Conflict, Part II

The founder's optimism far exceeded his customer's interest. His aggressive expansion vapourized the cash he raised to start up the business. His options were to sell or liquidate.

The firm that bought them was a multi-line company of online advertising & e-commerce driven businesses. The new owners set about trying to make their new acquisition profitable. They looked for revenue synergies by cross-selling to existing accounts. They also reduced costs by closing the acquired company's office, integrating people into corporate reporting structures, consolidating overhead functions, and standardizing procedures with those of the parent company. By the time they were done, they had laid off more than half the staff. They also released the old management team, installing a salesperson from the acquired company as the Division Manager. He'd never run a business before, but the parent company expected that operations would sort themselves out, leaving the DM to develop a sales and client services team and concentrate on revenue.

The changes dragged on for months, leaving people confused and demoralized. Knowledge was fragmented and splintered. There was no one person who knew the business from end-to-end. Business knowledge existed in pockets and occasionally contradicted. There was business-partner-specific code and processes which people simply had no detailed knowledge of. The product administrator defaulted into the role of product manager. The few salespeople who survived the purge burrowed into long-standing customers as account managers.

To boost morale, and to discourage remaining employees from leaving, the parent company showered them with praise, promotions, pay, bonuses and benefits. Comp (including salary and stay bonuses) shot up by as much as 50%. Management also gave them the option to work from home, and set no expectation for in-office hours.

* * *

It didn't take long for the remaining staff to realize that their knowledge of the business gave them power. There was nobody with enough detailed business knowledge to challenge the new product manager: anything he said was treated as gospel truth. The e-commerce software was a mess: only somebody familiar with the code could make sense of it. The processes behind the business existed in the heads of a handful of people who worked independently of each other; processes from corporate were simply ignored.

The experience of having had their employer acquired, their co-workers canned, and foreign processes imposed on them, only to emerge as having "won the lottery" of compensation, benefits, title, independence, job security and power made the few surviving employees more than a little neurotic. Each jealously guarded the contextual knowledge they had. None would step outside the strict definition of what they understood their job requirements to be, even in situations where it was clear they were the only person with the business knowledge, client contacts or code familiarity to solve a problem. Knowledge sharing exercises were canceled due to last minute "customer emergencies". Account managers controlled and outright blocked access to customers. The DM made high drama when one of the legacy employees "rescued" a situation created by a corporate transplant, publicly hailing their efforts and creativity with code and client, while privately suggesting that the parent company people simply weren't competent.

People brought in from the parent company to work with this division took one of two paths. Senior employees quietly opted out of making any significant involvement: it was a lot easier work with those divisions of the company they were familiar with than to fight with entrenched legacy employees. Junior employees had no such luxury and soldiered on, trying to make the best of it. Although they learned little bits of the business every day, their long, steep learning curve on a blind journey of discovery made them prone to errors. Unfortunately, by continuing to give it their best shot, the juniors were complicit in reinforcing the narrative spun by the legacy staff; their senior staff, having self-selected out, offered them no reinforcement.

* * *

Two years after the acquisition, sales were a bit better and costs a bit lower, but they were nowhere near their profitability and cash flow goals. The company president couldn't understand why the acquired business still wasn't integrated with the rest of the company. He had faith in corporate staff, but despite their reassurances they still seemed a long way off from integrating the business. The legacy people intimated that the new people just weren't up to scratch, while the DM told him the legacy people were the only reason that business was still functioning.

But everybody reassured the president that they were committed to the company's goals.

* * *

Conflict arises when interests collide. The intensity of the conflict is a function of the degree to which people are committed to their objectives as opposed to a common or group objective.

This chart, adapted by Gareth Morgan from the work of K.W. Thomas, shows the intersection of the degree to which people pursue their goals versus group goals.

The Micro Level: Individual's Goals versus Organizational Goals

This is easy to understand at a micro level. For example, suppose a lead developer has had a vacation scheduled for a long time, but a business critical project this developer is working on is in trouble and the project manager believes it is the wrong time for the dev lead to be out of the office on vacation. How the actors deal with this conflict falls into one of five categories. They may avoid the confrontation, deferring any decision, waiting to see if the situation changes. For example, the project situation may improve to a point that the manager may not have to ask the lead to postpone vacation. They may become competitive with each other: the manager might call on an executive to reinforce how critical the project is to the dev lead, while the employee might make subtle threats to transfer or quit if his vacation is cancelled. They may completely accommodate the project goal, with the employee volunteering to defer vacation for the greater good. They may try to reach a compromise where the employee shortens the duration of the vacation. Or they may try to collaborate on a solution, where the employee takes the vacation but agrees to schedule a time each day for the team to reach out, and to participate in some team meetings.

Obviously, situations influence behaviours: a person might be passive about working late nights but very insistent about taking a vacation. And in any conflict, the actors may take multiple tacts through resolution: each party may start with avoidance to see how the situation develops, while one gradually shifts to a competitive posture and the other calls for accommodation.

The Macro Level: Collections of Individual's Goals versus Organizational Goals

At a macro level, this model helps us recognize general behaviour patterns within an organization. Consider our case study. For a group of employees, the thrill of a start-up quickly changed to the fear of a retrenchment. That retrenchment created feelings of powerlessness while rupturing any trust they might have extend the new owners. In the aftermath, however, power shifts from the acquirer to the acquired: the buyer is beholden to the contextual knowledge held by the remaining employees, and telegraphs that dependency by showering those who remain with compensation and titles. The acquirer has created a toxic sociological cocktail within the acquired business. Because of the retrenchment, each person will be looking out for themselves. Because of the cutbacks, business knowledge is fragmented and each person is deeply entrenched into a fragment. Because of the rabid awarding of titles and pay, people have personal interests to defend (e.g., they would not command these salaries elsewhere, nor would they have these titles in similar firms). Because of the asymmetry in contextual knowledge - none held by the acquirer, all held by the acquired - the acquirer is at the mercy of the acquired, meaning the acquired have the power to place their own agendas first.

This creates a business stalemate. No one person knows the business from end-to-end. Each person defends their power position by inflating the value of their contextual knowledge and resisting attempts to share, dilute or obsolete it. Any new person brought into this business will subsequently be thwarted from learning it because of the extremes to which people will guard the information they possess. Management will be reduced to one of two states per the model: avoidance, or compromise. In our case study, the senior corporate employees choosing to stay away from this business are avoiding conflict. To them, it's more hassle than it's worth, the hassle being the constant need for compromise: whenever a corporate goal needs to be met, the parent company management has to negotiate for participation and responsibility from each person, and micro-manage each to verify that personal preferences and priorities don't impair or impede a group goal. Achievable corporate goals will be very, very modest compared with the effort expended.

Managing Through Stalemate

We can understand managing through this stalemate in light of the unitarist and pluralist philosophies presented in Part I of this series. As mentioned above, a unitarist philosophy in the presence of so many entrenched, individual interests will at best result in compromise. Group goals compete with individual goals; it is only through formal authority that the unitarist can press an agenda forward. But in our case study, that authority is limited by management's captivity at the hands of its own people. The result is compromise and, in our case study, chronic underperformance of the business in question.

But a pluralist will be similarly frustrated. The pluralist will expect people will want to collaborate to accommodate the greatest number of individual goals and needs while pursuing the organization's goals. But in our case study, people are already empowered and power shifts among actors depending on the situation (leaving the manager to constantly chase rather than lead), while individual interests are competing in such a way that stymies facilitation of a group outcome. Collaboration requires individual agendas to be out in the open and accepted by all members. When they are not, there is a fundamental lack of trust. In this case, there are many hidden agendas: people protecting titles and compensation, for example. Collaboration will not come naturally and, as it is a threat to the status quo, may not be coachable in the situation. All the process and facilitation in the world will not overcome institutionalized neuroses. Facilitation will devolve into interrogation to obtain facts and, at best, reach a compromise among competing interests.

The conflict model above helps us to recognize this as a behavioural problem, not a process or organizational structure problem. A patient manager, whether unitarist or pluralist, can break the stalemate by rebuilding the culture. She can do this by changing incentives so that legacy people aren't rewarded for preserving a perverted status quo, but instead rewarded for group goals. This removes barriers to change. She can also bring in new people to reconstruct the business knowledge by engaging with clients and developing new software and services, gradually strangling and replacing legacy assets. This both captures and deprecstes contextual familiarity, simultaneously rebuilding both the business and the culture from the outside-in. If successfully executed, these activities will break the stalemate. However, the prevailing organizational culture after the change - accommodating, collaborating, competing, avoiding or compromising - will still reflect the fundamental philosophy of the leader.

A Portrait of Disconnected Leadership

It takes a long time to change organizational behaviours, and longer still to see tangible results. It's difficult, if not impossible, to measure behaviour change. Committing to this kind of change requires executive understanding of businesses as social systems and executive commitment to a future state defined by behaviour patterns. In our case study, if the executives in the buying firm don't recognize the sociological toxicity they created through their business decisions, they're not likely to understand the need to reform the business completely. Nor will they likely be willing to make the investment.

This exposes a third way we can apply this model: how do different actors perceive the organization? In our case study, we have a leadership disconnect: the executive is unaware of the presence of individual agendas which are crowding out the group goal. He shows characteristics of a unitarist leader, unaware of how management fostered this situation, denying the relevancy or existence of individual agendas relative to group goals, and thinking about his under-performing division as an execution problem. This means he assumes the organization is in the "accommodating" quadrant of the matrix. Yet the presence of so many individual agendas being vigorously pursued puts the business squarely in the "competing" quadrant. The executive interprets this as an execution problem, when it is a sociological one.

Which brings us back to the subject of conflict. If conflict is the medium through which an organization maintains relevancy and currency, the prevailing organizational pathology is an indicator of its survival capability. A willingness to acknowledge and integrate multiple agendas, needs and goals makes for a turbulent organization, but one that constantly changes, innovates and evolves. Denial or suppression creates extremes: an "every person for themselves" competitive free-for-all that slowly erodes an organization with internal strife, or an organization that experiences a stable trajectory - possibly for a long period - that decays suddenly owing to its inability to impose its will forever. Organizations that avoid conflict or are constantly compromising with themselves are organizations adrift.

Not all conflict is healthy, but conflict is inevitable. The leader who chooses to embrace and harness conflict will have a dynamic, vibrant organization. The leader who chooses to suppress, ignore or avoid conflict will run the organization into the ground.

Choose wisely.

Conflict, Part I

Product management was never a formal responsibility; it just sort of happened.

Early on, it was driven by what the technical wizards came up with. But the magic left the development team years ago: it had been gutted by several rounds of staff cuts that took the garrulous personalities and innovative thinkers. It took the wind from development's sails: those who were still on the payroll were just happy to have kept their jobs. They adopted a "just tell us what you want us to do" attitude about the products.

At that point, product decisions were made by sales. The sales team was larger than it had ever been, but it had struggled. Each quarter they set lofty sales targets, and each quarter they fell short. This made them jittery about revenue: they spent more time in internal meetings discussing how not to lose revenue than they did meeting with clients to find ways to generate more. In addition, product training hadn't been refreshed in years, and they never formalized an onboarding process for new salespeople, so their grip on the products they were selling and the clients to whom they were selling was not that strong. The net effect was a chronic lack of confidence: the sales team automatically negotiated from a position of weakness and never met a dollar of revenue they didn't like. The impact on product was to pile on feature after feature and request after request.

Company leadership eventually formed a product management team, staffing it with existing employees. Although they had product responsibility, it was clearly going to take some time for this group to learn enough about the customers, users and the products to be effective in a product management role.

This created a product leadership vacuum that was partially filled by the graphic design team.

Like most software companies, user experience was originally driven by developers: screen layout, workflow, and even general appearance were byproducts of decisions made during development. Uncharitable customer feedback on usability of the software led to the creation of a small in-house graphic design team. They met with instant success: the polish they put on the software won praise from customers.

At some point, the graphic design team began to self-style themselves as a User Experience (UX) group. This was a logical evolution that would provide career development opportunities. It was also an essential competency that was conspicuous by its absence in a software company. Executive leadership was thrilled by what they saw as the design team stepping up to fill an essential need. They gave the team encouragement, and a slightly bigger budget.

As practiced, UX was largely an extension of graphic design work, creating more comprehensive interface design at the panel level. In one sense, this was pragmatic: because the company had not historically invested in skill acquisition and capability development, it was reasonable to assume UX skills would be acquired incrementally and the capability developed organically. In another, it was naive: the UX team weren't familiar with things like personas, value stream mapping and other essential inputs to software design. They were on a self-directed voyage of discovery, moving at a slow pace. Capability would trail aspiration for a long, long time.

This put UX and development into direct conflict with each other. UX felt that development was uncooperative with the design process: they saw development doing their own thing, or stonewalling, or being outright obstinate. Development had a different perspective. They saw design infringing on work that had always been the purview of development. They also felt it wasn't improving the development process: more detailed screen layouts without accompanying context about users and scenarios wasn't all that helpful, and it was eating into the alloted time for coding and testing. Development felt increasingly frustrated, believing they had less time and less control over what they did.

One day, following a particularly contentious design meeting, the development director put his complaints, criticisms and demands into an e-mail to the head of design. He was tired of design impinging on development's turf, taking too much time to do inadequate work and leaving development to scramble to meet deadlines and struggling to work within a UX framework he felt was incomplete. The e-mail was not personally insulting, but his frustrations were obvious. And although he proposed some reassignment of responsibility, his main message to design was "back off".

The e-mail didn't just travel from the development director to the head of design. Each shared it with superiors and colleagues. It eventually found its way to the company president and CEO.

The president reacted by sending a one-line e-mail to the development director: "I won't tolerate behaviour like this in this company!"

* * *

For most managers, conflict is unwelcome. It creates work: the manager has to smooth over hurt feelings, come to the defense of an accuser or accused, and navigate the power politics that conflict stirs up. It exposes ambitions that set a tone of competitiveness, distrust or fear. It lays bare opinions, frailties and passions that many believe have no place in the workplace. It creates the appearance that the manager doesn't have control of his or her people.

But conflict in an organization is inevitable. Conflict arises from the collision of competing interests, and every company has a rich diversity of interests. There are the company goals (in effect, those set by leadership), such as revenue targets. There are objectives people have for their departments, such as to add new positions and hire more people. There are individual goals, such as career ambitions or control over what one works on. These interests will never be in perfect alignment. And they are always present: it is irrational to expect there will never be conflict, that company interests are the only ones that matter and that people will subordinate their interests to those of their employer.

Conflict is also healthy. It exposes fault lines, real and imagined, in an organization. It indicates engagement: when people don't feel motivated enough to enter into conflict, it suggests they're not optimistic that their goals can be met by the organization, or that they don't believe the organizations goals are worthwhile. It also fosters innovation: passionate, engaged people publicly advocating divergent opinions will come up with creative solutions to organizational problems. Lethargic passengers in an organization rife with groupthink will not.

As I wrote above, it is irrational for a leader to expect that there will never be conflict. Yet many leaders intrinsically assume that people subordinate themselves in service to the company. In doing so, leaders deny the relevancy and even the existence of interests outside of those held by the leadership. This is, according to Burrell and Morgan¹ what is called a "unitary" philosophy of management. The organization is seen as being united under a common set of goals and uniformly pursuing them as a team. Authority is derived from the hierarchy and responsibilities are narrow: managers have the right to manage and employees the duty to obey, and everybody is expected to do no more and no less than the job to which they have been assigned. Unitary leaders regard conflict as uncommon and temporary, something to be removed by managers. Instigators of conflict are regarded as troublemakers.

The unitary philosophy aligns with traditional ways of seeing an organization: as a top-down, command-and-control, static operation. At first glance, unitary leadership would appear to be out of touch and out of date in the era of mobile and empowered knowledge workers in increasingly dynamic businesses. Still, it remains very appealing to leaders, managers and subordinates alike. For one thing, it deals with sociological complexities of the workplace by ignoring them. For another, it imposes a facade of unification under which symbols, rituals, process and reporting structure can be brought to bear to create organizational order. As a result, it reduces management to a technical problem of defining and tracking tasks, and measuring performance against those tasks. This is the key to its appeal: business is a whole lot easier when it's a one way street!

An alternative² to the unitary philosophy, called pluralism³, conceptualizes the organization as a coalition of diverse people. To the pluralist, conflict in an organization is inherent and routine, and the pluralist leader looks at conflict as an opportunity for change and evolution. Authority in the organization is diversified and constantly changing, as are each person's scope of responsibilities. People are expected to seek ways to collaborate to achieve organizational goals. This final point is key to understanding the role of conflict. In the unitary organization, people are confined to roles and the manager creates order. In the pluralist organization, people constantly collaborate to create a new order.

Let's look at our case study from a pluralist leadership perspective. First, the pluralist must understand the other person before trying to be understood themselves. The development director may feel frustrated, but has to realize that development abdicated leadership years ago when it became a passenger in product management. The spat with design is simply the latest event in a long trend of largely self-inflicted decline. The development director must also recognize how the design team was trying to evolve a design capability. Similarly, the UX lead must understand the gap between interface design and UX and how development has historically bridged that gap while it develops. Next, the organization leader must then facilitate a collaborative outcome that will improve the state of the organization overall, not a compromise that subordinates one collection of objectives to another to expedite the task at hand. In this case, the company might hire in analysts or train people in developing personas and workflows and restructure the development cycle to incorporate more thorough user experience design activity.

The extent to which a leader accommodates versus imposes has a dramatic impact on the character of the organization he or she leads.

The pluralist organization is a "big tent" that welcomes diversity and divergent opinions and goals. It will be attractive to drivers (people who get stuff done) and creative thinkers. Each person must be a pluralist: they have to work in collaboration with other people to achieve the maximum superset of outcomes. As a group they must be highly skilled, but to a person it is less important to be skilled than it is to have the disposition to learn. This is because the capability of the group supersedes that of any one person, whereas the aptitude to learn and change makes for stronger interpersonal partnerships. The result is an organization of peers that is more flat than hierarchical, that moves in fits and starts but requires less hands-on, in-the-weeds management. Facilitators do well in the pluralist organization, task tyrants do not.

In comparison, the unitary organization does not accommodate alternative (let alone competing) goals to those set by the business leadership. As a result, it will attract passengers, people who are largely content to do as they are told. This means the unitary organization will be less diverse, more sullen, and more fragile than the pluralist organization. But that isn't to say that the unitary organization is staffed with soulless go-bots who do the bidding of their paymasters: every person in a unitary organization will still harbor personal objectives, some which will be in perfect alignment with those of the organization, and some which will be wildly divergent to them. Each person will still go in pursuit their own objectives to one degree or another, but because a unitary organization has no tolerance for goals other than its own, people will pursue their objectives below the organization's radar to avoid conflict. The proliferation of all these invisible individual agendas reduces management to meticulous supervision of and continuous negotiation with each employee just to achieve the simplest of organizational objectives. Ambitious goals are out of the question.

The pluralist organization is more vibrant, diverse and robust than its unitary counterpart. These are important characteristics for professional, knowledge and creative businesses. They are also increasingly important to industrial firms as they become more knowledge-based businesses. At a macro level, businesses have to be more environmentally aware and adaptive to a degree their industrial forebears did not. At a micro level, highly skilled technical and knowledge workers are scarce, increasingly complex business context makes people far less interchangeable, and employee mobility has never been greater.

Being a pluralist is a struggle against entrenched patterns and expectations. Stories of leadership are dominated by people who espoused a unitary philosophy, from Julius Caesar to Steve Jobs. Unitarism is entrenched in business and even societal norms.

Still, it is a choice that every leader makes, and the decision to impose, deny and steamroll or accommodate, facilitate and explore will impact the nature and character of the organization. For the leader, one truth stands above all others: you get the organization you deserve.

Choose wisely.

 

 

¹Morgan, Gareth. Images of Organization, page 189.

²There is another alternative to the one discussed here, called radicalism. We'll look at radicalism and why we need more radicals in the software business in a future post.

³Ibid.

Debt, Fear & Demographics: The Ingredients of Stagnation

You developed a simple tool for individuals and small groups. You never imagined it would be a runaway hit. Revenue poured in, would-be investors called constantly, The Wall Street Journal ran features on you twice, marketing chiefs from a dozen S&P 100 firms wanted you in workshops to figure out how to "partner", and your founder was presenting keynotes and on panels every few weeks. You were the classic tech success story.

Ideas poured in as fast as the revenue, and some copycat products sprung up. You knew you weren't keeping up, largely because under the hood, the product wasn't very flexible. When you started this thing, the goal was to get product out the door to see if people would like it, not design for every possible need. The R&D team (the original developers - a new team was hired to maintain the existing product) concluded they could build a much better product from scratch having learned so much the first time round. Many more layers of abstraction, more flexible and open architecture, and a DSL for creating plug-in apps to sit on top of what was really more of a Platform than just a Product. The existing software couldn't support that. So you gave them approval to make version 2 a complete rewrite. They went off to a special location, separate from everybody else, to develop The New Platform.

That decision was, in retrospect, what killed the company.

It wasn't so bad that the R&D team took twice as long as they had originally forecast. It's that what they delivered was so commercially bad: bug laden, unstable, unreliable. Customer service complaints skyrocketed & new product sales collapsed. You gradually pulled more and more people into fixing the code; before long, it was an operational black hole of time and effort. When, a year later, the product was stabilized, revenues had fallen by nearly 80%.

That was when the CFO sat down with the CEO, told her that cash reserves were all but depleted, and that operating costs needed to be culled.

* * *

A few months ago, I described zombie businesses as a financial phenomenon wrapped around an operating crisis. First, a financial crisis triggers deep operating cuts that gut a business of its capability. This leaves it operationally inert. Over time, revenues go down as products & services grow stale in the hands of rudderless development and depleted operations staff. At the same time, costs go up as golden handcuffs are slipped on to people to prevent employee defection. Long after the financial crisis, the business may still have a well established set of products, a bit of brand recognition, a blue chip client list and many years of history. But a zombie business is not good investment because the cost to re-humanize it is prohibitive.

That's the financial perspective. The operating crisis at the core of this bears further examination.

Edward Hadas, a columnist at Breakingviews, recently wrote that a stagnant economy has 3 key characteristics: debt, fear, and demographics. Oppressive levels of debt devote money to interest payments, denying new and productive assets of it. Investors, gripped with fear, avoid making high risk investments. And when economies stagnate, people have fewer kids; this depletes the economy of its working age population, which slows growth and dynamism.

These same characteristics apply to a bombed-out tech business. Developers spend time servicing technical debt at the cost of developing new software assets. Executives are afraid to take the risk of new investments and assets get stale. Managers cling to existing employees, who rob the company of growth and dynanism by clinging to existing code, concepts and techniques.

An economic crisis (e.g., the rapid evaporation of liquidity) can usher in a period of economic stagnation (little economic development), but crisis and stagnation are not one and the same. Nor does the prior necessarily lead to the latter. An economic crisis can be cathartic, purging an economy of legacy constraints that serves to initiate a period of investment and development. The same is true of an operational crisis. A sudden loss of capability can trigger a period of stagnation, where what was once creative problem-solving work is reduced to checklists of tasks. Or it can trigger a period of dynamic change, where legacy business and technology constraints are thrown off and the company reinvents itself completely.

It isn't the crisis, but the reaction to it, that matters. The crisis is immediate; the stagnation settles in over a long period of time. The longer it has to settle in, the further assets and skills decay in an environment of timidity, old ideas, and increasing tech debt, the more costly it will be to revive the business.

It is an oversimplification to say that stagnation is a collection of choices people make, and that people are bound by limitations of their own making. Neither an economy nor a business can will itself out of stagnation, and not everybody has the leadership or appetite for risk to make bold decisions in a familiar (if decaying) environment. But how we react to a triggering financial crisis determines the fate of operations. If the reaction is to retrench and preserve, a financially-induced operational crisis will lead to stagnation. If the reaction is to reinvent and rebuild, it will not.

Self-Insuring Software Assets

When we buy a house, we also buy insurance on the house. Catastrophic events can not only leave the homeowner without shelter, they can be financially ruinous. In the event of a catastrophe, the homeowner has to be able to respond quickly to contain any problems, and be able to either enact repairs herself, or mobilize people and materials to fix the damage. Repairs require building materials and a wide variety of skills (electrician, mason, carpenter, decorator). Most homeowners don't have the construction skills necessary to perform their own repairs, so they would have to set aside large capital reserves as a "rainy day fund" to pay for such repairs. But homeowners don't have to do this, because we have homeowner's insurance. In exchange for a little bit of cash flow, insurance companies make policyholders whole in the event of a catastrophe by providing temporary shelter, and providing the capital and even the expertise to make repairs in a reasonable period of time.

When we build software, we don't always buy insurance on the software. For software we build, we underwrite the responsibility for the fact that it will be technically sound and functionally fit, secure and reliable, and will work in the client and server environments where it needs to operate. As builder-owners, we have responsibility for these things during the entire useful life of the software. This obligation extends to all usage scenarios we will encounter, and all environmental changes that could impair the asset. If regulation changes and we need to capture additional data, if a nightly data import process chokes on a value we hadn't anticipated, if our stored procedures mysteriously fail after a database upgrade, if the latest release of FireFox doesn't like the Javascript generated by one of our helper classes, it's our problem to sort out. There is nobody else.

In effect, we self-insure software assets that we create. When we build software, we underwrite the responsibility for all eventualities that may befall it. Self-insuring requires us to retain people who have the knowledge of the technology, configuration and code; of the integration points and functionality; of the data and its structures; and of the business and rules. It also requires us to keep sufficient numbers of people so that we are resilient to staff turnover and loss, and also so that we can be responsive during periods of peak need (the technology equivalent of a bad weather outbreak). Things may be benign for most of the time, but in the event of multiple problems, we must have a sufficient number of knowledgeable people to provide timely responses so that the business continues to operate.

The degree of coverage that we take out is a function of our willingness to invest in the asset to make it less susceptible to risk (preventative measures), and our willingness to spend on retaining people who know the code and the business to perpetuate the asset and to do nothing else (responsiveness measures). This determines the premium that we are willing to pay to self-insure.

In practice, this premium is a function of our willingness to pay, not of the degree of risk exposure that we are explicitly willing to accept. This is an important distinction because this is often an economic decision made in ignorance of actual risk. Tech organizations are not particularly good at assessing risks, and usually take an optimistic line: software works until it doesn't. If we're thorough, previously unforeseen circumstances are codified as automated tests to protect against a repeat occurrence. If we're not, we fix the problem and assume we'll never have to deal with it again. Even when we are good at categorizing our risks, we don't have much in the way of data to shed light on our actual exposure since most firms don't formally catalogue system failures. We also have spurious reference data: just as a driver's accident history excludes near-miss accidents, our assessments will also tend to be highly selective. Similarly, just as an expert can miss conditions that will result in water in the basement, our experts will misjudge a probable combination of events that will lead to software impairment (who in 2006 predicted the rise in popularity of the Safari browser on small screens?) And on top of it all, we can live in a high risk world but lead highly fortunate lives where risks never materialize. Good fortune dulls our risk sensitivity.

The result is that the insurance premium we choose to pay in the end is based largely on conjecture and feeling rather than being derived from any objective assessment of our vulnerability. Most people in tech (and outside of tech) are not really cognizant of the fact that we're self-insuring, what we're self-insuring against, the responsibility that entails, and the potential catastrophic risks that it poses. Any success at self-insuring software assets has little to do with thoughtful decision making, and more to do with luck. If operating conditions are benign and risks never manifest themselves, our premium looks appropriate, and even like a luxury. On the other hand, if we hit the jackpot and dozens of impairments affect the asset and we haven't paid a premium for protection, our self-insurance decision looks reckless.

Insuring against operating failures is difficult to conceptualize, more difficult to quantify and an even more difficult to pay for. We struggle to define future operating conditions, and the most sophisticated spreadsheet modeling in the world won't shed useful light on our real risk exposure. Willingness to pay a premium typically comes down to a narrative-based decision: how few people are we willing to keep to fix things? This minimal cost approach is risk ignorant. A better first step in self-insuring is to change to an outcome-based narrative: what are the catastrophes we must insure against and what is the income-statement impact should those happen? This measures our degree of self-insurance against outcomes, not on costs.

Zombie Businesses

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Return of Financial Engineering - and What it Means for Tech

Soon after the financial crisis began in 2008, companies shifted attention from finance to operations. Finance had fallen out of favour: risk capital dried up, asset prices collapsed and capital sought safe havens like US Treasurys. The crisis also ushered in a period of tepid growth undermined by persistent economic uncertainty. This limited the financial options companies could use to juice returns, so they focused on investing in operations to create efficiencies or fight for market share. In the years following the crisis, the "operations yield" - the return from investing in operations - outstripped the "financial yield" - the return from turning a business into a financial plaything.

Since the start of the crisis, central banks have pumped a lot of money into financial markets, principally by buying up debt issued by governments and financial assets held by banks. This was supposed to spur business activity, particularly lending and investing, by driving down the cost of both debt (lower lending rates) and equity (motivating capital to seek higher returns by pursuing riskier investments).

Whether lending and investing have increased as a result of these policies is debatable. One thing they have done is encourage companies to change their capital structure: low interest rates have made debt cheaper to issue than equity, so companies have been busy selling bonds and buying back their own stock. There are financial benefits to doing this, namely lowering capital costs. It benefits the equity financiers by concentrating ownership of the company in fewer hands. But beyond reducing the hurdle rate for investments by a few basis points - and not very much at that given low interest rates - this doesn't provide any operational benefit.

What's not debatable is that it's brought about a return of financial engineering. CLOs and hybrids are back. Messers Einhorn and Buffet are engineering what amount to ATM withdrawals through preferred share offerings from Apple and Heinz, respectively. The OfficeMax / Office Depot merger is addition through subtraction: projected synergies exceed the combined market cap of the two firms.

When financing yields are higher than operating yields, business operations take a back seat to financial philandering. Consider Dell Computer. Dell's business lines are either in decline (services) or violently competitive (PCs and servers). Does it matter whether Dell is funded with public or private money? Will being a private firm make Michael Dell better able to do anything he cannot do today? It is hard to see how it does. But it does let him play tax arbitrage.

This suggests a bearish environment for investment in operations. The shift to debt in favour of equity, the rise in share buybacks, dividend payouts and M&A suggest that companies have run out of ideas for how to invest in themselves. Cash flow that would otherwise be channeled into the business is betrothed to financiers instead. Debt yields are kept low and roll-overs made easier by stable and consistent cash flows, and equity easier to raise when cash flows from operations are both strong and consistent. This compels executives to set a "steady as she goes" agenda - not an aggressive investment agenda - for business operations.

A reduction in business investment is not particularly good news for tech firms selling hardware, software or services to companies. But it's not all bad news. Rewarding financiers by a starving business for investment makes a company sclerotic. That clears the way for innovators to disrupt and grow quickly. But until those innovators rise up, finance is positioned to stymie - not facilitate - business innovation.

Investing in Software Through Experts, Analysis or Discovery

Whether investing in equities or in software, there are three distinct approaches to how we make an investment decision: based on our intuition or experience, based on our analysis of an opportunity, or based on our ability to rapidly discover and respond to market feedback. Let's look at each in turn.

When we invest based on experience, our decisions are rooted in the expertise we've gained from things we've done before. When based on intuition, our decisions are based on strongly held convictions. An equity investor familiar with retail might recognize demographic changes in specific geographic areas (e.g., migration of families with young children to Florida and Texas) and intuitively invest in firms exposed to those changes (such as commercial construction businesses operating in those areas). In the same way, somebody who has first hand experience can invest in developing a technology solution: the inspiration for Square, Inc. came from a small firm that couldn't close a sale because it couldn't accept credit cards. Although expert investing will likely involve a little bit of analysis, for the most part the investor relies on gut. Because we invest primarily on the courage of our convictions, capital controls on intuitive investments tend not to be very strict. In absolute terms, the capital commitment is generally small, although in relative terms the committed capital may be quite large especially if it is a private placement. As a result, the capital tends to be impatient: trust in an expert lasts only so long; investors will get cold feet quickly if there aren't quick results.

We can invest based on research and analysis. Value investors in equities study company fundamentals looking for firms with share prices that undervalue the assets or the durability of cash flows. In the same way, we can look for value gaps in business operations or market opportunities and identify ways that technology can deliver value to fill those voids. The foundation of the analysis are things such as value-stream mapping, or competitive analyses of solutions developed by sector and non-sector peers. From this, we can produce a financial model and, ultimately, a business case. We need expertise to develop a solution, but by and large we make our investment decision based on the strength of our analysis. In absolute terms, the amount of committed capital can be quite large. But, having rationalized our way to making an investment, the capital controls tend to be strict, and the capital tends to be patient.

Finally, we can invest based on our ability to discover and adjust based on market or user feedback. Traders move in and out of positions, adjusting with changes in the market and hedging based on how the market might change. Over a long period of time, the trader hopes to end up with large total returns even if any given position is held for only a short period of time. We can do something similar with software, using approaches like Continuous Delivery and Lean Startup. In this approach, we aren't just continuously releasing, but rapidly and aggressively acquiring and interpreting feedback on what we've released. We can also use things like A/B testing to hedge investments in specific features. When we invest this way, we do so based not so much on our expertise or analysis, but based on our willingness and ability to explore for opportunities. Capital controls are strict because we have to explain what features we're spending money on and how we're protecting against downside risk of making a mistake. The capital backing a voyage of discovery will be impatient, wanting frequent assurances of positive feedback and results. But at any given time, the amount of committed capital is small, because investors continually evaluate whether to make further investment in the pursuit.

Each of these approaches makes it easy to answer "why" we are making a particular investment. Why should we part with cash for this particular feature? Go ask the expert, or see how it fits in the business case, or go get user feedback on it. "Why" should drive every decision and action made in pursuit of an investment. Without the "why" there is no context for the "what". In its absence, the "what" will suffer.

No approach is universally superior to another. The approach we take has to play to our strengths and capabilities. Either we have people with expertise or we don't. Either we have people with analytic minds and access to data or we don't. Either we have the ability to rapidly deliver and interpret feedback or we don't. The approach we take must also be suitable to the nature of the investment we're making. A voyage of discovery is well suited for developing a product for a new market, but not for an upgrade to a core transactional system. The business case for investing in a customer self-service solution is going to be much more compelling than a business case for developing a product for an emerging market segment.

Just because we take one of these approaches is no guarantee of success. Not all investments are going to pay off: our experts may turn out to have esoteric tastes that aren't appealing to a mass audience. Our thoroughly researched market analysis might very well miss the market entirely. We might deliver lots of features but not find anybody compelled to use them.

Worse still, each of these approaches can be little more than a veneer of competency to unprofessional investing. A hired-in expert may be a charlatan. Many a manager has commissioned a model that inflates benefits to flatter an investment - only for those benefits to never be realized. Just because we can get continuous feedback from users does not mean that we can correctly interpret what that feedback really means.

Most of the time, of course, we take a hybrid approach to how we invest. We supplement expertise with a business case, or we charter an investment with a business case but use Continuous Delivery to get feedback. However we go about it, we need to get the essential elements of the approach right if we're to have any chance of success. Otherwise, we're just unprofessional investors: investing without experience, thoughtful analysis or an ability to respond quickly is reckless use of capital.

Entirely too much software investing fits this bill.

Sector Seven Is Clear

Many years ago, there was a television ad that showed an intruder being chased through a building by two security guards. The guards chase him from room to room, and ultimately down a long hallway. At the mid-point of the hallway, there's a line painted on the floor and wall. On one side of the line is a large number 7, on the other is the number 8. The intruder runs down the hallway, over the line. The two security guards come to a sudden stop right at the line. They watch as the intruder continues to run down the hallway into some other part of the building. After a pause, one of the security guards grabs his walkie-talkie and announces: "sector seven is clear". The intruder is still in the building, but the security guards no longer consider him to be their responsibility.

Every now and again I reference this ad in a meeting or presentation, in the context of Industrial IT. I've been reminded of it again recently.

Industrial IT encourages specialization: It is easier for HR to hire, staff, train and procurement to contract for people in specialist roles. And specialization is comfortable for a lot of people. Managers - particularly managers who have a poor grip on the work being done - like specialization because it is easier to assign and track tasks done by specialists. People in execution roles take comfort in specialization. It's easy to become proficient in a narrow field, such as a specific database or programming language. Given the slow rate of change of any given technology, you don't have to work too hard to remain acceptably proficient at what you do. You only face a threat of obsolescence. A commercial technology with sufficient market share and investment mitigates that risk to the individual.

Specialization means the most critical information - systemic understanding of how a solution functions and behaves from end-to-end - will be concentrated in a few people's heads. This knowledge asymmetry means those few people will be overwhelmed with demands on their time, creating a bottleneck while others on the team are idle. There will be a lot of hand-offs, which increases the risk of rework through misunderstanding. Because no single specialist can see a solution through to completion, nobody will have ownership for the problem. At least, not beyond making sure Sector 7 is clear.

I've written about it many times before, but Industrial IT prioritizes scale over results, specialists over professionals, predictability over innovation, and technology over value. Industrial IT is large but fragile: it struggles to get anything done, there aren't enough heroes to go around, its delivery operations are opaque, and it produces high-maintenance assets.

Even when there is executive commitment to change, it takes a long time and concentrated effort to change the industrial mind-set at a grass roots level.

We have to reframe problems above the task level. Everything we do should be framed as a meaningful business result or outcome, complete with acceptance criteria against which we can verify success in the business context. For example, the problem isn't to fix the payload of a specific webservice, the problem is to allow multiple systems to integrate with each other so that sales transactions can be exchanged. Agile Stories are particularly helpful for defining actions this way, whether new feature or defect. Stories make it possible for each person to explain why something is important, why something is valuable, why they are working on it. Back to our example, I'm fixing this webservice because until I do, there won't be order flow from a principal commercial partner. Stories are also helpful as they let us measure the things we do in terms of results, and not effort.

But there's more to this than process. Each person must feel personal ownership for the success of their actions. The job isn't to code to a specification, or to test against a test case. The job is to create a solution that enables a business outcome. Each person must ask questions about the completeness of the solution, and be motivated to verify them in the most complete manner possible.

Which makes the point that this is, fundamentally, a people challenge. We're asking people to change how they understand the problems they're solving and what "done" means. We're asking them to change their behaviours in how they investigate, test and verify what they do. More broadly, we're asking them to build a contextual understanding for the work they do, and more importantly why they are doing it. And we are asking them to take responsibility for the outcome: I will know this is complete when ...

Do not under-estimate the challenge this represents. The transition from industrial to professional is amorphous. There are false positives: people who sign up for this too quickly don't understand what's going to be required of them. It isn't long before the never ending chorus of "I don't" starts: I don't know how to do something, I don't have that information, I don't know how to find that out. And we can't take anything for granted. We must constantly challenge people's contextual understanding: can they explain, in a business context, why they are working on something, who it benefits, why it is important.

Not everybody will make this transition. For some, because this isn't their calling: not all assembly line workers can become craftsmen. Others will self-select out, preferring the comforts afforded by a specialist's cocoon.

All of these things - changes in process, practice, behaviours and people - require a tremendous amount of intestinal fortitude. The would-be change agent must be prepared for a frustratingly slow rate of change, and to invest copious amounts of time into people to help them develop new context and new muscle memories. On top of it, leaders are in short supply and mentors are even scarcer in Industrial IT shops. Legacy assets and systems (and their legacy of patchwork integration, bandaged maintenance and situational knowledge) will slow the rate at which you can make new hires productive.

The benefits of changing from industrial to professional are obvious. While the destination is attractive, the journey is not - and be under no illusions that it is. But who we work with, how we work, and what we get done in a professional IT business make it worth doing.

Engaging Auxiliary Forces for Strategic Software Solutions (Part II)

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

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

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

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

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

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

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

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

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

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

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

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

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

Engaging Auxiliary Forces for Strategic Software Solutions (Part I)

At one point or another, most firms will engage "auxiliary forces" - contract with firms for development teams - to develop software for them. If Machiavelli were sourcing software projects, he wouldn't approve.

"These arms [auxiliaries] may be useful and good in themselves, but for him who calls them in they are always disadvantageous; for losing, one is undone, and winning, one is their captive."

Niccolo Machiavelli, The Prince, Chapter XIII

Machiavelli counsels the prince against the use of auxiliary forces in battle. An auxiliary is not the same thing as a mercenary. A mercenary is a hired gun, loyal only to him or her self. A prince engages an auxiliary when he arranges for another principality to supply forces. The members of an auxiliary force will be loyal to their leader. The risk to the warring prince is that the kingdom with which he has entered into partnership will change terms during or after the battle.

Thus Machiavelli favours the use of one's own forces for important work. It is easier for the prince to align his force's interests with his own interests, and subsequently count on their loyalty and service because everybody stands to gain the same things for the same risks. In the heat of battle, mercenaries are likely to flee, while an auxiliary is likely to seek negotiations that minimize losses. After the battle, the auxiliary is likely to seek negotiations with the prince who invited them into the campaign. (More about this, below.)

Of course, business isn't warfare. But there are some business lessons we can learn just the same.

In software development, auxiliary forces have their place, particularly for utility services sourced for utility solutions. Consider an ERP implementation, complete with code customization. There is a large, diversified sell-side labor market, many alternative sources of that labor, pricing is more formulaic, risks and success criteria are known to some degree of specificity, and the work is not deemed strategically critical (not when everybody has an ERP). This commoditizes the sell-side offering, which favours the buyer.

The sell side has power in utility work only in times of acute labour shortage, which gives the sell side pricing power. But tight supply doesn't make a commodity into a strategic resource; it simply makes it a more expensive commodity. Like any commodity, shortages tend not to last very long: buyers will be priced out of the market (curtailing demand), while suppliers will find ways to create new labour capacity such as training new people (increasing supply). And sellers of services deal in a perishable commodity: time. Only in periods of very high demand will sellers press forward a negotiating advantage borne of tight supply. A billing day lost forever is strong incentive to a seller to do a deal. Whether a buyer engages for a utility service by contracting mercenaries (hired guns under the direction of the buyer) or by hiring an auxiliary (a partnership for delivery of the solution as a whole), the buyer has the upper hand when buying utility services. Or, perhaps, it is more accurate to say that the advantage is the buyer's to lose.

On consideration, Machiavelli wouldn't mind auxiliary forces when they're deployed for utility purposes. It is foolish to distract your best people with non-strategic pursuits.

But he would not approve the use of auxiliaries to achieve strategic solutions. The buyer of a strategic, unique, competitively differentiated solution must put more scrutiny on suppliers, navigate custom pricing, underwrite general and ambiguous risks, and has less certainty of the outcome and the business impact. The buyer will also be weighing intangible advantages in potential sellers, such as business domain or advanced technology knowledge. This makes for a small, opaque and poorly diversified market for any given strategic investment. This favors the seller.

By engaging auxiliary forces, the buyer can get a head start on a strategic solution. But then, it doesn't matter how you start, but how you finish.

A territory conquered by an auxiliary leaves the auxiliary with a strong negotiating position: as the saying goes, possession is nine-tenths of the law. The auxiliary force, in possession of the conquered land, can set terms for turning it over to the prince. This can also be true for strategic software investments. Strategic software doesn't end with a single act of delivery. It will need further investment and development. Their knowledge of the created software - the business domain, the code, the deployment scripts, and so forth - give the auxiliary force a familiarity of "the terrain" that the buyer simply doesn't have. This gives the auxiliary firm an outsized position of power to renegotiate terms with the buyer (e.g., usurious terms for ongoing development and maintenance), or to negotiate with firms who are competitors to the buyer to create a similar solution.

But what about intellectual property and contract laws? Don't they protect the buyer? When the focus shifts to contracts, it means both parties have brought in the lawyers. Lawyers are simply another type of armed force, one that can be both highly destructive and very costly. Lawyering-up simply escalates an arms race between the buyer and seller (or in Machiavelli's parlance, the prince and the auxiliary).

It's no surprise that Machiavelli concluded that auxiliary forces were not worth the risk in strategic undertakings. Anything of strategic importance to the prince must ultimately be done by the prince and his own forces.

This is an easy rule to write, but not an easy rule to live. Building a force (or in software terms, a team) capable of creating a strategic software solution requires world-class knowledge, experience, and facilities. It requires trained personnel and the ability to continue training. It requires the ability to recognize greatness and potential, and the ability to hire both. It requires innovation in tools, techniques and results.

It was Peter the Great's aspiration for Russia to have an ocean going navy. But he didn't start by emptying his treasury on local contractors to build his boats and hire people off the streets to serve as his officers. He studied English ship building and hired German Naval officers to train his officers and enlisted ranks. He invested in developing a capability. He played the long game to allow Russia to become a capable naval power, and not simply a nation with a floating armed force. When time permits, when one has the luxury of playing the long game of disruption, one can own, rather than rent, capability.

Time does not always permit the long game, especially in businesses whose models are being stampeded by software. If the competition has moved first, if one has to respond swiftly, one has no choice but to rely on auxiliaries or mercenaries if one is to continue to compete.

How best, then, for the buyer to engage an auxiliary or mercenary force, given Machiavelli's counsel? We'll look at the terms for this kind of an engagement in Part II.

Patterns for Buying and Selling Software Services

How we contract for software services has a big impact on how successful a software team will be.

There are three common ways of buying development and related services: we can contract for bodies, experts or a solution.

Contracting for Bodies

The simplest way to contract for services is a body shop or staff-augmentation contract. We're developing software in Java, we need Java developers, so we ring up a staff-aug firm and we rent Java developers. Fortune 100 companies rent people by the tens of thousands on staff aug contracts. Staff aug represents a substantial amount of revenue to firms ranging from the largest IT consultancies to local boutique shops. Body shopping is a big business: the margins are thin, but the volumes more than make up for it.

A volume buyer will have Vendor Management Office that consolidates buying requests from across the company, validates the time for they'll be needed (either project based or BAU based), makes the request consistent with position specs they put out to tender (Senior Developer, Lead QA, that sort of thing), and sources a body from the cheapest provider. This gives the scale buyer the appearance of quality control over the bodies they rent. It also eliminates all negotiation: sellers are given a position to fill at a price point; negotiation is simply "take it or leave it" to the seller.

In staff-aug, the seller isn't underwriting delivery risk (that is, of a project), they're only underwriting competency risk of the person they staff. Competency is established relatively quickly, within the first month or so: the staffed body is found to be either acceptable or, at the minimum, not unacceptable. For the seller, although the margins aren't very good, body shop contracts are low touch, it's consistent cash flow, and the easy money is hard for many to resist. Best of all to the seller, delivery risk is completely underwritten by the buyer: the buyer is hiring people on a contract basis to execute the tasks they've determined need to be done. If the project tanks, the buyer has to orchestrate and cover the costs of the rescue, whereas the seller stands to gain through an extension or expansion, and faces no downside risk of a clawback. Terms are often unfavourable to the seller: net 60 isn't uncommon. But cash flows are temporal: once or twice a month, just like payroll. You can set your watch by it. Body shop contracts are like ATMs to sellers.

Contracting for Experts

Another way to contract for services are expert or consulting contracts. A team wants an expert to solve a particular problem, something quite difficult or esoteric: we need a build guy, so we contract for a build guy. The contract may or may not be results based: in general terms, the buyer knows the outcome they want (a reliable, consistent build), but doesn't know exactly what that should look like (a build triggered with every commit, a build pipeline to stage automated test execution) or how to achieve it (developers need to code to keep the build working, not change the build so their code compiles). Execution tends to be highly collaborative: the buyer wants the expert rubbing elbows with the people in the team so that his knowledge gets transferred.

Risk is shared between buyer and seller. If the buyer sees things improve or if the expert gives insight that the team were never going to come up with on their own, they believe they got value for money and they pay. If the buyer doesn't see things improve or if the expert tells them things that they already knew, they don't believe they got value for money and they don't pay. The seller runs the risk that their expertise is sufficient for the situation, that there won't be personality conflicts that undermine their effectiveness, and that the buyer is sophisticated enough to consume the seller's expertise. Thus the risk is shared, and it's up to both parties to get to an acceptable outcome.

Expert consulting is appealing to independent contractors or boutique firms that are essentially collections of branded independent contractors. It is also appealing to large sellers if they believe leasing out an expert will lead to a large body shop or solution contract later.

Buyers pay dearly for experts, which means sellers get fat margins off the work. But sellers charge a premium for a lot of reasons. It is mercenary work to large firms because it doesn't build the seller's business (renting experts generally doesn't scale) and comes at high risk that the expert will quit to join or contract directly with the buying firm. Not everybody is cut out for expert consulting: in addition to needing marketable expertise, a good consultant requires a high EQ and a high degree of situational awareness. Contracts tend to be short duration, but take a long time to define (specify deliverables) and negotiate (intense rate negotiation). They are also high-touch, since the price attracts scrutiny from a lot of people on the buy side. On small contracts (measured in days or weeks), contracts are fixed price and cash flows are end-of-contract. When they're low six figures (such as a large team for a short time), it's money down with the remainder at completion. They're temporal if the engagement lasts for a long time.

Contracting for Solutions

The third form of contract is a project or solution contract. We're implementing SAP, so we need both the core modules and customization done to those modules. We know accounting, but we don't know how to implement SAP, or migrate our data into it, or code in ABAP. So we contract with an implementation and development firm. The ideal firm knows our line of business: e.g., if we're a retailer, we want a solution firm that knows how to configure SAP for retail, knows some really neat shortcuts and tricks, and some obscure 3rd party vendors with some interesting tools targeted at retail. That vertical expertise isn't strictly necessary, but at the least the buyer expects the seller will come to grips with the business domain pretty quickly.

In solution contracts, the sell side underwrites the risk of delivery. Of course, that's true only as far as the contract is concerned: in the event of a project failure, even if the buyer can claw back money from the supplier, the buying business is denied the working software it wanted at the time it wanted it. And the seller will have some people involved in development - people who know legacy systems, and various SMEs. But within the context of the services contract itself, the buyer turns over responsibility for development entirely to the supply firm: project management, user experience, requirements analysis, development, testing and sometimes even deployment and post-implementation services. If the project craters, it is the seller who must orchestrate and cover the costs of the rescue. Whatever marginal amounts the seller can squeeze out of the buyer during the rescue won't be enough to cover the entirety of the downside. Thus the seller underwrites the risk.

To the sell side, the margins are generally good but depend on the seniority of who gets staffed. The temptation is there to juice margins by staffing the delivery team with less experienced people (skill leverage is no different from financial leverage this way). But by the same token, sellers can be talked into "buying the business" - agreeing to enter a solution contract at a lower amount - if they believe that an initial solution sale will lead to subsequent (and significant) revenue. Cash flows can be either lump sums that start with prepayment, or time & material. Very large T&M projects will have a hold-back on each invoice and a rate discount at specified spend thresholds. Sellers can be rewarded for early delivery.

The Right Contract for the Right Situation

Each of these types of contracts have their place. A buyer who is managing and staffing a project team can successfully rent people, especially if the buyer has the means of thoroughly screening and assessing candidates and the willingness to reject people who are not up to scratch. A buyer who recognizes an acute need can contract an expert for a diagnosis and a solution path. Expert engagements are successful when the buyer understands what they're buying, is willing to accept that their self-diagnosis may be wrong and that the expert may steer them into a completely different direction than expected, and has the intestinal fortitude to follow-through. Solution contracts work when the supplier firm has the expertise in end-to-end delivery, a full set of capabilities, and depth of experienced personnel to come to their own rescue if the project ends up in trouble.

Commercial relationships hit the skids when buyer or seller - or both - fail to recognize the appropriate commercial relationship and the nature and responsibility for the risk. A seller who only employs developers - no UX, BAs, PMs, QA, etc. - cannot responsibly enter into a solution contract because they are not contributing enough to the entire solution. A buyer who wants to cherry pick people from multiple suppliers to form a single project team cannot hold any one supplier firm responsible for delivery. A seller supplying experts or bodies cannot compensate for inadequacies of the buyer, whether that's subject matter expertise or technical knowledge.

Sellers have to have enough self awareness to know the types of contracts they can responsibly enter into. Solution firms struggle with bodyshop contracts because the firm's unique value (in what they know or how they work) is neutered in a "rent a body" commodity sale. Solution firms also have low tolerance for long-running expert engagements, as they tie up expertise needed in high-risk solution contracts. Body shop firms tend to have very narrow experts who struggle in consulting engagements. They also lack management expertise or any "greater than the sum of our parts" value to be able to provide a business solution.

Buyers need to understand what's appropriate for them to buy. A buyer with little experience managing software development can't rent bodies because they can't manage them effectively. A buyer with a large, complex captive IT organization that contracts with a solution firm will suffer endless headaches caused by turf battles and disputes over "how to do things" among the buyer's and seller's staff.

Commercial relationships work best when both buyer and seller clearly understand the extent of each party's obligations, the risks that each are assuming, and how they're each mitigating those risks. In the end, a seller may not make a sale, and a buyer has to look for another supplier, because what's good for one is not good for the other. But it's a far, far better thing, over short term and long, that buyer and seller do good business than bad business together.

The Quality Call Option

On time. On scope. On budget. The holy grail of industrial, cost-center IT. Plan your work and work your plan. Be predictable.

As a set of goals for software development, this troika is incomplete because it neglects quality. That is a costly omission. Poor quality will ultimately steamroll the other three project variables: we'll be late, we'll remove features, and we'll spend a lot more money than we want to when we are forced to chase quality. We assume quality at our own risk.

Why do so many otherwise smart people take quality for granted? Mainly because they can't see how easily quality is compromised in development. It's easy to assume that requirements and specifications are sufficiently thorough, the developer just needs to work to the spec. It's easy to assume that we're hiring competent developers who write high quality code, and most buyers don't know what to look for or how to look for technical quality. It's easy to assume our Quality Assurance phase will guarantee solution quality by inspecting it in, instead of agonizing over how to build it in through every action we take in development.

And we tend not to realize that quality is in the eye of the beholder. When we have long feedback cycles - when it could be days, weeks or even months before one person's work is validated by another - the person responsible for creation is de facto the person responsible for validation. When "on time / on budget / on scope" is the order of the day, nobody is going to cast a critical eye over their own work.

It takes a while before we find out that one person's "done" is another person's "work-in-progress". The moment when a quality problem makes itself known is the moment when our implicit assumptions about quality start to become expensive.

There are a few simple things managers can do to give quality the same prominence as time, cost and scope. The first is to reduce the number of hand-offs in the team, and to strengthen those hand-offs.

Every hand-off injects incremental risk of misunderstanding. The greater the number of hand-offs, the greater the risk that we will have integration problems or understand the problem differently or solve the wrong problem. Development teams have a lot of specialists, both role (business analyst, developer, user experience designer, quality assurance analyst) and technical (mobile client developer, server-side Java developer, web client developer, etc.) Our ideal team is staffed by generalists who can each create a whole business solution. If we don't have people with generalist skills today, we must invest in developing those capabilities. There's no way around this. And there's no reason to accept technical specialization: we don't need to have mobile client developers as well as services developers and database developers. We can invest in people to become mobile solution developers who can write client and server code. Generalization versus specialization is our choice to make.

It takes time to professionalize a development team that has too many industrial characteristics. Until we've got a team of generalists, we have to make do with our specialists. As long as we do, we have to improve the fidelity of our hand-offs.

Rather than performing technical tasks in isolation, we can have specialists collaborate on delivering functional requirements. Have developers - even if they are fluent in different technologies - actively work together on completing an entire functional solution. That's easy to write but difficult to do. We must expect that we'll need to facilitate that collaborative behavior, particularly in the early going: collaborating on delivery of a functional solution is not natural behavior for people accustomed to going flat out to complete code by themselves.

We can increase collaboration across roles, too. We can have business analysts and developers perform a requirement walk-through before coding starts. We can have a business analyst or QA analyst desk check software before a developer promotes it as "development complete". We can insist on frequent build and deployment, and iterative QA. All of these shorten our feedback cycles, and gives us an independent validation of quality nearer to the time of creation.

This type of collaboration might seem matter-of-fact, but it doesn't come naturally to people in software development. A manager has to champion it, coach people in it, witness it first hand to assess how effectively people are performing it, and follow through to make sure that it takes place on its own.

Stronger hand-offs will slow down coding. The act of creating code will take longer when we insist that BAs do walkthroughs with developers, that developers collaborate on business solutions, and that QA desk-checks before code is promoted. But the velocity at which a team can code is not the same as the velocity at which a team can deliver software at an acceptable level of quality. It's easy to cut code. It's not easy to cut code that is functionally and technically acceptable. That means the former is a lousy proxy for the latter, and our management decisions are wildly misinformed if we focus on "dev complete".

Knowing the velocity at which a team can deliver a quality product gives us far more useful managerial information. For one thing, we have a much better idea for how long it's likely going to take to deliver our desired scope to an acceptable level of quality. This makes us less vulnerable to being blindsided by an overrun caused by lurking quality problems. We also have a better idea for the impact we can expect by adding or removing people. A team focused just on delivering code might deliver more code in less time if it has more people. But quality problems tend to grow exponentially. When quality is not a consideration in project planning, we tend to forget the dichotomy that a larger team can need more time to complete software of acceptable quality than a smaller team.

Another thing we can do is make our quality statistics highly visible. But visibility of the data isn't enough; we have to visibly act on that data. It's easy enough to produce information radiators that profile the state of our technical and functional quality. But an information radiator that portrays a decaying technical quality picture will have a negative effect on the team: it will communicate that management doesn't really care. Something we're prepared to broadcast is something that we have to be prepared to act on. When we expose quality problems we have to insist on remediation, regardless if that comes at the cost of new requirements development. That puts us face-to-face with the "quality call option": developing more bad stuff is less valuable than developing less good stuff. That might seem obvious, but it doesn't fit into an "on time / on scope / on budget" world. It takes courage to exercise the quality call option.

Finally, we have to look not just at project status data, but at flow data. Projects throw off copious amounts of flow data - trends over time - that most managers ignore. These are a rich source of information because they indicate where there are collaboration - and therefore quality - problems. For example, we can easily track a build-up in the number of defects that developers have tagged as ready for retest, but are not retested in a timely fashion by QA. We can look for a pattern of defects raised that are dispositioned as "not a defect". We can monitor defects that are reopened after retest. And we can look at the overall ratio of defects to test activity as an indicator of fundamental asset quality. The patterns of change in this data over time will indicate performance problems that undermine quality.

As people who understand how to deliver software, we have to insist on quality being on an equal footing with cost, scope and time. Getting that footing is one thing, keeping it is another. We need to measure both asset quality and team performance in terms of results of acceptable quality. We need to scrutinize our project data for threats to quality. We need to foster individual behaviors that will reduce self-inflicted quality problems. And we have the courage to broadcast our state of quality and act decisively - to exercise the quality call option - to defend it.