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, 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.