Create Policies to Invest Good Money Before It Goes Bad
Create Policies to Invest Good Money Before It Goes Bad
When you’re driving a car, you can wait until the fuel gauge drops toward empty before you refill the tank, and once the tank is full again you can rev the car back up to full speed. It just isn’t possible to manage growth in the same way—to wait until the growth gauge begins falling toward zero before you seek a fill-up from new-growth businesses. The growth engine is a much more delicate machine that must be kept running continuously by process and policy, rather than by reacting when the growth gauge reads empty. We suggest three particular policies for keeping the growth engine running. Taken together, the policies force the organization to start early, start small, and demand early success.
Launch new-growth businesses regularly when the core is still healthy—when it can still be patient for growth—not when financial results signal the need.
Keep dividing business units so that as the corporation becomes increasingly large, decisions to launch growth ventures continue to be made within organizational units that can be patient for growth because they are small enough to benefit from investing in small opportunities.
Minimize the use of profit from established businesses to subsidize losses in new-growth businesses. Be impatient for profit: There is nothing like profitability to ensure that a high-potential business can continue to garner the funding it needs, even when the corporation’s core businesses turn sour.
Start Early: Launch New-Growth Businesses Regularly While the Core Is Still Healthy
Establishing a policy that mandates the launch of new disruptive growth businesses in a predetermined rhythm is the only way that executives actually can avoid reacting after the growth engine has stalled. They must regularly launch or acquire new-growth businesses while their core businesses are still growing healthily, because when growth slows, the dramatic change in the company’s values that ensues makes growth impossible. If executives do this, and continue to shape the strategies of those businesses to be disruptive, soon a new business or two will punch into the realm of major revenue every year, ready to sustain the total corporation’s growth. If executives use their corporations’ investment capital when they can be patient for growth, the money will not spoil. It remains fresh, able to fund new-growth businesses.
Acquire New-Growth Businesses in a Predetermined Rhythm
Some executives of large, successful companies fear that even if they develop high-potential ideas and business plans for disruptive growth businesses, they just won’t be able to create the processes and values required to nurture them. They therefore are inclined to buy disruptive growth businesses, rather than to make them internally. Acquisition can be a very successful strategy if it is guided by good theory.
Many corporate acquisitions are triggered by the arrival of an investment banker with a business to sell. Decisions to acquire or not are often driven by discounted cash flow projections and an assessment of whether the business is undervalued or fixable or can yield cost savings through synergies with an existing business. Some of the theories that are used to justify these acquisitions prove to be accurate, and the acquisitions create great value. But most of them don’t.
Corporate business development teams can just as readily acquire disruptive businesses. If they wait until the growth trajectories of these companies are obvious to everyone, of course, the disruptive companies may be too expensive to acquire. But if a business development team identifies candidates through the lenses of the theories in chapters 2 through 6 rather than waiting for conclusive historical evidence, then acquiring early-stage disruptive growth businesses in a regular rhythm can be a great strategy for creating and sustaining a corporation’s growth. In contrast to the acquisition of mature businesses that put a company on a higher but still flat revenue trajectory, acquiring early-stage disruptive companies can change the slope of the revenue trajectory.
One company whose fortunes have been heavily shaped by acquiring disruptive businesses has been Johnson & Johnson. For most of the 1990s, J&J was organized in three major operating groups—ethical pharmaceuticals, medical devices and diagnostics (MDD), and consumer products. Figure 9-1 shows that in 1993 the consumer and MDD groups were comparably sized, each generating just under $5 billion in sales. They subsequently grew at very different rates. The consumer business’s intrinsic growth trajectory was essentially flat, and it grew by acquiring big new revenue platforms, such as Neutrogena and Aveeno, whose growth trajectories were similarly flat. Although these acquisitions put the revenue line of the consumer group on a higher platform, they did not change the slope of the platform—and remember that it is changes in the slope of the platform, not the level of the platform, that create shareholder value at an above-average rate. Even with the acquisitions, the consumer group’s total revenues only grew at about a 4 percent annual rate over the decade.
Figure 9-1: Johnson & Johnson Consumer Products (CP) Versus Medical Devices & Diagnostics (MDD) Revenue and Operating Profit, 1992–2001
Sources: Johnson & Johnson financial statements; Deloitte Consulting analysis.
In contrast, the MDD group of businesses grew at over 11 percent annually over the same period. This was driven by four disruptive businesses, each of which the company had acquired. J&J’s Ethicon Endo-Surgery company makes instruments for endoscopic surgery, a disruption relative to conventional invasive surgery. Its Cordis division makes instruments for angioplasty, which is disruptive relative to open-heart cardiac bypass surgery. The company’s Lifescan division makes portable blood glucose meters that enable patients with diabetes to test their own blood sugar levels instead of needing to go to hospital laboratories. And J&J’s Vistakon disposable contact lenses were disruptive relative to traditional lenses made by companies such as Bausch & Lomb. The strategies of each of these businesses fit precisely the litmus tests for new-market disruption described in chapter 2. Together, they have grown at a 43 percent annual rate since 1993, and now account for about $10 billion in revenue. The group’s overall growth rate was 11 percent because the other MDD group companies—those not on disruptive trajectories—grew in aggregate at a 3 percent annual rate. Both the consumer and MDD groups grew through acquisition. The growth rates of the two groups differed because MDD acquired businesses with disruptive potential, whereas the consumer group acquired premium businesses that were not disruptive.
Hewlett-Packard also sustained its growth for nearly two decades after its core lines of business matured, using a hybrid strategy for finding disruptions. Its acquisition of Apollo Computer, a leading workstation maker, was the platform upon which HP built its microprocessor-based computer businesses, which disrupted minicomputer makers such as Digital Equipment. HP’s ink-jet printer business, which today provides a significant portion of the corporation’s total profit, was a disruption that was conceived and launched internally, but within an organizationally autonomous business unit.
GE Capital, which was the primary engine of value creation for GE shareholders in the 1990s, has been a massive disruptor in the financial services industry. It has grown through a hybrid strategy of incubating disruptive businesses in some segments of the industry and acquiring others.
Start Small: Divide Business Units to Maintain Patience for Growth
The second policy imperative is to keep operating units relatively small. A decentralized company can maintain the values required to see and enthusiastically pursue disruptive innovations far longer than can a monolithic, centralized one, because the size that a new disruptive venture must reach to make a difference to a small business unit is more consistent with the revenue ramp of a new disruptive business.
Compare the perspective in a monolithic $20 billion company that needs to grow 15 percent annually with the perspective in a $20 billion corporation that is composed of twenty business units. The managers of the monolithic company will have to look at every proposed innovation from the perspective of needing to find $3 billion in new revenues beyond what was done in the prior year. The average perspective of the twenty business unit managers in the decentralized company, in contrast, is that they need to bring in $150 million of new business in the next year. In the multiple-business-unit firm there are more managers seeking disruptive growth opportunities, and more opportunities will look attractive to them.
In fact, most of the companies that appear to have transformed themselves over the past thirty years or so—companies such as Hewlett-Packard, Johnson & Johnson, and General Electric, for example—have been composed of a large number of smaller, relatively autonomous business units. These corporations have not transformed themselves by transforming the business models of their existing business units into disruptive growth businesses. The transformation was achieved by creating new disruptive business units and by shutting down or selling off mature ones that had reached the feasible end of their sustaining-technology trajectories.
One reason the mortality rate of independent disk drive companies measured in The Innovator’s Dilemma was so high was that they all were single-business companies. As monolithic organizations—even relatively small ones—they had never learned how to manage nascent disruptive growth businesses alongside larger, maturing businesses. There were no processes for doing this.
In following the policy we are recommending, managers again need to be guided by theory, not by the numbers. Accountants will argue that redundant overhead expenses can be eliminated when business units are consolidated into much larger entities. Such analysts rarely assess the impact that consolidation has on the consequent demands in those mega-units that any new businesses that are launched must get very big very fast.
Demand Early Success: Minimize Subsidization of New-Growth Ventures
The third policy, which is to expect new-growth businesses to generate profit relatively quickly, does two important things. First, it helps accelerate the emergent strategy process by forcing the venture to test as quickly as possible the assumption that there are customers who will pay attractive prices for the firm’s products. The fledgling business can then press on or change course based on this feedback. Second, forcing a venture to become profitable as soon as feasible helps protect it from being shut down when the core business turns sour.
Honda: An Example of Forced Floundering
Not having much money proved to be a great blessing for Honda, for example, as it attacked the U.S. motorcycle market. Founded in postwar Japan by motorcycle racing enthusiast Suchiro Honda, by the mid-1950s the company had become best known for its 50cc Super Cub, designed as a more powerful but easy-to-handle moped that could wind its way through crowded Japanese streets for use as a delivery vehicle.
When Honda targeted the U.S. motorcycle market in 1958, its management set a seat-of-the-pants sales target of 6,000 units a year, representing 1 percent of the U.S. market. Securing support for the U.S. venture was not merely a matter of convincing Mr. Honda. The Japanese Ministry of Finance also had to approve the release of the foreign currency needed to set up operations in America. Hard on the heels of Toyota’s failed introduction of the Toyopet car, the Ministry was loathe to give up scarce foreign exchange. Only $250,000 was released, of which only $110,000 was cash; the rest had to be in inventory.
Honda launched its U.S. operations with inventory in each of its 50cc, 125cc, 250cc, and 305cc models. The biggest bets were placed on the largest motorcycles, however, because the U.S. market was composed exclusively of large bikes. In our parlance, Honda set out to achieve a low-end disruption, hoping to pick off the most price-sensitive customers in the existing market with a low-price, full-sized motorcycle.
In 1960 Honda sold a few models of its larger machines, which promptly began to leak oil and blow their clutches. It turned out that Honda’s best engineers, whose skills had been honed through developing products that performed well in short stop-and-go bursts in congested streets, didn’t know what they didn’t know about the demands of the constant, high-speed, over-the-road travel that was common among motorcyclists in the United States. Honda had little choice but to invest its precious currency in sending the defective bikes via air freight back to Japan. The problem almost broke Honda.
With almost all of its resources devoted to supporting and promoting the problematic larger machines against well-financed and successful incumbents, the Honda personnel in the United States turned to using the 50cc Super Cubs as their own transportation. They were reliable, cheap to run, and Honda figured they couldn’t sell them anyway: There simply was no market for motorbikes that small. Right?
The exposure the Super Cub got from the daily use of the Honda management team in Los Angeles generated surprising interest from individuals and retailers—not motorcycle distributors, but sporting goods shops. Running low on cash thanks to the difficulties encountered in selling the big bikes, Honda decided to sell the Super Cubs just to stay afloat.
Little by little, continued success in selling the Super Cub and continued disappointment with the larger machines eventually redirected Honda’s efforts toward the creation of an entirely new market segment—off-road motorbikes. Priced at one-fourth the cost of a big Harley, these were sold to people without leather jackets who never would have purchased deep-throated cycles from the established U.S. or European makers. They were used for fun, not over-the-road transportation. Apparently a low-end disruption wasn’t a viable strategy because there just weren’t enough over-the-road bikers who were overserved by the brands and muscle of Harleys, Triumphs, and BMWs. What emerged was a new-market disruption, which Honda subsequently did a masterful job of deliberately exploiting.
What pushed Honda to discover this market was its lack of financial resources. This prevented its managers from tolerating significant losses and instead created an environment in which the venture’s managers had to respond to unanticipated successes. This is the essence of managing the emergent strategy process.
It is important to remember that this policy—to limit expenses and seek early profit in order to accelerate the emergent strategy process—is not a one-size-fits-all mandate. In circumstances in which a viable strategy needs to emerge—such as new-market disruptions—this is a helpful policy. In low-end disruptions, the right strategy often is much clearer much earlier. As soon as the market applications become clear, and a business model that can viably and profitably address that market has emerged, aggressive investment—impatience for growth—is appropriate.
Insurance for When the Corporation Refocuses on the Core
Another reason why turning an early profit is important to a new business’s success is that funding for new ventures very often gets cut off not because the ventures are off-plan, but because the core business is sick and needs all of the corporation’s resources to recover. When the downturn occurs, new-growth ventures that cannot play a significant and immediate role in the corporation’s return to financial health simply get sacrificed, even though everybody involved knows that they are cutting off the road to the future in order to salvage the present. The need to survive trumps the need to grow.
Dr. Nick Fiore, who periodically speaks to our students at the Harvard Business School, is a battle-scarred corporate innovator whose experiences illustrate these principles in action. Fiore was hired at different points in his career by the CEOs of two publicly traded companies to start new-growth businesses that would set their corporations on robust growth trajectories. In both instances, the CEOs—powerful, reputable executives who were secure in their positions—had truthfully assured Fiore that the initiative to create new-growth businesses had the full and patient backing of the companies’ respective boards of directors.
Fiore cautions our students that if they ever receive such assurances, even from the most powerful and deep-pocketed executives in their companies, they had better watch out.
When you start a new growth business, there is a ticking clock behind you. The problem is that this clock ticks at a variable rate that is determined by the health of the corporate bottom line, not by whether your little venture is on plan. When the bottom line is healthy, this clock ticks patiently on. But if the bottom line gets troubled, the clock starts to tick real fast. When it suddenly strikes twelve, your new business had better be profitable enough that the corporate bottom line would look worse without you. You need to be part of the solution to the corporation’s immediate profit problems, or the guillotine blade will fall. This will happen because the board and the chairman have no option but to refocus on the core—despite what they may have told you with the best and most honest of intentions.
This is why being impatient for profit is a virtuous characteristic of corporate capital. It forces new-growth ventures to ferret out the most promising disruptive opportunities quickly, and creates some (always imperfect) insurance against the venture’s getting zeroed out when the health of the larger organization becomes imperiled.
Figure 9-2 summarizes the virtues of policy-driven growth. It shows that appropriate policies, if well understood and appropriately implemented, can generate an upward spiral to replace the death spiral from inadequate growth that we described at the beginning of this chapter. When this happens, companies place themselves in a circumstance of continual growth. They invest their good money and avoid letting it go bad. This is the only way to avoid letting the growth engine stall and to sidestep the death spiral from inadequate growth.
Figure 9-2: Self-Reinforcing Spirals from Adequate and Inadequate Growth
The literature assessing the performance implications of merger and acquisition activity is enormous, and surprisingly unambiguous. Many studies have revealed that many, and perhaps even most, mergers destroy value in the acquiring firm; see, for example, Michael Porter “From Competitive Advantage to Competitive Strategy,” Harvard Business Review 65, no. 3 (1987), 43–59, and J. B. Young, “A Conclusive Investigation into the Causative Elements of Failure in Acquisitions and Mergers,” in Handbook of Mergers, Acquisitions, and Buyouts, ed. S. J. Lee and R. D. Colman (Englewood Cliffs, NJ: Prentice-Hall, 1981), 605–628. At best, the only winners appear to be the sellers; see, for example, G. A. Jarrell, J. A. Brickley, and J. M. Netter, “The Market for Corporate Control: The Empirical Evidence Since 1980,” Journal of Economic Perspectives 2 (1988): 21–48, and M. C. Jensen and R. S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11 (1983): 5–50. Even if acquisition targets are “well-selected” from a conventional strategic point of view, there is significant evidence to suggest that implementation difficulties can derail the realization of any putative benefits; see, for example, Anthony B. Buono and James L. Bowditch, The Human Side of Mergers and Acquisitions: Managing Collisions Between People, Cultures, and Organizations (San Francisco: Jossey-Bass, 1988), and D. J. Ravenscraft and F. M. Scherer, “The Profitabiliy of Mergers,” International Journal of Industrial Organization 7 (1989): 101–116.
We wish to emphasize that our message is not that acquisitions can solve a company’s growth problems. As we note in the text, even the successful acquisition of mature businesses does not change the growth trajectory of a corporation—it just places corporate revenues on a higher but flat plateau. In the late 1990s Cisco followed a very different acquisition strategy from the one we have described at J&J’s MDD business. Cisco’s packet-switching routers had created a powerful wave of disruption versus Lucent and Nortel, which made circuit-switching equipment for voice telephony. Most of Cisco’s acquisitions were sustaining relative to its business model and market position, in that they helped the company move up-market better and faster. They did not constitute platforms for new disruptive growth businesses.
This is one of the conclusions of Professor Donald N. Sull’s recent book, Revival of the Fittest (Boston: Harvard Business School Press, 2003).
We worry, in fact, that exactly this sort of reasoning has caused Hewlett-Packard’s senior executives to combine the company’s business units into a few massive organizations. The reorganization facilitated cost cutting, no doubt. But in our view, it can only exacerbate the company’s battle with its values at a time when reigniting growth is very important. At the same time—and this is why good theory is so important—“smallness” versus “bigness” is not the right categorization scheme when thinking about the benefits of these kinds of mergers or the advantages of smallness achieved by organizational separation or spin-outs. Consolidation can yield important cost savings, but as we point out in this chapter, it can corrupt the values needed to pursue potential disruptive opportunities. Smaller organizations—or big organizations that are blown apart into a series of smaller organizations—might have an easier time dealing with the challenges of embracing disruption-friendly values, but as we point out in chapters 5 and 6, organizations must also cope with the demands of architectural interdependencies, which can often require larger, more integrated organizations. In our view, it’s not so much about making trade-offs; that is, accepting inevitable compromises, as it is about recognizing the circumstances one is in and adopting the appropriate solution to the most pressing problem.
We have often been asked how much money a venture should be allowed to lose, and how much time it should take until profits should be expected. There can, of course, be no rigid rules, because the fixed-cost intensity of each business will vary. Mobile telephony was a disruptive growth business that entailed large fixed-cost investments, and hence more significant losses than would many others. In making these recommendations, we simply hope to offer to executives the guiding principle that losing less is more.
Honda’s experience is summarized on pages 153 to 156 of The Innovator’s Dilemma. That account has been condensed from a case study by Evelyn Tatum Christensen and Richard Tanner Pascale, “Honda (B),” Case 9-384-050 (Boston: Harvard Business School, 1983).
Searching for unanticipated successes, rather than seeking to correct deviations from a plan, is one of the most important principles that Peter F. Drucker taught in his classic book Innovation and Entrepreneurship (New York: Harper & Row, 1985).
This tendency to refocus immediately on the core when things get bad, even at the expense of the long-term solutions to the problem that caused the core to get sick, is known among behavioral psychologists as “threat rigidity.” See chapter 4 for more on this.
Fiore’s experiences are detailed in Clayton M. Christensen and Tara Donovan, “Nick Fiore: Healer or Hitman? (A)” Case 9-601-062 (Boston: Harvard Business School, 2000).
Presentation by Dr. Nick Fiore to Harvard Business School students, 26 February 2003.