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 #516: Avoiding Driveways

THE STORY
My wife and I disagree on which types of roads are safer. I think expressways are safer. She thinks city roads are safer.

My logic goes like this: Accidents happen when the unexpected happens (like someone turning off or entering the street) or when change occurs (like a change in speed). By that reasoning, on a city road every driveway, every parking lot entrance/exit, every intersection, every stop sign, every traffic light is a place where an accident can happen, because they are potential sources for the unexpected or change. So, in a few miles of city driving, you may drive past literally thousands of these potentially dangerous locations.

By contrast, on an expressway, I only have to worry about the few cars immediately surrounding me and the rare entrance/exit ramp. That’s a lot fewer potential accident triggers.

My wife’s logic is simpler. The higher the speed, the more dangerous the accident, so drive on slower roads to be safer.

THE ANALOGY
Business strategies can take you on many journeys, including acquisitions, joint ventures, start-ups, brand extensions, new geographies, new customers, and so on. And statistics show that most of these actions end up as failures. There is no safe alternative—acquisitions, joint ventures, start-ups and other business changes all are statistically more likely to fail than succeed.  

It’s like driving when you know that you are more likely to have an accident than not. It’s enough to make one hesitant to get in the car.

But if you don’t get in the car, you will never reach your strategic destination. And because of all the changes in the environment, the status quo will eventually become obsolete. Therefore standing still is not an option, either. It too will eventually be a failure—a horrible accident.

So the business strategy dilemma is similar to the one in the story: What is the safest route to take to avoid terrible accidents?

THE PRINCIPLE
The principle here is that tactics like acquisitions, start-ups, joint ventures, and diversifications are not by themselves the salvation of your company. In fact, they statistically increase your risk for failure. Instead of being your salvation, they are merely tools—and dangerous ones at that. To be successful, one needs a strategy for how to use these tools—a path which optimally avoids most of the accidents which often accompany these tools.

So which path should one take:

1. My wife’s approach (go slow in the city to avoid the biggest accidents);
2. My approach (go fast on the expressways which avoid the uncertainties which increase accidents by avoiding driveways and intersections);
3. Or a combination of paths?

Going Slow

Applying my wife’s advice, the answer would be to go slow. In some cases, that is good advice. Remember, the strategic goal is not to be the first to arrive, but the first to succeed. A strong and savvy follower is often more successful than the reckless trailblazer. As the old saying goes in US westerns, it is the advance scout who gets hit with the most arrows.

For example, Coke did not invent diet cola or cola in cans or caffeine-free cola or sports beverages or pretty much any other beverage innovation in the last 50 years. Yet, Coca Cola is a leader or strong player in just about any non-alcoholic beverage segment currently in existence. Why? Coke is a great fast-follower. By building superiority in distribution, points of customer contact and marketing, Coke can overcome the small innovators over the long haul. Coke lets everyone else take all the risks and then—once a successful innovation becomes apparent—they swoop in and eventually take over. They let other, faster people have all the accidents.

There are several effective tools in the “go slow” approach, like stage-gating and real options. The basic idea is to chop up a grand goal into smaller sub-goals. You aim for the nearest sub-goal. Depending on the success of that early effort, you will make changes in subsequent sub-goals or perhaps halt the project completely. This keeps all your accidents small.

A similar approach is doing a lot of beta-testing. Rather than speeding as fast as possible down a path, you pause to consumer-test the concept and make adjustments based upon the tests. Amazon is famous for doing a lot of testing.

However, the “go slow” approach often has its limits. Sometimes, the dynamics of the market do not provide the luxury of going slow. Faster competitors can get too much of a first-mover advantage (not all of us have as much power to overcome as Coke).

And even the “go slow” approach can eventually require big moves into big acquisitions, big joint ventures, big divestitures and the like. So even though you have eliminated some of the potential accidents, there can be many more that the go slow approach cannot avoid. So going slow it may be part of the solution, but it is not the whole answer.

Avoiding Driveways

So that leads to my go fast approach on the expressways. Accidents are minimized on the expressway because many of the causes for accidents are taken away—driveways, intersections, stop signs and traffic lights.

The business equivalent to avoiding driveways is to look at where the inherent risks are in each business tactic and then try to eliminate them. For example, key sources of accidents in joint ventures come from items like divergent objectives, conflicts between core businesses and the joint venture, governance issues, power issues and so on. The more you can eliminate these sources of accidents up front, the fewer the accidents. These are joint venture equivalents to driveways, intersections and stop signs. The more you can specifically eliminate risks in these areas, the less likely your joint venture will have an accident.

Similarly, in acquisitions many of the risks have to do with things like over-evaluating synergies, paying too much, poorly integrating the two companies, dealing with divergent corporate cultures, underestimating negative customer reactions, and so on. If you can eliminate these sources of accidents, your acquisition is more likely to be successful.

The folks at McKinsey did research and discovered that the companies which are most likely to avoid accidents in acquisitions are the ones who do a lot of acquisition and have built core competencies in how to do acquisitions well. In other words, the successful acquirers have enough experience to know where all the driveways and intersections are and have competencies in finding paths to avoid them (their expressways).

So the idea here is to first understand the key sources of risk in whatever tactical tool your choose. Then, take a path of implementation which avoids these sources of risk (Better yet, make understanding and avoiding core competencies of the firm).

For example, don’t even try to do a joint venture with someone who has a radically conflicting strategic agenda. That’s like driving the wrong way on a one-way road. You are just begging for an accident. Instead, take the expressway where that intersection doesn’t even exist.

A Combination

In reality, a combination of the two approaches can often work best. Don’t be so hasty that you take needless risks. Taking time out for stage-gating or beta testing can be very prudent. On the other hand, large, gutsy moves may eventually be required to reach a better tomorrow. Rather than delay them too long, move forward quickly, but smartly by proactively avoiding specific areas which are most likely to increase the risk of a failure/accident.

SUMMARY
Tactics like acquisitions, start-ups, joint ventures, and diversifications are not by themselves the salvation of your company. Instead, they are necessary, but dangerous tools which increase one’s risk of failure if used improperly. To improve one’s likelihood of success with these tools, consider the following:

1. Before rushing full speed ahead, take time to de-risk the overall strategy. Consider additional tools like stage-gating, real options, and beta-testing to make sure your ultimate goal is correct.
2. Consider building competencies which can make you a great fast-follower towards good strategic goals “proven” by riskier firms.
3. When implementing tools like acquisitions to reach the goal, understand the risks inherent to the particular tool. Then specifically address those risks prior to acting, so that those risks can be avoided.
4. Consider building core competencies in handling these tools before using them.

FINAL THOUGHTS
So, in a way, I guess my wife and I are both a bit right in our approaches to safe driving.