How To Keep Your Company Alive – Observe, Orient, Decide and Act

This article previously appeared in the Harvard Business Review. It’s been updated with new information about the U.S. Paycheck Protection program and the Economic Injury Disaster Loan program.


What cashflow-negative companies must do to survive

We’re in uncharted territory with the Covid-19 pandemic. But it’s increasingly looking grim.

Companies that outlast this crisis will have CEOs who can rapidly assess these new circumstances, recognize new patterns and opportunities, and act with urgency to take immediate action to pivot and restructure their companies. Those that don’t may not survive.

So here’s a five-day playbook to help CEOs of cash-flow negative startups, or ones about to go negative, assess the new normal and respond with speed and urgency.

Your Company Survival Depends on A Simple Formula
Your company’s survival in this downturn can be captured in a simple formula.

Survival = (speed of your understanding of the situation) x (the magnitude of the pivots/cuts/lifeboat choices you make) x (the speed of your time to make those changes)

Notice that the word speed appears twice. This is not the time for committees, study groups or widespread consensus building. Even with imperfect information, the future of your company depends on your ability to make rapid decisions and start acting.

If you’re a CEO who can’t quickly bias yourself for action and if you wait around for someone to tell you what to do, then your investors, or more likely the market, will make those decisions for you.

Huge segments of the economy have shut down: travel, hospitality, restaurants. Any place with a fixed cost that relies on foot traffic will come under pressure. With millions of people out of work in the next quarter, it’s obvious that discretionary purchases like furniture, fashion, lifestyle will take a hit. But other businesses like law firms, contracting firms, real estate firms, will take hits, too. The ripple effects won’t be obvious at first. Your customers will no longer be your customers. Your revenue plans are no longer valid. To understand the state of things, you need to rapidly assess your internal and external environments going forward.

Day 1: Prepare An Assessment of the Internal and External Environment:
What did the external and internal environment look like for your company today? What do you believe the world will look like for each of the next five quarters? For companies burning cash, such as startups, how much cash do you have? What’s your monthly cash burn at your new low revenue level? How many months of cash do you have?  Cut costs to stay alive for 24 months.

External Assessment

  1. State of the economy
    • Unemployment %
    • Shelter in place yes/no?
  2. Health of Your Current Target Market(s)
    • Actively buying? Not returning calls? Out of business?
  3. Emergence of New Market(s)
    • Are there new opportunities?
  4. Forecasted recovery date
    • Workers can return
    • Your customers start buying
  5. Check if the the Paycheck Protection Program, (here and here) which provides 100% federally guaranteed loans to small businesses, can apply to your company. Also see if the the Economic Injury Disaster Loan program applies.
  6. If you were raising money, validate whether your investors are still on board – with the same terms – or at all

Internal Assessment

  1. Operating Numbers
    • Liquidity and likely cash-out date under your worst-case scenario
    • Accounts receivable, accounts payable
    • Sales pipeline/forecast
    • Marketing programs spending
    • Payroll costs/other variable costs
  2. Sources of additional capital – For existing companies: debt commitments, and new lenders. Can the Paycheck Protection Program, (here and here) be a source of capital?For startups: source of VC money?

Don’t overthink this. And most importantly do not outsource this to your staff. Set up a war room and work with your CFO and C-level staff together until it’s done. That will start to get your team aligned about the size of the problem. The CEO should dial through as many of the largest existing customers to get a firsthand understanding of the magnitude of any revenue shortfall. If you were expecting angel or venture funding get on the phone to your investor(s). Some VC’s are walking away from signed term sheets. Others are cutting their valuations. The CFO should be on the phone to sources of additional capital. There is no market research that’s going to get it “right.” No one can predict how this plays out and for how long. All we know is that it’s going to be very different than it was a few weeks ago and likely going to be worse a few weeks from now.

Day 2: Iterate the assessment with your investors/board
Whatever assessment you develop, you need to get feedback from your board and investors. While you’re seeing just your own company, hopefully they’re getting data from multiple companies across a wider set of industries. If you’re a startup you’ll also get a sense of how much of a nuclear winter the funding scene is for your market/company.

Boards need to insist on an immediate assessment and be actively engaged. I listened in on a board call with an enterprise software company this week, and when the CEO said, “Our VP of sales assured me our pipeline won’t be affected.” Board members gave her a wakeup call: there was either going to be a much more realistic assessment tomorrow based on her first-hand customer conversations, or a new CEO. Some CEOs can and will rise to the occasion by themselves but having a unified board can accelerate the process.

But what if you think the situation is more dire and you disagree with your board’s assessment? CEOs in this position are going to face a major career decision – go along with advice you think will damage/destroy the company – or put your job on the line. Remember, a year from now no one wants to be the CEO of a company out of business whose lament is, “I did what the board told me to do.”

Once you have agreed on what the world will look like, it’s time to build the plan for your new company. This plan has three parts: Pivots to your new business model, changes to your operating plan, and what initiatives you save for the recovery. The plan must also take into account that this crisis has exposed how vulnerable companies are to a single source of supply. CEOs of companies that manufacture goods in the U.S. are about to face a moral dilemma. China and South Korea are starting their factories up again. Going forward, do you move your supply chain from China or at least create a second source from other countries? Do you source/build things there while laying off people here? What does your board suggest? What do you think is the right thing to do?

Days 3 and 4: Prepare new business model and operating plan
First, think about potential pivots. Ask yourself: Are there now new customers, new services and new channels to pursue? Which parts of your business model can now serve the new normal where business is booming – remote work/education, social cohesion over distance, telemedicine, home delivery, etc.?

For example:

  • If you had brick and mortar locations, how much can you pivot to Ecommerce (for basics), so customers can acquire goods without having to leave the house? Can you also offer specialized services?
  • Automated delivery services – the more people you can take out of the equation, the safer the product. Are there parts of your supply chain that can be repurposed? What about parts of your manufacturing lines?
  • Online/Virtual learning – schools will need to embrace virtual learning in a way they haven’t before.
  • B2B – cloud services, online meetings, virtual workforce management, collaboration tools. With more work from home happening, all of these services will see increased demand from companies
  • Virtual Travel/Tourism – how can consumers get out without leaving the safety of their house?
  • Remote Workforce automation – past the obvious conferencing tools, how do you maintain cohesion and coordination?
  • Remote health care – Can you do initial triaging/diagnosis online before having a patient come in?
  • Personalized Video Entertainment – VOD, AVOD, Short Form Social Sites, Twitch, etc. …

Next, plot out the changes to your operating plan. What cuts will you make to spending programs – marketing, service, manufacturing, R&D? What are your “lifeboat choices” – what layoffs to make, renegotiate payables, rents, leases, how to trade off cash management versus revenue growth? How can you shift focus to customer retention versus acquisition?

As part of these operating changes, make sure your heads of HR and finance recognize that they have entirely new jobs.

Your CFO now becomes the head of cash management. Draw down all debt commitments. Ask existing and new lenders for additional funding. Call all large vendors and ask for lower prices. If appropriate, offer to sign a longer agreement in exchange for lower cash payments in 2020 and 2021. See if your fixed costs are really fixed, or will they agree to defer some for higher payments at a future date. Make sure your CFO is familiar with the Paycheck Protection Program, (here and here) as a potential source of cash and to avoid/defer layoffs.

Nothing is more important than assuring the company can continue to pay its employees.

Your head of HR is now head of layoffs. He or she has 48 hours to grow into it, or you need to find someone else from the ranks to do it. Before layoffs, cut all salaries by 20%. Cut CXO salaries by at least 30%. Award equity to employees equal to the value of their reduced salaries. Try to protect the most vulnerable employees. Letting people go needs to be done with compassion and adequate compensation. And if you do it correctly, it will hopefully be done just once.

For those remaining employees, offer remote therapy to deal with the stress of working from home and pay for any equipment/network upgrades.

As you make these plans, remember: There will be a morning after. What changes in your industry will be permanent? If you have sufficient cash reserves, what initiatives do you want to keep in the lifeboat that may give you the ability to take advantage of these changes? To recover and grow quickly? Or to launch new products? Or if you have sufficient cash, now is the time to hire great people who were never available.

Although you prepared the internal and external assessment with just your C-level staff, now you want to rapidly engage the collective intelligence/wisdom of the company. Ask everyone in the company to suggest changes to the business model, operating plan and recovery plan.Your employees likely have ideas and see opportunities not visible in the C-suite. This will signal to every employee that now is the time for all-hands-on-deck and that you will be making decisions to quickly separate the crucial from the irrelevant.

You need to communicate, communicate and communicate some more to your employees about why you’re asking for their ideas. This is the perfect time to start a daily update from the C-suite. This is critical if your employees are working remotely. Let them know what you’re learning and then when you begin implementing changes, tell them why.

Day 5: Iterate with investors/board
Whatever business model, operating plan and recovery plan you come up with, you need to get feedback from your board. Keep in mind they’re likely dealing with multiple companies rapidly replanning, so remind them about the assessments you mutually agreed on. Then walk them through why the changes you’re suggesting match that plan. They may have seen new ideas from other companies in their portfolio so be open to additional suggestions.

Beyond the five-day plan, I want to specifically address two of the most challenging parts of the new operating plan you need to address: Layoffs and culture.

Carpenters use the aphorism “Measure twice, cut once.” The same applies to layoffs. In every downturn I’ve lived through, there were CEOs who handled layoffs as “a death by a thousand cuts.” For example, in a company with 1000 employees, they’d layoff a 100 people the first month, another 100 the next month, then a 100 the third month to downsize to 700 people over several months. Rather than being productive, the constant layoffs were demoralizing and paralyzed the remaining workforce. Employees saw that the direction was a downward spiral with no end in sight. And everyone worried: “Am I next?”  I’ve watched other CEOs immediately layoff 400 people and have 600 left. If/when they overshot, they could rehire 100 people (including some of the same people who had been laid off). While the mass layoffs created an immediate shock, people adjusted. They worried but began to feel more secure. When hiring began again, everyone was relieved: “The worst is over. Things are getting better.” (Remember to investigate whether the Paycheck Protection Program can save some or all of those jobs.)

To begin adjusting the culture to this new reality, communicate these business model and operating plan changes to your employees. Offer relentless optimism for survival, but ruthless cost-cutting (starting with the CXO salaries.) Let them know that as CEO you are going to be micromanaging for survival and expect each of them to do the same. You’re going to be relentless, direct and clear that once decisions are made, there are no disagreements. And remind them that together you are all working to save the company and their own jobs.

At some point this crisis will run its course. Running this five-day playbook will help your business survive so when the recovery does come, you’ll emerge stronger and ready to hire and grow again.

Lessons Learned

  • CEOs need to take control and take drastic action. Be decisive and do it immediately
  • Survival = (speed of your understanding of the situation) x (the magnitude of the pivots/cuts/lifeboat choices you make) x (the speed of your time to make those changes)
  • Involve the board and the rest of the company
  • Communicate with all employees daily
  • Move with speed and urgency, you have days — not weeks or months
  • As painful as it might be, when you make cuts do it once
  • Assume you’ll emerge on the other side. What will you wish you had kept?

AgileFall – When Waterfall Sneaks Back Into Agile

This article previously appeared in the Harvard Business Review

AgileFall is an ironic term for program management where you try to be agile and lean, but you keep using waterfall development techniques. It often produces a result that’s like combining a floor wax and dessert topping.

I just sat through my a project management meeting where I saw AgileFall happen first-hand. The good news is that a few tweaks in process got us back on track.

I just spent half a day with Henrich, the head of product of a Fortune 10 company. We’re helping them convert one of the critical product lines inside an existing division from a traditional waterfall project management process into Lean.

Henrich is smart, innovative and motivated. His company is facing disruption from new competitors. He realized that traditional Waterfall development wasn’t appropriate when the problem and solution had many unknowns.a

This product line has 15 project managers overseeing 60 projects. Over the last few months we’ve helped him inject the basic tenets of Lean into these projects. All are Horizon 1 or 2 projects – creating new features for existing products targeting existing customers or repurposing existing products, tools, or techniques to new customers. Teams are now creating minimum viable products (MVPs), getting out of the building to actually talk with users and stakeholders, and have permission to pivot, etc.  All good Lean basics.

AgileFall in Real Life
But in our latest meeting I realized Heinrich was still managing his project managers using a Waterfall process. Teams only checked in – wait for it – every three months in a formal schedule review. I listened as Henrich mentioned that the teams complained about the volume of  paperwork he makes them fill out for these quarterly reviews. And he was unhappy with the quality of the reports because he felt most teams wrote the reports the night before the review. How, he asked, could he get even more measures of performance and timely reporting from the project managers?

At first glance I thought, what could be bad about more data? Isn’t that what we want – evidence-based decisions? I was about to get sucked down the seductive path of suggesting even more measures of effectiveness when I realized Henrich still had a process where success was measured by reports, not outcomes. It was the same reporting process used to measure projects that used linear, step-by-step Waterfall.

(To be fair to Henrich, his product team is a Lean island in a company where Waterfall still dominates. While his groups has changed the mindset and cadence of the organization, the folks he reports up to don’t yet get Agile/Lean learning and outcomes. They just want to see the paperwork.)

In both managing down and up we needed a very different project management mindset.

Lean Project Management Philosophy
So our discussion was fun. As the conversation progressed, we agreed about the ways to manage projects using a few operating principles of Lean/Agile project management (without ever mentioning the words Lean or Agile.)

  1. It was the individuals who were creating the value (finding solution/mission ft) not the processes and reports
  2. However, the process and reports were still essential to management above him.
  3. Having the teams build incremental and iterative MVPs was more important than obsessing about early documentation/reporting
  4. Allow teams to pivot to what they learned in customer discovery rather than blindly follow a plan they sold you on day one
  5. Progress to outcomes (solution/mission ft) is non-linear and not all teams progress at the same rate

Pivoting the Process
With not too much convincing, Henrich agreed that rather than quarterly reviews, the leadership team would to talk to 4-5 project managers every week, looking at 16-20 projects. This meant the interaction cycle – while still long – would go from the current three months to at least once a month.

More importantly we decided that he would focus these conversations on outcomes rather than reports. There would be more verbal communication and a lot less paper. The reviews would be about frequent delivery, incremental development and how leadership could remove obstacles. And Henrich’s team would continue to share progress reporting across the teams so they could learn from each other.

In sum, the radical idea for Henrich was tha this role was not to push the paperwork down. It was to push an outcome orientation down, and then translate its progress back up the chain. While this was great for the teams, it put the onus on Henrich to report progress back up to his leadership in a way they wanted to see it.

I knew the lightbulb had fully gone on when near the end of the meeting Henrich asked his team, “Going forward, who are the right team members to manage a Lean process versus a Waterfall?” And I smiled when they concluded that Lean could be managed by fewer people who could operate in a chaotic learning environment, versus a process-driven, execution one.

I can’t wait for the next meeting.

Lessons Learned

  • AgileFall is a seductive trap – using some Lean processes but retaining the onerous parts of Waterfall
  • The goal of leadership in Lean product management is not to push the paperwork down. It’s to push an outcome orientation down and translate its progress back up the chain

Startup Stock Options – Why A Good Deal Has Gone Bad

A version of this article first appeared in the Harvard Business Review

VC’s have just changed the ~50-year old social contract with startup employees. In doing so they may have removed one of the key incentives that made startups different from working in a large company.

For most startup employee’s startup stock options are now a bad deal.

Here’s why.

Why Startups Offer Stock Options
In tech startups stock options were here almost from the beginning, first offered to the founders in 1957 at Fairchild Semiconductor, the first chip startup in Silicon Valley. As Venture Capital emerged as an industry in the mid 1970’s, investors in venture-funded startups began to give stock options to all their employees. On its surface this was a pretty radical idea. The investors were giving away part of their ownership of the company — not just to the founders, but to all employees. Why would they do that?

Stock options for all employees of startups served several purposes:

  • Because startups didn’t have much cash and couldn’t compete with large companies in salary offers, stock options dangled in front of a potential employee were like offering a lottery ticket in exchange for a lower salary. Startup employees calculated that a) their hard work could change the odds and b) someday the stock options they were vesting might make them into millionaires.
  • Investors bet that by offering prospective hires a stake in the company’s future growth- with a visible time horizon of a payoff – employees would act more like owners and work harder– and that would align employee interests with the investor interests. And the bet worked. It drove the relentless “do whatever it takes” culture of 20th century Silicon Valley. We slept under the tables, and pulled all-nighters to get to first customer ship, man the booths at trade shows or ship products to make quarterly revenue – all because it was “our” company.
  • While founders had more stock than the other employees, they had the same type of stock options as the rest of the employees, and they only made money when everyone else did (though a lot more of it.) Back then, when Angel/Seed investing didn’t exist, to get the company started, founders put a lot more on the line – going without a salary, mortgaging their homes etc. This “we’re all in it together” kept founders and employees aligned on incentives.

The mechanics of a stock option was a simple idea – you received an option (an offer) to buy a part of the company via common stock options (called ISOs or NSOs) at a low price (the “strike price”.) If the company was successful, you could sell it at a much higher price when the company went public (when its shares were listed on a stock exchange and could be freely traded) or was acquired.

You didn’t get to own your stock options all at once. The stock trickled out over four years, as you would “vest” 1/48th of the option each month. And just to make sure you were in the company for at least a year, with most stock option plans, unless you stayed an entire year, you wouldn’t vest any stock.

Not everyone got the same amount of stock. The founders got most of the common stock. Early employees got a smaller percentage, and later employees received even a smaller piece – fractions of a percent – versus the double digits the founders owned.

In the 20th century, the best companies IPO’d in 6-8 years from startup (and in the Dot-Com bubble of 1996-1999 that could be as short as 2-3 years.) Of the four startups I was in that went public, it took as long as six years and as short as three.

One other thing to note is that all employees – founders, early employees and later ones – all had the same vesting deal – four years – and no one made money on stock options until a “liquidity event” (a fancy word to mean when the company went public or got sold.) The rationale was that since there was no way for investors to make money until then, neither should anyone else.  Everyone—investors, founders and startup employees—was, so to speak, in the same boat.

Startup Compensation Changes with Growth Capital – 12 Years to an IPO
Much has changed about the economics of startups in the two decades. And Mark Suster of Upfront Capital has a great post that summarizes these changes.

The first big idea is that unlike in the 20th century when there were two phases of funding startups–Seed capital and Venture capital–today there is a new, third phase. It’s called Growth capital.

Instead of a startup going public six to eight years after it was founded to raise capital to grow the company, today companies can do $50M+ funding rounds, deferring the need for an Initial Public Offering to 10 or more years after a company is founded.

Suster points out that the longer the company stays private, the more valuable it becomes. And if during this time VC’s can hold onto their pro-rata (fancy word for what percentage of the startup they own), they can make a ton more money.

The premise of Growth capital is that if that by staying private longer, all the growth upside that went to the public markets (Wall Street) could instead be made by the private investors (the VC’s and Growth Investors.)

The three examples Suster uses – Salesforce, Google and Amazon – show how much more valuable the companies were after their IPOs. Before these three went public, they weren’t unicorns – that is their market cap was less than a billion dollars. Twelve years later, Salesforce’s market cap was $18 billion, Google’s was $162 billion, and Amazon’s was $17 billion.To Suster’s point, it isn’t that startups today can’t raise money by going public, it’s that their investors can make more money by keeping them private and going public later – now 10-12 yearsAnd currently there is an influx of capital to do that.

Founders Rule
The emergence of Growth capital, and pushing an IPO out a decade or more, has led to a dramatic shift in the balance of power between founders and investors. For three decades, from the mid-1970s to the early 2000s, the rules of the game were that a company must become profitable and hire a professional CEO before an IPO.

That made sense. Twentieth-century companies, competing in slower-moving markets, could thrive for long periods on a single innovation. If the VCs threw out the founder, the professional CEO who stepped in could grow a company without creating something new. In that environment, replacing a founder was the rational decision. But 21st century companies face compressed technology cycles, which create the need for continuous innovation over a longer period of time. Who leads that process best? Often it is founders, whose creativity, comfort with disorder, and risk-taking are more valuable at a time when companies need to retain a startup culture even as they grow large.

With the observation that founders added value during the long runup in the growth stage, VCs began to cede compensation and board control to founders. (See the HBR story here.)

Startup Stock Options – Why A Good Deal Has Gone Bad
While founders in the 20th century had more stock than the rest of their employees, they had the same type of stock options. Today, that’s not true. Rather, when a startup first forms, the founders grant themselves Restricted Stock Awards (RSA) instead of common stock options. Essentially the company sells them the stock at zero cost, and they reverse vest.

In the 20th century founders were taking a real risk on salary, betting their mortgage and future. Today that’s less true. Founders take a lot less risk, raise multimillion-dollar seed rounds and have the ability to cash out way before a liquidity event.

Early employees take an equal risk that the company will crater, and they often work equally as hard.  However, today founders own 30-50 times more than a startup’s early employees. (What has happened in founder compensation and board control has mirrored the growth in corporate CEO compensation. In the last 50 years, corporate CEO pay went from 20 times an average employee to over 300 times their compensation.)

On top of the founder/early employee stock disparity, the VC’s have moved the liquidity goal posts but haven’t moved the vesting goal posts for non-founders. Consider that the median tenure in a startup is 2 years. By year three, 50% of the employees will be gone. If you’re an early employee, today the company may not go public until eight years after you vest.

So why should non-founding employees of startups care? You’ll still own your stock, and you can leave and join another startup. There are four problems:

  • First, as the company raises more money, the value of your initial stock option grant gets diluted by the new money in. (VC’s typically have pro-rata rights to keep their percentage of ownership intact, but employees don’t.) So while the VCs gain the upside from keeping a startup private, employees get the downside.
  • Second, when IPO’s no longer happen within the near time horizon of an employee’s tenure, the original rationale of stock options – offering prospective hires a stake in the company’s future growth with a visible time horizon of a payoff for their hard work – has disappeared. Now there’s little financial reason to stay longer than the initial grant vesting.
  • Third, as the fair market value of the stock rises (to what the growth investors are paying), the high exercise price isn’t attractive for hiring new employees especially if they are concerned about having to leave and pay the high exercise price in order to keep the shares.
  • And finally, in many high valued startups where there are hungry investors, the founders get to sell parts of their vested shares at each round of funding. (At times this opportunity is offered to all employees in a “secondary” offering.) A “secondary” usually (though not always) happens when the startup has achieved significant revenue or traction and is seen as a “leader” in their market space, on the way to an IPO or a major sale

The End of the High-Commitment/High-Performance Work System?
In the academic literature, the work environment of a startup is called a high-commitment/ high-performance work system. This is a bundle of Human Resources startup practices that include hiring, self-managing teams, rapid and decentralized decision-making, on-boarding, flexible work assignments, communication, and stock options. And there is evidence that stock options increase the success of startups.

Successful startups need highly committed employees who believe in the goals and values of the company. In exchange for sharing in the potential upside—and being valued as a critical part of the team, they’re willing to rise to the expectation of putting work and the company in front of everything else. But this level of commitment depends on whether employees perceive these practices to be fair, both in terms of the process and the outcomes.

VCs have intentionally changed the ~50-year-old social contract with startup employees. At the same time, they may have removed one of the key incentives that made startups different from working in a large company.

While unique technology or market insight is one component of a successful startup everyone agrees that attracting and retaining A+ talent differentiates the winners from the losers. In trying to keep companies private longer, but not pass any of that new value to the employees, the VC’s may have killed the golden goose.

What Should Employees Do?
In the past the founders and employees were aligned with the same type of common stock grant, and it was the VCs who got preferential stock treatment. Today, if you’re an employee you’re now are at the bottom of the stock preference pile. The founders have preferential stock treatment and the VC have preferred stock. And you’re working just as hard. Add to that all the other known negatives of a startups– no work-life balance, insane hours, inexperienced management, risk of going out of business, etc.

That said, joining a startup still has a lot of benefits for employees who are looking to work with high performance teams with little structure. Your impact likely be felt. Constant learning opportunities, responsibility and advancement are there for those who take it.

If you’re one of the early senior hires, there’s no downside of asking for the same Restricted Stock Agreements (RSAs) as the founders. And if you’re joining a larger startup, you may want to consider those who are offering restricted stock units (RSUs) rather than common stock.

What Should Investors Do?
One possibility is to replace early employee (first ~10 employees) stock options with the same Restricted Stock Agreements (RSAs) as the founders.

For later employees make sure the company offers “refresh” option grants to longer-tenured employees. Better yet, offer restricted stock units (RSUs). Restricted Stock Units are a company’s promise to give you shares of the company’s stock. Unlike a stock option, which always has a strike (purchase) price higher than $0, an RSU is an option with a $0 purchase price. The lower the strike price, the less you have to pay to own a share of company stock. Like stock options, RSU’s vest.

But to keep employees engaged, they ought to be allowed buy their vested RSU stock and sell it every time the company raises a new round of funding.

Lessons Learned

  • Venture Capital structures were set up for a world in which successful companies exited in 6-8 years and didn’t raise too much capital
  • Venture capital growth funds are now giving startups the cash they would have received at an IPO
    • “Growth Capital” moved the need for an IPO out another five years
    • This allows VCs to capture the increase in market cap in the company
    • It may have removed the incentive for non-founders to want to work in a startup versus a large company
    • As stock options with four-year vesting are no longer a good deal
  • Investors and Founders have changed the model to their advantage, but no one has changed the model for early employees
    • VCs need to consider a new stock incentive model – RSA’s for the first key hires and then RSU’s – Restricted Stock Units for everyone else
  • Large companies now have an opportunity to attract some of the talent that previously went elsewhere

The Fatal Flaw of the Three Horizons Model

A version of this article first appeared in the Harvard Business Review

I’m a big fan of McKinsey’s Three Horizons Model of innovation. (if you’re not familiar with it there’s a brief description a few paragraphs down.) It’s one of the quickest ways to describe and prioritize innovation ideas in a large company or government agency.

However, in the 21stcentury the Three Horizons model has a fatal flaw that could put companies out of business and government agencies behind their adversaries. While traditional analysis suggests that Horizon 3 disruptive innovations take years to develop, in today’s world this is no longer the case. The three horizons are not bound by time. Horizon 3 ideas – disruption – can be delivered as fast as ideas for Horizon 1 – existing products.

In order to not be left behind, companies / government agencies need to focus on speed of delivery and deployment across all three horizons.

When first articulated by Baghai, Coley and White in the 20th century, the Three Horizons model was a simple way to explain to senior management the need for an ambidextrous organization – the idea that companies and government agencies need to execute existing business / mission models while simultaneously creating new capabilities.

The Three Horizons provided an incredibly useful taxonomy. The model described innovation occurring in three time horizons:

  • Horizon 1 ideas provide continuous innovation to a company’s existing business model and core capabilities.
  • Horizon 2 ideas extend a company’s existing business/model and core capabilities to new customers, markets or targets.
  • Horizon 3 is the creation of new capabilities to take advantage of or respond to disruptive opportunities or to counter disruption.

Each horizon requires different focus, different management, different tools and different goals. McKinsey suggested that to remain competitive in the long run a company allocate its research and development dollars and resources across all three horizons.

And here’s the big idea. In the past we assigned relative delivery time to each of the Horizons. For example, some organizations defined Horizon 1 as new features that could be delivered in 3-12 months; Horizon 2 as business/mission model extensions 24-36 months out; and Horizon 3 as creating new disruptive products/business/mission models 36-72 months out.  This time-based definition made sense in the 20th century when new disruptive ideas took years to research, engineer and deliver.

That’s no longer true in the 21st century.

Today, disruption Horizon 3 ideas – can be delivered as fast as Horizon 1 ideas.

For example, Uber took existing technology (smartphone app, drivers) but built a unique business model (gig economy disrupting taxis) and the Russians used existing social media tools to wage political warfare. Fast disruption happens by building on existing technologies uniquely configured, packaged and/or delivered, and combining them with a “speed of good-enough deployment as a force multiplier” mindset.

What’s an Example of Rapid Horizon 3 Implementation?
In the commercial space AirBnB, Uber, Craigslist, Tesla, and the explosion of machine learning solutions (built on hardware originally designed for computer graphics (Nvida)) are examples of radical disruption using existing technologies in extremely short periods of time.

In the government space, Russian interference with elections, and China building island bases in the South China Sea as well as repurposing ICBMs as conventional weapons to attack aircraft carriers, are examples of radical disruption using existing technologies deployed in extremely short periods of time.

What’s Different about Rapid Horizon 3 Disruption?
These rapid Horizon 3 deliverables emphasize disruption, asymmetry and most importantly speed, over any other characteristic. Serviceability, maintainability, completeness, scale, etc. are all secondary to speed and asymmetry.

To existing competitors or to existing requirements and acquisition systems they look like minimum viable products – barely finished, iterative and incremental prototypes. But the new products get out of the building, disrupt incumbents and once established, they then refactor and scale. Incumbents now face a new competitor/threat that obsoletes their existing product line/infrastructure/business/mission model.

Why Do the Challengers/new Entrants Have the Edge?
Ironically rapid Horizon 3 disruption is most often used not by the market leaders but by the challengers/new entrants (startups, ISIS, China, Russia, etc.). The new players have no legacy systems to maintain, no cumbersome requirements and acquisition processes, and are single-mindedly focused on disrupting the incumbents.

Four Strategies to Deal With Disruption
For incumbents, there are four ways to counter rapid disruption:

  • Incentivize external resources to focus on your goal/mission. For example, NASA and Commercial Resupply Services with SpaceX and OrbitalATK, Apple and the App Store, DARPA Prize challenges. The large organizations used startups who could rapidly build and deliver products for them – by offering something the startups needed – contracts, a distribution platform, or prizes. This can be a contract with a single startup or a broader net to incentivize many.
  • Combine the existing strengths of a company/agency and its business/mission model by acquiring external innovators who can operate at the speed of the disruptors. For example, Google buying Android. The risk here is that the mismatch of culture, process and incentives may strangle the newly acquired innovation culture.
  • Rapidly copy the new disruptive innovators and use the incumbent’s business/mission model to dominate. For example, Microsoft copying Netscape’s web browser and using its dominance of operating system distribution to win, or Google copying Overture’s pay per click model and using its existing dominance in search to sell ads. The risk here is that copying innovation without understanding the customer problem/mission can result in solutions that miss the target.
  • Innovate better than the disrupters. (Extremely difficult for large companies/government agencies as it is as much a culture/process problem as a technology problem. Startups are born betting it all. Large organizations are executing and protecting the legacy.) Successful examples, Apple and the iPhone, Amazon and Amazon Web Services (AWS). Gov’t agency and armed drones.

Lessons Learned

  • The Three Horizons model is still very useful as a shorthand for prioritizing innovation initiatives.
  • Some Horizon 3 disruptions do take long periods of development
  • However, today many Horizon 3 disruptions can be rapidly implemented by repurposing existing Horizon 1 technologies into new business/mission models
  • Speed of deployment of a disruptive/asymmetric product is a force multiplier
  • The attackers have the advantage, as the incumbents are burdened with legacy
  • Four ways for the incumbents to counter rapid disruption:
    • Incentivize external resources
    • Acquire external innovators
    • Rapidly copy
    • Innovate better than the disrupters

Is the Lean Startup Dead?

A version of this article first appeared in the Harvard Business Review

Reading the NY Times article “Jeffrey Katzenberg Raises $1 Billion for Short-Form Video Venture,” I realized it was time for a new startup heuristic: the amount of customer discovery and product-market fit you need to find is inversely proportional to the amount and availability of risk capital.

And while the “first mover advantage” was the rallying cry of the last bubble, today’s is: “Massive capital infusion can own the entire market.”

Fire, Ready, Aim
Jeff Katzenberg has a great track record – head of the studio at Paramount, chairman of Disney Studios, co-founder of DreamWorks and now chairman of NewTV. The billion dollars he just raised is on top of the $750 million NewTV’s parent company, WndrCo, has raised for the venture. He just hired Meg Whitman. the ex-CEO of HP and eBay, as CEO of NewTV. Their idea is that consumers will want a subscription service for short form entertainment (10-minute programs) for mobile rather than full length movies. (Think YouTube meets Netflix).

It’s an almost $2-billion-dollar bet based on a set of hypotheses. Will consumers want to watch short-form mobile entertainment? Since NewTV won’t be making the content, they will be licensing from and partnering with traditional entertainment producers. Will these third parties produce something people will watch? NewTV will depend on partners like telcos to distribute the content. (Given Verizon just shut down Go90, its short form content video service, it will be interesting to see if Verizon distributes Katzenberg’s offerings.)

But NewTV doesn’t plan on testing these hypotheses. With fewer than 10 employees but almost $2-billion dollars in the bank, they plan on jumping right in.

It’s the antithesis of the Lean Startup.  And it may work. Why?

Dot Com Boom to Bust
Most entrepreneurs today don’t remember the Dot-Com bubble of 1995 or the Dot-Com crash that followed in 2000. As a reminder, the Dot Com bubble was a five-year period from August 1995 (the Netscape IPO) when there was a massive wave of experiments on the then-new internet, in commerce, entertainment, nascent social media, and search. When Netscape went public, it unleashed a frenzy from the public markets for anything related to the internet and signaled to venture investors that there were massive returns to be made investing in anything internet related. Almost overnight the floodgates opened, and risk capital was available at scale from venture capital investors who rushed their startups toward public offerings. Tech IPO prices exploded and subsequent trading prices rose to dizzying heights as the stock prices became disconnected from the traditional metrics of revenue and profits. Some have labeled this period as irrational exuberance. But as Carlota Perez has so aptly described, all new technology industries go through an eruption and frenzy phase, followed by a crash, then a golden age and maturity. Then the cycle repeats with a new set of technologies.

Given the stock market was buying “the story and vision” of anything internet, inflated expectations were more important than traditional metrics like customers, growth, revenue, or heaven forbid, profits. Startups wrote business plans, generated expansive 5-year forecasts and executed (hired, spent and built) to the plan. The mantra of “first mover advantage,” the idea that winners are the ones who are the first entrants in their market, became the conventional wisdom of investors in Silicon Valley.“ First Movers” didn’t understand customer problems or the product features that solved those problems (what we now call product-market fit). These bubble startups were actually guessing at their business model and did premature and aggressive hype and early company launches and had extremely high burn rates – all predicated on an IPO to raise more cash. To be fair, in the 20th century, there really wasn’t a model for how to build startups other than write plan, raise money, and execute – the bubble was this method, on steroids. And to be honest, VC’s in this bubble really didn’t care. Massive liquidity awaited the first movers to the IPO’s, and that’s how they managed their portfolios.

When VC’s realized how eager the public markets were for anything related to the internet, they pushed startups with little revenue and no profits into IPOs as fast as they could. The unprecedented size and scale of VC returns transformed venture capital from a financial asset backwater into full-fledged player in the financial markets.

Then one day it was over. IPOs dried up. Startups with huge burn rates – building leases, staff, PR and advertising – ran out of money. Most startups born in the bubble died in the bubble.

The Rise of the Lean Startup
After the crash, venture capital was scarce to non-existent. (Most of the funds that started in the late part of the boom would be underwater). Angel investment, which was small to start with, disappeared, and most corporate VCs shut down. VC’s were no longer insisting that startups spend faster, and “swing for the fences”. In fact, they were screaming at them to dramatically reduce their burn rates. It was a nuclear winter for startup capital.

The idea of the Lean Startup was built on top of the rubble of the 2000 Dot-Com crash.

With risk capital at a premium and the public markets closed, startups and their investors now needed a methodology to preserve capital and survive long enough to generate revenue and profits. And to do that they needed a different method than just “build it and they will come.” They needed to be sure that what they were building was what customers wanted and needed. And if their initial guesses were wrong, they needed a process that would permit them to change early on in the product development process when the cost of changes was small – the famed “pivot”.

Lean started from the observation that you cannot ask a question that you have no words for. At the time we had no language to describe that startups were not smaller versions of large companies; the first insight was that large companies executed known business models, while startups searched for them. Yet while we had plenty of language and tools for execution, we had none for search.  So we (Blank, Ries, Osterwalder) built the tools and created a new language for innovation and modern entrepreneurship. It helped that in the nuclear winter that followed the crash, 2001 – 2004, startups and VCs were extremely risk averse and amenable to new ideas that reduced risk. (This same risk averse, conserve the cash, VC mindset would return after the 2008 meltdown of the housing market.)

As described in the HBR article “Why the Lean Startup Changes Everything,” we developed Lean as the business model / customer development / agile development solution stack where entrepreneurs first map their hypotheses about their business model and then test these hypotheses with customers in the field (customer development) and use an iterative and incremental development methodology (agile development) to build the product. This allowed startups to build Minimal Viable Products (MVPs) – incremental and iterative prototypes – and put them in front of a large number of customers to get immediate feedback. When founders discovered their assumptions were wrong, as they inevitably did, the result wasn’t a crisis; it was a learning event called a pivot— and an opportunity to change the business model.

Every startup is in a race against time. It has to find product-market fit before running out of cash. Lean makes sense when capital is scarce and when you need to keep burn rates low. Lean was designed to inform the founders’ vision while they operated frugally at speed. It was not built as a focus group for consensus for those without deep convictions.

The result? Startups now had tools that sped up the search for customers, ensured that what was being built met customer needs, reduced time to market and slashed the cost of development.

Carpe Diem – Seize the Cash
Today, memories of frugal VC’s and tight capital markets have faded, and the structure of risk capital is radically different. The explosion of seed funding means tens of thousands of companies that previously languished in their basement are getting funding, likely two orders of magnitude more than received Series A funding during the Dot-Com bubble. As mobile devices offer a platform of several billion eyeballs, potential customers which were previously small niche markets now include everyone on the planet. And enterprise customers in a race to reconfigure strategies, channels, and offerings to deal with disruption provide a willing market for startup tools and services.

All this is driven by corporate funds, sovereign funds and even VC funds with capital pools of tens of billions of dollars dwarfing any of the dollars in the first Dot Com bubble – and all looking for the next Tesla, Uber, Airbnb, or Alibaba. What matters to investors now is to drive startup valuations into unicorn territory (valued at $1 billion or more) via rapid growth – usually users, revenue, engagements but almost never profits. As valuations have long passed the peak of the 2000 Internet bubble, VC’s and founders who previously had to wait until they sold their company or took it public to make money no longer have to wait. They can now sell part of their investment when they raise the next round. And if the company does go public, the valuations are at least 10x of the last bubble.

With capital chasing the best deals, and hundreds of millions of dollars pouring into some startups, most funds now scoff at the idea of Lean. Rather than the “first mover advantage” of the last bubble, today’s theory is that “massive capital infusion owns the entire market.” And Lean for startups seems like some quaint notion of a bygone era.

And that explains why investors are willing to bet on someone with a successful track record like Katzenberg who has a vision of disrupting an entire industry.

In short, Lean was an answer to a specific startup problem at a specific time, one that most entrepreneurs still face and which ebbs and flows depending on capital markets. It’s a response to scarce capital, and when that constraint is loosened, it’s worth considering whether other approaches are superior. With enough cash in the bank, Katzenberg can afford to create content, sign distribution deals, and see if consumers watch. If not, he still has the option to pivot. And if he’s right, the payoff will be huge.

One More Thing…
Well-funded startups often have more capital for R&D than the incumbent companies they’re disrupting. Companies struggle to compete while reconfiguring legacy distribution channels, pricing models and supply chains. And government agencies find themselves being disrupted by adversaries unencumbered by legacy systems, policies and history.  Both companies and government agencies struggle with how to deliver innovation at speed. Ironically, for this new audience that makes the next generation of Lean – the Innovation Pipeline – more relevant than ever.

Lessons Learned:

  • When capital for startups is readily available at scale, it makes more sense to go big, fast and make mistakes than it does to search for product/market fit.
  • The amount of customer discovery and product-market fit you need to do is inversely proportional to the amount and availability of risk capital.
  • Still, unless your startup has access to large pools of capital or have a brand name like Katzenberg, Lean still makes sense.
  • Lean is now essential for companies and government agencies to deliver innovation at speed
  • The Lean Startup isn’t dead. For companies and government the next generation of Lean – the Innovation Pipeline – is more relevant than ever.

Why the Future of Tesla May Depend on Knowing What Happened to Billy Durant

A version of this article appeared in the Harvard Business Review

Elon Musk, Alfred Sloan, and entrepreneurship in the automobile industry.

The entrepreneur who founded and grew the largest startup in the world to $10 billion in revenue and got fired is someone you have probably never heard of. The guy who replaced him invented the idea of the modern corporation. If you want to understand the future of Tesla and Elon Musk’s role – something many want to do, given the constant stream of headlines about the company — you should start with a bit of automotive history from the 20th Century.

Alfred P. Sloan and the Modern Corporation
By the middle of the 20th century, Alfred P. Sloan had become the most famous businessman in the world. Known as the “Inventor of the Modern Corporation,” Sloan was president of General Motors from 1923 to 1956 when the U.S. automotive industry grew to become one of the drivers of the U.S. economy.

Today, if you look around the United States it’s hard to avoid Sloan. There’s the Alfred P. Sloan Foundation, the Sloan School of Management at MIT, the Sloan program at Stanford, and the Sloan/Kettering Memorial Cancer Center in New York. Sloan’s book My Years with General Motors, written half a century ago, is still a readable business classic.

Peter Drucker wrote that Sloan was “the first to work out how to systematically organize a big company. When Sloan became president of GM in 1923 he put in place planning and strategy, measurements, and most importantly, the principles of decentralization.”

When Sloan arrived at GM in 1920 he realized that the traditional centralized management structures organized by function (sales, manufacturing, distribution, and marketing) were a poor fit for managing GM’s diverse product lines.  That year, as management tried to coordinate all the operating details across all the divisions, the company almost went bankrupt when poor planning led to excess inventory, with unsold cars piling up at dealers and the company running out of cash.

Borrowing from organizational experiments pioneered at DuPont (run by his board chair), Sloan organized the company by division rather than function and transferred responsibility down from corporate into each of the operating divisions (Chevrolet, Pontiac, Oldsmobile, Buick and Cadillac). Each of these GM divisions focused on its own day-to-day operations with each division general manager responsible for the division’s profit and loss. Sloan kept the corporate staff small and focused on policymaking, corporate finance, and planning. Sloan had each of the divisions start systematic strategic planning.  Today, we take for granted divisionalization as a form of corporate organization, but in 1920, other than DuPont, almost every large corporation was organized by function.

Sloan put in place GM’s management accounting system (also borrowed from DuPont) that for the first time allowed the company to: 1) produce an annual operating forecast that compared each division’s forecast (revenue, costs, capital requirements and return on investment) with the company’s financial goals. 2) Provide corporate management with near real-time divisional sales reports and budgets that indicated when they deviated from plan. 3) Allowed management to allocate resources and compensation among divisions based on a standard set of corporate-wide performance criteria.

Modern Corporation Marketing
When Sloan took over as president of GM in 1923, Ford was the dominant player in the U.S. auto market. Ford’s Model T cost just $260 ($3,700 in today’s dollars) and Ford held 60% of the U.S. car market. General Motors had 20%. Sloan realized that GM couldn’t compete on price, so GM created multiple brands of cars, each with its own identity targeted at a specific economic bracket of American customers. The company set the prices for each of these brands from lowest to highest (Chevrolet, Pontiac, Oldsmobile, Buick, and Cadillac). Within each brand there were several models at different price points.

The idea was to keep customers coming back to General Motors over time to upgrade to a better brand as they became wealthier. Finally, GM created the notion of perpetual demand within brands by continually obsoleting their own products with new models rolled out every year. (Think of the iPhone and its yearly new models.)

By 1931, with the combination of superior financial management and an astute brand and product line strategy, GM had 43% market share to Ford’s 20% – a lead it never relinquished.

Sloan transformed corporate management into a real profession, and its stellar example was the continuous and relentless execution of the GM business model (until its collapse 50 years later).

What Does GM Have to Do with Tesla And Elon Musk?
Well, thanks for the history lesson but why should I care?

If you’re following Tesla, you might be interested to know that Sloan wasn’t the founder of GM. Sloan was president of a small company that made ball bearings that GM acquired in 1918. When Sloan became President of General Motors in 1923, it was already a $700 million company (about $10.2 billion in sales in today’s dollars).

Yet, you never hear who built GM to that size. Who was the entrepreneur who founded what would become General Motors 16 years earlier, in 1904? Where are the charitable foundations, business schools, and hospitals named after the founder of GM? What happened to him?

The founder of what became General Motors was William (Billy) Durant. At the turn of the 20th century, Durant was one of the largest makers of horse-drawn carriages, building 150,000 a year. But in 1904, after his first time seeing a car in Flint, Michigan, he was one of the first to see that the future was going to be in a radically new form of transportation powered by internal combustion engines.

Durant took his money from his carriage company and bought a struggling automobile startup called Buick. Durant was a great promoter and visionary, and by 1909 he had turned Buick into the best-selling car in the U.S. Searching for a business model in a new industry, and with the prescient vision that a car company should offer multiple brands, that year he bought three other small car companies — Cadillac, Oldsmobile, and Pontiac — and merged them with Buick, renaming the combined company General Motors. He also believed that to succeed the company needed to be vertically integrated and bought up 29 parts manufacturers and suppliers.

The next year, 1910, trouble hit. While Durant was a great entrepreneur, the integration of the companies and suppliers was difficult, a recession had just hit, and GM was overextended with $20 million in debt ($250 million in 2018 dollars) from all the acquisitions and was about to run out of cash. Durant’s bankers and board fired him from the company he had founded.

For most people the story might have ended there. But not for Durant. The next year Durant co-founded another automobile startup, this one started with Louis Chevrolet. Over the next five years Durant built Chevrolet into a competitor to GM. And in one of the greatest corporate comeback stories, in 1916 Durant used Chevrolet to buy back control of GM with the backing of Pierre duPont. He once again took over General Motors, merged Chevrolet into GM, bought Fisher Body and Frigidaire, created GMAC GM’s financing arm and threw out the bankers who six years earlier had fired him.

Durant had another great four years at the helm of GM. At the time he was not only running GM but was a major Wall Street speculator (even on GM stock) and was big in the New York social scene. But trouble was on the horizon. Durant was at his best when there was money to indulge his indiscriminate expansion. (He bought two car companies – Sheridan and the Scripps-Booth – that competed with his existing products.) But by 1920, a post-World War I recession had hit, and car sales has slowed. Durant kept building for a future assuming the flow of cash and customers would continue.

Meanwhile, inventory was piling up, the stock was cratering, and the company was running out of cash. In the spring of 1920 with company had to go to the banks and he got an $80 million loan (about a billion dollars in 2018) to finance operations. While everyone around him acknowledged he was a visionary and a world-class fund raiser, Durant’s one-man show was damaging the company. He couldn’t prioritize, couldn’t find time to meet with his direct reports, fired them when they complained about the chaos, and the company had no financial controls other than Durant’s ability to manage to raise more money. When the stock collapsed Durant’s personal shares were underwater and were exposed to being called by bankers who would then own a good part of GM. The board decided that the company had enough vision — they bought out Durant’s shares and realized it was now time for someone who could execute at scale.

Once again, his board (this time led by the DuPont family) tossed him out of General Motors (when GM sales were $10 billion in today’s dollars.)

Alfred Sloan became the President of GM and ran it for the next three decades.

William Durant tried to build his third car company, Durant Motors, but he was still speculating on stocks, and got wiped out in the Depression in 1929. The company closed in 1931. Durant died managing a bowling alley in Flint, Michigan, in 1947.

From the day Durant was fired in 1920, and for the next half a century, American commerce would be led by an army of “Sloan-style managers” who managed and executed existing business models.

But the spirit of Billy Durant would rise again in what would become Silicon Valley. And 100 years later Elon Musk would see that the future of transportation was no longer in internal combustion engines and build the next great automobile company.

Days of Futures Past for Tesla
In all of his companies, Elon Musk has used his compelling vision of a future transformed to capture the imagination of customers and, equally important, of Wall Street, raising the billions of dollars to make his vision a reality.

Yet, as Durant’s story typifies, one of the challenges for visionary founders is that they often have a hard time staying focused on the present when the company needs to transition into relentless execution and scale. Just as Durant had multiple interests, Musk is not only Tesla’s CEO and Product Architect, overseeing all product development, engineering, and design. At SpaceX (his rocket company) he’s CEO and lead designer overseeing the development and manufacturing of advanced rockets and spacecraft. He’s also the founder at The Boring Company (the tunneling company) and co-founder and chairman of OpenAI. And a founder of Neuralink a brain-computer interface startup.

All of these companies are doing groundbreaking innovations but even Musk only has 24 hours in a day and 7 days in a week. Others have noted that diving in and out of your current passion makes you a dilettante, not a CEO.

One of the common traits of a visionary founder is that once you have proven the naysayers wrong, you convince yourself that all your pronouncements have the same prescience.

For example, after the success of the Model S sedan, Tesla’s next car was an SUV, the Model X. By most accounts, Musk’s insistence on adding bells and whistles (like the Falcon Wing doors and other accoutrements) to what should have been simple execution of the next product made manufacturing the car in volume a nightmare. Executives who disagreed (and had a hand in making the Model S a success) ended up leaving the company. The company later admitted that the lesson learned was hubris.

The Tesla Model 3 was designed to be simple to manufacture, but instead of using the existing assembly line Musk said, “the true problem, the true difficulty, and where the greatest potential is – is building the machine that makes the machine. In other words, it’s building the factory. I’m really thinking of the factory like a product.” Fast forward two years and it turns out that the Model 3 assembly line was a great example of over-automation. “Excessive automation at Tesla was a mistake. To be precise, my mistake” Musk recently tweeted,

Sleeping on the factory floor to solve self-inflicted problems is not a formula for success at scale, and while it’s great PR, it’s not management. It is in fact a symptom of a visionary founder imposing chaos just at the time where execution is required. Tesla now has a pipeline of newly announced products, a new Roadster (a sports car), a Semi Truck, and a hinted crossover called the Model Y. All of them will require massive execution at scale, not just vision.

Unlike Durant, Musk has engineered his extended tenure and this year got his shareholders to give him a new $2.6 billion compensation plan (and it could potentially be worth as much as $55 billion) if he can grow the company’s market cap in $50 billion increments to $650 billion. The board said that it “believes that the Award will continue to incentivize and motivate Elon to lead Tesla over the long-term, particularly in light of his other business interests.”

Elon Musk has done what Steve Jobs and Jeff Bezos did – disrupt a series of stagnant businesses controlled by rent seekers, permanently changing the trajectory of multiple industries – while capturing the imagination of consumers and the financial community. Just a handful of people with these skills emerge every century. However, fewer combine the talent for creating an industry with the very different skills needed for scale. Each of Tesla’s stumbles has begun to squander the very advantage that Musks vision gave the company. And what was once an insurmountable lead by having an economic castle surrounded by a defensible moat (battery technology, superchargers, autonomous driving, over the air updates, etc.) is closing rapidly.

One wonders if $2.6 billion in executive compensation would be better spent finding someone to lead Tesla to becoming a reliable producer of cars in high volume – without the drama in each new model.

Perhaps Tesla now needs its Alfred P. Sloan.

Lesson Learned

  • Founders/visionaries see things other don’t and the extraordinary ones create new industries
  • When technology changes are rapid you want the founder to continue to run the company
  • However, when success depends on exploitation and execution at scale their impatience for continuous innovation and invention often gets in the way of day-to-day execution
  • The best ones know when it’s time to let go

Why GE’s Jeff Immelt Lost His Job – Disruption and Activist Investors

This article first appeared on the Harvard Business Review blog

Jeff Immelt ran GE for 16 years. He radically transformed the company from a classic conglomerate that did everything to one that focused on its core industrial businesses. He sold off slower-growth, low-tech, and nonindustrial businesses — financial services, media, entertainment, plastics, and appliances. He doubled GE’s investment in R&D.

In his Harvard Business Review article summing up his tenure, Immelt recalls that the two things that influenced him most were Marc Andreessen’s 2011 Wall Street Journal article “Why Software Is Eating the World,” and Eric Ries’s book The Lean Startup.

Andreessen’s article helped accelerate the company’s digital transformation. GE made a $4 billion bet on connecting industrial equipment via the Internet of Things (IoT) and analytical software with a suite of products called the “Predix Cloud”.

In response to reading Eric Ries’s The Lean Startup, GE adopted Lean and built their Fastworks program around it. Beth Comstock, GE vice chair responsible for creating new businesses, embraced the lean process. Over a period of years, every GE senior manager would learn the Lean Startup, and GE would be the showcase for how modern companies use entrepreneurial management to transform culture and drive long-term growth.

Innovation at GE was on a roll.

Then it wasn’t.

In June 2017, the board “retired” Jeff Immelt and promoted John Flannery to CEO. Since then Flannery has replaced Immelt’s vice chairs responsible for innovation. Beth Comstock is out. So is John Rice, the head of Global Operations along with CFO Jeffrey Bornstein.

Last week’s Wall Street Journal story on GE opened with, “John Flannery, the leader of General Electric for just 2½ months, has already begun dismantling the legacy of his predecessor…” Flannery has pledged to unload $20 billion of GE businesses in the next two years. “We need to make some major changes with urgency and a depth of purpose. Everything is on the table,” Flannery said on a conference call to discuss quarterly earnings. “Things will not stay the same at GE.”

Instead of lean innovation programs, there is a mandate to cut $2 billion in expenses by the end of next year, lift profits and raise the dividend.

So what happened? Are lean innovation and the Startup Way a failure in large companies?

In fact, what happened is activist investors.

During Jeff Immelt’s tenure GE’s stock-market value fell by about half. Its stock is trading where it was 20 years ago. So far in 2017, GE is the worst performing stock on the Dow Jones Industrial average.

In 2015 Trian Partners, an activist investor, bought $2.5 billion of GE stock – about 1.5% of the company. The firm wrote a white paper, “Transformation Underway… But Nobody Cares” which essentially said that GE stock was undervalued because investors didn’t believe that Immelt and GE management would do the things needed to deliver a higher stock price and dividends.

Trian was pretty clear about what they thought the company should do:

  • Take on $20 billion in debt (returning the cash to shareholders by buying back GE stock).
  • Increase operating margins to 18% (by cutting expenses).
  • Buy back more stock than the $50 billion stock purchase plan GE already had in place.

Immelt believed that doing these three things would optimize the stock price and increase the value of Trian’s investment, but the debt and cuts would endanger GE’s long-term investment in innovation.

And now Immelt is now the ex-CEO, and Trian Partners just a got a seat on the GE board.

Activist Investors
The “corporate raiders” of the 20th century have rebranded themselves as “activist investors” of the 21st. With refrains of “unlock hidden value” and “increase shareholder value,” and powered by over $120 billion in assets, activist investors like Trian look for companies like GE (or Procter and Gamble) that have a share price which is underperforming relative to its peers (or those with large amounts of cash on their balance sheets). They then buy stock in these public companies and attempt to convince management to increase the price of the shares.

One key difference in 21st century activists is that they don’t need to buy much of the company’s stock to gain control. (Trian only owns ~1.5% of the GE and P&G shares.) They do it by influencing the votes of the majority of the shareholders. And in the 21st century, the majority of public company shareholders are institutional investors (banks, insurance companies, pensions, hedge funds, REITs, investment advisors, endowments, and mutual funds), not individuals. (In 2015, the 10 largest shareholders in a typical S&P 500 company held almost half of the company’s stock.)  What gives institutions even more say is that while individual shareholders vote their shares 30% of the time, institutions vote their shares 90%. (In the case of P&G, 40% of its stock was owned by small investors, helping the company fight off a 2017 proxy battle with Trian.)

After the crash in 2001 and the financial crisis of 2008, traditional investors who previously held their shares for the long-term — public pension funds, institutional investors and money managers — are now more interested in short-term gains. This means that company boards who used to side with management no longer automatically protect them, and as Jeff Immelt discovered, may even side with an activist.

Activist investors have a simple goal: increase the value of their investment. But first they need to get management of a company to change their existing strategy. To do that, they start with an implicit (GE) or explicit (P&G) threat of a proxy fight for a seat on the company board.  Next, they make a public presentation to management — like Trian’s “Transformation Underway… But Nobody Cares” — explaining what actions they think the company should take to increase the price of the stock.  Next, they use the financial press and blogs to spread their message to the institutional investors. If that still doesn’t work, they can start a proxy fight and try to gain control of shareholder votes so they can replace the board — and ultimately the company management.

If their campaign is successful, like Trian’s was at GE, they’ll have a seat on the board and a new CEO and management. They’ll have GE execute a playbook to increase the value of their investment: share repurchase programs, increased dividends, and, to reduce expenses, layoffs, factory closings, spin-offs of profitable parts of the company, sell-offs of the least profitable divisions, and asset stripping. And as Trian’s presentation suggests, they’ll get GE to take on more debt to buy back stock. And often they calculate that selling the sum of parts is greater than keeping the company together as a whole. Or they may even put the entire company up for sale.

There is an upside to an activist investor taking a run at a company. It’s often a cattle prod to a stagnant company, or one ignoring disruption by new startups. GE’s gross margin was 21% last year, compared with 28% at United Technologies and 30% at Siemens. At a minimum, as is happening to GE now, it forces a company to go through a review of its strategy. (At GE the biggest problem in 2017 was major revenue misses in their Power business.) The new GE CEO is focusing on a back-to-basics approach to the business: dramatically reducing expenses, with the visible symbols of getting rid of company planes, company cars, and delaying a fancy new headquarters, etc.

The bad news is once they take control of a company, long-term investment is not the goal of an activist investor. They often kill any long-term strategic initiatives. Often the short-term cuts directly affect employee salaries, jobs, and long-term investment in R&D. The first things to go are R&D centers and innovation initiatives.

So What is a CEO to Do?
A CEO of a public company needs to know what explicit and implicit guidance they are getting from their board and institutional investors.

Large public companies like Amazon, Tesla, Netflix, etc. capture the imagination of investors and can focus on revenue and user growth instead of on the bottom line. Almost 20 years after Amazon was launched, it has massive revenue growth and barely has a meaningful profit. Investors in these companies believe that the company’s investments in user growth will result in long-term profits. (Newly public tech companies are now going public with dual-class stock, which allows the founders to have more voting rights than the general public. This protects them from activist investors and allows them to put long-term interests ahead of quarterly results.)

But GE’s core businesses don’t have the scale of those online businesses. No innovation program, lean or otherwise, would have helped the dismal performance of their Power segment.

Companies and government organizations are discovering that innovation activities without a defined innovation pipeline results in innovation theater.  And an innovation pipeline needs to be driven with speed and urgency and results measured by the impact on the top and bottom line.

In hindsight, GE Fastworks wasn’t the problem at GE, and while the Predix Cloud has had a painful birth, GE’s investment in the industrial Internet of Things (IoT) and lean will pay off in the future. But the impact of future innovations couldn’t compensate for poor execution in its traditional businesses. GE’s board was not happy with their margins, stock price, and how Wall Street viewed the future of the company. The immediate threat of a proxy fight with an activist investor forced a decision on the future direction of the company.

Why Uber is The Revenge of the Founders

A version of this article is in the Harvard Business Review

Uber, Zenefits, Tanium, Lending Club CEOs of companies with billion dollar market caps have been in the news – and not in a good way.  This seems to be occurring more and more.  Why do these founders get to stay around?

Because the balance of power has dramatically shifted from investors to founders.

Here’s why it generates bad CEO behavior.

Unremarked and unheralded, the balance of power between startup CEOs and their investors has radically changed:

  • IPOs/M&A without a profit (or at times revenue) have become the norm
  • The startup process has become demystified – information is everywhere
  • Technology cycles have become a treadmill, and for startups to survive they need to be on a continuous innovation cycle
  • VCs competing for unicorn investments have given founders control of the board

20th Century Tech Liquidity = Initial Public Offering
In the 20th century tech companies and their investors made money through an Initial Public Offering (IPO). To turn your company’s stock into cash, you engaged a top-notch investment bank (Morgan Stanley, Goldman Sachs) and/or their Silicon Valley compatriots (Hambrecht & Quist, Montgomery Securities, Robertson Stephens).

Typically, this caliber of bankers wouldn’t talk to you unless your company had five profitable quarters of increasing revenue. And you had to convince the bankers that you had a credible chance of having four more profitable quarters after your IPO.  None of this was law, and nothing in writing required this; this was just how these firms did business to protect their large institutional customers who would buy the stock.

Twenty-five years ago, to go public you had to sell stuff – not just acquire users or have freemium products. People had to actually pay you for your product. This required a repeatable and scalable sales process, which required a professional sales staff and a product stable enough that customers wouldn’t return it.

Hire a CEO to Go Public
More often than not, a founding CEO lacked the experience to do these things. The very skills that got the company started were now handicaps to its growth. A founder’s lack of credibility/experience in growing and managing a large company hindered a company that wanted to go public. In the 20th century, founding CEOs were most often removed early and replaced by “suits” — experienced executives from large companies parachuted in by the investors after product/market fit to scale sales and take the company public.

The VCs would hire a CEO with a track record who looked and acted like the type of CEO Wall Street bankers expected to see in large companies.

A CEO brought in from a large company came with all the big company accoutrements – org charts, HR departments with formal processes and procedure handbooks, formal waterfall engineering methodology, sales compensation plans, etc. — all great things when you are executing and scaling a known business model. But the CEO’s arrival meant the days of the company as a startup and its culture of rapid innovation were over.

Board Control
For three decades (1978-2008), investors controlled the board. This era was a “buyer’s market” – there were more good companies looking to get funded than there were VCs. Therefore, investors could set the terms. A pre-IPO board usually had two founders, two VCs and one “independent” member. (The role of the independent member was typically to tell the founding CEO that the VCs were hiring a new CEO.)

Replacing the founder when the company needed to scale was almost standard operating procedure. However, there was no way for founders to share this information with other founders (this was life before the Internet, incubators and accelerators). While to VCs this was just a necessary step in the process of taking a company public, time and again first-time founders were shocked, surprised and angry when it happened. If the founder was lucky, he got to stay as chairman or CTO. If he wasn’t, he told stories of how “VCs stole my company.”

To be fair there wasn’t much of an alternative. Most founders were woefully unequipped to run companies that scaled.  It’s hard to imagine, but in the 20th century there were no startup blogs or books on startups to read, and business schools (the only places teaching entrepreneurship) believed the best thing they could teach startups was how to write a business plan. In the 20th century the only way for founders to get trained was to apprentice at another startup. And there they would watch the canonical model in action as an experienced executive replaced the founder.

Technology Cycles Measured in Years
Today, we take for granted new apps and IoT devices appearing seemingly overnight and reaching tens of millions of users – and just as quickly falling out of favor. But in the 20th century, dominated by hardware and software, technology swings inside an existing market happened slowly — taking years, not months. And while new markets were created (i.e. the desktop PC market), they were relatively infrequent.

This meant that disposing of the founder, and the startup culture responsible for the initial innovation, didn’t hurt a company’s short-term or even mid-term prospects.  A company could go public on its initial wave of innovation, then coast on its current technology for years. In this business environment, hiring a new CEO who had experience growing a company around a single technical innovation was a rational decision for venture investors.

However, almost like clockwork, the inevitable next cycle of technology innovation would catch these now-public startups and their boards by surprise. Because the new CEO had built a team capable of and comfortable with executing an existing business model, the company would fail or get acquired. Since the initial venture investors had cashed out by selling their stock over the first few years, they had no long-term interest in this outcome.

Not every startup ended up this way. Bill Hewlett and David Packard got to learn on the job. So did Bob Noyce and Gordon Moore at Intel. But the majority of technology companies that went public circa 1979-2009, with professional VCs as their investors, faced this challenge.

Founders in the Driver’s Seat
So how did we go from VCs discarding founders to founders now running large companies? Seven major changes occurred:

  1. It became OK to go public or get acquired without profit (or even revenue)

In 1995 Netscape changed the rules about going public. A little more than a year old, the company and its 24-year-old founder hired an experienced CEO, but then did something no other tech company had ever done – it went public with no profit. Laugh all you want, but at the time this was unheard of for a tech company. Netscape’s blow-out IPO launched the dot-com boom. Suddenly tech companies were valued on what they might someday deliver. (Today’s version is Tesla – now more valuable than Ford.)

This means that liquidity for today’s investors often doesn’t require the long, patient scaling of a profitable company. While 20th century metrics were revenue and profit, today it’s common for companies to get acquired for their user base. (Facebook’s ~$20 billion acquisition of WhatsApp, a 5-year-old startup that had $10 million in revenue, made no sense until you realized that Facebook was paying to acquire 300 million new users.)

2.     Information is everywhere
In the 20th century learning the best practices of a startup CEO was limited by your coffee bandwidth. That is, you learned best practices from your board and by having coffee with other, more experienced CEOs. Today, every founder can read all there is to know about running a startup online. Incubators and accelerators like Y-Combinator have institutionalized experiential training in best practices (product/market fit, pivots, agile development, etc.); provide experienced and hands-on mentorship; and offer a growing network of founding CEOs. The result is that today’s CEOs have exponentially more information than their predecessors. This is ironically part of the problem. Reading about, hearing about and learning about how to build a successful company is not the same as having done it. As we’ll see, information does not mean experience, maturity or wisdom.

3.     Technology cycles have compressed
The pace of technology change in the second decade of the 21st century is relentless. It’s hard to think of a hardware/software or life science technology that dominates its space for years. That means new companies are at risk of continuous disruption before their investors can cash out.

To stay in business in the 21st century, startups  do four things their 20th century counterparts didn’t:

  • A company is no longer built on a single innovation. It needs to be continuously innovating – and who best to do that? The founders.
  • To continually innovate, companies need to operate at startup speed and cycle time much longer their 20th century counterparts did. This requires retaining a startup culture for years – and who best to do that? The founders.
  • Continuous innovation requires the imagination and courage to challenge the initial hypotheses of your current business model (channel, cost, customers, products, supply chain, etc.) This might mean competing with and if necessary killing your own products. (Think of the relentless cycle of iPod then iPhone innovation.) Professional CEOs who excel at growing existing businesses find this extremely hard.  So who best to do it? The founders.
  • Finally, 20th century startups fired the innovators/founders when they scaled. Today, they need these visionaries to stay with the company to keep up with the innovation cycle. And given that acquisition is a potential for many startups, corporate acquirers often look for startups that can help them continually innovate by creating new products and markets.

4.     Founder-friendly VCs
A 20th century VC was likely to have an MBA or finance background. A few, like John Doerr at Kleiner Perkins and Don Valentine at Sequoia, had operating experience in a large tech company, but none had actually started a company. Out of the dot-com rubble at the turn of the 21st century, new VCs entered the game – this time with startup experience. The watershed moment was in 2009 when the co-founder of Netscape, Marc Andreessen, formed a venture firm and started to invest in founders with the goal of teaching them how to be CEOs for the long term. Andreessen realized that the game had changed. Continuous innovation was here to stay and only founders – not hired execs – could play and win.  Founder-friendly became a competitive advantage for his firm Andreessen Horowitz. In a seller’s market, other VCs adopted this “invest in the founder” strategy.

5.     Unicorns Created A Seller’s Market
Private companies with market capitalization over a billion dollars – called Unicorns – were unheard of in the first decade of the 21st century. Today there are close to 200. VCs with large funds (~>$200M) need investments in Unicorns to make their own business model work.

While the number of traditional VC firms have shrunk since the peak of the dot com bubble, the number of funds chasing deals have grown. Angel and Seed Funds have usurped the role of what used to be Series A investments. And in later stage rounds an explosion of corporate VCs and hedge funds now want in to the next unicorns.

A rough calculation says that a VC firm needs to return four times its fund size to be thought of as a great firm. Therefore, a VC with a $250M fund (5x the size of an average VC fund 40 years ago) would need to return $1 billion. But VCs own only ~15% of a startup when it gets sold/goes public (the numbers vary widely). Just doing the math, $1 billion/15% means that the VC fund needs $6.6 billion of exits to make that 4x return. The cold hard math of “large funds need large exits” is why VCs have been trapped into literally begging to get into unicorn deals.

6.    Founders Take Money Off the Table
In the 20th century the only way the founder made any money (other than their salary) was when the company went public or got sold. The founders along with all the other employees would vest their stock over 4 years (earning 1/48 a month). They had to hang around at least a year to get the first quarter of their stock (this was called the “cliff”).  Today, these are no longer hard and fast rules. Some founders have three-year vesting. Some have no cliff. And some have specific deals about what happens if they’re fired, demoted or the company is sold.

In the last decade, as the time startups have spent staying private has grown longer, secondary markets – where people can buy and sell pre-IPO stock — have emerged. This often is a way for founders and early employees to turn some of their stock into cash before an IPO or sale of company.

One last but very important change that guarantees founders can cash out early is “founder friendly stock.”  This allows founder(s) to sell part of their stock (~10 to 33%) in a future round of financing. This means the company doesn’t get money from new investors, but instead it goes to the founder.  The rationale is that since companies are taking longer to achieve liquidity, giving the founders some returns early makes them more willing to stick around and better able to make bets for the long-term health of the company.

7.   Founders take Control of the Board
With more VCs chasing a small pool of great deals, and all VCs professing to be the founder’s best friend, there’s an arms race to be the friendliest. Almost overnight the position of venture capitalist dictating the terms of the deal has disappeared (at least for “hot” deals).

Traditionally, in exchange for giving the company money, investors would receive preferred stock, and founders and employees owned common stock. Preferred stock had specific provisions that gave investors control over when to sell the company or take it public, hiring and firing the founder etc.  VCs are giving up these rights to get to invest in unicorns.

Founders are taking control of the board by making the common stock the founders own more powerful. Some startups create two classes of common stock with each share of the founders’ class of common stock having 10 – 20 votes. Founders can now outvote the preferred stock holders (the investors). Another method for founder control has the board seats held by the common shareholders (the founders) count 2-5 times more than the investors’ preferred shares. Finally, investors are giving up protective voting control provisions such as when and if to raise more money, the right to invest in subsequent rounds, who to raise it from and how/when to sell the company or take it public. This means liquidity for the investors is now beholden to the whims of the founders. And because they control votes on the board, the founders can’t be removed. This is a remarkable turnabout.

In some cases, 21st century VCs have been relegated to passive investors/board observers.

And this advent of founders’ control of their company’s board is a key reason why many of these large technology companies look like they’re out of control.  They are.

The Gift/Curse of Visionary CEOs
Startups run by visionaries break rules, flout the law and upend the status quo (Apple, Uber, AirBnB, Tesla, Theranos, etc.). Doing something that other people consider insanity/impossible requires equal parts narcissism and a messianic view of technological transformation.

Bad CEO behavior and successful startups have always overlapped. Steve Jobs, Larry Ellison, Tom Seibel, etc. all had the gift/curse of a visionary CEO – they could see the future as clearly as others could see the present. Because they saw it with such clarity, the reality of having to depend on other people to build something revolutionary was frustrating. And woe to the employee who got in their way of delivering the future.

Visionary CEOs have always been the face of their company, but today with social media, it happens faster with a much larger audience; boards now must consider what would happen to the valuation of the company without the founder.

With founders now in control of unicorn boards, with money in their pockets and the press heralding them as geniuses transforming the world, founder hubris and bad behavior should be no surprise.  Before social media connected billions of people, bad behavior stayed behind closed doors. In today’s connected social world, instant messages and shared videos have broken down the doors.

The Revenge of the Founders – Founding CEOs Acting Badly
So why do boards of unicorns like Uber, Zenefits, Tanium, Lending Club let their CEOs stay?

Before the rapid rise of Unicorns, when boards were still in control, they “encouraged” the hiring of “adult supervision” of the founders. Three years after Google started they hired Eric Schmidt as CEO. Schmidt had been the CEO of Novell and previously CTO of Sun Microsystems. Four years after Facebook started they hired Sheryl Sandberg as the COO. Sandberg had been the vice president of global online sales and operations. Today unicorn boards have a lot less leverage.

  1. VCs sit on 5 to 10 or more boards. That means most VCs have very little insight into the day-to-day operation of a startup. Bad behavior often goes unnoticed until it does damage.
  2. The traditional checks and balances provided by a startup board have been abrogated in exchange for access to a hot deal.
  3. As VC incentives are aligned to own as much of a successful company as possible, getting into a conflict with a founder who can now prevent VC’s from investing in the next round is not in the VCs interest.
  4. Financial and legal control of startups has given way to polite moral suasion as founders now control unicorns.
  5. As long as the CEO’s behavior affects their employees not their customers or valuation, VCs often turn a blind eye.
  6. Not only is there no financial incentive for the board to control unicorn CEO behavior, often there is a downside in trying to do so

The surprise should not be how many unicorn CEOs act badly, but how many still behave well.

Lesson Learned

  • VC/Founder relationship have radically changed
  • VC “Founder Friendly” strategies have helped create 200+ unicorns
  • Some VC’s are reaping the downside of the unintended consequences of “Founder Friendly”
  • Until the consequences exceed the rewards they will continue to be Founder Friendly

How companies strangle innovation – and how you can get it right


A shorter version of this post first appeared on the HBR blog

I just watched a very smart company try to manage innovation by hiring a global consulting firm to offload engineering from “distractions.” They accomplished their goal, but at a huge, unanticipated cost: the processes and committees they designed ended up strangling innovation.

There’s a much better way.

An existing company or government organization is primarily organized for day-to-day execution of its current business processes or mission. From the point of view of the executors, having too many innovation ideas gets in the way of execution.

The Tidal Wave of Unfiltered Ideas
Pete Newell and I were working with a company that was getting its butt kicked from near-peer competitors as well as from a wave of well-funded insurgent startups. This was a very large and established tech company; its engineering organization developed the core day-to-day capabilities of the organization. Engineering continually felt overwhelmed. They were trying to keep up with providing the core services necessary to run the current business and at the same time deal with a flood of well-meaning but uncoordinated ideas about new features, technologies and innovations coming at them from all directions. It didn’t help that “innovation” was the new hot-button buzzword from senior leadership, and incubators were sprouting in every division of their company, it just made their job more unmanageable.

One of the senior engineering directors I greatly admire (who at one time or another had managed their largest technology groups) described the problem in pretty graphic terms:

The volume of ideas creates a denial of service attack against capability developers, furthers technical debt, and further encumbers the dollars that should be applied towards better innovation.”

Essentially, the engineering organization was saying that innovation without a filter was as bad as no innovation at all. So, in response the company had hired a global consulting firm to help solve the problem. After a year of analysis and millions of dollars in consulting fees, the result was a set of formal processes and committees to help create a rational innovation pipeline. They would narrow down the proposed ideas and choose which ones to fund and staff.

Build the Wall
I took one look at the process they came up with and could have sworn that it was invented by the company’s competitors to throttle innovation.

The new innovation process had lots of paperwork – committees, application forms and presentations, and pitches. People with ideas, technology or problems pitched in front of the evaluation committee. It seemed to make sense to have have all the parties represented at the committee, so lots of people attended – program managers who controlled the budget, the developers responsible for maintaining and enhancing the current product and building new ones, and representatives from the operating divisions who needed and would use these products. Someone with an idea would fill out the paperwork justifying the need for this innovation, it would go to the needs committee, and then to an overall needs assessment board to see if the idea was worth assigning people and budget to. And oh, since the innovation wasn’t in this year’s budget, it would only get started in the next year.


As you can guess in the nine months this process has been in place the company has approved no new innovation initiatives. But new unbudgeted and unplanned threats kept emerging at a speed their organization couldn’t respond to.

At least it succeeded in not distracting the developers.

This was done by smart, well-intentioned adults thinking they were doing the right thing for their company and consultants who thought this was great innovation advice.

What went wrong here? Three common mistakes.

First, this company (and most others) viewed innovation as unconstrained activities with no discipline. In reality for innovation to contribute to a company or government agency, it needs to be designed a process from start to deployment.

Second, the company had not factored in that their technology advantage attrited every year, and new threats would appear faster than their current systems could handle. Ironically, by standing still, they were falling behind.

Third, this company had no formal innovation pipeline process before proposals went to the committee. Approvals tended to be based on who had the best demo and/or slides or lobbied the hardest. There was no burden on those who proposed a new idea or technology to talk to customers, build minimal viable products, test hypotheses or understand the barriers to deployment. The company had a series of uncoordinated tools and methodologies as activities, but nothing to generate evidence to refine the ideas, technology or problems as an integrated innovation process (though they did have a great incubator with wonderful coffee cups). There were no requirements for the innovator. Instead the process dumped all of these “innovations” onto well-intentioned, smart people sitting in a committee who thought they could precompute whether these innovation ideas were worth pursuing.

An Innovation Process and Pipeline
What the company needed was a self-regulating, evidence-based innovation pipeline. Instead of having a committee vet ideas, they needed a process that operated with speed and urgency, and innovators and stakeholders who curated and prioritized their own problems/idea/technology.

All of this would occur before any new idea, tech or problem hit engineering. This way, the innovations that reached engineering would already have substantial evidence – about validated customer needs, processes, legal, security and integration issues identified — and most importantly, minimal viable products and working prototypes already tested. A canonical Lean Innovation process inside a company or government agency would look something like this:

As the head of the U.S. Army’s Rapid Equipping Force, Pete Newell built a battle-tested process to get technology solutions deployed rapidly. This process, called Curation, gets innovators to work through a formal process of getting out of their offices and understanding:

Internal and External Survey

  • Other places the problem might exist in a slightly different form
    • Internal projects already in existence
    • Commercially available solutions
  • Legal issues
  • Security issues
  • Support issues

Use Cases/Concept of Operations

  • Who are the customers? Stakeholders? Other players?
  • How did they interact? Pains/Gains/Jobs to be done?
  • How does the proposed solution work from the viewpoint of the users?
  • What would the initial minimal viable products (MVPs) – incremental and iterative solutions – look like?

In the meantime, the innovators would begin to build initial minimal viable products (MVPs) – incremental and iterative tests of key hypotheses. Some ideas will drop out when the team itself recognizes that they may be technically, financially or legally unfeasible or they may discover that other groups have already built a similar product.

One of the quickest ways to sort innovation ideas is to use the McKinsey Three Horizons Model. Horizon 1 ideas provide continuous innovation to a company’s existing business model and core capabilities. Horizon 2 ideas extend a company’s existing business model and core capabilities to new customers, markets or targets. Horizon 3 is the creation of new capabilities to take advantage of or respond to disruptive opportunities or disruption. And we added a new category, Horizon 0, which defers or graveyards ideas that are not viable or feasible.

At the end of this prioritization step, the teams meet another milestone: is this project worth pursing for another few months full time? A key concept of prioritization across all horizons is that this ranking is not done by a remote committee, but by the innovation teams themselves as an early step in their discovery process.

Solution Exploration/Hypotheses Testing
The ideas that pass through the prioritization filter enter an I-Corps incubation process. I-Corps was adopted by all U.S. government federal research agencies to turn ideas into products. Over a 1,000 teams of our country’s best scientists have gone through the program taught in over 50 universities. (Segments of the U.S. Department of Defense and Intelligence community have also adopted this model as the Hacking for Defense process.)

This six- to ten-week process delivers evidence for defensible, data-based decisions. It tests the initial idea against all the hypotheses in a business model (or for the government, the mission model) canvas. This not only includes the obvious — is there product/market (solution/mission) fit? — but the other “gotchas” that innovators always seem to forget. The framework has the team talking not just to potential customers but also with regulators, and people responsible for legal, policy, finance, support. It also requires that they think through compatibility, scalability and deployment long before this gets presented to engineering. There is now another major milestone for the team: to show compelling evidence that this project deserves to be a new mainstream capability and inserted into engineering. Or does it create a new capability that could be spun into its own organization? Or does the team think it should be killed?

Once hypothesis testing is complete, many projects will still need a period of incubation as the teams championing the projects need to gather additional data about the application as well as may need to mature as a team before they are ready to integrate with a horizon 1 engineering organization or product division. Incubation requires dedicated leadership oversight from the horizon 1 organization to insure the fledgling project does not die of malnutrition (a lack of access to resources) or become an orphan (no parent to guide them).

Trying to integrate new, unbudgeted and unscheduled Horizon 1 and 2 innovation projects into an engineering organization that has line item budgets for people and resources results in chaos and frustration. In addition, innovation projects not only carry technical debt, but also organizational debt.

Technical debt describes what happens when software or hardware is built quickly to validate hypotheses and find early customers. This quick and dirty development results in software that can become unwieldy, difficult to maintain and incapable of scaling. Organizational debt is all the people/culture compromises made to “just get it done” in the early stages of an innovation project. You clean up technical debt through refactoring, by going into the existing code and restructuring it to make the code stable and understandable. You fix organizational debt by refactoring the team, realizing that most of the team who built and validated a prototype may not be the right team to take it to scale but is more valuable starting the next innovation initiative.

Often when an innovation pipeline runs head-on into a process-driven execution organization, chaos and finger-pointing ensues and adoption of new projects stall. To solve this problem we acknowledge that innovation projects will need to refactor both technical and organizational debt to become a mainstream product/service. To do so, the innovation pipeline has engineering set up a small refactoring organization to move these validated prototypes into production. In addition, to solve the problem that innovation is always unscheduled and unbudgeted, this group has a dedicated annual budget.

Disruptive Products
Some products and services going through the pipeline create new capabilities or open new markets. These Horizon 3 disruptive innovations need to separate from the existing development organizations and be allowed to grow and develop in physically separate spaces. They need the support and oversight of the CEO.

Fast forward a year, and slowly, like turning a supertanker, the innovation pipeline we proposed is taking shape. The company has adopted Lean language and process: curation, prioritization, three horizons, I-Corps – business/mission model canvas, customer development and agile engineering.

Lessons Learned

  • Every large company and government agency is dealing with disruption
  • Most have concluded that “business as usual” can’t go on
  • Yet while the top of the organization gets it, and the innovators on the bottom get it, there has been no relief for the engineering groups trying to keep the lights on
  • Innovation isn’t a single activity; it is a process from start to deployment
  • In “execution engines,” committees and broad stakeholder involvement make sense because experience, knowledge, and data from the past allow better decision-making
  • In “innovation engines” there isn’t the data to decide between competing ideas/projects (since nobody’s been in the future), so the teams need to gather facts outside their cubicle or building quickly
  • A self-regulating, evidence-based Lean Innovation process will deliver continuous innovation and disruptive breakthroughs with speed and urgency

Free Reprints of “Why the Lean Startup Changes Everything”

The Harvard Business Review is offering free reprints of  the May 2013 cover article, “Why the Lean Startup Changes Everything

Available here

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