Thursday, March 10, 2011

Strategic Planning Analogy #381: Strategy Backstop

Back when my son was young, we lived next door to a city park. Many times we would walk over to that park to play a little “two-man baseball.”

In two-man baseball, you only have two positions—a pitcher and a batter. The problem occurred when the batter would hit the ball out into the outfield. Since there was nobody in the outfield to catch the ball, the pitcher would have to run out there and try to find the ball in the tall grass. And since there was nobody in the infield to throw the ball to, the pitcher would have to run the ball back to the infield.

Unfortunately, running out to the outfield and back was usually longer than the distance to run the bases. Therefore, any ball hit into the outfield usually scored a home run.

Fortunately, neither of us was all that good at hitting the ball, so that problem wasn’t as bad as it could have been. Instead, we had a different problem. We would swing the bat and usually miss. Since we didn’t have a catcher, the ball would continue to zoom past the batter.

Fortunately, there was a backstop fence behind home plate. Any ball that went past the batter would hit the backstop fence and stop, making it easy to retrieve.

What we really needed was another backstop fence behind the pitcher. The way, any ball hit towards the outfield would be intercepted by the fence and drop down by the pitcher.

The purpose of the backstop fence in baseball is to stop bad pitches and bad hits from flying away into a space where they do not belong, protecting spectators from injury. In the business world, bad things can happen as well. Therefore, businesses look for their own form of backstops—ways to minimize any negative implications when things go wrong.

A lot of research has been done lately into the science of risk. What these studies have found out is that humans tend to put a lot more weight on the negative consequences of a decision and a lot less weight on the positive upside of a decision. In other words, humans tend to make decisions more around the principle of minimizing loss than in trying to maximize gain. It takes an awful lot of positive upside to get us to accept a little bit of downside.

The mathematicians and statisticians will tell us that this is “irrational” behavior. They would say that as long as the upside is only slightly higher than the downside, a “rational” person should move forward.

But consider how risk can impact the career of a business decision maker. If the person makes a decision which turns out badly, they could lose their job. If they make a decision which turns out well, often nothing happens, since that is what was expected. Only when an outcome is outstandingly positive well beyond earlier optimistic expectations does a career get rewarded. Why take on the risk of getting fired unless there is enough upside to provide the chance for personal reward?

I think this explains why scientists find us fearful of a little loss and desiring a huge gain in order to offset the risk. But regardless of whether or not this behavior is “rational,” it is reality, so we need to work with it.

Therefore, if we want a company to embrace a strategy, we need to make sure the leaders feel comfortable about the risk. And that means that the potential downside needs to appear a lot smaller than the potential upside. And one of the key ways to do this is by putting a lot of “backstops” into your strategic plan.

The principle here is that strategy is not just about trying to move a company forward. It is also about trying to prevent a company from moving backward. If you ignore the fears of moving backward, you will never get the company to embrace your plan to move forward.

Strategies usually involve change. And with change comes the risk of something going wrong. And when something goes wrong, the negative consequences can be huge. Not only can the company move backwards, but so can people’s careers. This creates fear about adopting the strategy.

Just as backstops in baseball stop balls from taking a dangerous trajectory, strategy backstops try to stop the negative consequences when something goes wrong.while implementing strategic change. By helping to minimize negative consequences, the strategy becomes more desirable to management.

Strategy backstops tend to fall into two categories: Control (Ownership) and Controls (Exit Ramps).

1) Control (Ownership)
For a strategy to succeed, a number of things have to happen to the company’s advantage—a lot of decisions have to go your way. The more other people control those decisions, the more likely they will decide in a manner which is not in your favor. Their strategic agendas may not be the same as yours; in fact, their aims may be the opposite of yours. Therefore, if you want to minimize the risk of decisions going against you, it helps to control as many points where decision-making takes place as possible.

For example, think about access to critical supplies for your business model. If you want to ensure timely access to a sufficient amount of those supplies, you may want to exert more control over your suppliers. Perhaps you need to acquire your supplier in order to ensure that your strategic concerns are their top priority. Perhaps you need to renegotiate your supply agreement.

It appears that Apple is switching suppliers for its memory chips from Samsung to TSMC. Although there are many reasons for doing so, one reason appears to be because Samsung makes devices which directly compete with Apple devices. As a result, Samsung’s strategic goals with their chip supply may diverge at times from Apple’s. By switching to TSMC, Apple should have more control over its chip supplier.

This principle not only works upstream with suppliers but also downstream with distribution channels. Coke and Pepsi have been acquiring their bottlers. The reason is because Coke and Pepsi see the value in increasing the control over how their products are distributed. This is particularly true for the faster-growing non-traditional beverages, where Pepsi and Coke had less contractual control over the bottlers. The ownership created a backstop for strategies around these newer beverages.

Of course, the more of the process you own, the greater are your share of the losses if the process goes badly. Therefore, sometimes a good backstop is to give up some of the ownership. By not having 100% of the ownership, you do not have 100% of the losses.

This is common in Hollywood, where movie ventures are funded by multiple motion picture companies. The risk is shared amongst them. There are lots of ways to structure joint ventures and strategic alliances so that the burden of potential loss is shared, creating a backstop.

Franchising is another example. Franchisees put up the investment capital and take on the risk of the franchisee failing. Ironically, even though the franchisor is giving up ownership to the franchisee, the franchisor is in some ways actually gaining more control. Because the franchisee has a greater vested interest in making the venture a success, they are more likely to help the strategy succeed than a mere employee. So with franchising, you lower your share of any loss while simultaneously increasing the motivation of the operator to make the venture a success. Now that’s a good backstop.

2) Controls (Exit Ramps)
One big bet can look a lot riskier than a many small bets. Therefore, one way to reduce perceived risk is by dicing up one big decision into a lot of small decisions. The more opportunities you have to make decisions, the more opportunities you have to opt out or modify the approach early, before the losses get too large.

Think of it as being like two different expressways. One has exits every fifty miles; the other has exits every mile. If you accidentally find yourself going in the wrong direction on the first expressway, you have to go fifty miles before you can make a correction. On the second expressway, you are never more than a mile from being able to make a course correction. The more exit ramps you put into your strategy, the sooner you can correct course (before the losses become huge).

There are many processes to do this, such as stage gating or real options. The general principles work something like this. First, you develop key success indicators—metrics which help you tell whether or not you are on the right course. These are your controls, like a GPS on the dashboard on your car. Second, you develop a process where there are many opportunities to assess your progress. These are like building lots of exit ramps.

Then you monitor your controls. If the controls say you are off course, you make a correction at your next exit ramp.

What are examples of exit ramps? If you are a retailer, instead of signing up for a twenty year lease, you can sign up for a five year lease with three five year renewal options. That gives you more opportunities to walk away if the store is not performing. If you are in the oil drilling business, instead of buying a property where you think there may be oil, do a short lease to test for oil, with an option to buy later. Design contracts with lots of clauses for opting out if key measures are not met.

Sure, all of these exit ramps may cost you a little bit more, reducing upside potential a little. On the other hand, they reduce the downside risk by a lot. And, in the end, minimizing the downside seems to be more desirable than maximizing the upside.

If you want people to embrace your strategy, then you had better understand the psychology behind risk. In general, downside potential is weighed far more than upside potential. Therefore, people are more likely to embrace your strategy if there are lots of backstops embedded in the plan to minimize risk. Common backstops include increasing control of key decision points and increasing the number of opportunities to opt out or modify the decision (like stage gating or real options programs).

Since most decision makers want a high upside to compensate for any downside, if you cannot reduce the downside through backstops, then look for ways to increase the upside. For example, Disney tries to leverage its investments into as many selling opportunities as possible. A successful Disney movie can be leveraged into lots of toy sales, amusement park rides, Broadway plays, TV shows, licensing agreements and so on. All of these add-ons make the downside risk on that movie venture appear less threatening.

1 comment:

  1. Gerald Nanninga,
    I loved your statement, "The principle here is that strategy is not just about trying to move a company forward. It is also about trying to prevent a company from moving backward."
    Being on unstable top or peak may send a company either forward or backward. A bifurcation that exists and we have to live with it.
    As much as I enjoyed reading this post, yet I felt somehow strange. Baseball is not a familiar game in this part of the world and I had to "Google" to translate some terms. In spite of this handicap I immensely enjoyed reading this post.