Strategic Planning Issue: 3 Pieces of Paper

BACKGROUND
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.

THE OLD PAPER: CHECKS
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.

THE TRANSITIONAL PAPER: STOCK CERTIFICATES
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 PAPER: DEAL PAPER
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.

IMPLICATIONS
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.

SUMMARY
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.

FINAL THOUGHTS
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.

Strategic Planning Analogy #552: Dead By 45

THE STORY
A few years ago, I went to a conference on Big Data put on by IBM. The first thing I noticed was that almost everyone attending (other than myself) looked younger than my children (who were in their early 30s).

After a particular seminar session at this conference, one of these young attenders asked the speaker a question that went something like this:

“What do I do about these old people in my company (old defined as over 40) who don’t get it and are don’t want to get things accomplished our way?”

The speaker answered the question something like this:

“I used to tell people like you to be patient. Those old people will be irrelevant soon enough and then you can proceed. But now I see that they are already irrelevant, so just ignore them and move on. Treat them as if they were dead.”

That was not very assuring to people like me, who still think 40 is young.

THE ANALOGY
If you read the literature about the new economy, it is common to find references to the idea that anyone over 45 should be treated as dead. The idea is that if you haven’t made your millions by 45, you never will, so anyone over 45 who hasn’t already made it is irrelevant…they may as well just give up.

You may not buy into this philosophy, but it is common among the many of the key players in the new economy. And since people act based upon what they believe, this belief system is impacting the way the new economy acts.

All strategies work within the context of the environment around them. If you want your strategy to succeed in the new economy, you should consider how the “death at 45” philosophy impacts the context in which you are trying to succeed. If you don’t, death of your business is a very real possibility. You really will become irrelevant.

THE PRINCIPLE
The principle here is that even if you do not want to play by the rules of “Death at 45,” many of your competitors may be. This may cause them to take actions which seem irrational to you and your rules. But it will be very rational based on THEIR rules. And their actions will disrupt your business in ways that will be nearly impossible to deal with unless you get a grip on their mindset.

Therefore, we will first look at how the “death at 45” system works. Then we will see how it impacts the status quo and what the status quo can do strategically in this new world.

The Rules of “Death at 45”

The rules of “Death at 45” are as follows:

1. The only way to (legally) make it big by 45 is to cash out. You have to transfer the ownership of your concept to someone else who is willing to pay you big dollars for it. That would be to one of three choices: private equity, going public, or selling the business to another, larger business (like selling to Google).
2. Since there is really only one meaningful transaction (when you cash out), there is really only one meaningful customer (the one you sell out to). All the other transactions related to running your business pale by comparison. They are little more than “proof of concept” examples to show to your one meaningful customer.
3. The only income statement that matters is the personal income statement (how well did I do when I cashed out). It really isn’t all that relevant if your business model is profitable or even if there is not a clear path to profitability in the future. If you play the game well, even poor business models can cash out at a high price.
4. Given the weak ties between financial performance and cash out potential, the game is played a lot like the lottery. Both the buyers and the sellers do a lot of transactions because they don’t know which venture will be the big one. Since the best way to win the lottery is by purchasing a lot of tickets, the best way to win by 45 is to pursue a lot of potential cash out ventures. If it looks like the current business model isn’t leading to a quick cash out, either radically change the model or dump it and move on to the next one.

Competing Against Death at 45 Businesses

So let’s say you are an older, status quo company trying to compete against an upstart playing by these rules. They can make your life very difficult, because their rules allow them to play differently than your rules allow you play.

1. The large, established firm has pretty much already cashed out a long time ago. Without another strong cash out option, the established firm has fewer ways to make it big. It is stuck in the old, slow process of trying to increase sales and decrease costs with a relatively mature model. The new firms don’t concern themselves as much with this, because they have better options.
2. The potential owners of the “Death at 45” companies aren’t necessarily looking for profits, especially not in the near term. By contrast, the established companies have owners who want to see increasing profits on a quarterly basis. It is very difficult to increase profits quarterly when your competitor isn’t all that interested in making any profit at all.
3. Even if the established company tries to instill some of the culture of a business start-up into their system, it won’t be the same, because employees in the established firm won’t see as clear a path to their personal cash out potential. Since the big company they work for isn’t on a full cash out path, all that entrepreneurism effort will not reward them as well as it would in working for the right “Death at 45” company.
4. When you are a tiny start-up, it is easy to radically flip the business model or shut down and start over again if things aren’t leading to a quick cash out. It is much more difficult for a large, established firm to be as flexible.

The increased flexibility and lack of a need to make immediate profits gives the “Death by 45” companies an apparent “unfair” advantage. But fair or not, that is reality.

What to Do?

So what should the established players consider doing to better compete in this environment?

1. Structure your firm to be more like a holding company. Rather than defining yourself as being in a particular singular business (working in a singular manner), define yourself as a flexible holder of many types of business models and structures which can come and go as needed to be in the right place at the right time. For example, GE has used a holding company approach to effectively flex over many decades. It is now flexing away from lending and flexing towards the Internet of Things. Taking the holding company route will cause you to act more like a private equity firm. It will give you more opportunities to cash out.
2. Work on changing the profile of your equity holders. Amazon can cause a lot of problems for its competition because its shareholders are less interested in near-term profit than the shareholders of its competitors. Just think of what you could do if you had Amazon-like shareholders behind you.
3. Play YOUR game. Just as the little guys can do things you can’t do, you can do cool things they can’t do. You have economies of scale, distribution, a brand name, business synergies, people who have a lot of experience, and so on. Play a game that puts THEM on the defensive.

SUMMARY
Although we only scratched the surface of this topic, we have seen that different mindsets will cause you to operate your business differently. Someone operating under the “Death by 45” mentality will have strategies very different from people in older, larger, established firms. The problem occurs when these two types of firms compete against each other in the marketplace. Their different approaches create an unlevel playing field. For example, the “Death by 45” company is less encumbered with a need to make money versus the establishment counterpart.

To win in such a world, it helps to first understand the thinking behind all the players you are competing with. That will help you understand the rules they play by. Second, one needs to find a strategic path that neutralizes the advantages of other mental models while taking advantage of what your position offers.

FINAL THOUGHTS
It is important to remember that nearly all the attempts to make it big by 45 fail. For every successful Google, there are millions of attempts that never make it to the cash out stage. The odds of personally winning with this strategy are extremely low. By comparison, the established firm has much better odds of carrying on.

Strategic Planning Analogy #346: Right to Play

THE STORY
Poker chips have value…but what kind of value? Some peg their value at their exchange rate—you can cash in poker chips for money at a pre-determined rate of exchange. However, that value can only be realized if you turn in your chips. In other words, this value in the chips can only be realized if you stop possessing them.

Since very few business places allow you to spend poker chips like money, that value can only be realized when you have real money. So the real value, in that case, is in the money, not the chips. If people stop exchanging your chips into money, the value in those chips vaporizes.

To me, the more powerful value in the chips is what they allow you to do while you still possess them. The unique value of poker chips is that they allow you the opportunity (i.e., give you the right) to play poker. Before you can play poker, you need to have first made an investment in poker chips. Without the chips, you cannot play. That is the true power and value inherent in poker chips.

THE ANALOGY
Poker chips are a lot like market share. There is value in having a lot of market share…but what kind of value? One type of value would be to use your power of market share to create excessive profits. In many ways, this would be like cashing in your poker chips for money. And, like poker, if you cash in your market share “chips” you can no longer use them to play the game.

The logic works like this. To create excessive profits, you need to extract excessive value out of your marketplace transactions. The more value you take out of the transaction, the less value there is for the customer on the other side of the transaction. In a competitive marketplace, there will be alternatives to your excessive greediness—alternatives which provide greater value to the customer. Customers will start switching to these alternatives. As a result, your market share will go down. In other words, when you seek excessive profits, you are typically cashing in (or losing) your market share chips.

To me, the greater value in market share is like the second value for poker chips mentioned above—the value in being allowed to continue to play the game. In this case, the “game” is the game of business. If you want a business which endures and produces a return year after year after year, you have to leave a large percentage of your chips on the table. In other words, you need to continue to invest in providing the type of value needed to hold market share if you want to continue to play the game. Otherwise, your market share will drop until you are no longer able to play.

THE PRINCIPLE
The principle here has to do with transformation. When a company is very successful and creating high levels of market share, there is a tendency to not want to transform the business model. After all, the current model is working quite well. Why kill the goose that is laying the golden eggs? Why risk current profits for the uncertainty of what would happen if you transform the business?

The Innovator’s Dilemma
Clayton Christensen wrote about this problem in the book “The Innovator’s Dilemma.” Briefly, the premise of the book is that innovation leads to marketplace disruption which creates great success for the innovator. This success makes the innovator want to cling to the status quo that his innovation produced. Unfortunately for this innovator, marketplace innovation cannot be stopped. If this innovator will not continue to innovate, others will, creating disruptions that make the original innovation obsolete. The irony is that the only way the innovator can continue to succeed is by destroying the current model of success and replacing it with successive disruptions of new innovation.

This is very similar to the poker chip analogy. Refusing to reinvest in additional disruptive innovations is like refusing to put chips on the poker table. When you have a lot of chips, the temptation to cash in (take excessive profits) is huge. But if you do, you lose the right to continue playing.

Trying to keep the high profits of the old innovation is taking excessive profits out of the game. You are no longer investing in the new innovations that will increase value to the customer. Others, who are still investing in innovation, will create greater value and take away your market share (your chips), leaving you with nothing.

Yes, it takes money away from today’s profits when you spend it on innovation. And yes, your immediate profitability may go down during the disruptive phase. BUT, if you do not ante up with these investments, you can no longer play the game. Your long-term profit stream potential goes away because you are no longer competitive once the next disruption occurs. In search of a small pot of success today, you sacrifice your ability to earn any future pots of success.

I was reminded of this dilemma when reading of a paper published on August 4th by Kristina McElheran of the Harvard Business School. This study looked at how market leadership impacted the way a business innovates. The conclusion of the study was that market share leaders may invest more in incremental innovation, but spending on truly disruptive innovation is more likely to come from non-leaders. In other words, leaders have more at stake in the status quo, so they are less willing to invest in innovations which disrupt it. The disruptions come from those who have less at stake in the status quo.

This is just the Innovator’s Dilemma all over again. The problem has not gone away. Leaders are still cashing in their chips, rather than making the investments needed to continue to play the game.

Therefore, if you are currently in a position of market share power, you need to ask yourself this question:

Am I going to use this power in a way which allows me to continue to play the game or am I going to cash out early?

Cashing Out
Even if you still choose to cash out early, by asking the question it is at least a conscious choice that you have made based on weighing the alternatives. If you do not ask the question, you may end up cashing out by accident, and have a lot fewer chips to cash in than you had anticipated.

Selling out near the peak (before the next disruption has its impact) is a viable strategy. If you do this, you can often walk away from the game very wealthy. This is a proactive strategy with careful analysis of the environment and understanding the timing of trends and inflection points. You are putting yourself up for sale while you still have leadership benefits (i.e., still have lots of chips to cash in).

This is very different from trying to cling to the status quo as long as you can and then selling as a last resort. While clinging to the status quo, your market share is being disrupted by the next innovation. You are losing your market share chips to the next innovator. By the time you get around to selling, you have very few chips left to cash in.

Staying to Play
If you choose to stay to play, then that requires a different set of actions. You need to take some of your profits and reinvest them into the game, in order to maintain value leadership. The trick is trying to optimize the balance between the current inward cash flow from the status quo with the outward cash flow needed to create the next disruption in your favor.

At least as a leader, you have the potential to orchestrate how that transformation occurs better than others (provided you do not get too greedy in the short-term). Take advantage of the opportunity. Be proactive in guiding the transformation (rather than resisting it).

SUMMARY
Markets continue to innovate. If you resist innovation and do not transform your business, you will lose to the next round of innovators. Therefore, either cash out while still at the top or reinvest in disruptive innovation at levels necessary in order to continue to play the game for a long time.

FINAL THOUGHTS
In poker, you can sometimes get away with bluffing. In business, you may be able to fool the customers for a short while, but eventually they will figure it out and shift their business to the place where they receive the best value. Innovation leads to better value. Therefore, if you want to maintain leadership, follow the innovation to the greater value.