So much time is spent talking about start-ups, early product/market fit and fund-raising that one important point seems to get the short shrift: managing - and anticipating - the transition from rapid growth to maturity. In essence, a billion-dollar problem with billion-dollar consequences. Vivek Wadhwa recently penned an insightful post from the policy perspective as to why small ventures, and not big businesses, should be the beneficiary of favorable investment and tax treatment. Managing a flattening growth curve in its core business is an issue that has confronted Microsoft for the better part of a decade, and which is just now starting to weigh on Google. It gets at issues such as creative destruction, capital structure, dividend policy, culture and core competencies. The period from rapid growth to maturity is becoming ever-more compressed as competitive advantages are simply not sustainable in an innovation-driven, technologically-enabled world. Open source software and cheap hardware has substantially lowered barriers to entry, and monopoly profits are aggressively attacked by new entrants in virtually real-time. This will become an increasingly hot topic as the darlings of yesterday begin to lose their luster, and the discipline meted out by the public markets will begin to shape the decision-making of corporate leadership. A much more flexible governance paradigm will be required to effectively manage Corporation 2.0, and some old - and destructive - habits will have to fall by the wayside if the next-generation corporation is going to maximize shareholder value not just for today but over the long haul.
Microsoft’s long and twisted road is a cautionary tale from the past. Over the course of a generation we’ve seen Microsoft come out of nowhere to become arguably the most powerful corporate enterprise on the planet, only to stumble badly, straying catastrophically from its core mission and burning $100 billion+ of shareholder value. As growth in its core enterprise OS business began to flag, it aggressively sought to both diversify its bets and to create entire new business lines that were not at all related to what made it successful in the first place. But let’s be clear: flagging growth does not mean growth approaching zero, it means when the rate of growth has begun to sharply drop off, when the “denominator effect” of a very large and successful franchise has made historical levels of high double-digit and triple digit year-on-year growth a mathematical impossibility. So when growth in its core franchise began to flag and when a rapidly changing information transmission landscape - wireline, wireless and broadband - sowed the seeds of fear in senior management, Microsoft went on a historic diversification program. It made a series of minority, billion-dollar investments in businesses such as AT&T, Comcast and Nextel. It then went into the consumer hardware business, championing devices such as the Zune and the Xbox, plowing tens of billions of dollars into its Home & Entertainment business. It also sought to use its monopoly power in its OS business as a strategic weapon in building its Internet franchise, creating years of litigation and management distraction as challenges in the US and European courts played out. And over the past decade Microsoft’s equity market value has dropped from around $500 billion to $200 billion in nominal terms. It has unquestionably been a tough period for the vaunted Microsoft.
So why the problems? How could Microsoft have seemingly blown what looked to be such an unbeatable hand? Here are a few hypotheses:
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Style drift. Microsoft displayed extreme prowess at selling packaged software for the enterprise. They then tried their hand in an array of unrelated fields: hardware, consumer products, “strategic” investing, etc. Success at software simply hasn’t translated.
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Excess financial resources. Enterprise software became akin to a gushing oil well. They discovered it, capped it, extracted (and continue to extract) value from it, and the margins from extraction are extreme. The problem is that it is a depleting asset, akin to the AOL dial-up service (except on a much greater and more profitable scale). Plentiful cash from this depleting asset was diverted from shareholders or growth projects in related businesses into those largely orthogonal to its core business. Result: strategic and financial disaster.
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Management meglomania. Admitting mistakes has not been one of Microsoft management’s strong suits. Is it just me or does it seem that the window-to-the-livingroom strategy built around the Xbox360 has become a win-at-all-costs death match? No business should have this character; execution should be rational and based on the prospect for profits by driving value to end-users. The “We’re in it to win it” and “We’ll spend what it take to make it successful” protestations of Steve Ballmer sound confident, passionate and completely horrifying to a Microsoft shareholder.
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Lack of comfort with the monetization stage of the business. Sick amounts of oligopoly profits have not been enough for Microsoft management. They want to continue selling themselves as a (rapid) growth company. Merely harvesting and distributing profits is seemingly a sign of defeat: making far-off bets on growth using shareholder resources appears to fit better with their DNA. Problem is, shareholders can neither eat ego nor will they wait around for large lottery-ticket type bets to pay off.
There have also been massive changes to the technology and innovation landscapes over the past 25 years that make Microsoft somewhat of an anachronism. A few of these changes include:
- The rise of Open Source as a vehicle for constantly improving core technologies (separate from the commercialization, support and customization of these technologies).
- The emergence of Cloud Computing as a vehicle for accessing cheap processing power and storage, tilting the balance of innovation from large, well-funded but bureaucratic incumbents to smaller, nimbler start-ups.
- The creation of a global technology labor pool where virtually any kind of development project can be built both well and at relatively low cost.
- The willingness of large enterprises to test new products and services from early-stage companies, acknowledging that reliance on large legacy providers is not enough for them to maintain their competitive edge.
So what does this all mean for Corporation 2.0, an enterprise that, while large, remains flexible, innovative, and continues to create value for customers and shareholders throughout its life cycle? With the radical transformation of the technology landscape, I do not believe that there are many valid oligopolies left. Microsoft, Oracle, SAP… their rise to power took billions of dollars of investment and created enormous barriers to entry when the world was dependent upon proprietary software. Scale benefits did exist in the creation and maintenance of these large software packages. Once installed, with the painful integration required, there were huge (and generally unacceptable) costs of switching. In today’s world, barriers to effectively competing with these behemoths are getting smaller every day. Similar barriers are crumbling on the hardware side of the equation, with virtual storage and access to flexible processing power. The winners of Corporation 1.0 may necessarily give way to a whole new set of entrants based on shorter, more iterative development cycles, cheaper, less costly infrastructure and distributed development environments.
I think the issues necessary to succeed in the Corporation 2.0 world break down into two separate but related buckets - strategy and financial. Here are some initial thoughts:
I. Strategy 2.0
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Be constantly in a phase of creative destruction. The highest-profile example of this is Netflix. They started a business knowing that it would become marginalized in the relatively near future, made it successful, extracted profits, and plowed those profits back into a business that directly competed with its golden goose. Crazy? Not if the focus is on creating long-term value for both customers and shareholders. They are now running head-long into streaming video, which sets them up for tomorrow’s environment while harvesting gains from today’s mail-order DVD rental business. Could you imagine if Microsoft had both anticipated the rise of cloud computing and shared applications and offered it commercially? Would it be selling less software? Probably. Might its short-run profits suffer? Yes. Would it be better positioned for the future? Undoubtedly. Like so many businesses that made the shift from enterprise sales to SaaS; expensive in the short run but vastly more profitable and sustainable in the long run.
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Know your core competencies and avoid style drift at all costs. Software development? Marketing and distribution? Predictive analytics? Whatever it is, entering into businesses that are largely unrelated to the core is a recipe for disaster. This is not new news; it has been happening since the dawn of time. But companies keep making the same mistakes. Microsoft is simply among the most visible examples due to its scale and profile, and the magnitude of the dollars that have been spent ostensibly in the name of “building shareholder value.” Ha.
II. Financial 2.0
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Don’t be afraid to harvest and pay out profits. Managements are so afraid of losing their growth stock luster that they will often enter into ill-conceived diversification projects and M&A transactions to please the Wall Street analyst and investor communities. Every constituency is hurt by these steps but one - company management. If a business is maturing, vastly profitable and perhaps not in need of much incremental investment, the by all means dividend cash out to shareholders. Too much cash burning a hole in the corporate pocket can only lead to bad outcomes. To be clear, this is separate from an amount of cash reserves to handle variability in the economic and competitive environments.
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Segregate cash cows from rapid growth businesses. Let’s say that a company’s core competencies has led it to build a very profitable cash cow (like Microsoft’s Enterprise Software business) but also lends it to a series of high-growth investment opportunities in related areas. The cultures and compensation regimes of these business lines should be different. The businesses should be financed differently. Management of these businesses require different skill sets. Corporation 2.0 will need to be much more flexible than Corporation 1.0, able to seamlessly make the jump from rapid growth to mature businesses and back again.
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Take the long view. The quest for short-run profits has and will always be a fool’s errand. Notwithstanding the compression of product and technology cycles, it is more important than ever to eschew investor pressure and to manage the business for maximum long-term profits. This means on optimally managing the cash cows, internally financing strategically important and relevant high-growth projects while paying out excess amounts to shareholders. Investors may complain that paying out cash means the company is no longer a growth company and penalize the P/E ratio over the short run, but operating success will ultimately provide vindication and recognition in the marketplace. Warren Buffett may be many things, but one thing he is is true to his mission and deeply knowledgeable of Berkshire Hathaway’s core competencies. Corporation 2.0 should aspire to such discipline and perspective.
None of these changes are easy, but are much easier if they are built into the fiber of a company from the outset. Most Corporation 1.0 leaders are likely beyond hope. Their cultures will make them unable to adapt, they will suffer a loss of key talent and radical re-positioning of multi-billion enterprises employing thousands of people is painful, complex and generally unsuccessful. Young companies born and bred on open source, cloud computing and flexible and iterative development environments have a rare opportunity to position themselves for generational success. But it will require a lot of planning, tremendous guts and laser focus on avoiding conventional wisdom as espoused by Wall Street. I am excited to see who is up to the challenge.
2 weeks ago
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