gibbs says, “In what kinds of jobs is this most important? Those where creativity, innovation, new ideas are needed. Where the environment is changing and you need someone to think and develop new approaches to the problem. Where you can assess their fit and talent relatively quickly. And, look for a person with a very interesting track record of success, creativity, possibly even changing fields and taking some risks. Unlike in stock markets, risk is often a good thing in a new employee. Employers out there – take a chance on someone!”

If you are looking for a job, you might want to make it easy on firms to take a chance on you. Offer to structure your pay and benefits with performance based incentives. You produce, everyone wins.

Something to think about when unemployment is close to 10%.

****a similar example is in the book Personnel Economics In Practice that I linked to at the top of this blog.

Welcome Instapundit readers, and thanks for the Instalanche!

Thanks for the link.

  • Tim McDonald

    Um, expected output is .5(500,000) PLUS .5(100,000) or 300,000.

    And you made the same mistake on expected profit.

  • El Presidente Castro

    The problem is the personnel manager is not rated on the 10 year earnings of a new hire. The personnel manager get hit for every employee that doesn’t work out and Johnny’s manager takes credit for the long term earnings. Johnny’s manager also writes a nasty note to the personnel manager’s boss when Johnny flames out, quits or gets fired. Personnel managers realize this and hire the most boring and safe candidates. Welcome to the corporate world; the personnel manager only cares about maximizing his own 10 year earnings.

  • Mike Gibbs

    Tim, Jeff’s assuming output is negative 100k in the bad state for Johnny (e.g., a trader who loses money for you). In the profit equation, there’s also subtraction of the salary of 100k.

  • adam

    Johnny will demand a raise once it’s apparent that he’s a star. TANSTAAFL holds for businesses as well as individuals.

  • Greg Jungman

    @Tim, it wasn’t a mistake, Jeff tried to indicate in the prior paragraph that the employee could have a negative effect on profit, that’s why it’s a minus.

  • Foobarista

    Hires don’t typically work this way. A bad hire can cost a lot more than their salary by poisoning the whole team.

    Big companies can send bad hires off to an unimportant department where they can be safely fired if it isn’t easy to fire them, but small organizations can’t do that and are always extremely careful with “risky” hires if they know what’s good for them.

    I’ve worked in one startup that blew up due to “personnel issues” which got to the level of near civil wars. One could argue that this was partially due to poor leadership (which it was), but there were also difficult – but extremely smart – people involved.

    If you’re an “edgy” sort of person who is probably a risky hire, you may be better off being a consultant or starting your own business. After you’ve established a track record of success, you’ll find it easier to find work if that’s what you want. If you aren’t confident enough to start out on your own, you may have to check the edginess at the door for awhile and suck it up.

  • ck

    Hire the white guy, you can fire him if it doesn’t work out.

    admin says: Uh, that’s not coherent to the conversation. I will let it pass that you are attempting to be jocular. But, ’twas not a knee slapper.
    You will do better next time.

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  • Steve Adams

    @adam there may not be free lunches but there are reduced cost lunches. (in inefficient markets like hiring)

    In my experience employing people in that situation, they will want a raise – but generally not a 50% raise. Also, I’m happy to share the upside with them as long as they know that if the upside goes away so does their raise. Many places won’t do that.

    So, target unique situations for those call option employees. Someone in a tight structure where 20% raises aren’t available. We had a great employee (college dropout no less) for a while who now is an independent consultant. We still hire him for projects and he still makes us money. Definitely a profitable option.

    I think the option model is great for new hires, new projects, and acquisitions too. I use it mentally for lots of decision making in areas of risk and make more money from it that way then from the stock market version of the things. :)

  • gullyborg

    Something else to consider when unemployment is high: companies that are hurting will let their least productive workers go, while trying their hardest to retain their best employees. as as a result, the labor pool becomes saturated with under-performers. When you have two applicants before you, and one has some relevant experience and is the “safe” hire while the other is from outside the industry, lacks the relevant experience on paper, but seems to offer something intangible and is the “risky” choice, it may well be that your “safe” candidate is looking for work because he wasn’t a good performer within your industry. True, the “risky” candidate may be unemployed because he wasn’t a good performer in his previous industry – but then, he may have been in the WRONG industry. So, do you want the person who couldn’t keep a similar job to the one you are filling, or the person who might bring some fresh energy into a new field?

  • MarkD

    Something else to consider when unemployment is high. Companies are foced to let go of good workers, who, all things being equal, they would have kept. Sometimes entire companies or divisions are closed. Of my last five hires, I found a great one that way.

    As usual, the correct answer is, “it depends.” This article points out one more thing to consider.

  • Mike Gibbs

    Foobarista raises a good concern. One thing that can help is to hire someone on a probationary basis. Hire for a specific consulting project first, for a contractually specified fixed period of time, or similar. Such arrangements are common in Europe (where firing costs are high) for example.

    I love the comments about very talented people out there looking for work, possibly changing industries. The recession’s been so deep that there are a lot of very good guys out there. I think those commenters are right that it makes a risky hire argument more compelling now.

    Adam, I’m a Chicago economist, so I live by TANSTAAFL! You’re right that a ‘star’ will need a raise eventually. But there are some other things going on. First, someone may be a star for your firm, not so much at other firms, do to firm-specific fit of talent. Then their market value – which you have to match – can be below their value to you, & you still profit. Second, it’s not always easy for someone to prove their high value to the outside market. Depends on the particular job.

    Third, you may be able to benefit in the beginning if not later. Think about putting the risk on the hire to prove themself, not just on you. Use low initial pay, backloaded pay based on performance. In fact, that’s a good idea anyway. Risky hires often have a better idea of their capabilities then you do. If they’re willing to take a risk on themself, that’s a useful signal about their upside potential.

  • arlo

    Unless they are a white male under 40, you don’t just fire them after a year for “underperformance.” You’re also ignoring the HR costs related with firing someone, as well as the possibility that the problem child will squeak past their performance development plan, and then you’re stuck with another period of lackluster performance. Lather, rinse, repeat.

    It seems to me you really underestimate the damage a risky hire can cause.

  • sestamibi

    The labor market would operate far more efficiently (and avoid those situations where a decision drags on for months on end) if firms would select 3-5 qualifying candidates and then let them bid for the position. Lowest salary package wins.

  • Mike Gibbs

    On underestimating damage of a risky hire: such risks can indeed be high. Where they are, the logic of this blog post won’t work & shouldn’t be used. However, that’s not true in all work environments. The main point of the post is the talent can be viewed as a “real option.” Turnover reduces downside risk (though doesn’t eliminate it), in which case payoffs from hiring may mimic those of a call option. As with call options, higher risk of the underlying security – in this case a new hire – may increase the value of the option. The logic will certainly not apply everywhere, but it is a useful idea. I suggest many firms are too risk averse in hiring, & should think more creatively about hiring, structuring job offers, & turnover.

    (Arlo: see my earlier comment re probation or fixed term contract.)

    It is worth noting that organizations where human capital & innovation are most important do this kind of thing all the time, if less consciously than laid out above. The best research universities (such as U. Chicago) are an example. Most professors will not get tenure (in our Economics department, no new hire received tenure for something like 20 years in a row). Leading professional service firms usually use a similar model of up-or-out. A pharma company in Korea of which I am familiar uses similar methods for its R&D group. There are many such examples.

    In such environments, it can be healthy to structure the organization & personnel policies to have higher than average levels of turnover. Design the org. to constantly sift people, looking for interesting people, new ideas & the latest innovations from academia or elsewhere.

  • GV

    The risky hire does indeed pay off. I started choosing inexperienced, smart, hard working, degreed in the wrong discipline candidates (e.g. math majors) in place of experienced in the specific job candidates (10 years at Stodgy Corp). It worked quite well. I ended up gradually moving them to more important positions. They think outside the box more often. Fifteen years later, some work for me still, only at my own company. They get paid far more than anywhere else.

    A top performer is often 2 standard deviations better than average, which means paying them 1 standard deviation higher is a bargain.

    Words of wisdom: Within reason, a top notch worker is never overpaid. Underperformers are always overpaid.

  • cle

    I am in a regulated industry where the firing costs are quite high and I concur that for me these are higher than was allowed for in the example. I also note in reading this thread that there is a difference between risky to fire, and risk of performance. Within this difference I note that many well-meaning affirmative action rules might hurt those intended to be helped by raising the cost of firing which raises the risk of hiring making them uneconomic hiring risks.

    We have had great success hiring people who have “Petered” out; they have risen to their level of incompetence by rising to a level in their firms where they have to manage people which they despise (the managing, not the people, I think). We give them a lateral in pay, no direct reports, they have to do everything themselves and have flexible hours. They know what needs to be done better than I do and can do it without supervision. That saves me time. Best hires over and over, with very low risk.

  • Steve

    @cle – great insight on the “Petered” out group. I’ve seen lots of folks in the spot but never hired from it . . .yet. Thanks!

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