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The Physics of Business Growth
Mindsets, System, and Processes
By Edward D. Hess Jeanne Liedtka
Stanford University Press
Copyright © 2012 Board of Trustees of the Leland Stanford Junior University
All right reserved.
ISBN: 978-0-8047-8477-1
Chapter One
Fighting the Physics of Growth
Ask managers at any level, in almost any organization, and they'll tell you that they struggle to produce the kind of profitable organic growth that investors demand. Consistently, organic growth is at the top of the list of challenges for business leaders—and at the top of their list of essential capabilities for ensuring success. And yet, there has been a surprising lack of attention to helping managers develop this ability. In fact, it is not even clear what the behaviors associated with successful growth leadership even look like—or what the organizational enablers of such behavior might be. That is why we have written this book.
For more than 15 years, we have been exploring—at first independently and recently together—how successful organic growth actually happens in organizations (see The Authors in back of book). Through our research and work with businesspeople, from frontline managers to CEOs, we've concluded that organizations are often their own worst enemy. They don't give managers and employees the tools to find growth; their business mindset and processes don't support people who do somehow stumble upon growth opportunities; and their corporate cultures, measurements, and rewards seal the deal by turning growth into an unnatural act.
People, process, culture, measurements, and rewards—all of these, as they exist in most organizations today, are at odds with what we think of as the "physics of growth." It is a physics that is radically different from the one we prepare managers to succeed in. Our aim here is to help you understand the difference between the physics of stability and the physics of growth, and to provide you with a map and a set of practical tools to navigate this brave new world.
What Do We Mean by the "Physics of Growth"?
After years of studying growth and working with managers at all levels trying to achieve it, we have come to believe that organic growth is, in fact, governed by its own natural laws, an underlying reality that sets the context for growth and innovation in much the same way that Einstein's law of relativity accounts for the movement of objects in the space-time continuum—or the way the underlying economics of an industry drives the success of business models. The most fundamental natural law of organic growth is that the only certainty is uncertainty. The dominating forces are ambiguity and change; the processes at work involve exploration, invention, and experimentation. These elements, taken together, capture the distinct physics of organic growth.
Unfortunately, this physics is very different from the one that has long informed the design of business organizations; that physics is characterized by stability, predictability, and linearity. In both environments, people seek control over outcomes, but how they go about achieving that differs radically. Analysis, prediction, and rules usually work to achieve control in a stable, predictable environment where the process is geared for execution. But those approaches often backfire badly in the face of growth's uncertainty. Ignoring the physics of growth is like ignoring gravity: through sheer courage and herculean effort, managers can make things happen, but in doing so they continuously fight relentless forces that slow them down and sap their energy. Courageous and naturally growth-oriented leaders may still find a way to produce the growth they are asked to deliver (we've studied them and how they accomplish this)—but these managers tend to be few and do not a strategic capability make.
Many of the cultural values, systems, and processes in large organizations fight the physics of growth and its emphasis on exploration and invention rather than execution. The result is that growth leaders feel as if they are "swimming in molasses," as one manager described it. That is because even the best managed (perhaps especially the best managed) large organizations are beautifully designed to produce standardized, low-variance results through careful execution in an environment of predictability. They employ talented leaders at all levels who have learned (and may well be predisposed) to focus on efficiency and control. Because of this, they excel at execution—and at driving waste and variation out of the system—and they have a state-of-the-art tool kit for accomplishing this. Unfortunately, the pursuit of growth and innovation is inherently messy and inefficient. Unlike execution, exploration is a high-variance activity, and if, as work in the area of total quality management (TQM) would suggest, "variation is the mother of waste," it is also often the mother of invention.
The mindset, culture, and processes that drive successful execution in an existing business can, if unexamined, drive innovation into the ground, exhausting and discouraging the very people who are trying hardest to accomplish it, and killing inventive ideas before they see the light of day. Sporadic interventions and innovation consultants can help, as can people who courageously press on with innovation despite the odds. But these strategies work in spite of organizational forces, not because of them. Building a strategic capability for growth requires engaging the hearts and minds of employees at every level and giving them new tools to achieve a better balance between invention and execution. That's what this book is all about.
Learning from Las Vegas and Silicon Valley
You can learn a lot about the physics of growth by comparing who wins and loses in a Las Vegas casino. When it comes to growth, most managers, sadly, are like the little old lady with a cup of quarters playing the slots, just pulling the handle and hoping for the best. Sophisticated growth leaders—those who understand and leverage the physics of growth—are probably at the craps table. Craps is the preferred game of most professional gamblers (we are told) because it offers the most potential for making serious money—if you know how to play. It may look like the professional craps player is throwing the dice and hoping, just like the old lady at the slots, but there is a lot more going on. Discipline and focus, not luck, are the hallmarks of great craps players: they know how to manage the game in real time, assessing and sticking to what they can afford to lose, placing many bets, figuring out when to double down and when to get out, and staying alert to emerging opportunities and new developments. Sure, the odds are still in favor of the house; that is the reality of the game. But the chances of beating the odds are a lot higher at the craps table than they are at the slot machines.
Closer to home, this physics of growth is well understood by venture capitalists. VC firms' track records are not stellar: somewhere around two of every ten investments turn out to be winners. Do VCs consider themselves dismal failures? No, because they understand that the force at play here is uncertainty. And so they see themselves as managing portfolios of growth opportunities. Some of these will do well, but most, they realize, will not. They also know that their ability to predict at the early stages which two ventures will succeed is poor. They do not attribute this to their personal failings; instead, they recognize that the inability to predict is a property of the uncertainty surrounding any new business. Like professional gamblers, they develop a set of practices that acknowledge this reality: they bet heavily on the individual leader of a new business and look for people with experience (expecting both some successes and some failures in their background); they try to keep their bets small and affordable until they have better data; and they develop approaches that help them get in and out of new ventures intelligently and swiftly. Their goal, in other words, is to succeed—or fail fast and cheap.
When large organizations pursue growth, their mindsets are often completely out of sync with the reality that guides both craps players and VCs. Chances are that these organizations expect ten out of ten projects not only to win, but to win big. They demand that their managers and employees produce growth, inadvertently thwart their attempts, and uphold a system in which pulling the plug on a failed growth opportunity is a career-threatening act. Would-be growth leaders in this environment are like professional gamblers who are unable to act independently but instead receive instructions from on high—from a source that has little information about what is happening this minute in this particular game. Not a formula likely to win at craps—or in business.
What is behind this mismatch of expectations and realities? We believe it is a set of misconceptions about corporate growth. Let's look at what we know (or think we know) about how organizations achieve healthy growth.
Growth Myths
When it comes to growth, we have been taught the following "truths": Businesses either grow or die; all growth is good; growing bigger is always better; and public companies should grow in a linear manner as evidenced by ever-increasing quarterly earnings. Surprisingly, these beliefs have been embraced without rigorous analysis about how well they describe the actual growth trajectories of robust businesses. Nonetheless, they are the foundation of the short-term business mentality dominant in many C-suites, boardrooms, and Wall Street firms. And they are pure and simple fiction. These beliefs ignore the physics of growth. Businesses do not have to grow to stay alive; growth is not always good; bigger is not always better; and continuous linear growth is the rare exception, not the rule. Blindly following the dictates of these myths can drive bad corporate behaviors and inhibit real growth and innovation. It also can lead to artificially induced business volatility, lost opportunity, and premature destruction of businesses.
Yet, so powerful is the imperative for businesses to report growth that companies engage in a widely acknowledged "earnings game" to meet short-term projections instead of focusing on the hard work of managing portfolios of organic growth opportunities. This game takes the form of the "creation" of earnings through accounting elections, valuations, reserves, liberalizing credit policies, channel stuffing, deferring needed expenditures, selling assets, and myriad structured financial transactions. These non-authentic earnings are too often generated solely to meet Wall Street's growth and earnings demands.
You don't have to look far to see the downside of those demands: shareholder value squandered on overpriced and inappropriate acquisitions, managers chasing the wrong customers or cutting corners to meet inflated forecasts, CEOs with solid strategies hung out to dry for missing EPS projections by pennies. To satisfy Wall Street's obsession with growth, businesses are encouraged to make imprudent decisions that can harm their fundamentals in the long term. And, in some cases, those decisions simply camouflage a business's poor performance and underlying weaknesses. What is clear is that at its best, this earnings game makes it difficult for investors to assess the underlying strength of a business; at its worst, it incentivizes short-term profits to the detriment of a business's long-term health.
The earnings game also influences the planning and budgeting processes that businesses put in place in the name of "growth"—processes that set revenue and profit targets for growth projects without asking about the new ideas behind them and whether they will create value for identifiable customers. Strategic planning processes, which often are no more than glorified budgeting exercises, almost invariably ignore the physics of growth. Even when managers do attempt to put some real strategies behind the numbers, they often assume a one-to-one match between specific projects and financial flows. Thus, the strategy-making process pays little attention to the portfolio nature of growth investments. As one senior executive manager explained it:
We have a portfolio view of our business. And by portfolio view I mean a PowerPoint slide. And that's exactly what it is—it's a PowerPoint slide. It does not drive our behavior. If we had ten product developments going on, we are banking on each one of those hitting at approximately the right time, generating revenue at the right time, for us to roll up and make a plan that we are then committed to. So, it's not that we lack a strategic view of our business. I don't think we take a strategic view of our portfolio of initiatives and say that really to be successful over time I need to make sure that at least two big bets are going to come off, and over the next five years I need to have at least two products that are going to generate $50 million of revenue or $100 million of revenue annually, therefore I need in my portfolio four of those types of developments. Somehow we don't connect that kind of strategic view of the business and the markets with our portfolio of how we're actually going to achieve that.
The rallying cry becomes Supersize it! In a big organization, focus and control are key; too many new initiatives can dissipate corporate attention and resources. And so we don't want to waste time with anything small. But at what cost? The bigger-is-better mentality holds the same risks for "healthy living" in organizations as it does in a fast-food drive-thru. It actually increases the difficulty of finding good growth by increasing its riskiness, for obvious reasons: If it's big, why hasn't somebody already done it? And how do you tell in its infancy how big a new idea might become? Ask the folks at former PC market leader Compaq why they ignored the new business model offered by Dell and allowed themselves to lose leadership to an undergraduate starting out of his dorm room. We are betting that they will tell you that the opportunity to go direct to customers just didn't look big enough to risk disrupting their existing distributor relationships. Neither did offering $4 cups of coffee before Starbucks tried that small move. The impatience for big wins leads to expensive fiascos and missed opportunities.
With the obsession with size comes the notion that managers must "prove" the value of an idea before devoting any resources to it. This is, of course, a fool's errand. We state the obvious when we point out that managers asked to prove the value of a business proposition that doesn't yet exist will mostly never get out of the starting block. They would have to make up the numbers, and the only people generally allowed to do that and get away with it are expensive consultants (and until recently, investment bankers). So the best that mere managers can do is extrapolate from some data they've already got. But that kind of information is not very convincing, especially if the idea contains much that is innovative. Such information has all kinds of assumptions built into it that reflect the past and don't necessarily have anything to do with the future. It's easy to find fault with these kinds of data, and the ROI police generally do. The end result is that managers get caught in a debate about proof that never moves out of the conference room.
Making things worse, the hours spent in that conference room don't make anybody any smarter. Managers in large organizations have been encouraged to stay inside for too long, doing analysis and trying to plan the future using data from the past. While some forecasting and planning based on historical data is certainly sound—after all, that is the only data we've got to start with—relying too heavily on this approach in uncertain situations interferes with the pursuit of healthy growth. It encourages managers to abandon potentially good initiatives that don't have easily available existing data and to take more risk than is necessary (by staying with historical data rather than seeking new data from the market) in pursuing those that they do select. The kinds of processes that lead to good growth encourage employees to leave the building and learn something—from customers, collaborators, value chain partners, or even other industries.
The twin emphases on "big wins" and "proof " contribute to the disastrous prevalence of mergers and acquisitions. For decades, academic research has demonstrated that most acquisitions fail to create value for shareholders—more often, they destroy value—yet this cold, hard reality has done little to dampen the acquisitive appetites of organizations desperate for growth. Why? Because acquisitions seem bigger and thus more apt to be "needle movers" than organic growth initiatives, and their value seems easier to "prove" with historical data—even though this value usually fails to materialize. Paradoxically, a strong record of M&A success can actually decrease managers' appetites for the uncertainty surrounding organic growth.
(Continues...)
Excerpted from The Physics of Business Growth by Edward D. Hess Jeanne Liedtka Copyright © 2012 by Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Stanford University Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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