SOPHISTICATED FINANCE

Planning for the Unkown

Someone asked me to do a lecture titled "Planning for the unkown". Initially it sounds like an oxymoron. However, after a little thought I came up with an approach. The process is described below.

Planning is a process, which means that it involves discipline, focus and a step by step approach. However, any process is only as good as the thinker and thinking in the process. Therefore, to consider the unkown, we must first recognize that the unkown is outside of current human knowledge. Therefore, we need a technique that helps us to think outside of human knowledge.

A technique I like for this purpose is "relax the assumption". This technique is based on the bias we have all developed in our thinking and problem solving. The technique focuses on identifying and relaxing a key assumption in a problem in order to develop a solution, e.g. the laptop relaxed the desk assumption. However, this technique only helps in planning if we know what to think about.

The topics to think about for business planning are:   

1. economy
2. regulatory
3. competition
4. market
5. technology

Admittedly pretty obvious in hindsight. The hard part is to identify what assumptions to change for each of these five factors. Drumroll!! Focus on the key parts of the business model and relax assumptions about pricing, sales and distribution as they relate to each of the five factors. For example, the current discussions in Europe about no charge for roaming on cellular phones might have surfaced if one relaxed the pricing assumption during the consideration of regulatory. Amazon would have possibly shown up if one relaxed the store assumption (distribution) in a market or competition analysis for booksellers.

Now that we understand how to find the unkown, please keep an eye out for the next Google :) Also, remember that identifying the problem is the hard part. The solution is easy. If you forgot, read this post.

 

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Mission

Google Discovers Lessons from the Military

There is a very interesting post about the changes in the hiring practices at Google on iDoneThis Blog. According to the post, Google is moving away from its reliance on test scores and credentials (attendance at top universities, e.g. MIT, Stanford). The People Analytics Department analyzed data on successful Googlers and found that the most innovative workers have two characteristics:

1. Strong sense of mission
2. Desire for autonomy

The U.S. military has a well developed concept of leadership, where everyone is taught the following priorities:

• Mission
• People (subordinates)
• Self

The U.S. military also operates on a philosophy where command is delegated down to the lowest level, in contrast to other military systems (Russia) where command is highly centralized. For example, sargeants in the U.S. military are taught "in the absence of orders, take initiative". Despite common misconceptions, the U.S. military has always advocated autonomy.

While data analysis is a great discipline, perhaps Google needs more veterans. More on the military philosophy is in this post "The Eight Commandments of Management".

Image credit: collagemuseum.blogspot.com

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More on Disruptive Innovation

In a recent video interview with Mark Suster here, Clayton Christensen, the renowned HBS professor, presented some additional thinking on his theory of disruptive innovation. What was new for me was Christensen's position that disruptive innovation only applies in industries with a technology core. What Christensen means is that if an industry/product is using technology and that technology is critical to the customer experience and value creation (for the customer), then there is the possibility for disruption.

Certain industries lack such a technology core. Christensen sites the hotel industry as an example. The hotel industry cannot be disrupted. A hotel chain can only emulate a competitotr with a richer feature set for the customer. Disruption through technology is not possible. Other "old" industries such as restaurants and construction probably are in the same situation as hotels.

Another group of industries which lack a technology core are probably heavily regulated industries such as healthcare and education. Until very recently neither industry used technology for a better customer experience and only relied on technology for improved administration or staff productivity (doctors). 

Of course, the absence of a technology core does not prevent outsiders from introducing customer facing technology to "disrupt" the industry. Coursera, the online university, would be an example.

Christensen has a very gloomy outlook for the future of HBS and universities in general. He asks us to pray for HBS. If we are praying for HBS then we need constant prayer vigils for some other universities.

Christensen also believes that university education must be more focused on teaching the practical skills required by employers. For business and engineering schools I would agree. However, some of the best disciplines to develop critical thinking are philosophy, economics and history. Not sure that any of these disciplines would meet Christensen's standards for practical training.

One of many other posts referencing Christensen's thinking is here. The post references his theory of how to size a market.

Wars and Other Crises

After class Monday one of my students from the Middle East asked me a question. At the end of every semester, I give an advice lecture. One theme is that all the foreign students should go home after completing their studies. Less competition and better opportunities in the developing world. However, such advice came up in Monday's lecture. The student wanted to know if he should go home to a country with high inflation and the likelihood of a devastating attack from a foreign power. 

One technique for responding to tough and unusual business problems is to look for similar situations. I told the student to study Brazil during the period of high inflation and look for industries that were able to maintain profitable growth. How to handle a possible war was a more challenging question. I recommended that he study Lebanon, which has had many conflagrations and look for industries that were able to grow. Industries that appear in the analysis of both countries would be candidates for further exploration.

Employee Reviews of Managers

I have always believed that when a good employee leaves it is a failure of the manager. Managers are responsible because they have four key responsibilities:

1. They are responsible to set clear objectives
2. They are responsible to insure that employees are compensated at market rates or better
3. They are responsible to develop their subordinates
4. They are responsible to behave in a way consistent with employee expectations, which to some degree is a function of the country/culture in which you are located

Managers are also expected to be fair and wise. Wise is the harder requirement. "Not all smart men are wise but all wise men are smart". Fair and wise can make up for failings in 1-4 above. 

However, short of consistent departures of good staff, there is little feedback for a manager to know how well he is managing subordinates. One way to address this issue would be to have a formal process for subordinates to review their bosses. Daniel Tunkelang has a good article on LinkedIn about this topic.

In all my years in management I have never been through a subordinate review of my performance, but in my teaching I frequently ask students for suggestions to improve the course and my teaching. The students really enjoy such an exercise, critiquing the professor, and their feedback is extremely helpful.

Except for references to sarcasm, my teaching style appears to be working reasonably well. Yesterday's discussion of my sarcasm led one student to say "you are not sarcastic, you are just extremely blunt". Very encouraging for the process of student feedback that the student felt comfortable enough to be so honest and trusting. Would be nice to see such behavior in management reviews.

Note: Interesting article on research into sarcasm by P. Valerie Dauphin is here. Summary of research is below.

“With speaker intent in mind [from all points of view] sarcasm is used as a means of verbal aggression; with victim’s reactions in mind, sarcasm is taken as a more severe form of criticism than found when criticism is directly expressed."

A Better Approach to Design

Over the years I have been involved in several design projects for retail stores, shopping centers and merchandise. Mostly, I participated because skilled professionals were not available. I have no formal training in design or related disciplines.

Recently I joined a team of both design professionals and corporate executives to develop a new product. In three months this team produced a totally new product in the category and initial reactions are very positive. The team consisted of only 4-5 people who had a strong vision of what the product needed to be, relied on their experience rather than exhaustive research and aimed to produce a working concept rather than a completed design. Also, the product significantly evolved in terms of 1-3 key features throughout the design process.

What I find interesting about our approach is that it mirrors the advice of UX Magazine in an article yesterday-Lean Strategy for UX Design. UX Magazine advice:

1. Have a clear strategic vision for the product
2. Have a working theory of what the product should be
3. Target to deliver the product in its simplest form
4. Planning should be ongoing rather than carved in stone at the beginning of the project

The full article is worth a read.

Another Look at ROI

I have done finance for almost 40 years and I have done it in almost all its forms--capital raising, trading securities and funding operations. Whenever I am involved in an operating company people always ask me what ROI do we need to reach to justify an investment. In routine, repetitive investments (such as opening another retail store) I almost always have a quantatative target and it tends to be much, much higher than the cost of capital. I have seen several CFOs who use the same technique of setting very high ROI targets. If you use such a technique in routine, repetitive investments you generally get people focused on the efficiency of capital, which is a good thing. Given the high hurdle rate for ROI you also get people focused on customers and revenue. These are equally good results.

However, in other situations I never use ROI. These investments are for strategic reasons or to build comparative advantage against the competition. Until today I had never found anybody who shared this view--ignore ROI for strategic investments that build the foundation for the company future.

In a post today on company sustainability, the AVC blog shared the same view.

"ROI is not the right framework for companies to evaluate investments. ROI is for the wall street folks. They will use it to decide if they want to invest in your company. But when you make investment decisions in your company, don't use the tools that wall street uses. Use the tools that animals use. Survival instincts. What will it take to ensure that your company is around in ten years, fifty years, 100 years? That's how to think if you want to stay in business."

I always say that I specialize at the intersection of finance and strategy and almost always strategy is more important than finance!

Theory vs Practice

One of the ongoing debates in education and particularly in the field of entrepreneurship is whether learning can be purely through practice or whether theory plays a role. Students tend to prefer the practical and practice approach. I on the other hand prefer a blend of theory and practice. For example, many algorithms, heuristics and processes such as business model development, Porter's Five Forces and the concepts of value creation and value capture can help to prevent costly mistakes that squander capital for the entrepreneur.

Today's post in Equity Kicker has a quote from Ralph Waldo Emerson which makes the same point eloquently.

"Without ambition one starts nothing. Without work one finishes nothing. The prize will not be sent to you. You have to win it. The man who knows how will always have a job. The man who also knows why will always be his boss. As to methods there may be a million and then some, but principles are few. The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring principles, is sure to have trouble.

9 Subjects Every CEO Needs to Understand.

Lately I have been spending a lot of time on developing a new brand. It is the first time in my career that I have faced this challenge or at least recognized the need to do it. What surprised me is that in the last two weeks I found 5-6 new, excellent articles on branding, but can remember few articles on the subject in the last seven years of online reading. Has branding all of a sudden become popular or is it that I am now paying attention to the subject. Obviously, it is the later, which prompts today's post.

There are probably 9 business topics that everybody should understand and/or be archiving good articles for future use. Trust me, at some point in your career, if successful, these are the subjects you need to understand well:

1. Corproate culture
2. Strategy
3. Branding
4. Product development and customer need
5. Sales
6. Public relations
7. Capital raising
8. Interviewing for hiring
9. Leadership

I would add microeconomics but nobody writes about it. Start archiving good articles on these subjects. I recommend Evernote as the repository.

As soon as I organize my thoughts on branding I will share them in a post.

The Military View of Management and Leadership

I have written frequently about the military (~20 posts) for their insights into management, leadership and the difference between the two disciplines. Previous posts include here and here. The quote below comes from an interview with General Russell L. Honore in Gallup Business Journal. (General Honore took over the management of relief after Hurricane Katrina.)

"GMJ: What do you do when people buck the arrangement? How do you motivate them to do what they don't want to do?

Gen. Honoré: There's a construct for that. You've got three groups of people in your organization. First, you've got the people who, when you say it, will get it done. Those are the people who want to replace you.

Then you've got the people who are on the team but aren't necessarily motivated to get the task done. Those people are in the middle. You can't run the organization without them, so you take them as they are. They are committed to the company, they're committed to the unit, but they don't work with the enthusiasm of that first group.

And then you have the third group. They're very effective, but they don't seem motivated. They argue with you. What you must decide is, is it OK to have a person from the third group on the team, or should you get rid of him? Members of that third group can be very competent, and many leaders let them go because they aren't jumping up and down every time the boss walks in.

So an art of leadership is to sort those three groups out. You don't have to worry about the ones who want your job. They're clapping every time the boss says something, and they're willing to do whatever it takes to be on the team and be solid key players. Then you've got those who don't cheer, but they get it done. But the third group could be the most productive, because sometimes the least conformist member of that group can say, "Yeah, this is what the boss says, but this is what the organization needs." Some of your best innovation may come from the mavericks."

Read the whole article. I should give a quiz on the article. Maybe only the mavericks will read it without a quiz.

Image credit: Wikipedia

Incentives for Social Responsibility

If you have ever designed a compensation scheme for a sales force, you know that frequently there can be unintended consequences. The sales people find the way to maximize their income regardless of what the corporate objectives were intended to be. The best sales people appear to be the most insightful in identifying the unintended income consequences. While this example might suggest more careful development of salesperson compensation schemes, the other thing it points out is that people behave in ways to maximize their compensation. That might be described as human nature, to state it politely.

Recently I was talking to a senior executive from a Fortune 500 company about their social responsibility programs. They confirmed that each project has to satisfy an ROI target and that the company could afford to do more social projects if leadership was so inclined. As a way to incentivize top management, I suggested that senior manager bonuses be broken down into two parts:

1. 50% of bonus based on financial results such as profit, cash flow or stock performance;
2. 50% of bonus based on the scope and quality of social programs

The executive thought such a scheme would definitely change executive behavior even if evaluation of No. 2 was purely subjective. The definition of "social" could be defined by the board or we could use a concept like Michael Porter's "shared value". I do not think such a scheme would have much negative effect on stock price and might even attract a new group of investors.

Just an idea but if you want to change behavior, change the incentives.

 

Another Benefit of Women

Fast Company has a great post today on some research by Credit Suisse. Key findings:

1. "Only 41% of companies on the MSCI World Index, a collection of global stocks, had any women on their boards at the end of 2005. By the end of 2011, it had increased to 59%."
2. "Between 2005 and 2007, when economic growth was relatively robust, there was little difference in share price performance between companies with or without women on the board."
3. "From 2008 onwards, as volatility increased, the companies with female board members outperformed the others."

So when times get tough in the business, look to women...which you should have learned from your mother at about age 3. Credit Suisse's conclusion: "More women in the group signaled a greater collective intelligence."

 

A Simple Definition of Business Strategy

Have you ever asked someone to define a common business term such as marketing. The answers are almost always long winded rambling responses. Good thinkers, however, provide simple and elegant definitions.

HBS Professor Cynthia A. Montgomery provides a simple and elegant definition of strategy in a short article in HBS Working Knowledge. She poses four questions that every strategy must answer:

1. What does my organization bring to the world? 
2. Does that difference matter? 
3. Is something about it scarce and difficult to imitate? 
4. Are we doing today what we need to do in order to matter tomorrow?

Professor Montgomery also makes an important point about formulating strategy. The rigorous analytical approaches to strategy pioneered by Michael Porter and other HBS faculty have placed too much emphasis on the process and perhaps inadequate emphasis on answering the four fundamental questions.

Note: Marketing--customer acquisition and customer retention--from another HBS faculty whose name I cannot remember.

 

Some Good Articles on Innovation and Strategy

Two themes that interest me are strategy and innovation and how they are applied to economic development, entrepreneurship and social ventures. Two articles this weekend on these themes were noteworthy.

In "The Hardest Question Any Leader Can Ask" there is a particularly good point on strategy as it relates to business model:

"Business model innovation must be a strategic objective or it won’t happen.

One of my biggest pet peeves is setting strategy one tactic at a time. It drives me crazy to be surrounded by people and organizations that think if they just work hard enough and do more things that a strategic direction and destination will emerge. It seems that most of the world works this way. It is terribly inefficient. How many people and organizations do you know that pedal the bicycle like crazy but never seem to arrive anywhere. They just keep pedaling harder hoping that something will eventually stick. It is exhausting watching them. Why not establish business model innovation as a strategic objective, a specific destination, and work hard on those things that help you get there. It seems so simple. Setting a strategic direction provides a way to know which tactics are aligned and contribute to reaching the destination. The destination may change along the way requiring different tactics, and that is OK, but not having a destination at all is a ticket to nowhere."

In "A 5-point checklist to create lucrative opportunities with disruptive technologies" the author list five ways to disrupt a market and gets it absolutely correct:

1. Destroy your product
2. Make your product solve meaningful problems
3. Make your product insanely simple
4. Make your product smart
5. Give your product away

Read the article to understand the logic of each method.

Pricing Strategies

In my theory of business model, I propose three key concepts that need to be considered in each new business concept:

1. the growth driver
2. pricing model
3. distribution

Today's post is on pricing. There are sixteen pricing alternatives, as outlined in my book. Each alternative represents a different way to monetize a transaction or capture the value. The reason that there are so many alternatives for pricing is that there are so many ways to share value with a customer.

As Marco Bertini and John T. Gourville, professors at London Business School and HBS respectively, make clear in their excellent new article, "Pricing to Create Shared Value", pricing is not a zero sum game. "Companies have traditionally treated value in the marketplace as a fixed pie and have reasoned that they must compete with their customers to appropriate as much of it as those customers will relinquish." Thinking of the customer as merely a pocketbook robs the company of the opportunity to understand the customer need, build a better relationship and share the value created. 

The notion of "shared value" presented by Bertini and Gourville is attributed to Michael Porter and this article by Porter. Personally I think they have a different notion of shared value from Porter or perhaps they have explained the idea better than Porter did. Bertini and Gourville's notion of shared value is consistent with my view of social entrepreneurship, wherein the company shares as much value with the recipient as possible while still achieving cash flow breakeven.

 

Management Tip--Figure Out the Ending

On the io9 blog Emma Coats lists the 22 lessons she has learned about storytelling while working at Pixar, the animation film studio. Rule 7, "figure out the ending" because "endings are hard, get yours working up front" prompts today's management tip.

Most "experts" say that you should first write the business plan and then write the executive summary. I do it just the opposite. I write the executive summary first where I am forced by space limitations to cogently and concisely layout the key factors that will be compelling to an investor. If I write a full business plan I then know which key points require amplification and substantiation. I am basically following Ms. Coats recommendation. (Hint: With a good 2-3 page summary you do not need a business plan.)

Maybe another business problem will help to explain. Suppose revenue is lower than plan and you conclude that you need to raise prices. You could do an exhaustive analysis of product pricing and competition, but the better thinking should be devoted to the question "how do we increase the perceived value of the product by the customer". In the end price increases only work if the customer perceives an increase in value. Therefore, by forcing ourselves to think about the end result we are better able to solve the problem and execute a solution.

Obviously it takes some experience and discipline to use a "figure out the ending approach" but you should produce a better quality result.

Image credit: smallbiztrends.com

Everett Rogers on Successful Product Development

John Gourville answered the question "Five Ways to Make Your Company More Innovative" with this response in HBS Working Knowledge:

"For the last 50 years, innovation theorist Everett Rogers told us that the difference between a successful product and an unsuccessful product has to do with how the product is designed-the physical attributes of the product. And he came up with five factors:

1. Relative advantage: Is it better than what it's replacing?
2. Compatibility: Is it compatible with the way people currently do things?
3. Complexity: Is it too complex to use?
4. Trialability: Can you try it in small doses?
5. Observability: Can you watch other people use it?

All of those things are inherent in the product itself. Rogers's research found that 75 percent of the variance between products that succeed and products that don't succeed has to do with those five factors. Once you have those things, if they are all pointing in the right direction, it's a lot easier to market the product."

 

Management Tip

I have worked with a lot of subordinates over the years. What I always tell my staff is "don't do what I say, do what's right". This approach gives them a shared responsibility for the outcome and generally prevents bad decisions (on my part). Also, I think it reduces the likelihood of subordinates trying to guess what I will do in a situation. Just recommend what you think is the best solution.

Apparently Steve Jobs gave the same advice to his successor at Apple, Tim Cook, as related in this story from Ars Technica.

Jobs advice "to enjoy the journey" is also good advice. 

Make Fewer Excuses

Daniel Kahneman (Photo credit: Wikipedia)

Forbes had an interesting article on how to be successful. Citing the research of Nobel Laureate psychologist Daniel Kahneman, the article states that emotional intelligence (EQ), moral intelligence and body intelligence are more important than IQ in predicting individual success. To improve moral intelligence, how one manages "integrity, responsibility, sympathy, and forgiveness", Forbes recommended to make fewer excuses.

I am very fond of lessons from the military (several links here) in teaching individual behavior and management. New soldiers are taught three ways to answer a question:

1. Yes sir
2. No sir
3. I do not know sir

From the beginning soldiers are taught not to make excuses. You will also save a lot of time by eliminating excuses :)

 

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• Research Paper - IQ vs. EQ (thinkingbookworm.typepad.com)

Thoughts on Humility

Gaston Acurio at Madrid Fusion 2006 (Photo credit: Wikipedia)

On a recent flight all my electronic devices needed a charge so I read the American Way magazine in Spanish. One story featured renown Peruvian chef Gaston Acurio. When asked to what he attributed his success, he said humility. Humility enabled him to objectively evaluate the results of his cooking and spot the errors.

This point struck a cord because the night before I heard Mohammed Yunus speak at the Hult Global Case Challenge in New York. As a Nobel Prize winner and probably the inventor of social entrepreneurship, the man has some accomplishments to tout. However, the most noticeable quality about Professor Unus is his humility. In a thirty minute speech he never used the word "I" to describe his accomplishments in Bangladesh.

Unus sounded very much like Albert Einstein. I have been reading the arts and letters (not the physics) of this very accomplished thinker. The book is titled Ideas and Opinions. One consistent theme in Einstein's writings and speeches is the fun he poked at organizations (and himself) that gave him awards. Again, humility comes through as one of the strongest messages.

In the matter of 24 hours I have three great examples of world class practioners, all in very different disciplines, but all demonstrating the value of humility. I suspect that you do not become humble after you become world class, but rather humility facilitates world class work. By not being so self-centered you have an easier time to spot your errors (Acurio) and you probably devote more time to your work and less to self-promotion. 

Another benefit of humility is you worry less. All of the students presenting at the Hult Case Challenge were jazzed up and very nervous. Not uncommon at a big event with many people presenting. In a perfect world maybe they were so excited because they did not want to fail their team members, but I suspect that there is another reason. They were all worried about looking bad in front of the audience. Humble people do not worry about such matters and just do the best they can.

Want to worry less. Be more humble.

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• Humility and Anxiety (memoirandremains.wordpress.com)