In business, 1+1 does not equal 2

When we are in elementary school, our teachers tell us 1+1=2 and that makes sense to us. We can count on our fingers and toes, counts beads, count friends, whatever we do we come up with the same result. It is a tangible and consistent result. In the same way, 2+2=4. No matter what we do we always come up with the same result. This is great because no matter who you are or where you come from we can all agree on this facts: 1+1=2.

However, from a business perspective this is not true. Business people don’t even want this to be true. For people in business 1+1 equals any number you want as long as it is at least 2.

I know, this sounds absurd. It isn’t. Just don’t tell my elementary school teach, or my accountant. Here is why.

Business is about creating value for your customers. Whatever activities the business engages in each one of them seeks to be greater than the sum of the parts. How much greater is question of perception.

How much does 1+1 make in your business?

ROKC’n M&A

A couple of ROKC enthusiasts have approached us about applying ROKC to Merger & Acquisition so we decided to post an article with our thoughts on the subject.

Let’s start with a quick review of the ROKC approach:

  • A business has a key component, an asset it owns or controls that gives it a competitive advantage in the markets in which it operates.
  • The competitive advantage is sufficient robust over a foreseeable period of time that the opportunity to build a business out of the key component presents itself.
  • The business owner can now set out to use the key component in the production of a product for a given market segment and packs it with features that will appeal to that same market segment.
  • The product must help the consumer reduce the uncertainty of their life in some perceivable fashion.
  • A certain amount of time and energy will also be employed to communicate the product’s value to the market segment so that they want to buy it, in some instances buying it as many times as possible in others just once.
  • The above must generate enough residual value to allow the business to identify, monitor and mitigate risks to the key component and the competitive advantage it bestows, to the transformational processes by which it produces the product and incites the consumer to acquire the product, and to the overall business risks related to operating in that market.
  • There must be enough value generated from the above to cover the cost of capital and return money to investors, and still reinvest in the business’s future before the key component’s competitive advantage disappears.
  • Once the key component has lost enough of its competitive advantage the business owner will have either found a new one or the business will close.

It is from this standpoint that we  look at how mergers & acquisitions make sense for a company by asking the question: “How does a merger or an acquisition help the business maximize the Return on Key Component within its perceived lifetime?”

The simplest M&A example is acquiring marketshare. The ability of any business to scale only through organic growth is limited. It requires going through successive cycles of buying and selling until it has accumulated enough capital to penetrate new markets. This is a slow process which can ultimately cut into the key component’s market effectiveness leading to a loss of competitive advantage before fully exploiting its economic potential. Think of the short lifetime for a patent before it falls into the public domain; you have to get a return on all the monies invested to file the patent before it expires or a competing technology comes along. Consequently, buying companies, nationally and internationally, is a way to greatly accelerate the scaling process.

Another reason for M&A activity is to kill off a competing technology. In this instance, the acquisition target will be a direct competitor who is bought with the objective of acquiring their key component and quashing it. This allows the acquiring company to reduce the risk to its own key component while at the same time getting access to the target’s clients.

In other cases, the target company’s key component will enhance the buyer’s key component. Facebook acquired Instagram because Instagram’s level of user engagement to share photos was so much better than Facebook’s. Facebook’s key component is valuable only if there is user engagement.

More recently there is the phenomenon of “acqui-hiring” in which a company buys another business to gain access to their talent. It seems this is case for Yahoo’s acquisition of Tumblr whereby it got access to David Karp, the company’s CEO. Marisa Meyer, CEO of Yahoo, not only bought the Tumblr business with all that it entails but also hopes Mr. Karp with help her revive Yahoo.

As with many large companies that are good at doing one thing on a very large scale it is very difficult for the behemoth to change direction. Consequently, a portfolio approach allows the holding company to manage the risks associated with a loss of competitive advantage by acquiring new high growth companies in which it can invest while milking the declining business for the cash with which to do it. Once the declining business reaches a certain level of returns it is sold off and the newer growing business becomes the face of the business.

These are just some of the ways in which a business can engage in M&A to maximize its Return On Key Component. Certainly there are other more complex scenarios but this is enough to give you an appreciation for how the ROKC method is applied to M&A. We are happy to learn about others. Feel free to share.

Patterns of Behavior

Have you ever wondered how people work? How the world works? I have.

Ever since I was a kid I tried to make sense of the world I live in. Maybe I tried harder than most kids my age but then again maybe my world was a bit more complex than most. Or maybe, it was just a question of my own sense of not fitting in anywhere.

I grew up in New York City back in the 1970s. It was a rough city back then. Not like now; it is more of a shopping mall. It was a city of tribes: Blacks, Whites, Latinos; Irish, Jews, Italians, Chinese. Drive by shootings were common place. Drugs were the norm. And getting mugged or robbed was…..well, it happened to me a couple of times. Nonetheless, I was lucky. My dad provided well for the family and my brother and sister and I grew up in an upper middle class home.

In a way, that just complicated things further.

Mom is Jewish – American with origins in the Ukraine and the Baltics, and an artist. Dad is an immigrant Italian, a Catholic and a scientist. Both very anti-religion. Mom shunned her family and embraced Dad’s. Dad worked in an almost exclusively Italian milieu so all our “aunts, uncles and cousins” were either Italian or  first generation American. All three of us went to a school with kids from all over the world and travelled quite extensively. Our school friends and teachers came from everywhere: Japan, Venezuela, Spain, France, Cuba, Israel, India, Italy, and so on.

Oddly enough, I don’t think I met an actual American until I went to college! Then again, maybe it was in graduate school where I met my first American.

One guy who I did my MBA with once expressed surprise at my lack of religious schooling because he thought I didn’t have the moral fiber to not kill anyone and feel guilty. I guess he didn’t realize that growing up in the Judeo-Christian tradition is enough to not go out and kill people. And, another who couldn’t believe I knew nothing about the great American sport of baseball. I didn’t. (I went to my first baseball game later on life and had to have the game explained to me.)

After my MBA, I moved to France and started a family there. It was a shocker for me even though I had many school friends from France. The people I encountered in France were real Frenchmen not the Americanized French kids I went to school with. After a few years in France, I moved the family to Italy thinking it wouldn’t be a problem. A European is a European, right? Wrong.

Even though half Italian and having spent many a summer with friends and family, I was once again an outsider. And, my French wife didn’t like Italians. She once started screaming at a bunch of high school kids just as they were getting out of school about their conformity in clothing. Was I embarrassed? You bet ya!

My work obliged to travel all around Europe. So I met people from other countries all the time. This allowed me to notice differences between them and me. And when my business trips were with colleagues from a third country, I couldn’t help but be struck by the differences between us all.

Over a lifetime of experience, observation and study, I can safely state that we are all different. Much more different than we think.

Sure, we can wear the same brands, use the same software, frequent the same social networking sites, read the same books, …… we can globalize as much as we want, but in the end that is not what is important. Globalization is economics, which has very little to do with who we are.

It is within this great big muddled life of mine that I have tried to make sense of the world.

After many years, I have arrived at a paradigm that works for me and, I hope, will work for you. In this article, I will do my best to explain what is to me a very simple tool for understanding the world we live in. Hopefully, you, the reader, benefit from this tool in your everyday life and be all the better for it in your dealings with others.

Patterns

For centuries, man has always thought that what distinguished him from the animals was his intelligence. Man’s ability to think.

On the hand, man was this wonderfully intelligent being capable of building stupendous monuments, writing great literature, developing the sciences, and so on. On the other, animals were viewed as unthinking beasts that could be killed for sustenance or used in some other way for our benefit. But anyone who has actually spent any time with animals will be able to tell you that they too have a capacity to reason. Sure it may be limited (we have only just begun to understand this so we don’t know how much) but it is there. Likewise, we have all encountered people who are not the brightest bulbs on the tree.

In his book, “Thinking, Fast and Slow” (Farrar, Straus and Giroux; 1 edition (October 25, 2011)), Dr. Daniel Kahneman puts thinking into perspective. He explains that there is a fast or autonomic way of thinking; and, a slow or deliberate way of thinking. In summarizing his decades of work, he concludes that we think mostly using our fast thinking brain and not very often with our slow one.

I don’t plan on entering into the details of this work – you can read it on your own, it is fascinating – but I do want to posit that our automatic/fast way of thinking is probably the result of learned patterns of behavior. Man is really quite good at pattern recognition.

Interestingly, while reading Dr. Kahneman’s book I noticed that a great many of the tests he ran on test subjects gave surprising results that provided insights into the workings of the human mind but that he could not be readily explained. One of the first illustrations Kahneman provides is a simple math problem that most people got wrong. Aside from the doctor’s insights into the results, I think it is fair to say that the solutions provided by the test subjects was primarily the result of their discerning a pattern in the information provided in the test question. As I read his book I could see that a large number of these test results could be best understood by applying reasoning based on pattern recognition.

Based on this interpretation, discerning patterns is key to understanding the world.

The Pattern Paradigm

Over many years of peeling the onion I have been able to confirm that patterns of behavior are key to understanding the people I met. Most people simply communicate instinctively without giving much thought to what they say. This is quite normal because the contrary would be very tiresome. This is what Dr. Kahneman calls thinking fast. However, if you start to peel back the layers of that fast talking and dig down to its roots you find that person’s belief system is at the core of their thought process.

Let me explain.

At our center, underpinning our very existence, is our belief system. Whether it is a religion, a philosophy, a sect, a new-age belief system it makes little difference. Our belief system feeds into every part of how we see the world. This is makes sense since belief systems are the oldest part of our societies. Likewise, this serves an important purpose: social cohesion. The closer our neighbor’s own belief system is to our own the greater the connection.

In Europe, even today, there is a very noticeable difference in how business is conducted in the predominantly Protestant North and the predominantly Catholic South. In the Protestant tradition, there is nobody between you and God, and you have to work every day to go to heaven. In the Catholic tradition, there is the Pope and you can be an ass your entire life just as long as you confess and receive last rites you will go to heaven. These are patterns of behavior most people don’t even question but which dominate how they see and act in the world.

The next level up is the communities common experience or collective consciousness. This part of the individual is the shared experience or history that binds together the communities’ members. Usually, this shared experience is passed down from generation to generation through storytelling and mythology. After all history is a “story”.

Notwithstanding the importance of a common experience it seems to be a very weak component. Over and over again, I have been amazed by how unevenly this “factual” experience is actually lived by the people. Not even the scientific method breaks through to people. Just by way of an example, on a television game show in France, about 75% of the public said that the Sun orbited the Earth instead of the Earth orbiting around the Sun. Copernicus and Galileo must have been turning in their graves!

The next pattern that influences how people perceive the world comes from their family experience. All families sit around a meal telling stories about one ancestor or another, just like they do about a living family member or close friend. These stories and the patterns of behavior also shape the learned patterns of behavior through which new generations see the world.

Lastly, there is our own individual experience. As any psychologist will attest, what our parents did to us as children and what we did to ourselves can make us or break us. Only after we get over all our issues can we be well-adjusted and happy individuals.

These spheres of influence taken together form our automatic selves. We just are. We just do. We don’t think too much anything in particular. Even if every once in a while we do take the time to verify that this internal reality corresponds with outside one this is a rare and infrequent event for most of us.

Cultural fit

And rightly so, because when we do ask these questions we risk breaking the connections we have with our community.

Connection

Just consider for a moment what happens to us when we start to question all the patterns of behavior that we have learned over our own brief lifetime? You go to school to engage in some profession only to discover that there are no jobs in that field. You work in a particular profession for many years before being down-sized and finding out that your profession is obsolete. You are a parent one day and not the next. So on and so forth. All those patterns disappear in a what seems like a brief instant and you feel, what is called, disaffected.

Your life in shambles you turn to your family and friends for support but they turn you away. Next you turn to your community and find no support there. So down you go into the rabbit hole ending up on the doorstep of your belief system.

Traditionally, it is the church that provided for the weakest members of society. Nowadays, there are government sponsored programs as well. But it is easy to understand how certain not well-intentioned organizations can attract followers.

Humans need connections.

As a result of this most basic human necessity, when a stranger comes into a community the force shields go up. Defensiveness becomes the norm. Protection the imperative. No matter how open the stranger is to the community, they will not be met by the same degree of openness. It is just the way it is.

When your key component is at risk

Many recent businesses are built on software, their key component. This software is then patented to protect the company from competitors providing the same product using their hard earned intellectual effort. The patent is issued by the government giving its owner an effective monopoly over that property, intellectual property.

All this may change. The U.S. Supreme Court has agreed to hear a case that may lead to different criteria for what is patentable and what is only copyrightable. Any change may have a significant affect on a business’s competitive advantage, thus we call this competitive advantage risk.

As pointed out in ROKC, Leadership built on the Return On Key Component, a key component provides a competitive advantage that if high enough can lead to the creation of a viable and robust business. Once the investment has been in made in creating a product and selling it, the company will also have to engage resources to manage the risks inherent in the business. The first and most important risk to cover is that affecting the key component.

In this case, patenting is a way to protect the key component which covers the risks associated with others using that property without authorization or compensation. Although a strong form of risk management, patents need to be maintained and are subject to attacks from competitors. They are strong protection but not guarantees.

The fact that Supreme Court is hearing this case, Alice vs CLS, means that some patents may be invalidated effectively reducing, or eliminating, the competitive advantage they provide to the business and wiping out large amounts of company value.

Like the old saying goes: There are no guarantees in life. Apparently, not even in patents.

Communicating With Customers

In the ROKC approach to business we do our best effort to break a business down into its component parts:

  • Key component
  • Competitive Advantage
  • Transformational Process – Production
  • Transformational Process – Consumption
  • Risk Management

where all processes and risk management activities focus on maximizing the return on key component. And, each business component has an opportunity associated with it that a good leader can use to build a business.

In other words, you may have a key component which provides the opportunity to build a business. But an examination of the competitive advantage may be perceived as low in which case it is difficult – if not impossible – to actually build the business. Conversely, the competitive advantage may be high but the transformational processes may be difficult to achieve once again nipping the business in the bud. Or, the transformational processes may be easy but risk management too consumptive of resources leaving no excess value to reinvest in the business and return to investors. Exploiting all these opportunities to create a viable and robust business requires a skilled leader; a leader who may need to evolve with the business as it grows or a series of different leaders for each growth phase the business goes through.

In many situations the founders do an excellent job of getting the business off the ground but lack the management skills to take it further. They should not let their egos get in the way and reach out to those with the managerial skills to grow the business. This period is a great opportunity for the founders to learn the skills they need to develop and then take the reins at a later time. By way of an example, take a look at Google. Eric Schmidt was brought in and ran the company for many years while Larry Page learned from him, then Larry stepped in to the CEO spot. No harm in that.

In fact, many founders excel exploiting the competitive advantage their key component provides them with and can even give it expression in a product or service. The real challenge comes when they have to make the product or service acceptable to their customer base. We call this the Transformational Process – Consumption: How to make a product or service that customers want to consume.

The TP – Consumption includes a vast array of processes that depend on the product or service that his been made which in turn depends on the competitive advantage which takes us back to the key component. For example, in a market that is still very production oriented the importance may be placed on the product features or benefits, whereas in a consumption oriented market the emphasis might be place on the brand or other intangibles. Consequently, how and what is communicated to customers will vary accordingly.

One of the best presentations I have come across to illustrate in a very pragmatic and amusing way is a TED Talk from 2009 done by Rory Sutherland, a British “Ad Man”. In this talk, Rory makes a very persuasive case for generating value from the intangibles of a product using communication to influence customer perception.

“Advertising adds value to a product by changing our perception, rather than the product itself. Rory Sutherland makes the daring assertion that a change in perceived value can be just as satisfying as what we consider “real” value — and his conclusion has interesting consequences for how we look at life.”

(Source: Life lessons from an ad man – TEDGlobal 2009)

Here are links to other Rory Sutherland TED Talks.

Do you need to be a Nobel Candidate to get a Job?

Watch this Wall Street Journal interview by Francesca Donner with Wharton Professor Peter Cappelli to learn “Why Jobseekers Don’t Land Jobs”. Peter Cappelli explains why the hiring process is frustrating for employers and job seekers and how to fix the problem. Click here for the video.

In ROKC, Leadership built on the Return On Key Component, we identify the same issues but drill down to a finer level of analysis by positing that employers – fundamentally in the United States but also elsewhere – have achieved significant productivity gains by treating corporate functions as if they were services bought in from outside. Here is a passage from ROKC explaining this analysis:

“As you may have already discerned, as important as it may be to have talented people working with the business on the transformative process, it is in risk management where truly talented people are required. If you remember that the transformative process is where value creation occurs then you will quickly understand the company can accept small imperfections here. Likewise, if your recall that risk management predominantly destroys the value created by the transformative then you can imagine that any small imperfection here can have a potentially exponentially destructive impact on the ROKC. Consequently, the risk of having the most talented person in a risk management role is far more important for the business to succeed.

The first way to manage talent risk is to hire people with the assets that match the company’s assets. In this case, a hire is comparable to an external professional who possesses their own key component. The only difference is the amount of time this person is required by the company, making it more economical to employ them directly. This one-person business partner helps the business succeed by using their own key component exclusively for the benefit of one client, an in-house client.

Accordingly, a company using Great Plains accounting software will seek to hire an “Accounting Expert in Great Plains.” Similarly, a business using Magento e-Commerce Suite will not seek any old e-commerce specialist but one having “Experience with Magento.” Or, a company using SAP will hire an expert in SAP, another using Six Sigma will want a black belt and so on and so forth. But it doesn’t stop here, an apparel company will want a hire with industry or even sector experience: “Must have apparel industry experience.” or “Must have 5 years in luxury women’s footwear.”, respectively.

As much as this approach tries to increase the chances that the hire knows how to use the company’s assets when they walk in the door it, which reduces talent risk, it increases the risk of group think. The circulation of human resources within the same industry over time will blind everyone to systemic risks like those that brought the financial system in 2008. Back then, analysts priced financial products using a 40% recovery rate because it was considered the industry standard instead of questioning this one very important assumption which might have avoided the crash altogether, according to some industry experts. Bringing in a fresh set of eyes who contributes non-industry standard views can actually be more important for risk management than recruiters think.

In-house functions that cannot be manage risks with ease may be better done by outside specialist. These are companies who built their business on their key components and now sell them to help manage their client’s risk. Traditionally, experts like doctors, lawyers, auditors, architects, psychologists, scholars fulfilled this role. Nowadays, there are whole battalions of local, national and international companies to whom a business can outsource their risks: warehousing, transportation, supply chain specialists, website hosting, cloud hosting, Saas, Iaas, App developers, ecommerce management services, order fulfillment, payment gateways, digital marketing agencies, engineering firms, security firms, shared services and so on.

Compared with the past when businesses did almost everything in-house, today companies are essentially flat. Or, as I like to say, an upside down banana peel; flat with a small rise in the middle. Today’s modern businesses, especially the big ones, have become a swarm of businesses where each worker bee is specialized in its task. One business may buy the inputs for a product while another manages the supply chain that gets the inputs to where they need to be used, a shipping company gets the inputs there, and a contract manufacturer builds the product. Meanwhile, an IT company provides the software that allows everyone in the process to see what’s going on and an accounting company posts the financial flows to the accounts of multiple legal entities above. While this is going on orders are being taken, advertising is being conceived of and produced, social media experts are tweeting, and so on. Each of these companies absorb a part of the risk traditionally held by the big company.

As we have argued throughout this book, the ROKC method focuses the business on its competitive advantage in order to maximize shareholder returns. But it can also maximizes stakeholder satisfaction. The decision to maintain a process and/or its risk management in-house, like the decision to externalize it, means that those talented people who work with the company on the ROKC will feel that they are providing real value. This brings real satisfaction to everyone.”

It is also interesting to note how the lion’s share of productivity gains occur in the U.S. and other “economically liberal” countries. Often this has been attributed to the speed with which information technology has been adopted by a country in general and businesses in the specific but this is not all the story because every country uses information technology. The most significant productivity gains have been in countries where company formation is easy, like the U.S., U.K., and other culturally Protestant nations. Shedding corporate jobs is the easy part. Finding new employment opportunities is more difficult the process of “creative destruction” does not work properly.

During the Great Recession, many European governments were put under extreme pressure to reform their labor markets, which they did. But without the commensurate reduction in the barriers to company formation – administrative, taxation, hiring, access to capital and such – the result has been high unemployment especially amongst the younger segments of the population.

This phenomenon serves to illustrate the misconception many business people hold that Europeans are inherently lazy: the siesta, long vacations, short workweeks, and so on. The fact of the matter is rigid labor legislation is the counterpart the hegemonic economic actors have to pay for quashing competition within their borders. But enough about this subject that could take up a whole book on its own.

Although Peter Cappelli’s points are very close to my own there is a whole structural analysis that is missing but can be found in the politics of each country. In my humble opinion, it is only through legislative action that it will be possible to reverse the tide by placing wages and individual freedoms at the center of the debate. “A fair day’s wage for a fair day’s work.”

Competitive Advantage clearly defined

Excellent synopsis. Makes me want to read this book,The End of Competitive Advantage: How to Keep Your Strategy Moving as Fast as Your Business, by Rita Gunther McGrath. Thanks.

The only question I have is how “competitive advantage” is defined, or not. It seems that a competitive advantage can be derived from any part of a business. Although this may be the case, I don’t think it goes far enough.

I would argue that competitive advantage is derived from the ownership or control of a particular asset. For example, a parcel of land might be more competitive than a neighboring parcels because of soil quality, sunlight, access to water and other such factors. This definition is consistent with the history of the world – most of it anyway – and the political, social and economic institutions that have been created. In other words, the asset owner can not only stake their rights to the property but the state will protect those rights. Based upon this certainty, a property owner can build a business that employs the asset if, and only if, it creates enough value to mitigate all the risks inherent in the business.

Over time, the asset may lose its innate qualities and consequently its competitive advantage or a new way of achieving the same benefit may make it less competitive or even obsolete. As the Fujifilm example illustrates a leader must be aware of these risks and manage them in a timely manner or become a Kodak.

By defining the competitive advantage in this way we take take the discussion from the general to the specific and better understand how leadership, strategy, processes, risks and market combine to create economic value.

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