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.

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.