Dealing_with_Darwin

“Best in Class” is a Sucker Bet

As my colleagues and I developed our model for Return on Innovation, we saw three sources of attractive returns.  They are:

1. Differentiation leading to sustainable competitive advantage.  The return comes from customers preferring your offer over the competitor’s (more revenues) and paying a premium for it (higher margins).

2. Neutralization of a competitor’s current competitive advantage.  The return comes from being able to compete in more sales opportunities than you previously could (leading to incrementally more revenues, but not better margins).

3. Productivity leading to better overall profit margins.  The return does not come from any change in competitive advantage but rather from your ability to accomplish the same outcomes with fewer resources.

Note the difference between the first two goals, neither of which correlates to best in class.  Differentiation requires you to be unique in class or “beyond the class.”  Unless you escape from the norms of the category, you cannot gain sufficient bargaining power to drive increased sales and higher margins. 

By contrast, neutralization requires only that you make it “into the class,” that is, meet the minimum market standards for an acceptable performance.  Once you have, you can check this item off your list, and your competitor has lost the leverage it once held.

Best in class falls between these two goals.  It is not sufficiently differentiated to be unique, and thus it does not create bargaining power.  But it goes well beyond the minimum acceptable standard, which means you have spent a bunch of resources beyond what you had to and achieved no economic return for so doing!

That’s why “best in class” is a sucker bet.

In essence, best-in-class projects should be classified as waste.  That is, they are competitive advantage projects that aim too low.  They do achieve some level of differentiation, but it is not enough to create the bargaining power with customers that leads to higher revenues and margins.  In effect they are a form of corporate entertainment whereby teams enjoy the moral authority of a lofty-sounding objective but in fact have no accountability for any measurable economic outcome. 

Darwin will not be fooled.

Paper or Plastic? It Really Matters When Your Are Buying a Company

I was thinking about the Skype acquisition by eBay the other day—some $2 to $4 billion dollars, depending on earn-outs—and how shocking that sum sounds, especially for a company with very small revenues.  But management and investors both make a big mistake when they equate paying cash for a company to buying it with stock.  The two are radically different transactions, and to say that they converge on a common price is to misunderstand the nature and function of currency.

Paying cash for a company makes sense for accretive acquisitions which will improve the acquiring company's financials in the coming year, top and bottom line.  After all, cash is money that you could have given back to investors, and so when you don’t, it is right that you put it to work in ways that will generate immediate returns for them at your existing P/E ratio.

Paying equity for a company is an entirely different matter.  It makes sense when you are making strategic acquisitions that are dilutive in the short term but which you expect will fundamentally change your competitive advantage profile, and thus your earnings potential, in the long term.  In effect, you are not acquiring a going concern but instead mixing two gene pools to create a next generation of capability.  You are going to create a new P/E ratio.

Equity is not actually currency, it is ownership rights, and although markets are willing to trade one for the other, they should not confuse the two.  eBay gave up around 4% of its ownership rights to gain Skype.  That is a good deal if Skype can change eBay’s future earnings potential by more than 4%, a bad deal if it cannot  The cash value of the transaction is a distraction in this calculation.

Too many boards and CEOs are unwilling to pay up for major acquisitions because they see them only as adding in cash flows and not as marriages with the potential to create wholly new offspring.  As a result they do not improve their competitive advantage sufficiently to deal with the next round of natural selection in their marketplace.  Their stocks languish and eventually decline because, like marriage-averse bachelors, they are never able to take the plunge.

Values-Based Performance and Performance-Based Values

Values-based performance characterizes collaboration cultures who commit to altruistic ideals, live these values in their work, and earn thereby the trust of customers and partners .  Performance-based values characterize competition cultures who continually hold themselves accountable to objective metrics of success, regardless of who gets uncomfortable.  The two cultures tend to repel each other, creating nice guys who finish last and jerks who drive Porsches.  But sustainable, good-to-great companies have to combine both. 

I think the proper path here is to begin by establishing values-based performance (no Enrons need apply) and then realize that every time we do not hold ourselves accountable to performance commitments, we are actually selling ourselves short.  Why do we do this?  Because we flinch in fear of the pain that confrontation entails. We are not being nice to the other person, we are protecting ourselves from the demands of stepping up.  Once we acknowledge that this, in effect, means we are not living our values, we can use the energy of shame to change our behavior. 

Finally, this all ties in to Dealing with Darwin because natural selection is the ultimate performance management system, and like it or not, we are all being managed by it.