Relational Contracts

Introduction

Our second paper focused on the following hypothesis: Google’s primary source of competitive advantage is in its core organizational competence of innovating better than its competitors. In this paper we describe five relational contracts that Google has with its employees that have allowed it to develop and grow this competence over the past several years. Fundamentally, all of these contracts share a common promise: Google asks its employees to work harder and smarter, constantly improving the product and the company, and in return promises unprecedented benefits, opportunity, and resources, as well as brilliant fellow coworkers. Below we go into each of these specific contracts in detail.

The analysis in this paper is based on three interviews we conducted with current and past Google employees in March 2008. Please see Figure 2 in the Appendix for more information on the interviews.

Relational Contracts

“Into being challenged? Into having fun? Want to change the world? If the answer is yes, then you’ve come to the right place.” – Google Jobs Website

Overall, Google offers its employees the following proposition: If you come to Google and work hard and make us better, we will take care of you and give you the support to pursue your imagination, and together we will change the world. As you can see from the charts in Exhibit 1 in the Appendix, this fundamental contract requires a few promises on both sides. The relational contract from the Google employees’ perspective requires that they take real ownership for their work.  They agree to buy in to the mission of the organization and to bring all of their passion and creative energy to bear to accomplish those goals.  In exchange for their commitment, Google provides a great environment to work in.  Their rewards include talented coworkers to work with, great facilities, benefits without compare and the support of the organization.  For the employee, the primary defection motivation is simply to free-ride.  One could come in to work, eat free lunches and enjoy the other benefits without contributing to the fullest.  The punishment, however, is no longer havingthe opportunity to work in such a unique environment.  In addition, Google goes to great lengths to recruit the types of people that value these opportunities so this punishment is a significant deterrent.

Over time, this basic agreement has developed in several more specific contracts, five of which we describe in detail below. However, we should note that there is one important contract that we have chosen to ignore, one based on financial rewards: If you work hard, you will make a ton of money. While this reward likely benefited Google in its initial years, we do not believe that has contributed to its long term success, especially not to the firm’s accomplishments post-IPO.

Contract #1: Reciprocity

Reciprocity was one of the reasons stated in our interviews for why Google’s employees feel compelled to work so hard.  As Cialdini put it, “People tend to return a favor.”  In the words of our interviewee, “You feel like you are being done right by the company, and you want to do right by them.”  In this most basic of contracts, employees feel more compelled to go the extra mile because of all the lengths the company seems to go for them.  Google provides free meals, game rooms, in-office masseuse, company trips and other seemingly excessive perks.  All of these things contribute to making the employees feel like the stars of the show.  They feel valuable and appreciated and in return for this, they are more motivated to go beyond simply collecting a paycheck and chasing a promotion.  They commit to performingat the highest sustainable level they can.  The contract is that the employees work and produce like stars and in exchange, Google agrees to treat them and recognize them as such.

Google provides this wonderful environment and resources for their employees, and in exchange, those employees invest themselves in their work.  The defection motivation for Google is to save money.  All of those benefits cost money.  In one of our interviews someone mentioned seeing pictures in Mountain View of the company ski trip from years ago.  The earlier pictures showed a bunch of people all clearly having a good time.  Later images showed the group had grown to an entire ice rink full of people.  Today, the company ski trip still happens and the number of employees have sky rocketed.  It would be much less costly if Google cut back on these types of expenditures.  However, these are the very things that Google’s culture is built upon.  As Google grows, concerns increase that they are no longer the nimble startup with the fun culture and this further increases the importance of maintaining those cultural artifacts.  The punishment scenario if Google did opt for the less costly strategy would be damage to their culture and subsequently more trouble attracting and retaining talent.

Contract #2: Change the World

Another motivator for Google employees is an idealistic vision of and belief in the company’s stated goals.  “Organize the world’s data.”  That is a grand goal, but Googlers see their opportunities to be even larger.  Whether they areengaging in engineering a more democratic wireless spectrum auction, investing in clean technologies or just using the company stipend to purchase a hybrid, Googlers see their jobs as an opportunity to reach far beyond their offices and affect change in the world.  The contract is that employees can change the world in a very visible way and Google will support their efforts and provide them a platform to launch these efforts.  In exchange for this opportunity, employees dedicate themselves to both philanthropic efforts and those more closely aligned with Google’s core business.  Google gets motivated and energized employees as well as all the inherentand external benefits of being a good corporate citizen.  The defection motivation for employees is to only do the philanthropic and completely neglect the more profitable segments of business and the punishment is to no longer be able to work at Google, or in the long term, to contribute to driving Google’s costs up while bringing in no profit and putting Google out of business. However, punishment again is losing the opportunity to work at Google and lose the opportunity to do those philanthropic efforts in the first place.

Contract #3: Have a Big Impact

Just as grand, but slightly less philanthropic, Google employees cherish the opportunity to have impact.  There is a great feeling of satisfaction knowing that you are working on tools that millions of people use.  The percentage of people in the United States on the Internet who do not actively interact with some part of the Google landscape must be small and the percentage that hasn’t heard of Google is even less, if not zero.  Knowing that you, through your work, have that kind of reach is very satisfying, according to another interviewee.  The contract is that employees have the opportunity to work on applications that millions of people will use and in exchange for that, those employees will dedicate themselves to building useful and scalable applications.  The defection motivation is to slack on the building of quality apps and the punishment is to no longer have the opportunity to create products on such a grand stage.

Contract #4: Be Entrepreneurial

One of the advantages of working at Google is that the firm is a place where one can be entrepreneurial yet have the resources and safety of a large company. The contract here is that Google asks its employees to be entrepreneurial and think of new initiatives, and in return promises support and resources, all just on the strength of a good pitch: “You feel like you can get things done because you have a sound case and sound reasoning”. This allows employees to feel empowered with the ability to change the direction of the company. In one example, one Googler wanted to move back to his home country, and made a case for starting a new Google office there, on the strength of the local technical talent. The company agreed to start the satellite office. Google also offers a technical playground for its employees and asks them to play in it. The firm has collected massive amounts of data in some of the largest data centers in the world; if you can make a strong case for analyzing that data, Google will make it available to you.

The much heralded 20% Rule is a critical way that Google achieves this relational contract. With this policy, Google asks each of its employees to spend 20% of their time working on their own initiatives. However, there is no explicit contract around the 20% time; nor is there a concrete way for anyone to know if you are slacking off in your 20% time. Instead, Google makes a point: we are giving you time to act creatively and grow the company, but we will not track your work.  Instead, we simply trust that you are spending your time wisely. While it is still unclear to us how much value the 20% Rule generates for the company, it is clear that with this program, Google sends themessage that the firm wants the employee to be innovative.

Under this relational contract, both Google and the employee have the temptation to defect. For Google, defection means not making the effort to support employee initiatives, and instead eliminating pet projects to cut costs. Defection for the firm also means tracking the 20% Rule more closely to “ensure” a certain level of innovation. However, the punishment on both fronts is that the employee is then less likely to start new initiatives, in effect short-circuiting the innovation process that Google needs to stay successful. For the employee, defection again means slacking off and not fully utilizing your 20% time. However, punishment here is that, by free-riding, an employee misses out on key opportunities and wastes the chance to act as the local entrepreneur, perhaps even gets fired. By cooperating, the employee gets the ability to pursue his or her new initiatives, and Google gets a more innovative workforce.

Contract #5: Make us better

Employee empowerment also allows Google to create a culture of continuous improvement, in which Google creates an environment that involves employees in solving firm problems, captured by one of interviewee as, “If you think this is a problem, then go fix it, and if you make a good enough case, we will give you the resources to fix it.” The contract here is employees will strive to solve internal firm problems, making the firm better, and Google will provide the resources and support. Again, the 20% Rule plays a strong role here, providing employees the vehicle with which to work on fixing their and their coworkers’ internal problems. Defection and punishment here are similar to that in Rule #4, while cooperation for the employee is more focused on “problem-solving” than on “new initiatives”.

Conclusion

We believe that much of Google’s success to date can be traced to its ability to motivate its employees to work harder, be more innovative, and solve more problems than their counterparts at the firm’s competitors. Still, it is worth noting that the company is rapidly growing, having increased in size from 5,000 employees two years ago to roughly 15,000 today. According to one of our interviewees, the relational contracts at the firm appear to have changed from pre-IPO (1998-2004) to what it is now (2005-2007). Today, at 15,000, Google is far different than the Post-IPO firm of 5,000 it was in 2004; one can expect its relational contracts to continue to change.

What will be interesting to watch, and indeed, what many employees are actively watching, is how Google maintains the key contracts despite this growth, and what new contracts the firm develops given its rapidly increasing size. In addition, Google has been insanely profitable for the past several years; it will be interesting to see how the company reacts when it encounters itsfirst major down cycle and faces the temptation to defect on some of its contracts, as another of our interviewees has pointed out.

However, regardless of what happens in the years to come, so far Google appears to have been very successful in motivating its employees and keeping them happy. An interesting further analysis would be to interview employees who have worked at Google and its competitors, and determine whether Google employees are in fact more productive than at other firms like Yahoo!. Such an analysis would definitely help in understanding the role these contracts have played in the firm’s undeniable success.

Appendix

Figure 1: Overall Relational Contracts between Google and its Employees

 

 

 

Figure 2: Interview Detail

We conducted three interviews with current and former Google employees in the week of March 10^th, 2008. The general profiles of these three are:

1.     Former Google summer Sales intern, now current MIT Sloan MBA

2.     Former Google Product Manager who spent one year at the firm, now current MIT Sloan MBA

3.     Current Google Engineer who has been with the firm for two years, starting when the company was 5,000 employees (current size is around 15,000)

 

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It should be noted that this paper focuses on the relational contracts Google has with its employees. While we also looked at Google’s relationship with its partners (i.e., advertisers), we believe that this relationship is less of a contract than of a business decision guided by metrics, not to mention less critical to Google’s long-term success.

http://www.google.com/intl/en/jobs/index.html, copied on March 13^th, 2008

Source: Interviews

Some of Google’s most innovative external products have come out of the 20% Rule: Gmail, GTalk, Google Calendar, Google News, etc. In addition, we have heard anecdotally that many internal (and not externally visible) products/ improvements have also come out of 20%.

Some anecdotal evidence: “Countless added value of the 20% Rule goes towards internal productivity.”

What are the core competencies?

Introduction

In our first paper we argued that Google’s long-term competitive advantage stemmed from an organizational competence that focused on experimentation, innovation, and problem solving, and that the firm over time transformed these benefits into the structural advantages of economies of scale (EOS) in network effects and workforce. Since then we’ve adopted a less sanguine view on Google’s structural advantages, in particular realizing that Google’s network effects are limited, largely owing to low switching costs for consumers. Furthermore, their initial advantage, the PageRank algorithm, is now publicly known and elements are widely adopted.  Also, the firm operates in a highly competitive industry. With these thoughts in mind, we have come to conclude that Google’s long term success has most likely stemmed from its organizational competence.

A recent blog post (see Appendix A) by Hal Varian, Google Chief Economist, supports our claim. In his post, titled “Our Secret Sauce”, he first debunks three main sources of structural advantage: cost side EOS (scale advantages stop benefiting fairly quickly), switching costs (fairly low for consumers), and network effect (personal utility not really affected by utility of others). Instead, he emphasizes that Google has been successful because of “learning by doing”: in other words, because Google can innovate faster than its competition. In the rest of this paper, we try to understand what this “learning” represents and why other firms cannot innovate as fast as Google.

In short, we agree that Google has been successful largely because it can innovate faster than its competitors, and we attempt to articulate the specific organizational competencies that have allowed Google to do this better than others. We believe that Google’s organizational competence is a fundamental obsession with innovation, enhanced by a culture that encourages experimentation and irreverence, all in a fun environment. In turn, this innovative and fun environment fuels their EOS in workforce, which is what allows Google to attract the talent it needs to stay successful.

What are the Core Competencies?

The core competencies of Google center around innovation. Search is an industry where obstacles to entry are few.  Supply side economies of scale are limited, switching costs are negligible and network effects, minimal.  Google’s primary industry, online search, has no significant barriers to entry, as we established above.  Its secondary industry, advertising, is little better.  An online advertiser knows exactly what the conversion rate is of its placements and if someone can provide a better rate, there is no reason for them to stay. For Google to remain ahead of its competition in these two industries, it has to be constantly pushing the edge of the envelope to get better at what they do and provide more value to their customers.  As a result, they have to constantly innovate, hire the best talent possible and provide an environment where that talent can be most productive.

Google is constantly working to improve the relevancy of their search and of their products over all.  Relevancy speaks to how appropriate search results are but also, more generally, to how appropriate their other applications are to their customers’ needs.  Again, this necessity stems from low switching costs: Google has to provide its customers with what they want better than anyone else, otherwise those same customers can easily go elsewhere.

Google’s innovation manifests itself externally with their products but also internally with their organizational design and incentives.  In order to attract and retain top talent, Google has to also provide their employees with what they want (although admittedly these employees have higher switching costs than customers).  What do smart and talented employees want?  They want to solve challenging problems.  They want to be surrounded by a similar caliber of colleague.  They want to be recognized for their contributions and have opportunities for advancement. This fun and challenging environment helps drive further innovation externally.

Two other internal competencies help develop innovation at Google: experimentation and irreverence. Google’s employees are encouraged to experiment and take risks.  For instance, engineers are encouraged to spend 20% of their work time on personal projects.  AdSense, GMail and GTalk all came out of 20% projects.  While some value from these projects is the additional traffic and revenue they bring to Google, they also serve as role models for how employees can innovate. Those are experiments that have gone well but how does Google respond to failed attempts?  Megan Smith, VP of New Business Development, when speaking at MIT Sloan, related a story of one of her failures while at Google.  This failure lost millions of dollars.  She took a big swing and came up short.  She said that when she sat down to discuss the results of her effort with Larry and Sergey they actually thanked her for the willingness to take that chance.  Rather than being punished, she was commended for the effort; Google rewarded the big swing.

In encouraging innovation and taking risks, Google embraces irreverence.  Their “Do No Evil” mantra speaks to their counter-culture stance and willingness to reexamine commonly held assumptions.  Employees are motivated to solving problems in the best way possible rather than simply how everyone else does it or how it has always been done.  Their public offering by dutch auction is an example of this as is their ability to reinvent webmail. This irreverence no doubt also encourages employees to improve continuously on Google’s products themselves.

At the same time, innovation feeds back into the fun environment, creating a reinforcing loop where people have more fun at work because they and their coworkers are working on innovative products. In addition, an innovative and fun environment feeds into the EOS in workforce, as Google finds it easier to attract additional employees by offering them a place where they’d enjoy working. This loop is especially important considering that the EOS in the workforce is the main structural advantage that Google enjoys.

Conclusion

We conclude that the only way for Google to remain outstandingly successful is to continue to innovate faster than its competitors and invest in its EOS of workforce. However, if Google has limited structural advantages, then this implies an interesting hypothesis: Google’s ability to scale is limited by the EOS in the workforce, which may see diseconomies of scale fairly soon (20,000 employees? 50,000?). We concede that it may seem unlikely that Google will soon hit a limit on its scale, leading us to consider that Google may have other structural advantages that we have not seen. But if we are correct, then it seems plausible that Google is a firm that largely lacks structural advantages and must chiefly rely on its organizational competencies in order to continue to succeed.

However, this will likely prove to be an increasing challenge for Google, as traditionally it has been the smaller technology companies that have innovated. In which case, could another search engine that is sufficiently faster/ better than Google fairly quickly supplant the Search Giant, ending the reign of one of the fastest growing companies of our time?

Appendix A

 

Excerpt from “Our Secret Sauce”:

If it isn’t economies of scale, lock-in, or network effects, what is it that explains Google’s success?

The answer, at least in my opinion, is a much older economic concept called “learning by doing” that was first formalized by Nobel Laureate Kenneth Arrow back in 1962. It refers to the widely-observed phenomenon that the longer a company has been doing something, the better it gets at doing it.

Google has been searching the web for nearly 10 years, which is far longer than our major competitors. It’s not surprising that we’ve learned a lot about how to do this well. We’re constantly experimenting with new algorithms. Those that offer an improvement get rolled into the production version; the others go back to the drawing board for refinement.

So I would argue that Google really does have a better product than the competition — not because we have more or better ingredients, but because we have better recipes. And we are continuously improving those recipes precisely because we know the competition is only a click away. We can’t fall back on economies of scale, or switching costs, or network effects, to isolate us from the competition. The only thing we can do is work as hard as we can to keep our search quality better than that of the other engines.

Source: “Our Secret Sauce,” Hal Varian, Google Chief Economist.

http://googleblog.blogspot.com/2008/02/our-secret-sauce.html

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Here is the thought experiment: What would happen if another company – say telepathic.org – came out with a new search engine that could read your mind and give you the exact results you wanted? In this scenario, Google has no real structural advantages (aside from maybe EOS in workforce) that would keep consumers from switching en-masse to that new site.

There are two other theories to how Google’s 20% projects are effective, yet perhaps not obvious to outsiders: some help improve Google’s website behind the scenes; and having to think differently during their 20% time may also help employees to be more creative during their 80% time.

Who is their most important rival? Why has it been unable to duplicate Google’s success?

Google’s most important rival is Yahoo!,  the incumbent in the search and advertising space when Google first launched.  Yahoo! has been unable to duplicate Google’s success due to two factors: an initial lack of understanding of the value of search, and later, a cultural ability to match Google’s efforts in search. Yahoo! initially started advertising with the objective of getting more attention for their ads, without focusing as much on relevancy.  Larger flashier ads would get more attention.  Allowing customers to pay for search result rankings would put their results in a location that users would see more often.  Google on the other hand strived to make their ad results more relevant.  This served to make Google’s search better as well as their hit rate on advertisements.

When Yahoo! did realize that they had missed the boat, they did not have the culture or organizational design to match Google’s focus.  While Google embraced a technocratic culture, Yahoo! adopted one centered on media, which prevented them from being as innovative. As the problem grew, bad morale started to reinforce their cultural problems, leading finally to the “Peanut Butter Manifesto” from an internal Yahoo! employee asking for massive organizational change.  Yahoo! has since been unable to make the drastic changes organization-wide necessary to right the ship.  They have always have pockets of excellence but they were never able to leverage that as an organization. While it is possible that Yahoo! may have been successful had it adopted a strategy congruent to its culture and media assets, it nonetheless continued to measure itself versus Google, and has repeatedly been unable to compete.

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“Yahoo Memo: The ‘Peanut Butter Manifesto’”, Source WSJ.

 http://online.wsj.com/public/article/SB116379821933826657-mbjXoHnQwDMFH_PVeb_jqe3Chk_20061125.html

 

What lies at the root of their competitive advantage? Has it changed over time?

We believe that Google’s competitive advantage in both the online search and search-based advertising markets started by having better IP and underlying hardware/ software than its rivals, combined with an organizational competence that focused on experimentation, innovation, and problem solving. Over time, the firm translated these benefits and culture into structural advantages through economies of scale in network effects and workforce, which have in turn allowed the company to grow its market share year after year.

Google’s main early advantage was due simply to building a better mouse trap.  Google provided more relevant search results with their, at the time, revolutionary PageRank algorithm.  PageRank uses the number of documents that refer to a given result to weight that result relative to others.  Developed by Larry Page and Sergey Brin, the patent actually belongs to Stanford because the work was done while they were both at Stanford, however, Google licensed the patent.  By now, however, PageRank is well-known by its rivals, and cannot fully explain for Google’s success over time.

Another of Google’s key early advantages was its organizational competence that stressed experimentation and embraced technical problem solving, all the while maintaining an emphasis on fun. Google engineers are encouraged to spend one day of their workweek, or 20% of their work time, on their projects that interest them. Some of Google’s well known products, such as Gmail and Adsense, came from this 20% time.

In addition to experimentation, the Google culture also values fun, while maintaining a focus on the task at hand. Even from the beginning, the Google cofounders chose a logo that emanated playfulness and irreverence. Later on, as the company grew, it introduced lava lamps, exercise balls, even free food and dry cleaning, to help facilitate an enjoyable environment. The goal, however, was always to keep employees focused on their work and not to have them waste time with mundane chores.

What these advantages in IP and culture gave Google was a head start that it was then able to translate into the firmer structural advantages. The first structural advantage is in network effects with consumers. While Google had an early advantage in search result relevancy, its perceived lead persisted, even when Yahoo! finally narrowed that gap over time. We believe that this is because quality differences across search engines have become difficult to measure for the average consumer (instead of, say, restaurant quality), and that word-of-mouth in favor of Google is helping it maintain its lead. This advantage also helps in the advertising market, because search-based advertisers will flock to the site with the most traffic, assuming that the demographics of both sites are similar.

The second structural advantage that Google has built is economies of scale in its workforce. In 2007, Fortune named Google the number one place to work in the United States, featuring quotes from employees that explained that one of the largest draws at Google was the opportunity to work with other Googlers: “Hard-core geeks are here because there’s no place they’d rather be,” says a Google Webmaster; “You’ve got to ask yourself why these people are coming here… I think they come here to be energized by the people at Google,” says an engineer.

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Source: Wikipedia http://en.wikipedia.org/wiki/PageRank

 

“In a [8/2/06] talk at Stanford University, Marissa Mayer, Google’s Vice President of Search Products and User Experience, stated that her analysis showed that half of the new product launches originated from the 20% time.” Source: Wikipedia.

 

The Google logo features the company letters in primary colors, save the letter “l”, which the founders wanted to color green (a secondary color) to show their irreverence. Source: “How Google Got Its Colorful Logo”, Sonia Zjawinski, Wired Magazine, 2/12/2008.

 

Source: Fortune Magazine. http://money.cnn.com/magazines/fortune/bestcompanies/2007/full_list/

 

How has Google been outstandingly successful?

Google is the market leader in the online search and search-based advertising markets, where it competes largely against two companies: Yahoo! (which also competes in the same industries), and Microsoft (competes in multiple industries). While Google has benefited from a rapidly growing industry (particularly in the search-based advertising space), it has in particular taken a large share of this market, especially when compared to its main rivals; in addition, its lead has only increased over time.

We used two metrics to show that Google has been outstandingly successful in both of these markets: stock price performance over time versus its rivals; and its current market share versus those same rivals. First, we compared Google’s stock price performance to that of Yahoo! and Microsoft over the past few years, as a percentage of each company’s stock price on 9/1/2004 (the first day of the first full month of Google as a public company). As you can see in figure 1 in the appendix, Google’s stock price has grown 4x since that date, while Microsoft has less than doubled, and Yahoo! has declined in value.

We also looked at Google’s market share in the online search and search-based advertising market, where we found that Google is by far the market leader in both. In online search, one recent estimate puts Google at a 69% market share in online search, with Yahoo! a distant second at 17%, which is remarkable considering Yahoo! was the market leader in search when Google was founded in 1998.  In the search-based advertising, another source puts Google at a 70% market share. As you can see in figure 2 in the appendix, Google’s share in this industry has grown over time as well.

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Source: Compete.com, January 2008

 

Source: eMarketer, January 2008