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.

Tuesday, April 30, 2013

Zombie Businesses

The Lehman bankruptcy is best known as the event that triggered a financial crisis. For many firms, it also sowed the seeds of an operating crisis.

Revenues plummeted at the end of 2008. Companies retrenched by laying people off. Managers coped with smaller staffs by asking employees to perform multiple jobs and to work longer hours. With remaining employees grateful to have kept their jobs, and with the economy leveling off rather than staying in freefall, corporate profitability rebounded as early as 2009.

Smart business leaders knew this wouldn't last, because you can't run a business for very long by running people into the ground. True, jobs weren't a-plenty and a depressed housing market meant employees weren't going to chase dream jobs. Plus, economic indicators gave no reason to believe things were going to improve any time soon. Still, the employer's risk of losing people who held the business together increased every day that the "new normal" set in. Smart leaders got in front of this.

From early 2009, healthy companies boosted their capital spending.1 They used their capital in three ways.

The first was defensive. Managers classified as much work activity as "capital improvement" as they could. Doing so meant labor costs could be capitalized for up to 5 years. This let businesses retain people without eroding profitability. This prevented companies from losing employees with systemic knowledge of the business and intimate knowledge of customers.

The second was offensive, investing in core business operations. Companies invested in technology2 to lock in those post-layoff productivity gains, and to improve customer self-service offerings since they had fewer employees to service customers. These investments made operations a source of competitiveness by lowering costs, increasing efficiency, and making businesses more responsive to customers. This made these firms better able to compete for market share - essential in a slow-growth world.

The third use was financial restructuring and building reserves. This meant issuing debt, and retiring equity. Debt was cheap, as interest rates hit record lows during the crisis. Debt was also in demand, as market liquidity was making a "flight to quality" and many corporations sported high credit ratings and had large cash balances that could comfortably cover interest payments. Debt-for-equity restructuring lowered the total cost of capital. It also benefited boards and CEOs by concentrating ownership of the company in fewer people's hands.

Smart business leaders responded to the financial crisis not only by protecting operations, but by improving and reforming them, taking advantage of cheap capital during the crisis to pay for it.

But many small businesses, high-risk businesses, and poorly capitalized businesses had neither capital cushions nor creative accounting to protect their operations. All they could do was cut costs and hope for the best. And cut they did. The people who got salary bumps in the boom years from 2006 through 2008 became "high-salary outliers" in 2009. It didn't matter that those were the people at the core of the company's capability and drive. When facing financial ruin, the CFO calls the shots, and the pricey people are the first to go regardless the impact to operations.

These cuts may have staved off bankruptcy, but set the stage for an operating crisis by depleting firms of core operating knowledge and contextual business understanding. Cuts made at the beginning of the crisis left few people - and often no single person - fluent in the details of business operations. Those who remain can mechanically perform different tasks, but don't understand why they do the things they do. The business has continued to run, but it runs on momentum. It doesn't initiate change. It erodes a little bit here and there, as employees exit and clients find the offerings stale and go elsewhere. Costs increase as salaries and stay bonuses are showered on those with the most experience in the mechanics of the business. Pricing power decreases as employees lose the ability to articulate the value of what they provide to their customers. As more time passes, the more acute this crisis becomes: margins get squeezed while the business itself becomes operationally sclerotic.

Just as there are zombie loans (banks keep non-performing loans on their books because they don't want to take the writedown), there are zombie businesses. They transact business and generate revenue. They have years of history and long-standing client relationships. Such a business may look like it can be successful with some investment, but lacking that core operating knowledge, it's a zombie: animated but only semi-sentient.

These firms will only have attracted risk capital late in the post-Lehman investment cycle. Because they haven't been making investments in efficiency or customer service, their first use of fresh capital will be to hire new operational support people in an attempt to get caught up. That's costly and inefficient, and it just adds capacity of people who know how to perform the same mechanical tasks. It won't change the fact that austerity depleted the firm of fundamental operating knowledge. New managers brought in with this investment will struggle to unwind the piled on (and often undocumented) complications of the business, while new people in execution roles will get no further than replay of the mechanical processes for running the business.

Resuscitating these businesses - bringing much needed innovation and structural reform to a firm that has been starved of it for a long time - is a time-consuming and costly proposition. First, nobody has time to spare: they're constantly on fire trying to control operations and contain costs of the fragile machinery of the business. Second, they don't know what to do: because nobody knows the business context very well, there isn't anybody who can competently partner on initiatives to reform the business. Third, middle managers lack the will: the trauma of the cuts and years of thin investment will have rendered decision makers reactive (keep operational flare ups under control) instead of aggressive (reinvent the business and supporting systems). Fourth, those same middle managers can only conceptualize the business as what it has always been; they'll lack the imagination to see what it could be.

Surviving a prolonged downturn is not necessarily the mark of a strong business. As Nassim Taleb pointed out in The Black Swan, a lab rat that survives multiple rounds of experimental treatment (say, exposure to high dosages of radiation) isn't "stronger" than rats that do not. The survivor will be in pretty bad shape for the experience. The heroic story of the tough and resourceful survivor isn't necessarily applicable to the business that survives tough times. The apocryphal story of the zombie is a better fit.

1 Many businesses reported a significant uptick in capital spending from 2009-2011 compared to 2006-2008.

2 Strong corporate IT spending is one reason why the tech sector was counter-cyclical from 2009-2011.