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, January 31, 2016

Are Microservices to Ecosystems as Core Competencies were to Conglomerates?

As far back as the 19th century, industrial firms pursued vertical integration strategies. The thinking was that by owning the supply chain from raw materials to retail outlets, a firm had direct control over its entire cost structure, making it better able to squeeze efficiencies out of it and being less susceptible to supply shocks. This was important because, for large industrial firms, competing on price was the primary strategy for winning market share.

During the 1950's and 60's, companies also pursued conglomerate strategies: bringing seemingly unrelated businesses under one roof, sometimes seeking synergies (as Sears did owning a retail merchandiser and retail brokerage - "buy your stocks where you buy your socks"), and sometimes not (as LTV did owning a steel company and an airline). The rationale for the conglomerate was entirely financial: cheap (mostly debt) capital allowed large companies to grow through acquisition, and regulators were less likely to block acquisitions of unrelated firms on monopolistic grounds.

By the 1980s, both strategies had begun to lose favor. The financial benefit had evaporated: high interest rates clobbered the profits of debt-fueled acquisitions and forced divestiture. But the operating benefits weren't there, either. Different types of businesses (manufacturing, distribution, retail) require different types of leadership and have very different cultures. And, within each of those businesses, some functions are differentiating (such as fleet optimization for a logistics company) while some functions are not (nobody beats their competitors by having a superior accounting back office). Management thinking embraced "core competencies": own and hone the things that differentiate, rent and commoditize the things that do not. This also allowed for better matching of capital with company: the risks and returns from a company that owns a fleet of railcars is easier to assess than the risks and returns from a company that owns ore mines, railcars, and foundries. By breaking them up, the individual investor can choose what types of businesses to expose their capital to (a raw materials company, or an asset company, or a refining company), and the pricing of that capital more accurately reflects the risks.

Tech firms today are embracing the "vertical integration" and "conglomerate" strategies of yore by positioning themselves as "platform" and "ecosystem" companies. The thinking is that by combining multiple and diverse capabilities into a single offering, a company creates both efficiencies and synergistic value for counterparties in some activity, such as crowdsource funding or payments. The ecosystem strategy takes this even further, combining unrelated capabilities under one roof (eBay buying Skype in 2005, SAP developing HANA in 2010, Facebook buying Oculus in 2014), often justifiable if only because digital commerce is still in its infancy and nobody is really sure what's going to work and what's not.

But what if you could extract utility-like functionality from within an ecosystem into an independent company? Take payroll as an example: rather than have every Human Resources platform company need its own team of people to write and maintain state and federal witholding rules, hive those off into an independent business that makes them available as a metered service offering, charging a tiny usage tax (say, $0.001) each time it's invoked. The technology to do this is certainly available: code the algorithms as a microservice or a blockchain smart contract, and deploy them in an elastic cloud environment (as usage will tend to spike with pay cycles).

To the HR platform company, there are a lot of good reasons to do this. It monetizes a non-value generative activity (nobody subscribes to a payroll system because their implementation of the witholding rules are better than everybody else's). It throws off utility-like revenue streams that move in lock step with the broader job market. It disaggregates a staid HR utility function that needs to be deployed infrequently (potentially only as often as once per year, when new tax laws come into effect) from more innovative ones that are more exploratory in nature and demand frequent deployments (such as time entry performed through emerging wearable tech). It separates a legacy and risk-averse tech culture from a cutting-edge risk-prone one. It takes a high fixed cost for maintaining a non-differentiating characteristic off the P&L (teams maintaining rule-heavy legacy code are rarely inexpensive). It's stable cash flows would be attractive to debt finance, better aligning capital investment in HR technology. It removes asymmetric risk that can be more accurately insured (smothered in a platform, correct calculations offer no financial upside, while a faulty calculation exposes it to costly litigation and reputational damage).

True, it eliminates a barrier to entry of future competitors. And, while the market would support a handful of utilities to prevent monopoly, thin competition would give those utilities oligopic pricing power. But it creates a one-time financial windfall for the first movers, laggards would be pressured to subscribe by shareholders demanding the same structural benefits to the income statement, and low switching costs would keep utility pricing power in check.

Given that tech is in a period of both cheap capital (interest rates remain low, VC levels remain high, and companies such as Alibaba and Facebook can make acquisitions inexpensively with their own high-priced shares) and rapid growth (growth in consumption of tech products such as social media today mirrors growth in consumption of manufactured goods in the 50s and 60s), it's little surprise that we're seeing a return to industrial strategies past. But technologies like microservices and blockchain could be the modern equivalent of "core competencies" to sweep through businesses. Blockchain proponents already champion the potential of decentralized autonomous organizations (DAOs). With MBAs now eschewing investment banking in favor of tech companies, financial engineering of this nature isn't too far away.

Thursday, December 31, 2015

Counterfactuals

Earlier this year, my house should have burned to the ground.  A CR2032 battery exploded and caught fire in a confined place dense with flammable objects.  But my house didn't burn down: at the moment the battery exploded, I was sitting a few feet away from it. I heard a loud bang, investigated, and stamped out the fire within a few seconds.

I wasn't planning to be there at the time. A series of minor reschedules and reprioritizations had me sitting in my home office at the moment the battery exploded. I happened to be in the right place at the right time to prevent something from happening.  It was business as usual for the rest of the day.

There is no law or reason governing why I was there at the moment the battery exploded, or for the battery to have exploded at precisely that moment.  What if my schedule isn't rearranged and I'm not home when the battery explodes? What if it happens hours earlier or later when everybody is asleep in the house? I can't help but think that there are more quantum realities where something bad happened than there are where something bad did not happen.

But that isn't necessarily true.  The battery could have exploded at a time when nobody was around to put out the fire, but the ensuing fire may have simply died out causing no damage.  And maybe the chemical processes that triggered the explosion was itself an anomaly of circumstances set in motion by my presence in the room at that particular moment.  I have to be content with the only certainty I have, which is that a battery exploded and nothing bad happened.

Counterfactuals are messy because they're not provable.  Strategy and investing, execution and operations are loaded with counterfactuals.  They're each similarly messy because we don't really know what would have happened had we chosen another course of action.  Conventional wisdom says that Kodak should have bet on the digital technology they invented, and not dithered around with its legacy analogue business. But what if Kodak were to have invested heavily in digital and their distribution partners made good on their threats to shift the lucrative film processing business to Fuji?  Would Kodak's bet on the future have imploded for being starved of cash flow?  Hindsight isn't 20/20, it's narrative fallacy.

Just as it's difficult to have retrospective strategic certainty, it's next to impossible to forecast the outcomes of alternative paths, decisions or circumstances.  It sounds simple enough: invest in the highest-return opportunities, and consistently assess the performance of and the risks to delivery.  But we're forced to interpret and project from incomplete and imperfect information. Our plans and forecasts are just as likely to be narrative fallacy as fact-based assessments.  Microsoft paid dearly for Skype, but we can't know what might have been had it been acquired by Google or Facebook - and the possibilities may very well have justified the premium Microsoft paid.

The landscape of strategic software investing and governance is riddled with speculation.  As much as we would like to think we've made the best decision available to us, or dodged a bullet, we rarely know with certainty.  No matter how formulaic we're told that portfolio management or delivery operations can be, they will never be as optimal or predictable as promised, because business is imprecise and untidy.

Monday, November 30, 2015

Corporate Middle Management as an Autopoietic System

[T]he aim of such systems is ultimately to produce themselves: their own organization and identity is their most important product.

-- Gareth Morgan, Images of Organization, p. 236.

In the early 1970s, biologists Humberto Maturana and Francisco Varela coined the term autopoiesis to define the self-maintaining nature of living cells: biological cells produce the components that maintain the structure that creates more components (in this case, more cells). This is in contrast to allopoietic systems, which use components (raw materials such as silicon and plastic) to generate something (mobile phones and computers) which are distinct from the thing that created it (the factory where they are made).

In the mid-1980s, Gareth Morgan applied the concept of autopoiesis to organizational study.

They do so by engaging in circular patterns of interaction whereby change in one element of the system is coupled with changes elsewhere, setting up continuous patterns of interaction that are always self-referential. They are self-referential because a system cannot enter into interactions that are not specified in the pattern of relations that define its organization.

-- Ibid, p. 236

A few months ago, I described the organizational pathologies that we see in slow-growth, (mostly) equity funded firms: because it faces no real pressure (no credit rating to support, no competitive threats to revenue) it will suffer from operations bloat. A significant source of that bloat will be a large middle management.

Left unchecked, tech organizations will grow vertically around line activities (software products that support business functions) and horizontally around shared services (testing, infrastructure). They will also establish one or more program management offices to navigate delivery of complex business initiatives across the fractured organizational landscape. For every management expansion, there is an equal and opposite hiring spree. The host business will mirror tech's management structures, creating business product managers opposite technology line managers, and a business PMO responsible for business change management functions opposite the tech PMO responsible for delivery of tech assets. This management sprawl happens for a variety of reasons: people are promoted into management for fear they might quit, IT gets burned by a delivery failure and creates new hierarchy in response, a senior business manager doesn't want to be seen as mapping to a low level of the tech organization, a new boss prefers to delegate rather than get his hands dirty with the details, there is a low level of trust between tech and business and matching staff is how it maintains equilibrium, and so forth.

Middle management is not a value-generative function. Because they are not engineers or analysts, middle managers don't directly contribute to solution development. Instead, they negotiate on behalf of their sphere of responsibility with other middle managers. They create documentation templates, project control forms, release and implementation workflows, and program checklists to create contracts among other managers to secure the time and attention of the people who do contribute to solution development. These contracts implicitly protect every middle manager by sharing responsibility (my work was dependent on somebody else who failed to deliver) and deflecting responsibility (another initiative took priority so we had no choice but to let this other deadline slip). The web of contracts allows middle management to self-perpetuate.

[W]e can describe autopoietic systems as those producing more of their own complexity than the one produced by their environment.

-- Carlos Gershenson, Requisite Variety, Autopoiesis, and Self-Organization.

It also serves as the fuel for growth: perpetual negotiation spurs middle management to expand its library of templates, forms, workflows and checklists. That, in turn, adds to the structure, because it requires more middle managers to fill out more program documentation. For example, a few years ago, the logical database storage for a legacy asset was overwhelmed when a new type of transaction was implemented; since then, the infrastructure department requires every new initiative to complete a "long-term storage analysis forecast". But, some initiatives don't generate many transactions at all and will have little impact on storage allocated to any asset. The managers in those initiatives don't have to fill out a "long-term storage analysis forecast", but must still fill out a "storage analysis forecast exemption" form to document why management concluded the forecast document wasn't necessary.

In this way, middle management is autopoietic: based on a flow of documentation, it creates components (middle managers) that maintains the structure (the bloated middle management) that creates new components (more middle managers).

* * *

[T]he brain does not process information from an environment, and does not represent the environment in memory. Rather, it establishes and assigns patterns of variation and points of reference as expressions of its own mode of organization. The system thus organizes its environment as part of itself. If one thinks about it, the idea that the brain can make representations of its environment presumes some external point of reference from which it is possible to judge the degree of correspondence between the representation and the reality. This implicitly presumes that the brain must have a capacity to see and understand its world from a point of reference outside itself. Clearly this cannot be so[.]

-- Morgan, pages 237-8.

Suppose we want to introduce Agile into an organization because we want delivery to be more efficient and effective, and we want a better relationship between business and technology. One way we think we can do that is by simplifying our management processes and making them more collaborative, and Agile appears to offer us a means of doing that.

If we have a large middle management function, we can't expect that Agile will simplify our requirements, development, release, or change management activities. What we should expect is that Agile will get co-opted by the very structures that it is there to disrupt. A middle manager cannot comprehend Agile as a different means to an end, because the only end a middle manager is pursuing is successful contract negotiation with other middle managers. A release plan becomes a closed-ended project plan, Stories in an iteration become a commitment, tasks per each Story become the coin of negotiation with other managers for their "resources". Adopting Agile - everything from adaptive planning to continuous delivery - requires a level of abstract thinking about why we do the things we do and how they lead to a delivery outcome that will be well beyond that of an incumbent middle management. Any middle manager capable of abstract thinking will have left the organization long ago: survival requires concrete thinking within a very narrow scope of self-referential activity.

When we recognize that identity involves the maintenance of a recurring set of relations, we quickly see that the problem of change hinges on the way systems deal with variations that influence their current mode of operation. Our attention is thus drawn to system processes that try to maintain identity by ignoring or counteracting threatening fluctuations, and to the way variations can lead to the emergence of new modes of organization.

-- Ibid, p 239.

For a large middle management, Agile is not a welcome change. If we have business and tech people working together daily rather than having a temporally shifted conversation through documentation, if we have technology generalists rather than specialists, if we capture knowledge in automated tests and ops scripts, we need far less intermediation in the delivery process. This obviates the need for an expansive middle management function.

An autopoietic system is capable of autoimmune responses. Co-opting, described above, is one. Ignoring is another: enough people refusing to change can force management to re-think its commitment to that change. Subverting is a third: creating obstacles and impediments to change to sow uncertainty and doubt on its effectiveness are behaviors intended to reinforce middle management's identity. Autoimmune forces are powerful: a function that exists solely for its own perpetuation - even when not by charter, but as a matter of social contract among its members - will become shrill in its own defense.

The policeman is not here to create disorder. The policeman is here to preserve disorder.

-- Richard J. Daley, 48th Mayor of Chicago

What does change look like under these circumstances?

Clearly, it isn't willing acceptance by the incumbents. We can't expect actors in a system to accept change that results in the destruction of that system. As Upton Sinclair famously wrote, "it is difficult to get a man to understand something, when his salary depends upon his not understanding it."

By definition, change of an autopoietic system must be triggered internally, and happen as a result of randomness. Morgan argues that "random variation provides the seed of possibility that allows the emergence and evolution of new system identities." Random changes create the possibility of new relations, which, if they're not absorbed or stifled by other parts of the system, can lead to new identities. Morgan argues that "Human ideas and practices seem to develop in a similar manner, exerting a major transformational effect once they acquire a critical level of support." Nassim Taleb makes the same argument in his book, Fooled by Randomness.

The corporate change leader doesn't have the luxury of time for the forces of randomness to reform an entrenched middle management. There are two policies that can accelerate structural change: disallowing self-referential justification for middle management practices (that is, expanding its scope of reference so that every action must be justified by a delivery outcome, not a middle management negotiation), and aggressive dismantling of the middle management structures themselves. The prior, if not compromised, puts an incumbent invested in the status quo on the defensive and robs it of it's raison d'être. It also helps to identify people in middle management who are reformable and coachable. The latter reduces the need for the prior.

Bad events in organisations are generally the product of bad systems rather than bad people ... [W]e need to go on and ask what it is about modern corporate life that has made such misbehavior not only possible but appear increasingly common.

-- John Kay, Organisations advance by asking "what went wrong" rather than "who is to blame

It's hopeful to believe that an incumbent middle management will "see the light" once introduced to a different set of practices, mechanics and tools. But the broader corporate reality tells us otherwise. When we introduce change, we quickly come into direct conflict with a self-referential ecosystem that, despite obvious internal contradictions and shortcomings, has an extraordinarily strong survival instinct. We also discover latent, institutionalized corporate misanthropy directed at users, customers, suppliers and business partners. A change toward Agile, and the value system it represents, is less enabling, and more threatening, than we'd like to think. To be successful as change agents, we have to dismantle the structures, processes and people behind the status quo while simultaneously replacing them with a new normal.

Saturday, October 31, 2015

Potential and Motivation

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

-- Warren Buffett

For a business to have "potential", it needs opportunity, money, willingness, talent, and aptitude. Yes, a business without all of these things still has potential: it might be poorly funded but have knowledge-acquisitive people and a clear opportunity; it may have weak capability but good cash flow. But somebody agreeing to lead or acquire a business because of its "potential" still needs to compensate for deficiencies in any of these areas.

Potential needs a wake up call if it is to be realized. Sometimes, our source of motivation is external: new competitors, or a threat to our business model. It can be internal: an activist investor on the board forces the CEO to accept new operating targets.

Potential and motivation are both the purview of leadership. A good leader creates potential where there is none: putting someone in a stretch role, freeing capital for reinvestment through a restructuring, diversifying the product line by acquiring a business, hiring a strong product team to engineer and market new offerings. A good leader motivates with incentives and rewards, culture and risk-taking: define business objectives that require cleverness and innovation and not just operational efficiency; flatten and simplify the organization, distribute authority and responsibility; recognize team behaviors over individual heroism.

The intersection of motivation and potential is never as far down each axis as we hope because they're constrained by our ambition (or lack thereof), and by fear. We can't imagine things any different so we fail to define an opportunity. We see competitive threats developing but we lack the will to act. We are reluctant to make difficult staff cuts to free up money. We don't recognize the outdated skills of our people, the absence of abstract thinking, the dearth of current technologies and practices, so we do nothing to upgrade our talent base. We're afraid of offending our current employees by changing the compensation structure. We are more comfortable micromanaging, demanding commitment, and promoting people through hierarchy than we are giving people autonomy and rewarding them for innovation.

Worst of all is when we simply talk ourselves down: of course we want to get to such-and-such state someday, but we can't possibly make so much change so quickly. This amounts to regulatory capture of a leader's ambition - and by extension, of a business' potential - by the business itself.

The difference between a change leader and a caretaker isn't lofty vision or inspiring words, it's the ability to create maximum potential within the organization, and the motivatiors that drive people's behaviors and actions to realize it.

Wednesday, September 30, 2015

Capitalizing Tech in a Cloud / SaaS / Continuous Delivery World

Around 2010, when US companies could count on a recovering domestic economy, a weak US dollar, and growing emerging market economies, CFOs didn't need to work that hard to flatter the income statement. This has changed: the US recovery has been inconsistent, emerging markets are performing poorly and the US dollar is strong (taking the edge off overseas revenue). Plus, firms are carrying more debt than they were a few years ago, making the optics of the P&L that much more important.

One result of this is that tech capitalization is back. It never really disappeared, of course, it just wasn't as common. But while tech capitalization was dormant, tech has changed a lot - quite a lot, in fact.

First, Cloud, SaaS and BYOD change software and infrastructure from capital investments to rent expenses. Renting is an economic convenience more than it is a cost efficiency. Renting is no less expensive than owning (the person who rents a house has to cover the landlord's mortgage, capital improvements, taxes, etc. in the rent payment), so technology costs represent a larger - and discreetly measurable - operating expense. As an expense, it's increasingly being indexed to payroll (that is, headcount), which makes it more like a tax (I need one ERP user license for every employee in sales, so if my sales force grows, I need more licenses).

Second, Continuous Delivery - deploying software hourly or daily instead of monthly or quarterly - blurs the lines among traditional development stages. It makes our packages of deployable work far more atomic than the more traditionally coarse "release" or "project" level deployment. Plus, if we're experimenting through software to see whether there's a need (much less a solution) - something uniquely enabled by Continuous Delivery - our development can't be capitalized at all. It's R&D, which has to be expensed.

What does it mean? Well, we don't know. For one thing, we're not really there yet. We know that this echoes the supercycle of businesses separating into asset-light operating companies (e.g., retailers) and asset-heavy finance companies (e.g., REITs). But we also know that a lot of firms still license captive ERP systems (no SaaS), operate captive data centers (no Cloud), and issue hardware to employees (no BYOD). In development, Continuous Delivery is still more idea than implemented among firms predisposed to capitalize rather than expense their software development costs. The execution trend toward tech asset light matches - but lags - the financial trend.

For another, specifically with regard to capitalizing development, we fit Agile under FASB 350-40 without violating the intent of the original AICPA policy (SOP 98-1), but we never explicitly formulated policy to reflect how work got done in an Agile world. For as much as we made Agile perform better than Waterfall under capitalization policies (e.g., better opex/capex ratio), it's always been an ill-fitting Waterfall suit around an Agile body. Fast forward, an today we have Continuous Delivery, which takes Agile concepts of frequent delivery and Lean development practices to the next degree. This extends the already long tail: accounting policy (treatment) lags tech execution (Continuous Delivery is still wishful thinking in most firms) lags financial expectation (asset light).

But some things we do know, and point to what we should be paying attention to.

The CFOs interpretation of tech as a capital investment is not the same as tech as an operating expense or tech as a tax. The more tech becomes an expense or a tax, the more downward price pressure there will be on tech. This is great for a business, but it could portend the next collapse in tech pricing buoyancy.

Similarly, software development as an R&D expense does the CFO no favors on the income statement. Development labor has commanded a premium price for many years now - it's been counter-cyclical since 2009, rising while labor costs in the broader economy stagnated or sank. CFOs don't have a high tolerance for this. Importing a high cost of labor onto your statement of cash flows because you're investing in an asset that you expect will generate future cash flows is one thing. Importing a high cost of labor onto your statement of cash flows for an R&D experiment is entirely another. As CFO, you're more comfortable paying a premium for labor if you see a path to getting it back; you're less comfortable if you're spending on some "ideation" boondoggle. Labor scarcity, cheap capital, easy profits, and a growth-through-tech-frenzy make boondoggles less onerous; a change in those conditions will make them far less tolerable.

The prevailing business conditions are changing, bringing capitalization back with them. Or, at least, tech is being asked to bring capitalization back. Tech is less well prepared to answer: while tech has evolved beyond fixed assets in data centers and long-cycle Waterfall delivery, it never truly matured how it accounts for its costs in the context of the host or consuming business. If anything, it's thumbed its nose at finance, allowing labor scarcity to afford it the freedom to drive itself more toward a no-strings-attached expense.

If the capital cycle still matters, this is bad for tech. If the tech cycle trumps the capital cycle, it doesn't. We'll look into that a bit more closely next month.

Monday, August 31, 2015

Capital Structures and Organizational Pathologies: Tech Investments in Slow Growth Equity Funded Companies

The volatile nature of tech companies makes them better suited to equity funding as opposed to debt. Equity is high-risk capital: owners are exposed to the upside of growth (you stand to make a lot of money), but also the downside of failure (you stand to lose everything you put in). Debt is not: how much risk is there to the lender when the borrower guarantees a return? Plus, in the event of a liquidation, creditors are first in line to be made whole.

Of course, there is risk with debt finance: if the borrower gets in trouble and has difficulty servicing the debt, the value of the debt falls. And there is high-risk debt: junk debt gives high-risk borrowers access to debt finance and debt investors more risk exposure than debt usually permits. Also, tech companies that become utilities - think Oracle or Microsoft - do lend themselves to debt finance. But that's because they are utilities more akin to electricity and water than volatile, shoot-for-the-moon tech firms. We don't equate investing in Microsoft with investing in King Digital Entertainment.

On the whole, tech investors want exposure to runaway upside, not steady returns. We get this exposure through equity capital.

Portrait of a slow-growth (non-technology) firm. Less than 10% of it's Enterprise Value is debt. It has a strong market share position and slow annual growth that allows it to pay a slightly increasing dividend year on year. As technology starts to become more prominent in their industry, they appear to be well prepared to take it on.

But are they?

This is a firm under no real pressure. Because it doesn't have a credit rating to support, this firm will be sloppy in operations. Being slow growth, they'll feel no threats to revenue, and likely can't conceive of any, possibly even believing they are uniquely immune to competitive threats. Mollifying investors every year with a slightly increasing dividend will attract capital satisfied with steady returns, not agitating for growth.

Their strong market position and simple balance sheet will give them the patina of being a "tech ready" firm, positioned to be leaders of tech innovation that can further improve their grip on the market. The board might go so far as to insist on the CIO bringing tech investments up for consideration, and the CEO may bring attention to these during earnings calls.

But the culture is fundamentally risk averse: why mess with the good thing we have going? Bloat in their cost of operations will crowd out cash for investment. The nature of tech investing - burning through a lot of cash on development and marketing to grow a user base - will be unpalatable. What they have in the appearance of readiness to be tech investors quickly evaporates in the lack of will to follow through.

Which is not to say they don't invest in tech, but it is a "me, too" firm that invests in low-risk technologies in response to what competitors have done. It is not an industry disrupter looking to change the competitive landscape through tech. They'll see investments in tech that drive a bit more efficiency out of their existing way of doing things (such as manufacturing or supply chain technology) far easier to conceptualize and pursue than high-risk, exploratory investments or acquisitions.

It might seem that new leadership or a few quarters of revenue contraction could break the company out of its slumber. But for fundamental change to happen, a CEO has to sell the board on a vision for how the competitive landscape is changing and what the company needs to do to lead it; cut overheads and perks; get line managers to tighten operations; and convince shareholders that the money saved is best redirected toward the pursuit of the new vision. And that's just the start: follow-through execution to make the vision a reality requires a change in the culture.

Changing the culture from "coast" to "hustle" challenges the company's willingness to act, all the way to the board. Sadly, if the stock price gets a lift simply by basking in the reflected glory of actual tech innovators, the board is more likely to interpret it as a validation of its decisions to date than it is willing to depart from them. The firm may be tech ready, but it is change averse.

Friday, July 31, 2015

Capital Structures and Organizational Pathologies: Tech Investments in Debt-Fuelled Capital Intensive Companies

Portrait of a growing company: a corporate parent with two-thirds of its enterprise value in debt, running two separate but interdependent divisions: a capital intensive asset heavy business, and a cash generative consumer-focused operating firm.

If you're the CFO, your primary concern is the debt capital that's financing your growth. You want to keep your credit rating strong to minimize the cost of rolling over debt (to finance existing assets) and the cost of raising new debt (to fund expansion). Every extra dollar paid to service the debt is a dollar less yield the business generates for its own use.

The CFO keeps the credit rating strong by having consistently strong cash flow from operations.  Even if it doesn't generate enough cash flow to cover investing activities, strong and consistent cash flows show financial discipline in running the business, and potential for financial reward at greater scale; this encourages more investment and suggests only modest risk.

The two divisions have decidedly different cash needs.  The asset-heavy business consumes capital, while the asset-light operating company generates it.  There isn't much you can do to squeeze operating cash flow efficiency from the asset-heavy business, aside from minimizing overhead costs associated with investing activity.  But you can squeeze the operating company for efficiencies, reducing total labor costs with things such as customer self-service.  The more cash hungry the asset-heavy business is for investment, the more ruthless the operating business will be squeezed for efficiencies.

The P&L is also a source of trouble for the CFO. The expanding asset-heavy division will have more expenses than income.  It isn't a problem for a growing business to post losses, but the volatility of investing activity in the asset-heavy side of the business will put downward pressure on the credit rating.  That will lead the CFO to be creative with the income statement, through things like capitalization.

What does all of this have to do with software?  The asset-heavy division isn't going to be very software intensive.  The operating company is, though.  Suppose that the operating company is in a firefight for market share, where the primary weapons are customer-facing technology (as is happening in retail, entertainment, and, to a lesser extent, airlines - all of which have capital intensive asset-cos side-by-side with cash generative op-cos.).  With labor demand outpacing supply in tech, engineers and designers are expensive. They have to be compensated in cash, since the capital structure makes it difficult to compensate them in equity.  Plus, not being an engineering firm, the company will be slugging it out to find and retain qualified engineers.  From the CFO's point of view, software development - just some part of the operating company - has a spiraling cost of labor, and it's high-maintenance (e.g., requires a lot of care and attention to get and keep people) to boot.

This is where the "we have a software company within" myth starts to fall apart.

The economics of running a competive software business don't matter a damn to a CFO who is trying to sweat every penny out of an operating company.  True, having the patina of a tech business could juice the valuation, but only in terms of the equity, not the debt - primarily because tech firms just aren't financed with debt.  If you're going to debt markets, you need financial operating cred more than you need to show tech characteristics.  Plus, the growth that mollifies the credit raters enough to turn a blind eye to the saggy P&L will have been priced into the equity; in an asset-heavy business, tech will be priced in as a necessary cost of the operating company, not as an option call on the potential for explosive growth.

Another way to look at it is, any increase in the equity value that results from the appearance of being a budding tech business is a nice-to-have for management (who have equity & options). Otherwise, with such a large debt overhang, any tech patina isn't likely to have any real economic value, e.g., the creation of an inflated currency (the company's own stock) with which it can favorably engage as an acquirer of other companies.

The opco may need tech to be competitive, but that won't be the first priority.  No matter how important tech may be, financing the debt will always trump it.  For the CFO, the priority is cost discipline.  In execution, the CFO will keep tech leadership on a short budgetary leash, forcing it to choose between hiring a lot of people but not paying competitive wages / contractor costs (and, on average, have a lower skilled engineering staff), or hiring / contracting at market rates but not being able to hire nearly the number of engineers it needs.  Either way, software development is starved for investment, crowded out by the demands of debt finance.

Accounting treatment of the software will also have its effect.  Its penchant for large capital investments on the asset-heavy side of the house will lead the company to make large capital investments in software.  Because the CFO capitalizes software development costs, the company can't afford for those investments to fail, because a failure requires the entire cost to be written off in the current accounting period, which puts a dent in the P&L.  This means that the company isn't predisposed to R&D through software (making a lot of little, experimental investments); it's predisposed to making large, debt-fueled asset acquisitions and making good on the convenants that go along with them.  In practice, the company will inject more capital into distressed software projects rather than let them fail.

The portrait of a growing, debt-fueled, capital intensive business is the antithesis of a modern software company.  Software companies are high-risk businesses: investors wager that the people in the firm can not only create interesting technologies, but can find users for them, and ways to monetize them.  The predictability and stability demanded by debt service obligations don't give rise to innovation and disruption; they create stagnation and sclerosis.  That puts paid to any suggestion that a debt-fueled, capital intensive business is really a software company in disguise.

Next month, we'll look at other operating pathologies driven by the capital structure.