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.

Strategic Planning Analogy #482: Owning Vs. Driving

 

THE STORY
In automobile racing, the drivers get all the glory.  They are the heroes; the ones who get in all the photos and are adored by the race car fans.

Yet are the drivers really all that special?  Most are mere employees of large race car companies.  They don’t own the car they drive in the races.  Heck, they don’t even own the clothes they wear while driving.  Both the clothing and the cars are covered with decals and logos of the company sponsors who invest in these large racing enterprises.

Winning in car races requires more than just drivers.  There are the car designers, the pit crew, and a whole host of others.  Yet the glory goes to the one driving the car.

In an episode of The Simpsons, there was a child’s race of coasting “soapbox derby” cars down a hill.  While all the boys were clamoring to be the drivers, one of the coaster car designers lamented, “It’s all in the design.  The drivers are basically ballast in these cars.”  Yet the drivers get the glory.

 

THE ANALOGY
The drivers don’t own anything but they get all the glory.  That’s because, to most fans, it’s not who owns the car that is important, but who drives it. 

A similar idea applies to all businesses.  Many business leaders seem possessed with the idea that their company has to own a lot of things.  They are constantly involved in a wide variety of acquisitions and other M&A activity.  They focus on building a portfolio of owned businesses.

Yet is ownership really all that important?  In auto racing, the glory goes to the one who drives the car, not the one who owns it.  Similarly, as long as your company is driving the way an industry works, does it really need to own that many pieces of the industry?

The key is not ownership, but control.  And as long as you are in control (behind the steering wheel), you can have as many people putting their logos and decals on the venture as they want.  Because it is the driver who gets the biggest prize.

 

THE PRINCIPLE
The principle here has to do with control.  Those who control how an industry or business ecosystem works control how the money flows.  So a business with more control can make more of the money flow to themselves.  

Increasing ownership does not necessarily lead to increasing control and increasing profitability.  In fact, as we will see later, increased ownership can actually reduce control and profitability.

There are many alternatives to ownership, including alliances, joint ventures, partnering, outsourcing, buying on the open market, and a host of contractual arrangements.  These can often lead to greater control and greater profitability than ownership.  If you do these types of arrangements properly, you can be in the driver’s seat for the industry—and get the glory (and the biggest prize).

Problems With Transfer Pricing

Ownership can destroy control and profitability in many ways.  First, there is the problem of transfer pricing.  As an item moves through the pipeline—from raw material to the hands of the ultimate consumer—there are numerous places to transfer ownership, from the extractor to the part supplier to the assembler/manufacturer to the distributor to the retailer to the consumer. 

At each point along this chain a transfer price is negotiated.  Those with power control who benefits the most from how the transfer price is negotiated.  For example, Walmart is a very powerful part of many pipelines. When manufacturers sell to Walmart, I’m sure the Walmart does much better on the transfer price than do the manufacturers or other retailers negotiating with those same manufacturers.

A problem can frequently occur, however, if a company owns too many parts of that pipeline.  If they forward and backward integrate significantly through acquisition, they can end up owning most of the transfer points.  In essence, the company ends up negotiating with itself.  Therefore, the fully integrated company cannot use control, power and leverage to extract above average returns through transfer pricing.  After all, if you own both sides of the negotiating table, if one side wins and the other loses, you are no further ahead in total, because you own the winner and  the loser in the negotiation.  In other words, the extra ownership reduces your control over how the money flows in transfer pricing.

Problems With Alienation

The mere fact that you own an additional piece of the supply chain can destroy the value of what you have purchased due to the reaction of others.  For example, let’s assume you buy one of your suppliers—someone who was a supplier to you as well as some of your competitors.  Those competitors, who were happy to purchase from that supplier before you owned it, may no longer want to use the supplier after you own it, because they don’t want to give business to their competition.

For example, when Walmart purchased McLane Distribution, it thought it would gain knowledge of fast moving consumer good distribution in groceries.  What they failed to consider was how many convenience store customers would drop McLane as their supplier because they didn’t want to help Walmart.  Walmart had to sell McLane in order for McLane to keep its customers.  So, by owning McLane, Walmart destroyed McLane’s power to control its other customers.

Problems With Focus

The more diversified your ownership, the less focused one tends to be.  It takes considerable effort to be state-of-the-art at everything all the time.  There are more opportunities to slip up.  However, if you keep your sphere of ownership smaller, you can specialize at being the very best in a narrow focus.

There are reasons why people outsource things like payroll and IT and other back-office functions to specialists.  That way, they know that there is someone whose whole livelihood is based on being the very best in that area doing the work for them.  Specialization makes those outsourcing firms more powerful and it allows their customers to focus on the areas more critical to their success.  It is a win win.

Nike and Apple

Nike and Apple are two firms which avoid a preoccupation with ownership and instead preoccupy themselves with control.  In both cases, Nike and Apple focus on only two areas—design (business model and product design) and consumer image.  Pretty much everything else is outsourced (including the making of the products).  Nike and Apple own the key drivers for their whole ecosystems.  It puts them in a powerful position to drive how the rest of the entire ecosystem operates, even though they don’t own it.  And both are doing well.

Apple is able to focus in on what matters and leave the rest to the other experts.  And because it is the driver, it negotiates tough deals.  Just ask anyone in media who has had to deal with Apple.  By contrast, Sony tried to own everything—from design to manufacturing to even trying to own the media.  The added ownership worked against Sony.  They lost focus and could not win the battle on transfer pricing.  Worse yet, even though it owned most of the parts, Sony did not build as integrated a business model as Apple.  So Apple—owning fewer of the parts—created a superior integrated model.  Apple was like the race car driver—they didn’t own the car, but they made it go in the right direction because it was their hands on the wheel.  And now, Apple is very profitable and Sony is struggling.

Implications

The key implication of all this is that ownership should not be the automatic default option when looking at how to gain an element for one’s strategy.  In fact, there are so many reasons why other alternatives may be superior that acquisition may need to be the option of last resort.  Ownership may need to become the exception, not the rule.

Before jumping to the conclusion of ownership, check to see if there are ways to gain control without the need to own.  Find a way to drive someone else’s car and steal the glory.

And finally, instead of focusing on how to do M&A deals, focus on how to do non-ownership deals in such a way they you get to be the driver.

 

SUMMARY
When developing strategies, one often finds a need to add certain elements in order to succeed.  But just because you need them does not mean that you have to own them.  It only means that you have to control them.  And in many cases, you gain more control and more profitability if you do not own them.  Therefore, do not automatically default to acquisition as the way to get what you need.

 

FINAL THOUGHTS
A read a study recently which looked at businesses and their level of successes with acquisition, partnerships and building from scratch.  Their conclusion was that acquisition tended to produce the least amount of success when compared to building or partnering.  Their conclusion was to only acquire when building or partnering didn’t make sense.  That sounds logical to me.

Strategic Planning Analogy #475: Don’t blame the Violin

 

THE STORY
If you put a violin in my hand and told me to play it, I don’t think you would like the results.  It would sound awful.  After all, I’ve never had a violin lesson in my life.

I could blame the problem on the violin.  I could say that it was a bad violin and that is why the music sounded so poorly.

However, I knew someone who was the first chair violinist for an orchestra.  If you put that same violin in his hands, the music would sound quite different.  In his hands, the music would be wonderful.  So was the problem the violin or the one holding it?

 

THE ANALOGY
A frequent topic of business strategy is growth.  Often times, the growth strategy involves either acquiring another company or entering another business.  A lot of time and effort goes into determining whether what is a good company to acquire or a good business to enter.  Yet, in spite of all that analysis, a large percentage of growth strategies fail.

We can start blaming the failure on the growth target.  For example, we can say that the acquisition target was bad or the targeted new industry was bad.  However, for every industry where someone fails, someone else succeeds.  So is it really a bad industry?

The problem is similar to the violin.  In the right hands, the violin makes great music, whereas in the wrong hands, the violin produces an irritating screech.   The value of the sound coming from the violin is not primarily due to the quality of the violin.  Instead, the value is created by the quality of the hands playing the violin.

In the same way, the value of owning a particular business or being in a particular industry often has more to do with the quality of the company who is trying to obtain it than the quality of what is trying to be obtained.  So before you start blaming your growth target, take a moment to look at your own hands.  Are those the hands of a virtuoso in this venture or are your hands better skilled for something else? 

 

THE PRINCIPLE
The principle here has to do with strategic fit.  If the desired company or business is a bad strategic fit for you, it really doesn’t matter how great the desired target is.  In your hands, it will fail.  Therefore, a good strategic process should spend more time focusing on its own hands than on what it wants to put in it.

Wanting to Be in an Industry in The Worst Way

We can see this principle in action by looking at an example.  I have a friend who is looking at getting into the mobile payments industry.  This industry is concerned with figuring out how to transfer payments from the buyer to the seller when items are purchased on a smartphone.  Is this a good industry to get into?

Some facts would indicate that the mobile payments industry could be very lucrative.  Smartphone penetration is high and rapidly getting higher.  Long-term estimates of commerce over mobile phones is astronomical.  Even if you can only charge a miniscule fee for handling the payment transfer, the net revenue potential is huge.  So perhaps this is a great place to be.

But so far, we’ve only looked at the quality of the industry.  Predicting success by only looking at the industry is like trying to predict the value of the sound from a violin by only looking at the violin.  If we want to truly understand how the violin will sound, we also need to look at the hands of the one who wants to play the violin.

So I look at the hands of my friend.  He’s a great businessman with many skills.  However, for this venture, he has only a small pool of capital and a small staff of support.  He has never directly been in the payment transfer business.

I compare this to the hands of other people who would also like to own the mobile payments business:

1)      ISIS, a consortium of some of the largest mobile carries in the world (AT&T, Deutsche Telekon, Verizon, Vodafone) who want to cut out the middle man and do the transfers themselves.

2)      Merchant Customer Exchange, a consortium of some of the largest retailers in the world (Walmart, Target, Best Buy, CVS, etc.) who want to cut out the middle man and do the transfers themselves.

3)      Well capitalized companies willing to devote a lot of time and talent to owing the mobile payment space, like Google Wallet, Square, and PayPal (part of EBAY).

4)      And, of course, we cannot forget the sizable threat from the traditional payment transfer experts (Visa, Mastercard, AMEX).  They have a lot to lose if commerce moves from their stronghold to the mobile space.  They know the business and will fight strongly to keep it.

When I compare the hands of my friend to these hands, it is obvious that he is not the virtuoso in this space.  His hands are not good enough to win against these foes.  It is almost irrelevant how much potential the industry has.  He will never see it, because he will lose.

Now some would say that if an industry is large enough and profitable enough, there is room for smaller players (with lesser hands) to do well.    The problem with that thinking is that it doesn’t take into account the dynamics of an industry.  New, exciting industries eventually mature.  This usually causes the following:

1)      The industry consolidates to only a few survivors (almost none of the little guys survive to maturity).

2)      The profits are not spread equally.  The leaders get a disproportionate share of the profits with the lesser players being lucky if they break even.

3)      The intense competition to get to the top usually results in the profit level of the entire industry to drop.  That is why most mature industries have a return on investment near the cost of capital.

So, for my friend, entering this business would be a big mistake. It doesn’t fit his hands.

Wanting to Buy a Company in the Worst Way

A similar problem occurs in acquisitions.  One could analyze all sorts of acquisition targets.  You might find a company with a great business model, great people, and a great balance sheet.  Is that a great company to acquire?

Well, just as you cannot tell if a violin will sound great by only looking at the violin, you cannot tell if a company should be bought by only looking at the target company.  You also need to look at the company doing the acquiring.

The biggest problem is that thorough due diligence will typically find out what the underlying value of the target company as is would be.  And both sides of the negotiation will know that value.  Great companies will command a premium and weak companies will command a discount.  It is very difficult to steal away a company at a bargain price below market value.

In fact, acquirers typically have to pay a premium to obtain a company, often in the range of 20 to 40% above market value.    

So here’s the dilemma.  For this acquisition to be a great deal, you have to have such good hands that you can make the business perform at levels so superior to the status quo that you can cover the premium plus enough extra to cover your required rate of return.   If your hands aren’t skilled enough to do that, then you will lose, no matter how great a company the acquisition target is.

The irony is that supposedly “bad” companies may be better acquisition targets, because it may be easier to add value to them.  That is why there are firms out there like Cerberus, who specialize in investments in very weak firms.  They do well because they have developed skills in turning around weak companies.  In these specialized hands, they can add value to weak firms.  They are the virtuosos of turnarounds and can make good music even with a weak company.

What to Focus On

Therefore, strategists need to focus on the hands of their own company.  What instruments can they play well?  Which instruments will they play poorly?  What instruments could they learn to play well?

After this type of analysis, a couple of strategic results could occur:

1)      Build on a strength.  Great musicians practice all the time to enhance their skills.  Similarly, once a company determines its strategic path, it needs to continually enhance the skills needed to pull it off.  GE has been great for many decades in running diverse portfolios, because it knew that diverse portfolios succeed best when in the hands of great generalist managers.  So GE worked diligently to build a virtuoso group of generalist managers.

 

2)      Shore Up a Weakness.  If there is a strategic path you want to take, but don’t have the right hands for it, develop that skill before embarking down that path.  There is a reason why firms like Google devote so much effort into getting the best technical talent available.  They realize that to win in the spaces where they want to go requires virtuoso technical talent.  Without it, the strategy will fail, so they make sure that they have it.

 

SUMMARY
When embarking on a path to growth, don’t just focus on the growth target.  Instead, a majority of your focus should be on yourself.  It is only in understanding yourself that you will know where you can add value.  If you can add value, you can make even mediocre targets desirable.  And if you cannot add value, then you will not succeed in even the best looking area of growth.  So make sure you have a strategy for strengthening/creating skills at value creation as part of your overall strategy.

 

FINAL THOUGHTS
There are several instruments which I can play much better than a violin.  Those are the instruments which I should place in my hands.

Strategic Planning Analogy #447: You’re Buying People

THE STORY
Years ago, I was working on a deal to do a joint venture with a company in Korea. We had all sorts of lawyers on our side helping to craft the proper legal document. We noticed that our potential Korean partners were not using a lot of lawyers. We asked why.

The response? They said that they would rather save their money and have us spend all the money on legal issues. Then, at the very end, and only at the very end, would they bring in their own lawyer to help make the final changes.

We thought that was a bit risky on their part, but we went along with it. After all, that put our lawyer in control of the contract, so we figured we were getting a better deal.

Later on, as we started preliminary work on the joint venture, we learned that within the large family Korean business with which we had been negotiating, there were many different family factions. As it turns out, we had negotiated with the wrong faction of the family. As a result, the joint venture failed.

We may have had a superior legal document, but since it was negotiated with the wrong people, the deal was worthless. In the end, we took the bigger risk by relying on lawyers rather than in understanding the people.

THE ANALOGY
A lot of strategic planning involves doing deals with others. It could be joint ventures, mergers, acquisitions or some other arrangement. In doing these deals, it is easy to fall into the trap of seeing the deal as a legal or financial arrangement between two companies. Under that assumption, you would do as we did at that company in the story and put the emphasis on making the best legal arrangement we could. In other words, do a good job at doing the deal.

But successful strategies are not just about doing deals. Doing the deal is just a means to an end. Supposedly, the deal was done in order to accomplish a strategic objective. And supposedly, that objective could be better accomplished working with this partner rather than by doing it alone.

So, in reality, the most important aspect is not the creation of a deal between two companies, but in the creation of great working relationship between two groups of people. For, as we found out in Korea, if you are connected with the wrong group of people, it is irrelevant how good the deal was structured. The work was not going to get done.

So when structuring a strategic plan, don’t look at it as a series of deals which need to get done between companies. Look at it as a series of objectives which must be done by people, regardless of who they work for. Then focus on ways to get the best people in the best situation to get the best outcome.

THE PRINCIPLE
The principle here is that companies are made up of people. And if you want to do great things, you need to get the right people together in the right way. The best deals are not the deals with the best contract or the best pro-forma financial model. No, the best deals are the ones with the best results. So, rather than fretting primarily over the words and numbers on the piece of paper, focus on what creates the best results—the people and their working environment.

Listed below are a few examples of how to put this idea into practice.

1. People Due Diligence
Before deals are done, most companies will do due diligence. In other words, they will investigate the company before purchasing it. A lot of the items on most due diligence lists have to do with looking for hidden risks. The idea is that you don’t want to purchase a company with a lot of unknown legal or financial liabilities. Therefore, companies have their legal and financial experts “scour the books” of the acquisition target (that is, read all the legal documents and financial reports to make sure you know what you’re getting).

This is not a bad practice, but it is not enough. What you are purchasing most of all (in most cases) are the people who work for the company, along with the culture and the practices by which those people work. That’s where the biggest risk lies. The company may have wonderful documents and great balance sheets, but if the people, the culture and the practices are wrong, it really doesn’t matter. The work won’t get done. Therefore, the main focus of due diligence should relate to the people, practices and culture.

I can think of more than one occasion in my career when I was negotiating with another company and had to tell my superiors that we needed to stop the negotiations right away because we are dealing with the wrong people. They were untrustworthy and/or had questionable business practices and/or the culture didn’t fit. It was useless to work any further on hammering out a deal, because you could never work well with them under any contractual scenario.

So make sure your people due diligence is just as thorough as your financial and legal due diligence (if not even more thorough). My Korean friends in the story understood this and put more emphasis on people and relationships than they did on having hoards of lawyers trying to protect them with a piece of paper. If we had done the same, our people due diligence would have shown us that we were negotiating with the wrong branch of the Korean family.

2. Get the A Team
Over the years, I have dealt with a lot of consultants and financial advisory companies. People will ask me which are the good companies. I always answer by saying, “If you get the A Team, they are all good. If you get the B Team, they are all bad.”

In other words, you are not really doing a deal with a company, you are doing work with a group of people. If you get the wrong people, it really doesn’t matter which company they came from.

Therefore, when negotiating with consultants, financial advisors, other service companies, or potential joint venture partners, don’t just focus on terms and prices. Focus on the people. Request that particular people be a part of the team working with you (and that they spend at least a meaningful part of their time on your behalf). Make it a key condition for doing the deal. Put it in the contract.

3. Think Through the Process in Advance
Even if you have great people, you can still fail if the surrounding process and culture is wrong. Therefore, you should consider how the work is to be done before doing the deal. Then you can put the topic of how the work gets done into the negotiations.

For example, the two companies may have differing visions on how to do the work. If you find that out after the deal is done, it may be too late to reconcile the differences.

A key point of contention is often about intellectual capital or proprietary information. How much sharing of knowledge will take place? What skill sets or technology will be contributed? Will your teams be working side by side or will the work be segregated so that the other does not see how you fulfill your part of the deal? Don’t assume anything in this regard. Talk it out in advance.

In addition, by talking out the process during negotiation, one can get a great window into understanding the culture at the other organization. If the cultures are too divergent, it may not be possible to find a great working relationship. And even if you are acquiring the entire company, that does not mean that one can instantly fix such a cultural divide by merely imposing the acquirer’s culture onto the one being acquired.

Remember, companies are made up of people, and the people may resist the cultural change. These people were likely at the other company because they enjoyed that other culture. You could end up with defections, resistance, and demoralization if you push a foreign culture too quickly on a situation.

When you look at literature on acquisitions, a key source of failure is lack of cultural fit. Figure this out in advance.

4. Negotiate With Outcomes in Mind
In the end, success is not the deal but the outcome. Therefore, it may be desirable to negotiate the outcome as part of the deal. For example, some of the price can be pegged to future outcomes. Or outcome incentives can be negotiated as part of the deal. Buyout or separation clauses could be pegged to performance. At the very least, the deal could outline in detail what the outcome expectations are (by party), so at least you are going into the deal with a common goal.

SUMMARY
Strategies shouldn’t be focused on doing deals. They should be focused on accomplishing strategic objectives which improve the positioning and performance of the company. This is the ongoing work that is done by the people long after the ink on the deal has dried. Therefore, strategy needs to concern itself with the people and the processes and culture in which these people operate. Otherwise, you will have a lot of deals that get you nowhere. And that isn’t worth a whole lot.

FINAL THOUGHTS
How much of your strategic time is spent on looking at people and culture versus time spent on getting a deal done? Is your desk cluttered with legal documents and financial proformas or is it covered with people and cultural assessments?

Strategic Planning Analogy #441: Leaving Early

THE STORY
When I go to a sporting event, I like to stay until the very end. I figure that I paid for the whole game, so I may as well watch the whole game. And who knows, something exciting might happen at the very end.

Usually, however, the end is not very dramatic. And because I wait until the end, I get caught in terrible traffic jams. First, the jam of the people trying to get out, and then the jam of the cars trying to leave. It seems like forever to finally get on my way home. What a mess!!

The frustration of trying to leave gets larger than the excitement of seeing the game. At that point, I wish I would have left earlier.

THE ANALOGY
For every strategic business initiative, there is an important question to ask—When is it time to leave this initiative and move on to something else? There is a tendency for executives to act like my behavior at sporting events and stick around until the very end. And just like in sports, if you stick around until the very end of a strategic initiative, you end up in a mess.

Usually nothing very exciting happens at the end of a business initiative life cycle. Sales slowly fall away and losses begin to mount. You could leave early without missing any excitement (and avoid the losses).

And, if you leave this business sector ahead of the crowd, you can avoid the mad rush to the exits of everyone else later on. At the end of the cycle, when everyone is trying to leave, there is virtually no value in what is left behind (everyone is selling and nobody is buying).

Therefore, we should resist the temptation to stay until the end of the game and leave early. After all, there is always another game to play, and the sooner you leave the old one, the sooner you can prepare for the new one.

THE PRINCIPLE
The principle here is that a retreat or exit from a business is not necessarily a sign of failure. Often times, leaving early is the more successful alternative.

1. ALL Strategic Initiatives Eventually Die
The first thing to remember is that ALL strategic initiatives eventually die. Again, ALL strategic initiatives eventually die. Strategic initiatives follow a lifecycle of growth, maturity, decline, then death. If your company’s strategy is to ride an initiative all the way to the end, then you will die as well. If you don’t want to die along with that strategy, then you’d better leave early and move on to a replacement strategy.

Just because all strategic initiatives die is not to say that everything dies. Consumer desires for solutions to problems does not die. Consumer desires for status, comfort, performance, convenience and value do not die. The problem is that the way consumers satisfy these desires changes over time. New and better solutions (or business models) come about which are superior to the old ones. If you want consumers to continue getting their solutions from you, then you’d better keep advancing to the initiative with the superior solution.

Kodak stuck with analog film all the way to the end and died with the initiative. Had they left earlier, they would have had the opportunity to continue to thrive. After all, the consumer desire to capture memories still lives. The desire for visual imaging still lives. The desire to share experiences through pictures still lives. The only thing that died was the analog film initiative…and the companies who stuck with it until the end.

A large part of the entire social phenomenon on the internet is just a superior business model for solving the problems that Kodak used to solve—the sharing of experiences. By sticking around too long at the old game, Kodak got caught in the mess at the end and missed out on the new game of the social revolution (not to mention the whole digital imaging thing).

Don’t get caught into believing that you are the exception and that your strategic initiative will never die. At one time, Sears was by far the largest and most successful retailer on the planet. Consumers loved them. They seemed invincible. It looked like they would be successful forever. But times changed and Sears didn’t. Superior solutions appeared. Sears is now near death. Consumer purchasing did not die, but the Sears way of selling did.

2. Wanting to Win in the Worst Way Usually is the Worst Way
Failures don’t just happen at the end of the life cycle. Failures also occur during the process of innovation. Not every new idea is a good idea. In fact, most innovations fail.

In an earlier blog, we talked about some of the psychological biases which cause companies to want to stick with an innovation too long. Some of those factors include:

a) Innovation is Fun
b) Innovation Can Enhance a Career
c) All the Other Cool, Successful Companies are doing it.
d) My Ego/Reputation gets Entangled with the Reputation/Success of the Innovation.
e) The Budget/Plan is Depending on it.
f) There’s Nothing Else in the Product Development Pipeline, So it HAS to Work.

As a result, there is an inherent bias to stick with a bad innovation too long. We want so badly for the innovation to succeed that we try to create success out of our own desire when there really is no success to be found.

Wanting to succeed in the worst way is usually the worst way to try to succeed. We need to be rational and realize that and early exit from a doomed venture is often the smart move (and will save one from taking heavy losses and write-downs in the future).

3. The Last One Standing is Usually the Loser
A third place where sticking around too long can occur is when the “Roll-Up” strategy is used. The idea is to consolidate an industry by acquiring enough of your competitors to have the leading share (roll them all into one).

There is logic to using this roll-up consolidation approach. It creates economies of scale and there are benefits from reducing the number of competitors. It can also be a great way to expand geographically.

However, the roll-up strategy is best used near the beginning of the mature phase of the life cycle. After all, it does no good to be the great consolidator of a business if the business is near death. The consolidation only makes sense when there is still a demand large enough to want the large entity you are building.

During the 1970s through the early 1990s, Supervalu rolled up and consolidated the wholesale grocery industry. This strategy provided many years of success. However, the largest customer of the wholesale grocery industry is the small, independent grocer. Thanks to the rise of the Walmart Supercenter and the growth of large supermarket chains, the independent grocer was rapidly disappearing. Having the best wholesale grocery business is worthless if you no longer have independent grocery customers. The roll up strategy was starting to die.

Fortunately, Supervalu did not need to die. They changed strategies to become owners of large retail chains (primarily through the acquisition of Albertsons). Now they controlled their retail customer base. Another winner was the wholesaler Cardinal Foods. They sold out early in the consolidation and moved into the growing health care business, eventually becoming the successful Cardinal Health.

In a roll-up strategy, remember that when everyone is willing to leave (and sell you their business), you need to question why you want to buy them. Often, they are willing to sell out because either:

a) They think the business is dying; or

b) They think you are paying such a high premium to get the business that your price is far higher than the present value of future cash flows. In this case, you transferred all the value of the consolidation to the person who is leaving the business via your purchase price.

Either way, that is not a good sign for the consolidator. In the end, all strategic initiatives eventually fail, and consolidating a larger version of that initiative at the point when it fails just creates a larger failure.

Consolidating is nice at the beginning of maturity, but know when it is time to leave that strategy. Sell out early before the very end and let someone else be holding the large mess when the initiative is nearing death. After all, the last one standing when the initiative dies will die with the initiative. I spoke about this principle in more detail here.

4. Distinguishing Battles from Wars
Leaving an initiative early may look like failure, but an initiative is only one battle. The real goal should be to worry about winning the larger war, not a single battle.

The real war is to preserve and profitably grow the corporation. For a corporation to do so, it must continually shed its old initiatives and add new ones. Shedding the old is not a sign a failure, but a realization that the greater goal requires adapting to change. In fact, failure to shed is more likely to create ultimate failure.

Long-time enduring companies like Nokia and GE have had vastly different portfolios of businesses over the years. They were willing to leave industries before that game was over and move to the newer, better game. And when GE has temporarily faltered, it is usually because it stayed too long with a particular initiative.

SUMMARY
Leaving a business early may at first seem like failure, but it is usually the more profitable option. Strategic initiatives eventually die and you cannot stop that. Therefore, to prevent your company from dying, you need to move on. And the sooner you move on, the easier and more profitable your exit will be. Also, the sooner you move on, the easier it is to own the next big thing which is replacing what is dying.

FINAL THOUGHTS
When you see others starting to leave the game, consider it a warning sign that perhaps you need to consider leaving as well.

Strategic Planning Analogy #438: Business Vs. Capability

THE STORY
One day, Bob was sitting in his garage. Suddenly, his neighbor Joe was running towards the garage. Joe quickly looked around Bob’s garage and noticed a shovel.

Panting from being out of breath, Joe said to Bob, “I’ll give you $1000 dollars for that shovel.”

Bob replied, “Are you crazy? That shovel is hardly worth $10. Why you can get a brand new one at Home Depot for less than $30.”

Joe said, “I need a shovel right now. Will you sell me yours for $1000?”

Bob answered, “Sure, Joe, you can have it for $1000.”

Before Bob could finish his sentence, Joe had tossed $1000 at Bob, grabbed the shovel and ran.

At the time, Bob thought Joe was crazy for paying so much for his shovel. But he soon forgot about it.

A week later, Bob saw Joe driving a new expensive sports car. Bob asked Joe how he could afford such an expensive automobile. Joe replied, “I used that $1000 shovel to dig up a treasure chest that was full of millions of dollars of gold and jewels. If I hadn’t had a shovel at that exact moment, I would have missed the opportunity to dig up that treasure chest.”

Suddenly, the idea of paying $1000 for that shovel didn’t seem as crazy to Bob anymore.

THE ANALOGY
The value placed on an object can vary significantly between people. Bob thought his shovel was worth about $10. Joe gave it a value of 100 times that price.

Why such a big difference? Bob looked at his shovel as a standalone object. He knew that new shovels were worth about $30 and that he had an old shovel. Therefore, Bob figured that the worth of the object was about $10.

By contrast, Joe looked at the shovel as a capability tool. If used immediately, that tool would give him the capability to get a treasure chest worth millions. It was well worth paying $1000 to get access to millions.

Successful business acquisitions depend on an accurate assessment of value. And often times, the greatest value is not in the standalone business being acquired (the “shovel”), but rather the value of the capability it gives you (access to the “Treasure Chest”).

Therefore, if you want a great return on your acquisition investment, the best path can be to first have a strategy to locate treasure chests. Then acquire whatever tools are necessary to dig up that chest.

Otherwise, you can be like Bob. Sure, he paid a lot less than Joe for that shovel, but when Bob had the shovel all it did was sit in his garage. The return on that $30 investment for Bob was worse than the return Joe got with the same shovel for which he paid $1000.

THE PRINCIPLE
The principle here has to do with capability planning. I think this is an under-emphasized part of the strategic planning process. People love to spend time talking about financial targets or market positions. These are fun topics. However, unless you have the right capabilities in place, those financial targets and market positions will never become a reality—no matter how much you talk about them.

Capabilities can cover items such as technology, patents, expertise, distribution capacity, access to raw materials, access to scarce talent, access to real estate, access to legal rights, and so on. You could have everything you need except one of these items and fail miserably—because none of the rest of it works unless you also have that missing piece. It could be something small, like a shovel, but if that missing piece keeps you from the getting the treasure, then merely knowing where the treasure is can be worthless.

The Problem With the Standalone Approach
Most acquisitions are looked at primarily as standalone business opportunities. Sure, one factors in a few synergies, like reductions in overhead and overlap, but the vast majority of the value is typically from the business itself.

But here is the problem with that approach. First, you have to pay a premium to get the business. Depending on the industry and the time in the business cycle, that premium can be on the order of 30% or more.

Second, to make that acquisition worth doing, you need a return on investment which exceeds your cost of capital. In other words, if you pay 30% more and you earn 30% more, all you have done is break even. And that is an unacceptable return. Depending on your balance sheet and the time of the business cycle, your stakeholders may require an additional 10% improvement or more.

In the end, this means that the only way that a standalone business is worth acquiring is if you can get 40% more out of it than the so-called experts who are already running the business (I spoke about this in more detail here). Remember, if it were easy to make such a large improvement, why aren’t the current owners doing so?

A few reductions in overhead or overlap rarely are enough to fill this large of a gap. And the gap may even need to be larger than 40%, because most acquisitions have some built-in dis-synergies which also need to be overcome. An example could be customers who no longer want to buy from the company after it is acquired because they don’t want to do business with you. I spoke more about these dis-synergies here and here.

The only way to assure that you can cover a 40% gap is to look outside the standalone business. You probably need to create an entirely new business to supplement the old business to cover the gap. In other words, the only way you can afford to overpay for a shovel is if you can use the shovel to obtain new treasure.

As long as you focus on positions or profits, you will look for acquisition targets that have great positions and/or produce great profits. And those are the targets which will typically have the greatest premium prices and the lowest potential for you to come in and cover the 40% (or more) gap.

The Benefit of Capability Planning
Capability planning looks at acquisitions more as a means rather than an end in themselves. The prize is not the acquired business. No, the prize is the separate hidden treasure which can only be obtained if the acquired firm is used as a tool to reach it. It is the capability value, not the operational value which makes the acquisition worth doing.

Consider the Pringles potato chip business. Proctor & Gamble has been disappointed with this piece of their portfolio for a long time. They have tried to find ways to get rid of it for literally decades. The fact that P&G could not sell it for such a long period implies that there was not enough inherent in the standalone business to ever justify paying a premium. The gap could not be covered.

But then along comes Kellogg. They see a buried treasure—international growth for their Keebler snack business. Unfortunately, Kellogg is missing a key capability—access to powerful global snack distribution. Pringles has that capability. It is the shovel that will help Kellogg get to their buried treasure. There is probably more value in Pringles as a distribution capability for Kellogg than as a snack business. Therefore, Kellogg can afford to pay for Pringles when others could not. They can cover the gap, because they have an addition treasure beyond what Pringles offers as a standalone business.

Therefore, rather than developing “Business Acquisition Strategies” focus on “Capability Acquisition Strategies.” And don’t forget that many times you can obtain access to the capability without having to buy a company (and pay the huge premium). This opens up more options, like start-ups, aggressive hiring, strategic alliances, licensing, and so on.

Acquisition is just one way to get capabilities. As long as you see acquisitions as a means, rather than an end, you can compare it to alternative means for obtaining that end. This can lead to superior strategic moves.

SUMMARY
Most acquisitions destroy shareholder value. One of the reasons is because there is not enough of an opportunity within the core business to increase the value to cover the premium and the return on capital requirements. Therefore, if you want to create value with acquisitions, start first by looking for treasure beyond the core business. Then look for acquisitions which are a tool to get to that treasure.

FINAL THOUGHTS
There’s the old story that for the lack of a nail, a shoe was lost. For the lack of a shoe, a horse was lost. For the lack of a horse, a battle was lost. For the lack of a battle, a kingdom was lost. When you look at that big picture, it makes that nail appear pretty valuable. Strategists love planning out the big battles, but if the capability to put nails in the horseshoe is missing, it can all be for naught.

Often times the great leaps in value can come from these capability issues which at first appear minor or are often overlooked. Don’t overlook capability planning in your strategy work.

Strategic Planning Analogy #408: Poisoning the Well

THE STORY
There are lots of stories written and movies made about feuding families in rural areas. A common tactic used to attack the enemy in these stories family was “poisoning the well.” What would happen was that one family would sneak onto the other family’s property. They would then do something to the well water or reservoir of their enemy with the intent of either drying up the source of the water or making it unfit to drink. This was called poisoning the well.

This was a particularly nasty tactic, because if a farmer or rancher doesn’t have access to good water, their livelihoods are ruined. Not only is there nothing for the family to drink, but nothing to feed the cattle or water the crops. The family who was attacked in this way had few options. Often they just had to give up and move somewhere else.

What makes this tactic even scarier today is the fact that it is not that difficult for a terrorist to “poison the well” of major cities. Using modern chemistry, it wouldn’t take much for a terrorist to cause the major sources of water for huge cities to become unfit to drink. Suddenly, that old tactic takes on new significance.

THE ANALOGY
A similar situation occurs in the business world. However, instead of the well or reservoir being filled with water, it is filled with cash. Just as water is needed to keep the cattle healthy and the crops growing, cash is needed to keep the company healthy and growing. Cutting off the flow of water can ruin a farm or ranch. Similarly, cutting off the cash flow to a business can ruin it.

And just as the families in these movies and books had enemies, so do businesses. And if a company makes a strategic error, they can create a situation in which competitive forces “poison the well” of cash for a business. This can be so ruinous to a firm that the company can no longer exist.

Therefore, a key component of strategy needs to be protecting the well of cash so that it does not get poisoned.

THE PRINCIPLE
Today’s principle has to do with where the emphasis should be placed when looking at the strategic aspects of a potential acquisition. I believe that, in general, too much focus is placed on potential synergies from the acquisition (ways to boost cash) and not enough time is spent looking for the potential of the acquisition to poison the well of cash (ways to destroy cash).

As we will soon see, acquisitions can trigger competitive events which may cause a poisoning of the well. Since the purchase price in an acquisition is typically linked to the value of future cash flows, any poisoning of the well seriously diminishes the value of that acquisition (because there will be far less cash after the poisoning). It can cause you to grossly overpay for the acquisition if you do not take this into account during due diligence.

Ways in Which Acquisitions Can Poison the Well
There are many ways in which an acquisition can poison the well. For example, let’s assume you want to acquire one of your suppliers. That supplier may also be supplying your competitors (your enemies). The enemies will not want to do anything to help you, so if you buy that supplier, they may take their business with that supplier elsewhere. In other words, your ownership of that supplier can trigger competitors to take away their business and reduce the supplier’s cash flow. You have poisoned the well.

Let’s say you want to acquire your distributor. Suddenly, many of your enemies who also use that same distributor may no longer want to use them because they do not want to help a distributor owned by their enemy. Again, the cash goes down due to ownership change. You’ve poisoned your well.

Let’s say that you want to acquire a direct competitor. It may be that a lot of the customers using that competitor were doing so specifically because they did not want to give their business to you. Once you buy that competitor, it becomes a part of you. Therefore, the customers who were trying to avoid you will take their business away from the company you want to acquire. The well is poisoned.

I spoke about this concept in more detail in a prior blogs (here and here). You may want to go back and review them.

Synergies Aren’t As Great As One Thinks
Given the high potential for ruinous poisoning, you’d think that more attention would be given to it. Instead, my experience has been that the bulk of the strategic focus in acquisitions is around synergies.

Synergies are good and they should be looked for, but if we focus too long in this area, we may delude ourselves into seeing more synergies than really exist. Lots of studies have looked into why most acquisitions fail. One of the key conclusions which keeps coming up is that acquisitions rarely achieve as many synergies as one thinks prior to the deal. Apparently, much of that time focusing on synergies was focusing on illusions which will not occur. They deceive us into seeing more value than there really is.

Worse yet, all that time spent on the optimism over synergies may keep us from spending enough time on the pessimism of potential well poisoning. Too much optimism combined with not enough pessimism leads to grossly overvalued estimations of cash flow. The result is that companies pay too much for an acquisition and destroy company value.

The Google – Motorola Mobility Deal
The principle of poisoning the well can be seen in the potential acquisition of Motorola Mobility by Google. Does Google have enemies? Yes, indeed. There’s a reason why Microsoft filed a complaint with the European Commission back in April 2011, alleging that Google was engaged in illegal anti-competitive activity. There is a reason why several companies which don’t usually work well together (Apple, Microsoft, Research in Motion and Sony) combined to outbid Google for Nortel’s intellectual property back in July. They don’t like the power of Google and they want to keep Google from getting stronger.

Then comes the announcement that Google wants to acquire Motorola Mobility. As it turns out, not only does this action give Google’s enemies a chance to poison the well, it also gives Google’s “friends” an opportunity to poison the well.

For example, Microsoft is expected to use this event to tell people in the industry that they cannot trust Google and should put more of their priorities into the Microsoft/Nokia system. This can poison two wells. First, it can take sales that would have once gone to Motorola Mobility and shift them to Nokia. Second, it can make a higher percentage of phones carry the Microsoft software instead of Google’s Android system. The Microsoft system will shift more mobile advertising revenue to Microsoft (through Bing and other sources) which could really hurt Google’s cash flow.

Worse yet, this just might be enough of a boost to Microsoft to give them critical mass in the mobile marketplace, something they can build on and grow. Perhaps if Google had not announced this deal, Microsoft would have eventually given up on the mobile software due to insufficient demand. A similar situation could occur with Research in Motion, who might have eventually gone away, but now may have a chance to revive itself through the poisoning of Google’s well.

Even Google’s device partners (“friends”) in the mobile space (Samsung, LG and HTC) may now become less enamored with their partnership with Google. They may begin to think that Motorola Mobility will get preferential treatment over their own devices. As a result, they might hedge their bets by getting closer to Microsoft, shifting share away from Google’s Android.

If less of the really cool devices (from Samsung, LG, and HTC) carry Android, and if Motorola Mobility puts Android on inferior devices, then consumers may revolt and switch away from Android. Again, more poisoning of the well.

And if Android starts losing significant market share from all these poisonings, it may have less influence in getting priority for cool apps from the development community. This could start a downward spiral, as even more customers see a reason to switch to others who have cooler apps sooner.

The point here is that this type of deal can cause all sorts of negative poisoning of the well. I hope Google fully considered these ramifications when contemplating the deal.

SUMMARY
Acquisitions do more than create positive synergies. They can also trigger negative impacts on cash flow (poison the well). Since the true amount of synergies in a deal tend to be less than expected, and the poisoning of the well can be larger than expected, strategic emphasis during acquisition may need to shift from synergy to poisonings.

FINAL THOUGHTS
In the old stories, it was the enemy who poisoned the well. In business, we tend to poison our own well through poor strategic decisions. Shame on us! This is a preventable problem, because it is under our control. Make sure you consider the potential for poisoning the well whenever you contemplate a move which upsets the status quo.

Strategic Planning Analogy #274: Painting a New Name on the Ambulance

THE STORY
I used to live in a city where the citizens were upset with the ambulance service. The ambulance drivers were accused of being incompetent and dangerous, causing far too many accidents.

In response to citizen protests, the city suspended the license of this ambulance company and replaced them with a different ambulance company.

Unfortunately, this new ambulance company did not have any other operations in the immediate vicinity. Therefore, they needed to hire ambulance drivers in order to serve this city. As it turns out, pretty much the only people in the area who were qualified to drive an ambulance were the former drivers for the ambulance company which just lost its license. Consequently, most of the drivers for the new ambulance company were those same “incompetent and dangerous” drivers that worked for the old company.

So, other than a new name painted on the outside of the ambulance, we were pretty much back to where we started. So much for progress.

THE ANALOGY
In the story, the city tried to improve the performance of the ambulances. To do so, it changed ambulance companies. Unfortunately, what didn’t change were the people driving the ambulances. Since the poor drivers were the cause of the problem, the change in ambulance companies did not solve the problem. The only thing that changed was the name painted on the ambulance.

Many businesses fall into the same trap as this city. They develop strategies intended to change things for the better. However, because the underlying people and processes stay essentially the same, the situation does not get any better. It’s business-as-usual under a different label. These company strategies are about as useless as the idea that painting a new name on the ambulance is going to make those drivers any safer.

THE PRINCIPLE
The principle here is that significant changes in performance require significant changes in how things are performed. I know this sounds obvious, but actions like what happened with those ambulances seem to occur all the time. We put a new label on something and expect miracles. Concentrate more on labor (what they do) than labels (what they’re called).

This problem seems most acute under two situations: acquisitions and revitalization initiatives.

1) Acquisitions
When you are acquiring a company, you typically have to pay a significant premium price (over current market value) in order to get the deal done. This leads to an important question: What is your company going to do with those assets that is going to make them so much more valuable in order to justify that premium price?

Let’s face it. The current owners probably know a lot more about the company than you do. They are typically already working very hard to extract as much value out of it as they can. And, except for maybe a few people at the top, you are going to keep the same basic people that worked there prior to the acquisition. So why do you, as an outsider, think that the same basic organization is going to perform so much better just because you painted your name on the building?

Sure, people talk about all the “synergies” of putting the acquired company together with their own. My experience is that one never gets as many synergies as hoped for. Either the cultures don’t mesh or fewer things can be eliminated than planned. As mentioned in an earlier blog, using common shared services across multiple divisions quite often causes more net costs than savings. Unless you are planning on running the company significantly differently than before (and I truly mean SIGNIFICANTLY different), you won’t get much of a significant improvement.

Take the recent acquisition of Marvel by Disney. Disney paid a ton of money to get the company (a 29% premium over current value). Will Disney run the company significantly differently than the prior owners? Well, Marvel already was exploiting the value of its characters in movies, merchandise and theme parks (the very things Disney would do). In fact, one could argue that those prior contractual arrangements could make it more difficult for Disney to exploit them under the Disney umbrella.

And is Disney going to get rid of all the Marvel people? Of course not! Disney wants their creativity.

So, other than perhaps executing the prior strategy a little bit better, has Disney done much more than just “paint their name on the ambulance”? Even if they make Marvel 29% better, all they will have done is break even on the deal.

Let’s assume for second that Marvel was horrible at exploiting their assets, leaving huge potential for Disney. Typically, when a company is not doing well in exploiting their assets, astute investors assume that potential acquiring companies will also recognize this potential. These investors assume that eventually one of these firms will acquire the company to better exploit those assets.

As a result, the investors will often bid up the current price of a company ripe for acquisition to include a “potential acquisition premium.” Hence, when the acquirer pays a premium over the current value, they may be paying a premium on top of a premium already embedded in the stock price.

Make sure that when you put an acquisition into your strategy, you specifically outline in that strategy enough changes to that company in order to create enough value to justify the price. Otherwise, all you are doing is painting your name on their ambulance. For more on this topic, see this prior blog.

2) Revitalization Initiatives
In addition to acquisitions, strategies also often deal with revitalizing problem areas in a company’s current portfolio. These revitalization programs are often given fancy names, like “Vision 2020” (If you don’t believe me, just Google “Vision 2020” and see how many firms use that label for their strategic initiative).

The goal is to revitalize performance. However, these initiatives often try to create this revitalization using the same basic people whose poor performance created the need for revitalization in the first place. As we saw in the ambulance story, often times the people are one of the main causes of the original problem. Unless the people (or the culture surrounding the people) are radically changed, why should one expect revitalization?

This reminds me of an interesting story. Years ago, I worked for a firm that was having a sales slump due to a recession. The president of the company asked every employee to send him suggestions on new ideas to improve sales. One person replied, “Do you really think I was holding back on good ideas to increase sales until you asked for them? I’m already doing everything I can to increase sales.”

The point is that most employees are not worthless bums. They are generally good people already trying to help the company do well. Putting a new label on what they do is not going to suddenly make them significantly better. They are already putting in the effort. Unless you significantly change the quality of the people or the nature of the work process, you will get only minimal, short-lived improvement. All you have done is paint a new slogan on an old ambulance.

SUMMARY
Significant gains require significant change. If one has the same people doing essentially the same work, one should not expect much of an improvement. Just changing the label doesn’t change the results.

FINAL THOUGHTS
A pig is still a pig, not matter what you call it.

Analogy #217: Hot Potato

THE STORY
There’s a children’s game we played when I was young called “Hot Potato.” Although there are lots of versions of the game, it goes something like this:

First children stand, facing each other, in a circle. They have a small ball, which is called the potato. The ball is tossed around as if it is a hot potato—as soon as you catch it you quickly toss it to someone else in the circle so that it won’t (theoretically) “burn” your hand.

All the while you are tossing the ball around, someone else is keeping track of the time. When the allotted time is over, the timer yells “STOP!” Whoever has the hot potato in their hand when the time stops loses and has to leave the circle.

THE ANALOGY
A lot of business strategies rely on the tactic of buying or selling companies/divisions. In these transactions, assets change hands from one owner to another. It’s sort of like the game of hot potato. Property ownership gets tossed around from firm to firm, just like that ball gets tossed around with the children.

One time when asset tossing is particularly frequent is when the growth phase of an industry is long over and an industry is well into maturity or is starting to decline. The lack of growth creates a period of consolidation. At this point, a firm typically decides to either “get out” or “double-down.”

The ones who want to get out toss their assets away, as if it is a hot potato. The ones who want to double-down collect all of potatoes that the others are tossing out.

Just as in the game of hot potato, eventually the time for consolidation stops. In the game, whoever is holding the “potato” when the time ends loses the round. My observation is that more often than not, the company holding all the assets when the consolidation phase ends also tends to be a loser.

In this blog, we will see why.

THE PRINCIPLE
The principle here is that during consolidation, the company that is doing the consolidating more often than not creates less value than the one who is exiting the business. In fact, the consolidator often ends up destroying value.

Although not directly applicable, you could see some of this principle at work in the dotcom bubble. There were a lot of young college dropouts who started up all kinds of businesses. Eventually, big companies wanted to get in on the action, so they started buying up a bunch of these dotcom startups, with the hope of creating something great out the accumulation of many dotcom assets.

After the consolidation phase ended, businesses realized those assets were purchased at bubble-sized prices. After the bubble burst, the consolidators found they were holding onto fairly worthless assets, while the ones who sold out were sitting on piles of wealth beyond belief. The ones holding the hot potato when the bubble burst lost.

Now you may argue that this was not a true consolidation phase and that bubbles are not the norm. That may be true, but the principle still holds true. It just may take a little longer to see the results.

The rationale for doubling down during the consolidation phase tends to go as follows:

1) There are economies of scale on the cost side in becoming large.
The logic is that if I buy up the assets from others and combine them with mine, I can create a ton of synergies and eliminate a boatload of duplications and waste. For example, in the recent talks to combine Chrysler and GM, there are estimates that the economies of scale could possibly cut out $10 billion in costs.

2) There are top-line sales benefits if the number of competitors are reduced.
There’s a reason why governments tend to discourage monopolies or near monopolies. They believe that if too much power is placed in the hands of too few companies, prices will go up, hurting the consumer, and putting excessive profits in the hands of the remaining firms. Although a company would not admit this is true (in order to get the deal approved by the government), there is a belief that being a large player with fewer competitors is helpful in the fight for sales and profits in a no-growth industry.

Unfortunately, reality tends to makes these two points less powerful than they at first appear. Instead, what occurs is the following:

1) The consolidator overpays for the companies it purchases.
In today’s sophisticated environment, it is highly unlikely that one can acquire a business at a lowball price (the current situation with the valuation of banks and other financial institutions notwithstanding). Everyone knows all the tricks in how to valuate companies (or can hire someone who does). Therefore, one typically has to pay a fairly high price to consolidate the market. In other words, in the purchase price, the consolidator has to pay the other company a portion of the expected synergies in order to get a deal done. So the seller gets part of the benefits of the synergies without taking any of the risk.

2) The economies of scale are less than expected.
Although people may argue about the cause, the raw fact is that business plans tend to overstate the economies of scale—both in the amount and in how soon they will occur. As a result, most of the remaining synergies are too small to cover the premium price paid. And you probably gave that amount away to the seller when you overpaid.

3) Not all of the Sales Stick
There is a reason why some customers preferred doing business with your competitor rather than with you. For some reason, a certain percentage of the market preferred not to do business with you and chose the competitor in order to avoid doing business with you. When you buy that competitor, you are buying a customer list which includes people who have been avoiding you. They may continue to want to avoid you and defect to another firm once you make the acquisition. Therefore, there are usually top-line dis-synergies in an acquisition, causing your combined sales to be less than the sum of what each firm did separately.

4) The integration of the assets is harder than one thinks.
Pride, differing cultures, different IT systems, key employee defections, and other such factors often make integration of companies slower and more costly than anticipated. All those expected synergies come up short. You save less than you think.

5) The market shrinks faster than one thinks
The reason why industries stop growing is not because people stop spending. Typically, what happens is that another industry provides a superior solution and the growth moves to the superior solution. People didn’t stop buying photographic film because they stopped taking pictures. In reality, people are taking more pictures now than ever before. They just found digital photography to be a superior solution.

The problem in declining industries is that the consolidators tend to underestimate the growth of the new industry that is providing the superior solution, in part because they do not understand the new solution. In addition, they may not see how interconnected their old solution is to the new solution and not realize how the growth of the new is at the expense of the old. Kodak terribly underestimated the digital world, because it was not their world. They could not imagine cell phones replacing cameras.

Macy’s spent a fortune to consolidate the department store industry in the US. Unfortunately, many people have found superior solutions to the department store, such as the lower priced Kohl’s chain or in high-end specialty formats, like Williams Sonoma. In addition, apparel, the core of the department store, is not as hot a category as it used to be. The greater growth has been in areas like consumer electronics, which diverts money away from apparel into stores like Best Buy.

As I’ve mentioned many times before, study after study has shown that most acquisitions end up destroying value for the acquirer. A successful consolidation strategy usually depends upon making a series of acquisitions. Just getting one right is difficult. The likelihood that all will work is slim. That’s why the seller usually does better than the buyer.

So what is the solution?

1. Consider selling out early, while you can still get top dollar for your business. For more on this, see my blog “We Can All Act Like Sports Franchise Owners.”

2. If you still want to be the consolidator, make doing good acquisitions your core competency. Cisco succeeded in consolidation because they took the time to become world class at acquisitions. That became a big part of their value-added vision.

3. Discover early what superior solution is taking the growth out of your industry and shift to that superior solution. In other words, continue to be a growth company even through your industry is may not be by moving to where the growth is. Fuji saw that photographic growth was moving to digital and they rushed into the digital void early to stake out a position and sustain growth. Dayton Hudson saw that discount stores were growing at the expense of department stores, so they sold out of many of their department store divisions early and put the money into the faster growing Target chain.

SUMMARY
Becoming a consolidator can be an alluring strategy. You get to become the big fish in the shrinking pond. It strokes the ego to buy out those hated competitors and become the last big survivor. By contrast, selling out to the consolidator can look like defeat. However, the reality is that selling out is often the strategy which creates the greatest value, while the consolidator destroys value.

FINAL THOUGHTS
Remember the moral of the hot potato—if you hold on to it too long, you will burn your hand.