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Down to Basics: The Fundamental Theory of the Business

Roy Maurer and the Partners of The Clarion Group

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The Issue

It is easy for leaders – even those leaders who pay attention to changes in their markets – to live with prevailing notions of the business. Many highly respected business strategists have questioned how and why business leaders miss signals that, at least in retrospect, we know the market had been sending. More often they focus on missed opportunities for upside growth: the failure of leaders and companies to be innovative, to manage change and to move with agility in today’s rapidly evolving markets. But recent research1 also highlights a half-century long pattern of sudden and dramatic drops in growth and profitability on the part of Fortune 100 market leaders that threaten their economic viability. Typically these successful companies lose big – almost three-fourths of their market capitalization – in the decade following an unanticipated drop in sales. The conclusion of this research is that the root causes of dramatic revenue stalls were largely in the control of senior management. And the troubling question the authors pose is: “Why is management so often blindsided by these events?” Our experience, consistent with these findings, is that the root cause is often an inability on the part of senior leadership to recognize and challenge their own internal mental models – their fundamental assumptions about the business, the markets, and how they compete in those markets. We call these mental models the Theory of the Business, and we encourage leadership practices that challenge and test the economic logic and market relevance of their theories. We offer here our point of view on why clarifying and adjusting the Theory of the Business is such a difficult challenge for organizations and their leadership, and offer approaches to solve for it at the root cause level.

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2013 the Clarion Group, Ltd. All rights reserved.

Why So Difficult?

1. The Arrogance of Success

Certainly one disturbing answer is the extent to which some management teams have become disdainfully arrogant behind the success of their current business. Under the illusion of superiority, they ridicule those who dare to challenge sacred cows. This can happen even in the face of otherwise compelling market data to the contrary. For instance, there is a pattern of industry leaders initially ignoring low cost-entrants like Toyota or Charles Schwab. The result in both those cases was that incumbents were eventually forced to change their business models and compete from behind.

2. Doing All the Right Things

Just as often, however, resistance to challenging mental models is the unintended and unseen consequence of following superior management practices on the part of highly competent leaders. Architecting organizations for continuity and sustainability is a fundamental principle of business success. But, ironically, doing all the right things – the leadership actions that drive accountability, prioritize and communicate focused strategic objectives, align the organization around clarity of responsibilities, and ultimately achieve performance through efficiency and scalability – becomes part of the problem. This is because, over time, those internal mental models or business assumptions become overly solidified in management systems and structures, a process aptly termed “ossification.”2 Mental models take on a life of their own, permeating and potentially calcifying the culture and decision-making behaviors. The more pervasive the ossification, the more difficult it is to see, let alone challenge, business assumptions.

Despite the fact that the Swiss watch industry had been devastated by Japanese competitors in the early 80’s, it took an outsider, an engineering and industrial consultant, to turn the industry around. Nicolas Hayek expanded traditional management thinking away from its narrow focus to redesign and reposition watches as fashionable, economic accessories (Swatch). The ability to challenge fundamental assumptions or internal mental models requires a conscious departure from business-as-usual, from all the commonly accepted management practices that occupy the vast majority of leadership time, including the way strategy itself is often thought of and practiced. The responsibility to ignite new possibilities lies with leadership; waiting for a reversal of ossification to arise from deep within the organization is unrealistically expecting people to row against the current.

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Doing all the right things becomes part of the problem.

2013 the Clarion Group, Ltd. All rights reserved.

3. Coming to Terms with Impermanence To fully grasp the leadership paradox at the heart of “Doing All the Right Things” (see above), one must first acknowledge the nature of free market economies. Startling as it may seem, some of the most primary objectives of a business are at odds with the reality of market dynamics. While businesses strive to be sustainable and continuously profitable over time, the markets are fundamentally impermanent. The essential nature of markets is to create and destroy companies. Less than 15% of those companies first listed in the S&P 500 in 1957 remain there today, and only one has outperformed the averages. At this rate of turnover, the average life expectancy in the S&P 500 today is less than 10 years. Statistics alone tell us that maintaining market relevance and a profitable business model over time is fighting against all odds.

Impermanence is the rule, but many leaders don’t want to acknowledge that.

4. Keeping Pace with Market Dynamics The obvious conclusion is that our mental models, our assumptions about the business, must continuously match up against the impermanence of the markets to maintain relevance. Just holding steady is to hope beyond hope against the forces of time. A business model must be consciously evolved by its leaders; it must be challenged, adapted, at times even destroyed by its architects in order to be created anew. If not, then odds are it will be destroyed over time simply by remaining static in the market.

While the initial opportunity for Schwab came through unbundled low-cost fees when the SEC outlawed fixed commissions, the real differentiation came from his ability to constantly adapt and evolve the business model utilizing technologies, e.g., back office support to financial planners, TeleBroker trade execution, the OneSource web platform for mutual fund exchange, all of which successfully challenged assumptions about the way consumers invest.

Every business operates on assumptions about the market and how best to compete in that market: what products and services customers will buy, their value, how best to organize people and processes, where to manufacture and distribute products and services, etc. Whether explicitly stated or not – whether even conscious or not – these collective assumptions exist in the minds of business founders and their successors. Collective assumptions congeal into working mental models that shape and guide business decisions. While this is a perfectly natural and highly desirable aspect of human intelligence, we face an increasingly widespread problem: our ability to change deeply rooted mental models is not keeping pace with reality, with the frequency and scale of change in today’s markets.

Markets have always been impermanent. Economist Joseph Schumpeter referred to a process of “creative destruction” as early as 1942.3 However, broad, underlying market forces could go largely unnoticed in the past; historically, they were more gradual, more incremental and (in more than one sense of the word) more manageable.

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A business model must be challenged, adapted, at times even destroyed by its architects

Some of the most primary objectives of a business are at odds with the reality of market dynamics

the clarion group REAL. CLEAR. INSIGHT. 2013 the Clarion Group, Ltd. All rights reserved. Page 5

5. Speed, Complexity and Uncertainty But it’s not just the speed of change; it’s the pervasiveness and scope of change, the raw unpredictability and disruptiveness of market change today that make these dynamics both more visible and less manageable. As renowned strategist Gary Hamel declared, “Change itself has changed.”4 In this real-time, web-based, networked, componentized, on-demand, out-sourced, in-sourced, open-sourced global economy, threats to business models come from every corner of the market, not just from the obvious competitors. Today there is competition for everything, from everywhere, by everyone, all along an industry’s value chain, and maybe from outside an industry as well. In the face of high uncertainty and frequent change, where markets are so complexly interdependent, seemingly insignificant events in remote corners ripple across the markets with sudden, unexpected impact. Change is harder to see, harder to predict, and there is less time to adapt. 6. Inherited Models When a start-up company first enters a market, chances are their basic assumptions have been made explicit for investors to assess. An entrepreneur’s mental models are transparently described as a business model with a clear value proposition and economic logic to be tested in the market. Harsh as it is (high risk, high failure), there is a certain clarity and immediacy to the market feedback process for start-ups. But for successful companies with sustained history, testing business assumptions in the market can become more clouded, less transparent over time.

a. The vast majority of senior executives inherit business models not of their making – they are hired to assume leadership responsibilities in existing companies built around someone else’s (historical) mental models. Threatened by Pepsi’s success in regional grocery chains in the ’70’s, then-CEO Roberto Goizueta found it necessary to renegotiate and consolidate the territorial network of entrepreneurial bottlers that was a bedrock of Coca-Cola’s success for over half a century. Tough though it was, the end result of challenging a fundamental assumption of the business was the hugely effective management of profits along its entire value chain.

b. Rarely are underlying mental models or assumptions explicitly discussed, debated or challenged at that fundamental level; lacking sufficient clarity and transparency, the various members of a senior leadership team may carry differing assumptions in their minds without realizing it.

c. Given the scale and complexity of today’s companies, there are usually multiple business models at play simultaneously, typically operating in parallel, embedded side-by-side in different business lines or customer markets. Add layers of customer-centric market segmentation, regional variations, the interplay between local geographies and global operations, and it is hardly surprising that there can be lack of clarity at the very least, if not confusion or outright competition between multiple business models within one company.

2013 the Clarion Group, Ltd. All rights reserved.

Down to Basics As we all came to realize during the late housing-fueled finance turmoil, the mortgage on our home was sold by our bank, only to be packaged, collateralized, obligated, syndicated, pooled, structured, tranched, securitized, brokered, swapped, leveraged, mismatched and then finally shed – to the point where nobody knew who owned what or if what anyone owned was worth anything. The problematic but highly understandable human reaction to this quagmire persists as a fear-based drive to hold assets that are more simple, more understandable, more real, and more tangible: cash under the mattress, a Treasury bond, a gold bar, a silver bar. While this reaction may seem little more than wishful thinking, a bit naive for our complex world, the wisdom of its appeal is undeniable: let’s all get back to the basic building blocks of investing in things that we can actually understand.

We work with extremely competent executives who are deeply concerned about their blind spots. They worry about what they and their colleagues might not see about the future of their businesses, working as they do at the front edge of complex decision-making in a global market economy of enormous scope and speed. They are sincerely concerned about their customers and their businesses but, in an age of overwhelming information, there actually appears less that they can know for certain.

This uncertainty is compounded in times of market turmoil. The immediate question for many leaders is: “Where do we go from here?” In the near term, the safest answer may be to reassure employees and investors that they will ride out the roller coaster run and to stay focused on execution and results. However, the long-term winners will be those leaders who use the turmoil as an opportunity to re-examine their underlying mental models. The approach we recommend to clients, to gain this strategic advantage, is a bit of “down to basics” wisdom. Clarify and challenge the underlying assumptions of the business. Map out and create a clear and transparent business model for your company that can be shared and discussed. In parallel, map out and describe the profit logic and strategic leverage points along the industry value chain where you choose to compete. Underneath all the interdependencies and complexities, does it all make sense? Do we all agree that the economic logic of our business works? Do we see and know both the value proposition and the business risks that are assumed by our business model in the markets where we compete?

Leadership integrity and accountability require the courage to ask the tough questions at the fundamental, root cause level. The architects of business must be willing to identify the unspoken mental models that underlie their own decisions and invite others to challenge them. The collective senior leadership team must embrace the reality of market impermanence and work with the odds, not against them, by assuming that their prevailing business model is temporary at best.

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Long-term winners will be those leaders who use turmoil as an opportunity to re-examine their underlying mental models

Senior leadership must embrace the reality of market impermanence and assume that their prevailing business model is temporary at best

the clarion group REAL. CLEAR. INSIGHT. 2013 the Clarion Group, Ltd. All rights reserved. Page 7

We recommend to clients a Theory of the Business discipline. This discipline makes transparent the underlying assumptions or mental models of individuals and the organization as a whole. It intentionally requires and enables the organization to evaluate, challenge and redesign its business model whenever required by testing it against the markets. And it emphasizes the critical importance of anticipating shifts in the value chain of the industry that create opportunities but also destroy those who cling to outdated business models. Four principles of that discipline are explained below.

What Can Be Done

Create Transparency: Make the Unseen Seen First it is critical to simply bring the underlying organizational and leadership assumptions to light. By asking a series of penetrating questions and/or using alternative business model examples for comparison, identify the current business models being deployed, whether by design or by default. The shared intent driving this phase of work is to be as non-judgmental as possible – simply to see the reality of what is today, even if it is confusing or conflicting. If there are multiple business models at play, name them. If there are differing assumptions held by senior leaders, put them all on the table. This is often best accomplished by creating a separate team of highly competent and independent-thinking leaders. Make it clear that their charge is to investigate and report findings, even if the points of view are controversial and expose sacred cows. Conduct a realistic assessment of the warning signs of any imminent drop in growth. Based on that assessment, take the analysis to the root cause level, looking critically at the investment decisions and direction setting for the company that sit directly in the hands of the senior leadership team. Tough as it is, this needs to be as non-judgmental as possible, and requires a willingness on the part of all to look candidly at what is today.

the clarion group REAL. CLEAR. INSIGHT. 2013 the Clarion Group, Ltd. All rights reserved. Page 8

Boldly Challenge Deeply-Held Assumptions When the prevailing business model is mapped out, it must be tested against the reality of the markets. It is important to assume that the forces of ossification that fight for continuation of the existing mental models and assumptions are extremely strong and will prevail without dramatic intervention. One effective way to invite powerful challenges to the current business model is to assume it is already dying – assume the opposite of permanence. Conduct a retrospective analysis, a post-mortem; start looking back on your demise. For sufficient context in grasping the market dynamics of impermanence, examine the structure of the industry in which you compete and the strategies assumed or employed. Look to identify changing trends in the industry value chain from supplier to customer, the migration of value, shifting industry dynamics, etc. Where is the industry going? Play those out and hypothesize about what will change over the immediate future that will cause your business model to fail. Draft an analysis from the perspective of 2 to 3 years out looking back to today; what caused you to fail? Describe the stages of decline; what warning signs were ignored? Another way would be to invite in the perspective of a Venture Capitalist or Private Equity Investor who embraces market impermanence from a more objective and pragmatic position. Such people are likely to evaluate the profitability of proposed business models with a 3 to 5 year return rate hurdle that is free of many embedded assumptions. With that completed, or in parallel, identify 2 to 3 alternative business model strategies that you believe will succeed in the same market environment. And/or examine the business models of a range of competitors and determine if those market strategies will be successful or fail under the evolving market dynamics. Expand Perceptual Horizons The prior two principles provide for an ongoing senior leadership Theory of the Business discipline that is more foundational than the typical strategic process. It embraces market impermanence, transparency around fundamental business assumptions and mental models, a clear and objective articulation of the current business model in play, along with a realistic expectation of its remaining half-life, and alternative new business models actively under consideration for development and investment – all within the context of the industry dynamics in which you compete. With that discipline in place, leaders must continue to expand awareness of future market changes, both in terms of time and breadth. This will be necessary to be truly proactive, to take advantage of opportunities and avoid threats. Time. One recommended approach is to apply Horizon 1-2-3 thinking5 not only to products and services, but to entire business models, as well as the industry in which you compete. Which of your current business models are core and, though static, are providing attractive revenue for Horizon 2 growth models? Which should be abandoned? Which are driving near-term future growth, aligned to evolving market changes? Do you have an adequate pipeline of possible future business model designs in the works? Which are anticipating longer-term opportunities or threats arising from longer-term market dynamics? And who else is similarly or differently positioned in the broader network of the industry in which you compete?

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Breadth. Knowing that within complex, interdependent networked industries, threats (and opportunities) can arise everywhere, from everything and everyone means that companies must expand peripheral vision. Value is constantly migrating in and around industries; subtle changes at the periphery may be the first signal of an industry shift. Last decade’s mortgage-induced credit crisis was a seismic shift, causing enormous creation and destruction, reshaping the financial industry landscape overnight. On the industry shift Richter scale, this was a whopping 9.0. More often industries shift in fairly subtle ways over time. Small and distant Richter scale readings of 2 or 4 could be early indicators of underlying geological industry plates moving below the surface.

One recommended approach to expand the breadth horizon is to map out critical impact zones within the industry structure. Where is your business model highly dependent on other participants? Where are the points along the industry value chain that hold the greatest strategic leverage, or the highest profitability? Which positions are seeing more entrants? Which are losing participants? Where would possible changes present particularly serious threats or attractive opportunities? Using the scenarios identified in the post mortem for your business model, what industry positions along the value chain are most important to monitor with leading indicators?

Drive Growth

The intent of this business model discipline is to drive growth. All this increased transparency and awareness will bring little competitive advantage if the leadership team does not directly connect Theory of the Business to core growth disciplines developed and aligned in the organization. These include:

On the downside, change and adapt old business models to avoid drops in growth that come from failure to maintain market relevance and anticipate impermanence.

On the upside, incorporate a Horizon1-2-3 Growth discipline into business planning to anticipate and capture future possibilities.

Establish and invest in an Innovation Discipline to enable new growth, not just in product or technology, but in business model design as well.

Whether up or down, assume change is continuous and manage the organization accordingly. Develop change as one of the core competencies in the organization.

What is the Theory of Your Firm? Todd Zenger, HBR, June 20136

A recent HBR article addresses a closely related subject: creating a corporate theory that can be used as a guide to the selection of strategies.

A leader’s most vexing strategic challenge is not how to obtain or sustain competitive advantage – which has been the field of strategy’s primary focus – but, rather, how to keep finding new, unexpected ways to create value.

Traditionally, practitioners see strategy as the process of discovering and targeting attractive markets and then crafting positions that will deliver sustained advantage in them.

Unfortunately, investors don’t reward senior managers for simply occupying and defending market positions. They look for evidence that the company can continually find new competitive advantages. To do that, managers need a corporate theory that explains how they can create value by combining the company’s unique resources and capabilities with other assets.

A good theory incorporates foresight about an industry’s future, insight into which internal capabilities can optimize that future, and cross-sight into which assets can be configured to create value.

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About Us: Looking Forward

Often, after a crisis has unfolded in public, we learn of some gifted individual who accurately saw through all the complex interdependency of that particular house of cards and explained why it was unsustainable, even well before the collapse. In that moment, very possibly the most important question we should ask ourselves will be: “Why was that voice not heard sooner?” The leadership challenge looking forward is to make sure your company is one of integrity and transparency in which those discordant outside voices are heard, before the market shifts away from favoring your current business model. It is precisely because our mental models are biased and management structures are so strongly attached to what is, because we are so invested in what we have already built, that a conscious Theory of the Business discipline must be set up “outside the system” to boldly challenge the prevailing business model. Leadership must not only hear those outside voices; leadership must be one.

1 Olsen, van Bever and Verry, “When Growth Stalls,” HBR, March, 2008. 2 Foster and Kaplan, 2001, Creative Destruction 3 Joseph Schumpeter, 1942, Capitalism, Socialism and Democracy

(“Prevailing management practices focus on administering existing structures, whereas the problem of creating and destroying structures is equally if not more relevant.”)

4 Gary Hamel, Leading the Revolution, The Future of Management 5 Baghai, Coley, White, The Alchemy of Growth 6 Todd Zenger, What is the Theory of Your Firm? HBR, June 2013