Notes – The Physics & Chemistry of Leadership

Notes from a leadership talk given in 2013

  1. The Business Physics Law of Ownership: “the responsibility for the performance, productivity, morale and attitude of the employees rests with the leader”
  2. Four-House Management: “maintaining balance among all 4 houses is critical”
    1. growth
    2. control
    3. process
    4. culture; drives all the other houses
    5. Kotter-Heskett Question: adaptive cultures have higher productivity per employee and thus higher net profit
    6. Zappos Company Culture Handbook, available on website
    7. Steam Employee Handbook
    8. Lou Gerstner
  3. The Law of the Poker Chips: “never confuse activity with results”
    1. focus on blue chip items rather than white chip items (easily identified/quantified items that can be checked off)
    2. identify your REAL priorities; plan and organize EVERYTHING around these priorities
    3. attention is all there is
    4. Annie Maddox:
      1. the ability to concentrate
      2. the ability to operate w/ consistent self-discipline
      3. the ability to turn abstract objectives into concrete goals and achieve them
      4. the ability to build a cohesive, focused team around those objectives
  4. The Law of F & V: “my willingness to adapt will determine my performance potential”
    1. performance potential is a function of
      1. versatility
      2. flexibility
  5. Social Learning Theory: “self-management must precede people management because most organizational behaviors are learned through observation and modeling:”
    1. credibility killers
      1. unenforced policies or operational procedures
      2. failure to resolve weak performance or work execution issues, especially when they impact other employees
      3. failure to resolve employees toxic behavior issues
      4. apparent lack of responsiveness to correctable process problems
      5. emotionally immature behavior among leaders
    2. if you can simply manage your conversation, almost everything else in life will fall into place ~ Mike Corbit
    3. you don’t have to be a perfect leader but you do have to improve, if people see you making progress this gives you leverage
    4. Dr. Albert Bandura
  6. Propulsion Theory: “energy comes from purpose”
    1. emotional intelligence
      1. self-awareness
      2. self-control
      3. self-motivation
      4. empathy for others
      5. ability to influence others
    2. what do employees care about?
      1. treatment
      2. communication
      3. meaningfulness
    3. what is motivation?
      1. the internal force that prompts to action
  7. The Chemistry Law: “human behavior is based primarily on chemistry and emotion, not logic”
    1. “stress makes people stupid.”
    2. nothing grows in nature without stress
    3. growth only occurs with the carefully managed application of appropriate levels of stress
    4. the discovery principle: positive discovery triggers the release of chemicals whose net result is the feeling of physiological betterment
  8. The Law of Engagement: “increasing our level of engagement will increase their level of engagement”
    1. total, active involvement
    2. emotional connection
    3. full participation
    4. complete interlocking for the purpose of transferring power
  9. The Algebra Teacher: “leadership success depends on desire, willingness and ability to influence, teach and develop people”
  10. Pygmalion Management: “the leader knows that how they think about employees affects their performance because people will rise or fall to the level of our expectations”
  11. The Power of Electricity: “increased productivity is a result of increased self-esteem, which is a result of ongoing, learned and personal achievement”
    1. A leader is a dealer in hope. ~Bonaparte
  12. The Power of Self-Discovery: “questions are more powerful than answers”
    1. we want to ask enough well thought-out questions to lead to either self-discovery and progress on the employees’ part or useful understanding on our part
    2. “if it was your ship, what would you do?”
  13. The Law of the Cheetah: “productivity improves as communication improves because perception drives behavior”
    1. it is the responsibility of the manager assigning the task to ensure that the request was received, understood and executed
  14. Inertia and Entropy: “never ignore unsatisfactory behavior or performance”
    1. an object at rest tends to stay at rest, in motion stays in motion, unless acted upon by an outside force
    2. the natural progression of everything in the universe is from order to chaos
  15. Curing Frustration: “the primary difference between great managers and average managers is often their willingness and ability to take action”
    1. “action cures frustration”
    2. 6 basic functions of a supervisor
      1. hire carefully, and hire character first
      2. train, teach, instruct and develop
      3. monitor and evaluate progress
      4. provide feedback, adjustment and input for correction and improvement
      5. keep people focused
      6. create and maintain an environment that is inspiring and energizing
    3. EPT training
      1. you watch me
      2. we do it together
      3. I’m going to watch you
      4. we review it
      5. I watch you teach
      6. you take ownership
  16. The Power of Niagara Falls: “part of leadership is being aware of theater, which creates energy”

Review – Repeatability

Repeatability: Build Enduring Businesses for a World of Constant Change

by Chris Zook, James Allen, published 2012

What’s this book about?

I finished reading this book over three weeks ago. Since then, I have struggled to get myself to sit down and write a review. The primary reason I’ve struggled is because I am not sure I can say with confidence what this book is about, or to which genre it belongs. Is it about strategy? Business management? Business planning? Organizational theory? Something else?

“Repeatability” chants about simplicity, but it’s full of so many buzzwords, different-but-related ideas and proprietary-sounding business catchphrases that it’s hard at times to keep up. And perhaps I’ve dropped into the late middle of an earlier conversation, as the book references a “focus-expand-redefine” growth cycle elaborated upon in three earlier works known as “the trilogy”.

A more charitable explanation of my confusion might place the blame with the authors themselves. Take the way in which they describe the main shifts in strategy they say they are witnessing, which led them to write the book:

  1. less about a detailed plan and more about general direction and critical initiatives
  2. less about anticipating how change will occur, more about having rapid testing and learning processes to accelerate adaptation to change
  3. effective strategy increasingly indistinguishable from effective organization

The central insight from their research, the authors claim, is that,

complexity has become the silent killer of growth strategies

Why? The authors don’t take pains to explain or justify the assumption that the world is more complex and that “traditional” strategic notions no longer work in this new world order. They just accept it as common wisdom and run with solutions for responding to it.

Building “Great Repeatable Models”

The next several chapters detail what Zook and Allen call “Great Repeatable Models”, which are businesses defined by the following three principles:

  1. a strong, well-differentiated core
  2. clear non-negotiables
  3. systems for closed-loop learning

According to the authors, GRMs (germs?) were

sharply, almost obviously, differentiated relative to competitors along a dimension that also allowed for differential profitability

which I think is another way of saying they have a lucrative competitive advantage.

Similarly, the authors suggest that non-negotiables are a company’s

core values and the key criteria used to make trade-offs in decision making

while systems for closed-loop learning enabled GRMs to

drive continuous improvement across the business, leveraging transparency and consistency of their repeatable model

which I understood to mean that the businesses had a culture and process for improving their practices over time.

The Cult of the CEO

Chapter 5 of “Repeatability” seeks to demonstrate how the CEO is the guardian of the three principles of GRMs. While it clearly makes sense that the CEO, as the chief strategist and top of the organizational pyramid would have a role in implementing and enforcing a GRM, the authors offer little here to help other than numerous examples of success and failure in following the three principles followed by a hopeful conclusion that the “right leadership” will be in place to manage the delicate balancing act they specify as ideal. It seems to place the book in the Cult of the CEO genre (idealizing the role and superhuman nature of corporate chief executives) while simultaneously causing much of their writing up to that point to seem extemporaneous.

It’s almost as if the presence of the “right leadership” implies the presence of a GRM, and the absence of a GRM implies the absence of the “right leadership.” The book suffers from hindsight bias and tautological reasoning like this in numerous areas.

My own simple interpretation

The central tenets of this book are confusing, poorly defined and at times self-contradictory. Its research methodology (inductive empirical study to explain complex social phenomena) is frowned on by this Austrian economist. Ironically, it is the occasional element touched upon at the periphery of the book’s argument, rather than its core, where the authors manage to share something meaningful to solving the dilemmas of business people.

Unfortunately, the encouragement to keep the distance between the CEO and the customer minimal and to articulate a simple vision that even lower-level employees can grasp and rally behind, for example, is rather intuitive and obvious. Why would adding layers of bureaucracy and arbitrary decision-making, or creating a business plan so elaborate your employees don’t understand it, ever be a sound practice?

There’s a lot here including many case studies and other reference materials, but not all of it is useful or makes sense when viewed through the prism of the Great Repeatable Model. For some the digging required to find the occasional nugget of wisdom may be worth it but I can’t recommend such exertion for everybody.

The Long War: Changing Ownership, Management Incentives & Reporting Practices

Ian Cassel, founder of MicroCapClub.com, made a comment on Twitter today which grabbed my attention:

If a company is over $25m market cap they should have to have earnings conference calls w/ Q/A. Coalition Against Private Public Companies.

Shortly thereafter, he was asked by Jeff Moore of the Ragnar Is A Pirate blog:

How about if they have more than 100 shareholders?

To which Ian replied:

yes another good idea

At this point, I asked:

so you guys are for imprisoning and fining people because they won’t give you info you want?

Ian considered it and responded:

do I think every public company should, Yes. Force probably not, but cld be part of a tiered listing standard

I think this whole idea is worth a comment so I’m now going to give it one.

The first angle with which to approach Ian’s compulsory conference call proposal is the moral one and concerns the question, “Should managers of public companies, whatever their size, be compelled by force of law (ie, threat of fines or imprisonment for non-compliance) to provide the investing public conference calls regarding their earnings releases?”

The answer to such a question would hinge on whether or not, by refusing to hold such calls, these managers were committing an act of violent aggression against the investing public, such as theft, assault or fraud. If refusing to hold an earnings call is an act of theft, assault or fraud, clearly there is justification for compelling such behavior in order to remedy this affront to the rights of the individual members of the public and the answer would be “Yes”; similarly, if refusing to hold an earnings call does not represent the initiation of the use of force against members of the public, the answer to this question is clearly “No”.

I don’t want to waste anyone’s time going into a lengthy exploration of the facts on hand. I think it’s obvious that refusing to hold an earnings call is not an act of aggressive force and I don’t think Ian provided or attempted to provide any evidence that it was. In fact, he suggested this was not an issue to be handled by the law at all. I elaborated as much as I did, anyway, because there may be people reading this who did not understand the issue in this way and may have been confused prior to reading it. For their benefit, I state plainly now, the answer to the question is “NO”.

The second angle of approach is institutional. As Ian suggested in his final comment, the solution to this perceived problem could be handled at an institutional level (in this case, the voluntarily adopted rules and internal regulations of the listing exchanges) by adopting Ian’s preference for mandatory earnings calls at a certain market cap threshold as an observed “best practice” or condition of doing business on the exchange. If a company doesn’t want to follow it, they have the option of not being listed on the exchange observing such a rule. From a moral standpoint, there is no issue as there is no coercion, and compared to the alternative of creating a top-down, one-size-fits-all-companies-and-exchanges external regulation backed by force of law by government, this solution is indeed preferable because it at least allows for the possibility that some companies would not follow this practice and would find other avenues for listing their shares and allowing for equity exchange.

This leads to the third angle which, for lack of a better term, I’ll simply refer to as the “practical” considerations, of which there are several. For starters, I wonder if this is really an issue? In Ian Cassel’s (and Jeff Moore’s, perhaps?) world, it certainly seems to be. Ian Cassel’s world would be a happier place if all the public companies whose market caps were $25M or greater provided the public (of which he is a member and would stand to benefit) an earnings call upon release of each earnings statement. But embedded in such a proposal seems to be the belief that the world should reflect Ian Cassel’s preferences, and everyone else should bear the cost and expense of preparing and providing this information to Ian Cassel (and others of like mind).

Is this reasonable? If having better earnings communications from small companies is important to Ian, and if dialoging with management is a valuable commodity, Ian already has a course of action available to him to pursue such goals: he can make his own independent effort to email, write, call or visit in person the management of these companies and create a relationship whereby they would provide him answers to some of the questions he has in mind; or, he could acquire a sufficient number of shares of the company such that he is the owner of the company and the management is now fully responsible to him and he can have any and all information about the company that he pleases.

Neither of these actions require anyone being compelled to change their current practices. Both require nothing more than the expenditure of Ian’s own effort, time and wealth. If certain companies prefer not to establish such relationships or provide such information to people like Ian, Ian always has the option of walking away from them. And if he doesn’t have the financial resources to acquire such an ownership stake so as to make them more responsive to his inquiries, that would be a problem for him to solve by finding ways to produce more wealth for himself he could exchange with others for the privilege – it is not the responsibility of the company, its shareholders or anyone else.

Another practical consideration is the arbitrariness of the threshold for compliance. There’s nothing magic about a $25M market cap (nor a 100+ member shareholder base). The first number seems to be an attempt at defining “resourcefulness”, implying that a company with a certain sized market cap “should be able to afford” such accommodations. But market caps are not determined by managements and company resources, they are determined by the passions and dispositions of the investing public. It’s entirely conceivable that a company of truly inadequate resources (say, a book value of $50,000, just to harshly illustrate the point) could be bid up to a market cap of $25M in some bizarre turn of events. The fact that it has been so valued doesn’t make it more able to provide additional clarity about its business– and even if it did, it still doesn’t have an obligation to provide anyone anything like this. The shareholder base threshold is simple populism and the democratic principle– 99 of the shareholders could own one share at a penny a piece, with the remaining shareholder holding substantial control of the rest of the shares, making them truly insignificant in the ownership structure. But by creating arbitrary rules like this these individuals would create for the company sudden obligations simply by their existence.

Another practical concern is why a person, operating in the microcap space where an edge is often gained specifically because of the lack of consistent, clear information about these companies, would want to see measures taken which would serve to increase the “efficiency” of the market and thereby eliminate a lot of these mispricings and the opportunity to cheaply invest along with them. Sure, once you’ve put your money in you might have a self-interested reason to see everyone else suddenly figure out what a great company you’ve invested in because they have these wonderfully translucent earnings calls, but before that point you’d want to see opacity. Such a rule (compulsory earnings calls) would work to eliminate those opportunities before one could make their initial investment, not just after. As microcap investors, what we’re getting “paid to do”, essentially, is to find these opaque opportunities, get in there, agitate for change company-by-company and work to clear the dirt and smudges off the glass, so to speak. We want that to happen AFTER we get involved and BECAUSE we got involved, not before and regardless.

My final issue is with the cutely-named imaginary organization “Coalition Against Private Public Companies”. The implication is that public companies run like private companies constitute some kind of social ill. But if we look at the facts, it is often the owner-operator/private companies of the world which are most efficiently managed and whose business is best looked after compared to the alternative of entrenched, professional managers and disconnected, alienated and disinterested public shareholders (see this outstanding research piece by Murray Stahl [PDF] for a convincing argument, for instance). Indeed, it is often the public companies which are most dysfunctional– how is it preferable to have a management team obsessed with short-term earnings results, attempts to influence and gain the approval of Wall Street analysts, etc.? It’s perhaps syntactically confusing but what is really worth rebelling against is public private companies, not private public companies.

A public private is a company that SHOULD be private, but is in fact publicly traded and as a result the minority partners in the business, that is, the various outsider shareholders from the investing public, are treated like nuisances or smurfs whose capital is to be dissipated at the insider owners’ discretion. Such managers have no incentive to responsibly steward the outside shareholders’ capital because it doesn’t belong to the insiders and the outsiders are, in most cases, afforded an ambiguous and difficult, if not impossible, legal process to attempt to assert their equal status as capital owners. The most benefit they can receive from the capital is to issue some of it to themselves as generous salary or bonus payments, to use it as a tool for conducting ego-gratifying acquisition strategies or by sitting on it as a kind of future retirement/pension package to ensure they can care for themselves even in old age by remitting it to themselves as needed.

A private public company, on the other hand, is a company whose capital ownership is diversified and constituted by numerous members of the investing public, but which is managed and operated with the efficiency, passion, dedication and noble conservatism such as one would expect from a competent family dynasty or other limited, owner-operator control group or person. This is a company that treats capital as a precious commodity and always seeks to maximize the returns on its use which all members of the investing public so involved stand to benefit because they are treated as equals even though they have minority status. The fact that this company is publicly traded does not influence the decisions of the management and serves only to benefit all shareholders in the instances in which the management can buy back undervalued shares or issue significantly overvalued shares to raise cheap capital.

Truly, there are very few enterprises on all of planet earth that really provide their owners (shareholders) with outstanding additional benefits by virtue of their being publicly owned and exchanged. The more I think about the issue, the more I wonder why most public companies are public in the first place. Almost every IPO seems to represent an opportunity to cash in on delusional hopes and ignorant dreams rather than a genuine opportunity to “share the wealth” in exchange for some long-term capital necessary to fund profitable growth.

If I were to join a group agitating for change, I’d like to imagine it’d be called the “Coalition To Privatize Public Companies.” But honestly, I have no use for imagination, nor for agitation. I don’t seek to have others bear my cross, even as a joke or a day-dream. No, this is in fact a principle (one of several) of my efforts as a private, individual investor in the public market place and I intend to pursue it throughout my career.

It’s part of my long war.

Video – Seth Klarman On Leadership

The Harvard Business School presents Seth Klarman, founder and president of the Baupost Group

Major take-aways from the interview:

  • I don’t think a lot about being a leader; our goal is to be “excellent” and to be proud of what we do
  • Main principle for leadership or management-style: “Do unto others…”
  • Big believer in leading by example; you can’t expect other people to do things you’re incapable of or unwilling to do yourself
  • Sometimes organizations are stuck, people want to do more but they haven’t been asked the right way; don’t overlook the power of re-anchoring via leading by example
  • Leadership stems from credibility — credibility stems from being “right” over time and from having knowledge — and from moral values
  • Two important moral values for leaders:
    • Football field test; play the game from the center of the field, not near the sidelines, where it is easy to go out of bounds without intending to do so
    • WSJ test; live your life in a way that you would not be embarrassed to have it reported on the front page of the WSJ
  • Every quarter, I sit down with the non-investment team members of the firm and explain the current investment strategy; the idea is to help the rest of the firm understand why the firm is doing well or poorly; this creates a culture where everyone is on the same page
  • You want to create a culture where everyone is willing to stay late to finish a job if they have to, where people will spend time double-checking for mistakes; people paying attention to detail at every level of the firm is important
  • Leaders don’t take credit, they give credit; be quick to give everyone around you credit, it is empowering to those people
  • Turnover is a hidden cost of business; it can take so long to get someone up to speed, train them properly, get them to the point that they can contribute; treating employees properly and caring for them is a smart business decision
  • If you have someone who is not getting the job done, other people are probably carrying their weight and working extra hard for them, and this isn’t fair; good leaders need to be fair
  • Get a good mentor; find a place to work where they care about you, that will nurture you and be interested in your development; if you can find one it sets you on the road to success
  • An experience SK feels good about as a leader: the time the leaders of the firm decided to buy the entire firm playoff tickets for the Red Sox game that ended up being a historic game– an order of magnitude different from handing over a $1000 bonus
  • A mistake SK made as a leader: tolerating a “difficult person” for far too long, because they were a talented individual; it poisoned the well, tarnished the moral character of the firm, led to some financial losses; focused too much on the short-term pain rather than the long-term benefit of that decision
  • A leader is not afraid to fail, is not afraid to be wrong or to lose money in the short-term; a leader always adheres to their principles and standards
  • JP Morgan: “I can do the work of a year in 9 months, but not in 12”; it’s important to set time aside to refresh, relax, reflect
  • Marathon, not a sprint; don’t focus on the short-term because it causes anxiety and makes you hyperactive in an effort to compensate for short-term poor performance
  • You can’t be a leader if you burn out; find balance, seek a variety of interests
  • Working a couple years at an intense pace (80hrs+/week) is okay if it’s for a specific purpose; ideally, if you are going to work that hard, do something entrepreneurial, then you’re doing it for yourself and the benefits, if any, accrue to you
  • Understand that if you plan to compete by being willing to work 100 hours a week, you’ll be beat by people willing to work 110 hours

Review – Billion Dollar Lessons

Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years
by Paul B. Carroll and Chunka Mui, published 2008, 2009

The seven deadly business sins

The authors of Billion Dollar Lessons identified seven “failure patterns” that typify the path to downfall of most businesses:

  1. synergy; overestimating the cost savings or the profit-enhancement of synergy
  2. aggressive accounting; becoming addicted to creative accounting practices which eventually invites outright fraud to keep up with
  3. rollup acquisitions; assuming the whole is greater than the sum of the parts
  4. blindness to catastrophe; dancing on the deck of the Titanic, ignoring that the ship is sinking
  5. uneconomic adjacency acquisitions; assuming there are benefits to combining similar businesses which are actually dissimilar
  6. disruptive technology; committing oneself to the wrong technology and betting it all
  7. consolidation indigestion; assuming that consolidation is always the right answer and that it solves all corporate problems

In Part I, each chapter addresses one of these failure patterns, explaining the principles and problems of the failure pattern, giving numerous real-world examples of the pattern in action and finishing with a list of tough questions for managers and shareholders/board members to ask before pursuing one of the potentially flawed strategies mentioned.

In Part II, the authors offer a behavioral/psychological explanation for why companies and individuals routinely make these same mistakes, basing their assertions on the idea of “human universals.” The idea is that being aware of them is not enough– one must also put into place processes and self-check systems that are independent of any one person’s self-honesty (or lack thereof) to allow a company to essentially “check itself before it wrecks itself.” The most important corporate institution suggested is the Devil’s Advocate.

Illusions of synergy

According to the text,

A McKinsey study of 124 mergers found that only 30 percent generated synergies on the revenue side that were even close to what the acquirer had predicted… Some 60 percent of the cases met the forecasts on cost synergies

In general, there are three main reasons why synergy strategies fail:

  1. synergy may exist only in the minds of strategists, not in the minds of customers
  2. companies typically overpay for an acquisition, meaning the benefits from synergies realized are not enough to overcome the initial investment cost
  3. clashes of culture, skills or systems often develop following an acquisition, killing the potential for synergies

Double-check your synergy strategy by asking yourself the following tough questions:

  • Do you need to buy a company to get the synergies, or could you just form a partnership?
  • How do you know that customers will flock to a new product, service or sales channel?
  • If you think you’re going to improve customer service, then how exactly will that look from the customer’s perspective?
  • What could competitors do to hurt you, especially during the transition while you integrate the company you’re taking over?
  • Who in the combined organization will resist the attempts for revenue synergies? Whose compensation will be hurt?
  • What are the chances you’re right about revenue synergies?
  • What percent of your customer base might go elsewhere following this corporate change?
  • Acquisition cost:
    • What is the target company worth on a stand-alone basis?
    • What would the business be worth if you achieved all synergies mapped out?
    • What would the business be worth if you discounted the synergies, based on the fact that few companies achieve all the synergies planned?

Faulty financial engineering

Many companies find themselves in hot water because they believe their own creative accounting too much. They let sophisticated financial legerdemain conceal the uneconomic nature or riskiness of their business. Managers often become addicted to this accounting, finding themselves stuck on the “treadmill of expectations” and give in to the temptation to commit outright fraud to keep it going, destroying the business in the process.

There are four primary risks to financial engineering strategies:

  1. encourage flawed financial products which are attractive to customers in the short-term but expose the seller to incommensurate risk of failure over time
  2. hopelessly optimistic levels of leverage
  3. aggressive and unsustainable financial reporting
  4. positive feedback loops which cause the system to implode

Double-check your financial engineering strategy by asking yourself the following tough questions:

  • Can the strategy withstand sunshine? (Would you be embarrassed if it was widely known and understood?)
  • Can the strategy withstand storms? (Is it fragile and susceptible to being tipped over by less-than-perfect conditions?)
  • Will that accounting generate positive cash flow or just make the profit-and-loss statement look better?
  • Does the strategy make any sense? (ex, does it make sense to offer long-term financing on short-term depreciating assets?)
  • When does it stop?

Deflated rollups

According to business research,

more than two-thirds of rollups fail to create any value for investors

The rollup strategy is initially attractive because

the concept makes sense, growth is unbelievable, and problems haven’t surfaced yet

But they rely a lot on positive momentum to succeed because

Rollups have to keep growing by leaps and bounds, or investors disappear, and the financing for the rollup goes with them

There are four major risks to a rollup strategy:

  1. rollups often wind up with diseconomies of scale
  2. they require an unsustainably fast rate of acquisition
  3. the acquiring company doesn’t allow for tough times in their calculations
  4. companies assume they’ll get the benefits of both decentralization and integration, when in reality they must choose between one or the other

Double-check your rollup strategy by asking yourself the following tough questions:

  • Will your information systems break down if you increase the size of your business by a large factor?
  • What other systems might break down at the new scale?
  • How much of senior management’s time is going to go to putting out fires, coordinating activities, etc.?
  • How much business will you lose in the short run as competitors use takeover confusion to try to poach business?
  • What regulations might change and how will they affect the business?
  • Will your cost of capital really decline? If so, how much? How do you know?
  • If you think your pricing power will increase, why?
  • What will you have to spend, both in time and money, to get the efficiencies you expect from a takeover?
  • Who has a vested interest in keeping you from achieving all the efficiencies you expect?
  • How much will prices of acquisitions rise over time, as your rollup intentions become clear?
  • If you’re financing with debt, just how big a hit to your business can you withstand? What if you take a hit to cash flow for a period of years? If you’re buying with stock, what do you do if your stock price falls by 50%?
  • How do you prevent people from cooking the books when the bad times come?
  • Have you discounted the gains you expect to get from integration?
  • How much loss of revenue are you assuming if you replace local managers and systems?
  • What is the end game? How big do you need to get?
  • How slowly can you go?
  • Do you have to be a national rollup, or would a regional one make sense? Can you at least start as a regional rollup and work out the kinks?

Staying the (misguided) course

Businesses often adhere to a failed strategy or a dying technology because they either can’t envision how they’d adapt or can’t admit that they’re on a failed business course.

The three main risks to staying the course are:

  1. tend to see the future as a variant of the present
  2. tend to consider whether to adopt a new technology or business practice based on how the economics compare with those of the existing business
  3. tend not to consider all their options

Double-check your core strategy by asking yourself the following tough questions:

  • Are you considering all your options?
  • Declining business model, based upon Michael Porter’s five forces:
    • does your industry have a favorable structure for decline, where, like steel, it will provide profits even as it declines? Or, is your industry like traditional photography, which would mostly disappear once digital took hold?
    • can you compete successfully for the remaining demand, like Kodak, with a great brand? Or do you not only lack a brand but also lack other assets, such as a low cost structure?

Misjudged adjacencies

Adjacent market expansion entails attempting to sell new products to existing customers, or existing products to new customers, by building on a core organizational strength to expand the business in a significant way.

But sometimes, businesses expand into markets that seem adjacent, but are not– just because your branded-sunglasses customers like your sunglasses brand, doesn’t mean they’ll necessarily like it on their sportscar tires, or on their surfboards, because you imagine your market is “sport lifestyle.”

There are four fundamental risks to an adjacency strategy to be aware of:

  1. the move is driven more by a change in a company’s core business rather than by some great opportunity in the adjacent market
  2. lack of expertise in the adjacent market, causing misjudgment of acquisitions and mismanagement of the competitive challenges of the new market
  3. overestimation of the strengths of importance of core business capabilities in the new market
  4. overestimation of the hold on customers, creating expectations of cross-selling or up-selling that won’t materialize

Double-check your adjacencies strategy by asking yourself the following tough questions:

  • How do the sales channels differ in the new market?
  • How do the customers differ?
  • How do the products differ?
  • Are the regulatory environments differ?
  • Do you have at least a 30% advantage on costs before entering the new market?
  • What if the economy goes seriously south?
  • What if the sector you’re moving into goes into decline?
  • What if your expectations about opportunities for efficiency and revenue growth don’t happen?
  • How much do you have to be off in your estimates of cost savings or revenue increases for the adjacency strategy to be a bad idea?
  • What don’t you know about your new market?
  • What don’t you know about making acquisitions?
  • How many of your acquisitions will be lemons?
  • Will your customers really follow you into your new market?

Fumbling technology

Businesses often bet the farm on a technology that turns out to be nowhere close to as profitable and revolutionary as they initially expect it to. Often, market research is created which suffers from “confirmation bias”.

There are three important technological “laws” to be mindful of, which are often ignored, as well:

  1. Moore’s Law; computer processors double in power every eighteen to twenty-four months
  2. Metcalfe’s Law; the value of a network is proportional to the square of the number of users
  3. Reed’s Law; new members increase a network’s utility even faster in networks that allow arbitrary group formation

There are four major mistakes businesses make when evaluating a technological strategy:

  1. evaluate their offering in isolation, rather than in the context of how alternatives will evolve over time
  2. confuse market research with marketing
  3. false security in competition, believing the presence of rivals equates to a validation of the potential market
  4. design the effort to be a front-loaded gamble instead of developing it piece-by-piece

Double-check your technology strategy by asking yourself the following tough questions:

  • What will your competition look like by the time you get to market? What if you’re six months late? A year?
  • How does your performance trajectory compare with the competition’s?
  • Do your projections incorporate Moore’s Law, for both yourself and your competition?
  • Have you allowed for Metcalfe’s Law and what it says about the relative value of networks? Is Reed’s Law relevant?
  • Is the market real?
  • Do you have to do it all at once? Or can you try things a bit at a time and learn as you go along?

Consolidation blues

Consolidation seems to be a fact of maturing industries. As an industry matures, smaller companies go out of business or are acquired. Most business people figure they want to be the acquirer; in the process, they ignore the possibility that they might be more valuable as a target, or by sitting and doing nothing (neither consolidating, nor selling out).

There are four main issues that tend to muck up consolidation strategies:

  1. you don’t just buy assets as a consolidator, you buy problems
  2. there may be diseconomies of scale
  3. assumption that the customers of the acquired company will be held
  4. may not consider all options (being an acquisition target, doing nothing)

Double-check your consolidation strategy by asking yourself the following tough questions:

  • What systems might fail under the weight of increased size? How much would it cost to fix them? How long would it take? What revenue might be lost in the interim?
  • What relationships might be harmed?
  • What departments are too small, or are for some other reason not up to the task of handling the new size? Which people aren’t up to the task?
  • How much will be lost as people jockey for position in the new organization?
  • How much drag will develop as you try to find efficiencies by standardizing processes?
  • Who will resist change? How effective will they be?
  • What are all the reasons why customers might defect?
  • How does consolidation benefit the customers?
  • What percentage of customers do you think might leave? How much do you think you’ll have to pay to entice these customers to stick around?
  • What are some potential results if you sold out or did nothing, instead of consolidating?

Coda

In summary, the most common problems that result in business failure are:

  • Underestimating the complexity that comes with scale
  • Overstating the increased purchasing power or pricing power or other types of power that come from growing in size (beware of “critical mass” strategies)
  • Overestimating your hold on customers
  • Playing semantic games (any strategy that relies on a turn of phrase is open to challenge)
  • Not considering all the options
  • Overpaying for acquisitions

Avoiding these mistakes: the Devil’s Advocate

How can you avoid these mistakes?

Put in place a process for reviewing the quality of past decisions.

Watch out for cohesive teams who develop the traits of dehumanizing the enemy and thinking they’re incompetent; limiting the number of alternatives they will consider; show even more overconfidence than members would as individuals; create “mind guards” who stomp out dissent.

Probably most important, establish the institution of Devil’s Advocate. Either assign an in-house, permanent DA (who gains experience with each episode, but carries the risk of being labeled as the “naysayer” and ignored) or assign the role on a rotating basis with each new decision (preferable).

The Devil’s Advocate is a powerful tool for avoiding business failure because

More often than not, failure in innovation is rooted in not having asked an important question, rather than having arrived at an incorrect answer

Review – The Innovator’s Dilemma

The Innovator’s Dilemma: The Revolutionary Book That Will Change the Way You Do Business

by Clayton M. Christensen, published 1997

Technological innovation always means change, but which kind?

In the world of business technology, innovation can be thought of as coming in two distinct flavors:

  • sustaining, which are new technologies that improve a product or service in a way that is valuable to existing customers or markets
  • disruptive, which are new technologies that are uncompetitive along traditional performance metrics, which are unusable or undesirable to existing customers or markets but which nonetheless can eventually come to replace the traditional market over time

Throughout history, it is the best-in-class businesses which have the most difficult time with disruptive technologies to the point that disruptive technologies are usually the death knell for the leading businesses at the time. But this raises a question: if they’re such good businesses and they’re so well-managed, how come they can’t manage their way around disruptive technology in their industry?

The answer lies at the heart of what the author refers to as the “innovator’s dilemma”:

the logical, competent decisions of management that are critical to the success of their companies are also the reasons why they lose their positions of leadership

Why do good management teams and competent decision-making processes miss disruptive technologies? Disruptive technologies:

  1. are normally simpler and cheaper, promising lower margins, not greater profits
  2. typically are first commercialized in emerging or insignificant markets
  3. are usually unwanted and unusable to leading firms’ most profitable customers

But good management teams with excellent decision-making processes are fine-tuned to search out:

  1. higher margin opportunities at best, and opportunities with minimum margin requirements based upon their existing cost structure
  2. opportunities that market research and querying of leading customers show there is a present demand for
  3. markets and growth opportunities which can have a significant impact on their business relative to their current scale

In short, every successful firm has a unique “value network” DNA that allows them to be especially dominant within a certain set of competitive circumstances.

the value network — the context within which a firm identifies and responds to customers’ needs, solves problems, procures inputs, reacts to competitors, and strives for profit

But disruptive technologies present a paradigm shift of a market into a completely different “value network” that the firm has not been evolved to survive in which results in, similar to biology, an extinction event for firms with the wrong type of value network DNA.

Crafting a response to disruptive technology

But the reality of disruptive technology is not entirely depressing for successful firms, and they can develop successful strategies for coping with disruptive technologies if they first make themselves aware of the five principles of disruptive innovation:

  1. Companies depend on customers and investors for resources
  2. Small markets don’t solve the growth needs of large companies
  3. Markets that don’t exist can’t be analyzed
  4. An organizations capabilities define its disabilities
  5. Technology supply may not equal market demand

Each of these principles holds within it a potential misstep for successful firms within their traditional value networks trying to respond to a disruptive technology. Because firms depend on their customers (primarily their leading, most profitable customers) and investors for their resources, they are often incentivized to ignore the low margin disruptive technology because their customers initially don’t want it. And because disruptive technologies start in emerging or insignificant markets, successful firms often ignore them in favor of better growth opportunities. Meanwhile, firms that DO try to take disruptive technologies seriously often commit themselves to particular investment and marketing patterns based off of market research for a market that is dynamic and prone to sudden and rapid change. At the same time, that which makes a company excellent at doing A simultaneously makes the company horrible at doing B (where B is the opposite of A), and often disruptive technologies require B responses when successful firms are honed to operate at A. The final frustration for these successful firms occurs when they attempt to enter a disruptive market with a solution that technologically exceeds the needs of its current users, causing them to withdraw in defeat only to watch the market then take off anyway!

An ironic twist

As hinted at above, it is ironic that the very strengths of leading firms in adapting their business to sustaining technologies (improvements in performance in relevant metrics that their best customers demand) are the exact things that cause them to fail to respond to disruptive technologies in a profitable, dominant way. And to make a bad story worse, it is these strengths-as-weaknesses that allow entrants in disruptive technological markets to capture important first-mover advantages for themselves, constructing barriers to entry which are later often insurmountable for established firms.

To a dominant firm, disruptive technology looks like low-margin, small market business that neither their customers nor anyone else seems to be interested in. But for entrants in the disruptive market, with radically different cost structures than dominant firms and with organizational sizes and resources better matched to the opportunities presented, disruptive markets are a wild playground full of unchallenged opportunity.

And while the dominant firms look down at lower-margin, smaller market business and shake their heads dismissively, entrant firms look up above at higher-margin, huge market opportunity and lick their chops. Every business ultimately looks upstream for higher-margin opportunities than the ones they have at present.

Is it any wonder why dominant firms are continually defeated by surprise attacks from below?

How dominant firms can successfully respond to disruptive technology

The position of the dominant firm in the face of disruptive emerging technology is not hopeless. For every yin, there is a yang. By inverting the five principles of disruptive innovation outlined earlier, dominant firms can find five guidelines for successfully responding to disruptive technology:

  1. Give responsibility for disruptive technologies to organizations whose customers need them
  2. Match the size of the organization to the size of the market
  3. Discover new and emerging markets through a flexible commitment to “plans for learning” rather than plans for implementation
  4. Create organizational capabilities and strengths which are complementary to the unique demands of the disruptive market place
  5. Resist the temptation to approach the disruptive technology with the goal of turning it into something existing customers can use, rather than serving the customers unique to the market and searching out new markets entirely

Conclusion

This book was published 15 years ago. The subtitle is, “The revolutionary book that will change the way you do business.” I don’t know if 15 years is long enough in the business world for the ideas of a book like this to be fully adapted into the mainstream but I would guess it is not. I am no business expert but this material was completely uncharted territory for me.

Frankly, I never thought I’d enjoy reading something written by a Harvard business school professor as much as I did with this book. Whereas case studies, quirky charts and statistical evidence usually bore me to the point that I often skip over them, this book was something of a page-turner for me and I found myself eager to find out “what happens next” in each subsequent chapter.

As faddish as it has become as of late to hype the increasingly rapid change of markets and business practices in general, the reality is that most markets don’t change that quickly and most business practices are timeless themselves. But for those unlucky enough to find themselves, suddenly or otherwise, in a market or business that is changing due to disruptive technology, this book could be a lifesaver at a minimum and a handbook for profiting immensely from that change at best.

You can get the essential points of the book entirely from reading my review, or skim-reading the introduction and final chapters of the book (which present a comprehensive summary of the ideas outlined above). But the case studies are invaluable in driving the point home and there are numerous nuances to Christensen’s argument that are worth savoring and considering on their own. Because of this, I unequivocally recommend that every interested reader purchase their own copy and read it in full, and thereby grant themselves an invaluable competitive advantage in the market place, whichever value network they might happen to be competing within.