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.

Monday, December 31, 2012

Engaging Auxiliary Forces for Strategic Software Solutions (Part II)

I wrote previously that "if one is to compete, one has no choice but to rely on auxiliaries or mercenaries" when you have to respond quickly to a competitive threat. Before looking further at engaging auxiliaries, it's worth considering the "if one is to compete" statement. As unattractive as it may sound, a firm can opt out of competition. Sometimes, the most compelling business option is to run the business for cash. How have late moving legacy firms fared in industries that have undergone strategic shift? E.g., will RIM and Nokia destroy more value than they will create by being late followers of Apple and Android?

Opting out is strategically unattractive. (In fact, it's downright Machiavellian.) But it should never be ruled out. And there isn't much to be said for "putting up the good fight" if you're ill prepared to bring it. It's simply a very public form of corporate seppuku that vapourizes equity and destroys careers.

However, if a firm chooses to compete, and has neither the capability nor the luxury of time to create a capability, it has no choice but to rent that capability by entering into an agreement with an auxiliary or mercenary force. As I pointed out in Part I, this relationship favours the seller.

How can the buyer mitigate the risks? By knowing when and how he or she wants to exit the relationship.

Buyers of auxiliary forces are tempted by what appears to be the best of both worlds: contracting allows the buyer to get an asset developed with minimal effort on behalf of the buyer. But the economics work against the buyer as time passes. The longer a supplier relationship lasts, the greater the dependency of the buyer on the seller, the stronger the seller's negotiating position over time. And development doesn't end with a single act of delivery: there is considerable activity required at the margins, things ranging from data migration to usage analytics. These costs are the buyer's to underwrite. Suppliers are thus able to expand their range of services and derive more cash from the relationship. This increases the costs to the buyer, which erodes the viability of the sourcing strategy.

Anticipating the terms and conditions of the exit are subsequently of prime importance to the buyer.

If the buyer has no alternative but to engage auxiliaries - if, for example, the buyer is purely a marketing company taking a flyer on a technology investment - it faces a long-term relationship with a supplier. The buyer's best bet is to engage auxiliaries as long term equity holders with minority rights in the relationship. This aligns the seller with the buyer and reduces (but most likely will not eliminate) cash bled from the buyer to the seller. By contrast, if the buyer intends to derive significant benefit from the intangible (technology) assets and, by extension, leverage its capability in technology, the buyer must engage auxiliaries for a short period on a fixed income basis, all the while preparing to transition away from the seller to "one's own" forces.

Supplier relationships are economically sticky. Switching from one supplier to another is generally a poor exit strategy. Equity relationships are difficult to unwind amiably (that is, without attorneys). Fixed income relationships come at the cost of the buyer, who will be bled to death pumping cash into multiple suppliers who will not underwrite the cost of a transition.

Thus the onus is on the buyer to make quick but considerate decisions when engaging an auxiliary. In the case of an equity relationship, the buyer must convince the seller to accept a minority equity position, and determine the viability of the investment quickly (reward or wind it up) so that minority position doesn't languish. In the case of a fixed-income relationship, the buyer needs to be able to exit the supplier relationship for a team of "one's own" forces, relegating the supplier to a minimal role at a transitional moment.

But there are often circumstances that muddle a buyer's judgment. With a gullible or desperate supplier, a buyer can prolong a supplier relationship in the hope that an investment will prove viable. By playing labour arbitrage, a buyer can defer the difficult task of building one's own forces. But whether equity or fixed income, the buyer has to remember that the economics of an auxiliary relationship are in decline for the buyer the minute the ink is dry on a contract. When engaging auxiliaries, the buyer must make quick investment decisions and take quick action. The longer a supplier relationship lasts, the more the power in the relationship shifts to the seller.

No matter the nature of the relationship - equity or fixed income - the buyer must not enter into an "arms length" relationship with the seller. The buyer must be engaged with the seller, constantly monitoring and auditing the deliverables over the life of the relationship. A buyer must be capable of competently auditing the work being done by the supplier before entering into a supplier relationship. If he can't, he is not a qualified buyer and must be regarded as a principal source of risk to the capital being invested. Investors in strategic software are wise to challenge the capability of the buyer as well as the seller.

Entering into a supplier relationship buys time for the buyer to build his or her own forces. These forces must be of equivalent or superior capability to those of the supplier. It might not be of equal size - an indigenous team may be smaller in size than a rented team - but it must be of equal capability. An own force inferior to auxiliaries will be manipulated by the auxiliary to the disadvantage of the buyer. With a team of equal capability, the buyer can quickly eclipse the influence of the supplier in the fulfillment chain. A buyer can preserve credibility with a slower velocity from an indigenous team, but not lower quality.

Auxiliaries can be useful to buyers to compensate for a short-term vulnerability, but only if the buyer has an exit strategy. Sellers, not buyers, benefit from long-term supplier relationships for strategic solutions. Buyers must make quick decisions about investment viability, and take competent actions in building the forces necessary to sustain them.