January 2021 - Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages by Carlota Perez

This month we read Carlota Perez’s understudied book covering the history of technology breakthroughs and revolutions. This book marries the role of financing and technology breakthrough so seamlessly in an easy to digest narrative style.

Tech Themes

The 5 Technology Revolutions. Perez identifies the five major technological revolutions: The Industrial Revolution (1771-1829), The Age of Steam and Railways (1829-1873), The Age of Steel, Electricity and Heavy Engineering (1875-1918), The Age of Oil, the Automobile and Mass Production (1908-1974), and The Age of Information and Telecommunications (1971-Today). When looking back at these individual revolutions, one can recognize how powerful it is to view the world and technology in these incredibly long waves. Many of these periods lasted for over fifty years while their geographic dispersion and economic effects fully came to fruition. These new technologies fundamentally alter society - when it becomes clear that the revolution is happening, many people jump on the bandwagon. As Perez puts it, “The great clusters of talent come forth after the evolution is visible and because it is visible.” Each revolution produces a myriad of change in society. The industrial revolution popularized factory production, railways created national markets, electricity created the power to build steel buildings, oil and cars created mass markets and assembly lines, and the microprocessor and internet created amazing companies like Amazon and Airbnb.
The Phases of Technology Revolution. After a decently long gestation period during which the old revolution has permeated across the world, the new revolution normally starts with a big bang, some discovery or breakthrough (like the transistor or steam engine) that fundamentally pushed society into a new wave of innovation. Coupled with these big bangs, is re-defined infrastructure from the prior eras - as an example, the Telegraph and phone wires were created along the initial railways, as they allowed significant distance of uninterrupted space to build on. Another example is electricity - initially, homes were wired to serve lightbulbs, it was only many years later that great home appliances came into use. This initial period of application discovery is called the Irruption phase. The increasing interest in forming businesses causes a Frenzy period like the Railway Mania or the Dot-com Boom, where everyone thinks they can get rich quick by starting a business around the new revolution. As the first 20-30 years of a revolution play themselves out, there grows a strong divide between those who were part of the revolution and those who were not; there is an economic, social, and regulatory mismatch between the old guard and the new revolution. After an uprising (like the populism we have seen recently) and bubble collapse (Check your crystal ball), regulatory changes typically foster a harmonious future for the technology. Following these changes, we enter the Synergy phase, where technology can fully flourish due to accommodating and clear regulation. This Synergy phase propagates outward across all countries until even the lagging adopters have started the adoption process. At this point the cycle enters into Maturity, waiting for the next big advance to start the whole process over again.
Where are we in the cycle today? We tweeted at Carlota Perez to answer this question AND SHE RESPONDED! My question to Perez was: With the recent wave of massive, transformational innovation like the public cloud providers, and the iPhone, are we still in the Age of Information? These technological waves are often 50-60 years and yet we’ve arguably been in the same age for quite a while. This wave started in 1971, exactly 50 years ago, with Intel and the creation of the microprocessor. Are we in the Frenzy phase with record amounts of investment capital, an enormous demand for early stage companies, and new financial innovations like Affirm’s debt securitizations? Or have we not gotten to the Frenzy phase yet? Is the public cloud or the iPhone the start of a new big bang and we have overlapping revolutions for the first time ever? Obviously identifying the truly breakthrough moments in technology history is way easier after the fact, so maybe we are too new to know what really is a seminal moment. Perez’s answer, though only a few words, fully provides scope to the question. Perez suggests we are still in the installation phase (Irruption and Frenzy) of the new technology and that makes a lot of sense. Sure, internet usage is incredibly high in the US (96%) but not in other large countries. China (the world’s largest country by population) has only 63% using the internet and India (the world’s second-largest country) has only 55% of its population using the internet. Ethiopia, with a population of over 100M people only has 18% using the internet. There is still a lot of runway left for the internet to bloom! In addition, only recently have people been equipped with a powerful computing device that fits in their pocket - and low-priced phones are now making their way to all parts of the world led by firms like Chinese giant Transsion. Added to the fact that we are not fully installed with this revolution, is the rise of populism, a political movement that seeks to mobilize ordinary people who feel disregarded by the elite group. Populism has reared its ugly head across many nations like the US (Donald Trump), UK (Brexit), Brazil (Bolsonaro) and many other countries. The rise of populism is fueled by the growing dichotomy between the elites who have benefitted socially and monetarily from the revolution and those who have not. In the 1890’s, anti-railroad sentiment drove the creation of the populist party. More recently, people have become angry at tech giants (Facebook, Google, Amazon, Apple, Twitter) for unfair labor practices, psychological manipulation, and monopolistic tendencies. The recent movie, the Social Dilemma, which suggests a more humane and regulatory focused approach to social media, speaks to the need for regulation of these massive companies. It is also incredibly ironic to watch a movie about how social media is manipulating its users while streaming a movie that was recommended to me on Netflix, a company that has popularized incessant binge-watching through UX manipulation, not dissimilar to Facebook and Google’s tactics. I expect these companies to get regulated soon -and I hope that once that happens, we enter into the Synergy phase of growth and value accruing to all people.

Yes, I do. I will find the time to reply to you properly. But just quickly, I think installation was prolonged by QE &casino finance; we are at the turning point (the successful rise of populism is a sign) and maybe post-Covid we'll go into synergy.
— Carlota Perez (@CarlotaPrzPerez) January 17, 2021

Business Themes

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The role of Financial Capital in Revolutions. As the new technology revolutions play themselves out, financial capital appears right alongside technology developments, ready to mold the revolution into the phases suggested by Perez. In the irruption phase, as new technology is taking hold, financial capital that had been on the sidelines waiting out the Maturity phase of the previous revolution plows into new company formation and ideas. The financial sector tries to adopt the new technology as soon as possible (we are already seeing this with Quantum computing), so it can then espouse the benefits to everyone it talks to, setting the stage for increasing financing opportunities. Eventually, demand for financing company creation goes crazy, and you enter into a Frenzy phase. During this phase, there is a discrepancy between the value of financial capital and production capital, or money used by companies to create actual products and services. Financial capital believes in unrealistic returns on investment, funding projects that don’t make any sense. Perez notes: “In relation to the canal Mania of the 1790s, disorder and lack of coordination prevailed in investment decisions. Canals were built ‘with different widths and depths and much inefficient routing.’ According to Dan Roberts at the Financial Times, in 2001 it was estimated that only 1 to 2 percent of the fiber optic cable buried under Europe and the United States had so far been turned on.” These Frenzy phases create bubbles and further ingrain regulatory mismatch and political divide. Could we be in one now with deals getting priced at 125x revenue for tiny companies? After the institutional reckoning, the Technology revolution enters the Synergy phase where production capital has really strong returns on investment - the path of technology is somewhat known and real gains are to be made by continuing investment (especially at more reasonable asset prices). Production capital continues to go to good use until the technology revolution fully plays itself out, entering into the Maturity phase.
Casino Finance and Prolonging Bubbles. One point that Perez makes in her tweet, is that this current bubble has been prolonged by QE and casino finance. Quantitative easing is a monetary policy where the federal reserve (US’s central bank) buys government bonds issued by the treasury department to inject money into the financial ecosystem. This money at the federal reserve can purchase bank loans and assets, offering more liquidity to the financial system. This process is used to create low-interest rates, which push individuals and corporations to invest their money because the rate of interest on savings accounts is really really low. Following the financial crisis and more recently COVID-19, the Federal Reserve lowered interest rates and started quantitative easing to help the hurting economy. In Perez’s view, these actions have prolonged the Irruption and Frenzy phases because it forces more money into investment opportunities. On top of quantitative easing, governments have allowed so-called Casino Capitalism - allowing free-market ideals to shape governmental policies (like Reagan’s economic plan). Uninterrupted free markets are in theory economically efficient but can give rise to bad actors - like Enron’s manipulation of California’s energy markets after deregulation. By engaging in continual quantitative easing and deregulation, speculative markets, like collateralized loan obligations during the financial crisis, are allowed to grow. This creates a risk-taking environment that can only end in a frenzy and bubble.
Synergy Phase and Productive Capital Allocation. Capital allocation has been called the most important part of being a great investor and business leader. Think about being the CEO of Coca Cola for a second - you have thousands of competing projects, vying for budget - how do you determine which ones get the most money? In the investing world, capital allocation is measured by conviction. As George Soros’s famous quote goes: “It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.” Clayton Christensen took the ideas of capital allocation and compared them to life investments, coming to the conclusion: “Investments in relationships with friends and family need to be made long, long before you’ll see any sign that they are paying off. If you defer investing your time and energy until you see that you need to, chances are it will already be too late.” Capital and time allocation are underappreciated concepts because they often seem abstract to the everyday humdrum of life. It is interesting to think about capital allocation within Perez’s long-term framework. The obvious approach would be to identify the stage (Irruption, Frenzy, Synergy, Maturity) and make the appropriate time/money decisions - deploy capital into the Irruption phase, pull money out at the height of the Frenzy, buy as many companies as possible at the crash/turning point, hold through most of the Synergy, and sell at Maturity to identify the next Irruption phase. Although that would be fruitful, identifying market bottoms and tops is a fool’s errand. However, according to Perez, the best returns on capital investment typically happen during the Synergy phase, where production capital (money employed by firms through investment in R&D) reigns supreme. During this time, the revolutionary applications of recently frenzied technology finally start to bear fruit. They are typically poised to succeed by an accommodating regulatory and social environment. Unsurprisingly, after the diabolic grifting financiers of the frenzy phase are exposed (see Worldcom, Great Financial Crisis, and Theranos), social pressures on regulators typically force an agreement to fix the loopholes that allowed these manipulators to take advantage of the system. After Enron, the Sarbanes-Oxley act increased disclosure requirements and oversight of auditors. After the GFC, the Dodd-Frank act mandated bank stress tests and introduced financial stability oversight. With the problems of the frenzy phase "fixed” for the time being, the social attitude toward innovation turns positive once again and the returns to production capital start to outweigh financial capital which is now reigned in under the new rules. Suffice to say, we are probably in the Frenzy phase in the technology world, with a dearth of venture opportunities, creating a massive valuation increase for early-stage companies. This will change eventually and as Warren Buffett says: “It’s only when the tide goes out that you learn who’s been swimming naked.” When the bubble does burst, regulation of big technology companies will usher in the best returns period for investors and companies alike.

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June 2020 - Bad Blood by John Carreyrou

This month we review John Carreyrou’s chilling story of the epic meltdown of a company, Theranos. We explore bad decision making, the limits of technology and the importance of strong corporate governance. The saddest thing and the reason Bad Blood hits so hard is that Theranos was a startup that seemed to have everything: a breakthrough blood analyzer, tons of funding, excellent board representation, and a smart, visionary female CEO. But underneath, it was a twisted cult of distrust with an evil leader.

Tech Themes

The limits of technology. Sometimes technology sounds too good to be true. Theranos’ Edison and miniLab blood analyzers were supposed to tell you everything you could ever want to know about your blood. But they didn’t work and never had a shot to work. Stanford professor Phyllis Gardener even told Elizabeth Holmes (Theranos’ founder/CEO) early-on that an early patch-like design of the product would never work: “[Holmes] just kind of blinked and nodded and left. It was just a 19-year-old talking who’d taken one course in microfluidics, and she thought she was gonna make something of it.” It was debunked by almost every scientist as wild fantasy even prior to its commercial use and subsequent fall from grace. There is something so human about wanting to believe there are no limits to technology. In today’s day of fake technology marketing, it’s easy for messaging to slowly take over a company if left unchecked. Think about Snap’s famous declaration, “Snap Inc. is a camera company.” or Dropbox’s S-1 mission statement: “Unleash the world’s creative energy by designing a more enlightened way of working.” These statements ignore what these businesses fundamentally do - advertising and storage. Sometimes there are massive leaps forward, like the transistor, networked computing, and the internet, but even these took many many years to push to fruition. When humans hear a compelling pitch, it is natural to want to remove those limits of technology because the result is so astounding, but we have to remain skeptical or risk another Theranos.
The reality distortion field. Elizabeth Holmes was obsessed with Steve Jobs. Mired in this deep fixation, she also managed to subscribe to one of Jobs’ interesting habits: the reality-distortion field. While we’ve discussed the reality distortion field before in relation to Jobs, Holmes seemed to take it to a new level. Jobs would demand something incredible be done and a lot of times his amazing team could come up with the solution. Holmes also believed this but failed to consider two things: fundamental biology and her team. Biology, at its core, is just not as flexible as the hardware and software that Apple was building. Jobs demanded an excellent product, Holmes demanded a biological impossibility. Beyond searching to enable a biological impossibility, which to be frank, can pop up after years of research (see CRISPR), Holmes operated the Theranos cult as a dictator, ruthlessly seeking out dissenters and punishing or firing them. While Jobs challenged his team repeatedly while being a huge asshole, the team, for the most part, stayed in tact (Phil Schiller, Tony Fadell, Jony Ive, Scott Forstall, and Eddy Cue). There were certainly those who got fired or left, but Holmes active rooting out of non-believers severely limited the chances of success at the company. The additional levels of secrecy were even extreme for a stealth technology startup. Startup founders need to drink the kool-aid sometimes, it comes with being visionary, but getting so drunk on power and image can only lead to personal and business demise as was the case with Theranos.
When startups turn bad. Tons of startups fail, but only a few turn truly malicious. Theranos was one of those few. The company tested people’s blood and gave individuals fake, untested medical results, including indicators of cancer diagnoses! Even when reviewing other major business failures and frauds - Jeff Skilling at Enron and Bernie Madoff’s Ponzi Scheme - nothing compares to Theranos. While it could be argued that Enron and Madoff’s schemes did more and broader financial hurt to society, at least they were never physically endangering individuals. The only comparisons that may be warranted are Boeing and the Fyre Festival. The brainchild of famous clown, Billy McFarland, the Fyrefest certainly endangered people by marooning them on an island with little food. Furthermore, Boeing’s incredibly incoherent internal review process which knowingly led to the production of a faulty airline software system, also endangered people - including two flights that crashed because of its system. Did Elizabeth Holmes set out to build a dangerous device, knowingly defraud investors, and endanger the public? Probably not. It was one decision after another. It was firing CFO Henry Mosley who called out fake projections; it was hiring Boies Schiller to pressure former employees; it was enlisting Sunny Balwani to “run” the company. It was what Clayton Christensen calls marginal thinking - the idea that the incremental bad decision or the incremental costs of doing something frequently outweigh the full costs of doing something. The incremental cost of firing the CFO who wouldn’t make fake numbers was simply easier than facing the difficult reality that the product sucked, and they had pushed through too much investor money to start again. When things turn bad, at startups or other businesses, a trail of marginal decision making can normally be found.

Business Themes

The Pressure to Succeed. Stress seems to be a part of business, but the pressure can sometimes get too big to handle. Public companies, in particular, face growth targets from wall street analysts and investors. One earnings miss or even a more modest beat than expected can completely derail a stock (See pluralsight and alteryx graphs to the right). Public company CEOs and CFOs can be fired or have compensation withheld for poor stock performance. So when a young hot biotechnology startup wanted to launch a partnership with Walgreens, Dr. J and the Walgreens team were more than ready to fast track the potential partnership. Despite not being allowed to use the bathroom, see the lab or see a partial demo of the product, Walgreens pushed through a deal so that longtime competitor, CVS, wouldn’t get the deal. As then head of the Theranos/Walgreens pilot said, "We can’t not pursue this. We can’t risk a scenario where CVS has a deal with them in six months and it ends up being real.” When the partnership was announced, even the press release sounded oddly formulaic: “Theranos’ proprietary laboratory infrastructure minimizes human error through extensive automation to produce high quality results.” There was no demo. There was no product. There was only pressure at Walgreens to beat CVS and pressure at Theranos to make something from a fake device.
The Importance of Corporate Governance. Corporate Governance has historically rarely been discussed outside of academic settings but has come into sharper focus over the past few years. Some have recently tried to bring some of the prominent corporate governance issues such as member compensation and option grants for executives to the forefront. Warren Buffet even commented on boards in his 2019 annual shareholder letter: “Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year. And job security now? It’s fabulous. Board members may get politely ignored, but they seldom get fired. Instead, generous age limits – usually 70 or higher – act as the standard method for the genteel ejection of directors.” Boards are meant to help guide the company through strategic challenges, ensure the business is focused on the right things, and evaluate the CEO. Theranos’ Board of Directors was a laughable hodgepodge of old white men: George P. Shultz (former U.S. Secretary of State), William Perry (former U.S. Secretary of Defense), Henry Kissinger (former U.S. Secretary of State), Sam Nunn (former U.S. Senator), Bill Frist (former U.S. Senator and heart-transplant surgeon), Gary Roughead (Admiral, USN, retired), James Mattis (General, USMC), Richard Kovacevich (former Wells Fargo Chairman and CEO), and Riley Bechtel. The average age of the directors in 2012 was ~72 years old and few of these men could offer real strategic guidance in pursuing novel biotechnology. On top of that, as Carreyrou points out, “In December 2013, [Holmes] forced through a resolution that assigned one hundred votes to every share she owned, giving her 99.7% of the voting rights.” George Shultz even said later in a deposition, “We never took any votes at Theranos. It was pointless. Elizabeth was going to decide whatever she decided.” The episode brings more clarity to those CEOs and companies who hide behind their Board of Directors, who promise governance for investors, but rarely deliver on anything beyond pandering to the CEO’s whims. In another ludicrous comparison, Apple and Steve Jobs specifically have also been accused of shoddy corporate governance. In 2007, Apple famously backdated Jobs options, allowing him to make an instant profit, and did not even bother to report that it had issued the options. The best companies are not immune, and investors and employees should be aware of the qualifications and monetary interests of a company’s board members.
Search and Destroy. Only the Paranoid Survive, right? Wrong. There is such thing as too much paranoia. When you combine that paranoia with a manipulative persona, you get Elizabeth Holmes. It’s hard to believe that any startup or founder would need the level of security and secrecy that dominated the culture at Theranos. The list of weird security and legal gray areas include: personal security for Holmes, laboratory developed tests (instead of FDA approved tests), copious and vigorously enforced NDAs, siloed teams with no communication, and false representation in the media. Organizations are often secret and many startups operate in stealth to not give away details to competitors. Some larger companies launch new divisions in separate locations from their office, like Amazon a9. The Company hired private investigators (through its powerful law firm Boies Schiller) to threaten and track former employees including Erika Chung and Tyler Schulz. Tyler Schulz, grandson of board member George Schulz, was one of the key informants to author John Carreyrou. After he accused Elizabeth and Sunny of lying and potentially harming patients, he resigned and tried to convince his grandfather that it was all a sham. His grandfather agreed to speak with him one-on-one and at the end of the conversation surprised Tyler with two attorneys from Boies Schiller who almost forced Tyler to sign a confidentiality agreement. Tyler refused, which eventually led to the publication of Carreyrou’s first article. As early board member Avie Tevanian put it, “I had seen so many things that were bad go on. I would never expect anyone would behave the way that she behaved as a CEO. And believe me, I worked for Steve Jobs. I saw some crazy things. But Elizabeth took it to a new level.” Again, sadly, while Theranos may be the pinnacle of secrecy, paranoia and threatening behavior, eBay recently fired six employees for threatening online reviewers. On top of sending live spiders to the reviewers’ household, eBay team members would knock on their doors day or night, to scare the reviewers. How could these employees think this was ok? How could Elizabeth partake in this threatening and manipulative behavior? As Organizational Behavior professor Roderick Kramer reminds us: “‘Reality’ is not a fixed entity but rather a tissue of facts, impressions, and interpretations that can be manipulated and perverted by clever and devious businesses and governments.” Theranos’ fake Edison tests are reminiscent of Enron’s fake trading floor, where 70 low level employees once pretended to be busy to impress wall street analysts. Paranoia and secrecy are powerful weapons when left unchecked, and clearly Theranos' wielded those weapons to the fullest extent.

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April 2020 - Good To Great by Jim Collins

Collins’ book attempts to answer the question - Why do good companies continue to be good companies? His analysis across several different industries provides meaningful insights into strong management and strategic practices.

Tech Themes

Packard’s Law. We’ve discussed Packard’s law before when analyzing the troubling acquisition history of AOL-Time Warner and Yahoo. As a reminder, Packard’s law states: “No company can consistently grow revenues faster than its ability to get enough of the right people to implement that growth and still become a great company. [And] If a company consistently grows revenue faster than its ability to get enough of the right people to implement that growth, it will not simply stagnate; it will fall.” Given Good To Great is a management focused book, I wanted to explore an example of this law manifesting itself in a recent management dilemma. Look no further than ride-sharing giant, Uber. Uber’s culture and management problems have been highly publicized. Susan Fowler’s famous blog post kicked off a series of blows that would ultimately lead to a board dispute, the departure of its CEO, and a full-on criminal investigation. Uber’s problems as a company, however, can be traced to its insistence to be the only ride-sharing service throughout the world. Uber launched several incredibly unprofitable ventures, not only a price-war with its local competitor Lyft, but also a concerted effort to get into China, India, and other locations that ultimately proved incredibly unprofitable. Uber tried to be all things transportation to every location in the world, an over-indulgence that led to the Company raising a casual $20B prior to going public. Dara Khosrowshahi, Uber’s replacement for Travis Kalanick, has concertedly sold off several business lines and shuttered other unprofitable ventures to regain financial control of this formerly money burning “logistics” pit. This unwinding has clearly benefited the business, but also limited growth, prompting the stock to drop significantly from IPO price. Dara is no stranger to facing travel challenges, he architected the spin-out of Expedia with Barry Diller, right before 9/11. Only time will tell if he can refocus the Company as it looks to run profitably. Uber pushed too far in unprofitable locations, and ran head on into Packard’s law, now having to pay the price for its brash push into unprofitable markets.
Technology Accelerators. In Collins’ Good to Great framework (pictured below), technology accelerators act as a catalyst to momentum built up from disciplined people and disciplined thought. By adapting a “Pause, think, crawl, walk, run” approach to technology, meaning a slow and thoughtful transition to new technologies, companies can establish best practices for the long-term, instead of short term gains from technology faux-feature marketing. Technology faux-feature marketing, which is decoupled from actual technology has become increasingly popular in the past few years, whereby companies adopt a marketing position that is actually complete separate from their technological sophistication. Look no further than the blockchain / crypto faux-feature marketing around 2018, when Long Island iced-tea changed its name to Long Island Blockchain, which is reminiscent of companies adding “.com” to their name in the early 2000’s. Collins makes several important distinctions about technology accelerators: technology should only be a focus if it fits into a company’s hedgehog concept, technology accelerators cannot make up for poor people choices, and technology is never a primary root cause of either greatness or decline. The first two axioms make sense, just think of how many failed, custom software projects have begun and never finished; there is literally an entire wikipedia page dedicated to exactly that. The government has also reportedly been a famous dabbler in homegrown, highly customized technology. As Collins notes, technology accelerators cannot make up for bad people choices, an aspect of venture capital that is overlooked by so many. Enron is a great example of an interesting idea turned sour by terrible leadership. Beyond the accounting scandals that are discussed frequently, the culture was utterly toxic, with employees subjected to a “Performance Review Committee” whereby they were rated on a scale of 1-5 by their peers. Employees rated a 5 were fired, which meant roughly 15% of the workforce turned over every year. The New York Times reckoned Enron is still viewed as a trailblazer for the way it combined technology and energy services, but it clearly suffered from terrible leadership that even great technology couldn’t surmount. Collins’ most controversial point is arguably that technology cannot cause greatness or decline. Some would argue that technology is the primary cause of greatness for some companies like Amazon, Apple, Google, and Microsoft. The “it was just a better search engine” argument abounds discussions of early internet search engines. I think what Collins’ is getting at is that technology is malleable and can be built several different ways. Zoom and Cloudflare are great examples of this. As we’ve discussed, Zoom started over 100 years after the idea for video calling was first conceived, and several years after Cisco had purchased Webex, which begs the question, is technology the cause of greatness for Zoom? No! Zoom’s ultimate success the elegance of its simple video chat, something which had been locked up in corporate feature complexity for years. Cloudflare presents another great example. CDN businesses had existed for years when Cloudflare launched, and Cloudflare famously embedded security within the CDN, building on a trend which Akamai tried to address via M&A. Was technology the cause of greatness for Cloudflare? No! It’s way cheaper and easier to use than Akamai. Its cost structure enabled it to compete for customers that would be unprofitable to Akamai, a classic example of a sustaining technology innovation, Clayton Christensen’s Innovator’s Dilemma. This is not to say these are not technologically sophisticated companies, Zoom’s cloud ops team has kept an amazing service running 24/7 despite a massive increase in users, and Cloudflare’s Workers technology is probably the best bet to disrupt the traditional cloud providers today. But to place technology as the sole cause for greatness would be understating the companies achievements in several other areas.
Build up, Breakthrough Flywheel. Jeff Bezos loves this book. Its listed in the continued reading section of prior TBOTM, The Everything Store. The build up, breakthrough flywheel is the culmination of disciplined people, disciplined thought and disciplined action. Collins’ points out that several great companies frequently appear like overnight successes; all of a sudden, the Company has created something great. But that’s rarely the case. Amazon is a great example of this; it had several detractors in the early days, and was dismissed as simply an online bookseller. Little did the world know that Jeff Bezos had ideas to pursue every product line and slowly launched one after the other in a concerted fashion. In addition, what is a better technology accelerator than AWS! AWS resulted from an internal problem of scaling compute fast enough to meet growing consumer demand for their online products. The company’s tech helped it scale so well that they thought, “Hey! Other companies would probably like this!” Apple is another classic example of a build-up, breakthrough flywheel. The Company had a massive success with the iPod, it was 40% of revenues in 2007. But what did it do? It cannablized itself and pursued the iPhone, with several different teams within the company pursuing it individually. Not only that, it created a terrible first version of an Apple phone with the Rokr, realizing that design was massively important to the phone’s success. The phone’s technology is taken for granted today, but at the time the touch screen was simply magical!

Business Themes

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Level 5 Leader. The first part and probably the most important part of the buildup, breakthrough, flywheel is disciplined people. One aspect of Good to Great that inspired Collins’ other book Built to Last, is the idea that leadership, people, and culture determine the long-term future of a business, even after current leadership has moved on from the business. To set an organization up for long-term success, executives need to display level five leadership, which is a mix of personal humility and professional will. Collins’ leans in on Lee Iacocca as an example of a poor leader, who focused more on personal celebrity and left Chrysler to fail, when he departed. Level 5 leadership has something that you don’t frequently see in technology business leaders, humility. The technology industry seems littered with far more Larry Ellison and Elon Musk’s than any other industry, or maybe its just that tech CEOs tend to shout the loudest from their pedestals. One CEO that has done a great job of representing level five leadership is Shantanu Narayen, who took the reigns of Adobe in December 2007, right on the cusp of the financial crisis. Narayen, who’s been described as more of a doer than a talker, has dramatically changed Adobe’s revenue model, moving the business from a single sale license software business focused on lower ACV numbers, to an enterprise focused SaaS business. This march has been slow and pragmatic but the business has done incredibly well, 10xing since he took over. Adobe CFO, Mark Garrett, summarized it best in a 2015 McKinsey interview: “We instituted open dialogue with employees—here’s what we’re going through, here’s what it might look like—and we encouraged debate. Not everyone stayed, but those who did were committed to the cloud model.”
Hedgehog Concept. The Hedgehog concept (in the picture wheel to the right) is the overlap of three questions: What are you passionate about?, What are you the best in the world at?, and What drives your economic engine? This overlap is the conclusion of Collins’ memo to Confront the Brutal Facts, something that Ben Horowitz emphasizes in March’s TBOTM. Once teams have dug into their business, they should come up with a simple way to center their focus. When companies reach outside their hedgehog concept, they get hurt. The first question, about organizational passion, manifests itself in mission and value statements. The best in the world question manifests itself through value network exercises, SWOT analyses and competitive analyses. The economic engine is typically shown as a single metric to define success in the organization. As an example, let’s walk through an example with a less well-known SaaS company: Avalara. Avalara is a provider of tax compliance software for SMBs and enterprises, allowing those businesses to outsource complex and changing tax rules to software that integrates with financial management systems to provide an accurate view of corporate taxes. Avalara’s hedgehog concept is right on their website: “We live and breathe tax compliance so you don't have to.” Its simple and effective. The also list a slightly different version in their 10-K, “Avalara’s motto is ‘Tax compliance done right.’” Avalara is the best at tax compliance software, and that is their passion; they “live and breath” tax compliance software. What drives Avalara’s economic engine? They list two metrics right at the top of their SEC filings, number of core customers and net revenue retention. Core customers are customers who have been billed more than $3,000 in the last twelve months. The growth in core customers allows Avalara to understand their base of revenue. Tax compliance software is likely low churn because filing taxes is such an onerous process, and most people don’t have the expertise to do it for their corporate taxes. They will however suffer from some tax seasonality and some customers may churn and come back after the tax period has ended for a given year. Total billings allows Avalara to account for this possibility. Avalara’s core customers have grown 32% in the last twelve months, meaning its revenue should be following a similar trajectory. Net retention allows the company to understand how customer purchasing behavior changes over time and at 113% net retention, Avalara’s overall base is buying more software from Avalara than is churning, which is a positive trend for the company. What is the company the best in the world at? Tax compliance software for SMBs. Avalara views their core customer as greater than $3,000 of trailing twelve months revenue, which means they are targeting small customers. The Company’s integrations also speak to this - Shopify, Magento, NetSuite, and Stripe are all focused on SMB and mid-market customers. Notice that neither SAP nor Oracle ERP is in that list of integrations, which are the financial management software providers that target large enterprises. This means Avalara has set up its product and cost structure to ensure long-term profitability in the SMB segment; the enterprise segment is on the horizon, but today they are focused on SMBs.
Culture of Discipline. Collins describes a culture of discipline as an ability of managers to have open and honest, often confrontational conversation. The culture of discipline has to fit within a culture of freedom, allowing individuals to feel responsible for their division of the business. This culture of discipline is one of the first things to break down when a CEO leaves. Collins points on this issue with Lee Iaccoca, the former CEO of Chrysler. Lee built an intense culture of corporate favoritism, which completely unraveled after he left the business. This is also the focus of Collins’ other book, Built to Last. Companies don’t die overnight, yet it seems that way when problems begin to abound company-wide. We’ve analyzed HP’s 20 year downfall and a similar story can be shown with IBM. In 1993, IBM elected Lou Gerstner as CEO of the company. Gerstner was an outsider to technology businesses, having previously led the highly controversial RJR Nabisco, after KKR completed its buyout in 1989. He has also been credited with enacting wholesale changes to the company’s culture during his tenure. Despite the stock price increasing significantly over Gerstner’s tenure, the business lost significant market share to Microsoft, Apple and Dell. Gerstner was also the first IBM CEO to make significant income, having personally been paid hundreds of millions over his tenure. Following Gerstner, IBM elected insider Sam Palmisano to lead the Company. Sam pushed IBM into several new business lines, acquired 25 software companies, and famously sold off IBM’s PC division, which turned out to be an excellent strategic decision as PC sales and margins declined over the following ten years. Interestingly, Sam’s goal was to “leave [IBM] better than when I got there.” Sam presided over a strong run up in the stock, but yet again, severely missed the broad strategic shift toward public cloud. In 2012, Ginni Rometty was elected as new CEO. Ginni had championed IBM’s large purchase of PwC’s technology consulting business, turning IBM more into a full service organization than a technology company. Palmisano has an interesting quote in an interview with a wharton business school professor where he discusses IBM’s strategy: “The thing I learned about Lou is that other than his phenomenal analytical capability, which is almost unmatched, Lou always had the ability to put the market or the client first. So the analysis always started from the outside in. You could say that goes back to connecting with the marketplace or the customer, but the point of it was to get the company and the analysis focused on outside in, not inside out. I think when you miss these shifts, you’re inside out. If you’re outside in, you don’t miss the shifts. They’re going to hit you. Now acting on them is a different characteristic. But you can’t miss the shift if you’re outside in. If you’re inside out, it’s easy to delude yourself. So he taught me the importance of always taking the view of outside in.” Palmisano’s period of leadership introduced a myriad of organizational changes, 110+ acquisitions, and a centralization of IBM processes globally. Ginni learned from Sam that acquisitions were key toward growth, but IBM was buying into markets they didn’t fully understand, and when Ginni layered on 25 new acquisitions in her first two years, the Company had to shift from an outside-in perspective to an inside-out perspective. The way IBM had historically handled the outside-in perspective, to recognize shifts and get ahead of them, was through acquisition. But when the acquisitions occured at such a rapid pace, and in new markets, the organization got bogged down in a process of digestion. Furthermore, the centralization of processes and acquired businesses is the exact opposite of what Clayton Christensen recommends when pursuing disruptive technology. This makes it obvious why IBM was so late to the cloud game. This was a mainframe and services company, that had acquired hundreds of software businesses they didn’t really understand. Instead of building on these software platforms, they wasted years trying to put them all together into a digestible package for their customers. IBM launched their public cloud offering in June 2014, a full seven years after Microsoft, Amazon, and Google launched their services, despite providing the underlying databases and computing power for all of their enterprise customers. Gerstner established the high-pay, glamorous CEO role at IBM, which Palmisano and Ginni stepped into, with corporate jets and great expense policies. The company favored increasing revenues and profits (as a result of acquisitions) over the recognition and focus on a strategic market shift, which led to a downfall in the stock price and a declining mindshare in enterprises. Collins’ understands the importance of long term cultural leadership. “Does Palmisano think he could have done anything differently to set IBM up for success once he left? Not really. What has happened since falls to a new coach, a new team, he says.”