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Archive for October 31st, 2011

Does Profit Motive Kill Companies?

Posted by Bob Warfield on October 31, 2011

There’s an interesting article out in Forbes that contains a couple of fascinating ideas well worth digging into.   The first thing is their argument that Steve Jobs was able to eliminate Innovator’s Dilemma at Apple by getting rid of the profit motive.  The same article also mentions a fascinating study by Deloitte called “The Shift Index” that has determined:

U.S. companies’ return on assets (ROA) have progressively dropped 75 percent from their 1965 level despite rising labor productivity. Even the highest-performing companies are struggling to maintain their ROA rates and increasingly losing market leadership positions. Some of the 2010 findings include:

  • Less than a quarter of the U.S. workforce is passionate about their current work. Worker passion is a key requirement for effectively responding to the ongoing, disruptive changes in the business environment.
  • Performance continues to decline. Whether measured through return on assets (ROA), return on invested capital (ROIC) or return on equity (ROE), the long-term downward trend holds true. We discuss this in the context of several macro-trends –transition to a service economy, M&A activity, outsourcing, and growth of intangible assets.
  • The economic downturn, in particular the lack of access to capital, decreased consumer spending and the resulting business bankruptcies, has had an impact on some of the indicators. However, we believe these are short-term effects and that the long-term trends will resume. 
That drop in return is pretty hard to ignore.  The argument is that the Internet world has empowered customers and dramatically reduced the ability of hierarchical large organizations to extract large profit margins.  Are companies having a harder time differentiating, monopolizing, and then extracting huge profits because the Internet has made the markets more efficient by empowering consumers?  Some PhD economics candidate should do the research and statistics needed to find a correlation if one exists, because it is a fascinating proposition.  Meanwhile, let’s assume it’s true.  It certainly agrees strongly with the conventional wisdom about what the World Wide Web ought to do.
Perhaps one other force should be considered beyond (but somewhat related to) the Web, and that is competition.  I remember having a discussion via Letters to the Editor (quaint!) back in the 80’s with Bob Metcalfe, inventor of the Ethernet.  He was musing over the issue that year after year, economists could find no evidence that technology was increasing productivity at all.  He couldn’t understand how that could be possible.  At the time, I suggested competition as one answer.  If markets are competitive enough (e.g. efficient enough), as soon as one company gets an innovation, others must immediately seek out the same innovation, nullifying the differential advantage to the first company.  This is the view that sometimes innovation is an arms race.
I think that in general, this is true, unless the innovators can find ways of preventing their competitors from seizing the same advantages for themselves.  Companies have gotten pretty good at this by employing patent protection, network effects, and whatever else they can bring to bear.  Apple is well into the process of pressing this sort of advantage for their iOS devices, and companies like Google and Facebook are enjoying the protections of network effects to keep the likes of Bing and others largely at bay.  From everything I’ve seen about the results of Bing versus Google directed traffic to my web sites, the Bing traffic is much more likely to convert to a sale (i.e. the search engine did a better job of directing those who were actually interested), but there is so little traffic relative to Google that Bing and Yahoo together are not worth worrying about too much.  The proportion of traffic is much less than market shares would suggest–presumably if you are going to deliver more focused searches, there must be fewer of them.  It’s scary to think that Google might game that situation by “de-tuning” their searches a little bit.  But we digress.
The gist of the argument about return on capital and market efficiency is that innovation must proceed at an even faster pace and that the Innovator’s Dilemma will therefore become more and more common.  Once entangled in the web of misplaced incentives and forced cannibalization of valuable businesses, most large organizations cannot successfully navigate their way through.  They die or at the very least are severely injured by paradigm shifts.
As I look at Apple under Sculley and his successors, I don’t find this to be a “clean kill” sort of argument.  During that time was Apple actively suppressing Innovation in favor of Profit Motive?  Perhaps, but they certainly seemed to be trying to innovate.  Unfortunately, they shipped some turkeys at the time like Newton.  This leads me to the question around all of this that comes of peeling back a layer or two of the onion.  Is the problem with Profit Motive who it empowers in the organization rather than the motive itself?  For example, James Allworth says in his HBR blog that the only one at Apple concerned with profit is the CFO.  At companies that are highly profit incented, one typically finds a very highly paid VP of Sales and the CEO on commission and bonus plans that are heavily weighted to the short-term.  Marketers and engineers, not so much.  Sure, they may get bonuses, but they’re much smaller and these professions typically make due with stock options for the big swing.  Speaking of which, many argue that stock options turn into short-term motivators because they’re lottery tickets for executives who artificially increase the risk leverage to the company in hopes of blasting the options to sky-high valuations.  I’m more skeptical about that, but the argument is being made.
Look at it another way, and I wonder what VC’s and other investors think about this.  A great VP of Sales at a good opportunity can make something in the neighborhood of $1M a year in commissions.  Even if it is half that, we’re still talking a substantial number.  That compensation is not aligned with the VC’s or the rest of the management team’s goals very well though.  The VP of Sales may have a great year, followed by some famine.  The famine kills the valuation, possibly even the company, and those who are compensated with stock options either get hugely diluted or wiped out.  The VP of Sales is pretty well Teflon Man:
Yeah, we had a great year but the company just couldn’t innovate and eventually withered.  I had to move on.
That’s a pretty differential result from the rest of the company and it’s investors.  Lately, VP’s of Sales have been commanding the same or nearly the same options as the rest of the team, so they literally have no downside.  I’m not trying to pick on Sales, I’m just actively wondering what this kind of compensation does to the team dynamics and the running of the company through the thick and thin that is standard fare for small companies.  With that much at stake, and the CEO often being compensated similarly and a Sales guy himself, that’s a lot of force in the direction of maximizing those comp plans.  Perhaps Apple had a built-in advantage that their business model does not require a highly compensated VP of Sales.  One wonders what companies that do require a VP of Sales (i.e. those with large transactions) can do to combat any short-term tendency to avoid Innovator’s Dilemma.  It’s going to take one heck of a strong CEO to take the proverbial birds in the bush rather than the one in hand, and Boards should consider whether they want that CEO to be a Product Guy who is not compensated via too much short-term incentive rather than a Sales Guy who stands to make as much as the VP of Sales by goosing the numbers short-term.  Meanwhile it may all be for naught as Wall Street is almost entirely short-term focused as well.

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