I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Sunday, November 30, 2014

The CIO and M&A, Part I

"It is hard not to be cynical about this. M&A is a great process for creating fees for bankers, and for destroying the value held by shareholders."

-- John Authers, writing in the Financial Times

Industries tend to go through waves of deal-making. Sometimes it is divestiture or separation: sprawling firms that serve different buyers or markets don't achieve much in the way of operating efficiency, and a "conglomerate discount" priced into their equity means there is value that can be released by dividing a firm into multiple businesses. This is something H-P did in the late 1990s, and is about to do again. But usually, deals are acquisitions: competitors merge to gain more power over costs and prices (United Airlines merging with Continental); large firms acquire smaller ones to enhance their core (Yahoo has been on an acquisition tear in recent years), diversify their markets, or simply to prevent a firm from falling into the hands of competitors (Microsoft's acquisition of Skype).

The justification for a merger or acquisition usually involves some quantification of synergistic benefit: the two businesses have so much in common they can achieve greater profitability together far sooner than they would be able to on their own. This can be achieved through sales: Company A and Company B sell complimentary products to the same buyers; a merger of the two would allow for cross selling, resulting in larger and more lucrative sales. It can also be achieved through operating efficiencies: Company A and Company B can operate just as effectively with, say, 70% or less of their combined procurement, finance, accounting, HR and IT organizations.

The expected synergistic benefits to revenue and costs are calculated, then taxed and capitalized, to come up with a hard economic value to doing a deal. This makes them important to the CEOs involved because they help them sell their respective boards - and shareholders - on doing a deal. Their importance increases in direct proportion to the premium an acquirer is willing to pay to buy another firm. Synergies can be substantial: the proposed synergies of the merger between Office Max and Office Depot exceeded the combined market capitalization of the two firms.

* * *

"Most deals fail to create value because the buyer paid too much, or because the acquirer failed in the difficult task of sticking two companies together. Glossy proclamations of new strategic visions often boil down to a prosaic cost-cutting exercise, or into a failure of implementation."

IT is at the center of deal synergy. Obviously, we don't want to pay to maintain multiple e-Commerce sites or pay licensing fees for multiple ERP systems. But redundant IT systems can increase the cost of doing business: if we need people in finance to write custom reports to combine financial reporting across the two businesses, the merger has increased our total cost of operations. We need to combine systems, and do so quickly.

There are plenty of cookie-cutter frameworks for combining businesses, even their technology systems and operations. This also means there are plenty of platitudes to go round: "Involve the CIO as part of the executive team from the start" and "IT doesn't work in isolation". True, but not very helpful. Rubber hits the road in M&A in the actual combination - and reduction - of systems. Platitudes will not change an ugly operating reality.

IT in M&A can be a very messy business. For example, suppose Company A acquires Company B and intends to move Company B - running a highly customized & partially proprietary ERP - over to Company A's similarly customized, but commercial-off-the-shelf, ERP system. Company B has very different business processes and communication channels from Company A. The new divisional leader for that part of the combined company is from Company B and decides he wants those processes applied to the combined business. IT must now make changes to Company A's ERP system and dependent code to accommodate this change, in addition to migrating data. Costs just went up and the consolidation timeline just got longer - and depending on your point of view, it looks like an IT problem.

This also applies to the mundane stuff. For example, IT learns that the data and data structures in Company B don't exactly line up with Company A, so data migration is going to take more effort than originally expected. IT responds by creating data warehouses to house consolidated data so that Finance can run its consolidated reports. Costs just went up, as did operational complexity: those warehouses - and the ETL that refreshes them - have to be maintained and updated.

When companies pay a premium to fair value of net assets for a business they acquire, the excess is recorded on the balance sheet as goodwill. In theory, the value of the combined business should increase as synergies are realized, obviating the need for goodwill. The reality - and core to Mr. Auther's comments above - is that companies have a tendency to pay too much in acquisitions and end up taking a writedown. One study found that between 2003 and 2009, some 4,600 firms wrote-down goodwill due to impairment, amounting to 20% of total recorded goodwill. The study went on to report that there are some serious ramifications to this. For one thing, "the news of goodwill write-off [...] precede[s] CEO resignation and can trigger shareholder lawsuit." For another, "Firms with goodwill write-offs significantly under-perform in future." (Feng Gu, Goodwill and Goodwill Write-off: Economic and Accounting Implications)

So, in a M&A situation, there's a lot on the line for the CIO: you don't want to be the reason the boss loses his job, and you don't want to be a reason why the stock price underperforms. But your operating reality is messy: you're beholden to tribal knowledge of systems you've inherited through the acquisition, you're at the mercy of business decisions that are made for local optimization or simply local convenience, and you're under the gun to enable finance and accounting to create the patina of a combined business for the benefit of the people who approved the deal. As CIO, you'll be under pressure to extend and even bump your payroll to prevent loss of knowledge, create teams to chase business decisions with new software, and take on technical and operational debt to make good on immediate needs.

There is no playbook for this.

Next month, we'll look at how a CIO can square this circle.

Friday, October 31, 2014

Can a Business Rent a Core Capability?

Tech utilities - things that automate administration, enable communication or improve employee productivity - started as a labor expense, became a capital expense, and have now become a rent payment. This final state is an efficient economic relationship for buyer and seller. The buyer has more flattering financial statements and can negotiate for non-core services at a gross level (e.g., a single cost per employee). The seller's income is the rent they can extract from buyers. Utility sellers tend to enjoy monopolistic or oligopolistic market conditions, but there is still room for optimization and even disruption that drives prices down.

But disruptive tech is not a utility. It needs to be developed, and developing it requires a capability in technology (design, coding, testing, etc.) In recent years the trend has been toward renting that capability rather than owning it. This begs a question: can we rent the capability needed to deliver disruptive tech? If today's disruptive tech becomes tomorrow's status quo, doesn't that mean it needs to be part of a firm's core competency?

Two significant factors stand out when considering this question: the state of evolution of the (would-be) disruptive tech, and the extent to which it is genuinely disruptive.

Let's look at the latter part - the extent of disruption - first. New technologies disrupt by creating new behaviours and expectations among its users. In the process, it siphons market share by shifting market participants from one activity to another. Obtaining a book changed from making a trip to a bookstore to an online purchase that triggered a package shipment to an electronic distribution. Social media is a form of entertainment that shifts people's allocation of their leisure time.

Creating new behaviours is more disruptive than being the first to apply technologies established in one market segment into another: streaming video to personal technology on airplanes is interesting, and doubtless it will allow airlines to eliminate in-seat entertainment systems that add weight and burn jet fuel, but it brings established behaviours into a different context. Still, this is more disruptive than developing technologies that mimic existing functionality in the same segment: being late to the game with a "me, too" strategy does not generate much in the way of behaviour change.

With this in mind, let's consider the other dimension, the state of evolution of that technology: is it in research, is it an arms race, or is it a mature solution?

A company investigating a disruptive technology for its potential doesn't have to own the means by which it does that investigation. An exploratory investment is generally developed rapidly and deployed frequently to accelerate the rate of exploration. The differentiating value of effective exploration are speed, adaptability, and the ability to interpret the feedback from the experiment. It may succeed, or be a mild success, or be a complete bust. It's safe to rent as this is a non-operating capability. That a firm does this suggests the firm in question is slow growth and run for efficiency and lacks an R&D capability, but this describes a lot of firms: oil majors have separated into refiners and E&P, and pharma firms have similarly split into generics and growth / R&D firms.

However, a disruptive technology that rapidly gains adoption must become a core competency, and quickly at that. This is a phase when a firm is learning new rules for competition. Firms must learn what works and what doesn't (what we do and don't do), and what matters and what doesn't (what we measure and pay attention to, and what is just a distraction). Successful firms have to rapidly master new business operations under the pressure of scale and growth. Success is equal parts business and tech: the business is changing and the tech is brand new. Renting the tech capability puts a company at a disadvantage because it will not develop core competencies, fundamental skills, communication patterns, and organizational leaders critical to it's "new normal". In a tech arms race, it's not safe to rent.

The extent of disruption determines impacts the feasibility of renting. It is safer to rent capability where the tech follows established patterns. When a firm consumes established technologies to create products and solutions for a specific vertical, there is greater value in the business knowledge because the tech contributes less value to the solution. This makes it safer to rent the tech capability. The less disruptive, the less the risk: there's little point in owning a capability with a mission to mimic somebody else's tech.

Of course, the economics of renting or owning are muddled by other market forces. A start-up compensating employees with equity is not paying market value for its labor and is therefore renting, similar to how a lender owns a house that a borrower lives in. And tech buyers have no choice but to rent tech labor from services firms because of labor scarcity.

A company might have to rent because of prevailing labor market conditions, or because renting gives it a shot-in-the-arm that allows it to catch up when it is caught unprepared by a technology shift. But as Machiavelli counseled, one holds conquered territory with one's own forces, not mercenaries. A company has to own its core.

Tuesday, September 30, 2014

Tech: From Owning to Renting - to Owning Again?

In the 1970s, the predominant business strategy was vertical integration: own the value chain from raw materials to retail outlets. The research of the time supported this. The Profit Impact of Market Strategy database produced by the Strategic Planning institute concluded that diverse & vertically integrated businesses were significantly more profitable than narrow and focused businesses (PIMS 1977, slide 67). Michael Porter argued in Competitive Strategy that vertical integration enabled cost leadership, which was more likely to win market share than a strategy of differentiation. Vertical integration also created a barrier to entry to competitors, and provided defense against powerful buyers & suppliers and the threat of substitutes (Porter 1980, pages 9-15, 35-37). Corporate strategies assumed long-term existence and growth; this made employer-employee relationships more durable, so a firm could be a destination employer for people across a diverse range of roles. Companies like American Telephone & Telegraph and General Electric could pursue diversification and vertical integration in no small part because they could be all things to all people.

Business strategy changed in the 1990s, insisting that companies were better off focusing on "core competencies" while renting anything deemed non-core. A retailer, for example, should concentrate on sourcing merchandise to sell and developing the outlets through which to sell it, but rent the accountants, IT, back-office staff and real estate to operate and administrate the business. The thinking was that a firm could not be expert at doing everything, it would have cost bloat in non-core areas and lack the expertise to contain it, and that firms needed to pay ruthless attention to their core as competition would only intensify. It also became accepted that a firm could not be a destination employer for non-core employees and therefore could not expect to be attractive to top flight people across the board. Outsourcing for business and technology services reduced the number of employees and associated costs, allowed significant operating costs to be negotiated on a gross basis rather than an individual one, and made labor arbitrage accessible to firms for which it would have been too risky and difficult to pursue by themselves.

This change happened quickly. Perceptions of corporate durability imploded in less than a decade through consolidation (increase in M&A) and bankruptcy (over-leveraged with junk-grade debt and unable to make debt service payments). This eroded the employer-employee relationship and made any single firm less broadly appealing. Kodak outsourced IT to IBM in 1989, ushering in large-scale IT outsourcing that fueled the rapid growth of firms like Accenture and TCS over the ensuing two decades. GE created a business process outsourcer - Genpact - in the late 1990s, spinning them off as an independent company within 10 years. Firms separated asset ownership from asset usage, creating holding companies that own the real estate and rent it to subsidiaries that run business that occupy it. In a relatively short span of time, companies went from owning everything and renting nothing, to owning little and renting everything, with lots of financial intermediaries springing up to minimize tax burdens and squeeze rents.

In technology, cloud computing extends this story arc. Prior to the advent of computers, business was labor intensive. When companies first invested in computer technology by buying mainframes and hiring programmers, they did so to create efficiencies in their administrative operations. Companies reduced their labor expense, and the hardware and software they acquired appeared on the balance sheet as capital investments in the business. In the process, they also made business application development a "core competency" of their business. Within 40 years, most of those administrative processes were standardized by commercial-off-the-shelf ERP products. But that ERP solution still appeared as an asset on the balance sheet because software licenses, customization, and server infrastructure were capitalized assets of the firm, even if the people who led the customization and implementation were rented and not employees.

This is beginning to change. Cloud, Saas, and BYOD allow firms to rent technology rather than own it. As businesses have consumed increasing amounts of computer technology over the years - communication tools, productivity tools, business administrative software, servers, routers and end-user devices - company balance sheets have become increasingly "tech asset heavy". Renting makes their balance sheets "tech asset light". Rent payments put a dent in cash flow from operations, and the cost of renting can be higher than the cost of owning. However, renting improves performance ratios such as "return on assets" and "capital intensity". This flatters the CEO and the CFO.

Early computer technology transferred labor intensity of business activity (lots of clerks on the payroll, performing manual chores) to capital intensity (computers & software automating these chores, booked as capital assets), but it was still accounted for as something the business owned rather than rented. Cloud, SaaS and BYOD will drive out the lingering capital intensity by shifting the technology assets from "own" to "rent". A business still has costs associated with these things (it has to generate invoices and collect from customers), but as the underlying functions become more and more commoditized they offer no strategic advantage, and are instead treated as a tax on doing business. There is still room for innovation - new firms will emerge to offer new ways of providing these services to minimize this "tax" - but these are commodity offerings competing in a race to the bottom on price.

Businesses originally owned their tech capability, because that was the prevailing way that businesses operated, computers and computer skills were scarce, and firms derived significant competitive advantage from being early adopters. That changed because strategic thinking changed, technology became commonplace, and a lot of business technology became utilitarian. But what's true for utility tech is not true for disruptive tech, that is, tech that disrupts business models. Businesses are no longer consumers of tech, they are becoming tech. If every firm is a software firm, does technology need to return to the core? Will the business practices that developed and evolved with renting be adaptable, irrelevant, or an outright encumbrance? We'll look at those questions in the next post.

Sunday, August 31, 2014

Why Commercial Contracts Matter In Agile Software Development

"We value customer collaboration over contract negotiation." -- The Agile Manifesto

Contracts for software development have historically included language that specifically defines the software being developed. This protects the buyer from paying for an asset that does not serve its business needs, the seller from requirements drift or expansion, and allows both parties to agree to duration and cost.  Traditional development contracts also stipulate the process by which the software is to be developed and tested, and how changes will be accommodated.  Since the way something is produced has direct bearing on the quality of what gets produced, specifying the process protects the buyer from slipshod work practices, and gives the seller a formal framework to control the development lifecycle.  The parties are trading a long-dated asset for a series of short-dated cash flows; being specific about the work being produced and the means of production is a means of protecting each party's economic interests throughout.

But with Agile becoming more and more widespread, contracts that stipulate requirements, team composition and change control processes lock both buyer and seller into a commercial arrangement that is an encumbrance (requiring constant amendment to accommodate changes) and may actually interfere with delivery.  Agile development requires more flexible contracting.  So it comes little surprise that a core tenet of the Agile manifesto is that people involved in developing software should constructively collaborate with one another to deliver a valuable business asset, not conform to a strict protocol that defines allowable behaviours.

The rigidity of traditional contracts has led firms in the Agile development business to experiment with looser contractual language.  In principle, this makes sense.  Agile teams deliver more frequently, so the lag between the buyer's cash and the seller's delivery isn't as great as it is with traditional software development.  Frequent showcases and deliveries improve trust and confidence between buyer in seller in ways that can't be codified in the language of a contract.  The benefit of looser language is that as teams learn more about the actual business needs and technical complexity of what they are developing, they have more freedom to act (and react) as the situation warrants.  There should also be limited downside. Even if the contract is vague, a buyer won't pay if she doesn't like what the seller has produced, and a seller will suspend work if he has an unwilling or incompetent buyer.  The people involved have maximum leeway to get stuff done and they'll let each other know in the most direct means possible when they're not happy.

In place of precisely defined language, it isn't uncommon to see development contracts that capture none of the intent whatsoever, and define only a supply of an unspecified number of people for an indefinite period of time.  If the understanding ex-contract is that the seller is there to develop software for a particular purpose in a particular manner, the contract is, in theory, at best a formality and at worst takes too much time.  If the development work is treated as R&D rather than a capital investment, doing this doesn't flaunt accounting practices (which require strict definition of capital work).  And if one party is disappointed with another during development, they'll make that abundantly clear by suspending performance until they are happy.  This is the triumph of the desire to get stuff done over the formality of contract law.

"That is, while there is value in the items on the right, we value the items on the left more."

But contracts do matter.

A contract expresses the value each party places in the other and the respect they have for one another.  The preamble language defines who the parties are or think they are as an acknowledgement of the strengths that each bring to the relationship: they are disruptors ("re-imagining the classroom for the 21st century"), or market leaders ("the nation's largest provider of financial services to retirees"), or specialists ("the leading provider of software development services to municipal governments in the tri-state area").  This underscores goals of the buyer (the disruptor is buying an innovative solution; the market leader wants cost efficiencies) and the capability of the seller (technical, process or subject matter expertise) and why the two parties want to work together.  In the contract, if the buyer is just a business no different from any other, and the seller is just a provider of people, the relationship will eventually come to reflect this, too.

A contract communicates the outcome the parties are working toward.  If the buyer wants an asset, they are committing to developing an asset in conjunction with a partner, and both buyer and seller are drivers in achieving that goal.  If the buyer wants only to rent capacity from the seller, the seller will be a passenger in the buyer's goals.

A contract defines a bond between two organizations, a bond that is meant to be durable in good times and in bad.  The more closely twined buyer and seller, the more likely they are to resolve their differences and difficulties. The more disposable a relationship, the more likely one party will dispense with the other when greener pastures beckon.

We don't want contracts that are ignorant of the need for flexibility.  But convenience erodes commitment: flexibility achieved through ambiguity undermines a sense of partnership. It is better to achieve flexibility through provisions that define the parties, define the mission, and define a bond.  This creates a commitment to the principles of a relationship.

Contracts exist between companies; relationships exist among people.  A relationship will always trump what's written in a contract.  But people come and go, and relationships are constantly tested.  A contract easily exited undermines the commitment of a relationship.  Good contracts are not an encumbrance to delivery: they strengthen the commercial ecosystem through which delivery happens.

Thursday, July 31, 2014

The Fine Line Between "Stretch Role" and "Unqualified", Part II: The Growth Mask

When a business or a profession grows faster than the labor market it draws from, it suffers a capability deficiency: there simply aren't enough experienced people to go round. It also suffers a leadership deficiency: there aren't enough people with cross-discipline experience to make competent business decisions. When there are more leadership jobs than there are qualified leaders to fill them, people will be given responsibilities they would not otherwise have. Even though hiring decisions are made independently, macro forces can be responsible for people landing in stretch roles.

Volume Cures All Ills

Growth - be it a function of runaway demand or insatiable investor appetite - increases a business' tolerance for leaders who are coming to terms with their responsibilities. In no small part, this is because the performance of a rapidly growing businesses can be difficult to measure, while its business decisions - most importantly, where they concern cash - are blatantly obvious.

For example, early stage tech businesses tend to lack revenue and profitability but attract increasing numbers of users. They are measured on indicators such as total number of user accounts and number of active users. These are non-financial measures that are calculated differently across firms (e.g., a single person may have multiple accounts, while "active" is a relative term), making comparisons difficult. Because there is little history of tracking these types of metrics in business, it isn't clear how they truly relate to the long-term valuation of a business. Although the performance measures of a growth firm in an emergent industry are a bit foggy, the business decisions are crystal clear. The most important decision - what to do with cash - is cut and dried: plow it back into the business to fuel growth.

By comparison, well established businesses in industries like air travel or retail banking are expected to be predictable. They are meticulously measured on established accounting metrics such as earnings and cash flow, measures that are easy to understand and comparable within and across industries. But their business decisions - again, particularly those to do with cash distribution - are more complex: do we invest in the core for efficiency, diversify for growth, or distribute cash to shareholders? Stakeholders - employees, investors, customers - in a growing business will be tolerant of novice leadership; stakeholders in a mature one will not.

By way of example, social media firms had the benefit of time to adjust their products to be mobile centric rather than desktop centric. Although the chattering classes raised concerns, the total growth of social media prevented a sense of crisis from cratering equity values or inciting mass employee exodus. In contrast, retail firms haven't been so fortunate: ecommerce cannibalizes existing retail sales more than it increase them (to wit: Amazon's growth in retail has come substantially to the detriment of traditional retailers). Retail firms are not seeing their businesses grow rapidly because of technology, they're seeing their businesses change underneath them because of it. These firms don't have an abundance of time because their core businesses are vulnerable to rapid erosion. They are far less tolerant to leaders learning their trade.

Growth Makes Everybody Look Good

Although growth make it safer for people in stretch roles, they also make everybody look good, deservedly or not. The greater the success achieved by multiple businesses in the same sector, the less clear the contribution of the leadership to any firm's success. A rising tide simply lifts all boats. As Jeff Immelt famously quipped about commercial conditions during the 1990s: "A dog could have run a business".

Too often, we never really know the difference between a savvy business leader and person who simply got lucky. Many years ago, I sat on a panel with a renoun dot-com investor who had retained his fortune post-bubble by getting out just in time. Prima facie, he appeared to be the sage of Silicon Valley. On interrogation, it turned out that he'd cashed out several investments to free capital for a new round of leveraged bets on internet businesses, just as the bottom fell out of dot-com equities. He happened to be out of the market at precisely the right moment because he hadn't finished negotiating his new placements. It wasn't deep market insight that enabled him to call the market peak: he intended to be long the entire time, and was short only because dumb luck that had him cash out and head to the sidelines at just the right moment. The only sage advice he was qualified to give was to "be in the right place at the right time".

What If Everybody is Stretching?

In overheated sectors, we can easily end up with leadership teams who are reaching beyond their capability. The more the froth on the business, the more concern there is with fast action and the less concern there is with meaningful qualification of the people running it. We end up with an explosion of title inflation (a rise in the number of people with double-barreled titles beginning with words like "chief", "strategic" or "senior") without the concomitant increase in the number of experienced board members and executives to mentor these freshly minted leaders. It isn't uncommon for a high growth firm to build an entire leadership chain of stretchies - people in the wrong weight class, from the most senior executives right down to management on the line. This renders mentoring relationships irrelevant, and potentially damaging.

Explosive business growth can yield a new class of leaders. But in the absence of a strong foundation, it is just as likely to foment destructive organizational pathologies of paranoia and denial. The pinnacle of organizational absurdity is when employees, clients and investors are told quarter after quarter that every leader is "awesome", yet mysteriously, the overall business performance is disappointing. This isn't a business on the rise, it's a well funded frat party.

Where's your business?

Monday, June 30, 2014

The Fine Line Between "Stretch Role" and "Unqualified", part I

Everybody wins when somebody is put in a stretch role. Whoever does the hiring - a manager naming a first time tech lead or a board hiring a first time CEO - has propelled somebody's career. The investment in that person's success implies a commitment to a very active mentoring relationship. The person being asked to stretch is being given the opportunity to learn and mature, with a tacit expectation that they have freedom to try and fail while they are honing new skills.

We like seeing people in stretch roles, we like what it says about us as leaders that we put people in them, and we like the possibility that one day we, too will be given an opportunity to stretch.

A stretch role creates a halo effect for the person doing the hiring and the person being hired. For the management doing the hiring, it's a sign that the company is investing in the next generation of leaders, and that the firm demonstrably offers opportunity for advancement. For the individual being hired, it signals satisfaction of performance and expectations for great things. And, because everybody is taking a chance, it communicates an element of "risk", even in otherwise risk-averse corporate cultures.

But the halo reflects little brilliance. Stretch roles are too often made because there aren't any other viable choices. We rarely get to hire our ideal candidate, so we're going to have to settle in one way or another. Scarcity is a factor: in tight labor markets, availability becomes a skill. Plus, the longer a position goes without being filled, the worse the manager responsible for filling it looks - and the more likely that somebody higher up will conclude the position isn't all that necessary and will remove it from the budget. The decision to put somebody in a stretch role is very often simply that we can't think of any reason not to put you in this job. This is easily rationalized: emotionally, the benevolence of offering somebody a stretch role more than compensates for the risk that the person will not work out.

In the right circumstances, stretch roles grow people and businesses. They give a person license to test his or her boundaries, the freedom to experiment, and the opportunity to develop a unique style at something. But success depends on the circumstances: a short honeymoon period, being kept on a short leash by management, pressure to underwrite risks they don't completely understand, a "we never fail" corporate culture, no critical assessment of the person's areas of weakness, an absentee mentor or, worse, an incapable mentor, each stack the deck against the stretch candidate. A newbie in the job will not recognize the factors working against their success.

Throwing somebody into the deep end of the pool in their first swim lesson isn't enabling, it's overwhelming. Having somebody claw their way into a state where they can perform at a rudimentary level isn't professional development: it risks developing the wrong "muscle memories" for the job, and denies them the opportunity to achieve the meta-awareness they need to master their new role. It's also short-term career fatal: perpetually chasing responsibilities, constant drama and few successes alter the perception of the person from "aspirant stretchie" to "unqualified leader".

There is also the potential for long-term career damage. Over-promote somebody into a leadership role and they'll forever think they're leadership material. It may be that they simply aren't, but the stretch candidate is not likely to recognize this before or after being asked to take a stretch role; once invited, they've made the grade. The person who was on a stable career path ends up making frequent job-hops across firms just to maintain the same level of seniority.

Teams and departments suffer, too, not only from weak leadership at the helm but from the damage done to the confidence and trust among everybody else in the business. Plus, it sews seeds of doubt with the management who put the person in that role in the first place, often with damaging consequences (recall that Bill Ackman was ousted from the JC Penney board for having hired Ron Johnson as CEO).

Worse, the time spent with the wrong person in the role is time the business prolongs its people problems. Some years ago, I worked with a firm that had a strong tech culture but a weak sales one. There was high turnover of salespeople, and frequent vacancies in the sales team. A manager in the tech organization asked for a position in business development. Because of his credibility in tech delivery twined with an extrovert personality, management saw no reason not to give him the job. His lack of knowledge of business development, his lack of empathy for non-technical business buyers, and the absence of any strong sales leaders to mentor the new hire contributed to a disappointing year, culminating with his being asked to leave the sales organization and return to tech. Tainted by this failure, the would-be BDM left the company soon after. The company had not only engineered the loss of a respected member of the tech organization, it was no further along solving it's sales problem one year on.

(As to the person in question, his resume ticked technology, management and sales boxes, he already had a general management position at another tech firm in hand at the time he left. It was a short-lived gig as it became obvious very quickly that his capability did not live up to his resume.)

There's a simple litmus test we can apply to any organizational leader: would this person hold a comparable position in a comparable organization? An established leader capable of redefining and reshaping role clearly passes this test. An emerging leader who quickly takes to their new role while also disrupting conventional understanding of it will also pass this test. An aspirant leader being chased by demands and relegated to rote execution under constant direction of his or her superiors will not.

Every business has people in stretch roles. What are you doing with yours?

Friday, May 30, 2014

Deflation and Technical Debt

Technical debt is a useful metaphor for explaining why some code is faster to complete but more expensive to maintain. It is also helpful in explaining design decisions made for sake of expediency, or because of an outright lack of knowledge. Tech debt can be a real burden on development, particularly as it takes away time that would otherwise be directed toward productive investment in new feature development. This makes it tempting to interpret tech debt as a quantifiable economic or financial phenomenon. It is not. If we respect the accounting treatment of it as indirect, and extend the metaphor toward team dynamics and away from financial statements, it also helps us understand our ongoing ability to service tech debt.

Debt and Deflation

Edward Hadas argues that debt is an antiquated form of finance, "unnecessarily distant from economic reality". Fixed interest rates, maturity mismatches (banks borrow short and lend long) and variability in borrower's cash flows create unnecessary risks to borrower and lender alike. Financial institutions create all kinds of provisions and capital structures to underwrite uncertainty and absorb losses. If we set out to create finance today, we wouldn't use such a rigid structure as a primary investment vehicle.

Debt is a wager on future interest rates. The debtor is making an income backwardation play: that inflation will rise faster than the rate reflected in the interest rate, or that their real wages rise over the life of the loan. For example, in simple housing finance, a wage earner takes out a loan to buy a house. If inflation rises faster than expected (per the interest rate on the loan) and their wages keep pace with that higher inflation rate, the debt is easier to service because their income is higher. In this case, they've been inflated out of their debt. In addition, the debtor's wages can rise faster than inflation through salary increases (e.g., due to job promotions). This makes the debtor's real income higher, which also makes it easier to service the debt. The backwardation is that the projected future income at the time of the loan is less than what the spot income turns out to be in the future.

The lender is not entirely betting on the opposite. It is true that the lender comes out ahead if inflation rises more slowly than the rate reflected in the interest rate. But they also stand to gain from the debtor's ability to service a loan. An increase in real wages increases the debtor's ability to service the debt; this is reflected in the borrower's credit worthiness (rating or score). Lower credit risk increases the value of the debt instrument. A lender can sell the loan to somebody else for a higher price, which is their reward for underwriting the risk of the borrower at the time of origination.

For the borrower, deflation increases the real cost of debt. The less money a household earns, the harder it is for that household to service its debt. This is why central banks in highly indebted economies will pull out all the stops to fight deflation. Falling consumer prices reduce revenues. Falling asset prices reduce people's perception of their wealth, which reduces their willingness to spend. Deflation increases the burden of debt and intensifies contractionary forces on an economy. Mature economies - Europe, Japan, US - are debt-financed more than they are equity financed, and there are far more borrowers than lenders. It comes as no surprise that European Central Bank chief Mario Draghi committed to fight low inflation, Shinzo Abe's government in Japan expanded money supply to juice asset prices, and former US Fed Chairman Ben Bernanke committed to Quantitative Easing.

Technical Debt is an Indirect Economic Phenomenon, not a Direct One

In finance, the person using debt to finance an asset purchase is the person who is responsible for the debt. This makes sense in the business of software, because the person paying to acquire and operate software may be "borrowing" against future cash flows in the form of costs to service technical debt. The buyer of a software asset is the person footing the bill for people to service that debt.

But technical debt is an indirect economic phenomenon, not a direct one. That is, technical debt does not necessarily finance a software asset. Technical debt only has economic impact if costs required to service that debt are realized. For example, an asset with a lot of tech debt may not be subject to much maintenance activity, or suffer production instability requiring a lot of attention, or suffer performance problems (directly resulting from that tech debt) requiring additional investment to scale. In each of these cases, a tech-debt-heavy asset may have the potential to be high cost, but those costs may never be realized. If a cost is not realized, it is not a real economic cost. It only becomes an economic phenomenon if excess labor or infrastructure is needed to compensate for its presence.

This brings us to the limits of the tech debt metaphor. There is no bank offering technical debt loans: tech debt is conjured by people during moments of development. One can argue that tech debt borrows against the equity of the asset, but that does not hold up in accounting terms. With or without tech debt, we still carry the asset on the balance sheet at the same economic value: the total capital outlay less accumulated depreciation. The cost of servicing technical debt is a function of people's time, which is an operating cost. The expectation of future payroll costs that may be incurred to service technical debt is not a balance sheet liability that reduces an asset's equity, it's reported in the future period when it is incurred as an operating expense on our income statement and a drag on cash flow. Tech debt may or may not lead to reduced current and future profitability and cash flows; it does not intrinsically reduce the accounting value of an asset.

Only if the software itself is truly impaired - for example, owing to poor design decisions, our software doesn't scale beyond a single user and a significant portion of the asset is written off - is technical debt a direct economic phenomenon. However, in that case, "debt" is the wrong moniker: the asset is well and truly impaired, not merely leveraged by debt. If a business takes out a usurious loan to buy a truck, the truck isn't impaired by the loan or the high interest payments. If the truck is severely damaged in an accident, it is impaired and written down. Because of the optics, impaired software is more likely to receive additional investment than it is to be written off.

Since tech debt is an indirect economic phenomenon, we have to look at our principal actors differently. In technology, the people who are responsible for servicing the asset (e.g., the code) are the people who are responsible for tech debt. Remember, in finance, we don't borrow against an asset. We borrow against future cash flows of a household or company, using an asset as collateral should the borrower not have the cash to service the debt. In tech, our code may be the asset against which we have borrowed, but we're really borrowing against the time of the team (e.g analogous to future cash flows) responsible for it to service that debt. Tech debt is a call option on people's time at some point in the future, not the asset itself.

Thinking about it this way allows us to extend the debt metaphor a bit further.

Capability Deflation Increases The Cost of Servicing Technical Debt

We saw earlier that deflation impairs people's ability to service debt. The same applies to tech debt. The inflationary or deflationary forces that impact our ability to service tech debt are related to our capability. We "inflate" our capability - and thus reduce our burden of servicing tech debt - through skill development and productivity enhancement. Our skills improve through study and experience. Our productivity improves with knowledge, tools and process. Holding our tech debt static - that is, assuming our tech debt merely rolls over - our ability to service that debt improves with the inflation of our skills and productivity. Capability "inflation" is the same as a household seeing real wages increase. The stronger our capability, the less impact that tech debt has on a team, the more "value" it can produce.

The converse is also true: capability deflation increases the real cost of servicing tech debt. An erosion of skills, loss of situational knowledge, and reduction in productivity all contribute to capability deflation which increases the burden of technical debt. Again, holding our technical debt static, our ability to service it declines with the deflation of our skills and productivity. Just as deflation intensifies contractionary forces on an economy, so, too, does deflation intensify contractionary forces on a team: the greater the deflation, the greater the burden of servicing tech debt, the less "value" produced by a team (the equivalent of economic contraction). In extreme cases, as happens in financial markets, debt servicing "crowds out" our ability to invest in our business through software creation.

Whip Deflation Now?

In 1974, fighting what would become runaway inflation in the post-Bretton-Woods currency world, the United States launched a grassroots campaign encouraging all citizens to curtail consumption - and share their ideas for doing so - as a way to contain inflation. The campaign was entitled "Whip Inflation Now", or "WIN". In the immortal words of Alan Greenspan, "this [campaign] is unbelievably stupid".

Leaders of any tech organization are in a constant battle against capability deflation. People will quit and work somewhere else, taking their skills and situational knowledge with them. People's skills will erode as they become content maintaining a "software annuity" that pays them a high salary for low-effort maintenance work. Organizational memory erodes as people leave, and those who remain forget why specific design decisions were made. Demand outpaces supply for skilled software engineers, forcing firms to hire less skilled developers if they are to have developers at all. New technology obsoletes old technology, and old software becomes trapped in legacy infrastructure. As evolution gives rise to pure maintenance, the work becomes less and less engaging and attractive. All of these things are deflationary forces on team capability.

To keep capability deflation in check, we have to burn the candle from both ends: refresh skills, and refresh assets. Have "refactoring" hack nights to attack tech debt, run spikes to introduce new technologies into legacy code, and rotate people through different teams to disseminate situational knowledge. We can also make investment cases to retire legacy software assets, which we can help by drawing attention to the "tech currency" of the software assets in our production portfolio. We can also use the strangler pattern to incrementally retire legacy systems, reducing the economic cost - and uncertainty - of replacement.

There will always be tech debt, if for no other reason than one person's engineering masterpiece is another's code hairball. And there will always be the threat of capability deflation. We can fight capability deflation - we have no choice, we have to fight it - but we'll never defeat it. To keep it in check, have a corporate culture that values knowledge acquisition and collaboration, and an investment strategy that constantly reinvents the software that runs the business.