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.

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.

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.

Without the Right Capital Structure, There is no Software Company Within

Is every company destined to be a software company? From a production perspective, there's reason to believe so: relatively minor things that were once the domain of hardware (configuration set by switches on a circuit board), operations (merchandise re-ordering based on sales and quantities) or subscription (license fees paid for usage) have become things that are now the domain of software (configuration is set through a browser interacting with Java code running in a Linux variant deployed on a hardware device; algorithms that automatically re-order merchandise based on seasonal, demand & promotional variables; advertising-sponsored or use-metered interaction). Virtual data centers, real-time algorithmic pricing, and new media are simply larger versions of that same phenomenon.

Production isn't what it used to be. A century ago, production was king: demand outstripped supply in economies with emerging consumer classes, which gave power to producers. That has long since changed. Today, production has few sustainable advantages: it is over-built (e.g., automakers have far more capacity than demand), highly flexible (lower labor intensity and cheap capital means production can shift quickly in response to economic or political demands, but by extension means there is no intrinsic strength derived from a "highly skilled labor force"), and subject to constant innovation in inputs (look at the progress in materials science in the last two decades). Producers can only counteract deflationary forces at their core with ruthless cost control and brand allure. A producer does this with a combination of efficiency (squeeze every penny from raw materials sourcing to distribution) and by appealing to or outright fueling user vanity (engender customer identity in every facet of its business).

Software is the means through which both of these things are done: we can use software to gather data, analyze performance and adjust operations in near real-time; we can also use software to reinforce identity, influence attitudes and drive behavior of consumers. No software, no chance.

So producers have to become software companies. But what does that mean exactly?

To somebody running a business, it means realigning internal operations. We have to look at skills and capabilities: we're not going to be much of a software company if we don't employ any software engineers. There are process and cultural considerations, too: an "optimized" business might squeeze more performance out of operations through software, but is less likely to be capable of capitalizing on external data that allows it to "re-invent" its industry through software.

But skills, capabilities, processes and culture all wilt in the face of an overbearing capital structure. A company financed to produce long-term stable cash flows from operations isn't a company that is prepared to respond to threat of competitive innovation via software or anything else, let alone one that will be a source of competitive disruption. It might consume a lot of software. It might even create a lot of that software. But software intensity in what we do doesn't make us a software company, any differently than walking for miles every day makes us athletic. Operations and execution matter to the bottom line, but ultimately dance to the tune called by finance.

Next month, we'll look at the organizational pathologies created by different capital structures and how those make a firm that innovates and competes through software as opposed to a firm that ingests and consumes software.

Would Uber be so intriguing if we thought of it as the next American Airlines?

Suppose for a minute that self-driving cars become commercially available. Obviously, a lot has to happen before we get to that point, but suppose that it does. What happens to the economics of ground transportation?

Today, cars are owned or leased by individuals (households) or fleet operators (delivery firms or rental car companies). Auto manufacturers sell to dealers, who sell to individuals and firms; finance companies from universal banks to specialist lenders finance the trade. The buyer trades cash for utility (you have the car that suits your lifestyle), convenience (you have the car that you want any time you want it), and vanity (your car is a projection of who you want people to think you are). The rise in popularity of leasing hasn't changed things all that much because lessees make payments in exchange for possession that guarantees the same utility, convenience and vanity enjoyed by an owner-operator. Because there are millions of owners (and lessees), ownership is fragmented. Fleet operators have some buying power, but large fleets don't represent a very big portion of the total auto market.

Cars are underutilized: the average car sits unused about 95% of the time. This creates an opportunity to squeeze more efficiency out of the fleet. Enter firms such as Uber and Lyft: an idle person can take their idle car and give someone a ride. Of course, it isn't the car that's being shared, it's the labor: an UberX customer rents the driver, not the car. Uber brings new sources of labor into the market for personal transportation (competing against car ownership, car rental, taxi, limo, etc.), makes it conveniently accessible to passengers, and algorithmically optimizes pricing (the financially lucrative if socially unpalatable "surge pricing"). In a labor-intensive market prone to chronic shortages at the point of consumption (there never is a taxi when you need one in Manhattan...), this gives Uber and Lyft a price advantage over incumbents and attractive growth potential.

Enter the self-driving car. Suppose that we get autonomous self-driving cars that don't require a human operator backup. A self-driving car could deliver itself to a consumer and return itself to a vehicle pool. A vehicle that arrives when it's needed, and disappears when it isn't, changes vehicle consumption into an on-demand, short duration rental transaction. Companies that operate fleets of cars will initially compete on algorithms that maximize fleet utilization, plus inventory management that optimizes the mix of vehicles available in specific geographies at specific times (fuel efficient sedans for trips from home to the airport on weekdays, and light trucks for weekend DIY projects). The more efficient the dispatch and the more comprehensive the fleet, the easier it is for an on-demand service to satisfy an individual's need for utility, convenience and vanity in their choice of transportation.

In a world of self-driving cars, however, the service operator isn't optimizing labor, it's optimizing asset utilization. The economics of ground transportation will change to reflect this. A self driving car changes the current owner-operator (that is, the individual driver) into an on-demand renter-passenger. Rental transactions become simple debit or credit transactions between an individual and a fleet operator.

In this world, the users aren't the owners, but neither are the operators. Auto transportation will come to resemble the air travel business, where there are companies that own fleets of airplanes and rent them to companies that operate them to deliver passengers and packages. The fleet owners - firms like International Lease Finance - are asset-heavy companies that buy and insure aircraft from manufacturers (Boeing, Bombardier, Airbus) and lease them to airlines who operate them to deliver people and parcels. Being large buyers and large suppliers, the lessors concentrate ownership of the assets, which gives them negotiating power with both manufacturers and lessees. They are finance firms that throw off fixed-income-like returns to their investors.

The fleet operators are asset-light, leasing the aircraft (an operating expense) and slugging it out with one another for consumer market share. They throw off equity-like returns because they follow the ups and downs of the consumer economic cycle, facing the simple economic threats of substitution (videoconferencing has culled some demand for in-person meetings) and competition from start-ups siphoning off revenue of the most profitable routes (it isn't hard to start an airline, but it is hard to make money at it for any sustainable period of time, as the list of defunct carriers attests. It will be no less difficult to start an auto operating business).

The auto fleet operator - now an "asset sharing" company of assets it doesn't own, but rents - cannot compete for long solely on efficient dispatching and high asset utilization. Being operating companies of utility services, they compete on price, so they need to be merciless about increasing operating revenues and decreasing operating costs. They will develop complex pricing structures, just as airlines have done to charge premiums for better seats and extra bags. They will segment their market into a small premium segment that rents luxury vehicles and a mass segment that rents more humble rides. They will develop loyalty programs that rewards individuals for transaction volume and revenue contribution. And although it's tempting to think about fuel consumption as an individual responsibility as it is in the owner-operator model, the fleet operator will quickly realize that energy is a major cost component, and will hedge fuel costs as a way to lower their operating cost - or be able to offer lower operating prices vis-a-vis competitors.

We have cars that can drive themselves today. But a lot has to change before a significant number of the cars on the road drive themselves - and not just because of the equipment, infrastructure and policy needed to make it happen. Cars are vanity purchases. Suburban transportation and lifestyles are bound to automobiles. The convenience factor, particularly in periods of high demand, will compel many to continue to own or lease. The individual ownership or lessee model won't change any time soon, so this future is still a long way out.

Still, it suggests that the future of the dial-a-car business will be an exciting one, but for a different set of reasons than anybody is projecting today: intense competition, race-to-the-bottom pricing, volatile earnings, and the occasional trip through bankruptcy. Not exactly the kind of future that captures the imagination.

Matrix IT Organizations, Part II: The Inmates Are Running the Asylum

A few months ago, we took a look at the pathologies of matrixed organizations: no focus, amateur management, and people waging turf wars to secure power that they can exercise without consequence. The result is stationary organizational inertia, the portrait of a seized-up business.

When non-executives enjoy power without responsibility, the corollary is that executives suffer responsibility without power. The organisation cannot pursue a consistent or coherent strategy, and may find it difficult to take any decisions at all.

-- John Kay, How a proud corporate history can lead to poor governance

Matrices empower petty bosses but disenfranchise organizational leaders. The owner of a product P&L doesn't "own" the people who produce it: executors report to managers in other parts of the organization, are shared with other teams, and may be so over-subscribed they have little time to devote to any one of them. Non-technical product leaders will struggle to navigate business goals to completion through the sea of technical tasks their teams force them to sail in. Knowing their skills and institutional knowledge are in short supply, individual executors and their supervisors get to pick and choose what they work on. The product leader ends up negotiating in all directions - with the people nominally on their team, those people's managers, and their peers struggling with the same organizational dynamic - to secure the time, attention and cooperation of labor. This isn't leadership, this is perpetual pleading, often just to complete the most marginal of tasks.

The chaotic process is vigorously defended by claims of democratic legitimacy, and by reference to the traditions and distinctive values of the organisation. But the democracy is a sham, and the values and traditions [...] encourage a tendency to self-congratulation immune to deficiencies in current performance.

-- Ibid.

Although power rests with people in execution, few will derive any joy from the situation. Whether they have power or not, executors are constantly pulled in multiple directions at the same time. In an organization over-run with demands, people will resort to coping mechanisms. One is process: if they can't control demand they can control the means by which people making demands interact with them, giving them some semblance of "control" over their universe. Another is denial: as Dr. Kay points out, they've lost the ability to recognize that the business context itself is idiotic, yet will take triumph at how well they cope. To wit: revenue is declining, infrastructure is decrepit, quality is poor and we can't make even the most simple of decisions, but my goodness we are so much better at communication since we adopted Scrum. High five!

This is organizational madness, and the inmates are running the asylum.

Companies don't set out to be organized as matrices. They resort to it when revenues fail to keep pace with the costs of doing business. When they do, it suggests that the business is trying to do too many things at the same time. It also suggests that many of the things the business is trying to do don't generate much revenue. Put more simply, the business is distracted by a lot of bad ideas. This isn't a problem of organization or of operations leadership, it's an executive leadership problem twined with weak corporate governance that has failed to keep that executive on a short leash.

I once worked with a private equity-backed firm that had a portfolio of four very different digital media products in different stages of maturity, with limited cross-product synergies. Two were past their peak and in unarrestable decline, one was ex-growth, one was growing. The technology organization - including software development - was shared across all products, with tech costs subsidized by the entire business. The company was unprofitable, dependent on life support from private equity injections. To justify those, the corporate headline was growth, although they tried to make the case that there was a profitability story in some of the lines.

We calculated product-specific P&Ls. These revealed that no product was operationally profitable if it had to carry the burden of its actual tech costs. This was due to product customizations given away by sales as a way of luring in new clients to replace lost ones. The slipshod software that resulted from those freebie customizations came with high running costs; company and customer alike got what was paid for in that unfunded customization.

We also did a revenue analysis. It revealed significant client churn across the lines, and that pricing of the growth business was so anemic that it would never achieve sufficient organic growth to provide the revenue the firm expected. Worse still, this sole growing market was maturing rapidly, creating downward price pressures they could do nothing to combat.

Operations and technology were as described in this and the prior blog: unable to focus, fiefdoms without responsibility, and so forth. Being unable to put a floor under the declining businesses' revenues plus a permanent pricing impairment on the "growth" business meant operations and technology would always be starved for cash. There is no wizardry that would turn this around; it was simply a collection of bad businesses.

The sane alternative was to simplify and focus: dispose of the declining and ex-growth businesses or run them for cash; sell the growth business or acquire competitors to consolidate the industry to achieve scale; and invest in organic development of a new media property. Unfortunately, the CEO saw a portfolio of properties that had thousands of visitors and just enough revenue that he could convince the board to keep the funding taps open, because there had to be a pony in there somewhere.

The options aren't all that great in this situation, which is why professionals aren't attracted to them in the first place. If you're brought in as Chief Executive or part of an executive team with an explicit mandate from the board to make sweeping change, you have a chance. But if you have a weak board overseeing a delusional CEO and a sales force for whom every dollar of revenue is the same, all producing initiatives that require tech and operations to compromise to compensate for a lack of revenue, you're wasting your time: you're in the asylum, and there's no one to hear you scream.

Activist Investing in Strategic Software Chapter 1 Excerpt - Why Governance Matters

I've published drafts of the introduction and first 4 chapters of my book, Activist Investing in Strategic Software. I still have some citations to finalize, several visuals to integrate and a lot of editing to do. But the foundation is there. A sample of the book (currently, just the introduction) is available on from the site.

Here's an excerpt from Chapter 1, Why Governance Matters.

* * *

That there are abundant examples of bad governance but few examples of good ones comes as no surprise. What passes for "good" in governance is not all that remarkable. Boards, being the representatives of investors, are expected to be independent, diligent, and uncorruptable. Independent members of corporate boards are assumed to be people of capability and integrity. People in governance roles are expected to discharge their duties competently; meeting expectation is not exceptional. Hence we have few examples of good governance but many examples of bad.

This doesn't help us understand why governance is important.

Poor governance, such as in the cases of Olympus, Hollinger, Madoff, or the United Nation's Oil for Food program, can lead to devastating outcomes that are plain as day after the fact. Yet as we established in the prior section, there are objective characteristics of good governance: set expectations, invest authority, and validate results. And there is research to suggest that the presence of these have a significant impact on bottom-line results.

In a study of 1,500 companies by Harvard professor Paul Gompers, well governed organizations outperformed poorly governed ones by 8.5% annually. “Well governed companies face the same kind of market and competitor risks as everybody else, but the chance of an implosion … by ineffective management is way less.”

-- Gavin Anderson, Chairman, Governance Metrics International

Good governance reduces risk of bad things happening, and there is reason to believe it is a contributing factor to superior performance

Just as a corporation is an investment of capital, so, too, is strategic software. What is true for a company at a macro level should be true at a micro level. The characteristics of good corporate governance should be present in IT governance: an independent board that sets expectations, chooses and changes leadership as necessary, and validates results reported by that leadership.

Activist Investing in Strategic Software

A few years ago, I felt I had enough experience - and had put enough thought into the subject - to write a book on governance in software development. I had observed that most tech firms and captive IT organizations are largely left to self-govern, and both are pretty light touch about it. I had also observed that governance is widely misunderstood and the term is used in technology in a lot of different ways, almost universally incorrectly. With more ambitious investments being made in software and the success rate of large projects not getting all that much better, the need for better governance was there. Plus, it seemed to me that if IT didn't get its act together soon enough, the CFOs of the world were going to get IT's act together for it, so it also made sense to write it from a bit more of a financial rather than an operations perspective.

The timing was good, too, because the prior decade had given us some very well documented examples of egregiously bad corporate governance, ranging from isolated cases of accounting fraud (Worldcom and Parmalat) to the near-collapse of the banking industry that resulted from so many firms taking too much risk onto their balance sheets, their boards having absolutely no idea they had done so. There was some nascent research suggesting that good governance has a measurably positive impact on business outcomes, and also that "activist investors" - people who force their way onto the board of a company to agitate for change - were by and large net positive to a business. All together, we had great examples of how not to govern as well as behaviors we could use as a standard to define what governance really means - practiced or otherwise - in software development.

Within a couple of years, I had written enough material to compose a draft. Then I took a hiatus from it.

In the years since I wrote the first draft, a tension has developed between advocates of "innovation" and champions of "scale" in software development. In one corner are the enterprise development people who say control over operations yields predictable results. In the other are the lean startup people who say that discipline in execution twined with feedback loops is control enough, so just let people go on voyages of discovery and you'll have far better business results. The control camp claims that innovation is possible in their way because it embraces Agile (evidently, all you need are "innovation sprints"). The lean camp claims they can scale to the size of a large business (which may be true, but they're light on practical details). Both say they can revolutionize business itself.

But both camps take an execution (that is, operations) perspective. Execution is important, but if we're going to make organizational impact, we have to do it from a financial, not an operational, perspective. Operations are cost. Investments are value. To change the business of software, we have to speak the language and act the part of the latter. It doesn't matter how revolutionary or how beneficial a different way of delivering software can be to a company: nothing that comes out of either camp is going to cause the authors of Fundamental Accounting Principles to overhaul their text.

I am once again writing the book. I will publish it iteratively. It is still early days - no cover art, not much of a landing page.

But today, the first draft of the first chapters of my book, Activist Investing in Strategic Software, is available on Leanpub.

Matrix IT Organizations, Part I: Turtles all the way Down

Multiple layers of authority overlap both horizontally (different people and committees engage with the same issue) and vertically (many decisions are liable to review by some other body). The lack of focus in decision making results in an absence of executive authority; while professional management is subject to random amateur interference. In consequence, able people are not easily attracted to management roles; and so the amateurs view the professionals with often justified and frequently reciprocated contempt.

-- John Kay, How a proud corporate history can lead to poor governance

A business has many sub-organizations. They may be functional (sales, accounting, etc.) or regional (EMEA, Americas, etc.), or specialized (e.g., product). A company may consist of all three: regional sales and marketing teams, working with multiple product teams, all of whom share corporate-level finance and legal. We want the organization structure to balance customer service with operating efficiency: completely autonomous divisions offer high customer service at a cost to our customers or to our profitability, while completely silo'd organizations squeeze every penny of efficiency at a cost to customer service. Competitive customer service at the lowest cost of execution lies somewhere in between these extremes.

Captive IT faces the same challenge as the rest of the business: organize to provide the greatest level of service while containing costs. IT generally organizes around technical roles: we have infrastructure people, database people, helpdesk people, software development people, and so forth. We also have specializations therein: we have ERP developers, who are not the same as our front-end developers, who are not the same as our legacy system developers. And none of them are quite the same as our QA people.

These sub-specializations are fairly well entrenched because career path is generally associated with role, and even specific technologies. For one thing, deeper expertise in a narrow set of technologies will command a higher salary than shallow expertise in a wide range of technologies. For another, a manager is unlikely to promote a promising member of the web development team to be tech lead of an ERP team because the technical knowledge is not transferable.

IT leaders structure their organizational hierarchy with this in mind. For utility functions, this works just fine: provisioning hardware and e-mail accounts is the same no matter who the user is. But in strategic software development, the business domain influences technical implementation, so IT needs tighter alignment with the business. The specialist IT structure is mapped to more granular business customers in a matrix: we form delivery teams to support a business line or a specific product owned by the business, but each team's tech lead reports to a VP of engineering within the tech organization.

Like everybody else, IT is under cost pressure. The greater the pressure, the more likely IT leadership is to make something into a shared service, which translates into fewer people owning multiple responsibilities for multiple teams. Quality assurance, project management, and techops, for example, can provide greater service when paired with a business partner, but become organizations unto themselves (with fewer staff) as a means of creating cost efficiencies.¹

From an organizational perspective, this makes things somewhat untidy within IT because we have a matrix (shared services) within a matrix (development teams organized by business line, but reporting up to an engineering leader). If there is a shared service within a shared service, such as DBAs being part of techops, we have a matrix within a matrix within a matrix. It's turtles, all the way down.

Add to this the recent phenomenon of product organizations. A product hierarchy - common but by no means exclusive to tech firms - is chartered to elevate users (people who use the software) and customers (those who pay the bills for those who use the software) in ways that subject matter experts and software engineers are not able to. As the proxy for consumers and buyers, they influence priorities and packages of functionality. But product owners don't necessarily have strong footing in either the business domain or software development. In practice, they act as a referee between SMEs and engineers. At best they're an emerging function clawing at opportunity from a different perspective; at worst they're another level of intermediation in the decision making process.

And so we have the situation described above by John Kay: no small number of people being brought to bear on a problem, but a structural inability to get results.

With no defined power structure, the vacuum is filled by people who turn non-executive roles into a near full-time occupation. [...] Petty politicians enjoy the feeling of being at the centre and jostle for power; the power they seek is not the ability to get things done but the negative power that comes from “no decision without me”. Secrecy about matters of no significance bolsters their sense of self-importance.

-- Ibid.

Instead of better business alignment, we have fragmented ownership and competing priorities and agendas. Matrices create, rather than alleviate, impediments to getting things done.

In Part II, we'll look at executive disenfranchisement in the matrix organization.

 

¹ It's worth noting that the decision to make something a shared service is frequently justified as a means of promoting "best practices". Functions like QA or devops that are fragmented into separate product teams will show inconsistent performance; consolidating them into a single function should, in theory, be a step toward making them more consistent (ignorant of technical, asset or personnel restrictions on that). The irony is that somehow, "best practices" - whatever that's supposed to mean - will compensate for the fact that a critical function is deliberately being starved of investment.

The CIO and M&A, Part II

Integrating businesses is no small task.  Established workflows, systems and tools are vigorously defended yet poorly understood.  Fearing for their jobs, people will equate systemic knowledge with job security.  Many in the acquired business will cling to their legacy identity. Organizational politics - and power plays - will alter tactical integration plans.  But it is the business goals that investors signed up for - not the internal special interests - that will determine the fate of the leadership responsible for the integration.  How do we stay focused on these?

Be a business leader, not a technology partner. Technology leadership must be fluent in the broader business context of the integration and be prepared to make decisions on behalf of the business, not just the technology applied to the business.  This means being or bringing in business process analysts to simplify the operations - and with it, the technology - of the business itself.

I wrote last month that most material on the role of IT in M&A are platitudes, and this certainly smacks of one.  But the fact is, this is not something that IT departments have in recent years positioned themselves to do.  The change in moniker from "Information Systems" to "Information Technology" has been a detriment to CIOs: the word "systems" implied responsibilities inclusive of business and technology, whereas the word "technology" suggests it is solely responsible for tech.  As a result, there is less expectation that tech will shape business decisions as much as it will carry them out.  It doesn't help that business analysis skills remain low in captive IT.

M&A gifts captive IT with the opportunity to be the "resident adult" in sorting out intransigent participants in an integration. However, that opportunity exists only if it is prepared to act as a business leader and not merely a technology supplier.

Slowly strangle, don't wholesale replace. Existing systems are complex: they have highly specialized rules that were developed over a number of years, they were developed with very different architectural principles than would be applied today, and the older the underlying technology the scarcer the technological know-how there is to incrementally change them.  This makes it easy to make the case that dueling systems are incompatible with one another, are no less valuable owing to the criticality of the specific edge cases they accommodate, and can only be replaced through a large "enterprise"-scale rewrite.  Thus we have no choice but to maintain the status quo, and only costly and high-risk change can possibly sweep it away.

The headwinds to change blow fiercely; there are always plenty of reasons not to do something.

Unless both organizations have extraordinarily geriatric technology, proposing an enterprise refit will be met with skepticism in the boardroom that will cast doubt on our leadership capability.  Even a big-bang retrofit of one incumbant technology to take the place of another will receive only a grudging endorsement.  Both scenarios also create tactical confusion: should existing systems be modified to meet immediate business needs or do we wait for the big-bang replacement?  And what do we do if that big bang replacment gets delayed?

We avoid this trap by strangling existing software.  In effect, we allow our portfolio of assets to continue to evolve with the business while simultaneously deprecating and retiring them.  We do this gradually, identifying specific functionality that can be integrated and replaced.  We have the practices and technologies today - from continuous integration to feature toggles to branch by abstraction - to make this a matter of will.  It is also palatable to the board because it gives us a means to show how we are structurally reducing our cost of operations in a manner that will support the business in the short-term and sustain it in the long-term, not a slash-and-burn approach that makes it thinner at the cost of making it more sclerotic.

This will mean making some unpleasant decisions. We may have to create new code - a lot of new code - to integrate old code on our way to fully retiring it.  We may have to integrate in unpalatable ways (e.g,. at the database level) where legacy systems do not support modern architectural principles.  And there will be times when the extent of integration will makes our collection of assets very complicated.  This means that our measure of success isn't just getting things deployed, but getting things removed.  To the CIO, the critical measure is a composite "simplicity index" of all IT systems, not "integration progress" in simply making systems work together.

Insist on excellence in engineering.  When the clock is ticking, there will be temptation and pressure to cut corners.  We can create the appearance of integration with quick and dirty solutions, and all that matters in the end is that it works, not how it works.

The phrase "we'll fix it later" probably has the lowest conversion rate of any statement made in business. An implcit expectation in M&A is that we are investing in simplicity and robustness, not complexity and brittleness.  The reality is, we're not going to get money later to pay down technical or operational debt we take on. If the combined landscape has more moving parts and fragmented institutional knowledge than the sum of the parts of the combining companies, we'll have a higher cost of operations and, therefore, have failed.

Investigate, measure, and draw attention to quality of engineering.  Instrument all code, looking specifically for complexity, duplication, testability, and test coverage.  Incentivise good engineering practices and reward teams that make structural and procedural improvements.  Take deliberate action against poor engineering decisions: delay an implementation rather than accept a poor one.  We have to live with the consequences of our decisions; make clear that we have invioable standards of performance.

Nobody is irreplaceable.  Inheriting somebody else's code is never much fun.  We have to deconstruct what other people were thinking at the time they created it, while simultaneously trying to understand the business context that existed at that time versus the context that exists today.  It's much easier to fight for funds to perpetuate a legacy team than it is to take responsibility for cleaning it up.

Two things to remember: it's just code, and the people behind both the code and the business usually don't have as much systemic or contextual knowledge as we project into them that they have.

To the first point, most code is not as algorithmically complex as we are told that it is.  The implementation might be complex, but implementation decisions are generally easy to discern (somebody really liked Java interfaces, so everything is implemented as an interface).  Once we figure that out, it's fairly straightforward to restructure the code and increase test coverage to make it more testable.  This is true for current and legacy languages alike.

To the second point, don't assume that the business leaders have as solid a grip as you'd hope they do as to why they do the things they do.  Some years ago, I was working with a firm to redesign fleet maintenance operations.  The existing suite of software tools were a combination of RPG, Visual Basic, Java and Excel, tied together with a number of manual integration steps.  The business operations leaders could only understand operations in the context that the technology allowed them to do these things.  We had to understand their business operations better than they did to get them to understand the actual value stream.

Do not be held hostage by tribal knowledge or the perception of that tribal knowledge.  Reward people for knowledge sharing and provide career paths for people to move beyond system caretakers to leadership roles that builds on their experience in mission-critical systems and knowledge of how the business itself operates.  Do not be afraid to cut people loose who are obstacles to change, no matter how entrenched they are perceived to be. Best of all, replacing legacy systems will reduce pockets of that knowledge: we start the clock ticking on it the minute we start to retire it.

Put your personal credibility on the line for these things.  A CIO has only as much time as the M&A horizon to create a common culture within the technology organization. Whatever the cultural norms are of the two firms at the start, insisting on engineering excellence, business leadership, and gradual improvement while being willing to accept responsibility for cutting loose tribal knowledge sets a decisive tone of change within an organization.  This creates both a new mission and a new identity for everybody.

Most importantly, we have to make it clear to all and sundry that we are every bit as much on the line for these things as they are.  We will take responsibility for a delay in implementation where quality is sub-standard.  We will develop new leaders in our organization rather than being forced to retain people in existing roles.  Our actions will speak louder than our words.

Nobody is irreplaceable.  If we fail to deliver, we'll find that out to be true for us, too.

The CIO and M&A, Part I

"It is hard not to be cynical about this. M&A is a great process for creating fees for bankers, and for destroying the value held by shareholders."

-- John Authers, writing in the Financial Times

Industries tend to go through waves of deal-making. Sometimes it is divestiture or separation: sprawling firms that serve different buyers or markets don't achieve much in the way of operating efficiency, and a "conglomerate discount" priced into their equity means there is value that can be released by dividing a firm into multiple businesses. This is something H-P did in the late 1990s, and is about to do again. But usually, deals are acquisitions: competitors merge to gain more power over costs and prices (United Airlines merging with Continental); large firms acquire smaller ones to enhance their core (Yahoo has been on an acquisition tear in recent years), diversify their markets, or simply to prevent a firm from falling into the hands of competitors (Microsoft's acquisition of Skype).

The justification for a merger or acquisition usually involves some quantification of synergistic benefit: the two businesses have so much in common they can achieve greater profitability together far sooner than they would be able to on their own. This can be achieved through sales: Company A and Company B sell complimentary products to the same buyers; a merger of the two would allow for cross selling, resulting in larger and more lucrative sales. It can also be achieved through operating efficiencies: Company A and Company B can operate just as effectively with, say, 70% or less of their combined procurement, finance, accounting, HR and IT organizations.

The expected synergistic benefits to revenue and costs are calculated, then taxed and capitalized, to come up with a hard economic value to doing a deal. This makes them important to the CEOs involved because they help them sell their respective boards - and shareholders - on doing a deal. Their importance increases in direct proportion to the premium an acquirer is willing to pay to buy another firm. Synergies can be substantial: the proposed synergies of the merger between Office Max and Office Depot exceeded the combined market capitalization of the two firms.

* * *

"Most deals fail to create value because the buyer paid too much, or because the acquirer failed in the difficult task of sticking two companies together. Glossy proclamations of new strategic visions often boil down to a prosaic cost-cutting exercise, or into a failure of implementation."

IT is at the center of deal synergy. Obviously, we don't want to pay to maintain multiple e-Commerce sites or pay licensing fees for multiple ERP systems. But redundant IT systems can increase the cost of doing business: if we need people in finance to write custom reports to combine financial reporting across the two businesses, the merger has increased our total cost of operations. We need to combine systems, and do so quickly.

There are plenty of cookie-cutter frameworks for combining businesses, even their technology systems and operations. This also means there are plenty of platitudes to go round: "Involve the CIO as part of the executive team from the start" and "IT doesn't work in isolation". True, but not very helpful. Rubber hits the road in M&A in the actual combination - and reduction - of systems. Platitudes will not change an ugly operating reality.

IT in M&A can be a very messy business. For example, suppose Company A acquires Company B and intends to move Company B - running a highly customized & partially proprietary ERP - over to Company A's similarly customized, but commercial-off-the-shelf, ERP system. Company B has very different business processes and communication channels from Company A. The new divisional leader for that part of the combined company is from Company B and decides he wants those processes applied to the combined business. IT must now make changes to Company A's ERP system and dependent code to accommodate this change, in addition to migrating data. Costs just went up and the consolidation timeline just got longer - and depending on your point of view, it looks like an IT problem.

This also applies to the mundane stuff. For example, IT learns that the data and data structures in Company B don't exactly line up with Company A, so data migration is going to take more effort than originally expected. IT responds by creating data warehouses to house consolidated data so that Finance can run its consolidated reports. Costs just went up, as did operational complexity: those warehouses - and the ETL that refreshes them - have to be maintained and updated.

When companies pay a premium to fair value of net assets for a business they acquire, the excess is recorded on the balance sheet as goodwill. In theory, the value of the combined business should increase as synergies are realized, obviating the need for goodwill. The reality - and core to Mr. Auther's comments above - is that companies have a tendency to pay too much in acquisitions and end up taking a writedown. One study found that between 2003 and 2009, some 4,600 firms wrote-down goodwill due to impairment, amounting to 20% of total recorded goodwill. The study went on to report that there are some serious ramifications to this. For one thing, "the news of goodwill write-off [...] precede[s] CEO resignation and can trigger shareholder lawsuit." For another, "Firms with goodwill write-offs significantly under-perform in future." (Feng Gu, Goodwill and Goodwill Write-off: Economic and Accounting Implications)

So, in a M&A situation, there's a lot on the line for the CIO: you don't want to be the reason the boss loses his job, and you don't want to be a reason why the stock price underperforms. But your operating reality is messy: you're beholden to tribal knowledge of systems you've inherited through the acquisition, you're at the mercy of business decisions that are made for local optimization or simply local convenience, and you're under the gun to enable finance and accounting to create the patina of a combined business for the benefit of the people who approved the deal. As CIO, you'll be under pressure to extend and even bump your payroll to prevent loss of knowledge, create teams to chase business decisions with new software, and take on technical and operational debt to make good on immediate needs.

There is no playbook for this.

Next month, we'll look at how a CIO can square this circle.

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.

Tech: From Owning to Renting - to Owning Again?

In the 1970s, the predominant business strategy was vertical integration: own the value chain from raw materials to retail outlets. The research of the time supported this. The Profit Impact of Market Strategy database produced by the Strategic Planning institute concluded that diverse & vertically integrated businesses were significantly more profitable than narrow and focused businesses (PIMS 1977, slide 67). Michael Porter argued in Competitive Strategy that vertical integration enabled cost leadership, which was more likely to win market share than a strategy of differentiation. Vertical integration also created a barrier to entry to competitors, and provided defense against powerful buyers & suppliers and the threat of substitutes (Porter 1980, pages 9-15, 35-37). Corporate strategies assumed long-term existence and growth; this made employer-employee relationships more durable, so a firm could be a destination employer for people across a diverse range of roles. Companies like American Telephone & Telegraph and General Electric could pursue diversification and vertical integration in no small part because they could be all things to all people.

Business strategy changed in the 1990s, insisting that companies were better off focusing on "core competencies" while renting anything deemed non-core. A retailer, for example, should concentrate on sourcing merchandise to sell and developing the outlets through which to sell it, but rent the accountants, IT, back-office staff and real estate to operate and administrate the business. The thinking was that a firm could not be expert at doing everything, it would have cost bloat in non-core areas and lack the expertise to contain it, and that firms needed to pay ruthless attention to their core as competition would only intensify. It also became accepted that a firm could not be a destination employer for non-core employees and therefore could not expect to be attractive to top flight people across the board. Outsourcing for business and technology services reduced the number of employees and associated costs, allowed significant operating costs to be negotiated on a gross basis rather than an individual one, and made labor arbitrage accessible to firms for which it would have been too risky and difficult to pursue by themselves.

This change happened quickly. Perceptions of corporate durability imploded in less than a decade through consolidation (increase in M&A) and bankruptcy (over-leveraged with junk-grade debt and unable to make debt service payments). This eroded the employer-employee relationship and made any single firm less broadly appealing. Kodak outsourced IT to IBM in 1989, ushering in large-scale IT outsourcing that fueled the rapid growth of firms like Accenture and TCS over the ensuing two decades. GE created a business process outsourcer - Genpact - in the late 1990s, spinning them off as an independent company within 10 years. Firms separated asset ownership from asset usage, creating holding companies that own the real estate and rent it to subsidiaries that run business that occupy it. In a relatively short span of time, companies went from owning everything and renting nothing, to owning little and renting everything, with lots of financial intermediaries springing up to minimize tax burdens and squeeze rents.

In technology, cloud computing extends this story arc. Prior to the advent of computers, business was labor intensive. When companies first invested in computer technology by buying mainframes and hiring programmers, they did so to create efficiencies in their administrative operations. Companies reduced their labor expense, and the hardware and software they acquired appeared on the balance sheet as capital investments in the business. In the process, they also made business application development a "core competency" of their business. Within 40 years, most of those administrative processes were standardized by commercial-off-the-shelf ERP products. But that ERP solution still appeared as an asset on the balance sheet because software licenses, customization, and server infrastructure were capitalized assets of the firm, even if the people who led the customization and implementation were rented and not employees.

This is beginning to change. Cloud, Saas, and BYOD allow firms to rent technology rather than own it. As businesses have consumed increasing amounts of computer technology over the years - communication tools, productivity tools, business administrative software, servers, routers and end-user devices - company balance sheets have become increasingly "tech asset heavy". Renting makes their balance sheets "tech asset light". Rent payments put a dent in cash flow from operations, and the cost of renting can be higher than the cost of owning. However, renting improves performance ratios such as "return on assets" and "capital intensity". This flatters the CEO and the CFO.

Early computer technology transferred labor intensity of business activity (lots of clerks on the payroll, performing manual chores) to capital intensity (computers & software automating these chores, booked as capital assets), but it was still accounted for as something the business owned rather than rented. Cloud, SaaS and BYOD will drive out the lingering capital intensity by shifting the technology assets from "own" to "rent". A business still has costs associated with these things (it has to generate invoices and collect from customers), but as the underlying functions become more and more commoditized they offer no strategic advantage, and are instead treated as a tax on doing business. There is still room for innovation - new firms will emerge to offer new ways of providing these services to minimize this "tax" - but these are commodity offerings competing in a race to the bottom on price.

Businesses originally owned their tech capability, because that was the prevailing way that businesses operated, computers and computer skills were scarce, and firms derived significant competitive advantage from being early adopters. That changed because strategic thinking changed, technology became commonplace, and a lot of business technology became utilitarian. But what's true for utility tech is not true for disruptive tech, that is, tech that disrupts business models. Businesses are no longer consumers of tech, they are becoming tech. If every firm is a software firm, does technology need to return to the core? Will the business practices that developed and evolved with renting be adaptable, irrelevant, or an outright encumbrance? We'll look at those questions in the next post.

Why Commercial Contracts Matter In Agile Software Development

"We value customer collaboration over contract negotiation." -- The Agile Manifesto

Contracts for software development have historically included language that specifically defines the software being developed. This protects the buyer from paying for an asset that does not serve its business needs, the seller from requirements drift or expansion, and allows both parties to agree to duration and cost.  Traditional development contracts also stipulate the process by which the software is to be developed and tested, and how changes will be accommodated.  Since the way something is produced has direct bearing on the quality of what gets produced, specifying the process protects the buyer from slipshod work practices, and gives the seller a formal framework to control the development lifecycle.  The parties are trading a long-dated asset for a series of short-dated cash flows; being specific about the work being produced and the means of production is a means of protecting each party's economic interests throughout.

But with Agile becoming more and more widespread, contracts that stipulate requirements, team composition and change control processes lock both buyer and seller into a commercial arrangement that is an encumbrance (requiring constant amendment to accommodate changes) and may actually interfere with delivery.  Agile development requires more flexible contracting.  So it comes little surprise that a core tenet of the Agile manifesto is that people involved in developing software should constructively collaborate with one another to deliver a valuable business asset, not conform to a strict protocol that defines allowable behaviours.

The rigidity of traditional contracts has led firms in the Agile development business to experiment with looser contractual language.  In principle, this makes sense.  Agile teams deliver more frequently, so the lag between the buyer's cash and the seller's delivery isn't as great as it is with traditional software development.  Frequent showcases and deliveries improve trust and confidence between buyer in seller in ways that can't be codified in the language of a contract.  The benefit of looser language is that as teams learn more about the actual business needs and technical complexity of what they are developing, they have more freedom to act (and react) as the situation warrants.  There should also be limited downside. Even if the contract is vague, a buyer won't pay if she doesn't like what the seller has produced, and a seller will suspend work if he has an unwilling or incompetent buyer.  The people involved have maximum leeway to get stuff done and they'll let each other know in the most direct means possible when they're not happy.

In place of precisely defined language, it isn't uncommon to see development contracts that capture none of the intent whatsoever, and define only a supply of an unspecified number of people for an indefinite period of time.  If the understanding ex-contract is that the seller is there to develop software for a particular purpose in a particular manner, the contract is, in theory, at best a formality and at worst takes too much time.  If the development work is treated as R&D rather than a capital investment, doing this doesn't flaunt accounting practices (which require strict definition of capital work).  And if one party is disappointed with another during development, they'll make that abundantly clear by suspending performance until they are happy.  This is the triumph of the desire to get stuff done over the formality of contract law.

"That is, while there is value in the items on the right, we value the items on the left more."

But contracts do matter.

A contract expresses the value each party places in the other and the respect they have for one another.  The preamble language defines who the parties are or think they are as an acknowledgement of the strengths that each bring to the relationship: they are disruptors ("re-imagining the classroom for the 21st century"), or market leaders ("the nation's largest provider of financial services to retirees"), or specialists ("the leading provider of software development services to municipal governments in the tri-state area").  This underscores goals of the buyer (the disruptor is buying an innovative solution; the market leader wants cost efficiencies) and the capability of the seller (technical, process or subject matter expertise) and why the two parties want to work together.  In the contract, if the buyer is just a business no different from any other, and the seller is just a provider of people, the relationship will eventually come to reflect this, too.

A contract communicates the outcome the parties are working toward.  If the buyer wants an asset, they are committing to developing an asset in conjunction with a partner, and both buyer and seller are drivers in achieving that goal.  If the buyer wants only to rent capacity from the seller, the seller will be a passenger in the buyer's goals.

A contract defines a bond between two organizations, a bond that is meant to be durable in good times and in bad.  The more closely twined buyer and seller, the more likely they are to resolve their differences and difficulties. The more disposable a relationship, the more likely one party will dispense with the other when greener pastures beckon.

We don't want contracts that are ignorant of the need for flexibility.  But convenience erodes commitment: flexibility achieved through ambiguity undermines a sense of partnership. It is better to achieve flexibility through provisions that define the parties, define the mission, and define a bond.  This creates a commitment to the principles of a relationship.

Contracts exist between companies; relationships exist among people.  A relationship will always trump what's written in a contract.  But people come and go, and relationships are constantly tested.  A contract easily exited undermines the commitment of a relationship.  Good contracts are not an encumbrance to delivery: they strengthen the commercial ecosystem through which delivery happens.

The Fine Line Between "Stretch Role" and "Unqualified", Part II: The Growth Mask

When a business or a profession grows faster than the labor market it draws from, it suffers a capability deficiency: there simply aren't enough experienced people to go round. It also suffers a leadership deficiency: there aren't enough people with cross-discipline experience to make competent business decisions. When there are more leadership jobs than there are qualified leaders to fill them, people will be given responsibilities they would not otherwise have. Even though hiring decisions are made independently, macro forces can be responsible for people landing in stretch roles.

Volume Cures All Ills

Growth - be it a function of runaway demand or insatiable investor appetite - increases a business' tolerance for leaders who are coming to terms with their responsibilities. In no small part, this is because the performance of a rapidly growing businesses can be difficult to measure, while its business decisions - most importantly, where they concern cash - are blatantly obvious.

For example, early stage tech businesses tend to lack revenue and profitability but attract increasing numbers of users. They are measured on indicators such as total number of user accounts and number of active users. These are non-financial measures that are calculated differently across firms (e.g., a single person may have multiple accounts, while "active" is a relative term), making comparisons difficult. Because there is little history of tracking these types of metrics in business, it isn't clear how they truly relate to the long-term valuation of a business. Although the performance measures of a growth firm in an emergent industry are a bit foggy, the business decisions are crystal clear. The most important decision - what to do with cash - is cut and dried: plow it back into the business to fuel growth.

By comparison, well established businesses in industries like air travel or retail banking are expected to be predictable. They are meticulously measured on established accounting metrics such as earnings and cash flow, measures that are easy to understand and comparable within and across industries. But their business decisions - again, particularly those to do with cash distribution - are more complex: do we invest in the core for efficiency, diversify for growth, or distribute cash to shareholders? Stakeholders - employees, investors, customers - in a growing business will be tolerant of novice leadership; stakeholders in a mature one will not.

By way of example, social media firms had the benefit of time to adjust their products to be mobile centric rather than desktop centric. Although the chattering classes raised concerns, the total growth of social media prevented a sense of crisis from cratering equity values or inciting mass employee exodus. In contrast, retail firms haven't been so fortunate: ecommerce cannibalizes existing retail sales more than it increase them (to wit: Amazon's growth in retail has come substantially to the detriment of traditional retailers). Retail firms are not seeing their businesses grow rapidly because of technology, they're seeing their businesses change underneath them because of it. These firms don't have an abundance of time because their core businesses are vulnerable to rapid erosion. They are far less tolerant to leaders learning their trade.

Growth Makes Everybody Look Good

Although growth make it safer for people in stretch roles, they also make everybody look good, deservedly or not. The greater the success achieved by multiple businesses in the same sector, the less clear the contribution of the leadership to any firm's success. A rising tide simply lifts all boats. As Jeff Immelt famously quipped about commercial conditions during the 1990s: "A dog could have run a business".

Too often, we never really know the difference between a savvy business leader and person who simply got lucky. Many years ago, I sat on a panel with a renoun dot-com investor who had retained his fortune post-bubble by getting out just in time. Prima facie, he appeared to be the sage of Silicon Valley. On interrogation, it turned out that he'd cashed out several investments to free capital for a new round of leveraged bets on internet businesses, just as the bottom fell out of dot-com equities. He happened to be out of the market at precisely the right moment because he hadn't finished negotiating his new placements. It wasn't deep market insight that enabled him to call the market peak: he intended to be long the entire time, and was short only because dumb luck that had him cash out and head to the sidelines at just the right moment. The only sage advice he was qualified to give was to "be in the right place at the right time".

What If Everybody is Stretching?

In overheated sectors, we can easily end up with leadership teams who are reaching beyond their capability. The more the froth on the business, the more concern there is with fast action and the less concern there is with meaningful qualification of the people running it. We end up with an explosion of title inflation (a rise in the number of people with double-barreled titles beginning with words like "chief", "strategic" or "senior") without the concomitant increase in the number of experienced board members and executives to mentor these freshly minted leaders. It isn't uncommon for a high growth firm to build an entire leadership chain of stretchies - people in the wrong weight class, from the most senior executives right down to management on the line. This renders mentoring relationships irrelevant, and potentially damaging.

Explosive business growth can yield a new class of leaders. But in the absence of a strong foundation, it is just as likely to foment destructive organizational pathologies of paranoia and denial. The pinnacle of organizational absurdity is when employees, clients and investors are told quarter after quarter that every leader is "awesome", yet mysteriously, the overall business performance is disappointing. This isn't a business on the rise, it's a well funded frat party.

Where's your business?

The Fine Line Between "Stretch Role" and "Unqualified", part I

Everybody wins when somebody is put in a stretch role. Whoever does the hiring - a manager naming a first time tech lead or a board hiring a first time CEO - has propelled somebody's career. The investment in that person's success implies a commitment to a very active mentoring relationship. The person being asked to stretch is being given the opportunity to learn and mature, with a tacit expectation that they have freedom to try and fail while they are honing new skills.

We like seeing people in stretch roles, we like what it says about us as leaders that we put people in them, and we like the possibility that one day we, too will be given an opportunity to stretch.

A stretch role creates a halo effect for the person doing the hiring and the person being hired. For the management doing the hiring, it's a sign that the company is investing in the next generation of leaders, and that the firm demonstrably offers opportunity for advancement. For the individual being hired, it signals satisfaction of performance and expectations for great things. And, because everybody is taking a chance, it communicates an element of "risk", even in otherwise risk-averse corporate cultures.

But the halo reflects little brilliance. Stretch roles are too often made because there aren't any other viable choices. We rarely get to hire our ideal candidate, so we're going to have to settle in one way or another. Scarcity is a factor: in tight labor markets, availability becomes a skill. Plus, the longer a position goes without being filled, the worse the manager responsible for filling it looks - and the more likely that somebody higher up will conclude the position isn't all that necessary and will remove it from the budget. The decision to put somebody in a stretch role is very often simply that we can't think of any reason not to put you in this job. This is easily rationalized: emotionally, the benevolence of offering somebody a stretch role more than compensates for the risk that the person will not work out.

In the right circumstances, stretch roles grow people and businesses. They give a person license to test his or her boundaries, the freedom to experiment, and the opportunity to develop a unique style at something. But success depends on the circumstances: a short honeymoon period, being kept on a short leash by management, pressure to underwrite risks they don't completely understand, a "we never fail" corporate culture, no critical assessment of the person's areas of weakness, an absentee mentor or, worse, an incapable mentor, each stack the deck against the stretch candidate. A newbie in the job will not recognize the factors working against their success.

Throwing somebody into the deep end of the pool in their first swim lesson isn't enabling, it's overwhelming. Having somebody claw their way into a state where they can perform at a rudimentary level isn't professional development: it risks developing the wrong "muscle memories" for the job, and denies them the opportunity to achieve the meta-awareness they need to master their new role. It's also short-term career fatal: perpetually chasing responsibilities, constant drama and few successes alter the perception of the person from "aspirant stretchie" to "unqualified leader".

There is also the potential for long-term career damage. Over-promote somebody into a leadership role and they'll forever think they're leadership material. It may be that they simply aren't, but the stretch candidate is not likely to recognize this before or after being asked to take a stretch role; once invited, they've made the grade. The person who was on a stable career path ends up making frequent job-hops across firms just to maintain the same level of seniority.

Teams and departments suffer, too, not only from weak leadership at the helm but from the damage done to the confidence and trust among everybody else in the business. Plus, it sews seeds of doubt with the management who put the person in that role in the first place, often with damaging consequences (recall that Bill Ackman was ousted from the JC Penney board for having hired Ron Johnson as CEO).

Worse, the time spent with the wrong person in the role is time the business prolongs its people problems. Some years ago, I worked with a firm that had a strong tech culture but a weak sales one. There was high turnover of salespeople, and frequent vacancies in the sales team. A manager in the tech organization asked for a position in business development. Because of his credibility in tech delivery twined with an extrovert personality, management saw no reason not to give him the job. His lack of knowledge of business development, his lack of empathy for non-technical business buyers, and the absence of any strong sales leaders to mentor the new hire contributed to a disappointing year, culminating with his being asked to leave the sales organization and return to tech. Tainted by this failure, the would-be BDM left the company soon after. The company had not only engineered the loss of a respected member of the tech organization, it was no further along solving it's sales problem one year on.

(As to the person in question, his resume ticked technology, management and sales boxes, he already had a general management position at another tech firm in hand at the time he left. It was a short-lived gig as it became obvious very quickly that his capability did not live up to his resume.)

There's a simple litmus test we can apply to any organizational leader: would this person hold a comparable position in a comparable organization? An established leader capable of redefining and reshaping role clearly passes this test. An emerging leader who quickly takes to their new role while also disrupting conventional understanding of it will also pass this test. An aspirant leader being chased by demands and relegated to rote execution under constant direction of his or her superiors will not.

Every business has people in stretch roles. What are you doing with yours?

Deflation and Technical Debt

Technical debt is a useful metaphor for explaining why some code is faster to complete but more expensive to maintain. It is also helpful in explaining design decisions made for sake of expediency, or because of an outright lack of knowledge. Tech debt can be a real burden on development, particularly as it takes away time that would otherwise be directed toward productive investment in new feature development. This makes it tempting to interpret tech debt as a quantifiable economic or financial phenomenon. It is not. If we respect the accounting treatment of it as indirect, and extend the metaphor toward team dynamics and away from financial statements, it also helps us understand our ongoing ability to service tech debt.

Debt and Deflation

Edward Hadas argues that debt is an antiquated form of finance, "unnecessarily distant from economic reality". Fixed interest rates, maturity mismatches (banks borrow short and lend long) and variability in borrower's cash flows create unnecessary risks to borrower and lender alike. Financial institutions create all kinds of provisions and capital structures to underwrite uncertainty and absorb losses. If we set out to create finance today, we wouldn't use such a rigid structure as a primary investment vehicle.

Debt is a wager on future interest rates. The debtor is making an income backwardation play: that inflation will rise faster than the rate reflected in the interest rate, or that their real wages rise over the life of the loan. For example, in simple housing finance, a wage earner takes out a loan to buy a house. If inflation rises faster than expected (per the interest rate on the loan) and their wages keep pace with that higher inflation rate, the debt is easier to service because their income is higher. In this case, they've been inflated out of their debt. In addition, the debtor's wages can rise faster than inflation through salary increases (e.g., due to job promotions). This makes the debtor's real income higher, which also makes it easier to service the debt. The backwardation is that the projected future income at the time of the loan is less than what the spot income turns out to be in the future.

The lender is not entirely betting on the opposite. It is true that the lender comes out ahead if inflation rises more slowly than the rate reflected in the interest rate. But they also stand to gain from the debtor's ability to service a loan. An increase in real wages increases the debtor's ability to service the debt; this is reflected in the borrower's credit worthiness (rating or score). Lower credit risk increases the value of the debt instrument. A lender can sell the loan to somebody else for a higher price, which is their reward for underwriting the risk of the borrower at the time of origination.

For the borrower, deflation increases the real cost of debt. The less money a household earns, the harder it is for that household to service its debt. This is why central banks in highly indebted economies will pull out all the stops to fight deflation. Falling consumer prices reduce revenues. Falling asset prices reduce people's perception of their wealth, which reduces their willingness to spend. Deflation increases the burden of debt and intensifies contractionary forces on an economy. Mature economies - Europe, Japan, US - are debt-financed more than they are equity financed, and there are far more borrowers than lenders. It comes as no surprise that European Central Bank chief Mario Draghi committed to fight low inflation, Shinzo Abe's government in Japan expanded money supply to juice asset prices, and former US Fed Chairman Ben Bernanke committed to Quantitative Easing.

Technical Debt is an Indirect Economic Phenomenon, not a Direct One

In finance, the person using debt to finance an asset purchase is the person who is responsible for the debt. This makes sense in the business of software, because the person paying to acquire and operate software may be "borrowing" against future cash flows in the form of costs to service technical debt. The buyer of a software asset is the person footing the bill for people to service that debt.

But technical debt is an indirect economic phenomenon, not a direct one. That is, technical debt does not necessarily finance a software asset. Technical debt only has economic impact if costs required to service that debt are realized. For example, an asset with a lot of tech debt may not be subject to much maintenance activity, or suffer production instability requiring a lot of attention, or suffer performance problems (directly resulting from that tech debt) requiring additional investment to scale. In each of these cases, a tech-debt-heavy asset may have the potential to be high cost, but those costs may never be realized. If a cost is not realized, it is not a real economic cost. It only becomes an economic phenomenon if excess labor or infrastructure is needed to compensate for its presence.

This brings us to the limits of the tech debt metaphor. There is no bank offering technical debt loans: tech debt is conjured by people during moments of development. One can argue that tech debt borrows against the equity of the asset, but that does not hold up in accounting terms. With or without tech debt, we still carry the asset on the balance sheet at the same economic value: the total capital outlay less accumulated depreciation. The cost of servicing technical debt is a function of people's time, which is an operating cost. The expectation of future payroll costs that may be incurred to service technical debt is not a balance sheet liability that reduces an asset's equity, it's reported in the future period when it is incurred as an operating expense on our income statement and a drag on cash flow. Tech debt may or may not lead to reduced current and future profitability and cash flows; it does not intrinsically reduce the accounting value of an asset.

Only if the software itself is truly impaired - for example, owing to poor design decisions, our software doesn't scale beyond a single user and a significant portion of the asset is written off - is technical debt a direct economic phenomenon. However, in that case, "debt" is the wrong moniker: the asset is well and truly impaired, not merely leveraged by debt. If a business takes out a usurious loan to buy a truck, the truck isn't impaired by the loan or the high interest payments. If the truck is severely damaged in an accident, it is impaired and written down. Because of the optics, impaired software is more likely to receive additional investment than it is to be written off.

Since tech debt is an indirect economic phenomenon, we have to look at our principal actors differently. In technology, the people who are responsible for servicing the asset (e.g., the code) are the people who are responsible for tech debt. Remember, in finance, we don't borrow against an asset. We borrow against future cash flows of a household or company, using an asset as collateral should the borrower not have the cash to service the debt. In tech, our code may be the asset against which we have borrowed, but we're really borrowing against the time of the team (e.g analogous to future cash flows) responsible for it to service that debt. Tech debt is a call option on people's time at some point in the future, not the asset itself.

Thinking about it this way allows us to extend the debt metaphor a bit further.

Capability Deflation Increases The Cost of Servicing Technical Debt

We saw earlier that deflation impairs people's ability to service debt. The same applies to tech debt. The inflationary or deflationary forces that impact our ability to service tech debt are related to our capability. We "inflate" our capability - and thus reduce our burden of servicing tech debt - through skill development and productivity enhancement. Our skills improve through study and experience. Our productivity improves with knowledge, tools and process. Holding our tech debt static - that is, assuming our tech debt merely rolls over - our ability to service that debt improves with the inflation of our skills and productivity. Capability "inflation" is the same as a household seeing real wages increase. The stronger our capability, the less impact that tech debt has on a team, the more "value" it can produce.

The converse is also true: capability deflation increases the real cost of servicing tech debt. An erosion of skills, loss of situational knowledge, and reduction in productivity all contribute to capability deflation which increases the burden of technical debt. Again, holding our technical debt static, our ability to service it declines with the deflation of our skills and productivity. Just as deflation intensifies contractionary forces on an economy, so, too, does deflation intensify contractionary forces on a team: the greater the deflation, the greater the burden of servicing tech debt, the less "value" produced by a team (the equivalent of economic contraction). In extreme cases, as happens in financial markets, debt servicing "crowds out" our ability to invest in our business through software creation.

Whip Deflation Now?

In 1974, fighting what would become runaway inflation in the post-Bretton-Woods currency world, the United States launched a grassroots campaign encouraging all citizens to curtail consumption - and share their ideas for doing so - as a way to contain inflation. The campaign was entitled "Whip Inflation Now", or "WIN". In the immortal words of Alan Greenspan, "this [campaign] is unbelievably stupid".

Leaders of any tech organization are in a constant battle against capability deflation. People will quit and work somewhere else, taking their skills and situational knowledge with them. People's skills will erode as they become content maintaining a "software annuity" that pays them a high salary for low-effort maintenance work. Organizational memory erodes as people leave, and those who remain forget why specific design decisions were made. Demand outpaces supply for skilled software engineers, forcing firms to hire less skilled developers if they are to have developers at all. New technology obsoletes old technology, and old software becomes trapped in legacy infrastructure. As evolution gives rise to pure maintenance, the work becomes less and less engaging and attractive. All of these things are deflationary forces on team capability.

To keep capability deflation in check, we have to burn the candle from both ends: refresh skills, and refresh assets. Have "refactoring" hack nights to attack tech debt, run spikes to introduce new technologies into legacy code, and rotate people through different teams to disseminate situational knowledge. We can also make investment cases to retire legacy software assets, which we can help by drawing attention to the "tech currency" of the software assets in our production portfolio. We can also use the strangler pattern to incrementally retire legacy systems, reducing the economic cost - and uncertainty - of replacement.

There will always be tech debt, if for no other reason than one person's engineering masterpiece is another's code hairball. And there will always be the threat of capability deflation. We can fight capability deflation - we have no choice, we have to fight it - but we'll never defeat it. To keep it in check, have a corporate culture that values knowledge acquisition and collaboration, and an investment strategy that constantly reinvents the software that runs the business.