Friday, August 28, 2015

Strategic Planning Issue: 3 Pieces of Paper

There has been a lot of discussion about how we have entered a “new economy” or a “post-capitalism business environment.” The idea is that businesses can no longer be managed like they used to. Profit has become less important. Being a good corporate citizen has become more important. A new relationship with employees is needed. And on and on the list goes. If you want to be successful now, you have to abandon the old rules and embrace the new rules. Traditional capitalism is passé. Embrace the new economy.

A lot of sophisticated reasons are usually given for the need to change. They usually include factors something like these:

  1. Changing Customers: The internet has shifted the balance of power from the company to the customer, and the customer isn’t all that interested in how profitable you are, but rather how nice you are.
  2. Changing Employees: The Millennial generation expects more from its employers than mere profit machines. If you want to hire the best of the Millennials, you have to satisfy their more diverse requirements for an employer.
  3. Changing Approach to Problem Solving: The world is full of serious global problems. Individual governments have not proven themselves to be particularly effective at solving them (they just talk and squabble with each other). However, if you point large international businesses at these problems, you may get a more effective outcome.
These all sound so noble and sophisticated and academic. And there is some truth in all of this. But I think the main reason why business is changing is a lot less noble, sophisticated and academic.
I think the main driver of change is the change in the type of paper we use to compensate employees.

In the middle of the 20th century, most of one’s compensation came in the way of a check. The vast majority of it was in the form of a regular paycheck. Then, at the end of the year was a bonus check.

The most important thing one needs to know about checks is that they only have value if there is enough money in the checking account to cover the check. Therefore, to keep the employees from rioting, you need to ensure that money is flowing into the checking account at levels to cover the checks.

In the middle of the 20th century, the primary source for the money in the company’s checking account was either profits or standard bank debt. And you couldn’t get standard bank debt unless you could prove to the bank that the company was on a path to create enough profits to pay off the debt.

Therefore, success at that time required a high focus on creating profits and significant cash flow on a regular basis. And the best way to do that was via traditional capitalism. It was all about profit, so that you could keep writing those checks.

As we moved towards the later portion of the 20th century, compensation practices were changing. For executives, the percentage of their total compensation from their base of paychecks was shrinking. Non-base compensation as a percent to total was increasing. And instead of just being a bonus check, the non-base compensation was increasingly coming from stock or stock options.

Now stocks are different from checks. You don’t need a lot of money in the bank to issue stock. In fact, you don’t need any money at all in the bank to issue stocks. I had a lot of friends who worked at Best Buy in the early days, when the company always seemed to be on the verge of bankruptcy. The company couldn’t afford to write bonus checks, so it kept giving everybody tons of Best Buy stock. 
Although the stock had little value at the time, there was at least the hope that it could become very valuable in the future (which is better than a bounced check). And, in the case of Best Buy, eventually that stock did became extremely valuable (and made many of my friends very wealthy).

In a compensation world full of stock paper rather than check paper, management priorities start to change. It is no longer about focusing on keeping the checking account balance high through growing today’s profits. Now, it was about finding ways to increase the value of the stock.

Yes, the economists will tell you that there is a correlation between profits/cash flow and stock price. In other words, if profits keep going up, stock prices tend to go up. But the correlation is not as close to 100% as it is with check balances. Other things now start getting in the way.

As it turns out, there are a variety of other tools to increase stock price beyond activities to increase current profits. They include activities like:

  1. Changing People’s Perception of the Future: If you get people to think to that the future will get a lot better for your company, the stock price will go up, even if nothing is different in profitability today.
  2. Making the Company Bigger via M&A: At that time, growth through acquisition tended to increase stock prices, because the combined bottom line was larger. However, if you paid too much for the acquisition without meaningfully changing the rate of profitability, you were actually destroying value. But this was sometimes overlooked by the market at that time.
  3. Stock Buy-Backs: Earnings per share is a ratio. There are two ways to increase the ratio: either increase the numerator (earnings) or decrease the denominator (number of shares). So by buying back shares, I can increase the price per share without having to deal with profits.
So, as you can see, by shifting the paper from checks to stocks, I’ve moved a bit further away from pure capitalism. The profit motive is diminished a bit and other things are coming into play.

Probably the best example of this transitionary period would be to look at Enron. Enron was one of the most extreme at using stock as a compensation tool. It dominated the total compensation package, it was administered quarterly, and it was the driving force behind Enron’s everyday decision-making.

The extreme focus on raising stock prices at Enron lead to far less focus on profits. In fact, in the final years of Enron, they typically weren’t paying taxes, because they weren’t really making profits. But the stock price kept skyrocketing, making the employees wealthy, because of the stock tricks they were using.

Of course, eventually they lack of a profitable business model eventually caught up with them and the company collapsed (along with the stock price).

The new economy of today tends to be more about start-ups in the social media and technology space. There are a couple of things worthy of note in how these companies operate.

First, their checking accounts are not filled with money from profits or standard bank debt. They are filled with money from firms that invest in start-ups. In other words, the start-ups are writing checks that draw from someone else’s source of money, not their own.

Second, nearly all of the compensation comes from when the start-ups cash in, by either going public with an IPO or by selling at some outlandish price to someone like Google, Facebook or Apple. Regular payroll checks are an insignificant percent of the total compensation. The work is done to get to the point of cashing in. You’re looking to sign the deal paper that makes the cashing in possible. Practically your whole life’s earnings come from that single point in time when you sign the deal paper and sell out.

In this scenario, profits have moved from being less important to almost being non-important. Since the money at first comes from private equity investors and later from whomever you sell out to, profits are never a big part of the equation.

If the profit prognosis in the early stages becomes too dire, you typically don’t try to fix it. Instead you shut down the start-up and try again. That is why I sometimes refer to this as the “Lottery Economy”: You just keep trying start-ups until you luck into a winner.

When the whole operating model is built around getting to the “cash in” deal paper, you naturally have moved quite far away from traditional capitalism.

It is like people who flip houses for a living (buying houses with no intent of living there, but only to sell at a profit). They don’t invest in improving the foundational issues in the house. They invest the cosmetic issues that make a house more appealing to the next buyer without having to spend a lot (called curb appeal).

In the same way, the start-ups in the new economy don’t build the foundation for profits but work on the cosmetics that make it more appealing when it is time to cash in.

The implications here are that although there are some noble, sophisticated reasons for why the economy has changed, that is not the whole story. It may not even be the main story. The main story may be about how people are getting compensated.

Knowing the primary cause of the change is important because of what it implies. If the new economy is primarily a result of a changing environment, then we have to adapt to the new environment. But if it is primarily due to a change in compensation tactics, then perhaps the old rules of capitalism are not as obsolete as we think.

My fear is that extremism in the Deal Paper economy may lead to the same thing as extremism in the Stock Certificate economy. We may end up with a repeat of Enron, where the abandonment of profit as the focus eventually catches up to us and everything collapses.

Yes, the economy appears to be operating under new rules. But until we fully understand the cause, we may want to be careful about the extent to which we embrace them. The dominance of profits in business may not be completely dead—just asleep.

This only briefly touches on the subject. It is too much to cover in a single blog. But hopefully this can get the conversation started.