Astute Competition: The Economics of Strategic Diversity

ASTUTE COMPETITION THE ECONOMICS OF STRATEGIC DIVERSITY TECHNOLOGY, INNOVATION, ENTREPRENEURSHIP AND COMPETITIVE STRA...

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ASTUTE COMPETITION THE ECONOMICS OF STRATEGIC DIVERSITY

TECHNOLOGY, INNOVATION, ENTREPRENEURSHIP AND COMPETITIVE STRATEGY SERIES Series Editors: John McGee and Howard Thomas Published SANCHEZ, HEENE & THOMAS Dynamics of Competence-Based Competition DAI Corporate Strategy, Public Policy and New Technologies BOGNER Drugs to Market SUSMAN & O’KEEFE The Defense Industry in the Post-Cold War Era NORDBERG The Strategic Management of High Technology Contracts: The Case of CERN SCHULZ & HOFER Creating Value with Entrepreneurial Leadership and Skill-Based Strategies SHAVININA Silicon Valley North Forthcoming title FIEGENBAUM The Take-off of Israeli High-Tech in the 1990s: A Strategic Management Perspective Other titles of interest DURING, OAKEY & KAUSER New Technology-Based Firms in the New Millennium HOSNI Management of Technology: Internet Economy KATZ Advances in Entrepreneurship, Firm Emergence and Growth, Volume 7: Corporate Entrepreneurship LIBECAP Advances in the Study of Entrepreneurship, Innovation and Economic Growth, Volume 15: Intellectual Property and Entrepreneurship Related journals – sample copies available online at www.sciencedirect.com

Journal of Business Venturing Journal of Engineering and Technology Management Journal of High Technology Management Research Technological Forecasting and Social Change Technovation

ASTUTE COMPETITION THE ECONOMICS OF STRATEGIC DIVERSITY PETER JOHNSON Exeter College, University of Oxford, Oxford, United Kingdom

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First edition 2007 Copyright r 2007 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the Publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively, you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material. Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress ISBN-13: 978-0-08-045321-7 ISBN-10: 0-08-045321-X ISSN: 1479-067X (Series) For information on all Elsevier publications visit our website at books.elsevier.com

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For Juliet

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Contents

Preface

ix

Foreword

xv

Abstract

1

Part I: Concepts 1.

The Economics of Strategic Diversity

5

2.

Strategic Ecology

29

3.

Business Models

53

4.

Routes to Competitive Advantage

73

5.

Economic Rents

99

6.

The Return on Resources

111

Part II: Techniques 7.

Business Development

129

8.

Corporate Strategy: Purpose

141

9.

Corporate Strategy: Techniques

157

10.

Start-up Strategy

191

11.

Summary, Observations and Conclusion

211

Subject Index

223


Preface In 1981, when I was a young strategy consultant about to go to business school, I looked forward to the publication of Michael Porter’s Competitive Strategy with great anticipation. I thought that it would unlock the competitive mysteries of how one business thrives when another fails. Unfortunately, while the book was interesting and informative, I was perhaps one of a very small minority of readers who felt profoundly disappointed with the content of the book. It provided few specific, honed concepts or examples from practice to help businesses formulate winning strategies that allowed them to make more money than their competitors. Porter’s Five Forces framework provided the means to assess the context in which businesses compete against each other, but in terms of just how they competed against each other we were told only that businesses pursued either cost leadership, or differentiation or a niche focus. These prescriptions were much too broad to be straightforwardly applicable to specific businesses. For instance, when I carried out a structural industry analysis for clients, this did not provide any implications as to what exactly my clients should do, but simply revealed a void of ignorance: given this is the context how can we make more money sustainably than the businesses we are competing against? What should we do? How can we establish a cost advantage? What are the relevant costs? Along which lines can we differentiate ourselves in an advantageous way? How can we mix elements of cost advantage and differentiation to improve our standing in the eyes of customers in a way that allows us to make more money than the businesses with which we compete? How big is a niche, and how is it to be defined? The structural analysis was a starting, not a finishing point; it was largely descriptive, not prescriptive. I thought that perhaps Porter’s second book would fill the gap, but it did not. To be fair, no one else has written compellingly about these issues. What is missing is a comprehensive account of heterogeneous competition between businesses to supplement Porter’s structural analysis of industries (which economists call industrial organisation) — in other words, a fourth leg to economics, which consolidates and systematises what we know about how businesses really compete, to add to microeconomics, macroeconomics and industrial organisation. I hope that this book represents a valid step on that path, introducing concepts and techniques that can form part of this new fourth leg within economics called the Economics of Strategic Diversity (ESD), which sets out the fundamentals of heterogeneous

x

Astute Competition: The Economics of Strategic Diversity

competition and provides a richer, thicker account of how businesses make money from competitive success. How can this goal of a fourth leg be achieved? Few would deny that there are a number of concepts and tools that managers can apply in day-to-day contexts to help them make better strategic choices for their businesses. These tools and concepts help to explain why some businesses make much more money than others. Many of them, in one guise or another, are familiar either to a smart CEO or to the senior practitioners in strategy consulting firms. Unfortunately, few consulting partners or chief executives have the time or patience necessary to articulate on paper some of the concepts and tools that they have found most useful in their careers. To make matters worse, from time to time senior personnel are seduced into a faddish preoccupation with a particular technique (such as the experience curve, time-based management or total quality) in order to win client business. This book attempts to address this situation. My purpose is to elucidate various strategic concepts and insights relevant to an explanation of heterogeneous competition, gathered over a period of more than twenty-five years working as an advisor and as an entrepreneur in a wide range of companies, industries and countries. Some readers, though, may ask how they can be assured of the conclusions drawn in this book when they are not supported by statistical analysis of empirical studies using large data samples. Not only does this statistical approach to management research present enormous practical difficulties, but it also presupposes that this is a sensible method to adopt. The answer is that the conclusions are supported by insight and reason, are causally persuasive and have explanatory power. Unlike microeconomics, which typically deals with idealisations, in strategy we are dealing with specific, real situations that cannot be analytically rendered by washing them in a sea of statistical data. Instead, we may make headway through conceptual analysis, as our colleagues do who are psychologists, philosophers or anthropologists. Developing a perceptive account of strategy that fully explains heterogeneous competition entirely from inferences based upon available business statistics would be like trying to develop an account of justice based upon crime numbers. Throughout the book I talk about businesses rather than firms, departments, divisions, companies, corporations, ventures and entities. This not only avoids ambiguities introduced by ownership and structure, but also serves to focus the discussion on the people, activities and resources that collectively supply customers with products or services and deal with competitors. Businesses compete, and those working within a business usually have a very clear sense as to how their business competes and what it does and does not comprise. It seems sensible therefore to articulate competitive strategy in terms of businesses. This focus on businesses does not preclude that some of the concepts and tools discussed will also be relevant to public organisations, non-profits and government agencies. From the outset, it has been my intention to avoid making the book overly lengthy, while still including relevant examples and linking the narrative to the established business literature. Where possible I have used slightly disguised versions of favourite analyses and displays taken from actual client situations. To this end the book does not include a large number of structured cases for class exercises and

Preface

xi

discussion, which risk rapid obsolescence. Instead, I hope the book will stimulate critical thinking on the part of the reader about strategic issues facing the businesses that he or she is involved in. For this to be successful, I assume that the reader is a strategist and has good underlying familiarity with the prevailing notions of strategy, perhaps gained from working in either a strategic or business development role in a company or a consultancy, or perhaps as an entrepreneur. One final point: too much of what is taught as ‘‘strategy’’ is overly grandiose and normative, targeted at the opulent, ponderous realm of the large multinational corporation. What is said here about strategy is intended to hold true for businesses large and small, new or old. The book is structured in two main parts. After the introductory chapter, Part 1 aims to provide a rigorous account of the five key strategic building blocks that underpin an analysis of heterogeneous competition. In straightforward language these conceptual anchors aim to answer five related questions: (i) How do you define your business correctly? (ii) How do you develop a way of carrying out your business that creates value for your customers? (iii) What advantages do you enjoy compared to your competitors in carrying out business your way? (iv) How does that competitive advantage give rise to sustainable profits? and (v) How do we judge whether those profits, in relation to the resources used up by the business, are sufficient to keep investors happy? To answer each question requires the application of an associated strategic concept: (i) the relevant strategic ecology allows you to define your business correctly; (ii) how you conduct your business is described by your business model; (iii) by careful crafting of a distinctive business model you can create a route to competitive advantage; (iv) that competitive advantage will allow sustainable profits that arise from economic rents to compensate you for the use of resources; and (v) the ensuing return on resources will determine whether investors are happy or not with the performance of your business, and hence the value of your business. How do these questions and concepts tie together into chapters? Chapter 1 provides an introduction and justification for ESD, which can help make up for the inadequacy of the other fields of traditional economics in explaining the behaviour of businesses. At the heart of ESD is the general observation that, for businesses, a strategy is a coherent and consistent pattern of action expressed through a business model leading to the appropriation of sustained economic rents. Chapter 2 then explains the relevance of knowing the correct strategic ecology in defining a business and its relevant competitors. Having established an understanding of the strategic ecology and the competitors relevant to a business, Chapter 3 makes explicit how the behaviour and configuration of this business can be described by its business model, and that what is meant by a business model can be made explicit using matrix algebra. For those less comfortable with matrices, it suffices to say that one can define business models explicitly in a manner that resembles chemical formulae or genetic codes. In making the models explicit, it does not require that all managers in a business share exactly the same model: there may be some cognitive element contributed by the manager. But if different managers have different perspectives on the business model of their business, these matrix methods at least have

xii


the merit of making the differences apparent. Furthermore, one can use these matrix methods to show how managers modify these formulae or codes that describe how they compete in their business, just as scientists do in clever chemistry or genetic engineering. These codes also provide a formal means of incorporating the resourcebased and positioning views of strategy as separable parts of the business model. But what is the point of creating and enhancing these business models? The answer is spelt out in Chapter 4, which explains how managers can refine and exploit business models so that they establish competitive control of resources. As the chapter makes clear, there are many ways that businesses can formulate strategy to confer a competitive advantage. Competitive advantages in turn give rise to sustained economic rents that justify the business’s use of resources and can be used to reward investors. Chapter 5 reveals that the principal type of rent is an opportunity rent that arises from heterogeneous competition, as opposed to the more familiar, monopolistic, oligopolistic and innovation rents that are well developed and described in traditional economics. But how does a manager know whether these rents are enough to keep investors happy? Chapter 6 sheds some light on this question by outlining how resource margins (i.e. the return on resources), which measure the rents obtained in relation to the resources consumed, can be happily integrated into modern financial theory to provide a robust measure of strategic valuation that meshes strategy, accounting, microeconomics and finance. Resource margins provide a practical handle on what makes investors happy. The five strategic concepts covered in Part 1 form the cornerstones of this account of ESD. I make no claim that this is a fully comprehensive account of heterogeneous competition, but I do believe that the concepts outlined are among the primary building blocks necessary for an account to be adequate, and the treatment in this book is the first to attempt to integrate them. Part 2 deals with how these strategic concepts, embedded in various analytical techniques and tools, can illuminate strategy practice. The reader will note the intention is not to deconstruct each practice (such as mergers and acquisitions) into a mechanistic, detailed Airfix blueprint constructed from variants of the five strategic concepts. Business situations are too varied and subtle to allow this. Instead, I hope to illustrate how the five preliminary strategic concepts of Part 1 can be put to work through the techniques and the tools actually used in real situations — in fact, the practical application came first, and their success led me to think about the underlying strategy concepts that ensured they worked. Chapter 7 explains how a successful business can continue to develop by exploitation of new business ecosystems adjacent to its starting base. This chapter analyses the conceptual linkages that underpin the related trilogy of strategic ecology, adjacency and synergy. The linkages between these concepts arise from the fact that the criteria we use to assess that two businesses are different (strategic ecology), form the basis also for explaining the extent to which the two businesses are the same (adjacency), and for determining what the businesses have in common (synergy). Effective corporate strategy makes the value of the whole corporation greater than the sum of the values of its parts. Chapter 8 develops this notion of corporate

Preface

xiii

strategy by showing how it is possible to extract greater sustained economic rents from a set of businesses than the businesses would generate on a stand-alone basis. Chapter 9 describes a number of techniques and tools to help corporations to add value to their constituent businesses: portfolio profiles, retrospective scenario-based valuation, mergers and acquisitions (M&A) selection methods and valuation grids. Start-up strategy is explained in the penultimate Chapter 10, where an explicit distinction is made between the strategy to build a new business and the strategy of the business that is built. The book concludes with a final summary chapter, Chapter 11, but each chapter also ends with a conclusion, a summary of key points and a small number of questions to be considered by the reader. In preparing the book I was very aware of my indebtedness to former colleagues, mentors and students. In particular, I would like to thank Richard Koch, James Lawrence, Robert Ashcroft, Herve Dumesny, Robin Field, Toby Lenk, Mark Tanzer, Toby Wyles, Jean Louis Velaise, Sylvain Garnaud, Ray Porter, Anthony Rice, Hans Moock, Timothy Sims and Timothy Scholes for their support and contributions when we all worked together at The LEK Partnership; Dr. Uday Phadke, James van Oosterom, and Mike Vieyra, all colleagues at Cartezia Limited; Michael Holmes and Alexis Zervoglos of Opsys Limited; Quintus Travis, Dr. Adrian Travis and Dr. Tim Cooke, all directors of Cambridge Flat Projection Displays Limited; David Nierenberg formerly of Bain & Company and now running the D3 Family Fund; Professor Hank Chesbrough of the Haas Business School (a stalwart reader and source of advice); Professor John Kay, formerly of the Said Business School; Professor Howard Thomas and Professor John McGee of Warwick Business School. At Oxford, Dr. Dieter Helm, Professor David Faulkner, Professor Colin Mayer, Dr. Robert Pitkethly and Dr. Steve New made helpful contributions. Jonathan Davis of the Intelligent Investor has corrected much poor expression and long-windedness. Aryeh Ganz of Sagen Asset Management corrected many mistakes and gaps in explanation. My especial thanks go to Professor Marilyn Butler and the Fellows of Exeter College who have provided the environment to carry out this work. My students have provided a valuable sounding board, and I would particularly like to mention Neil Marson, Andrej Machacek, Lindsay Gallagher, Thomas Cochrane, Marcus Holmlund and Jenny Svanberg. In conclusion, I also express my sincere thanks to my family and friends who have supported and encouraged me throughout this project. Peter Johnson Oxford May 2006


Foreword It is with great pleasure that I write the foreword for this important monograph on the subject of competitive strategy and strategic diversity. Unlike many academics in the field, Peter has a background both in academia and consulting. He was a scientist by training and went to Business School in the early 1980s, following which he had a distinguished consulting career in a range of companies, most notably L.E.K. Consulting. More recently, he has become Bursar of Exeter College, Oxford and a Lecturer in Strategic Management in Oxford University. In that capacity, he has developed a very interesting set of strategic management teaching materials and has diligently applied his original consulting thinking to his work at Oxford. I am particularly impressed with Peter’s attempts to set out the fundamentals of heterogeneous competition and to develop a more comprehensive theory of competitive success. His framework and his business model are very thoughtful and insightful and his use of concepts drawn from a range of literature, particularly the finance literature, makes this a ‘‘must read’’ for scholars in strategic management. Indeed, I think that the ideas are so important that the insightful reader should be able to develop four or five propositions about competitive strategy which can be used both in practical contexts and, more importantly. from an academic viewpoint in the development of new theory and applied research in the field of competitive strategy. I wish the reader every success in paging through this text, which provides a novel and insightful viewpoint about astute competition. As editor, I have enjoyed both reading the manuscript and seeing it come to fruition in this publication. Howard Thomas (Dean) Warwick Business School 3rd October, 2006


Abstract The concepts and techniques in this book explain how individually distinct businesses compete against each other within a defined strategic ecosystem. Using matrix methods to describe explicitly the strategic architecture of different business models, the author develops a credible notion of business genomics that anchors (i) the economics of strategic diversity (an area ill addressed by current theories of the firm in traditional economics); and (ii) the integration of the resource-based and marketpositioning perspectives on strategy. Astute articulation of a business model confers a competitive advantage, thereby creating opportunity rents. These rents, captured as a return on resources, generate shareholder value in a valuation framework entirely consistent with CAPM.


Part I Concepts


Chapter 1

The Economics of Strategic Diversity Contemporary neoclassical1 economics does not provide an adequate account of the competition between diverse businesses. To sense this inadequacy, have a look at some of the main economic texts in your local bookshop, including one on macroeconomics, one on microeconomics and one on industrial organisation. From an inspection of the material, it is clear that students of economics are well versed in the technical analysis of monopolies, oligopoly and perfect competition; they also understand the aggregate collective effect of businesses in defining the wider economy that is the subject of policy and welfare considerations. Trade and tariffs are well plumbed. Furthermore, those who study industrial organisation are able to discern industries, which succumb to greater or lesser degree to the norms of the Structure–Conduct–Performance (SCP) paradigm developed by Bain and others in the 1950s, where the Structure of an industry determines the Conduct of industry participants, which in turn determines Performance. At the level of individual decisions in microeconomics, we can also talk of prices, costs and margins for homogeneous products. Nowhere though do we encounter a business as the object of investigation in traditional economics.2 In other words, there is a huge gap in the economics coverage of commercial activity.3 Why is this? Part of the reason is that the focus of economists is on markets rather than on businesses. Often traditional economists contrast the operation of businesses with the operation of markets. They would like to believe that in an ideal world, we would be able to live, to work and to go about our lives obtaining all necessary goods and services from well-functioning markets. But (fortunately), man does not inhabit an ideal world, and so in our account businesses are relied upon to overcome market imperfections.4

1

In what follows, we often refer to contemporary neoclassical economics as traditional economics. Richard Rumelt (1984: 566) voiced similar concerns in Towards a Strategic Theory of the Firm: To the uninitiated, it appears obvious that the study of business strategy must rest on the bedrock foundations of the economist’s model of the firm and the theory of industrial organization. Nevertheless, until very recently, there has been a virtually complete absence of any intersection between business policy and economic theory y because the neoclassical theory of the firm was created by assuming away the very existence of those phenomena that most concern students of business policy. 3 Good summaries of how economists think about strategy are contained in The Economics of Strategy by David Besanko, David Dranove and Mark Shanley (Besanko et al. 2000), and The Modern Firm by John Roberts (2004). 4 Economists have identified and discussed many of these imperfections, for example, imperfections related to the rewards of shared work (Alchian & Demsetz (1972); incomplete contracts Grossman & Hart (1983, 1986)), or where the transactional costs of the market are higher than internalised alternatives (Coase 1937; Williamson 1975). 2

6


Within the framework of nominal market superiority, however, the role of a business is relatively minimalist, supposedly well captured in terms of a production transfer function that describes how correctly priced inputs are combined into correctly priced outputs. Management and strategy seem to have little importance: notionally at least, we could optimise the production function with but a few hours of linear programming. The role and status of managers may thereby be reduced to that of the lowly mechanicals in Shakespeare’s Midsummer Night’s Dream. Perhaps one can discern a slightly richer role for businesses within the transactional cost framework of Williamson. Here businesses plug the gap when it is too expensive or impractical to deal in markets because of transactional complexity, cost or opportunism.5 Businesses represent a fall back or default solution, a type of second-class citizen in the world of resource allocation. Such approaches, however, do not do justice to the rich, competitive creativity of successful businesses. It is not an accurate reflection of the centrality of businesses to the economy to regard them as fundamentally a remedy for imperfections in markets, or the result of human limitations or self-interested behaviour. Businesses have a much more positive purpose. They provide a powerful mechanism to harness resources in a compelling and efficient fashion. Businesses get things done, facilitating intent and action in a way that is fundamentally beyond the scope of the market mechanism. We can consider businesses to be the vehicle to extract economic rents through the competitive control of resources; they are the building blocks of heterogeneous competition.6 To make stark the minimalism of the transactional cost account, we could for instance, as an extreme, ask whether we could similarly replace families by market arrangements between children, parents and carers if transactional costs were sufficiently low. Most of us would think that even if we could contract the many services that arise in families, this contractual situation would not capture the essence and the purpose of a family. It is also often assumed that markets are inherently fair, liberal and cheap to run: far from it. Markets can only function with infrastructure, standards, regulation and policing. Financial markets are far from being laissez-faire deregulated networks. Instead, a huge body of legislation and infrastructure must support established economic markets in order for them to function efficiently. In the absence of these supports those who transact in these markets are at the risk of fraud, opportunism and mispricing. As John Kay, the economist, has pointed out, there are many situations for which we can never envisage an acceptable market solution, even an expensive one (for example, divorce insurance).7 Yet in many of these circumstances, solutions that satisfy the economic needs of purchasers have been or could be provided by businesses.

5

Even when transactional cost economics is integrated with the resource-based view of the firm (Foss & Foss 2004) we still lack any account of the internal architecture and workings of a business. 6 By rent we mean economic profit, and we will use the terms interchangeably. Economic profit is the difference between the present values of revenues and costs where inputs (capital, land and human resources) reflect their opportunity cost. Positive rents coincide with positive net present values (NPVs). Rents will be discussed more fully in Chapter 5. Loosely, we can think of rents as being the sustained profits in a business used to satisfy shareholders. 7 See Kay (2003).


7

Given the relative paucity of established markets, it is also apparent that there are very few situations where the cost of infrastructure, regulation, policing and the provision of information would give rise to a timely and efficient allocation of resources using the market pricing mechanism. This is not surprising given that many of the exchange prerequisites for functioning bilateral markets are seldom met: consistent adequate supply, liquidity, relatively homogeneous buyers and sellers, persistence of participants etc. In attempting to substitute markets for businesses, the situation is also made profoundly more difficult by the concurrence of multilateral relationships frequently required to deliver products and services. Nearly all established markets involve a bilateral contract between only two participants. To replicate a typical business, however, we must contemplate the contemporaneous efficient execution in parallel markets of a multitude of multilateral contracts between suppliers, customers, distributors and activity providers, where the concurrent contracts with other groups of customers, distributors etc. in the parallel markets are interdependent.8 Imagine trying to be a guerrilla leader in a market-transacted setting. This multilateralism of business relationships means their topology is different from the topology of markets or the topologies of hierarchies.9 What this means is that you cannot convert a structure of business relationships into a market structure by stretching, leveraging, amplification or distortion, just as it is impossible to change two overlapping circles into a square. This frustrates many economists who would like to reduce businesses to markets by idealisation, exaggeration or some other smooth, orderly transformation. In order to change one topology to another, the only transformations that work are ones that involve radical restructuring with disruptive, discontinuous changes that destroy the original relationships. This is tantamount to saying that the only way we can eliminate the need for businesses in favour of markets is by destroying them. The solution lies in the establishment of mutually beneficial, adaptive relationships based upon trust and commitment between a multiplicity of parties: employees, suppliers, customers, distributors and managers.10 Teams involving both those inside and outside the business often handle the dynamic management of these relationships, building loyalty and continuity to counter opportunism and bounded

8

Teece et al. (1997: 517) reached a similar conclusion writing: If the ability to assemble competences using markets is what is meant by the firm as a nexus of contracts, then we unequivocally state that the firm about which we theorize cannot be usefully modelled as a nexus of contracts y.Moreover, the firm as a nexus of contracts suggests a series of bilateral contracts orchestrated by a coordinator, where our view of the firm is that the organization takes place in a more multilateral fashion, with patterns of behaviour and learning being orchestrated in a much more decentralized fashion. 9 Business topology can be oversold: too often unreflective emulation of business practices can lead to the inappropriate advocacy of a business topology to structures where it does not fit e.g. schools, universities, government, which probably have their own topologies of inter-relationships. 10 Relationships are not reducible to a set of bilateral contracts as economists who attempt to describe firms in terms of the contract between a principal and agent (agency theory) would have us believe. Roberts (2004) makes a brave case for agency theory but ultimately falls back on relationships, teams, leaders and imagination to describe effective business structure, strategic implementation and motivation.

8


rationality. As a result the great majority of economic transactions rely upon nonmarket mechanisms. Establishing the internal infrastructure, culture and organisation to support teams and relationships is a major distinctive element in the resource configuration of many businesses: what we might call nexus management. Like people, businesses are unique and the teams working in them expect strategies to reflect the specifics of the business, not averages or generalisations drawn across a large number of other businesses, which are each in fact distinct. Furthermore, businesses like individuals learn and adapt, particularly in the light of generally held assumptions about how businesses behave or conform to expectations. In talking to the key individuals in a business, it soon becomes apparent that heterogeneity is the key to generating returns different from those of competitors. Richard Rumelt got it right when he said:11 Similar firms facing similar strategic problems may respond differently. Firms in the same industry compete with substantially different bundles of resources using disparate approaches. These firms differ because of different histories of strategic choice and performance and because managements appear to seek asymmetric competitive positions. (Foss 1997: 132) Economics heads in the opposite direction since it is determined to eliminate or render irrelevant the specifics of the individual situation. As a result, markets are the antithesis of businesses — all the non-systematic, business-specific information is washed away in the economists’ assumption of efficient and deep product markets: this is what transactional cost economics tells us happens when markets function well. The transactions are nominally the same and as a result individual businesses are not relevant to the making of purchasing decisions because they all offer whatever it is that the market provides. But this emphasis on anonymity in economics goes beyond the featureless neutrality of markets.12 The entire approach of traditional economics is to try to introduce homogeneous elements to make a situation tractable — essentially various forms of everything else being assumed to be the same — in order to establish a general conclusion of the form ‘whenever we have X, then Y follows’. More fully, though, we should say that ‘whenever we have two situations that only differ in so far as X occurs in one and does not in the other, then Y will occur in the situation that X occurs’. This uniformity of background assumption is generally known as the ceteris paribus 11

Nelson & Winter (1982) similarly observe that different firms have different histories and routines and face different menus of business opportunities. 12 Nicolai Foss (1996: 18) aptly summarised many of our misgivings when he wrote: This [analysis] indicates in turn a third lesson to be drawn from the evolution of Porter’s thinking: the need for a theory of the firm in strategy research. By ‘a theory of the firm’ is here meant a theory that is substantially ‘thicker’ in its conception of the firm than the standard neoclassical production function view. Such a theory of the firm is ‘thicker’ in the sense that it explicitly views firms as essentially heterogeneous entities, heterogeneity being based on firm’s heterogeneous endowments of resources and capabilities. Without such a theory, it is hard to fully address corporate strategy issues, to understand how resources and capabilities underpin strategies, to address longer-run issues in strategy etc.


9

assumption e.g. same product, same production processes, same customer needs.13 In real business situations, it is extremely rare for conditions to repeat themselves, in other words, for ceteris paribus to hold. In a similar fashion, the force of ceteris paribus thinking extends to the way economists think about the businesses themselves. Traditional economic analyses of business problems show little understanding of the heterogeneous internal structure of businesses that result from their selection of business model. While Michael Porter and other industrial organisation theorists perceive the existence of cost- and valuebased sources of competitive advantage, they are not able to link in a specific way these advantages to the configuration of the firm. The typical assumption is that the differences relate either to economies of scale and scope, or to operational efficiency. Very little attention is given to differentiated internal structures since this undermines the powerful underlying requirement that competing businesses are relevantly similar, permitting the application of ceteris paribus thinking.14 It is easy to suspect that traditional economists cannot in fact explain how businesses make a sustained profit.15 In a world of perfect competition supernormal profits will be zero, and the suggestion of economics is that anything other than this outcome is either inefficient, transient or morally reprehensible. This failure to understand the source of sustained business profits probably arises from the focus of traditional economics on only three types of competition (monopoly, oligopoly and perfect competition — all of which are selected and investigated because they are susceptible to mathematical analysis) and associated rents. The critical oversight relates to opportunity rents, which as we will see in Chapter 5 are the predominant source of business profits arising from the constant interaction of heterogeneous suppliers and customers in competitive exchanges. To give a further sense of how the homo- and heterogeneity angles of economics and business traditionally play out, consider markets and the basis of competition. Frequently when economists talk of a market, they assume that a crisp, uniform view of a homogeneous product or service is available. This is seldom the case. For example, just try to give a succinct definition of what individuals obtain from a concert, or a new or unfamiliar purchase. Much of traditional economics represents an idealisation of what takes place in practice. In practice, it is often difficult formally to establish the existence of such entities as ‘the product’, ‘the price’ and ‘the cost’.

13

Some readers may say that while these ceteris paribus assumptions occur in microeconomics, they do not in macro. Perhaps so, but what then happens in macro is that all the heterogeneity of firms is pooled and neutralised by talking of the economy or companies either as a whole or on an average. Either way, the individual characteristics of companies are eliminated. 14 Richard Rumelt (1984) voiced similar concerns about the analysis of firm behaviour in industrial organisation and microeconomics simply in terms of the price and output decisions of homogeneous firms differing only in scale that are assumed to supply homogeneous products. 15 We may note wrily that it was not until 1992 that economists Joseph Mahoney & Rajendran Pandian (1992: 367) could state with earnest conviction the everyday observation that: The preponderance of empirical evidence suggests that firms’ strategies may influence their rent stream.

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When pushed, economists traditionally resort to cross price-elasticities (how changing the price of one type of a product or service affects the sales of another) to establish the boundaries of a market, as they did for market investigations for the UK Monopolies Commission. Relevant competitive definitions may, however, be more complex than this: there are often several different strategic segments within a single market that are competitively distinct, but which are sensitive to each other’s prices: sit-down restaurants and take-away foods for instance, or web-based or retail sales of personal computers. Based on cross-elasticities of price, economists are unlikely to distinguish between these very different segments that, as far as the economists are concerned, belong to a single market. Economists also tend to regard differentiation within a product or service as a variant of price, when in fact price may not be a criterion that determines purchase. For example, think of the colours of the iPod music players offered by Apple, which sell at the same price, but which have strongly different appeal to purchasers: colour often determines whether a purchase occurs or not. We find that often a reasonable price, not necessarily the best price, is a threshold requirement for a product or service to be bought; however, the dominant criterion that triggers a purchase decision relates to aesthetics, ease-of-use, name recognition or some other set of considerations. When we turn to the basis of competition between businesses, economists usually assume that strategic positioning problems are essentially pricing problems, and this single price variable entirely captures the decision criteria of the purchaser. In a parallel simplification, the problems considered by the economists are nearly always bilateral (buy X from A or X from B) or involve N equal firms. Seldom, for instance, do the problems involve distribution channels, and where they do, traditional economists assume that differences in distribution are entirely accommodated by a price difference. In practice though, not only may we contemplate many possible purchase decision criteria other than price, but we may also recognise that other factors can influence demand: previous purchases, emotional factors and awareness to mention a few. It is not surprising to find that in strategy exercises, interviews are conducted with customers first to establish their needs (which are considered to be threshold requirements that any potential supplier must meet), and then to establish purchase decision criteria by which one of several potential suppliers is actually selected. Price as a unique competitive concept only has real application where the strategic context of purchase involves genuine substitution. Where products are not direct substitutes, more often price is simply an implicit average of varying idiosyncratic values across varied purchasers: like temperature in physics, price is a macroscopic property of a lot of entities, but not well defined for a single, given entity. For example, in the case of process control valves, different valve products from different suppliers have different process control characteristics, different maintenance and replacement characteristics. Each purchaser uses each valve in a slightly different way because the process plant of a purchaser is specific to that purchaser. When we talk of the price of a particular type of valve, we refer to the average across a number of historic purchases, which may not in fact correspond to the amount paid in any


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actual transaction that occurred. Furthermore, prospectively, the price of a future purchase of this valve may have a wide set of values depending on the material and support options and number of valves chosen — it is hard to say what the price will be. We observe in practice that very often things of significant value are idiosyncratic for both individuals and businesses, as well as for buyers and for sellers. Only by ignoring many other relevant aspects of competitive interaction can a tractable situation for the economist be obtained, and the consequence is that very few business situations fit their mould. The reader might ask himself or herself whether economics and its derived analysis could help him or her to craft the best personal career strategy. It might help to know various economic facts, for instance, that most graduates from a particular university work for the government, that average starting salaries for architects are fifty thousand dollars, that it usually takes eight years to become a partner of a consulting firm. All these types of information help to define the context where an individual competes against others for a top spot, but they do not address the critical question of how a given individual should act given his or her talent, resources and preferences in order to get ahead of his or her direct competitors. The same is true for a particular business: the owners are not interested in averages, medians and norms that comprise the economics of the setting. Instead they are interested in their own, very particular, distinct business strategy and its trajectory and momentum. Another major reason why economics fails to capture adequately business behaviour relates to notions of performance. The focus of traditional economics on best performance naturally leads to optimisation, i.e. absolute performance, as opposed to doing better than the others, i.e. relative performance. In business, whatever optimisation occurs is extremely transient. Managers think much more about doing a good job, not the best job. Doing a good job means doing better than recognised competitors. Optimisation assumes durable elements of stability and rigidity in order for a solution to emerge, which are neutrally termed constraints by traditional economists, and endure infrequently in practice. Similarly, the economists’ assumption of equilibrium limits the problems that are considered to ones that are recurrent and well structured, thereby reducing the variability allowed in the situation and removing the impact of a disruptive dynamic.16 Most managers in most businesses would find it very difficult to give any sense to equilibrium beyond collusion to bring about an oligopoly. While many managers implicitly, if not explicitly, seek a collusive entente in their businesses, it is hard to give formal precision as to what equilibrium means across a set of competing heterogeneous businesses given the businesses have different business models and objectives. As a result of the focus on optimisation and equilibrium, most of the discussions in current economics centre on a narrow range of business problems: horizontal and vertical integration, scale and scope, entry decisions and transactional cost alternatives of entities, where these optimisation and equilibrium techniques can be employed.

16

As Mahoney & Pandian (1992: 369) observe: This static equilibrium approach (of neoclassical economics) consequently does not address the competitive process, which is of central concern in strategy.

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Given the role businesses play in the economy, it is seriously wrongheaded to consider a generalised account of the competitive success of business to be a largely unworked footnote to the models economists have provided for extreme and ideal situations such as monopoly, oligopoly and perfectly competitive simple markets. Instead, we face the stark reality that traditional economics is at best adequate only to address a small minority of transactional contexts. Where businesses are the primary vehicle for the efficient exchange of economic resources, we do not have an adequate and well-developed explanatory account: an account of heterogeneous competition. Part of the reason, I suspect, is because academics historically have had neither involvement in, nor curiosity about, the actual operations of businesses. Setting this observation aside, the reader might, though, at this point happily accept that economics does not have the answers for business, thinking all along that Strategy, a separate discipline, explains how heterogeneous businesses compete. Well does it?

Strategy as a Solution to the Problems of Economics Strategy provides an account of competition between heterogeneous businesses. Traditional economics, by contrast, offers a theory of homogeneous product competition best exemplified by commodity markets. From a practical point of view, however, neither strategy nor traditional economics have a great deal of daily impact on a business. Most conversations and interactions in business are much more mundane: Shall we add a third production shift? What discount should we pay to Seaquest? Shall we hire Bill Smith? Few managers think in terms of elasticities, demand curves (nor strategic ecology, nor the return on resources, for that matter). Nonetheless, the concepts developed in both the areas of strategy and traditional economics help to shape the way we perceive the world, and relevant strategy or economic terms do enter the dialogue of senior managers and policy makers at critical moments. What then is the relationship between these two subjects? Over the past one hundred and fifty years, conceptual developments in both strategy and traditional economics have influenced management thinking and management action. For example, in traditional economics the frameworks of industrial organisation have been used to investigate monopolistic situations from the perspectives of businesses, customers and society as a whole, with a view to obtaining socially advantageous outcomes concerning the provision and pricing of basic products and services. Telephones, utilities and railways come immediately to mind. Similarly, our understanding of the nature of transactional economics has allowed us to develop a more useful understanding of the use of different contractual entities such as markets or companies for different types of purpose. From the strategists, the resource-based account of businesses has allowed managers to focus and hone scarce business resources by emphasising those valued and distinctive competences that are the source of a competitive advantage. This in turn has led to new, effective tools and methods for the dynamic management of valuable human resources in ways that exploit talent, create value and build a distinctive organisation. Furthermore, corporate business portfolio techniques have been used


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to identify and build shared corporate advantages across a group of businesses in order to deliver higher returns on the resources employed than the businesses themselves would separately generate. It is not hard to see that in general terms many of the tools and perspectives of traditional economics and strategy are mutually helpful and complementary — so, is that the end of the story? Unfortunately not. Currently, there are several competing strategy positions or strategy schools, each of which asserts its pre-eminence and authority at the expense of the others. For instance, positioning-based strategy, first popularised by General Electric, then McKinsey & Company, then the Boston Consulting Group then Michael Porter. The positioning-based school puts competitive success down to picking the right business areas to be in. By contrast, the resource-based school (developed by Prahalad, Hamel, Peteraf, Rumelt and others),17 makes the priority figuring out what you are good at and sticking to it. More recently, great interest has been shown in game theory as a framework for strategy, building on the work of Von Neumann and Nash. In addition, there are strategy schools that place the greatest emphasis on the design of the organisation, on the institutional determinants of success, on business population demographics, and there are yet other schools. There are overlaps, conflicts, agreements and disagreements between these schools or positions — but mostly there is a muddle, where much of the dialogue seems to be orthogonal. The debate over strategy is confused, imprecise and ambiguous. How can we improve on this mess?18 First, we need to say what the term strategy means. Often the protagonists talk very loosely, failing to distinguish strategising from the determinants of successful strategy, or from the process of strategy formulation. In fact, the mixing up of terms beginning with the common stub of strat has led to a general presumption that there is a degree of arbitrariness with regard to what strategies are, and that there are several equally valid, alternative notions of what a strategy is or should be (ten distinct schools have been discerned by Henry Mintzberg, the business academic and critic of the overly analytic predisposition of much business teaching).19 We might ask ourselves whether we would come to the same conclusions with regard to perhaps a more familiar notion, for instance that of ‘policy’. When we read in the press that the government is pursuing a particular policy, we may stop to wonder whether this is a sensible thing for the government to do, or whether the policy has been well articulated or well executed, but we seldom stumble over the basic notion of a ‘policy’. We all seem comfortable with the way that we and others use this word: we know the meaning of this word through our use of it, and there is essentially a single shared meaning, not a multiplicity of meanings according to a person’s beliefs or point of view.

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A good summary of the resource-based school is provided by Nicolai Foss (1997) Nicolai Foss (1996: 14) is more polite when he observes: Management studies as a whole may be representative of this kind of undisciplined eclecticism and the strategy field certainly shows this quality. Many textbooks in strategy bring together insights from social psychology with insights from economics, from political science, from information theory, etc., for the purpose of arriving at useful checklists, but do not make any attempt to examine whether these insights really fit each other. 19 See Mintzberg (1990b). 18

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To understand better the muddled nature of much of the strategy debate, when you next encounter the word strategy you may unpick the principal threads that are often twisted together in the use of the word strategy: (i) strategy meaning strategising, which is a human conceptual activity carried out when individuals jointly discuss how a business might compete; (ii) strategy meaning strategy formulation, which describes step by step how individual strategies are planned, defined and made explicit; (iii) strategy meaning a wider set of strategy processes and behaviour within businesses, which typically include the formulation, elaboration, implementation and monitoring of a particular strategy; and (iv) strategy meaning a business strategy, which enables a business to outperform its competitors, which this book is about. Unfortunately, as if the situation were not messy enough already, the word strategy may also be affected by what precedes it. Consider the terms: Strategy, the strategy, a strategy, our strategy, and the parallel terms: Law, the law, a law, our law. When we are talking about Strategy or Law, our conversation may have a metaphysical taint: What did God have in mind for these terms? Questions relating to the second pair of terms (the strategy, the law) are questions of knowledge or matters of fact: for instance, does the law or the strategy require me not to smoke? When we ask what is a law or what is a strategy, the question is one relating to semantics (meaning) and is the one that we are trying to elucidate here. Finally, the fourth pair of terms, our strategy and our law, may be concerned with a more narrow inquiry into the specific pattern of actions of the business currently under the microscope, or, for instance, the actions of the local court. Let us then consider what precisely we mean by ‘a strategy’. In order to provide greater precision and to avoid falling into these linguistic traps ourselves, we can fall back on the general account of meaning (developed with some success and acceptance among philosophers of science and language) by the philosopher Hilary Putnam in the 1970s. According to Putnam, to provide an adequate account of the meaning of a term we need to supply (i) the sense or connotation of the term; (ii) the referent or denotation of the term; (iii) an archetype; and (iv) a causal history of the use of the term. As a first pass in providing a Putnamesque account of what we mean by strategy, we might be satisfied (i) with the intuitive sense given by saying a strategy is a pattern of coherent and consistent action expressed through a business model leading to the appropriation of sustained economic rents. This is the sense of strategy that we will elaborate and defend in this book. To this we might add (ii) the referent being the specific changes in a given business model between two moments in time, and with (iii) an exemplification of what was held to be ‘a strategy’ by considering one or two well-known companies and their business models as the basis of an archetype. In terms of a causal story, we could ask colleagues to pursue the use of the term strategy through the dusty annals of business literature to find its origins.20

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Further refinement may lead us to include the requirement that strategy must be based upon intent, but this is an issue not fully settled and worthy of further debate elsewhere.


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Completing this task of meaning specification in no way undermines distinctions to be drawn about the way that strategies are conceived, put into place, measured or changed (which as we have seen are often sloppily covered under the same word). Nor does it undermine the research that has highlighted processes that play out in different types of organisation that facilitate the emergence of more or less deliberate, or more or less emergent, strategies. As a simpler but consistent alternative to Putnam, we may also propose another way to gain greater insight into what is a strategy. As discussed above, there are two strong prevailing traditions in the strategy literature today, which are often seen as opposing and contrasting. The portfolio-based approach emphasises that, to be successful, companies must choose strategies that direct a company’s activities towards those business areas that structurally seem to offer the most favourable returns. The contrasting resource-based view seeks instead to place the greatest emphasis on the competence of an organisation as the starting point for strategy formulation. If the portfolio-based view may be likened to the set upon which a drama takes place, and if the resourced-based view may be captured in the choice of actors, then we may interpret our key notion of strategy as relating to the critical element omitted in both these accounts, namely that of the plot i.e. what the play is about.21 In business, what we are about is a pattern of coherent and consistent actions expressed through a business model leading to the appropriation of sustained economic rents within a strategic ecosystem. This is the plot. Having then defined carefully what we mean by strategy and noted its complementarity to traditional economics, we then ask whether it would be possible to integrate our definition more rigorously and systematically into the body of economics, and thereby address its failure to provide an adequate account of business. Since the focus of strategy is the behaviour of heterogeneous businesses on distinct paths, we believe this requires the recognition and further development of a distinct area of economics, a fourth leg,22 which we call ESD, and which formally underpins our notions of strategy.23 How might this be provided?

Key Elements in ESD In the ensuing chapters the economic foundations of strategic diversity are elaborated. Readers who have read the preface closely may wish to jump immediately to the next section, which discusses the impact on economics arising from a successful account of ESD. 21 Perhaps, Henry Mintzberg (1995) should add plot to his famous ‘Five P’s of Strategy’ (plan, pattern, ploy, position, perspective). 22 To complement the existing broad legs of microeconomics, macroeconomics and industrial organisation. 23 The formal need for several aspects of ESD was anticipated by Mahoney & Pandian (1992) when they identified in their Conversation of Strategic Management the following research priorities: (i) the development of an endogenous theory of heterogeneity; (ii) the integration of the resource-based view with strategic group analysis; and (iii) the integration of the resource-based view with industry analysis.

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As a first step, we need to identify the strategic ecology that surrounds a business. Within this ecology different businesses express different economic personalities. These are captured through the precise identification of their business model using techniques based on matrix algebra, which I call business genomics. Just as with plants and animals, it is possible to isolate individual characteristics of different businesses by isolating their business genes. Chapter 2 describes the ecosystem in which a business lives. The traditional concept of market segmentation is sidelined in favour of a concept that embraces both the business with its individual genome, its competitors and the potential customers. By capturing the interaction between the competitive behaviour and product offerings of businesses, together with their suppliers and distributors, and the perceived dynamic needs of consumers, the ecosystem provides the relevant frame of reference for crafting business strategy. Competition is not conceived of as a strategic group of competing businesses each sharing a similar business model, but rather as a competitor group in which a number of competing businesses employing different alternative business models vie for the customer’s attention. It is noted that there are multiple routes to success and to the achievement of the prize of economic rents, but these routes require careful, detailed investigation. Broad brush generic strategies will not do. The relevant ecosystem for a business is a matter of fact, established empirically, and not a matter of theory or internal perception. As a consequence, the boundaries and nature of the ecosystem are subject to dynamic influences resulting from the behaviour of customers, suppliers and competitors and outside parties. Sometimes an ecosystem splits; sometimes two ecosystems coalesce. Such changes have a profound impact on the strategies of businesses that form part of the ecosystem. Within a strategic ecosystem, cradled by mobility barriers that put a brake on the entry of new competitors, diverse businesses compete for the value-added from which to extract rents. How can we be specific about how businesses are different? How can we develop an account of business genomics? Business models provide the answer. They are the business analogue of genes in people. Chapter 3 develops the idea of the business model and related business genomics in depth. By use of matrix algebra it is possible to codify and handle simultaneously a business model defined as D, R, S, V, P, M and G, where D is Distribution, R is Revenue, S is Supply chain, V is the Value matrix, P is Production, M is Marketing and G is General overheads. Each letter represents a matrix, and when the business is accurately encoded, and the matrices related to each other, the firm’s genome and hence business model is specified. The following chapter (on Routes to Competitive Advantage), puts the business model to use. The development of the business model within a chosen ecosystem is a dynamic process. Changes in technology, in customer preferences and in the abilities of competitors means that ecosystems evolve, and are sometimes subject to periods of abrupt change. Managers can modify the internal structure of their genome, and reconstruct their interface with the customer. This enables the constraints of path dependency to be somewhat overcome. Using the mechanics of business model matrix algebra, we can articulate and test business models that describe diverse competitive behaviour in such a way as to define the likely rent and value creating consequences (and eventually competitive elasticities i.e. the changes, say, in market


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share that arise from changes of a particular aspect of a business model) that arise from different courses of action. The application of metrics to strategic diversity will permit the emergence of a distinct field of strategometrics within ESD. By using strategometrics we can actually measure the consequences of changes in the business model and hence the strategy of a competitor within a given ecosystem over time. Like a doctor dealing with a variety of patients who share some similarities, strategists should be able to formulate empirically tested strategic prescriptions for businesses that sufficiently take into account their individuality to provide genuine solutions that work. The medicine provided should bring about specific targeted changes in the business model (with, one hopes, limited side effects). Business models age, however, and constant attention needs to be paid to ensuring that a business model remains competitively viable. Since an ecosystem is a secure enclave (though perhaps short lived or transitional), protected by mobility barriers, distinct, diverse businesses are able to extract economic rents by exploiting the isolating mechanisms (identified by economists and summarised by Richard Rumelt as the foundation of rents)24 that arise in their interactions with customers. Some of these rents are well explained by economists, but the most frequent sources of rent for diverse businesses are not. Opportunity rents are the most common type, and they arise from the diversity of businesses and customers and can be appropriated by a finely tuned business model. If a diverse business produces rents within its ecosystem, how should we value them in relation to the resources that the business consumes and in relation to the expectations of financial markets? The chapter, titled The Return on Resources, explains rigorously how to quantify financially the extent of the rents a business achieves. By gauging the magnitude of these rents in relation to the resources that the businesses each use to create them, we are able to value the businesses themselves using established financial theory to provide a strategic valuation that meshes strategy, accounting, microeconomics and finance. The chapter focuses on the discounted value of the ratio of economic rents to resources employed, what we call the resource margin (RM), over the lifetime of the business. The RM concept is held to be an improvement on the conventional measures of IRR, DCF and EVA.25 The concept of RM is fully compatible with the Capital Asset Pricing Model (CAPM). Having described the strategy of a business in its ecosystem, we turn to the question of how a business can extend its activities into other ecosystems where it may continue to benefit from the advantages conferred by its particular business model. The concept of adjacency is introduced as the route to business development. It should be noted that this is consistent with current strategic thinking with concepts of Operating within the Heartland (developed by Goold et al. 1994) and the Dominant

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Rumelt (1984: 566) wrote: I shall therefore use the term isolating mechanisms to refer to phenomena that limit the ex post equilibration of rents among individual firms y. The importance of isolating mechanisms in business strategy is that they are the phenomena that make competitive positions stable and defensible. 25 These acronyms stand for internal rate of return, discounted cash flow and economic value added, respectively.

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Logic concept (of Bettis & Prahalad 1986). The application of the concept of adjacency alone, however, is generally insufficient to produce a sustained satisfactory financial return. Synergies of a static and dynamic nature should also be sought within a business, together with the proactive enhancement and evolution of the strategic ecosystem, to meet the changing dynamics of the market place. This completes the foundation of the account of ESD and comprises the first part of the book. The second part provides techniques and applications drawn from actual business situations where this approach to ESD is put to work.

The Impact of a Successful ESD on Economics Often traditional economics seems more precise, quantitative and mathematical than strategy. Using utility preference functions, sophisticated customer weightings, differential equations and the like, a number of microeconomic problems yield elegant mathematical solutions, so economists are no longer embarrassed to go for a beer with physicists. Points of equilibrium and optima are definable in an objective, impersonal fashion lending credibility to the results developed by theorists. This seems quite different to a lot of strategy work, which is often developed from a particular perspective, and is incomplete, approximative and inconclusive. The relative ages of the subjects explains much of this terminological and quantitative divide: a review of the works of Adam Smith, David Ricardo and Alfred Marshall, for instance, reveals that these great men first pioneered conceptual developments that were subsequently mathematically unpacked by their followers. A similar situation may exist now with strategy concepts: the thinking is powerful but early, and exact mathematical investigation and testing is in its infancy. Today, at the cutting edge of strategy, iterative gaming, dynamic cost modelling, relative utility mapping for competing products and penetration analysis, for instance, are all making strategic modelling more mathematical, as is evident from the sophisticated analyses of strategy consultants. As a major step towards a more quantified and rigorous approach to strategy, the matrix methods of business genomics, developed later in this book for business model manipulation, will lend themselves easily to extended scenario and quantitative analysis (as mentioned strategometrics to emulate econometrics, and in conjunction with a given ecosystem, the related field of business kinetics). The adoption of these tools and methods will result in a step-change reduction of the subjectivity of discourse that perhaps flavours much contemporary discussion of strategy in a disadvantageous manner. Over time it will be surprising if we do not witness a general sharing of quantitative techniques and methods between traditional economics and ESD. What we might anticipate is that the strategy maths will become more complicated and messy because product offerings will be multivariate, not just priced-based. Also, competitors will have very distinct individual cost and distribution functions. This means the behavioural dynamic between competitors will be unlikely to involve optimisation or equilibrium, typically the settlement conditions currently used by economists


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to obtain distinct families of mathematical solutions to the equations they apply. Similarly, the mathematical strategist will not be able to rely on the routine of backward induction that characterises more formal game-theoretic approaches to strategy, because the multiple equilibria that are likely to characterise the diversity of strategic choices and business models of diverse competitors will undermine this approach. A more developed approach to ESD is also likely to lead to a new generation of base concepts that carry over into other traditional areas of economics. Here, though, the economics will probably catch up with new product or service technology: so new terms in traditional economics for individual combinations of products and services with latent mutability and redefinition will probably emerge and allow new aggregate, customised individual services to be conceptualised, costed and priced on an individual basis by competitors. So the economic analysis of the changing dynamics of demand for products and services across similar types of customer–supplier exchange — ones which define a distinct strategic ecosystem — may become possible. As a result we can anticipate the emergence of a set of dynamic ecosystem-based concepts within economics where the definition and the relative strength of competitor products or services is (i) multivariate, not simply based on price alone, and (ii) evolves with the dynamic evolution of ecosystems as a consequence of competitive behaviour. Hence the fine, dynamic and multivariate nature of competitive ecology might be introduced into economics in a way that is compatible with business strategy. What is key to introduce in addition, though, from strategy into economics is a sense of internally driven, organic adaptation and learning on the part of both businesses and customers that shapes their dynamic development and interaction. Within this context of flux, strategic ecosystems represent small islands that happen to have a longer transactional half-life before decay, and which as a consequence offer some local stability that is dynamic, steadily evolving and of finite life. The flux and change reflect the creation and eventual depletion of competitive advantages deployed through the business models of ecosystem competitors. No doubt traditional economics can and will be enriched by the introduction and working up of notions such as dynamic ecology and shifting competitive advantage, but finding richer concepts for performance and structure other than optimisation and equilibrium may remain elusive outside ESD because some of the conceptions of what is a best outcome may be specific to the particular situation in hand. The possibility of a parochial non-optimal notion of ‘best’ may arise, for instance, when we can only understand and gauge the dynamics of the behaviour of different businesses in the same ecosystem in terms that are locally defined relative to the other ecosystem-based competitors, each an individually distinct business. There is no absolute, just a parochial, sense of best. As a result there may be no single best outcome, nor a small set of optimal outcomes: we may have to be satisfied with ‘better than’ as opposed to ‘best’, when we think of performance and behaviour. For example, within a particular ecosystem a business may pursue a strategy of cost parity together with pricing superiority of ten per cent relative to its largest rival

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because it believes this strategy will allow it to exert the greatest control over resources in the ecosystem. The costs and prices of the business, and hence its performance will then depend in part on the behaviour of its main competitor. If that competitor bases its behaviour dynamically on the choices of a third business, the set of best outcomes may be complex and ambiguous. Applying the techniques of optimisation and equilibrium may be difficult given the interdependence of at least these two players. Many outcomes are possible. In a similar fashion, based on ESD, we might anticipate an expansion of the objective function of businesses within economics beyond simply shareholder profit maximisation. We have noted that the purpose of strategy for a business is the appropriation of sustained economic rents sufficient to satisfy the requirements of investors. This is a wider remit than shareholder profit maximisation, particularly when we bear in mind that investors may include the government, customers, suppliers, employees and the local community, who may each be held to be investors in the business on the basis of their particular contributions, which may not have been fully reimbursed by the business when their contributions are recognised. In talking of the appropriation of rents, we have not made any specific assumption about reinvestment or distribution of returns relative to the requirements of these different categories of investors. Within the framework of contract law, how returns are allocated between the various constituents that comprise the nexus of a business will be determined by the policies, skills and experiences of the senior managers. What is of most critical interest is the level of return on the resources consumed: is the business making good use of its resources relative to the risks it encounters and relative to other possible uses of its resources? Exactly how these returns are split between managers, employees and sources of capital or assets is distinct from the question of their size in relation to the resources consumed, which is of critical interest to strategists. What may prove more difficult to resolve between traditional and diversity economics is the broader set of constituency objectives — sales, growth, pay, shareholder returns for example — that are messily traded-off and compromised in businesses (often differently weighted by the various participants in a business such as owners, managers and employees) compared with the single, classical economic assumption of profit maximisation. The identification of strategic diversity as a fourth leg of economics allows us to deal with some of the outstanding difficulties and conflicts that currently define the relationship between strategy (understood as the application of the economics of diversity to generate valued economic rents for the owners of a business) and traditional economics. Does that mean we can expect diversity economics to coalesce into an extended version of traditional economics? Do further inherent differences and distinctions exist, which prevent this from happening? (WARNING: For those more pragmatic readers, satisfied with the approach taken so far, who are interested in results rather than the relationships between bodies of knowledge, I say grab a beer and skip to Chapter 2, because this material will not interest you, so do not waste your time on it. For those few who remain attentive, let us turn, then, to the survival prospects for ESD).


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Lasting Distinct Features of ESD While we may expect economics to evolve to cope more usefully with the dynamics and multi-faceted nature of competition, a number of deep-seated differences relating to the use of taxonomies instead of laws, to the importance of holism, adequacy, selfreference and ambiguity in competitive behaviour mean that ESD will not be reducible to traditional economics: it will indeed constitute a fourth leg. Laws and Taxonomies Economists usually extrapolate the repeated observation of causally connected events in the past to the future. This means that they expect existing laws and theories of economics to hold forever. For instance, if you have a certain market structure, with prices set in a particular way, and buyer preferences of a certain type, economics leads us to expect that a particular outcome will occur whenever these conditions prevail. Like much of physical science, to be useful the theories of microeconomics need to be generalisable, universal and applicable to populations of businesses, and not to be overly constrained by the specifics of a given situation. For example, prices always fall when there is excess supply, ceteris paribus, not just as a matter of fact but because this reflects a truth about the nature of the world in which we live. Philosophers would say that the law has some necessary force, some nomological clout. In contrast to the presumed theory-driven reproducible behaviour of homogeneous markets, the best we can hope to witness for the strategic development of an individual business is an approximative similarity to some other situation we have encountered before, which we consider to be similar in some relevant respects. Based on that presumed similarity, and some adjustment for the specifics of the situation, our experience and causal understanding of patterns of competition give us a probabilistic set of outcomes for the business under scrutiny, but the situation is far from deterministic. Even where we could reproduce a particular business situation on a number of occasions, it is still possible that outcomes for the business might be variable and probabilistic given the complexity of the interactions of the factors at play that determine the performance of the business. In fact, the majority of strategy situations are one-offs, where we try to deal with the huge complexity of the determinants of outcomes by identifying a small number of critical factors that are reminiscent of other situations previously encountered — a risky reduction, in case we get it wrong, but a necessary one. In ESD we try to isolate one or two critical determinants of outcomes in a specific setting. In traditional economics, by contrast, we try to eliminate or neutralise the specificity of the situation by assuming that a given supplier is identical in all critical respects to its competitors. As a result, much of ESD is situation-specific, and tractable only on the assumption of relevant case examples. Unlike traditional economics, which seeks reproducible, universal laws and theories that contain some sort of behavioural compulsion or necessity, ESD is rooted in taxonomies of cases and examples (which require continuous renewal).

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Disaggregation and Holism A more subtle but related difficulty also arises from attempting to reduce major business issues and questions entirely into the standard concepts of microeconomics by assuming that a business can work out its best overall trajectory by disaggregating its options into individual decisions about prices, products and customers in an externalised market. Supposedly, if these individual micro decisions are optimised, by their aggregation, the business as a whole will be optimised. This is not necessarily the case. Each of these micro decisions of the individual business is assumed not to affect the external market, which is typically taken as having a fixed demand profile upon which business pricing decisions are formulated. Similarly, no account is typically taken in microeconomics of the interdependence and aggregation of these individual decisions over time. In other words, the problems of optimal business performance are reduced to the resolution of a large number of smaller, simpler problems about prices, products and customers at a given moment in time — and supposedly that is all that business issues and questions ultimately comprise. There are a number of deep-seated difficulties related to the use of this set of externalised micro concepts. In reality, business is not like this, and a business is an integral, interactive part of the complex ecosystem within which it participates.26 Customer needs and demands are not part of an externalised independent entity, ‘‘the market’’, against which the business can optimise product and pricing tactics to maximise profit.27 Instead, the customers and the business, together with its suppliers, competitors and other parties form an interactive, holistic system. A supposed optimisation of a set of disaggregated parts of the business system (for instance a particular set of customers) will ultimately run into problems of self-reference because changes in the parts will result in second order changes to the overall system that will in turn affect the supposed disaggregated parts, as the business system is not strictly disconnected and independent of its parts. These second and higher order changes in the system may lead to sub-optimal outcomes. The following example makes these abstract thoughts more specific. If we designed, on the basis of extensive customer research, a long-lasting, good quality car that was comfortable to drive based on current driving conditions, we might be able to offer financing arrangements that led every one who is not a current car owner to buy one of these cars. We might find, however, that so many new customers purchased this car that many of the assumptions made in our extensive research about driving and the car’s comfort features turned out to be undermined by the high level of take-up. For example, the seats might have been designed for a typical journey time of two hours, but because the car proved so popular, huge numbers of consumers bought the car. This resulted in very crowded roads and very lengthy traffic jams. Typical journeys often exceeded the two hours that the seats were designed for,

26 What academics have termed autopoietical systems that involve some degree of self-reference or actingupon-itself. 27 Philosophers and classicists might note how this economic noumenon echoes Platos’ theory of forms.


23

so the failure of this feature (comfortable seats) was a secondary and unanticipated consequence of the car’s general initial success. A culmination of these secondary consequences might even be sufficient to undermine the eventual sales of the car. The logical difficulty here is that we have assumed that we can analyse the situation in terms of the next individual consumer willing to buy a car in a context where the factors determining the rationale for the purchase are entirely independent of the individual. In aggregate, this independence assumption could be incorrect. In this example we can see that there is an interaction between our supposed external knowledge and our actions. Only when solving certain types of local problems can we assume that we are ‘‘outside’’ the system, which we wish to affect in order to bring about a particular system outcome that is in our interest. Being an insider strategically limits the power of those theories, such as traditional microeconomics, that posit an independent, external context that can be manipulated to achieve an optimal outcome.28 The lack of an independent, externalised business environment means that strategy formulation and execution involve complex echoing or resonating behaviours that cannot necessarily be entirely disaggregated into smaller, discrete, micro decisions that are focussed on a very short period, if not a single instant, of time. There may be other reasons besides this acting-upon-itself feature of the business system (which can be incorporated in ESD) to think that real business may not be reducible to microeconomics, just as there may be reasons to think there is more to the behaviour of the material world than can be explained by atoms, quarks or string theory. Reductionism and Categories First, let us consider business-to-business interaction within an ecosystem. It is apparent that some aspects of strategic behaviour reside at the higher system level of resource and competitor management, and most specifically relate to the specification of actions and responses that will confer on a fungible, textured basis, the competitive control of resources within an ecosystem to a business. What the explicit examination of a business model in Chapter 3 makes clear is that within a strategic ecosystem a business comprises a nexus of relationships between suppliers, sales partners, allies and competitors that is typically configured differently from that of other businesses in the same ecosystem. Examples of such group phenomena include (i) business culture, (ii) a coherent reinforcing strategy where one function supports another,29 (iii) reciprocal partner and alliance support, and (iv) a commanding industry reputation for trust and fairness. The atomistic ontology of traditional microeconomics, typically comprising products, prices and customer benefits linked by discrete interactions, overlooks the more contextual and interconnected nature of

28

This is not news to a physicist: Heisenberg and Schrodinger independently came to realise that in science there is not a chasm between the observer and the observed. If measurements are fine enough, the observer will affect the observation, and the observer and observed are both parts of an interconnected system. 29 This self-reinforcing aspect is well developed by Finn Jackson (2004) in his book The Escher Cycle.

24


complex events both within businesses and between businesses. In summary, we may conclude that strategic business success is not to be found solely in the structure of a business’ products and markets but includes the dynamics of its behaviour and relationships as well. A second and related reason for thinking that ESD may not be reducible to traditional microeconomics concerns the relationship between the business and its customers (as opposed to other businesses). The types of entity that feature strongly in strategy, and are relevant to this external interaction with customers, include relationships, brands, channels, benefits, assurances, warranties, reputations, assistance, loyalty, image and perception, trust and confidence (to name a few). These terms, which might easily feature in a strategic articulation of the relationship between a business and its customers, are conceptually of a higher order of complexity and do not seem obviously reducible to some construct created from the notions of price, cost and volume that define microeconomics. Philosophers would probably suggest that we need to distinguish several categories of entities: for instance, those of microeconomics (prices, volumes, products, elasticities etc.), and those of group phenomena (reputation, culture, reciprocity etc.). By doing so, we lower the risk of making a category error, which would occur if we tried to formulate all our explanations simply by using one category of entities to the exclusion of other categories. This is what would occur if we were to think that all ESD talk were reducible to the entities of microeconomics alone. Ambiguity The externalised focus of economics on prices, products and markets also conveys a high sense of certainty concerning the states, considered to be common and definable, which businesses find themselves in — for example, consider a state of a business where setting prices equal to average costs seems like a sensible decision to maximise output without losses. The tidiness and simplicity of this kind of situation is likely to be very elusive in reality, since most businesses serve different types of customer with different needs at different prices via different channels (Again, what is the price, the cost?). The result of this variety is that there is much ambiguity with regard to outcomes and state descriptions in typical businesses that sell other than a commodity product.30 Consider, for example, a business that makes robust digital timers that are used to determine the length of seed feeds for chickens. Imagine a weapons company in another country discovering that these timers are cheap, reliable and can also be used to trigger land-mines, and that the company invites the timer business to submit a quotation to supply timers in competition with the weapons company’s traditional supplier. Is the business that makes the timers a farming or a weapons business?

30

Dierickx & Cool (1989) also identify ambiguity in the accumulation of strategic assets (resources) as a source of competitive advantage.


25

Until the weapons company makes a decision it is impossible to resolve this ambiguity of definition: the particular and important ambiguous aspects of this timing business are determinable only by subsequent external events. The potential states of the business exhibit a high degree of contingency. Other latent possibilities for the path of the business will still exist and represent further ambiguities. The nature of the business is fundamentally underdetermined by the possibility of this superposition of a multitude of states. What this example highlights is that from the perspective of ESD, as contrasted with traditional economics, the question of business definition is a superposition of various different possibilities at any moment, as opposed to being determined fixedly by the enumeration of products, prices and customers as the economists prefer. This ambiguity of state is very familiar to senior managers who continuously struggle with the question of business definition for a given business and its reformulation, particularly since the ongoing settling of the question of definition will lead to the commitment of resources in a particular direction, which may or may not give rise to an acceptable level of return for investors on the resources consumed.31 In light of the detailed specificities, current and potential, of each business, the proponents of ESD may be inclined overall to be more modest than traditional economists. In particular, they may view their explanations and methods at best as descriptive not normative. This means the ESDers may content themselves with the fact that certain strategies do seem to work in certain contexts, not that they should work. As a result ESDers may be quite instrumentalist in their acceptance of these strategies rather like the advocates of alternative medicines: they work and it is not critical that we should know exactly why some work and others do not. Certain recurrent findings by ESDers may also warrant the articulation of a set of phenomenological (i.e. practical, observable) laws — for example, that mature consumer products businesses seldom support more than four major competitors or a Herfindahl index of less than two thousand. These rules-of-thumb-type laws can be of considerable use to managers, but unlike the traditional laws of economics, they do not presuppose a particular pervasive underlying universal theory that gives them legitimacy.32 If one asked an experienced general manager or strategy consultant, they could probably formulate a number of such practical laws, but would be well aware of their limitations in application, and would probably not be able to provide a theoretical basis. For example, many products demonstrate recurrent experience effects where real costs decline by twenty to thirty per cent for each doubling of accumulated experience.33 No theoretical justification of why declines frequently fall

31

The precipitation of a particular business definition with resulting activities and profits is reminiscent of the collapse of the wave packet in quantum mechanics as a result of measurement, popularised in the literature by the hypothetical example of Schrodinger’s cat, which was held to exist in a superposition of quantum states, both dead and alive, until it was observed in its radio-actively triggered cat trap. 32 There are many similar phenomenological laws in physics, often used by practical physicists in the lab e.g. Newton’s Law of Cooling. 33 A law more familiar to the reader may be Moore’s law relating to the doubling of computer processing power every 18 months to two years.

26


within this range exists today, but awareness of experience effects can help managers to formulate strategy for their business. The laws observed are firmly inductive in nature, in contrast to the deductive presuppositions of the theoretical results of microeconomics.34 In fact, in proffering an account of what constitutes strategy, the author starts from the premise that no universal, general theory of what constitutes strategy is or ever will be available. Instead, we face in strategy a situation similar to that which Sigmund Freud confronted in psychology. The best that we can hope to offer is a series of useful case examples within a taxonomic framework that provides insight and guidance to strategy practitioners. The kind of tidiness that is admired and developed in physics is not within the grasp of strategy for reasons that will be discussed later in this book. A worthy goal is the elaboration of a series of causal business models, which provide satisfactory business explanations for those strategy case examples that are deemed to be reliable templates, and which describe certain classes of competitive activity deployed by heterogeneous businesses. To shun grand theory is not to be defeatist but rather to acknowledge through careful reflection the boundaries to knowledge within this domain. Such a perspective is not necessarily limiting. Freud himself treated fewer than forty patients in his lifetime as a practising psychiatrist. From this small number of deep interactions, he was nonetheless able to develop a profoundly powerful series of psychological models that have subsequently shaped and enriched our understanding in this area, even if they have been superseded.35 Such a causal and explanatory grasp is also available to us in the field of strategy, but it does not require us to believe in idealised universal theories of competitive interaction where the strategies of individual businesses are captured by the precise measurement of a series of pre-specified critical parameters. Pierre Duhem, the French philosopher of science, disturbingly revealed at the turn of the twentieth century,36 that this has always in fact been the case in practical everyday science where working scientists rely heavily on phenomenological laws (rules of thumb) rather than grand theory. It is better to realise the limitations of formal theory and focus on understanding how competitive advantages arise through the formulation of strategy in specific instances, rather than to pray to a false god called Universal Theory who has long been shunned by the applied scientist. ESDers may also accept that successful strategies are satisfying a complex series of objective functions, some of which may be obscure or hard to delineate, in contrast with the unilateral classical profit maximisation of the economist. Content with discrete, localised success within particular businesses in certain recognisable strategic contexts, ESDers may not feel concerned that they have no grand, universal theory of

34

Similar views are articulated by Rumelt (1984). Interestingly, the Jungian distinctions between the persona, conscious and sub-conscious aspects of personality also have parallels in business: we may care to distinguish between the enunciated official view of strategy, the shared collective conscious awareness of the strategy and a deeper unperceived realm of hidden motivations. 36 See Duhem (1914, 1991). 35


27

competitive advantage. To some extent, the orientation of the economist towards findings that are universal and generalisable results in an impoverished focus on homogeneous competition that is limited in its application to real business situations. Instead, it may be better to work with many different sets of rich business models, each set locally limited in its application, rather than to try to develop more generalisable, extended theories, which have only limited content and power. This is a sensible way to establish a generality extending beyond the specifics of a small set of interesting individual strategic situations: taxonomies may dominate theories because businesses instances are too rich and complex to yield to generalised theory, as is largely the case in botany, biology and law. ESDers may not feel concerned that they cannot provide a complete causal account as to why certain strategies work in certain segments for certain types of competitor: it may be sufficient to be able to say which strategies work where, and to have more limited expectations with regard to their generalisability. Were we collectors of different sorts of businesses, we might expect to run a sizeable business zoo.

ESD as a Fourth Leg In this chapter we have highlighted the recognised inadequacies of traditional economics in describing accurately the behaviour of businesses. To deal with this inadequacy, we have suggested that ESD be recognised and further developed as a fourth main area of economics to complement macroeconomics, microeconomics and industrial organisation. ESD directly addresses the heterogeneity of businesses that is the source of competitive advantage in distinct strategic ecosystems. Using the matrix mechanics of business genomics, it suggests the possibility of a rigorous analysis and quantification of strategic behaviour that results in rents that can be valued using established financial theory. Usefully, it also permits the integration of recognised strategic perspectives such as those based on positioning or resources into a single framework.37 We drew attention to some advantages that arise were ESD to be promoted and further developed, both for the field itself and for traditional economics. At a deeper level, however, there are profound distinctions to be drawn between traditional economics and ESD that relate to (i) their theoretical versus taxonomical underpinning, (ii) local performance measures, (iii) non-reducibility, self-reference and holistic features, and finally (iv) state ambiguity. If we accept that these foundational differences between traditional economics and ESD are likely to persist, and that the two subjects are complementary and well served by a number of shared mathematical techniques, then surely it makes sense to promote ESD as a distinct fourth leg to a redefined economics to add to macroeconomics, microeconomics and industrial organisation.

37 Birger Wernerfelt (1984: 171) anticipated this complementarity, writing: For the firm, resources and products are two sides of the same coin y. Both perspectives on the firm are reflected in the literature on strategic management.

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Summary 1. Traditional economics is concerned with homogeneous competition, optimisation and equilibrium. The focus of the ESD is heterogeneous business competition that is specific, dynamic and seldom recurrent. Homogeneous competition is a rarity. 2. In general terms, traditional economics has failed to provide an account of the individual business (with the one exception of the monopolist). This oversight could be corrected by establishing ESD as a fourth leg to complement macroeconomics, microeconomics and industrial organisation focussing on heterogeneous competition. 3. While we may expect traditional economics to evolve to cope more usefully with the dynamics and multi-faceted nature of much competition, a number of deep-seated differences relating to the use of taxonomies instead of laws, to the importance of holism, adequacy, self-reference and ambiguity in competitive behaviour, mean that ESD will not be reducible to traditional economics.

Questions 1. To which of your businesses can the classical economic concepts of homogeneity, optimisation and equilibrium be applied? What have been the results of the application of these concepts? 2. To what extent do your current competitors employ business models similar to yours, and do you expect your and their business models to converge over time? To what extent do they presume or incorporate the theories of microeconomics (supply, demand, marginal economics) or industrial organisation (industry barriers, Porter’s structural analysis, monopoly and oligopoly)? 3. What are the major ambiguities you currently face with regard to the definition of your current business model? How do you expect this situation to develop over time?

Chapter 2

Strategic Ecology Strategy describes competition between companies, businesses or individuals that are distinct, that is, heterogeneous. Strategy becomes observable when companies, businesses or individuals compete in a given arena. Put into practical terms, for businesses within a given strategic ecosystem, a strategy is a coherent and consistent pattern of action expressed through a business model leading to the appropriation of sustained economic rents. When we say coherent we mean that elements of the strategy are complementary and appropriately reinforce each other (as opposed to being at odds with each other). For example, it would not be inconsistent with British Airways’ existing strategy if British Airways were to begin to manufacture ice cream. On the other hand, this decision would be considered by most parties to be incoherent relative to the basic business of running an airline. Coherence conveys a sense of integration and relatedness of actions that binds them together in the pursuit of a common goal. By consistent, we mean that the strategy does not give rise to a contradiction. For example, if British Airways were to spend a large amount of money advertising a special set of family flight promotions, and yet at the same time, were not to provide the type of seating accommodation suitable to cater for a typical family, these two elements of strategy would be contradictory and the strategy itself will be deemed to be inconsistent. By talking of a pattern of action,38 it will be clear that the recognition of a given strategy will both be a question of perception and a question of judgement made over a period of time. The notion of a pattern, presupposes some underlying sense of relatedness or relevance for the component actions that link together to comprise the strategy in question. While it may prove difficult to provide an abstract account of relatedness or relevance, from a more distant externalised perspective, we may see the application of these notions exhibited in the pursuit by the company of a path. Individual actions are related or relevant to other actions in so far as they are aligned with the general orientation of the path of the company — for mathematicians, a sort of vector that links the company at two different points in time.39 In so far as we are able to discern a path, we are not only able to identify a strategy, whether implicit or explicit, but are also able to make sense of the progress of the company within a sea of otherwise overwhelming and seemingly disconnected data and events.

38

Andrews (1971) and Mintzberg (1990a) similarly identify strategy with a coherent pattern of action. In the next chapter, we will introduce a matrix formulation of a business model, and the vector analogy for a path could be pursued formally in terms of matrix dot products over time. 39

30


To discern a path would require an observer to focus on a number of discrete, externally observable attributes that describe the behaviour of the company. For example, the attribute in question might relate to choices of product, or choices of distribution channel, or choice of partner or measures of strategic performance. One of the most useful ways to describe these attributes is through a codified business model. By tracking the business model over time we have a means to assess the path of the business and the coherence and consistency of its behaviour. If the pattern of action expressed by the business model is coherent, consistent and satisfies customers well, it will give rise to sustained economic rents arising from the value created in an exchange of utility between the business and its customer in a transaction. Putting the extreme situation of monopoly aside, the behaviour of a business and the success of its strategy and resulting economic rents will, however, be strongly conditioned by the behaviour and strategies of its competitors. How do we establish the relevant set of competitors? For as Howard Thomas, John McGee and Mark Pruett identified: Firms do not exist in isolation: they also clearly are concerned with and influenced most directly by a relatively small set of competitors. Centring research attention on a firm’s most highly relevant competitive conditions (its group membership and dynamics) y seems a particularly fruitful way to advance strategy research. (McGee et al. 1995: 268)

Strategic Ecology Strategic ecology is the sine qua non of business strategy. How can a business follow a strategy without an accurate understanding of its surrounding environment? How can a business appropriate sustain economic rents against competitors without a clear understanding of their positions and trajectories? The identification of the relevant strategic ecology establishes the relevant set of competitors for a business. A strategic ecosystem delimits the discrete value-added40 generated by the exchanges that take place between a family of customers and a set of competing suppliers. As such it may be likened to the ecosystem within which a living organism finds itself. The origins of the ecosystem lie in the complex tangle of interactions between customers, competitors, intermediaries and other third parties, which together consume resources, create added-value and comprise a relatively stable nexus where demand and supply rub shoulders. From an economic point of view, this nexus is sufficiently stable to allow one or more competitors in the ecosystem to appropriate sustained economic rents over an extended time period. One can visualise ecosystems as medieval hillside castles standing out of the flat landscape or as islands in the ocean: in either metaphor an enclave exists in which it is possible to survive for reasonable periods by living by ones wits.

40

By value-added, we mean revenues less the cost of bought-in third-party products and services, what economists would call net output.

Strategic Ecology

31

Avinash Dixit, the financial theorist, has provided a useful economic account that helps to explain how ecosystem barriers arise.41 Using the theory of real options, he shows that in order for a business to contemplate entry into a new business area under conditions of uncertainty, the magnitude of returns required exceed customary Internal Rate of Return (IRR) assumptions (based upon the CAPM) because entry dissipates the value associated with options to delay entry into the new business. In other words, the returns on entry have to be higher than initially assumed to compensate for the value of waiting to enter. The creation of these raised IRR thresholds, (an articulation of what strategy researchers have called mobility barriers), are the basis for the observed ecosystem barriers. In a similar fashion, uncertainty creates real options for incumbents, which will keep them within an ecosystem when returns are below usual required levels of return because of the value attached to the chance that things might improve: as we see in siege warfare, castles keep citizens in as well as keep the enemy out. If we (i) hold the uncertainty of market demand that new entrants face to be partly determined by the behaviour of leading incumbents, and (ii) we can anticipate cost advantages, derived from greater ecosystem volume and experience, which confer greater ‘‘stick-it-out-and-see-value’’ for incumbents, we can see that ecosystem barriers will arise, which (i) deter new players from entry, and which (ii) increase the susceptibility of newcomers, relative to established incumbents, to exit when demand and price fall. When this economic view is further augmented by a view of greater uncertainty arising from competitive retaliation, it follows that new entrants will need to show considerably enhanced rates of return to justify an entry attempt because the walls or moats surrounding the targeted domain will be significant. So much for the economic models — whether a particular ecosystem exists or not is a matter of fact: strategic ecology is not a matter of codification, nor definition nor a perceptual construction (a marketing perspective, a collision of brands, ‘‘an image of reality’’). The strategic ecosystems in which a business competes can only be determined through conjecture and refutation validated by empirical investigation. For instance, following the approach originally outlined by my former business partner Richard Koch,42 in order to determine whether two clusters of competitive activity A and B are individually distinct, and whether they constitute distinct strategic ecosystems, we might pose the following series of empirical questions that may be grouped under the following headings.43 Competition 1. Are competitors the same in A and B? 2. Are the relative market shares of competitors different in A and B? 3. Is our/their profitability similar in A and B? 4. Is it possible to exit from one ecosystem while remaining viable in the other? 41

See, for example, Dixit (1992). See for example Koch (1995). 43 From the perspective of an economist these questions help us to identify mobility barriers, and Mark Pruett, Howard Thomas and John McGee provide a summary of the sources of mobility barriers in their second paper on strategic groups McGee et al. (1995). 42


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Marketing 5. 6. 7. 8. 9.

Are Are Are Are Are

the customers, their needs and purchase criteria the same in A and B? the products or services in A and B substitutes for each other? prices the same in A and B? channels of distribution different for A and B? brands and promotion common to A and B?

Resources 10. 11. 12. 13. 14.

Is there sharing of costs or assets between A and B? Do A and B have a similar capital intensity? Is the cost and margin structure similar for A and B? Is there experience sharing between A and B? Do A and B share the same principal suppliers?

Management 15. Are managerial priorities similar in A and B? 16. Do A and B share a similar skill set and knowledge base? Geography 17. Are there regional barriers that separate A and B? Technology 18. Do A and B share product or process technology? 19. How relevant is R&D in A to B and vice versa? Regulation 20. Do regulatory barriers exist between A and B? Using the experience and judgement of many years of strategic ecology analysis to weigh the answers to these questions allows us to determine whether A and B are distinct strategically (typically, greater weight is given to the first nine questions and question thirteen).44 Sometimes, the conclusion may be uncertain suggesting an opportunity to tip the strategic ecology balance in favour of one participant at the expense of another. It is important to emphasise, though, that the answers to each question are strongly datadriven, and not left to judgement if at all possible, beyond the determination of the weighting. Getting answers to these questions involves a lot of work: (i) interviews with customers, competitors, suppliers, regulators, experts; (ii) extensive numerical data analysis of prices, volumes, costs, experience curves, budgets, accounts, expenditures over many periods; (iii) exhaustive coverage of trade press, fairs and market studies. Typically, an ecological investigation might take a small team a month or more. Often we can corroborate the answers to many of these questions by examining the internal and external aspects of the business models of the businesses that 44 In carrying out strategic ecology exercises we should pay a good deal of attention to market shares, relative market shares, margins and experience sharing in areas A and B, since these often provide the strongest prima facie evidence that two ecosystems are distinct. See Koch (1995: 26).

Strategic Ecology

33

compete in ecosystems A and B (Chapter 3 makes clear just what we mean by a business model). Two findings in particular stand out. First, although businesses in the same ecosystem may have very different business models, where the business models of two distinct players embody similar external elements (that is, those elements that govern the customer interface), this will tend to suggest they operate in the same ecosystem. Second, as will become apparent in Chapter 3, the criteria that are used to discriminate between different business models are theoretically intertwined with the criteria and questions used to settle questions of ecology. The linkages between strategic ecology, business models and adjacent ecosystem development are further explored in Chapter 7. This use of business models in ecology is sufficiently important and subtle that it is worth amplifying. When investigating the business models of distinct players as part of an ecology analysis, what is important is the insight gained from the understanding of how the different business models work. This analysis goes beyond a simple focus on which aspects of the business models of different players are the same, where the search for common elements erroneously assumes that ecosystems are characterised by the use of a common business model. Some businesses in the same strategic ecosystem may exhibit some similarities in their business model, but other competitors may approach the business differently. By understanding the business models of many players, we can develop answers to the ecology questions, but it would often be a gross simplification and an error simply to identify different strategic ecosystems with different business models.45 Unfortunately, life ain’t that simple. The information provided in answering these strategic ecology questions is also directly relevant to the application of Porter’s Five Forces structural analysis to the ecosystem. For instance, answers to the marketing questions will enable us to assess the power that buyers exert on businesses within the ecosystem; similarly, we will be able to determine the strength of supplier power from the answers to the cost questions. More generally, the strategic ecology criteria we use to determine the existence or not of structural (mobility) barriers surrounding a particular set of business activities will necessarily provide the foundation for an analysis of the impact that these structural barriers in turn will have upon the businesses that lie within them. In order to determine whether the structural barriers exist, we need to investigate what gives rise to them as well as the effect the barriers have. In other words, there is a direct conceptual linkage between strategic ecology criteria and the structural factors, which impinge upon the performance and behaviour of businesses within the ecosystem. Information in a particular case about one set of concepts (strategic ecology) informs us about the other (structural characteristics). Furthermore, as we shall see later, both sets of concepts also find a counterpart in the external elements of the business model of each competitor within an ecosystem.

45 Unhappily, this assumption that relevant strategic groups are characterised by a common business model undermines much of the strategic group analysis that is undertaken by businesses and MBA students following on from the work of Michael Porter. You do not have to be the same to compete.

34


This emphasis on the empirical nature of strategic ecology contrasts strongly with the use of statistical clustering techniques, which have been employed in recent academic studies that aim to discriminate as strongly as possible between different groups of competitors within a defined industry, where each member of a group is very similar (because groups are defined on the basis of similarity), and different strategic groups are then held to define different ecosystems.46 Strategic ecology is a matter of fact, not a matter of statistical definition, and the emphasis is on differences in the arrangements between businesses, their customers and competitors, rather than on what is the same.

Examples of Strategic Ecology To those readers less familiar with these concepts, some examples of strategic ecosystems may be helpful. But first, a word about the choice of terms. In carrying out strategic ecology assignments for clients, my partners and I traditionally talked about strategic segments rather than strategic ecosystems. Because the word segment is much used in marketing and cost analysis, however, I decided in this book to use the term ecosystem instead, so as to avoid any confusion brought about by using the word segment. In some of the diagrams, which are disguised versions of actual client presentations, in one or two cases the word segment remains. Where this occurs, understand ecosystem where segment is used unless otherwise alerted. At first sight it may seem that the tens of thousands of Heating, Ventilating and Air-Conditioning (HVAC) contractors in the United Kingdom all compete with each other. More careful analysis, however, reveals that most HVAC businesses recurrently face only a handful of competitors. Different ecosystems are discernible, determined by the complexity and value of the underlying equipment installed as well as by the need for design or maintenance skills. In addition, quotation, insurance liability and litigation skills may characterise the types of work bid for. When one overlays a local, regional and national geographic dimension, the rich texture of a narrow level of strategic ecology within this industry becomes apparent. Similarly, in the valve and pump industries, in spite of the fact that there are several hundred businesses in each of these industries in the United Kingdom, few of the businesses compete head-to-head. The products designed, manufactured and distributed by these companies vary significantly depending upon their engineering complexity and degree of customisation. In addition, valves and pumps have very different characteristics depending on the needs of industry end users. Finally, the nature of the installation, maintenance and replacement economics may differ very substantially. Various combinations of these factors impinge upon the viability of different strategic and operational options for participants in the pump and valve industries that affect the nature of the manufacturing, supply, design and servicing capabilities of the business (as shown in Figure 1). Overlaid on top of this power/cost dimension

46

John McGee, Howard Thomas & Mark Pruett (1986, 1995) have reviewed many of the studies undertaken to find strategic groups using various classification systems.

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Figure 1: Pump Strategic Ecology. Segment 1 Percent of total revenue

2

3

4

Segment characteristics 100 PBIT Service costs

75

Labour 50 Raw materials 25 Distribution R&D Sales administration

0 Loss on sales of new pumps Power

< 1kW

1-250kW

250-1MW

>1MW

Unit cost (£)

5-25

200-300

1000-20000

20000-350000

Profit/ (loss) (%) 5 on new sales

0

(5)

(10)

Manufacture

Prod'n line

Prod'n line

Batch

Project

Distribution

Dealer

Dealer

Direct

Direct

Buying criteria

Reliability cost

Service cost

Performance cost

Performance cost

Key success factor

Input costs

Marketing

Manufacturing

Engineering

of strategic ecology is an end-use dimension, which determines the design and materials aspects of the pumps or valves. Over a period of time, the industry has evolved into approximately twenty different ecosystems characterised by complexity, value and end-user industry. Businesses typically participate in only one or two ecosystems, because different ecosystems require markedly different business models for a player to participate: a single business model, even if distinct from that of other players, is unlikely to confer advantages in different pump and valve ecosystems. A broad participant needs multiple model to compete in several different ecosystems, which splinters learning and is expensive. What an analysis of the pump and valve industries makes clear is how heterogeneous these industries in fact are, and how varied are the firms that compete in them — there is no single industry but instead many strategic ecosystems. Determining the boundaries between these distinct ecosystems takes a great deal of analytical effort.

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A similar fine-grained structure is evident in house wares. Although there are several hundred companies engaged in the provision of house wares in the United Kingdom, it is possible to distinguish businesses according to the materials base that they employ (wood, plastic etc.), and customer and distribution channel selections. The picture that emerges is again one where businesses typically compete directly with half-a-dozen to a dozen other businesses only. Strategic ecology may be very fine, triggered, for instance, by customer preferences rather than underlying technology or business economics. For example, in food manufacturing in Great Britain, red and brown ketchup represent distinct strategic ecosystems in spite of the fact that the products differ only in terms of colour. Red and brown sauce are consumed by very different social groups, with distinct geographic concentrations, served by quite distinct distribution channels and supported by different brands. In retailing, we often find regional and local effects are strategically dominant. In the case of retail car distribution, for example, dealer profitability often turns on the relative share that the dealership has on a local basis within a particular customer-defined product category. In other words, strategic ecosystems are often locally determined. Determining the correct ecology is strategically crucial. In the case of HVAC contractors for instance, a conglomerate, which owned a number of contracting companies, found it very difficult to make meaningful comparisons of the performance of the businesses that it owned, and hence difficult to evaluate performance or shape strategy. Only when a detailed strategic ecology analysis had been carried out, was it possible (i) to identify which companies belonged to the same strategic ecosystems; and (ii) to identify relevant competitors against whom performance could be gauged and competitive strategies elaborated.

Other Notions of Strategic Ecology This account of strategic ecology is to be strongly contrasted with a number of others. Following the early work of Hunt, Newman and Michael Porter, strategic ecology is often carried out at the level of an industry typically defined by a Standard Industrial Code (SIC) coding. Most often, the level of strategic ecology adopted is much too aggregate for strategic purposes.47 It is also the case that SIC codes have an administrative origin and reflect bureaucratic convenience in providing statistical information to government sources rather than the underlying strategic realities of customer and competitive behaviour. There is little to commend the strategic classification of businesses by an SIC code over a classification based on the alphabetical letter with which the business’s name begins. 47 As Richard Rumelt (1984: 558) observed: By taking the industry as the unit of analysis, industrial organization largely ignored the theory and evidence of intra-industry differences among firms. Thus, while great efforts have gone toward explaining inter-industry differences in the rate of return, it can easily be shown that the dispersion in the characteristic long-term rates of firms within industries is five to eight times as large as the variance in returns across industries.

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In many studies of strategic groups of businesses, researchers have focused on a single manufactured product within the United States, for example brewing or textiles. These product categories are much too broad to provide strategic insight to the hundreds of players that participate in more specific, smaller ecosystems within the industry. For instance, consider the car industry. Strategic groups were identified in a Harvard Business School case study48 within the automobile industry on a worldwide basis. One of the groups comprised large volume, mass-market producers such as Ford, Volkswagen and Fiat. Similarities and parallels between the strategies of these three companies were analysed. While such analysis may have provided heuristic value to those wishing to understand the behaviour of large automotive groups, the actual nature of competition that occurs at the level of a business within these groups is radically different. It is very likely that each of these groups participates in hundreds if not thousands of different strategic ecosystems. For example (i) European compact car engine blocks, (ii) Scandinavian major dealer floor plan financing, and (iii) French after-market telematics might all represent separate ecosystems. Each ecosystem requires its own business model and strategy. The view of the automotive industry from a global standpoint represents the aggregation of the very large number of individual businesses that have distinct ecosystem positions. Such an aggregate perspective is of little use from the point of view of formulating business strategy.49 To compete effectively, strategies are required for each ecosystem, and overall strategic priorities should emerge from the consolidation and integration of individual ecosystem strategies, rather than being imposed top-down from a simplified aggregate view of the industry concerned. Convenience is generally an enemy of strategic ecology: businesses frequently determine strategic ecology on the basis of customer, product, organisational or geographic dimensions, since these dimensions often correspond to the way that information within the business has been organised or reported, or to the way the business was set up or acquired.50 It is important to emphasise that none of these separate dimensions are individually necessary or sufficient to define the strategic ecosystem(s) within which a business operates.51 Strategic ecology arises from the existence of a viable competitive system involving customers, competitors and other parties joined together in a network of service or product delivery that creates value

48

HBS: Note on the World Auto Industry in Transition 0-382-122 1982. In a similar fashion to the auto analysis, Michael Porter and Elisabeth Teisberg published a tirade against the healthcare industry in the Harvard Business Review in June 2004. Whatever the competitive successes or failures of businesses and institutions involved in healthcare in the United States, it is hard to believe that they all participate in only one ecosystem called US healthcare. 50 Prahalad & Hamel (1990) in a similar way note the tyranny imposed by defining corporations by SBUs rather than core competences. 51 The consequence is what may be called the Red Sock problem. Imagine that a careful survey on a particular day shows that nearly all the historians in a university are wearing red socks. Much as this might be statistically well founded, and interesting, it is of little use dressing ones children in red socks in the hope that they will become historians. 49

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that is shared between the various system participants.52 To determine which ecosystem is relevant to their business, managers need to look at both the interface where competition takes place (the demand side), and how their own firm and competitors organise activities (the supply side). More technically minded economists have employed the notion of a market in which competitors compete as defined by cross-elasticities between potentially substitute products: if the products of two competitors have a high cross-elasticity, so that the pricing of one of the products has a significant impact on the demand for the other, then both competitors are held to participate in the same market. Experts have often deployed these arguments to determine questions of market share when acquisitions have been referred to competition authorities. In the view of the author, markets and strategic ecosystems are distinct notions, and markets often comprise several strategic ecosystems. For example, the sales of personal computers by retail and direct over the Internet represent distinct ecosystems, even though they have strong cross-elasticities. The ecosystems are distinct because they involve a different product mix, different supply infrastructure, different marketing and promotion, different sales and service support, and appeal to customers who have quite different purchase criteria once basic price competitiveness has been obtained. Not surprisingly, these ecosystems feature different competitors who employ different business models. Although these ecosystems exhibit high cross-elasticities because a low price is a threshold prerequisite to compete, attributes other than price actually determine the purchasing selections of customers between competitors. In other words price competitiveness is a necessary but not sufficient condition for a business to compete in either the offline or online ecosystems. Another familiar example is car exhaust fitters such as Kwikfit in the United Kingdom, who are in a different ecosystem from the service operations of vehicle dealerships, but where cross-elasticities are significant. In general, where a matching price is a necessary, but not sufficient purchase determinant, there may exist a number of distinct strategic ecosystems that are supported by different channels of distribution and business model.53 Complementing the heterogeneity of supply, the heterogeneity of customers also encourages the emergence of strategic ecosystems. Differences in access costs, storage, information, timing, purchase importance and psychology create the potential for fluid markets to coalesce around particular clusters of customer–supplier interaction that eventually become distinct strategic ecosystems. For example, online grocery shopping and supermarket shopping are probably distinct strategic ecosystems even though customers purchase the same grocery items.

52

The definition closest to what is advocated is the PIMS analysis of served market ecosystems based upon identified competitors in Buzzell & Gale (1987). 53 Fast food activities in different geographical locations probably represent another example: local prices may be heavily constrained by national advertising, but local concentration may deliver considerable financial benefits relative to widely dispersed outlets because of logistical arrangements. Strategic ecology is hence probably local rather than national.

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39

Because economists have focussed on homogeneous competition based upon price, they have adopted a definition of markets that is too broad to be relevant in many instances to heterogeneous competition characterised by purchase criteria beyond price alone. Not surprisingly, this broad market definition, which reduces the market share numbers of competitors, is the one that is employed by would-be acquirers. In this book we will talk about ecosystems, not markets. Over the past twenty years, much research has been conducted into the existence and behaviour of strategic groups. Building on the early work of Porter and Caves,54 management theorists contend that within an industry there often exist strategic groups of competitors who follow similar strategies and who are protected from encroachment from outsiders by the existence of mobility barriers that impose costs on any would-be new entrant. One might reasonably ask whether these strategic groups correspond to strategic ecosystems. In general, they do not. Strategic ecosystems do not arise simply because of the like-minded strategic actions of a number of competitors. Strategic ecosystems arise from the commercial interactions of customers, competitors, intermediaries and other third parties: nowhere within this empirically based account of strategic ecology is it assumed that competitors within an ecosystem are homogeneous from a strategic point of view. Far from it: in a very large number of cases an examination of ecosystem-based competition reveals that the strategies, assets and relative strengths and weaknesses of competitors are in general markedly different. No wonder Bruce Henderson, the early leader of the Boston Consulting Group, remarked that no two competitors can coexist for very long who make their living in the same way.55 An example provided by Howard Thomas, Mark Pruett and John McGee56 makes this non-uniformity of competition immediately apparent. In the brewing industry researchers have distinguished national, regional and local businesses. These different types of businesses are held to follow different types of strategy. Within a particular town or region, however, the strategic brewing ecosystem may include some businesses from each of these groups. For a local brewing business, the relevant set of competitors in the ecosystem will be a matter of fact determined by the behaviour of customers and business model choices of the different types of brewer. Some competitors of the local brewer may be local, some regional, some national. Different competitors within the local ecosystem may have completely different business models. By contrast, in the case of electrical and mechanical contractors, national players are largely absent from local ecosystems — not by choice or mistake, but as a consequence of the relative competitive strengths of national and local players in serving local customers. Businesses competing in a given ecosystem make better or worse returns based on the level of competitive advantage conferred by the strategies, which they have embedded in their business models. Differences arise because one business competes

54

See, for example, Caves & Porter (1977). See Henderson (1998). 56 See McGee et al. (1995). 55

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better than another, not because all the businesses within an ecosystem share the same business model and operate more or less efficiently at different scale points within an oligopolistic regime protected from outsiders by mobility barriers. Competition is not simply oligopoly tagged onto structural determinism, as Porter and the economists who have tried to apply the economics of industrial organisation to strategy would have us believe. Ecosystem barriers exist because of competitive risk, not because they are some shared oligopolistic asset, which arises because a group of businesses all select the same business model, and then act in collusion to erect barriers against new players in order to share the ensuing rich pickings based on the differences of scale between them. Instead, the entry barriers faced by a new player more likely arise because the player does not have a business model that confers advantages against the models of the existing players, which may be quite varied. As we discussed in Chapter 1, classical economics lacks a general theory of heterogeneous competition, and attempts to get around this problem by transforming business problems into cases of monopoly, oligopoly and perfect competition. The substantive differences in the competitive behaviour of businesses in a given ecosystem cannot be dismissed as differences in operational efficiency or scale, thereby leaving strategy choices to relate largely to the selection of ecosystems in which to participate. Instead, by pulling the various strategic levers available to it, and by distinctively deploying the resources it commands, a business can implement a distinctive business model within an ecosystem in the hope of appropriating greater ecosystem profits than its competitors. Businesses, like bugs, are very diverse.57 What this means is that there are multiple routes to advantage in an ecosystem: the proverbial more than one way to skin a cat, which economists more drily call the principle of equifinality. This is a very important observation. It explains how managers can link together these ideas of a strategic ecology with the ideas of core competence, dominant logic and similar notions emerging from the current resourcebased view of strategy. This approach contrasts strongly with the views of Michael Porter and others that the basis of strategy is correct positioning in attractive environments.58 It is essential to understand the ecosystem, and then develop a viable, quite possibly distinct, business model to survive and perhaps to thrive. If strategic choice simply reduces to choosing which strategic group your business should be in, then it is hard to make sense of the credible imperatives that businesses should seek to establish unique, hard to replicate competitive advantages. Conversely, by assuming that the relevant competitor set comprises only businesses with the same

57 Mintzberg (1990a) interestingly also adopts a taxonomical view in his account of the organisational configuration of companies and institutions. 58 Hatten et al. (1978: 17) wrote: The notion of strategy leads to the expectation that, within a given, industry or set of markets, different competitors with different resources should choose different means to attain their ends. Among other indications, this suggests that industry level models and indiscriminate pooling of data can produce results that are easily misled if used at the firm level. It also suggests that in the real world there really are different ways of ‘skinning a cat’, the firm too quick to copy a successful competitor, one which tries to emulate its competitors without careful thought, may overlook its own capabilities and work against its strengths.

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business model, we are then faced with explaining the evolution of a particular given business in terms of a series of hops from one competitor set to another as its business model evolves. This simply does not tally with experience. So to sum up, we have distinct businesses pursuing distinct strategies within a strategic ecosystem through the implementation of distinct business models. Some will be successful; some will fail. The ecosystem will be defined and protected, at least for a while, by mobility barriers against new entrants. Those businesses that succeed within the ecosystem will do so by extracting rents that arise in the exchange of value that occurs with customers. These rents from customer interaction that arise for a particular business within an ecosystem will be protected by a second set of barriers and advantages, which arise from the application of the business model — these barriers are what Richard Rumelt called isolating mechanisms.59 Just as mobility barriers provide some protection from outsiders for businesses within ecosystems, so within an ecosystem isolating mechanisms provide some protection from other insider competitors because of the particular features of a player’s business model. Strategy formulation then becomes really pertinent at the level of the individual business, not at the level of a competitor group of businesses that share a common business model.

Ecosystem Characteristics A recurrent theme of this book is that the performance of a business will be strongly influenced by both its context — revealed through strategic ecology — and its strategy, embedded in its business model.60 Ceteris paribus, businesses will make greater returns in more benign contexts and where they possess a more effective business model — a perspective that happily integrates both the resource-based and positioning schools of strategy. In terms of context, it is important to consider the structural attractiveness of the ecosystem or ecosystems within which a business operates. While we may investigate many features of an ecosystem, the dominant consideration is whether the ecosystem offers profitable, growing value-added to the businesses that compete within the ecosystem.61 Where there is profitable growing value-added, there will be greater opportunities for a business to appropriate sustained economic rents. It is better to live in the Garden of Eden than in the deserts of Moses. Figure 2 shows a collection of distinct strategic ecosystems that exist in the hotel industry in Europe. Participation in different ecosystems requires different business models, reflected in the hotel offering, location, marketing, pricing, group selling etc. The vertical axis measures the growth in value-added within the ecosystem; the horizontal axis measures profits (here under the acronym HPC, hotel profit 59

See, for example, Rumelt (1984). See the supportive research of McGahan & Porter (1997) and earlier work by Rumelt (1974, 1991) and Schmalensee (1985). 61 We remind readers that by value-added we mean revenues less the cost of bought-in third party products and services, what economists would call net output. 60

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Astute Competition: The Economics of Strategic Diversity Figure 2: Strategic Ecosystems in Hotel Chains 1998. High Low / Roadside 20

Economy Mid interior

Growth in Value Added (Percent)

Mid city Health & Holiday

Villages

Low Interior Prestige

High Interior Mid

High 10 High City Mid Prestige Prestige

Prestige Tourism

0

0

40

20 HPC/VA (percent) Scale

France

Italy

Germany

Spain

£ 100 m value added

contribution) in relation to the value-added within the ecosystem. The overall structural attractiveness of different ecosystems can be compared, while also recording the size of a client’s current businesses as measured by the value-added each business provides. What do we mean by profitable? Capital markets provide the answer: returns must equal or exceed what diversified investors expect on a risk-adjusted basis from investments made and resources consumed in the ecosystem, that is in terms of returns on value-added otherwise called the return on resources, which is discussed in Chapter 6. Figure 3 shows a similar graphical summary of value-added development for the suppliers of instrumentation testing systems: the size and rate of growth of valueadded (recorded by the CAGR, compound annual growth figures) and the profits available on this value-added (ROVA, return on value-added) were very different in

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Figure 3: Growth and Returns on Value-added. Value Added Structure: US Systems CAGR %

110

Millions of 1997 Dollars

100

ROVA = 19%

ROVA = 11% 5.0

50

0 1995

1997

Value Added Structure: Europe Systems 110

ROVA = 9%

ROVA = 7%

10.7

100 Millions of 1997 Dollars

CAGR %

50

0 1995 Profit

1997 Cost

the US and Europe. Understanding the reasons for these differences, and in particular structural features of the distinct US and European ecosystems, was critical for developing a recovery strategy for the systems businesses in the US and Europe. Whether profitable, growing value-added is available to participants is determined in part by exogenous factors impinging on the ecosystem of the type described in the Five Forces Model of Porter, i.e. the application of industrial organisation

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Astute Competition: The Economics of Strategic Diversity Figure 4: Power of Buyers — General. Choice

Relative Concentration of Players to Buyers

100x

O.K.

Attractive

Clout

1x

Unattractive

.01x 100x

O.K.

.01x 1x Relative Number of Players to Buyers

techniques at the ecosystem not industry level. In addition to the Five Forces analysis (of structural entry and exit barriers, the power of buyers and suppliers, threat of substitutes and general competitive rivalry), businesses may wish to look more closely at specific trade, legislation, life-cycle and technology factors, which impinge on the ecosystem concerned (all well covered by the general strategy and industrial organisation literature). A number of these factors, though, may be made more precise through quantification: for example we may assess buyer, supplier and competitor influences by measures describing relative Herfindahl summed-square concentration (‘‘clout’’) and relative numbers (‘‘choice’’) of buyers, competitors and suppliers as depicted in Figures 4–6.62 Figure 5 shows the application of these quantified measures to the buying channels operated by Tour Operators (TO) and Travel Agents (TA) in different European countries for hotel reservations. The picture of concentration developed contrasted strongly with the perceived fragmentation and lack of pricing pressure in hotel businesses.

62

The Herfindahl index for three competitors with shares of 40, 20 and 10 per cent is 2,100 ¼ (40 40)+(20 20)+(10 10).

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Figure 5: Power of Buyers in Hotels in Europe 1998.

Relative Concentration of Players to Buyers

100x

Spain TA

1x

Germany TA

France TA France TO Germany TO

.01x 100x

Spain TO

Italy TA 1x

.01x

Italy TO Relative Number of Players to Buyers

Figure 6 is the corresponding quantified matrix for suppliers. Similarly, in making Porter’s notion of competitive rivalry more precise in Figure 7, we may look at the average level of ecosystem profitability relative to the Herfindahl summed-square measure of concentration of competitors in the ecosystem. Typically, we would expect the average return on resources (see Chapter 5) used to compete in the ecosystem to be sufficient to meet the expectations of investors. If the level is beneath this threshold, then we must presume consolidation is under way if the market structure is currently fragmented, or strategic stalemate has occurred within the ecosystem where the ecosystem is highly concentrated. If on the other hand profitability is higher than the threshold, the ecosystem permits profitable niche differentiation (which may be vulnerable to consolidation) or collusive regimes if the concentration of players is very high.63

63 Industrial organisation economists may loosely associate the four quadrant positions with different competitive structures: Carnot oligopoly, Bertrand oligopoly, perfect competition and monopolistic competition corresponding to oligopoly, stalemate, fragmentation and consolidation.

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Relative Concentration of Players to Suppliers

Figure 6: Power of Suppliers — General. 10x

OK

Good

Bad

OK

1x

0.1x 10x

1x

0.1x

Relative Number of Players to Suppliers

Return on Resources (percent)

Figure 7: Ecosystem Pricing Environment.

Fragmentation

Oligopoly Approximated by market return Rm

Consolidation

0

Stalemate

2000 Concentration

10000

(Herfindahl score)

Figure 8 below shows an actual analysis conducted for chain hotels, and types of catering in Europe. The price environment for hotels was much more characteristic of fragmentation or oligopoly, as opposed to the environment of consolidation that characterised many of the public and contract catering businesses.64 Note that volume growth in an ecosystem is not necessarily evidence of attractiveness: it may simply signal the path to greater losses. Furthermore, growth in value-added may not be associated with volume growth. For example, in the tea

64

The horizontal scale is a Herfindahl scale where 1 corresponds to a Herfindahl measure of 10 000. ROVA stands for the return on value added, also called the return on resources.

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Figure 8: Pricing Environment in Hotels and Catering in Europe. European Opportunities Chains: Pricing Environment 40 SP

ROVA Percent

30

FR

G

Hotels

SP 20

Public catering

IT

FR

Contract catering G

10

SP G

IT 0 0.01

VA

IT

FR 0.1

0.15

Concentration of Competitors

1

£500M

market, packaging innovations have allowed value-added to grow while the quantity of tea consumed has declined. As we shall see in Chapter 9, we may wish to combine typical growth and ROVA into a single measure of attractiveness rather than relying on volume growth. Where a company is involved in a number of distinct strategic ecosystems, it may be helpful to define, compare and contrast the characteristics of the different ecosystems. Figure 9 shows a summary of structural features in this case aggregating various individual ecosystems into an overall industry appraisal (which fits with the Porter-industrial organisation frameworks conducted at the industry as opposed to the ecosystem level). The summary format can also be used at ecosystem level. In many cases the structural features of the ecosystem will endure long enough and be sufficiently determinable for us to apply these kinds of measure. In other situations, however, the context may be considerably more volatile and evolutionary (for example, exotic financial innovations in investment banking), supporting competitive ploys that are more transient and nimble. The routes to competitive advantage will depend greatly upon these structural differences of context. Understanding the structural characteristics of the ecosystem allows a business to frame its expectations for the growth of the value-added in the ecosystem, over which competitors compete, and to gauge the appropriability of sustained economic rents, as reflected in the return on resources invested in the ecosystem. Armed with this understanding of its ecosystem, and its competitor set, a business can then set about developing a strategy to outperform competitors or redefine the ecosystem(s) in which it competes.

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Astute Competition: The Economics of Strategic Diversity Figure 9: Appraisal Summary. European Opportunities Broad industry appraisal Hotels

Public Catering Contract Catering Airport Services

Supply/Demand Growth in value added

It

Fr

Sp

Fr

G

Sp

G

Fr

Sp

Sp

G

Return on value added

Sp

Chain concentration

G

G

Broadly attractive

Fairly attractive

Sp Fr It

Sp

Power of suppliers Power of buyers Barriers to Entry/Exit Economies of scale/scope Brand Identity

Attractive - Not Attractive

Somewhat attractive

Fairly unattractive

Ecosystem Dynamics It is important to emphasise the dynamic and fungible nature of strategic ecology. From a mundane point of view, we may observe that changes in customers, distribution arrangements and technology mean that strategic ecology will change and evolve. It is also the case that the existing strategic ecology may be vulnerable to the effects of new competitors entering a given ecosystem. There is, however, a more fundamental sense in which any given strategic ecology may be held to be precarious. In so far as an observed strategic ecology reflects the behaviour of ecosystem participants, it will be sensitive to changes in participant behaviour, which in turn may be influenced by the way a participant perceives its competitive situation. No presumption has been made in this account of strategic ecology that participants have in common a highly shared view or definition with regard to customers, costs or competitors. In strategic ecology what we are concerned with is a series of overlays of businesses, often defined differently by their managers, intersecting with one another, but not necessarily entirely congruent with one another. Given the heterogeneous nature and path dependence of competing businesses, it would be very surprising if businesses share the same cognitive database to describe

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their environment. Since strategic ecology is a combination of observation, analysis and judgement, competitors competing in the same ecosystem may have different ecosystem definitions, though often at least partially overlapping. What one business considers to be a product, a customer, a competitor or a valued resource, may be different from how these items will be treated by a competitor. Note, these differences do not arise typically from creative reinterpretation of empirical evidence, a sort of make-believe view of the business setting. Instead, they reflect the incomplete, ambiguous and conflicting nature of the empirical information available to a business at a particular moment: i.e. ignorance rather than imagination. This will particularly be the case if competitors participate variously in other business ecosystems that are related to the ecosystem under study or participate in different steps in the value-added chain that underpins the strategic ecology. This is not a trivial matter. Often economists blithely assume that participants are able to share common definitions of product, price and cost. Even a cursory exposure to the strategic realities of a business is sufficient to reveal how slippery these notions are. If different individuals in different purchasing companies purchase different product variants and service combinations and employ different purchasing channels, why should competing suppliers harmoniously agree that these customers define a common product? When it comes to price, how is price to be defined? How do we take account of channel economics, discounts, volumes, bundling, promotions, service levels, credit, replacement sales and stocking adjustments? For one client for whom the author worked, the prices of products were established using pricing manuals, which comprised over a 1,000 loose-leaf pages with an item price depending upon options, combinations, promotions, permutations, financing and prior purchases. If the notion of price is somewhat nebulous, the notion of cost is even more so. Given the distinctions between (i) fixed and variable, (ii) direct and indirect, (iii) incremental and shared, (iv) full and marginal, (v) incurred and opportunity costs, the determination of the cost of a product or service in many instances is a matter of judgement and purpose. Compound this situation with the volume interdependency of price and cost that give rise to circularity, and it soon becomes clear that ‘the product’, ‘the price’ and ‘the cost’ are an economist’s idealisation. It is no surprise that different competitors not only have a different perspective on the economics of their business, but also have different views of underlying strategic ecology. As examples of the blurriness of products, prices and costs consider consulting services and financial products such as insurance or pensions. Often many client personnel are involved in the purchase and application of consulting. The perspective they have on what defines the assignment, its consequences, its success or its end will be very different, vague and spread over time. Telling the CEO of a consulting firm that she must sell her consulting products at prices higher than costs is not insightful. Look at the pensions or insurance industry: exactly what are clients purchasing? Is it the same as what suppliers are providing? Benefits, costs and obligations are notoriously difficult to nail down. The edges of ecosystems are rather like the edges of deserts: rather hard to specify locally.

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These differences do not undermine our ability to observe de facto the existence and evolution of the strategic ecology that has appeared over time, but they raise our awareness of its contingent nature, and of the dynamic tension existing between participants within an ecosystem each of whom probably shares a slightly different perspective of its and others’ current and future positions. To the extent that they comprehend the basis and the fungibility of ecosystem definition, businesses may be able to take advantage of it, redefining and shifting strategic ecology to favour their own competitive advantages. Much competitive strategy relates to the subtle redefinition of ecosystem-based competition. Consider, for instance, the evolution of the strategic ecology of cameras. When the Japanese first asserted their dominance in the Single Lens Reflex (SLR) ecosystem, the product technology underlying the strategic ecology was largely optical. Many American and European competitors believed that the ferocity of competition between Japanese manufacturers would reduce the value-added within the SLR ecosystem undermining returns for all but the largest and most committed competitors. As a result, the US and European competitors for the most part withdrew from the ecosystem, or declined to participate. In fact, over the past three decades the Japanese have managed to redefine the camera ecosystem so as to maintain both the magnitude of its valueadded and the level of returns. The underlying product technology has shifted from optical to electro-optical to electronic computer hardware, and may yet evolve to being largely a digital software business. As George Stalk of the Boston Consulting Group observed, the essence of strategy is not the structure of a company’s products and markets but the dynamics of its behaviour.65 In considering the question of ecosystem redefinition, we may also consider the influence of path. On the one hand, the path dependence of existing competitors may attenuate their ability to redefine their ecosystem proactively even when the cognitive frameworks guiding their path have not imposed strategic myopia. This will put a brake on the rate of change of strategic ecology, the rate being dependent upon the size of path barriers and path momentum. On the other, the ability to reorient its path may allow a competitor to engage systematically in ecosystem redefinition to its benefit. Uncertainties, relating to the best mix of resources to satisfy customer needs and to allow profit appropriation, create an opportunity for creative companies to explore path variants. In undertaking such a reappraised ecology initiative, it is not necessary that the business be configured in an optimal way to support the new strategic ecology. It is sufficient for the business simply to be more advantageously configured than its next nearest competitor. In pursuing a dynamic reconfiguration of resources with the intention of changing strategic ecology, a competitor may rely upon a unique set of capabilities to pursue its strategy. This notion of uniqueness, however, does not imply non-replicability: the uniqueness is a temporal uniqueness arising from the business’ chosen path. Once competitors realise that their activities are subject to a redefined ecology that they are unable to resist, they may reconfigure their activities to respond to the new basis of

65

See Stalk & Stern (1998).

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competition. Whether the innovator who has initiated ecosystem redefinition ultimately suffers erosion of profit by its reconfigured competitors will depend upon its relative competitive position and upon its strategic path. We may think of strategic ecology as the shifting map of advantage. This dynamic approach to strategic ecology may lead us to consider that the individual business is an economic vehicle that can redefine ecosystems, products, prices and costs in order to deliver, through a choice of ecosystem and resource trajectory, rents that are conferred by customers. This dynamism is lacking in the classical, optimising oligopoly plus account of the business, but it forms the basis of the competitive control of value-added, which lies at the heart of business strategy and is discussed further in Chapter 4.

Summary 1. For businesses within a given strategic ecosystem, a strategy is a coherent and consistent pattern of action expressed through a business model leading to the appropriation of sustained economic rents. 2. Strategic ecology frames fine-grained competitive interaction since businesses compete in strategically relevant ecosystems, which differ in structure, characteristics and dynamic development. 3. Strategic ecology is a matter of fact not a matter of definition or choice, and ecosystems do not necessarily coincide with what economists call markets. 4. Strategic ecology is blurry, dynamic and changes as the result of competitive initiatives.

Questions 1. Applying the strategic ecology criteria listed in the chapter, does your business participate in one or more strategic ecosystems and what do you call these ecosystems? 2. What are the structural characteristics of the ecosystems in which you operate? In particular, what are the size, growth and profitability of value-added within the ecosystems and how has it changed over time? What structural factors account for these changes, and can they be made precise and be projected forward in time? 3. What is your relative position compared to your competitors in each of the ecosystems in terms of financial performance, and absolute and relative market shares? How has your position changed in each ecosystem over time and what future projections of relative performance can be extrapolated from current trends?


Chapter 3

Business Models We opened the previous chapter by stating that for businesses within a given strategic ecosystem, a strategy is a coherent and consistent pattern of action expressed through a business model leading to the appropriation of sustained economic rents. Having made clear what is meant by a strategic ecosystem, and by a coherent and consistent pattern of action, we now need to explain what a business model is. The purpose of this chapter is to put this notion on a clearer footing and provide some analytical tools that make explicit exactly what we are talking about in any given situation. The term ‘business model’ has become part of the common parlance of entrepreneurs, venture capitalists and strategists.66 While those who employ this term feel comfortable with its use and value the pithy insight it brings into business behaviour, there is some fuzziness in its meaning, and some overlap with the term strategy. Those who use the term would probably agree that a business model captures the configuration of a business in relation to its suppliers, partners and customers, describing how this configuration harnesses resources to deliver valued products or services in a competitive manner. The business model captures the key attributes of this competitive business system. How can we make these ideas more precise?

How to Formalise the Intuitive Account One way to do this might be to try to model explicitly what strategy is using a set of axioms and rules (a strict set-theoretic algebra), mirroring the efforts made first in the physical sciences in the 1940s and 1950s, and later in the social sciences in the 1970s and 1980s, to capture the formal meaning of scientific terms such as gravity or charge.67 We can sketch what the key elements of the formal components of such a system might comprise: (i) several sets of distinct entities such as customer groups, products, distributors, suppliers, principal resources (assets, activities, skills and knowledge); (ii) a lattice linking together nodes, which are formed from (subsets of) the sets of entities in a configuration that reliably mirrors the business; (iii) a set of mappings that encode the links in the lattice between the nodes providing specific information about the magnitudes of the links, for instance about volumes, costs or revenues. One way to visualise the lattice structure is as a molecule where atoms of different kinds are linked together by bonds that have different properties. Different atoms 66

Prahalad & Hamel (1990) for instance talk of strategic architecture. For those interested in pursuing such a model, the works of, e.g., Suppes & Zinnes (1963) in measurement, and that of Walsh in economics, provide precedents.

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represent groups of customers, distributors, products, suppliers and resources that are linked together in a common business model. The strength and the persistence of the bonds reflect the couplings that exist between parts of the business model. Distinct molecules may then represent different competitors: each chemical formula describes a business model. Where does strategy fit? Strategy then corresponds to the changes in the molecular structure of the business model over time. Mathematically, the structure of the lattice may be formally represented by matrices that span a multi-dimensional topographical space, operating on a series of structural vectors, such as prices or products. Changes in strategy over time will be reflected in changes in the matrices.

Formal Interpretation of Coherence and Consistency This formal matrix approach can also deal comprehensively with the notions of coherence and consistency that are built into what is meant by strategy. Those who do not feel comfortable with mathematical reasoning can take this on trust and skip to the next section. Intuitively, when we try to assess whether a strategy is coherent, we examine whether the molecule that represents the business model at one time overlaps with the molecule that represents the business at another time, asking ourselves whether we can smoothly transform one molecule into the other. Mathematically, we can define this overlap as a generalised vector dot product between the two business models in the vector space that describes the models. To allow for the possible rotating, stretching or shrinking of one of the molecules as we try to assess its overlap with the other molecule, we need to allow mathematically for the possibility of linear transformations of the matrix or vectors that describe the initial business model when we compare it with another. Using matrix algebra, we can undertake rotation, enlargement or reduction of the lattice structure. These mathematical transformations correspond to stretching or rotating the molecule that represents the business model. These transformations may represent observable changes in the business: growth, reorientation, downsizing comes to mind as interpretations of stretching or rotating the matrices that capture the business model. We can then formally develop a notion of congruence for a strategy by defining an overlap function at two times t and t0 between the molecular structure of the business models at those times in terms of the maximal generalised dot product between the matrix or vector structure at time t0 and the set of linear transforms of the matrix or vector structure at time t. A strategy will be formally coherent if over time subsequent versions of the business model are congruent with earlier versions. We can express this formally by the requirement that this congruence overlap function has a lower bound set at a defined level. In a similar fashion, we can give sense to consistency of a strategy within this framework. Imagine that between time t0 and time t we make a deliberate change to the business model that alters the lattice connecting nodes: either by creating or by breaking a link between nodes, or by introducing a new node. If as a result of this

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change, the lattice reconfigures in such a way that some other link is broken, then we may say that an inconsistency has been forced by the strategy. Because some inconsistencies may be graver than others, we can contemplate defining a utility measure upon the two structures that will allow us to state that if the change in a business model causes an adverse change in the utility measure in excess of a defined threshold, then the strategy is inconsistent.

An Example of the Business Model Matrices Tomakethismodelling more intelligible, let us consider the case of Clone Computers Inc. that assembles and sells personal computers. Imagine the following business system: Products Components Sources Supply partners Customer groups Customers Channels Streams of revenue Sales partners Applications

Desktop PCs, notebooks, PDAs, printers Monitors, keyboards, printers, processors Manufacturing, subcontractor, partner, webprocurement Clone Manufacturing Inc., Display Design Inc., Motherboards Inc., PC Imports Inc., Componentsource.com Corporate, individuals, schools Mr Jones, Mrs Smith, Acme Corporation, MegaChip Inc., Oakville Highschool Direct, agent, distributor, web Unit purchase, consumable purchase, rental, service contract Alpha Agents Inc, Boom Distributors Inc., Garage Distributors Inc., PCnet.com Desk top publishing (DTP), Bookkeeping (BK), Distance learning (DL).

Clone’s business model describes the way Clone conducts business. Let us assume that Clone focuses primarily on notebooks for schools, which it makes itself and which it sells through distributors and over the web. Recently, however, Clone decided to sell a full range of products through its own sales-force to corporate customers, which it purchases from Motherboards, with the exception of the monitors that it has built under contract by Display Design, and the printers that it imports. Clone also does a small amount of business, sourcing printers for individuals. We can represent this model by the following matrices: first, we may map distribution [Distributor Map]

Corporate Individual Schools

Own sale

Alpha

Boom

Garage

PCNet

1 0 0

0 0 0

0 0 1

0 0 1

0 1 1

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Astute Competition: The Economics of Strategic Diversity [Distributor Type] Direct

Agent

Distributor

Web

1 0 0 0 0

0 1 0 0 0

0 0 1 1 0

0 0 0 0 1

Own sale Alpha Boom Garage PCNet

We can multiply these two matrices together to produce a [Routes to Market] matrix, which defines the configuration of product ecosystems served by different types of distribution channel:

½Routes to Market ¼ ½Distributor Map ½Distributor Type Direct

Agent

Distributor

Web

1 0 0

0 0 0

0 0 2

0 1 1

Corporate Individual School

Note that the entries under the agent column are all zero. This information may still be significant if a competitor of Clone, for instance, uses Alpha Agents: the distribution entities considered must include all entities available to Clone and its competitors. We can also express these distribution relationships using the following notation: Groups by channel ¼ groups by distributors distributors by channels In a similar fashion we can define [Supplier Map] and [Supplier Type] matrices: [Supplier Map]

Monitors Keyboards Processors Printers

Clone

Display

Motherbd

PCImports

Cptsource

1 1 1 0

1 0 0 0

0 1 1 0

0 0 0 1

0 0 0 0

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57

[Supplier Type] Manufactg

Subcontract

Partner

Webprocure

1 0 0 0 0

0 1 0 0 0

0 0 1 1 0

0 0 0 0 1

Clone Display Motherbd PCImports Cptsource

If we multiply these two matrices together we generate an [Operational Configuration] matrix, which defines how different components are obtained:

½Operational Configuration ¼ ½Supplier Map ½Supplier Type Manufactg

Subcontract

Partner

Webprocure

1 1 1 0

1 0 0 0

0 1 1 1

0 0 0 0

Monitors Keyboards Processors Printers

This matrix describes the number and type of operational sourcing relationships. Notationally, we may also describe this in the following way:

Components by sources ¼ components by suppliers suppliers by sources A third set of matrices relate to customers. First, we may allocate customers to groups: [Customer Map]


Jones

Smith

Acme

Megachip

Oakville

0 1 0

0 1 0

1 0 0

1 0 0

0 0 1

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And then customers to different revenue streams: [Customer Type]

Jones Smith Acme Megachip Oakville

Unit pch

Con pch

Rental

Service

1 0 1 0 0

0 1 0 0 1

0 0 0 1 0

0 0 1 1 1

Combining the two matrices, we obtain: [Monetisation]


Unit pch

Con pch

Rental

Service

1 1 0

0 1 1

1 0 0

2 0 1

This matrix describes the structure of the revenue streams arising from different customer groups, described notationally as: ½Monetisation ¼ ½Customer Map ½Customer Type or Groups by streams ¼ groups by customers customers by streams

Application to Wireless Data Services This type of explicit thinking about business models has been very useful to a new company that provides wireless navigation and routing services to PDAs (Personal Data Assistants, such as the Palm Pilot and iPAQ). For instance, the groups targeted for these services include mobile professionals, who are early adopters of new technology, certain small businesses that involve frequent travelling to new destinations such as plumbers, and large companies with field engineers. Using the Routes to Market matrix allowed the company to distinguish and prioritise its marketing efforts:

Corporate Professional SMEs

Direct

Resellers

Distributor

Web

1 0 0

0 400 30

0 10 10

0 3 1

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Early market experience revealed that corporate sales only occurred through direct selling effort, in spite of the preliminary introductory role of distributors. Professional purchasers tended to buy from local resellers with whom the purchaser could enter into a sustained customised dialogue, but occasionally they would buy over the web once they had identified the best service configuration for their needs. The resellers in turn bought from an established, relatively small group of distributors, from whom professionals occasionally bought direct. SMEs tended to use a small number of specialist distributors from whom they bought a wider set of computer products and services. Understanding this matrix led the company to allocate its resources predominantly to the distributor channel for greatest early effectiveness. In a similar fashion the company has benefited from the explicit consideration of the Operational Configuration matrix as part of the evolving business model.

Sat Nav Maps User i-face Data feeds

Manufactg

Subcontract

Partner

Procure

0 0 1 0

0 0 0 1

1 0 0 0

0 1 0 0

Initially, the company decided to establish a partnership with a US company with existing satellite navigation software allowing it to focus on the development of user interfaces for a range of devices that incorporated ancillary sub-contracted live traffic data feeds. Maps to support navigation could be readily procured. Initially the partnership arrangements worked well, but once the first significant sales had occurred the US partner indicated that it wanted to renegotiate the partnership in order for it to establish its own European operations. In the light of this development, the company undertook a review of its arrangements and the matrix was used to frame discussions that resulted in a decision to subcontract the development of a simple satellite-navigation application rather than undertaking in-house development. Clearly, such discussions could have taken place without the matrices, but regular review and discussion of the various components of the business model had been facilitated by their use.

Further Development of the External Attributes of the Business Model The process of encoding the business model of Clone into matrices may be further developed to incorporate a product perspective or basis. For the sake of conciseness intervening steps have been omitted, but it is possible to produce quite straightforwardly the following results: [Product Choices][Routes to Market]

¼

[Distribution Matrix]

Products by groupsgroups by channels

¼

products by channels

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[Product Choices][Monetisation]

¼

[Revenue Matrix]

Products by groupsgroups by stream

¼

products by streams

[Modularity][Operational Configuration]

¼

[Supply Matrix]

Products by componentscomponents by sources

¼

products by sources

These matrices describe respectively the choice of channels to take products to market, the choice of monetisation streams arising from these products, and the choices that Clone has made in the supply chain of these products. Let us designate these three matrices D, R and S. Returning to the case of the wireless data services, much strategic discussion has taken place over the Revenue and Supply matrices (the Distribution matrix follows relatively straightforwardly from the Route to Market discussions of groups served by different channels). The company has developed high, mid and low specifications of navigation-enabled PDAs offering, respectively (i) no updating for traffic, (ii) updating and rerouting, and (iii) updating, rerouting and ancillary services. For the different offerings, there has been much discussion of the relative merits of simply selling the device versus a flat subscription versus a subscription that reflects usage versus rental options. The Revenue matrix quantified as a percentage of sales captures these options:

Basic Standard Pro

Device

Flat Sub

Usage

Rental

1 0.5 0.25

0 0.5 0.15

0 0 0.5

0 0 0.2

The Revenue matrix has allowed the company to keep control of its choices of revenue streams and prices as it responds to short- and medium-term customer and competitor developments. Given the need to respond dynamically to developments in the market place, the company has also needed to make regular explicit choices of supply for the offerings it has developed, particularly with regard to the sourcing of complementary hardware such as receivers where prices and specifications are evolving rapidly with increased market demand. The Supply matrix, especially when quantified for volumes and margins, has proved a useful tool both for short- and medium-term sourcing decisions. One final extension of the matrix model may be warranted,68 particularly for startup businesses: an extension to include the value proposition at the core of the business’s products or services. For businesses with radically new technology, it may be difficult to discern the customer application that creates the greatest value for the 68

I am particularly indebted to Hank Chesbrough (2004) for his working paper on business models and for his insightful comments about the inclusion of a value proposition within a business model.

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61

technology (as discussed in Chapter 10) — indeed, in some cases there may not be one: the technology might be fascinating but not valued at all by customers. For more established businesses, for example copiers, the value proposition may be unambiguous and we may all be thoroughly familiar with what the product or service does for the customer, so much so that we can talk directly about the product or service as opposed to the need or problem, which the product or service addresses for the customer. We could formalise the value proposition by defining a matrix as follows: ½Product Choices ½Applications ¼ ½Value Matrix Products by groups groups by applications ¼ products by applications The term applications might either cover a defined set of problems or needs or solutions, which the product or service addresses and for which the customer is willing to pay. The applications matrix should include the full set of applications addressed by all competitors. The sharpness of definition and underlying meaning of application will be a function of the maturity of group needs served and of the age of the business. In the case of Clone we have: [Product Choices]

PCs NBs PDAs Printers

Corporate

Individuals

Schools

1 1 1 1

0 0 0 0

0 1 0 0

[Applications] DTP

BK

DL

1 1 1

1 0 0

0 0 1

Corporate Individuals Schools

[Value Matrix]


DTP

BK

DL

1 2 1 2

1 1 1 1

0 1 0 0

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The Value matrix provides insight into the variety of product-application combinations leading naturally to questions of specification, functionality and overlap. Predominantly, Clone provides desktop printing solutions.

Internal Attributes of the Business Model This matrix approach to the codification of the business model may be further extended in order to capture internal attributes. To see how we might be able to do this, let us define three further sets of entities: Production activities

R&D, purchasing, scheduling, assembly, supervision

Marketing activities

Promotion, advertising, after-sales support, branding, market research

GS&A activities

General management, selling, administration

Following similar steps to those above for external attributes of the business model, we may then define similar structural matrices: [Supply][Production activities]

¼

[Production]

Products by sourcessources by production activities

¼

products by production activities

[Distribution][Marketing activities]

¼

[Marketing]

Products by channelschannels by marketing activities

¼

products by marketing activities

[Revenue][GS&A activities]

¼

[G S A]

Products by streamsstreams by GS&A activities

¼

products by GS&A activities

These structural matrices record the structure of activities that support choices of product source, channel and monetisation. If we denote them as P, M and G then together with D, R, S and V we have a fairly complete codification of the business model of Clone. The use of these matrices has also been particularly useful in the case of a university spinout that has developed a novel way to make very large flat panel displays using patented IP. Much discussion has taken place concerning the business model and how we expect it to change over time. The basic objective is to leverage the IP by committing limited capital and licensing the technology. For licensing to be credible, and adoptable, however, the company needs to validate the manufacturability of its technology and establish a supply chain of components manufacturers. This has led to an explicit discussion of the Production, Marketing and GSA matrices for different products that

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target different groups in order to establish competence and credibility without building non-critical resources. The structure of these matrices has been mapped out over a number of years in order to focus business building and funding efforts that are captured in the business plan. The P, M and G matrices have provided an efficient means to organise thinking around core competence definition and development.

The Application of Metrics The matrices developed describe the structure of the lattice that comprises the business model, but they do not provide any quantification of the relative magnitude of the relationships (the ‘‘molecular bonds’’) within the model. We can, however, obtain such a quantification by developing mapping functions d, r, s, v, p, m, i, which operate on each of the cell entries of D, R, S, V, P, M and G to convert the cell entry into a coefficient such as a percentage of revenues. For example, for Clone we have: [Product Choices] Corporate

Individual

School

1 1 1 1

0 0 0 1

0 1 0 0


[Routes to Market] Direct

Agent

Distributor

Web

1 0 0

0 0 0

0 0 2

0 1 1


When these matrices are multiplied together we obtain: [Distribution]


Direct

Agent

Distributor

Web

1 1 1 1

0 0 0 0

0 2 0 0

0 1 0 1

which we may then combine with the Marketing Activities matrix, which describes what activities are undertaken to support distribution of products by different

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channels. Let us assume that in the case of Clone the matrix is: [Marketing Activities] Promotion

Advertg

ASS

Branding

Mkt Res

1 0 1 0

1 0 0 1

1 0 0 0

1 1 0 1

1 0 0 0

Direct Agent Distributor Web

Then we may multiply this matrix by the Distribution matrix D to obtain the Marketing matrix M: [Marketing]


Promotion

Advertg

ASS

Branding

Mkt Res

1 3 1 1

1 2 1 2

1 1 1 1

1 2 1 2

1 1 1 1

This matrix describes the structure of product marketing initiatives. For instance, there are three instances of notebook promotion activity — two related to the promotions for Boom and Garage Distributors, and the other relating to promotions via the direct sales-force to corporates. There is no web-related promotion activity, even though Clone sells notebooks to schools over the web, because the web channel does not rely on promotions. To quantify these activities we can construct a mapping function d which multiplies each cell of M by a numerical value to produce a new matrix M0 , where each coefficient a11, a12, y a45 represents the percentage of product revenue given over to each marketing activity. We write this mathematically as: dðMÞ ¼ M0 where M0 is given by:


Promotion

Advertg

ASS

Branding

Mkt Res

a11 a21 a31 a41

a12 a22 a32 a42

a13 a23 a33 a43

a14 a24 a34 a44

a15 a25 a35 a45

If we multiply M0 by a revenue vector v (p1q1, p2q2, p3q3, p4q4), where p1 is the price of PCs, and q1 is the number of PCs sold, p2 is the price of notebooks etc., we will

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65

obtain a column vector, which comprises the amounts spent on each of the marketing activities summed over the four products: v M0

¼

[Marketing Spend] (Promotion $, Advertising $, ASS $, Branding $, Market research $)

In a similar fashion, we can allocate elements of costs, revenues and profits to each of the other matrices that comprise B in a way that is strategically insightful.69 At this stage, many readers may be numbed by the matrices and be asking themselves where all this is leading.

Business Genomics With some modifications we could use this same matrix approach to describe the business models of Clone’s competitors.70 As a result, we may in general use these matrix methods to define a business model B of any business as the conjunction of the internal and external matrices developed: B ¼ df ½D; R; S; V; P; M; G Were such formulations to be widely developed for business models, we could envisage more detailed study of different models giving rise to a new field of business genomics.71 To further the biological analogy, we might consider the decomposition of B into its seven elements as akin to establishing a set of seven genes that describe the inherent characteristics of a business. Following in the footsteps of the Profit Impact of Marketing Strategies (PIMS) pioneers, we can envisage a generalised investigation of the linkages between business models, labelled by a Standard Business Model Classification, and competitive success. Similarly, the pervasiveness of different families of business models by different groups sharing the same SIC code would be of interest to businessmen and academics alike. This taxonomical approach would make the study of business similar to the study of insects: we would aim to understand how particular species of businesses might have evolved in structurally different strategic ecosystems. Lessons for success learnt in one setting might allow us to avoid mistakes and failures in other areas: because we understand the factors that 69

Much of the work undertaken by strategy consultants on internal studies of clients focuses on the allocation of volumes, costs and revenues to the elements of various of the matrices introduced. 70 Alternative choices of basis to the product basis chosen for Clone (such as customer group or distribution channel) will allow the business model to be considered from the perspective of groups or channels etc. as opposed to the current basis of products. These alternative bases will require manipulation of the matrices for the new basis (mathematically this involves pivot techniques), but the information contained is the same as the product basis. 71 Leask & Parnell (2005) describe genomes in the pharmaceutical industry, but their notion of genome is narrowly focused on products as a way of describing the underlying business model of the pharma businesses.

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permit one insect or business model to succeed in a given context or ecosystem, we will be able to argue whether a similar insect or related business models in another context or setting. As an example, let us suppose that financial markets allow heterogeneous buyers and suppliers of heterogeneous financial products (which differ in terms of size, return, risk, liquidity, duration and taxation, for instance) to carry out transactions. An argument might then be made that the investment finance industry is similar in a number of respects to the fashion industry: investment banks may be likened to fashion houses like Gucci; investment products ranging from bank deposits, to equities, to layered Collateralised Debt Obligations (CDOs) may have their analogues in overcoats, dresses and designer outfits; in both industries some products might be sold through retail, some wholesale, some at special gatherings by invitation, etc. By using business genomics we might be able to analyse in a rigorous way the extent of similarity between business models in ecosystems of the two industries in ways which allow executives to formulate new competitive strategies based on the success of models in one ecosystem in the fashion industry translated into an analogous model in a structurally similar ecosystem in the investment industry, and vice versa.72 Within individual companies, using matrix algebra to formalise business model thinking can help general managers to visualise how their businesses are configured to compete with other players. The development of the molecular models allows managers to consider explicitly which aspects of the internal and external parts of the business model they might wish to change. (There is an implicit similarity, for instance, between B and the McKinsey 7S framework.)73 Equipped with an understanding of business genomics, strategic discussions can be focussed around a shared understanding of exactly how the model for a given business works. This eliminates ambiguity, talking at cross-purposes and differences of terminology. Organising quantitative data around the matrix structure of the business model allows managers to develop fresh insight into the critical relationships that exist in the lattice that unites suppliers, customers and partners. To set competitive strategy, managers may develop a series of initiatives, modifications or innovations in their current business model, which are then costed, evaluated and trialled. Through an iterative process, changes in the business model may he honed or crafted based on customer, partner and organisational feedback, field responses and on the anticipated modifications of business model of competitors, all this within a set of investor return or resource constraints. This is what we mean by explicitly choosing a strategy. Over a period of time it may be possible to develop aspects of the business model that are hard for other businesses to replicate

72 Business genomics would help managers protect themselves against false strategic analogies and satisfy the concerns raised for instance about the use of analogies by Gavetti & Rivkin (2005). 73 The 7S’s are Strategy, Structure, Skills, Staff, Systems, Shared Values and Superordinate goals. In fact the list might advantageously be extended to 10S’s with the addition of Science (technology), Stars (leaders) and Suppliers (platform architecture).

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successfully or profitably. This corresponds to crafted mutation to produce a species or a variant that is distinctive if not altogether unique. On the other hand, the eventual emergent business model may be different from what was intended because of ecosystem structural factors, the behaviour of competitors or customers etc. As a result, management may need to re-engage in the formulation of a new strategy embedded in new changes in the business model. These models may also be of particular use in settling questions of business development. All the research evidence points to the importance of relatedness, or what we call adjacency, as the critical determinant of successful business development. To establish whether a proposed development initiative is adjacent, managers could explicitly construct the business models of one or more participants in the target market. This would allow managers to make a rigorous comparison between the business models of the adjacent participants and of their own business, highlighting similarities that confer the opportunity for synergy or greater competitive advantage. One caveat in spite of what has gone before: the matrices need to be kept simple to be useful. Over-complication will distract from the development of major insights if it is not possible to visualise the key features of the model. It would not be difficult, however, to adapt some of the available combinatorial chemistry software programmes to be able to see a rotational multi-dimensional image of many business models. Also managers may want to focus only on one constituent part of the overall model at a time. Alternatively, they may want to use this way of thinking about business models to increase the precision and logic or their strategic discussions without formally enumerating the detail of the matrices. In conclusion, these simple mathematical techniques may be usefully applied to the analysis and management of competitive business models, resulting in a substantial improvement in the quality of strategic debate and an explicit means of setting strategic objectives.

Summary 1. We can use matrix methods to codify business models making explicit the internal configuration of the business and the interface it presents to customers in a way that is similar to genetic code. 2. The business model can be further quantified using the techniques of matrix algebra allowing volumes, costs, revenues and profits to be determined for the separate components of the business model. 3. A standard form of business model mechanics would allow a new field of business genomics to arise, which classified and explained the appropriateness and success of different business models in different strategic ecosystems. 4. Managers formulate strategy by planning and executing changes in their business model taking into account the context of the business and the business models of competitors.

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5. Addendum: Business model mechanics provide a means for academics to formalise the resource-based and positioning accounts of strategy within a new component of economics covering heterogeneous competition. This approach to strategy would lend itself to quantification and allow the development of a new discipline of strategometrics to complement traditional econometrics.

Questions 1. Can you develop a set of matrices that describe and quantify the business model of your current business? 2. How does your business model and associated matrices differ from the model of your most serious competitor? 3. How has your business model changed over the past five years and how will you modify it over the next five years to achieve greater competitive success?

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Addendum: Strategometrics By using the techniques of business model mechanics, we can address a significant shortcoming in the account of competitive strategy developed by Michael Porter. Foss identified the need for a theory of the firm in strategy research: By ‘a theory of the firm’ I mean a theory that is substantially ‘thicker’ in its conception than the standard neoclassical production view. Such a theory of the firm is ‘thicker’ in the sense that it explicitly views firms as essentially heterogeneous entities, heterogeneity being based on firms’ heterogeneous endowments of resources and capabilities. Without such a theory, it is hard to fully address corporate strategy issues, to understand how resources and capabilities underpin strategies, to address longer-run issues in strategy, etc. (Foss 1996: 18) The techniques outlined here in rudimentary form offer the starting point for such a thick theory of the firm, and as such the basis for a fourth leg to economics to complement industrial organisation, microeconomics and macroeconomics. From a conceptual point of view, let us then explore how the introduction of these matrix models confers a number of advantages. First, users of the models will be able to develop a common representational method to discuss business models. At the moment there is quite a lot of fuzzy arbitrariness relating to the discussion of business models. A standard representation would improve the quality of strategic dialogue. Second, the use of business model matrices may allow academics and advanced practitioners to develop a business model calculus (called strategometrics and complementing traditional econometrics), which includes a notion of the rate of change of a model over time (kinetics) and a consideration of how the model might be changed through interaction with other business models (catalysis). This calculus would also give rise to numerical competitive elasticities that might be used to analyse strategic choice. For example, one might look at changes of market share as a consequence of changes made to elements of one of the constituent matrices that comprise or result from B (such as a change in marketing spend v M0 ). If we hold business strategy to be defined as the change in B over time (S ¼ df dB/dt), we can also make sense of the debate concerning deliberate and emergent strategy: certain aspects of B evolve incrementally, other aspects can be explicitly managed. Consider also the moment of business inception when all elements of B are zero, i.e. at inception at t ¼ 0 we have B0 ¼ 0. Looked at over the period that covers the initial implementation of the business to time t, we can see that the change in the business model over this period is Bt – B0 ¼ Bt, which explains the confusion that sometimes arises when it is said that the business model is the strategy.74 More generally, we could use the overall business model B to moderate an assignment of inputs q to produce a value output vector v, which describes the 74

Joan Magretta (2002) exposes the loose usage of strategy and business model concepts, which this matrix articulation seeks to address.

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particular volumes or magnitudes of applications delivered to different customer groups (in the case of Clone this would be a vector describing a number of desktop publishing (DTP), bookkeeping (BK) and distance learning (DL) applications delivered to different customer groups). Using conjoint marketing techniques to produce a utility scale75 to measure the value attributed to the different applications by different customer groups, we would in principle be able to determine how customer utility U would change across different customer groups as a function of changes in B. In other words our calculus would allow us to see how utility would change within customer groups as a function of changes of business model, i.e. of strategy. This treatment could be further formalised by looking at partial derivatives @U/@B, @U/@D, @U/@R etc. and changes over time d/dt (@U/@B) etc. within the context of investment and return constraints, which would naturally lead to optimisation and analyses of equilibria. In other words, we would have a matrix algebra to analyse the effects of changes in a business model (which describes a heterogeneous choice of operating configuration and of marketing choices), across a heterogeneous interface of applications, which command different levels of utility for different groups of customers — we would have a formal, economic analysis of heterogeneous competition, which did not compress all aspects of competition into competition on price as traditionally occurs in microeconomics. This analysis could be considerably elaborated by using the formal mathematical and statistical techniques now well developed in econometrics. Furthermore, the explicit combination of internal and external business genes in the model B allows us to (i) provide a means to formalise the resource-based and capability views of the firm developed by Barney (1991), Peteraf (1993) and Prahalad & Hamel (1990), among others, and (ii) address the complementarity of the resourcebased/capabilities and positioning schools of strategic thinking.76 We can make sense of the internal elements of the business model matrix in relation to the resource-based and capabilities view of the firm if we extend the matrix approach to explain how the internal elements (P, M, G) of the business model encode a second set of entities (Costs, Activities, Skills and Knowledge). To understand this encoding, we may draw an analogy from the dimensional analysis of physical quantities. In most systems of measurement we have four or five fundamental quantities (for instance, mass, length, time, charge and permittivity, or permeability) and we may represent all other quantities by various dimensional combinations of these fundamental quantities.77 In a similar way, we might describe each of the internal elements of the business model (P, M, G) in terms of particular combinations of elements of cost, activity, skill or knowledge, which we record by structural matrices, just as we did with products, groups, sources, streams etc. In this way, we can accurately describe how resources and distinctive capabilities

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For example, using the packages developed by Sawtooth Software, of Ketchum, Idaho. Leask & Parnell (2005) come to similar conclusions. 77 For a full account of the dimensional representation of physical quantities see Johnson (1997). 76

Business Models

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(considered as a particular configuration of costs, activities, skills and knowledge) are embedded within the business model and how they change over time. Chapter 7 explains the Cost, Activities, Skills and Knowledge (CASK) framework further and describes how it underpins adjacent business development. Within the matrix description of a business model, the two mainstream schools of strategy (resource-based/capabilities and positioning) are represented respectively by the internal (P, M, G) and external elements (D, R, S, V) of the model. Using the matrix methods of strategometrics to describe explicitly both the resources employed in a business model and the customer–supplier interface, we can advance the conceptual framework of the resource-based view of the firm expressed by Peteraf when she stated: In the first section, a resource-based view of the theoretical conditions which underlie competitive advantage is presented. The first of these is resource heterogeneity, from which come Ricardian or monopoly rents. Ex post limits to competition are necessary to sustain the rents. Imperfect resource mobility ensures that the rents are bound to the firm and shared by it. Ex ante limits to competition prevent costs from offsetting the rents (Peteraf 1993: 180]. With regard to the external elements, their relevance to the business model is explained by the role that choices of distribution, revenue and supply play in determining strategic ecology, and assessing structural features of attractiveness within given ecosystems. Were we to possess a complete and accurate set of business models in a given ecosystem we would be in an excellent position to define ecosystem boundaries and to provide a Porter-style structural analysis of ecosystem attractiveness by comparing and consolidating the common external elements (D, R, S, V) of the business models of different competitors within a given strategic ecosystem. Indeed we might be able to formalise the definition of an ecosystem as a matrix product derived from the (D, R, S, V) of the business models of different competitors in the same ecosystem — a Strategic Ecology Matrix, which we denote by X. Similarly, we would be in an excellent position to answer the investigative strategic ecology questions posed in the previous chapter if we possessed (D, R, S, V) information for a number of businesses that we believed operated in more than one strategic ecosystem. The detail of the matrices would permit us to discern the distinct business models used to compete in different strategic ecosystems, and because strategic ecology is based on the external elements (D, R, S, V) of the business models of competitors, we do not need to assume that the competitors share the same internal business model elements (P, M, G) within a given ecosystem: significant differences may exist in the internal elements of the business model of different competitors. The use of the external matrix elements as the basis of strategic ecology would also allow us to develop overlap measures between the strategic ecology matrices X describing different ecosystems. These overlap measures could be used to establish synergy or adjacency metrics, which would be helpful to the analysis of business development into new ecosystems. Finally, we would be able to formalise the relationship between the strategic ecology of two business arenas and the adjacency of these two areas: the matrices used to ground strategic ecology between two

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ecosystems X and X0 , which highlight the differences between the ecosystems, would give rise to inverses, X1 and X0 1, which would capture what X and X0 have in common, thus grounding the adjacency between the two ecosystems. At the most conceptually ambitious level, one might even speculate about the development of a generalised business mechanics, like classical mechanics. It may prove possible to identify the eigenvalues and eigenvectors of the business model matrix B and its components. Like the principal axes of rotation, normal coordinates or principal moments of inertia, in traditional mechanics, the eigenvectors may have a particular significance associated with distinctive competence, or creating a specific axis of competitive advantage or a dominant source of utility for customers.

Chapter 4

Routes to Competitive Advantage The purpose of strategy for a business within a given strategic ecosystem is the appropriation of sustained economic rents sufficient to satisfy the requirements of investors.78 In general, the way to achieve this is by exerting competitive control over the resources employed within the ecosystem through the selection and adoption of a competitively superior business model.

Business Models As we have described in Chapter 3, a business model captures the configuration of a business within a strategic ecosystem through the principal strategic relationships between the business and its suppliers, partners and customers. It describes how this configuration harnesses resources to deliver valued products or services in competition with other businesses. It is possible to formalise this configuration using matrix methods. As we have shown earlier, we can usefully define a model of a business B as B ¼ df ½D; R; S; V; P; M; G where D, R, S, V, P, M and G are matrices describing (i) the external ecosystem interface, and (ii) the internal resource structure of the business. The seven elements are respectively Distribution choices, sources of Revenue and Supply arrangements, the Value matrix covering the variety of product-application combinations provided; Production, Marketing and General/selling/administrative activities. Formally, we may consider business strategy to be defined as the change in B over time.79

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The importance of rents has been well emphasised by Teece (1990: 45) who wrote: Many scholars of strategic management might agree — though they often do not say so — that a key, if not the, key issue is one of how to position and manage the firm so as to generate, augment, and protect ‘‘economic rents’’. 79 The more pedantic may claim that strategy defined in this way does not formally coincide with the definitions given in Chapter 1. The more pedantic are correct, but adopting the principle of intellectual charity, let us understand that when we are talking of strategy we are only interested in those situations where the changes in the business model describe a pattern of behaviour that is consistent and coherent in the pursuit of economic rents to satisfy investors. More deviant quixotic changes in business model are obviously possible and would clearly count as ‘‘strategies’’ too, even if they were not consistent and coherent. We are not interested here in those situations, and we could rule them out by adding to the definition given above a requirement that the changes in the business model conform to the norms of good behaviour. We can deal with the odd-balls later.

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The external elements (D, R, S and V) define the external interface between the business and its ecosystem observable in choices of distribution, revenue, supply and value proposition. Collectively, the set of structural choices made by ecosystem competitors determines strategic ecology, and underpins the attractive or unattractive structure of the ecosystem. In other words, if we possessed a complete and accurate set of business models for all competitors within a given ecosystem, we would be in an excellent position both to define ecosystems and their boundaries and to provide a Porter-style structural analysis of ecosystem attractiveness. We can make sense of the internal elements of the business model matrix (P, M and G) by reference to the resource-based view of the firm propounded by Gary Hamel and others: it is the coded description of the resources that are put to work as activities in the business in order to deliver products and services profitably. The level of economic profit in relation to the employment of these resources is an explicit measure of the success of the business model.80 A resulting advantage of this matrix approach is that the use of an explicit matrix model can help managers to be more precise in their strategic dialogue. For example, we can use the matrix to add flesh to notions such as reputation, architecture, distinctive competence that authors and others have described in less concrete terms as the basis of strategy. From a heuristic point of view, managers can use such models to consider explicitly the differences that exist in their business model relative to that of competitors, as well as a tool to examine possible changes in model available to them. Depending upon the specifics of the situation, we may also wish to expand the matrix elements in B. Sometimes the gain in descriptive precision, however, will be more than offset by a growth in complexity (some long-suffering readers may feel its rather late to be making this point!). Nonetheless, there is one particular expansion of the internal attributes that often merits development, conceptually at least, because it provides a key to business development, and cements the linkage between a matrix account of business models and the resource-based view of the firm. As things stand B only captures the various grouped activities of a company. Other aspects of the distinctive internal configuration of the business used to generate sustainable economic rents may merit inclusion. If we expand the matrix vectors to include assets, skills and knowledge (besides activities), the internal components of the business model provide a methodological hook for determining which ecosystems for possible new business activity have a high degree of overlap, what we call adjacency, with resources that are applied in the existing business model. This question of adjacent business development will be taken up in Chapter 7. The other advantage of including assets, skills and knowledge is that the configuration of these elements captures competences and capabilities, and their change over time can embed notions such as that of dynamic capabilities, developed by Teece and others. This represents further formal integration of the resource-based view of strategy.

80 It is important to realise that these internal elements cannot necessarily be bought and sold in resource factor markets as some economists (e.g. Barney (1986)) have assumed. Typically, these factor markets are incomplete as Dierickx & Cool (1989) point out.


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In talking of business genomics, or business model matrix algebra, it is clear the approach obviously lends itself to analogy with molecular formulae or genetic codes since the model structure captures the basic attributes upon which competitors differ. We can visualise discrete changes of business model in terms of addition or subtraction of atoms in the business model molecule. Externally, this would correspond to adding or taking away products, suppliers, partners, customer segments, revenue streams or distribution channels. Internally, the atoms in a simple matrix business model correspond to activities, which might be taken up, outsourced or eliminated on a product, channel and revenue or ecosystem basis. Business development activities, alliances and joint ventures, reconfigurations or acquisitions give rise to these types of change in business model and hence to a new strategy. Besides decisions that relate to the nodes in the lattice structure of the business model, we can also envisage altering (for example, reinforcing or weakening) the links or bonds between nodes or atoms as a consequence of strategic initiatives or the pulling of strategic levers within the business. The types of thematic strategic initiative or lever one might have in mind are pricing policy; investment in new products, technologies or processes; investment in marketing initiatives; cost reduction; internal reorganisation; new management systems; new leadership; changes in regulatory posture; investment in human resources and cultural change.81 The impact of such initiatives is to reinforce certain linkages within the model, perhaps at the expense of others. When we regard the business model as a type of molecular formula, it is a straightforward step to see how it can be considered to be a type of intellectual property (IP) of the business, occasionally patentable and often a valuable trade secret. We shall return to this view of business models as IP assets in Chapter 7.

Multiple Routes to Advantage When a business is confronted by a set of competitors in a given (strategic) ecosystem, one may ask whether there is one unique optimal strategy (and associated business model) available to the business in order to earn sustained economic rents that are sufficient to satisfy investors. It is the author’s experience, gathered from observing many different kinds of companies operating in many different types of businesses over many years, that in general there are multiple routes to sustained competitive advantage, and multiple associated business models (rather like the existence of several competing organisms in the same ecosystem). The possibility of a plurality of successful business models within a given strategic ecosystem arises from (i) the heterogeneous nature of the fine structure of the economic interface between businesses and customers, as well as (ii) the heterogeneous deployment of resources by businesses competing in the ecosystem resulting from earlier deliberate and emergent differences in the strategies of the businesses concerned.

81

Buzzell & Gale (1987) similarly identified a number of initiatives in their PIMS investigations.

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If we accept that there are multiple routes to success, success then may be sought in relation both to the configuration of resources used by the business (reflected in the business model), as well as in relation to the structural characteristics of the ecosystem to which the business belongs (as we shall see in Chapter 6, these two sets of considerations are formally captured by resource margins). The central question to ask is ‘How can we generate sustained, satisfactory rents from these resources embedded in this business model in this ecosystem?’ This pluralist view stands in contrast to one that holds success to arise from a single, one-and-only route to advantage defined by the optimal exploitation of the structural context of the ecosystem. It is wrong in the author’s experience to think that there is a single optimal configuration of the business model solely determined by (i) the external characteristics of the ecosystem within which the business competes together with (ii) the salient descriptive characteristics of the customers who buy the products or services concerned. Those who would espouse such a view naively place too much confidence in the power of classical optimisation methods. It follows, instead, that the choice of an effective business model (that is one which delivers sustained economic returns sufficient to satisfy investors) of competitor A is therefore not necessarily the same as the choice of an effective business model for a different competitor B in the same ecosystem. A and B have different histories, paths and destinies.

Personal Career Analogy Revisited We may illuminate these remarks by an analogy. Strategy for businesses has a great deal in common with strategy for individuals. Consider the case of career choice. Most graduates probably make a choice of career based upon three main sets of considerations: (i) what they are good at and enjoy doing; (ii) where the best career openings are; and (iii) what other graduates are planning to do. To succeed in winning a particular opening, an individual must be the most compelling candidate compared to the other candidates who apply for that same opening. These three sets of considerations have their business analogues: (i) internal resources and resource constraints; (ii) the structural attractiveness of ecosystems (captured by the growth of and return on resources within the ecosystem); (iii) and the behaviour of competitors. To enjoy success a business must be the most compelling supplier compared to the other competing suppliers when each contested opportunity for a sale arises with each customer. Through the process of satisficing, businesses aim for a pragmatic optimisation of these three sets of factors to produce sustained economic rents. For individuals, we aim at human rewards, what we might term human rents, earned on talent and commitment. In the case of individuals, we quickly recognise both that there is no single career choice that dominates all other options for an individual, and also that there are many different routes to success in life for any individual, i.e. to earning acceptable human rents. We are also very aware from personal experience that often the process of career choice is iterative, ambiguous and mistake-ridden.


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The situation is similar for businesses: given a set of resource constraints, an assessment of ecosystem structural attractiveness and an identified set of likely competitors, there is no single dominant choice of business model upon which success, in the form of sustained economic rents sufficient for investors, is predicated. Instead, there are nearly always several different routes to success for a business. Note that the existence of multiple routes does not of itself confer success: besides choosing a promising business model, a business has to implement it effectively. For both individuals and businesses, one very common source of failure to achieve satisfactory rents, human or economic, stems from the inability to pursue a consistent and coherent strategy on a sustained basis. Very often, individuals and businesses pursue contradictory or disconnected courses of action, with corresponding unsatisfactory results. In the case of individuals, it may take many years before the individual has the experience and honesty to discern the inconsistencies of choice and action. In businesses, the latitude for failure may be narrower, and the intrinsic impediments to a clear analysis of some of the available realistic competitive options are perhaps fewer. Using the human parallel, we can also understand the unruly, confused nature of strategic choice as well as the importance of path dependence. (The analogy is a useful tool: when confronted with some conclusion or finding that relates to strategy, see if it works for humans and careers).

Modes, Themes and Contexts It may appear that we have opened the strategic floodgates. How do we channel and manage the plurality of strategic choices and business models if there are many routes to success within a given strategic ecosystem? Fortunately, we can structure our thinking through the identification of a number of common unifying concepts that underpin those business models that are competitively superior, and through the pragmatic construction of a taxonomy of successful business models and cases. To ground these unifying imperatives we need first to consider how businesses behave. If we accept that businesses often allow us to achieve desired economic outcomes more effectively and more powerfully than markets, it follows that careful sustained observation of businesses may reveal common thrusts or unifying concepts, which are shared by different businesses as they modify their business models over time as a result of deliberate or emergent strategic choice so as to outperform competitors. Experience confirms this is so: we are often able to discern common approaches that explain how businesses get things done, which are causally intelligible, and at least partially predictive and prescriptive. These approaches inform and enlighten our understanding of the appropriateness and effectiveness of the strategy pursued by a given business at a given time in a given structural context. Aspects of the approaches may be replicable or transportable. With this increase in understanding, we can significantly narrow the range of strategic options that credibly allow a business to win competitive control of resources within an ecosystem in such a way as to secure sustained economic rents sufficient to satisfy investors. Hence we are able to usefully

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explain and anticipate the likely choices of strategy that are evident in the observed behaviour of businesses. Particularly useful to our understanding of why particular business models work in a given set of circumstances is an appreciation of modes of behaviour, themes and contexts. The experience curve, as popularised by the Boston Consulting Group, was a powerful strategic concept, well founded upon the observed productivity and learning improvements witnessed in a wide variety of industries. Unfortunately, the widespread assumption that greater relative experience conferred relative cost advantages led many businesses to pursue strategies that were hugely confrontational. In some industries (still comprising many distinct ecosystems) confrontation as a mode of competitive behaviour appeared to pay off (semiconductors for the most part, displays too), but in many others what resulted was a Pyrrhic blood bath (for example, steel, pulp and paper).82 As a practising consultant during this period I became convinced that there were modes of strategic behaviour other than confrontation. Support from this point of view came from the writings of Bruce Henderson, the early leader of the Boston Consulting Group, who had a more pluralistic attitude to competition than some of his adherents. Before a business acquiesces in all-out confrontation, it needs to satisfy itself that two alternative modes of competition are played-out or unavailable. The first is avoidance — through uniqueness or innovation; the second is coexistence. Clearly, these two modes echo the parallels in economics of monopoly and oligopoly. We can use the choice of mode to define the competitive posture of a business. Among the easiest circumstances in which to make money are those where there is established customer demand and where there is little pricing pressure because no other business is able to satisfy customers. Sometimes, unique business solutions arise because only a single business, as a matter of fact, has the knowledge or capability to satisfy demand, but unique circumstances may also arise for legal reasons, either relating to monopolies or patents etc. Here, the ground is well covered by traditional economics. Uniqueness, however, may also arise in a more dynamic, transient fashion in markets that we consider to be well contested. A business may be unique in the sense that no competitor is at that very moment able to replicate the economic capability of that business in the eyes of customers.83 Perhaps, subsequently, a competitor will be able to develop a matching capability, but the starting business may have further enhanced its capability in the meantime. Leadership and pre-emption, research and development, innovation and redefining the strategic ecology may confer lasting nonmonopolistic uniqueness, which may be cashable into sustained, superior returns.84

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See Fruhan (1972). By comparison, too much emphasis is placed by economists on the strict uniqueness of resources available to a company (e.g. Dierickx & Cool (1989) and Barney (1986)) as opposed to their dynamic configuration by a business model in ways that convey a competitive advantage. Often the consequence of the dynamic configuration of the advantage is that the business model is not usefully appropriable by others. 84 Similar thoughts have been expressed and developed by W. Chan Kim & Renee Mauborgne (2005) in their recent book Blue Ocean Strategy, Harvard Business School Press, 2005. 83


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In a coexistential mode, on the other hand, we can envisage non-collusive business model adaptation by competitors as a consequence of serendipity, relative strengths, timing or momentum in the pursuit of opportunity. Such adaptation permits coexistence by minimising confrontation. From a game-theoretic perspective, we can anticipate learned non-confrontational behaviour in a repeated non-zero sum environment. Like birds that live at different levels on a tree, businesses may site themselves in different parts of an ecosystem. Business development and rational expansion may favour the deepening of differentiated behaviour without the presumed backdrop of oligopoly. The birds that now thrive at the top of the tree may represent the survivors from a larger group, many of whom fed less well at other levels on the tree because they were less suited for that set of conditions. Consultancy businesses, for example, reflect this competitive mode: individual firms do develop path-dependent distinctiveness that validates non-confrontational pricing, while the existence of competitors stimulates overall demand for services. Typically, when the differentiation becomes acute, the existing strategic ecology evolves to create a new defensible ecosystem within which there is a pioneer: a new opportunity for a unique mode of competition rather like the splitting of an amoeba cell. Intertwined with the competitive mode of a business (avoidance, coexistence or confrontation), we may identify three thematic sources of competitive advantage within an ecosystem that help us to identify the unifying characteristics of the strategy of the business, as seen in the changes that occur in its business model over time.85 The thematic sources of advantage are relative product advantage, relative price advantage and relative cost advantage. These advantages are not dissimilar to Porter’s notions of niche, differentiation and cost-based strategies. In what follows for the sake of conciseness we talk of products, but the reader is asked to assume the notions apply equally well to services unless explicitly stated otherwise. When businesses enjoy a relative product advantage this often arises from research and innovation, for example Xerox’s first photocopiers. Often aspects of the advantage can be secured as protected IP. Competition based on product advantages is particularly prevalent in the pharmaceutical and biotechnology industries. Other opportunities to establish a relative product advantage may arise from the carving out and definition of new strategic ecosystems within an existing larger ecosystem currently served by businesses and competitors. For an initial period, one pioneering business may occupy the new ecosystem alone — think Apple and iPod. Over time, however, relative product advantages erode as competitors find their way round patents, reverse engineer products and work with customers. To combat the erosion, innovators often engage in product enhancements through quality, functionality and range-extension as the basis of advantage evolves towards relative price advantage. The transition to relative price advantage is often associated with the emergence of a dominant product design that crystallises the key functional

85 The origins of these advantages are perhaps to be found in Penrose (1959: 59) when she wrote: It is the heterogeneity y of the productive services available or potentially available from its resources that gives each firm its unique character.

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Astute Competition: The Economics of Strategic Diversity Figure 10: Brand Positioning Matrix. Digital Timers Price/Utility Matrix

Brand Leader

Commodity

Exit

Utility

Value Leader

Price

features of the product. In the case of personal computers, for example, the IBM 286 PC emerged as a dominant design, and competition passed from pure product innovation to features and quality advantages. Relative price advantage applies to those competitive situations where a business achieves a higher realised revenue per product relative to the products of competitors, because the products of the business are better conceived, of higher quality, more widely available, better known, better supported etc. In the pharmaceutical industry, the switch to pricing advantage is often associated with product line extensions: for example a time-release version of a drug, a child’s variant, a larger-dose version, a version for older people, alternative brand names etc. Many of Apple’s products, for instance, seek to obtain a pricing advantage based upon their design, functionality and ergonomics. Relative price advantage clearly echoes the emphasis placed on quality by ecosystem leaders discerned by Buzzell and Gale in their PIMS work.86 Branding is often used to sustain a relative pricing advantage aiming to convey to the purchaser either explicitly or tacitly the superior attributes of the product. Often specific strategies can be developed from a precise understanding of the relative price and utility rankings of products as determined by conjoint market research techniques that quantify the value of different product attributes. Figures 10 and 11 show the application of these techniques to digital timers. For the brand leader to be successful, the cost of supplying the attributes, which customers value highly must be sufficiently less than the revenues obtained from selling the product to generate returns that satisfy investors. For the commodity player, a minimal product may not require many of the expenditures of the brand

86

See Profit impact of marketing strategies, Buzzell & Gale (1987).


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Figure 11: Utility-Price Product Performance. 1280 SCALE

1270 1260

$1M

ND 136

1250

US 42+

1240

SON 132+

EPO-BASE

1230 US 48

Utility

1220

US 42

SALES

EPO-FULL

MAR 1

1210 US 7+

1200

CO004

US 10

MAR 1+ CO004+

1190 1180

SON 122

1170 US 7-K

1160 1150 1140 4

6

8

10 Price (Thousands of Dollars)

12

14

leader, and in spite of suffering a relative price disadvantage the business may be viable. The other positions on the price-utility matrix are unstable and likely to prompt change: the value leader is likely to gain share and threaten the brand leader, and the bottom-right hand quadrant is consistent with business exit.87 In terms of pricing dynamics, economists have looked at ‘‘tit-for-tat’’ pricing strategies in the context of repeated competitive games, and established that it is possible for firms to coexist indefinitely in a relatively benign pricing environment even if both firms are profit maximisers. This provides theoretical support for the coexistence of firms that each pursues a relative price advantage based upon a particular choice of a bundle of attributes. Relative price advantage can also be secured by shifting ecosystem boundaries. Where a business can cost-effectively integrate new functions or capabilities into its products, opportunities exist to redefine ecosystem boundaries. For example, to offset continued price erosion in its printer business and the emergence or solely costbased competitors, Hewlett-Packard has developed a range of printer products, which also photocopy and scan documents — a ‘‘photoscinter’’ — which pulls in features and technical capabilities previously located outside the consumer printer

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The use of these types of analyses has been well expounded by David Faulkner & Cliff Bowman (1995).

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Astute Competition: The Economics of Strategic Diversity Figure 12: Relative Cost Advantage. 'A' 'S Relative Cost Position Materials 15

Production Overhead

Percent of Sales

10

Production Labour 'A' Advantage

5

Marketing Discounts

0

'A' Disadvantage

(5)

Distribution Depreciation

(10) 'B'

'C'

Administration Selling

ecosystem. More resources are pulled into the ecosystem justifying higher prices than would otherwise be obtainable. When the rate of growth of customer demand begins to diminish, we often witness a shift to competition based upon cost advantages as designs stabilise, a small number of winners dominate and quality and support levels become common across the ecosystem. In the pharmaceutical industry this often coincides with drugs coming off patent when generic manufacturers enter production. Figure 12 shows the results of a detailed analysis of relative cost positions carried out for a large food manufacturing company. Such an analysis may involve several man-years of effort. When advantage is based predominantly upon cost, businesses typically are price takers, and businesses generate profit growth through a variety of cost-reduction techniques. Overhead value analysis, best-demonstrated practice, zero-base budgeting, valuechain reconfiguration, business process re-engineering are some of the common means to reduce cost. We can observe the transition from relative product to relative price to relative cost advantage in many industries, a dynamic consistent with Booz Allen’s life-cycle approach to business evolution. These three thematic advantages often coincide with the modes of behaviour that define competitive posture: avoidance with relative product advantage, coexistence with relative price advantage, confrontation with relative cost advantage. The linkage between mode and theme, however, is not a necessary one, and occasionally


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businesses adopt an unusual combination — for example, a joint-venture proposal to collaborate with competitors from an innovator, perhaps justified in order to stimulate greater demand from customers. This emphasis on collaboration might be particularly important to ensure the innovation gains acceptance where the business confronts complementary assets, strong network effects or an existing ecology of companies who have a strong vested interest in the status quo (for example it may make more sense to enlist Microsoft’s support with a software innovation instead of trying to displace a competing Microsoft application).88 To complete our account of the generic commonalities of many business strategies, we need to add an understanding of context, which derives from the ecosystem characteristics and the behaviour of ecosystem participants. It is the author’s experience that particular contexts favour particular combinations of mode and theme, not exclusively but to such a degree that we can offer good explanations as to why particular strategies work and others do not: the successful ones employ a mode and a theme that is well suited to the context. This is a commonsense outcome, which clearly lends itself to human and biological analogies. Senior managers and strategy consultants develop over their careers a repertoire of observed combinations of mode, theme and context, which they apply after adaptation to the specific competitive situations they confront. Some of these combinations have been given names such as The Experience Curve or Time-Based Competition, Total Quality Management or Open Innovation. One useful task in the development of strategy as a discipline is the compilation of a suitable taxonomy and enumeration to fill out the repertoire (as happens in good measure in Harvard Business School cases). Table 1 provides some examples of different types of business and a description of key aspects of the associated context. These examples represent a very small subset of the totality of business types and their associated contextual characteristics. To avoid the labour of a full compilation we can adopt a taxonomical approach to the identification of similar businesses and contexts in the same way that botanists for instance distinguish between flowers with four and flowers with six petals. The business model codification presented in Chapter 3 suggests that it may be possible to develop a discipline called business genomics, which might provide the underpinning to this taxonomy of businesses and contexts. Such classifications will often be a matter of judgement, however, and will be subject to evolution over time, but managers and consultants do employ explicit or implicit taxonomies to guide their actions and formulation of strategy because of the explanatory power these taxonomies provide. Disputes will arise but managers will be guided by the powerful, commonsense requirement of how well the contested frameworks fit the observed facts of competitor behaviour. As a guide to how these concepts might be developed and applied, Table 2 distinguishes certain generic contexts and suggests the common themes that

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Brandenburger & Nalebuff (1996) have dubbed this type of behaviour co-opetition, where the benefits of a greater pie often outweigh the attractions of a larger slice.

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Astute Competition: The Economics of Strategic Diversity Table 1: Businesses and Contexts.

Business

Ecosystem Context

Natural resource businesses: minerals, oil and gas

Very high entry/exit barriers, exogenous uncertainty of demand, volatile economics, leverage, oligopolies and alliances

Manufactured commodities: textiles, chemicals, fertilizers

Medium to high entry/exit barriers, cost reduction, capacity and cycle management, process innovation

System-based consumable businesses: fruit juice packing, printers

Low entry/high exit barriers, penetration marketing, maintenance of installed park, internal operational systems

Logistical businesses: containers, specialist trucking, auto delivery, airlines

High entry/exit barriers, stable demand, operational and system complexity, topology and loading, complex price and service factors

Consumer businesses: food, clothes, beverages

Medium entry/exit barriers, fluctuating demand, product development, production management, advertising, branding, promotion

Intermediary businesses: trading, broking, merchanting, investment banking

Low entry/exit barriers, rapid product service evolution, virtual markets, networks, volatility, fragmentation, spontaneity

Knowledge businesses: journals, databases

Low entry/medium exit barriers, unstructured demand, distribution plays and promotion, critical mass economics, creative knowledge

Professional businesses: lawyers, accountants, consultants

Low entry/exit, cyclical demand, Human Resource Management (HRM) and operational leverage, concepts and innovation, branding, reputation, networks

predominantly characterise the routes businesses follow to secure a sustained competitive advantage in those contexts. Note that placing an emphasis on common underlying themes is not inconsistent with the view that there are multiple routes to advantage. We observe that often the context favours certain routes over others, but there is not a single route, nor a ‘‘correct’’ strategy. Rather, observation shows that companies behave similarly to some extent when faced by a given generic situation, which is not to say that they all


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Table 2: Contexts and Advantages. Ecosystem and Competitive Context

Source of Advantage

Immature Innovation or pioneering Pre-emption possible Lacking precedents or learning

Relative product advantage First mover advantage Experience effects

Volatile/kaleidoscopic/dynamic Hustling Time-based

Fleetness and agility Speed

Stable Positioning fluidity Established needs and players Informed distinct customers

Relative price advantage Core competence alignment Differentiated ecosystem strategies

Mature/declining Strategic cost reduction End game

Relative cost advantage Manipulation of economic outcome

Asymmetric Location/access driven Distribution driven

Inability of others to replicate Unattractive duplication costs

Weaker players Niches available Reconfiguration possible Strategic focus

Specialisation Strategic leveraging of resources Deterrence arising from focus

behave the same.89 We also need to bear in mind that businesses do not often encounter these contexts afresh and unencumbered. The path dependencies of businesses will heavily influence their degrees of strategic freedom and explain why they behave differently to their competitors, even in circumstances where we are able to discern the source of advantage that a completely new business would pursue in that context. The final three entries in the table are not strictly contexts, but describe the situations often faced by followers. The purpose of the table is not to be exhaustive,

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Richard Nelson (1991: 9) echoes these thoughts: If one thinks within the frame of evolutionary theory, it is nonsense to presume that a firm can calculate an actual ‘best’ strategy. A basic premise of evolutionary theory is that the world is too complicated for a firm to comprehend, in the sense that a firm understands its world in neoclassical theory.

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but to give examples of the sources of advantage available to businesses in different ecosystem/competitive contexts. As mentioned above particular combinations of competitive mode, theme and context have been given names, for instance ‘‘Core Competence’’, ‘‘Strategic Leveraging’’, and we may liken them to the use of syndromes or complexes in psychology (for example, Munchausen’s syndrome). It is important when using such terms not to forget their particular origins and the limits of their scope of their applicability.

Competitive Control of Resources Let us return to the opening paragraph of this chapter: the purpose of strategy for a business within a given strategic ecosystem is the appropriation of sustained economic rents sufficient to satisfy the requirements of investors. In general, the way to achieve this is by exerting competitive control over the resources employed within a strategic ecosystem through the selection and adaptation of a competitively superior business model. Echoing Bruce Henderson, in broad terms competitive control means control of the access and use of the resources required to compete successfully.90 Working backwards through these statements, we may observe that we (i) have explained what a strategic ecosystem is, (ii) will explain in the next two chapters how sustained economic rents arise and how investors value them within the framework of the CAPM, as adapted for returns on resources, (iii) have given an account of what a business model is, and (iv) have explained how different models may be competitively superior by conferring different types of relative competitive advantage. What remains to be done is to unpack competitive control of resources.91 A business may be said to exert competitive control of resources if (i) it is able to control the return on, and growth of, its own resources; and (ii) it is able at least to influence the return on, and growth of, the resources of its competitors. For those who prefer the term value-added, the variables of control are the profitability and growth of value-added. Evidence of this control is the ability a business has to set prices, to resist cost and margin pressure, to design products and services that require resources, which are rewarded by customers, to capture and employ resources and activities and to

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Similarly, Mahoney & Pandian (1992: 364) state more passively: The existence and maintenance of rents depends upon a lack of competition in either acquiring or developing complementary resources. 91 In advocating the competitive control of resources, a strong distinction can be drawn with the work of Barney (1986) who attributes the sources of return in a business to its ability to buy the resources that comprise its business model in strategic factor markets. If there are imperfections in these factor markets, Barney attributes these to deficiencies in the information relating to expectations, or luck. Not only does such a view presuppose that such strategic factor markets exist, it also attributes no value to innovation, dynamics or business model architecture. Barney erroneously concludes that reliance on publicly available information will deliver normal profits when resources are acquired, and that quasi-rents only arise from informational advantage or luck.


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increase those resources and activities though growth in demand and through increases in share. Lack of control is evident in the inability to set prices, in the imposition of cost and margin pressure, in the loss and ceding of resources and activities, in the decline in resources and activity through loss of demand and of share. The degree of control for a business may extend from marginal interference to dominance of its competitors’ choices. From the point of view of making money, the more control the better. Businesses that select and adapt a superior business model will enjoy a competitive control of resources evident in pricing and costing behaviour that results in returns on, and growth of resources, higher than those of competitors. Why is control important? Because it allows a business to appropriate a larger share of the ecosystem economic rents available: less goes to competitors. This makes it easier for the business to earn a high and growing return on resources, all the easier to satisfy investors. How does a business establish control? We need to be more specific practically and conceptually. Equipped with a good ecosystem map, a fairly fully described business model of her own business and of one or two major competitors, a manager needs to consider the consequences at the customer interface of changes in her business model. These changes may be incremental, or more wholesale. To determine the consequences, we first require a good understanding of (i) the threshold requirements of customers; (ii) the purchasing criteria of customers according to which a supplier is chosen from the subset of suppliers that meet the customers’ threshold requirements; (iii) the relative standing of different suppliers in relation to these criteria; (iv) the buying process that customers typically follow; (v) the relative importance of different customers. Some of this information will be readily available, some will not; some of it will be relatively hard and quantifiable, some of it will be more subjective and incomplete. Market research methods, including conjoint techniques, may help to draw out the principal findings from customer responses. What is particularly important is to understand what elements of the marketing mix (product, price, promotion etc.) would be most highly valued by customers, allowing us to identify what Kenichi Ohmae, the former leader of McKinsey in Japan, popularised as Key Success Factors. Most companies do not undertake this kind of analysis preferring arms-length, third-party market data that is not specific to the individual company’s performance. The cost of this information is a factor, but one may legitimately infer a cognitive bias that ignorance is bliss. Once the customer information has been made useful, the task then is to identify how the business model might be adapted so as to deliver greater success in the eyes of the customers without compromising financial returns. The manager should seek to find business model changes that cannot easily be matched by competitors thereby conferring sustained relative advantages. Greater success with customers will reduce the strategic degrees of freedom of competitors, and on the back of a crafty business model, will deliver good returns allowing the business to grow its profitable resource base. All of this is obviously easier said than done. Within the confines of the existing strategic ecology, conceptually we can separate changes to the business model that maintain the current business–customer interface,

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and those that attempt to change it. The former are related to changes in the business model that improve operational efficiency and resource effectiveness. Michael Porter got it wrong when he claimed that the pursuit of operational effectiveness is not a strategy. Year on year some businesses just keep grinding out modest operational improvements by tweaking their business models. Just think of many capital-intensive process industries. Viewed over twenty years, we can discern significant changes in their business models and hence significant strategic change. Whether we assess the magnitude of change in the business model at any given point in time to be strategic or tactical is a question of judgement in any given case, but certainly those executives who are zealously pursuing business process re-engineering believe they are implementing business strategy. Where the changes in the business model are directed towards the business–customer interface, the business has the variables of its marketing mix at its command — whether four P’s, seven P’s or the 12 P’s that Borden92 originally considered as characteristics of the exchange between a business and its customers. If we focus on the four P’s, usually we are talking about changes in the business model that relate to a redefinition of product, or price, or marketing support (promotion) or how the product is delivered to the customer (place). Product redefinition may relate to functionality, quality, customisation or extension — all of which change what the customer is buying. Pricing covers how a customer pays for what he has purchased within the duration of his relationship with the business, and as discussed in Chapter 2 this is not adequately covered by the economist’s idealisation of ‘‘the price’’. Marketing support includes branding, delivery and after-sales support, all of which can be redefined through changes in the business model. Similarly, sales and distribution choices will affect how the product is delivered. The key message to deliver is the active consideration of how the mix might be redefined advantageously. Changes at the customer interface cannot be credibly entertained without a costing of proposed changes to the business model. We say costing rather than cost because of the elusiveness in most business situations of a simple notion of the cost. In the early 1980s the author was involved with a major new business initiative within a pan-European company that was clearly successful according to the marginal or incremental costing upon which the initiative was predicated. The success became so great, however, that fuller costing of overhead was imposed on the initiative by the company, with the result that the initiative was then subsequently constrained by a reduction in investment because the mid-stage full margins were moderate. As a result, competitors were given a breathing period, and the company failed to achieve the dominant position of leadership that would have generated significant fully costed profits. This example shows how it is important to think of explicit strategic choices as commitments to a path over a period of time where success is to be judged in relation to starting and end points. Assessment, crosssectionally, at a particular point in time may make managers draw inappropriate conclusions as in the case of the example.

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Borden (1964).


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A prerequisite of all of these methods of changing elements of a business model is a good understanding of the causal linkages that determine how suppliers, competitors and customers interact. For instance, if we note that in a particular business end user preferences determine installation timetables and that as a consequence lead times are often lengthy and variable, it will probably not make much sense to introduce changes to a business model, which place heavy emphasis on very rapid delivery times. What might be much more important is to have a system of communication with users that allows a business to respond dynamically to their shifting schedule preferences. Understanding the causal story is important. In the early days of the Internet few people were able to explain the linkages between advertising, promotion and web purchasing behaviour, and more generally how to ‘‘monetise’’ web activity — in simple language, what caused what? This led to a plethora of business models and much ill-informed speculation. Today, based upon a much deeper understanding of causal mechanisms, it is possible to identify a taxonomy of viable business models depending upon the topology, product and traffic characteristics of web-intermediated exchange. To obtain a good understanding of the causal linkages requires in-depth exposure to customer and competitor thinking so that one can explain why customers behave as they do, as opposed to simply observing how they behave. A well-articulated causal understanding of its customers allows a business to anticipate well how customers are likely to respond to business model changes. If the adopted costing supports the proposed changes to the business model and the causal consequences of the changes (i) on all the remaining constituent elements of the business model, and (ii) on customers and on competitors, have been well thought through and endorsed, then managers may move to implementation. In some situations managers may have sufficient information to construct an integrated strategic model of their business that explicitly links changes in product or service attributes to their customer, and ecosystem share consequences. Figure 13 shows the principal components of such a model. By using conjoint techniques, managers can determine the relative utility of the offerings of different competitors. Using a dynamic purchasing model that reflects product or service lifetimes, purchasing frequency and purchase probabilities, relative utilities over time can be used to project market share evolution. By using projected pricing data with share and volume forecasts, managers can project revenue. An operational model that reflects deliberate choices of attribute is used to capture the cost consequences. Clearly, an integrated model is costly to build, and will only provide useful output if the assumptions about customers, competitors and operations are sound. One situation where it proved to be useful was in the design of the business model for G3 wireless services in the UK in order to support the bid made by one of the successful applicants for the operating licences, which were auctioned for several billion pounds. Assuming investment in the model is warranted, and the assumptions are reasonable, the outputs can be summarised in terms of the change in profit, market share and customer satisfaction (utility) that arise from specific identified business model options. Equipped with knowledge of the profit, share and satisfaction consequences, managers

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Astute Competition: The Economics of Strategic Diversity Figure 13: Integrated Strategic Model. Choice of attribute values & prices

Conjoint calibration of attributes

Competitor attribute values & prices

Relative utilities

Purchasing model

Bass or other penetration dynamic

Projected shares

Operationalisation of attributes

Projected costs

Projected revenues

Projected profits

may select strategies that offer an acceptable trade-off between profit, share and customer satisfaction as a new business model is implemented.93 Managers can adopt a number of methods to generate new business models: incrementalism, systematic permutation-driven enumeration of possibilities, brainstorming, collective participation, external comparison, zero basing and third party referral are among the best of them. The essence of the process is creativity, innovation and synthesis, for which there is no unique deliberative procedure for success. The author’s starting bias with a client is usually to select a complementary mix of

93 A given set of profit-share-satisfaction trade-offs would constitute a strategy plane in a three-dimensional framework defined by profit, share and customer satisfaction axes. An acceptable business model would lie on this plane and acceptable business model changes would ideally map out a path within the plane (unless a competitive breakthrough allowed the business to move to a radically higher level of profit on a parallel plane).


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structured and unstructured approaches. Generally, it is not a problem to generate new possibilities — what is more difficult is thinking through causally how any new model will affect customer behaviour, and how customers and competitors will respond. This is important because successful managers, like chess players, need to anticipate rounds of response. Figuring out the end result for the incumbents, and then adjusting the business model so that the incumbents are not unduly threatened by elimination may, for instance, allow a business model innovation to gain acceptance. Sometimes it is possible to find business proxies or surrogates that may provide useful information about the response of customers, competitors and suppliers. These sources of information may be supplemented by brainstorming and by discussions with favoured suppliers, partners or customers, many of who will be keen to see improvements in a company’s business model. One general conceptual trigger for business model engineering is a review of the criteria used to establish strategic ecology. Readers will recall that ecosystem barriers establish an enclave that excludes all but the handful of businesses that become ecosystem competitors. These barriers reflect differences in the way the business activities of the ecosystem are configured relative to the way activities are configured in other strategic ecosystems, and these differences between ecosystems confer the potential for businesses to make adequate returns. We can extend this line of thinking a stage further to ask whether the same criteria can help us identify differences that could be created within the ecosystem by a new business model in such a way as to allow the creator to enjoy superior returns. Logically, we are exploring whether we could effectively establish a new (sub)ecosystem within the existing ecosystem on the back of a business model innovation. If the new business model allows us to create advantages through differentiation, this may give rise to defensible competitive barriers that are sometimes called mobility barriers by economists. A review of the twenty strategic ecology criteria developed in Chapter 2, provides a business with twenty potential axes for differentiating its business model: for example, changing product, changing competitor focus, changing profitability, changing distribution, changing promotion, changing geography, changing management priorities. It follows that the differences in economic activity captured by the strategic ecology criteria that give rise to the emergence of distinct strategic ecosystems can also be harnessed to create new business models. In other words, there is a clear conceptual linkage between strategic ecology criteria and the sources of competitive advantage. The basic message is being different is the way to make money. In years to come, if the approaches to business models and business genomics laid out in this book are held to have some validity, researchers may develop comprehensive compilations of business models, localising their potential success and describing how they extract rents from customers. Educators might help to make prominent types of model known to their students as they now do with the forms of organisation such as the M-form multi-business structure first researched by Alfred Chandler, the business historian. When contemplating business model adaptations, managers might have access to a richer stock of recognised variants. Since business model formulation will still require innovation and creativity, the availability of a set

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of template models is unlikely to lead to sustained competitive superiority, but may allow managers to avoid some of the more inept failures evident in the past. Usually, a manager will select a small number of new business model initiatives, which can be costed and projected over a sensible medium-term horizon, typically three or four years, often coinciding with the business tenure of the manager herself. Various types of scenario analysis and modelling technique may help to inform the manager with regard to the choice of alternatives. The value of such exercises, however, typically lies more in the heuristic value that resides in the models’ business linkages, than in the ability of the models to provide accurate future projections. Analysis gives rise to questions. For instance, the models often provide a means of surfacing counter intuitive outcomes and unintended effects. They help managers to examine the causal underpinnings of their business. The use of models and a selection framework will be discussed further in Chapter 9, where they are applied at a higher level of business selection and portfolio management, but the same techniques largely apply to selections of alternative business model initiative. Like the entrepreneur of a start-up business, it is important for a manager to seek feedback upon the proposed changes in the business model and, if at all possible, to test the proposed changes incrementally through trials, prototyping and limited market initiatives. In many businesses the progressive changes that occur in business models are the result of steady fine-tuning of the basic model over long periods of time rather than a reflection of instances of blinding insight on the part of a particular generation of managers. Henry Mintzberg captures this steady reformulation of strategy when he talks of crafting business strategy. Continuing the entrepreneurial parallel, one might also consider the business model to be an explicit IP asset, rather like a patent, copyright or formula. Sometimes such assets represent breakthroughs, but more often than not, they represent incremental improvements. As product and process development paths for traditional IP become better understood and managed, we can contemplate adapting techniques, processes and tools developed in these areas to the management of the process of new business model development: definition, project planning, testing and modification routines may all become appropriate for the systematic management of business model IP. In contemplating which of several strategic initiatives should be pursued, managers will clearly wish to make trade-offs concerning returns on resources, investment and the likelihood of success. The existence of resource constraints will limit the scope of possible changes to the business model. Clearly, the greater the resources that are available to a business, the greater the possible strategic degrees of freedom it may be able to exert. Success provides further resources creating additional options to exert competitive control over a business’ own resources and over those of competitors: we want to hem our competitors in and deny them initiatives that we are free to pursue. Viewed in this way, we can see that strategy involves a pragmatic, incomplete attempt at optimising a business model within the constraints imposed by resources. It is incomplete and pragmatic because the world is opaque, does not stand still and managers are human. One further factor that often gets overlooked in formal appraisals of strategic initiatives is that of path dependence. On the one hand, business managers must fight


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to overcome the enslavement imposed by earlier strategic choices; on the other, it is all too easy to lose a large amount of money trying to shift in a radical fashion the business model of an established business. Often it is possible to discern key elements of the business model of a successful competitor, and to move unthinkingly from this position of observation to one of emulation or duplication. Similar things happen in life: it is all too easy to engage in wishful thinking and envy those on a different path. Many new strategic initiatives fail because the resources and competences, upon which a successful competitor’s business model are based, are inaccessible, unavailable or poorly embedded in the business that is striving to improve its competitiveness. This is not a surprise — it is usually a direct consequence of the competitive success of the admired business, which as we have discussed, is predicated on their competitive control of resources, which means denying them to others: their competitive control of resources means that some paths are simply not available to others. Bearing in mind that one cannot simply hop onto the path pursued by another, it follows that the selection of the most appropriate strategic initiative for a business must be framed by a careful consideration of the path the business is currently on.94 Path dependency also sheds light on the importance of uniqueness in a business model. Many advocates of the resource-based view of the firm place considerable emphasis on the irreplicability and inimitability of the resource configuration of a successful business and often assert that uniqueness is a sine qua non of success. Often this emphasis is overstated, and usually for one of two reasons. First, competitors will in due course copy aspects of the business model, but in the meantime the pioneer will have further modified its model. The pioneer’s model is unique only in the sense that at any given time only one company employs that model: no one else has yet taken that path. The second reason to consider the emphasis misplaced is that often it does not make sense for competitors to imitate or replicate the model of the pioneer given the specifics of their own current business models and the paths they are on. The pioneer’s model retains a certain uniqueness not because it cannot be reproduced but because it does not make sense to do so. Finally, we may often observe that in many cases the success of a business model lies less in its constituent resources, which may be generally available, but more in how the resources are integrated and applied — not necessarily the novel combinations of resources envisioned by Schumpeter, the economist who believed in the creative destruction of innovation, but the savvy ones: think again about nexus management, and getting the pieces of the model to fit and stay together. The bottom line is that successful models more likely depend upon being different from those of competitors rather than unique in a lasting ‘‘curiosity’’ sense. Recognising the constraints of one’s own path is not an excuse for hopelessness. The same arguments also work in reverse and businesses can take advantage of the

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Teece et al. (1997) have described similar notions to these stressing how companies often compete through the management of their dynamic capabilities.

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momentum and path dependencies of others. To the extent that a business can exert greater competitive control and thereby win a greater share of the economic returns within a given ecosystem, existing path dependencies will make it difficult for other businesses to switch the path they are on to counteract the damage inflicted by the exercise of this greater competitive control. What is required is judicious selection of the best strategic initiatives that are assimilable by the business given the path it is on and the trajectories of others. Good managers usually have a feel for this. Since businesses confront radical shifts in technology or competition from time to time, it is also important to realise that even successful business models have their sell-by date. Faced by this possibility of a cognitive trap, managers should not let their recipe for success also be their recipe for failure. A successful business model will permeate the thinking and perceptions of management. For a significant period of time reliance on incremental changes to the model to deal with changes in ecosystem or competitor behaviour will be warranted — after all, the model has a track record of effectiveness in dealing with challenges because it is recognised as a successful model. This incrementalist approach, soundly based on inductive principles, may leave management vulnerable to more radical change. Rather like Bertrand Russell’s chicken, which assumed day after day that it would continue to be fed and watered, the day may arrive when the historic pattern is abruptly halted — in the chicken’s case it occurred in the form of a casserole. While managers steeped in the existing model may be able to call correctly the relative priorities of marginal actions, for instance, the benefits of a new advertising campaign relative to new packaging, it may be extremely difficult for them to recognise the priorities of new actions from scratch: for instance, move the business entirely on-line and source supply overseas. Psychological, financial and organisational commitments reflected in the existing model may constrain the breadth of business thinking. Up to this point, in considering how to compete more effectively, we have implicitly restricted the discussion to possible changes to the business model that are largely internal to the business. When confronted by a successful entrenched competitor, comparisons of existing business models and path dependencies may suggest only limited room to manoeuvre strategically. There are, however, a number of other sources of competitive advantage available, as has been touched upon in the preceding pages. Four specifically come to mind. First, it may be possible for a business to secure and maintain an asymmetric advantage. Perhaps this advantage arises from ownership of a particular asset, resource or capability, which is strictly limited by supply and which is particularly beneficial to the conduct of the business. For example, one might think of a fortuitous, historical distribution exclusivity, which enables a weaker competitor to make, what at first sight seems to be anomalous levels of financial return. A second possible response, highlighted by Drucker,95 is to employ what he calls entrepreneurial judo to catch or force a competitor off-balance strategically. What Drucker has in mind is the ability of some businesses to convert the superior resources

95

See Drucker (1985).


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and assets of their competitors from an advantage into a liability. As an example of this, one may consider the retail scales business. In the late 1970s, the development of load cells allowed manufacturers to produce retail scales that required very little servicing or maintenance. As a consequence of the introduction of these more accurate, low-cost scales, a number of the existing major scales manufacturers suffered severe financial distress because their servicing organisations, which hitherto had been a strong source of recurrent revenues, became a major cost liability. Often though, such a strategic initiative is only available to a new entrant to the ecosystem. In Chapter 2 we discussed the ability of businesses to reconfigure ecosystem boundaries to their advantage. This might take two particular forms: first, the delivery of new capabilities, functions and added value to customers may extend the ecosystem boundary itself; second, the ecosystem may be cut into pieces. Viewed through the lens of game theory, we may regard this form of redefinition of the strategic ecology as an attempt to change the game played against competitors that is implemented through an altered business model. As Nalebuff and Brandenburger have explored in their co-opetition concept, such changes of game may create new win-win outcomes sometimes involving the conversion of competitors into complementary elements of the new business model (in terms of the business model, a radical change of nodes). Extensive redefinition is tantamount to tearing up the map of competition in which existing paths are cut. More modest changes in business model may similarly represent attempts within the current game to modify the rules advantageously. The second form of ecosystem redefinition cuts an existing ecosystem into a number of pieces, thereby establishing new ecosystem boundaries, defended by the altered business model of those competitors that choose to specialise upon particular functions or customer groups. In this way, focus may allow a business to overcome the strengths of the business model of another competitor whose past success may subsequently inhibit its ability to defend itself against the change in strategic ecology. Splitting the commercial airline market between business and tourist users first seemed to offer higher returns to incumbents because of the associated price discrimination of ticketing. Unfortunately, it also permitted eventual ecosystem redefinition and allowed the emergence of low-cost budget airlines with operational and logistical focus on a particular set of destinations. The well-adapted business models of these new entrants have undermined the profitability of the incumbents. Finally, path dependencies and the business models of competitors cease to be relevant to competitive success when (i) we are dealing with a true innovation where paths have yet to form and the business model of the innovator is unique (for example, Apple’s i-Tunes Internet juke-box business in 2004); and (ii) where many paths are being followed concurrently. As an example of the latter, we may think of businesses characterised by short-lived product or service innovations that are easy to copy and transient: think of investment banking or trading activities, well described by Bhide’s notion of strategy as hustle.96 Inspection of Table 2 provides a

96

See Bhide (1986).

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description of the kind of context where asymmetrical, hustling and pure innovation may characterise business model choices. In summary, the competitive control of resources is achieved by modifying the components of the business model in such a way as to outperform competitors at the customer interface. This will allow a company to win business, extract profits and build its own resources within an ecosystem at the expense of its competitors who will find it increasingly difficult to unwind or unpick the elements of business behaviour that have conferred success. The measure of success is the appropriation of sustained economic rents that keep investors happy. Note that this is not the same as creating the absolute greatest value, what economists call the consumer surplus, for the customer, and counting on making a profit from their happiness that may or may not keep your investors happy. (One of the great early challenges of the Internet was getting customers to pay for things that they had been used to getting for free, i.e. making a profit out of the consumer surplus). There is a balance between satisfying your customers and your investors. Businesses need to be able to appropriate economic rents on a sustainable basis that customers are content to pay. If you can appropriate greater rents sustainably than your competitors, you will keep your investors happy: you will prosper; your competitors will decline.

Conclusion The purpose of strategy for a business is the appropriation of sustained economic rents sufficient to satisfy the requirements of investors. In general, the way to achieve this is by exerting competitive control over the resources employed within a strategic ecosystem through the selection and adaptation of a competitively superior business model. In this chapter we have explored the specific steps a business can take to adapt its business model to produce greater economic rents, and explained the types of modification that generally might occur.

Summary 1. For any given business within a strategic ecosystem there are multiple routes to competitive success but they all involve the securing of different types of economic rent that arise from the competitive control of resources exerted through relative product, price or cost advantages. 2. Competitive behaviour and the selection of an effective business model will be shaped by the mode of competition, by the thematic sources of competitive advantage and structural characteristics that prevail within the relevant strategic ecosystem. 3. Discernible common themes exist that explain how businesses assert competitive control, which are causally intelligible, and at least partially predictive and prescriptive.


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4. To exert greater competitive control of resources within an ecosystem, managers can modify either the internal resource structure or the external ecosystem interface of their current business model. The latter involves cost-effective redefinition of the marketing mix. 5. The differences in economic activity that give rise to strategic ecology can be harnessed to create new business models. The basic message then is being different is often the way to make money. 6. Redefinition of the strategic ecology and innovation may allow a business to overcome the constraints imposed by path dependency and by the control over resources exerted by competitors. 7. Business models are a form of IP that needs to be maintained and enhanced, but sooner or later they will reach their sell-by date when they become the recipe for failure not success.

Questions 1. For each of the businesses in which you participate, can you describe the mode of competition that prevails, the thematic sources of competitive advantage and the structural features of the associated ecosystems? 2. What evidence can you provide for each of your businesses to demonstrate your competitive control of resources or lack of control, and can you explain causally why you or your competitors are able to exert this control? 3. What methods do you employ to review, appraise and innovate business models, and how new, old and path-constrained are your existing business models? 4. What scope exists to modify your business models by (i) changing their customer business interface, (ii) internal reconfiguration of activities and resources, (iii) business redefinition arising from a fresh application of strategic ecology criteria?


Chapter 5

Economic Rents According to classical economics, the advantages that a business enjoys, unless it is protected by monopoly or stable oligopoly, will be eroded by competition until only normal profits sufficient to cover the costs of capital remain. How then can we expect businesses to enjoy sustained competitive advantages that result in superior i.e. nonnormal profits that endure for considerable periods of time? The answer lies in the ability of the business to generate abnormal profits by extracting different types of economic rent from its activities that are sustainable. Before looking at the different types of rent available, let us be more specific about what we mean by a rent. By rent we mean economic profit, and we will use the terms interchangeably. Economic profit is the difference between the present values of revenues and costs where inputs (capital, land and human resources) reflect their opportunity cost. Positive rents coincide with positive NPVs. In addition to monopoly and oligopoly rents, which have been very well worked by economists and will not be discussed here, other sources of rents available to businesses are Schumpeterian, Ricardian and opportunity rents.97 Schumpeterian rents arise from innovation: what Schumpeter described as novel combinations of resources. This coincides well with the notion of a relative product advantage that we discussed in the previous chapter. Sometimes innovators can protect their innovations by patents or copyright, which give innovators the right to sue imitators over a certain length of time. In many businesses, though, patents afford limited protection and the best defence against encroachment by imitators is continuous innovation and improvement. The reason why competition does not erode the superior profits of continuous, successful innovators is because competitors are unable to supply the latest innovation. For as long as a business is able, on a costeffective basis, to deliver innovations valued by customers, it will be in a position to benefit from sustained Schumpeterian rents and enjoy superior returns. Included within these innovations are innovations in the business model itself, which we may consider to be a form of IP. In his classic work Principles of Political Economy and Taxation, David Ricardo described how it was possible for individuals or businesses to extract rent from a unique combination of resources or an asset: think of the value of a fertile piece of land or of a particular location. The productivity of the land or location may exceed that of other nominally equivalent pieces of land or locations, and as a result rents generated from it may allow a business or individual to enjoy abnormal profits. In the case of

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Montgomery & Wernerfelt (1988) notably place a disproportionate emphasis on Ricardian rents arising from unique factors as sources of business returns.

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businesses we can think of many situations where a firm enjoys a special advantage from an asset or resource that it possesses: think of a lucky oil company, the Ritz Hotel or the Coca Cola brand name. Possession of these types of assets or resources may allow a business to extract rents that result in high levels of return over long periods of time. The size of the rent created is measured relative to the normal level of returns one might expect to enjoy in the oil, hotel or carbonated drinks business. Much prominence is given in economics to the first four categories of rent (monopoly, oligopoly, Schumpeterian, Ricardian), but it is probably the minority of businesses that can rely upon these rents as a source of sustained returns. Instead, the majority of businesses rely upon their ability to extract opportunity rents, and resulting opportunity profits from their activities. What are opportunity rents? The work of Oliver Williamson on transactional cost economics points the way.98 Williamson believes that firms exist because they provide a more efficient way than markets to handle complex, customised transactions in situations of bounded knowledge and opportunism. His focus is internal and oriented towards production and supply: the costs of organising, managing and coordinating supply and production through markets are often much higher than those that arise in a business. The same type of thinking can be extended to the business–customer interface: markets are often not capable of supplying customers precisely what they want when they want it in an efficient and effective way. Typically, business–customer exchange is deeply specific and idiosyncratic (on both sides), and this creates the opportunity to create value through exchange that is not zero-sum. Part of the value created accrues to the business as an opportunity rent for the specific, heterogeneous set of idiosyncratic resources deployed by the business, which enable the specific exchange to occur with the particular customer concerned. Businesses exist to extract these rents, not just to minimise the transactional costs of supply and optimise their production function (the focus of economists). If businesses extract opportunity rents successfully, they will earn superior returns. For the customer, the value created by the exchange exceeds the price she agrees to pay plus the costs of locating, assessing and executing the exchange: she enjoys what economists call a consumer surplus. For the supplier, the revenue received is greater than the supplied cost of the product plus general distribution costs plus the specific costs incurred in bringing the customer to the point of purchase execution. Some of these customer-specific costs of the supplier may increase the value that the customer attaches to the exchange (for example technical or comparative information). The exchange creates net value for the customer, and opportunity rents (price less the customer specific purchase execution costs) that exceed its non-customer-specific costs for the business, giving rise to opportunity rents. Even in situations where a business failed to enjoy any advantage over its competitors arising from the configuration of its business model, it would still be possible for the business to extract opportunity rents perhaps even sufficient to generate abnormal profits. In Chapter 4 we discussed how opportunity rents are often associated with relative pricing advantage for a business.

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See Williamson (1975).

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Figure 14: Idiosyncratic Exchange. Purchaser Perspective Revised

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An idiosyncratic exchange involves either implicit or explicit bargaining. As the bargaining takes place, both parties have the ability to ‘hold up’ each other.99 If the business or the customer tries to secure so large a proportion of the value created that the other party believes the total cost it incurs exceeds its opportunity cost of an alternative exchange, the exchange will not occur and both parties will incur the costs of failed exchange. Both parties will also incur new and perhaps additional specific costs as they seek alternative exchanges. The two parties face a variant of the game theoretician’s prisoner’s dilemma: a version with penalties. Figure 14 depicts elements of the exchange. In terms of businesses where opportunity rents are prevalent and easy to perceive, think of fashion boutiques or picture galleries: often it is hard to see how large numbers of these enterprises can co-locate on a general site, for instance Puerto

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The expression ‘Hold up problem’ was introduced by Victor Goldberg to describe how quasi-rents arise.

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Banus in Spain, and mostly prosper. I believe they survive on opportunity rents related to idiosyncratic and hard-to-repeat exchanges with customers, who risk disappointment if they take the risk of pursuing a better bargain elsewhere. In the upper half of the diagram we consider an idealised exchange (clearly defined product, price, etc.) from the purchaser’s perspective. The value the purchaser derives from the purchase is an idiosyncratic amount V but the purchaser incurs time and trouble in the purchase, denoted by the idiosyncratic access cost of AC1.100 If the value less the access cost exceeds the price paid, the purchaser will be happy and will enjoy a consumer surplus. Let us imagine that there is a price P0 that provides the supplying business with normal returns. Then if the price offered by the supplier is P0, the surplus for the supplier will be x+AC2 as depicted in the diagram by the leftmost column. The next column shows the surplus x that the purchaser would enjoy if she declined the initial exchange and undertook a second exchange suffering additional idiosyncratic access costs of AC2. The surplus is less than the surplus available from the first exchange, so most purchasers would make the first exchange and not the second. The magnitude of AC2 will depend on the obstacles and difficulties the purchaser faces in effecting a second exchange: these obstacles and difficulties are called isolating mechanisms.101 The supplier can, however, extract an additional rent from the exchange because the purchaser has committed specific access costs to the exchange. To see this, consider the second set of bars in Figure 14. Here the supplier had increased her price to P1, which exceeds P0 by AC2. At this price the rational purchaser is indifferent between the first and second exchanges.102 If the supplier increases the price by y beyond P1 to P2, a rational purchaser will decline the first exchange and look elsewhere to make the purchase, since the surplus of x available in the second exchange exceeds the x– y available from the first exchange. This is a bad outcome for the supplier who will have incurred idiosyncratic customer costs of CC1 for no revenue. The maximum rent available is the access cost of the second exchange AC2, so reflected in the difference in price the supplier can extract for his resources from the revised exchange P1 relative to the price available in the first exchange P0. In practice, however, there are likely to be competing suppliers who may have a different business model, or the same business model operating at a different level of efficiency or effectiveness. As a result, another competitor may offer a price Q1 that is different to P1. If the purchaser can access the competitor by incurring access costs AC2, then the additional profit available to the original supplying business may be

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Given the purchaser always incurs some access costs AC, one may say that the effective price should include these costs and hence the effective price will always be idiosyncratic, i.e. specific to the transaction, as opposed to the idealised nominal price P0. 101 Rumelt (1984: 567) wrote: A firm’s strategy may be explained in terms of the unexpected events that created (or will create) potential rents together with the isolating mechanisms that (will) act to preserve them. 102 When we consider the profit obtained in the first and second situations described in the two columns, we can identify the additional profit relative to the next-best exchange or use (assuming this is depicted by the second column). This allows us to equate our notion of opportunity rents with what Peteraf (1993) calls ‘appropriable quasi-rents.’

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constrained by the price offered by the competitor if Q1 is less than P1. This means the original supplier may be able to extract a sustainable opportunity rent whose size is determined in part by the pricing and other competitive behaviour of its rivals. In general, though, because of their involvement in a large number of transactions, the supplier will know how to set P1 so that it is unlikely that a purchaser will be able to offset her additional access costs AC2 by a price reduction. Typically, it will be better for the purchaser to accept the reduction in consumer surplus rather than risk an even worse second alternative exchange. The analysis of the exchange will also be made more fraught for both parties because of the uncertainty surrounding alternative exchanges. What we observe is that depending on the strategic ecology, context and choice of business models, it may be possible for a number of non-collusive competing businesses to prosper with differing levels of return within a given ecosystem supplying a number of reasonably satisfied customers. Idiosyncratic exchanges may also provide an opportunity for the purchaser to extract a rent as is shown in the lower half of Figure 14. Here we consider pricing reductions below P0 that the purchaser may seek to obtain from the supplier by exploiting the commitment costs CC1 the supplier has made to the purchaser. Following similar arguments to those of the previous paragraphs, we may conclude that the maximum rent available to the purchaser from a rational supplier is limited to the idiosyncratic customer cost of the next exchange CC2: if the reduction in the supplier’s profit (the analogue of the consumer surplus) from the price reduction in the first exchange exceeds the cost of organising a second exchange, the supplier will forego the first exchange. This is a bad outcome for the purchaser who will have incurred access costs of AC1 without the receipt of any value. Whether the supplier or the purchaser has the upper hand in the bargaining of the exchange will be determined by the relative magnitude of the access and customer costs. If AC2>CC2, we would expect the supplier to have the upper hand. This, for instance, is the case typically in restaurants, where individual customers have little clout in managing their surplus. If CC2>AC2, the purchaser will dominate. This situation arises for instance in selling consultancy assignments, or obtaining venture funding: all too often the ‘‘successful’’ bidder or investee is presented with a drop in project price or company value at the last moment, which reflects the extraction of a rent by the client or capitalist. The ability of one party to extract value is not always resented by the other: it depends upon what the other party gains from the exchange. For instance, in the case of women’s fashion, the very idiosyncratic assessment of value, and the high levels of access cost allow suppliers to extract very high rents.103 The purchaser is usually aware of the high rents, but obtains such a high consumer surplus from the exchange that the level of rent is not problematic. The fragmentation of women’s fashion

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The level of returns to the suppliers can also be accentuated through luxury branding, which acts both to increase access costs for the purchaser AC, as well as reducing the commitment costs the supplier incurs in providing value to a particular purchaser because the brand conveys information and quality assurance, which the supplier might otherwise have to demonstrate in an idiosyncratic way to the purchaser.

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Astute Competition: The Economics of Strategic Diversity Figure 15: Exchange Characteristics.

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increases access costs, and hence extractable rents. The higher rents offset the limited economies of scale and scope, and allow the large number of suppliers to be viable: the ecosystem structure and customer economics are compatible. If the consumer surplus available were to decline, rents would follow and there would be consolidation in the fashion sector. Figure 15 characterises the likely exchanges that may occur as a function of the significance of the customer and access costs in relation to the size of supplier profit or purchaser surplus for exchanges, which are either purchaser (CC2>AC2) or supplier (AC2>CC2) dominated. Loss and gain refer to the changes of value through the extraction of opportunity rents that determines the residual consumer surplus or profit for the customer and supplier, respectively. The upper matrix describes likely bargaining behaviour where purchaser access costs are bigger than supplier customer costs (AC2>CC2) i.e. supplier dominant. If the rent is significant in relation to profit for the supplier, but the surplus for the purchaser is large in relation to the rent, the purchaser is likely to cede to the supplier

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and accept a higher price than the price the supplier might be able to obtain elsewhere at relatively low incremental cost CC2. Similarly, if the rent (P1–P0) is small in relation to profit, the supplier may agree to pressure from the purchaser on pricing if supplier price changes are significant in relation to the purchaser’s consumer surplus. Where purchaser surpluses are large and incremental profits from rents are small, the two parties are likely to be indifferent about the final price of exchange. The hard bargaining will arise where the rent is significant in relation to profit for the supplier and in relation to the surplus available to the purchaser. Even here, however, it may be possible for exchange to occur, though at the risk of a bad bargain (see Figure 15). The lower matrix repeats these arguments for the situations where supplier customer costs are larger than purchaser access costs (CC2>AC2), i.e. purchaser dominant (careful inspection shows these matrices are not the same). A similar set of outcomes may be obtained for these idealised exchanges. In all quadrants it may be possible to achieve an exchange but the tough bargaining outcome is likely to represent more of a zero-sum encounter. As a consequence of the costs of failed exchanges, the business may very well be concerned to ensure generally that the rent is considered to be fair by its customers because its reputation may affect the number of exchanges that do occur, and hence the number of failed exchanges. The effect of an unscrupulous reputation may make a customer aware of the early need to increase search, experience or validation expenditures as part of the exploration of exchange, which will have the effect of reducing the opportunity cost for the customer of finding an alternative supplier, and increase the likelihood of a failed exchange for the supplier. Sometimes even though an exchange occurs, both parties may regret the transaction resulting in a bad bargain. As an example, consider the purchase of a house: sometimes the seller reduces price over a series of rounds of negotiation, while the buyer similarly strains to improve her offer. Subsequently, the seller may feel he should never have reduced the price, while the buyer may feel she paid too much, spoiling the enjoyment of the house. While the figures help to elucidate aspects of idiosyncratic exchange, it is important to bear in mind that only rarely will purchasers and suppliers be able to determine values, access and customer costs. Usually these will be uncertain and probabilistic, and an understanding of the attractiveness or disadvantage of exchange may only emerge over a period of time and a number of exchanges. The important conclusion is that opportunity rents represent a major source of value for many businesses. Idiosyncratic exchange goes well beyond considerations of price discrimination. Typically, economists describe price discrimination between customer groups that are internally homogeneous where the offered price of a homogeneous product is different between the groups of customers. Contrast idiosyncratic exchange, which takes place between heterogeneous customers who purchase idiosyncratic variants of a product through a non-uniform interface with businesses that are themselves heterogeneous in structure. Heterogeneity is the source of value in exchange, and the source of opportunity rents and profits. ‘The price’, ‘The cost’ and ‘The product’ are generalised idealisations on the part of economists that do not arise in actual exchanges. Rather, we have fuzzy, extended notions of price, product and cost in

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business. Out of the fuzziness arises the possibility of valued idiosyncratic exchange.104 The use of the word rent is not accidental. At the moment of exchange, the purchaser confronts a restriction in the supply of resources that provide the idiosyncratically packaged variant of the product to her at that particular time in that particular location. No other supplier is in the position to make that particular exchange. The purchaser is isolated by the circumstances of the exchange. If the price of the exchange is less than the value of the exchange to her then the exchange will take place. If the price is too high, both the purchaser and supplier will need to incur additional idiosyncratic costs in an alternative exchange. The restriction of supply gives rise to the possibility of a rent for the particular configuration of the supplier’s resources that enable the exchange. The amalgamation of all these micro-rents allows successful businesses to generate sustained non-normal returns. As described above, rents may also accrue to purchasers if customer costs are high and a transient restriction in demand can be created.105 Alfred Marshall termed the rents that arise from the resource configuration of business models quasi-rents.106 He wrote: Indeed, in some cases and for some purposes, nearly the whole income of a business may be regarded as a quasi-rent, that is an income determined for the time by the state of the market for its wares, with but little reference to the cost of preparing for their work the various things and persons engaged in it. (Marshall 1920: 626). Again a quasi-rent has been described as a sort of ‘‘conjuncture’’ or ‘‘opportunity’’ profit; and, almost in the same breath, as no profit or interest at all, but only a rent. For the time being, it is a conjuncture or opportunity income while in the long run it is expected to, and generally does, yield a normal rate of interest (or if earnings of management are counted in, of profit) on the free capital, represented by the definite sum of money that was invested in producing it. (Marshall 1920: 424) Some readers may object that for many popular goods exchange is not idiosyncratic. Consider, however, the realities of buying some sellotape from a shop, a familiar item for which we only need to search rather than experience before contemplating purchase. In determining the factors that determine the customer’s willingness to exchange, we may need to know (i) exactly what she plans to tape, and how the tape 104 Notions such as ‘The price’ are averaged attributes of large numbers of transactions in markets, just as the notion of temperature is an attribute of a large body of molecules in physics: individual molecules do not have a temperature. 105 Physicists may find the situation reminiscent of the transient creation of elementary particles in physics allowed under the uncertainty principle: the virtual particles created are collectively responsible for the electromagnetic properties of free space, but it is impossible to observe any of them. Here the idiosyncratic exchanges collectively give rise to adequate rents, but it is impossible to define fully the idiosyncrasy of the individual exchange. 106 See Marshall (1920).

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needs to appear when applied: widths, lengths and surface, (ii) how long the tape may remain usable if it is not all applied at once, whether previous purchases of tape from the same supplier have created a view on quality or usage, (iii) what rough magnitude of purchase or of tape she can contemplate, (iv) whether there are other purchases to be made that may give rise to other opportunity gains, (v) the length of queue, time available, helpfulness of assistants, (vi) the ease of locating, comparing tape within the shop, (vii) her mood and the importance of making the purchase, (viii) the method and timing of payment (cash versus debit card versus credit card versus cheque), (ix) the specifics of attempting to make purchases at other locations, and (x) the consequences of not making a purchase. Many of these factors are the target of store designers who aim to produce a particular shopping experience to facilitate a sale. For the supplier there are also many factors at work: (i) the possibility of selling the tape elsewhere in the shop at a higher price, (ii) the advantages of selling this particular roll versus others that have a longer or shorter shelf-life, (iii) the possibility of selling the tape to someone else perhaps in a bundle or under a promotion, (iv) the costs of replacing the roll of tape with a similar or dissimilar roll, (v) the costs of the particular roll sold after taking into account discounts, channels, bundles etc., as well as costing systems, (vi) the time delay before another customer is willing to exchange, (vii) the likelihood of returns from that particular customer, (viii) the loyalty bonus costs awarded to the customer, (ix) the possibility that the customer would willingly have paid more, (x) the availability of appropriate tape from other locations, (xi) the financial impact of different payment methods. Many of these factors form the basis of highly specific merchandising decisions within the store.107 We could go into greater and greater detail surrounding these idiosyncratic factors, and by doing so the exchange factors would holistically envelop huge numbers of other actors and players. In practice, individuals and businesses are boundedly rational and employ a number of methods to come to a conclusion: these include reliance on reputation and brand, averaging across a number of products or purchasers; satisficing, prior experience etc. As individuals we sometimes feel we have done well by the exchange and obtained a bargain. At other times we feel we have been taken advantage of. Over a period of time we are apt to modify our behaviour if we feel persistently disadvantaged. We may, for instance, use brands to inform and direct our purchases, or we may buy a subscription to a consumer association that allows comparison with the experience of other purchasers. What is not in doubt, however, is that successful businesses are able to capture opportunity rents from the customers within the confines of idiosyncratic win-win exchanges. So long as businesses and individuals remain different, opportunities will exist for rents to be extracted. Only when all businesses and purchasers become the same,

107 Interestingly, if we regard financial markets as the organised exchanges of financial products, which are heterogeneous (offering various return, risk, duration, liquidity and tax characteristics) between idiosyncratic suppliers and customers who have heterogeneous preferences, we can see that opportunity rents may arise, which generate sustained abnormal profits. If this is the case, then there is no reason to assume market efficiency involves arbitrage activity sufficient to eliminate abnormal returns.

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homogenous, will returns fall to the level of normal profits favoured in the discussions of economists. While we cannot formally rule out the possibility of a clone-like world, luckily the history of the world to date shows increasing heterogeneity, and hence offers the prospect of continuing opportunity profits for businesses. The recognition of this source of rents does not imply that businesses can count upon appropriating them for any sustained period. If the business models of competitors evolve advantageously, opportunity profits may erode and eventually become insufficient to satisfy investors. What the opportunity rents do allow is for businesses to make a living, provided they continue to compete keenly against other businesses in their ecosystem. They also explain in part why we often observe three or four businesses in many ecosystems: competition is not so instant and costless that eventually only one business survives. To be successful a business should strive to appropriate as great a proportion as possible of the opportunity rents available within an ecosystem. In practical terms this means selling the customer the right product in the right place at the right time so that the customer gains sufficiently by the purchase to be willing to reward the supplier more than the capital costs of his resources. This is no more than common sense. This section opened with a consideration of the various types of economic rent that can give rise to sustained superior returns. We have identified three sources (Ricardian, Schumpeterian, Opportunity) in addition to those traditionally investigated by economists. Equipped with an awareness of these sources, managers within a business can ask themselves upon which of these sources their current profitability depends. This will help them to isolate and reinforce the elements of their business model that enable them to appropriate this rent. Equally, an understanding of rents will allow managers to investigate whether any additional or alternative sources of rent may be available to them, helping them to formulate a more successful business model.108 It may be objected that we have overlooked economies of scale and scope as sources of sustained returns. Possibly so, but it may be argued that either the scale/ scope advantage is unavailable to other players and so is a source of Ricardian rents, or that if capacity additions can be made by others then it is not likely to produce sustained returns without oligopoly. Observing the loss-making overcapacity in cars, steel, LCDs, semi-conductors, I am inclined to accept the argument, but perhaps there are other instances worthy of attention. Certainly it is hard to accept the view of some industrial organisation theorists such as Michael Porter that the superior returns of many businesses are predominantly the consequence to returns to scale among look-alike members of a strategic group defended from outsider competition

108 The emphasis placed on opportunity rents as the source of sustained competitive returns as opposed to Ricardian rents, means that we do not have to belabour the scarcity and distinctiveness of what the business does. For instance, Dierickx & Cool (1989) talk about the flow and stock of strategic assets (resources) as conferring superior returns only if they are non-tradable, non-imitable and non-substitutable. These are too strong requirements — just think back to the example of the fashion businesses where opportunity rents support many players. All that is required is that the business makes good (i.e. competitive) use of the assets and resources at its disposal.

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by mobility barriers. Strategy, like life, is about the imaginative competitive struggle between diverse entities within an ecology, not the imitative conformity of colluding introverts.

Summary 1. Within a strategic ecosystem, superior sustained returns generally arise from monopolistic, oligopolistic, Ricardian, Schumpeterian or opportunity rents conferred by a successful business model. 2. Opportunity rents are the most prevalent and arise from the heterogeneity of businesses and customers. 3. Opportunity rents can be explained by the costs incurred in idiosyncratic exchange, which permit a range of outcomes from hold up by the customer to hold up by the supplier, but which also commonly give rise to win-win exchanges creating a value surplus for the customer, and a rent for the supplying business.

Questions 1. What types of rent can be extracted by your business(es) in the ecosystem(s) in which you operate, and are the rents sufficient to generate abnormal returns? 2. Are the rents that you extract greater or lesser than the rents extracted by your principal competitors in the ecosystems in which you operate? 3. Which aspects of your business model accounts for the differences in rent compared to your principal ecosystem competitors that you extract in each ecosystem in which you operate, and how have your and competitors rents and business models evolved over the past five years?


Chapter 6

The Return on Resources To recap the argument so far: for businesses within a given strategic ecosystem a strategy is a coherent and consistent pattern of action expressed through a business model that confers competitive advantage leading to the appropriation of sustained economic rents. The question remains of whether these rents are sufficient to keep investors happy. How can we settle this question? Clearly, we need to be able to quantify the rents in a way that takes investors’ needs into account. The way to do this is by valuing the rents obtained in relation to the resources consumed in obtaining them using a measure, which incorporates investors’ attitudes to the risks incurred in sustaining the rents.109 This measure of the return on resources we call the resource margin (RM) of the business. In this chapter we will describe the origins and pedigree of this measure, show how it ties in with modern financial theory (epitomised by the CAPM),110 and review some evidence for the reliability of this measure in valuation. First, though, we will quickly review other measures, which are more familiar to the reader, but which suffer a number of significant disadvantages.

Traditional Measures of Performance Until the 1960s, the vast majority of strategic investment decisions were predicated upon an evaluation of the likely return on investment (ROI) and the period by the end of which the investment would pay for itself (payback). In a similar fashion, strategic performance was assessed by looking at the accounting returns delivered over time upon the investment. Today most managers recognise that these measures are flawed. Payback does not take account of the time-value of money, and leads managers to discard projects with a relatively lengthy payback period in favour of projects with a short payback period even if the lengthy project is likely to enhance shareholder value much more substantially. Even when adjusted for timing, payback continues to be an inferior measure of performance because it ignores all the value created after the initial investment has been repaid.111 109 In line with orthodox prevailing financial theory, we unrealistically assume these preferences are captured by the mean and variance (risk) of returns normally distributed with a quadratic utility function. 110 While the author is fully confident that RMs are entirely compatible with more advanced theories such as Arbitrage Pricing Theory, time constraints have prevented the formal derivation of a proof that this is indeed the case. 111 A further difficulty arises because projects with the same payback period cannot be ranked relatively using this measure (Brearley & Myers (1996)).

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ROI measures are also problematic. The results are highly dependent upon accounting conventions, producing differing annual values for projects producing the same economic return.112 These difficulties can be overcome in the case of a single project with known cash flows over a finite life, but otherwise there is no general method for relating accounting returns to discounted cash flows. Averaging accounting returns over a number of years produces anomalous results that fail to capture the time-value of money. To complete an ROI evaluation, the results also need to be contrasted with some benchmark ROI value, which is often based on historic levels of return, and captures miserably the opportunity cost of investment. Often managers will calculate instead IRR for an investment. When carried out carefully, this method of assessing projects will coincide with NPV, but occasionally IRR will be misleading because of either (i) more than one possible IRR values for a given set of cash flows, or (ii) hidden assumptions about the lending and reinvestment of surplus funds, or (iii) IRR’s emphasis on the rate rather than the absolute magnitude of return. The preferred method of valuation taught at business schools around the world is NPV. This measure takes account of the time-value of money and opportunity costs. It is also additive for a series of investments. Relative to the other measures it is clearly superior, and produces helpful answers in the case of simple, short-lived and well-defined investment projects. Unfortunately, choices of strategy seldom have these characteristics. When strategies are assessed according to their present values, future cash flow streams are discounted at a rate that compensates for both the time-value of money and for the ‘‘risk’’ (uncertainty and risk) involved. This is the Discounted Cash Flow method (DCF). Experience has shown that significant problems occur in DCF forecasts of value for strategic options.113 These problems include: (i) predicting events that are many years away; (ii) sensitivity to the length of the event horizon considered; (iii) sensitivity to terminal value assumptions; (iv) sensitivity to discount rate choices; (v) insulation from external events; (vi) failure to incorporate credibly likely management action; (vii) failure to square with the actual value of transactions.114 Besides these internally oriented difficulties, other subtler assumptions are often made. For example, it is usually assumed that ownership is constant; DCF often overlooks strategic degrees of freedom created by good performance, or constraints imposed by short-term disappointments. More sophisticated modellers attempt to address some of these weaknesses by blitzing us with a myriad of scenarios. The trouble is that when the business is heading south at a rate of knots, ‘‘management by auto-pilot’’ does nothing to correct the situation. Real options may be grafted on, but who can claim to do anything but cherry pick the options that are most

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For a systematic review of the impact of accounting policy, see Edwards et al. (1987). For a rose-tinted account, see Copeland et al. (1995). 114 For greater detail see Brearley & Myers (1996), and Johnson (2003). 113


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expedient? If these difficulties were not enough, how are we to incorporate the longterm effects of government policy and other macro factors? If we accept that the problems with DCF cannot be brushed under the carpet, what can we do to overcome them? In recent years, the use of value-based planning systems among large corporations has increased significantly. Common to these approaches is the notion of a value-creating spread, where returns in a business exceed the returns required and expected by investors. Positive spreads result in increases in stock market value. These spreads are known as excess or residual returns. Fruhan laid much of the groundwork for this approach in his book Financial Strategy, where he described under what circumstances firms are likely to become a Hall of Fame Firm. Fruhan looked at the return on equity of all US non-financial companies, and showed that the most highly valued companies generated returns in excess of the required rates of investor predicted by the CAPM. He summarised his conclusions succinctly: Managers who are successful in either shaping or simply taking advantage of the competitive environment so as to earn returns in excess of their capital costs create enormous wealth for their shareholders (Fruhan 1979: 42). He explained this phenomenon in terms of a simple economic valuation model, which showed how the ratio of the market to book value changes for a company as a function of the size of the spread it enjoyed, the number of years the spread lasted and the rate of growth of the company (determined by the level of retention of profits). Fruhan went on to explain how spreads are grounded in microeconomic structure in terms of entry barriers building on the work of Bain (1959), Porter (1980) and others. In terms of barriers, he identified unique products, scale economies, absolute cost advantages and capital requirements. Furthermore, high-spread companies focussed on a narrow number of product lines. Chapter 4 provides an account of these types of competitive advantage. What is important to note is that the superior performance described is fully consistent with the account of ecosystems, business models, competitive advantage and rents of the first five chapters.115 If Fruhan is held to be the early pioneer of residual returns, it is Rappaport (1986) who made them familiar to the boardroom. His key insight was how to operationalise the notions of spread as a threshold operating margin after taking account of working capital and capital expenditures. In doing this he was much aided by the development of PC-based software, which allowed real-time modelling of businesses including the anticipated impact of management action on the creation or destruction of value. Typical inputs for the modelling are sales, margins and investment over the period when a positive spread is earned. Sensitivity analysis could easily be carried out: for example, the extra growth in sales required to produce the same strategy value for different levels of spread. The impact of capital efficiencies was 115

It is also noteworthy that Fruhan questioned the large cash balances held by companies, and their likely difficulty in sustaining valuation multiples, thus anticipating the LBO restructuring of the 1980s.

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immediately evident, and Rappaport’s approach provided a good way of looking at the critical operational drivers of value creation. Managers were required to take an integrated perspective on operations, considering both the profit and loss and balance sheet implications when planning a course of action. Managers were also able to examine explicitly the stock market’s expectations of residual returns compounded in the current stock price relative to the likely level of residual returns in the business. Unfortunately, although we need only consider the period when residual returns are positive, this is often a lengthy period and Rappaport’s approach ultimately suffers the same fate as DCF — very large variations in conclusions can be produced from very small changes in input values. Rappaport’s ALCAR software simply takes the pain out of calculation.

Resource Margins As we have discussed, value-added, (net output) is an important factor in the determination of competitive success. As industrial organisation research has revealed, the structure of an industry and how it evolves can be well captured by the analysis of the distribution of value-added between different industry participants and how this distribution shifts over time. Similarly, within an individual strategic ecosystem, we may consider much competitor activity to be a struggle to control and safeguard profitable value-added. Within each competing business, value-added corresponds to the competitively distinct resource base, which managers control and which they use to implement strategies — it is the platform within which reside core competences. Normally, value-added is taken to be defined as business revenues minus the cost of raw materials and purchases. Unfortunately, since the term ‘‘value-added’’ is loosely and overly used, and gives rise to confusion between (i) the value added to the net worth of a company beyond the contribution of rents that constitute the economic cost of book capital, and (ii) value-added as understood by tax authorities and economists, which is often taxed and (iii) the value-added in a general sense by good managers, we will generally prefer from this point forward to use the term resources rather than value-added to describe net output. It is possible to make the notion of resources precise through the specification of a business model and the identification of various activity matrices describing production, marketing and overhead activities associated with the business model (the internal elements (P, M, G) discussed in Chapter 3). If the objective of strategy is to increase the value of a business, then two key imperatives for competitive success are to grow the resources of the business, and to achieve a satisfactory level of return on those resources from the extraction of rents (economic profit).116 Let us represent the growth of resources of a business by g, and

116 By economic profit we mean the change in NPV of the flows arising in a business in a given period, and we will generally treat the term economic profit and rent interchangeably (although classical economists associated rents with land and profits with capital).


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the return on resources by the resource margin RM where: Resource Margin ¼ RM ¼

Economic Profit Economic Resources Consumed

Economic performance, measured in terms of the economic profit, that is the rents derived from the deployment of resources described in the previous chapter, drives valuation. As a consequence, strategists should pay particular attention to RMs, as opposed to any other performance measure in the articulation of strategies. Surprisingly, however, nearly all popular measures of performance do not relate profit to resources, and focus instead on the ratio of profit to sales, assets, equity or capital employed. This looks like common sense, but what measure do we use for economic profit? We propose to take accounting profit computed on a ‘clean surplus’ (or ‘comprehensive income’) basis, so as to include all changes in book value during the period in question, including exceptional and extraordinary items. Using the clean surplus basis allows us to tie together the accounting and cash-flow measures used in valuation. While for any given period there may be a difference in the accounts between economic depreciation of the assets (the change in the intrinsic value of the assets as determined by the cash value of what they can produce) and the depreciation recorded according to established accounting conventions, the accounting will eventually catch up with the cash-flow economics. Since we will be looking at RMs over a number of years, the effects of these depreciation-related timing differences will be mitigated. For the economic resources consumed we employ net output: the value of the business’ outputs less the cost of its inputs. This measure of clean surplus divided by net output, has distinguished antecedents dating back to Ricardo. Industrial economists, in particular, have done much research into the consequences of monopolies and oligopolies by looking at the relationships between concentration in an industry and a profitability measure called the ‘Price–Cost–Margin’ (PCM), which is arguably the cousin of RM: Price Cost Margin ¼ PCM ¼

Net output Employee compensation Net output

If employee compensation represents a large majority of value-added costs, then resource and PCMs will be approximately equal since the PCM numerator will approximate economic profit. The research by economists at an industry level has demonstrated the impact of concentration and barriers to entry on profitability (PCM), results made familiar to business through Michael Porter’s Five Forces model. In other words, industrial organisation research has revealed the relevance of RMs to performance at the level of industries. In adopting RMs as a strategic performance measure, the intention is to extend this approach to the level of businesses in individual ecosystems. High levels of average RM will arise through the erection and exploitation of ecosystem mobility barriers. Within a given ecosystem, individual businesses, however, will enjoy better or worse returns than the average as a function of their ability

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to sustain a relative competitive advantage against their ecosystem competitors.117 Valuing strategies then becomes a question of calculating and evaluating RMs. By focussing on growth and profitability in relation to resources, the RM framework can accommodate both the positioning and the resource-based schools of strategy. The performance of a business depends both upon the structural context in which all competitors find themselves, and the individual business’s ability to establish a competitive advantage relative to its competitors in that context. On the one hand, the context revealed by strategic ecology will determine the magnitude of resources over which businesses compete, the growth of those resources and typical levels of profit that may be sustained in relation to those resources. On the other hand, competitive advantage will determine the profitability and development of resources for the individual business relative to its competitors. In other words, the level of RM achieved by a business will depend upon how well it uses its resources relative to competitors (the resource-based view), as well as the attractiveness of the ecosystems it operates in (the positioning-based view), and the structure of the industry surrounding these ecosystems (Porter’s Five Forces). Similarly, the ability to generate superior returns in an ecosystem, and the attractiveness of ecosystems for new business development will be strongly influenced by the growth of resources. Typical average levels of RM earned in an ecosystem may be used to determine the ecosystem pricing environment as described in Chapter 2, where we looked in Figures 7 and 8 at the relationship between resource margins (RM, ROVA) and ecosystem concentration. In long-term competitive equilibrium we might expect businesses to earn the rate of return required by investors, which we may proxy in general by the expected rate of return on the stock market as a whole. If returns deviate from this level, we can gain insight into the competitive dynamics of the ecosystem. RM also allows interesting and meaningful comparisons between businesses that have markedly different capital requirements: contrast for example a hotel business, a contract catering business and a restaurant business. Traditional measures of performance such as return on capital employed or return on sales do not produce meaningful comparisons between these businesses. Hotel businesses show low returns on capital because capital growth through property appreciation is not usually included in profits; restaurants make income on moderate levels of assets; contract catering has paper-thin sales margins, but excellent cash characteristics. The use of RMs can allow meaningful comparisons to be made.

Hotels Restaurants Catering

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Capital Employed

Return on Sales

Return on Capital

Resource Margins

High Moderate Negative

High Moderate Very small

Low Good Non-sensical

Satisfactory Satisfactory Satisfactory

As we have discussed, the competitive advantage is reflected in what Rumelt calls isolating mechanisms.


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Investor Requirements One may inquire as to the precise nature of the linkages between RMs and investor rates of return. Consider the investment returns for a new equity funded business with a one-year lifetime. Imagine that investors provide funding sufficient to cover the cost of the business’ resources (net output) for one year. This means that the business can cover all its value-adding activities, but raw material and bought-in purchase costs are billed direct to the customer. If the business operates competitively, the return it achieves on the economic resources it consumes will be just sufficient to reward investors for the risk they have borne. This may be stated mathematically as RM ¼ r i.e. the RM equals the required rate of return of investors. This normative result is a general prerequisite for financial and physical markets to be in equilibrium.118 It is possible to incorporate RMs rigorously into a valuation framework that draws upon accounting information and is entirely consistent with financial theory.119 It is possible to show that: 1 Market Value r gX ¼1þ gt ðRMt rÞ Book Value r t¼1

where g is the rate of growth of resources (i.e. net output, value-added), g a discounting factor and RMt are the resource margins in successive years. In the case of g ¼ 0, this simplifies to: 1 X Market Value ¼1þ gt ðRMt rÞ Book Value t¼1

This equation states that for a business, the ratio of the market to book value of the business is given by one plus the sum of the discounted spread of the RM over the rate of return required by investors i.e the level of excess returns. The magnitude of this ratio is determined by the spread and by g making explicit the importance of excess RMs and the growth of resources in the creation of shareholder wealth through competitive advantage. Another way to interpret this equation is that the value of resources is the sum of extractable rents once investors have been paid for risk. In the previous chapter we explained the competitive origins of these rents. In practice, shareholder value will be created or destroyed according to whether RM>o r: in other words, residual resource margins RM – r will determine the value 118

The result is equivalent to assuming Tobin’s Q equals one. For interested readers, I have developed these results in much greater detail in the 1999/2001 valuation papers cited in the references. 119

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of the business. This immediately suggests that if we can determine the likely future pattern of the return on resources, we will be able to determine the future values of the business. How can we develop a view of the likely return on resources? The past pattern of returns on resources offers a good guide. Unlike many other financial measures, such as return on sales, or return on assets, return on resources is fundamentally embedded in the structural competitive context that surrounds a business. Different structural circumstances, combined with particular competitive advantages, will determine the level of economic rents available from the resources committed to the business, as has been seen at industry level in the work of economists who have studied industrial organisation, and as has been discussed in the previous chapter. This relationship between rents and resources is exactly what is expressed by an RM. In this way we make an explicit link at the level of a business between the structural context, the strategy pursued and levels of return that is robust, explanatory and well grounded. Accounting and financial theory then allows us to integrate the resource margin series into a numerical value. Because of its grounding in strategy and rents, we can place confidence in the use of RM patterns as a predictor of likely future resource margins over a short-to-medium-term window. Using the historic patterns to shape reliably our view of likely future returns may allow us to avoid much of the arbitrariness of typical DCF projections.120

Resource Margins and Economic Value Added (EVA) Those strategists familiar with more recent practitioner developments of the concept of EVA, may inquire how RM relates to EVA and whether it offers any advantages as a valuation concept. Because Stern Stewart’s approach makes managers account for capital in their business on a risk-adjusted basis, and because of its simplicity, it has won a large measure of acceptance as a single-period operating measure. Nonetheless, it has problems. The first is that a single-period residual return (EVA) measure is not necessarily reliable when it comes to maximising value. If a company always chooses the course of action that maximises the residual return in the next period, this may lead to the rejection of a strategy that maximises value over a number of periods. Remember, the first equation involved a summation of residual earnings over (theoretically) an infinite number of periods, not just one. In going from a horizon of ten or more years, to a single year, we seem to have gone too far. Second, the EVA in any given period is unlikely to equal the total return to shareholders in that period. As O’Hanlon & Peasnell (1998) have shown: Shareholder abnormal return in period t ¼ xat þ ðDGWt rGWt-1 Þ

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One practical consequence of the adoption of a standard taxonomy of business models, dubbed ‘‘business genomics’’, as mooted in Chapter 3, is that it would be possible to investigate statistically the linkages between model structures and returns on resources, replicating the earlier work done by the PIMS pioneers.


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where GWt is unrecorded goodwill at time t and DGWt is the single-period change in goodwill. The term in brackets is not generally zero, so shareholder return will not normally equal EVA, xat, the first term on the right hand side of the equation. Another problem is that companies systematically generate too many positive residuals. Investors are not stupid, so if nearly all companies earned positive residual returns, investor expectations would change and result in different required rates. Or, you might ask why, when residual returns are nearly always positive, do a large number of companies have a market to book ratio of less than one? Asset valuation is only one of a number of accounting problems, which each lead to modifications and revisions of accounting data — so much for the simplicity of the approach. But even if the book numbers were right, conceptual problems still remain. How do we treat unrecorded intangibles? How do we treat fluctuating cycles of working capital? To what extent should we look at gross rather than net assets? How should we think about the returns made on the efficient financing of operations? RM can be shown to be entirely consistent with Stern Stewart’s EVA approach, but it avoids some of the conceptual confusion associated with EVA. In particular, it provides a means of separating the capital tied up in funding the resources employed in a business from the resources used to pursue business strategy. The latter point is not trivial. Formally, it can be shown that: Market Value ¼

1 X rutþ1 gB þ utþ1 gt ðRMtþt rÞ y rg r gB t t¼1

where gB is the growth in book value yt and utþ1 is net output (value-added) in period t +1. What this says is that Market Value ¼

[Normal economic returns earned on resources] + [Abnormal returns on resources] + [Additional capital to fund application of the resources].

The EVA approach conflates questions of economic efficiency with questions of funding. Part of the capital yt is required to fund working capital because of the operating cycle of the business. This need for capital has nothing to do with the efficiency of the use of resources by the firm in competitive markets. We can imagine hypothetically, companies with incredibly rapid financing cycles (say, a single minute), or incredibly long accounting periods (say, a hundred years), where the book value of these companies is zero because the funding of assets is zero. It still makes sense to ask whether these firms have made a good use of resources even though you cannot calculate residual returns and hence EVA given the way it is calculated from book value if the book value is zero. In the same way that EVA mixes up resources and funding, it might be argued that EVA illogically mixes up past and present economic performances. EVA combines stock variables (assets and balance sheet items) and flow variables (P&L items)

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into a return measure of economic performance rather than relying entirely upon flows so as to produce an economic margin (or, to use that word again, a spread). For instance, the book value of equity includes not only the money spent in the past buying assets, but also reflects residual earnings elements from supposedly superior performance in the past, which have not been paid out as dividends. The result for EVA is a measure that tries to convey whether a business is using resources efficiently now by reference to the resources the business consumed previously. Some managers will rightly protest that they do not care about how the business performed in the past; what they want to understand is whether the business is making good economic use of resources it is consuming right now! In addition, RM values are not disproportionately positive (as judged by UK and US samples), and many of the EVA accounting revisions needed to compensate for divergences between book and replacement values of assets are avoided by focusing entirely on P&L as opposed to balance sheet measures. RM also avoids the mixing up of past and current elements of performance through the retention of historic spreads in the book value of the business that happens in EVA. The next section reviews statistical analysis carried out by the author for companies in the UK and the US that shows RMs to be significantly related to market value to resources ratios (M/R), and the associated valuation models to have more explanatory power than traditional market value to book and return on equity (M/B – ROE) models. This valuation model for M/R can be incorporated with scenario analysis to value strategic options (as described in Chapter 9). Readers who feel uncomfortable with statistics should skip the section, and take it on trust.

Testing of the Value Relevance of RMs Ordinary least squares regressions may be used to investigate the linkages between market value variables and measures of RM and growth. Table 3 records the descriptive statistics of the variables investigated for a sample of approximately 300 US manufacturing companies between 1993 and 1998, where RM, M, B, XSRM, RI and Table 3: Descriptive Statistics for Value Relevant Factors. No 5 yr average RM 5 yr growth in resources M/B M/Resources RM XSRM RI/B NI/B

Range Minimum Maximum

3357 2.24 3357 352.37 3357 20.27 3357 28.31 3357 2.71 3357 2.79 3357 3.57 3357 3.19

1.01 27.69 0.35 0.12 1.10 1.24 1.96 1.55

1.23 324.69 20.62 28.43 1.61 1.55 1.61 1.65

Mean

Std. Dev.

0.1086 8.8133 2.2945 2.0768 0.1119 0.0385 0.0308 0.1189

0.1108 11.2002 1.7715 1.9141 0.1411 0.1495 0.2381 0.1387


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NI denote resource margin, market value, book value, excess resource margins (on a clean surplus basis), residual income after deducting a rent for book capital and net income, respectively.121 As a first step, market to book and market to resources ratios were regressed against individual regressors to determine their value relevance. Growth refers to growth in resources. The results are shown in Table 4. If the normative assumptions that underpin ordinary least squares regression hold good, the analysis shows that RM, and resource growth are value-relevant factors not only for market to resource ratios, but also for market to book ratios. In fact, the explanatory power measured by R-squared is better for the model comprising (market to resource ratio; RM), than for the traditional model (market to book ratio; return on equity). We call these two models the M/R and the M/B models. It is also noteworthy that RMs are more relevant to the M/B model than ROE is to the M/R model. The t statistics are of limited significance because of large sample effects. It is also noteworthy that the Durbin–Watson statistics do indicate a high level of autocorrelation in the data sample. Stepwise multivariate regressions were then undertaken first for the market value to resource ratio (M/R) model, then the traditional market to book value model (M/B). The results for the RM model were of considerable significance (Tables 5 and 6). These results show that the RM model has high explanatory power if we assume that the conditions for reliable OLS regressions obtain. The t statistics are less significant than might first appear because of problems of large numbers and autocorrelation. Average and current RMs have good explanatory power but surprisingly growth of resources is a less valuable regressor: in spite of some significance as measured by the t statistic, the coefficient is relatively small. ROE and residual equity returns have a small influence on the regression results for market to resource ratios. The negative coefficient for equity returns suggest it operates as a corrective factor to the basic RM model. By way of comparison, results were determined for the traditional market to book ratio model. By using OLS, the market value to resource model has greater explanatory power than the traditional market to book value model for this set of companies. Average RMs contribute to the explanatory power of the traditional model, while current RMs introduce a corrective element to the model. Supplementary analysis has shown that the model can be improved by introducing a degree of company specificity. Difficulties arising from the statistical characteristics of the data set (particularly auto-correlation and heteroscedasticity), however, have to date precluded the formulation of a simple formulation of company-specific parameters suitable for testing by OLS methods. Investigations are in hand to derive a new company-specific model suitable for generalised least-square (GLS) methods.

121

See Johnson (2001b).

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Dep/Indep Variables M/B vs RM M/B vs XSRM M/B vs 5 yr av RM M/B vs 5 yr growth M/B vs ROE M/B vs residual ROE M/resources vs RM M/resources vs XSRM M/resources vs 5 yr av RM M/resources vs 5 yr growth M/resources vs ROE M/resources vs residual ROE

Adj R2

F statistic

T statistic

Significance

Coefficient

Durbin–Watson

0.110 0.092 0.108 0.028 0.288 0.155 0.295 0.219 0.300 0.020 0.080 0.058

413.832 343.063 409.181 98.934 1356.564 614.894 1404.699 944.360 1440.857 67.991 294.304 208.498

20.343 18.522 20.228 9.947 36.832 24.797 37.479 30.730 37.959 8.246 17.155 14.439

0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

4.160 3.609 5.274 0.0267 6.854 2.928 7.370 6.001 9.473 0.0240 3.920 1.945

0.572 0.542 0.509 0.469 0.814 0.536 0.811 0.677 0.690 0.475 0.509 0.457


Table 4: Regressions of Value – Relevant Factors.


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Table 5: Regression of Value Relevant Factors against M/R. Model Summary Model 1

R

R2

Adjusted R2

Std. Error of the Estimate

Durbin–Watson

0.614

0.377

0.376

1.5119

0.797

ANOVA Results Model 1

Regression Residual Total

Sum of Squares

Df

Mean Square

F

Sig.

4639.099 7657.111 12296.211

6 3350 3356

773.183 2.286

338.269

0.000

t

Sig.

13.830 11.561 0.430 19.825 3.047 5.652 2.316

0.000 0.000 0.667 0.000 0.002 0.000 0.021

Coefficients of Stepwise Regression Model 1

(Constant) RM XSRM Av RM 5 yr growth ROE RESROE

Unstandardised Coefficients

Std. Error

Standardized Coefficients

0.971 5.300 0.165 5.927 0.007 1.611 0.341

0.070 0.458 0.385 0.299 0.002 0.285 0.147

0.391 0.013 0.343 0.043 0.117 0.042

Link to Strategic Ecology and to Business Strategy Resource margins provide a strategic measure with which to assess ecosystem attractiveness and business strategy. We are able to interpret the attractiveness requirement of profitable, growing value-added elucidated in Chapter 2 in terms of a growth rate in resources, and a level of RM in relation to investor requirements. Against this structural background of ecosystem resource growth and profitability, we may then investigate the extent to which a business is able to appropriate economic profits, i.e. profits in excess of investor requirements that create economic wealth, as a result of a sustained competitive advantage conferred by the business model that underpins its strategy. As we explained in the previous chapter, very often the source of these economic profits is opportunity rents. Critical to the conferral of a sustained advantage, and the extraction of rents, is the effective competitive control of value-added within the ecosystem: giving rise to the mantra competitive control of resources. As we discussed in Chapter 4, in

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Astute Competition: The Economics of Strategic Diversity Table 6: Regression of Value Relevant Factors against M/B. Model Summary R

R2

Adjusted R2

Std. Error of the Estimate

Durbin–Watson

0.567

0.321

0.320

1.4605

0.796

Model 1

ANOVA Results Model 1

Regression Residual Total

Sum of Squares

Df

Mean Square

F

Sig

3385.728 7146.020 10531.748

6 3350 3356

564.288 2.133

264.534

0.000

Coefficients of Stepwise Regression Model 1

(Constant) RM 4.789 XSRM Av RM 5 yr growth ROE RESROE

Unstandardized Coefficients

Std. Error

Standardized Coefficients

1.358 2.121 0.000 0.489 3.128 0.013 6.302 0.407

0.068 0.443

0.169

0.372 0.289 0.002 0.275 0.142

0.041 0.196 0.084 0.493 0.055

T

Sig.

20.012

0.000

1.316 10.832 5.712 22.889 2.865

0.188 0.000 0.000 0.000 0.004

relatively stable contexts, this control is often manifest in a product, price or cost advantage relative to ecosystem competitors.

Summary 1. The key strategic measure of performance for a business within a strategic ecosystem is the amount of economic rent extracted in relation to the economic resources consumed by the business: the return on resources, which we measure in terms of an RM. 2. This measure overcomes a number of shortcomings in other traditional measures such as IRR, DCF and EVA, and has historical antecedents well known to economists.


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3. RMs are fully compatible with CAPM, and valuations based on RM measures are well grounded statistically, and causally underpinned by their origins in the competitive behaviour of businesses within an ecosystem. 4. The value of the resources in a business is the sum of extractable rents once investors have been paid for risk.

Questions 1. What level of RM have you historically achieved in each of the businesses by which you compete? How do RMs for these businesses compare and contrast with other measures of performance that you employ? 2. How does your RM performance compare to that of each of your major ecosystem competitors? To what structural factors, or aspects of competitive behaviour, or components of respective business models do you attribute these differences? 3. How have RMs evolved in the ecosystems in which your businesses participate, and how do you expect them to develop in future, and for what reasons?


Part II Techniques


Chapter 7

Business Development If we assume that the managers of a business have succeeded in establishing sufficient competitive control over resources within their ecosystem to satisfy the requirements of investors, it is natural to ask how the business can be further developed.122 An obvious next step is to assess whether it is possible to transfer the existing business model to new ecosystems. The feasibility and plausibility of a transfer or extension of business model will be strongly conditioned by the degree to which the target ecosystem is similar in relevant respects to the existing business: following in the steps of my former consulting partner Richard Koch, I call this relevant similarity adjacency. Not surprisingly then, business development should place considerable emphasis on establishing which ecosystems are strategically adjacent to a business’s core activities. By strategically adjacent ecosystems we mean ecosystems where it is possible to transfer elements of a business’s experience and resources upon entry, and perhaps entire elements of the actual existing business model. The extraction of benefits from this transfer is usually identified as a synergy between the two areas. In placing the emphasis upon strategically adjacent ecosystems, we recognise a necessary, but not sufficient, requirement for new business development: it must in addition also be possible to exert sufficient competitive control in the new business to earn economic rents that keep investors happy. One may develop further the understanding of adjacency by recognising that adjacency is closely related to the concept of strategic ecology: the very criteria that we used to distinguish different strategic ecosystems also represent a bridge that can be used to show how in specific, relevant respects, ecosystems are similar to each other, that is adjacent. In other words, in order to define things that are the same, we need to understand the criteria that make things different and vice versa. For each criterion that we used to evaluate whether two different markets represent different strategic ecosystems, we can define a corresponding element of adjacency. In Table 7 we have listed into groups the strategic ecology criteria provided in Chapter 2 and the corresponding general type of adjacency that these criteria give rise to. For instance, the first set of strategic ecology criteria concerns the degree of competitive overlap between two sets of business activity (which typically will be recognised as occurring in one or more strategic ecosystems), often measured by market share and relative market share. The same criteria allow us to establish whether the

122 We leave aside general business growth within the current ecosystem through the prolongation and extension of the existing business model: the paths of product development, brand building etc. are well trodden.

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Astute Competition: The Economics of Strategic Diversity Table 7: Strategic Ecology Criteria and Adjacencies.

Strategic Ecology Criteria

Adjacencies

Competition Market shares Relative market shares Profitability Exit dependency

Competitor overlap

Marketing Customers, needs and purchase criteria Substitutability Pricing Distribution Brands and promotion

Marketing overlap

Resources Cost and asset sharing Capital intensity Cost and margin structure Experience sharing Supply commonalities

Resource overlap

Management Key success factors Skills and knowledge

Management overlap

Geography Regional barriers

Geographical replication

Technology Products and processes R&D

Technology overlap

Regulation Barriers

Regulatory carryover

two areas demonstrate a competitive adjacency and a sense of competitive shadowing, where a common development question will be: ‘What can I learn from my competitors?’ A business may feel that it understands its competitors well, and that it competes well against them. This may lead it to enter new ecosystems where its competitors are present but where it is currently absent. From an overall business portfolio perspective, such a move may also be sanctioned even if the returns from entry are modest if the move enhances the competitive control of resources in the base business (further explored in the next chapter under corporate strategy). In a similar fashion one can use the elements of the marketing interface as criteria for strategic ecology. Here one may ask whether products, customers, purchase


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criteria, distribution channels, prices and margins between two business areas are similar. This similarity, in turn would give rise to an adjacency of product and customer portfolio, where a possible new business would be deemed to be adjacent because a number of the customers are held in common or because particular products can be sold to a wider variety of customers. In this circumstance business development managers may be asking themselves who else they can sell to or what else they can sell to existing customers. Two separate strategic ecosystems will often be distinguished because there is little resource or experience overlap between the two business areas. This resource and experience overlap might be measured in terms of shared costs or its absence might be recognised in terms of a lack of transferable experience or a lack of interdependency. The very same set of criteria gives rise to a complementary adjacency that might be named a resource adjacency. Two business areas are adjacent where resources and experience do overlap, even if overall we assess them as separate ecosystems. This adjacency can also be captured in terms of a typical question posed by management in pursuit of business development: ‘How can I make best use of my resources and experience?’ An extension of resource adjacency is to think in terms of management overlap: are the business priorities in terms of key success factors similar in two different areas, and is it possible to deploy similar skills and knowledge in the new area? Clearly, the question of what we consider to be a resource as opposed to a management adjacency is largely a matter of judgement. At the heart of management adjacency, is the degree of confidence managers have that they understand how to make money in the new business area: ‘Can we make money in this new ecosystem?’ One common major criterion for strategic ecology will be geographic. Two business activities may represent distinct ecosystems if they are identical in all respects except that significant regional barriers separate them. This again would give rise to geographic adjacency and associated development question of ‘Where else can we go?’ Technology can often be the uniting development thread (Cisco is a prime example of technology-led-related development by acquisition), but it is important to be mindful not to let the tail wag the dog: technology has little value without the commercial competence to extract rents from it. Finally, as we all know, regulation is a can of worms; but occasionally the regulators can do a business a favour by sanctioning new business entry to the detriment of others on the basis of the regulatory credentials of the existing business.123

123 It is interesting to note that, putting the subsidiary questions of geography, technology and regulation aside, the principal criteria for strategic ecology and for adjacency mirror the long-standing structure of the three C’s Harvard framework for strategy: competitors, customers and costs. When considering the question of strategic ecology one examines the degree to which, competitors, customers or costs are distinct in two business areas. In the case of questions of adjacency, the strategic triangle is again represented by likeness considerations: ‘To what extent are my competitors, customers or costs sufficiently similar in a new business area to encourage prospective business entry?’

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Putting Adjacency to Work Given the emphasis placed on adjacency as a concept underpinning business development, it is appropriate to inquire into the process one could envisage following to evaluate existing adjacencies with new business areas. The process for competitor or marketing (product and customer) adjacency is relatively straightforward involving systematic analysis of competitor plans and intentions in the case of the former, and of sales records and customer behaviour in the latter. Such methods can yield relatively easily and rapidly a comprehensive answer in these areas. Where a business has a fully articulated matrix specification of its business model (as described in Chapter 3), managers can speed the listing of marketing adjacencies using the Distribution and Revenue Matrices, D and R of the model, which describe respectively the choice of channels to take products to market, and the choice of monetisation streams arising from these products. The question of adjacencies of resources, however, is a less tractable problem to address. The process may be best broken down into a number of discrete phases: audit, appraisal, search and selection. In the audit phase, managers would typically identify the (shared) costs, activities, skills and knowledge embedded in the business: what I call a CASK profile. Shared costs relate to the indirect costs of the business that are shared across products or departments. Often these shared costs are recurrent across a number of accounting periods because they arise from the capitalisation or enjoyment of assets, for example buildings, plant and equipment, IP and other rights. These asset-related shared costs often take the form of depreciation, amortisation or general overhead. In addition there may be period-specific shared costs that are not directly attributable to a particular product, activity or department (for example local property taxes). Activities typically involve people and are usually associated with specific direct, nonshared costs, for example, the staff cost of auto assemblers. The dividing line between what is a direct, activity-related cost and a shared cost is not always clear, and managers will obviously have to use discretion in identifying which is which in a particular case. Underpinning activity managers may discern skills, for instance, the skills of dexterity and handling for the auto assemblers. To determine what the relevant skills are for a particular activity, managers may look at job advertisements and definitions: what skills do you have to have to carry out the job well? Finally, at the top of the hierarchy, sits knowledge: for the auto assemblers, perhaps knowledge of automobiles or of task scheduling. Knowledge, tacit and explicit, arises from an understanding of the application of particular skills through activity: an abstraction of what improves or enhances application. To make this less obscure, consider applying the framework to a university (Table 8). To develop a CASK profile of their business, managers need to undertake a systematic audit of value-adding resources within each step of a business’s activity. Such analysis of resources can be mapped out using a fairly standard table, where one would identify costs, personnel, facilities, technology, assets, skills and knowledge, customers and suppliers and other significant elements of the value-added by the business that confer advantages relative to competitors. Such an inventory can


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Table 8: CASK Analysis. CASK Element

Examples

Costs (shared)

Buildings Sports facilities Hostels Telephone system

Activities

Lectures Supervision Research Catering Maintenance

Skills

Tutoring Analysis Interviewing Culinary

Knowledge

Academic subjects Higher education Careers planning Psychology of learning

typically be constructed through a brief one- or two-day strategic workshop carried out by senior managers within each of the major parts of a business’s activities.124 Sifting through the table, managers will be able to organise the inventory into the CASK categories. In the case of a well-specified matrix business model, the profile will be much assisted by an examination of the Production, Marketing and GSA Matrices of the model (P, M and G). Very occasionally (as discussed in Chapter 4), matrices may have been explicitly or implicitly developed for the skills and knowledge embedded in the business model in addition to activities, making the CASK profile development a piece of cake. The audit phase would typically be followed by a period of appraisal where the long list of costs, activities, skills and knowledge identified by the audit are assessed and compared. Based around structured debates, a summary and prioritisation may be developed, which synthesises the common threads and elements defining the distinctive resources and key skills of a business. As a lens to focus the debate, we may ask which elements of the CASK inventory allow the business to exert competitive control over resources within the ecosystem. Such a debate might very well lead to an active discussion for a business as a whole of possible future visions, which

124

This CASK methodology, developed in the late 1980s, may be regarded as a specific means to isolate what Prahalad & Hamel (1990) call core competences.

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embody the optimum use of the skills and resources developed over a prolonged period of time. The outcome of the debate may be the identification of the combination of assets, activities, skills and knowledge that comprise the distinctive core of the business, its heartwood. We might call the envelope drawn around these elements the core competence (or competences) of the business, and using matrix methods we could define it in a very explicit way.125 One way then to think about senior management is to think of it as the management of the packaging of assets, activities, skills and knowledge into competences that allow businesses to exert competitive control over resources to create value in the market place.126 Once one has appraised the inventory of resources and skills within a business and developed a CASK profile, one is in a position to contemplate a phase of searching for external opportunities. Different processes may be followed in order to ensure that the options generated represent a thorough compilation of genuinely feasible opportunities while yet reflecting sufficient creativity in order to escape the linear extrapolation of past success. At this stage, for instance the benefits of the earlier construction of a series of possible future visions of the business might be brought to bear. One might be able to focus the process of search around the filling of gaps among identified resources necessary to achieve a particular ending vision. The result of following this type of adjacency analysis centred on core competences is an objective appraisal of available skills and resources and their relative importance and relevance to the business, as it exists today. This method permits a systematic review of related business development opportunities and provides a resolution of key choices, which means managers can make decisions with regard to investment in new technology, the pursuit of single or multiple new business initiatives and the choice of different markets. In addition, such an approach encourages an internally generated solution to future development allowing a high degree of consensus to emerge from within the business. With the benefit of the analysis, managers are then able to regard the CASK framework as a set of hooks to pick out new development opportunities on the basis of explicitly identified adjacencies. If the option generation process has been successfully carried out, one would expect a large number of adjacent opportunities to be generated. Table 9 represents a small part of a list of adjacencies developed for a business involved in an initial narrow instrumentation ecosystem based upon ultrasonics. Typically, when the adjacencies are listed we will find that adjacencies that rely on an overlap of shared costs and activities (the bottom of the CASK hierarchy) are generally small and local (micro adjacencies), while those that rely more on skills or

125 For the more technically inclined, it would be possible to define core competences from the coherent, consistent pattern of change of the matrices of the business model that relate to the internal aspects of the business model. This would mirror our definition of strategy as the consistent, coherent pattern of action captured by changes in the business model overall, which can be formally expanded as described in Chapter 1. For most of us, though, this is probably a bridge too far. 126 The recurrent systematic pattern of changes in the key elements of the CASK profile of a business over time can be identified with what Teece et al. (1997) call dynamic capabilities.


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Table 9: Possible Instrumentation Adjacencies. Adjacent Market

Reason for Adjacency

Analytical Instruments

Knowledge of properties of materials Skill in instrument design Instrument assembly activities

Metrology

Knowledge of wave properties Knowledge of ultrasound Skill in instrument design Instrument assembly activities

Process Instruments

Knowledge of ultrasound Knowledge of strain gauges Skill in instrument design Instrument assembly activities

Quality Assurance

Knowledge of materials properties Knowledge of aerospace specifications

knowledge (the top of the CASK hierarchy) point towards bigger opportunities that are further away (macro adjacencies). For example, in the case of universities, the ability to share the costs of hostels and infrastructure has led them into conference activities; on the other hand, knowledge and analytical skills has allowed them to establish quite wide-ranging consultancy businesses (for example, Stanford University originally established the Stanford Research Institute). Sorting through available options requires choices to be made. Criteria for narrowing down will obviously include the degree of overlap with key skills and competences of the organisation. In addition, there may be further prerequisites for success within each new business area. For instance one might recognise that pursuit of a particular business initiative would require a very high level of funding. Similarly, new business entry will impose strains upon any organisation and what may be feasibly contemplated will depend on what is considered to be an acceptable rate of change or evolution for the organisation in the first place. Finally, in selecting or prioritising particular areas, full account must be taken of external constraints such as those of regulation or politics. In circumstances where one has been able to narrow sufficiently the list of possible new business opportunities, one would carry out a phase of evaluation. In this phase one would typically consider the key characteristics of the adjacent business opportunity. This might be defined in terms of the ecosystem attractiveness criteria discussed in Chapter 2. Important considerations will include ecosystem size, growth of and return on resources within the ecosystem, competitive accessibility and other structural features made available from a Porteresque analysis of the ecosystem. In addition to the identification of resource adjacencies, CASK analysis also provides the platform to consider management, geographic and technological adjacencies on a ‘‘bottoms-up’’ basis. Sometimes, however, a simpler, quicker ‘‘top-down’’

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approach may be more cost justified to identify these categories of adjacency. In the case of management adjacencies this may involve a summary pair-wise comparison of the business models of the existing business and the available models in possible adjacent ecosystems. Similarly, systematic audits of knowledge, assets and locations may provide the key to unlock technology and geographic adjacencies. Finally, to complete the list of adjacencies, regulatory adjacencies may be assessed by recourse to lawyers and regulatory authorities. In general terms these latter categories of adjacency are easier to discern, and are analytically more tractable. What is common to the identification of every adjacency category, however, is the systematic application of an evaluative framework to the existing business and adjacent ecosystems.

Synergies or Strategic Revision To know which new business ecosystems are adjacent and attractive, unfortunately, is not enough: instead it is a case of so far, so good. What we also need to know is whether, having entered a new ecosystem, we can make enough money to keep investors happy. This requires us either to have analysed explicitly the strategy (i.e. business model evolution) and business plan in the new ecosystem, or at least to have a good strategic rationale for being able to make money. If the entry plan is fully developed, managers can subject it to customary evaluation techniques (see Chapter 9). In the case of a less developed rationale, there are generally two main paths to follow: either the adjacencies will allow the business to benefit from specific synergies on entry into the new ecosystem, or the insights conferred by the existing business model suggest a new way of doing business within the new ecosystem that differs from the business models of existing competitors. In the latter case of strategic revision, entry may be achieved through venturing or acquisition (again, see Chapter 9). The opportunity for synergies occurs because two businesses are adjacent; the businesses are adjacent because they score badly on the criteria for strategic ecology that allow us to determine whether two markets are in fact distinct ecosystems. Thus there is a trinity of linked concepts: strategic ecology criteria precipitate the investigation of adjacencies that give rise to synergies, which in turn can be used to evaluate the strategic ecology. The interconnectedness of the three concepts may be better understood by an analogy. Strategic ecology may be likened to defining the rules that identify a particular game. As discussed in Chapter 4, the criteria for investigating strategic ecology provide a starting point for redefining business models to get greater competitive control of resources. In the analogy, studying the individual rules of the game helps us to work out how we can exploit the rules to suit our particular competences and to achieve winning outcomes. Just as when we find a new game, it makes sense to find games that have similar rules, so it makes sense to identify adjacency using strategic ecology knowledge. Finally, we can benefit in the new game from the experience gained from the detailed exploitation of the rules in the old game: by analogy, this means that in adjacent businesses we can extract profit from synergies. The three


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concepts of strategic ecology, adjacency and synergy are different manifestations of the basic inter-relatedness of different business activities. To generate a list of synergies, we need then only to turn to our criteria of strategic ecology. The principal ones are competitor, marketing, resource, management, geography, technology and regulation synergies. Broadly, we can separate synergies into those that are static and those that are dynamic: the former basically relate to making better use of resources, i.e. some form of efficiency, while the latter allow a business to do something new — usually innovation or renewal — that may be thought of in terms of effectiveness. For the economist, static synergies arise because of economies of scale or scope either within the business or as a result of its external interfaces. Static synergies are more strongly associated with the Costs and Activities of the CASK framework than with Skills and Knowledge. Without trying to be exhaustive we may identify some common static synergies. In terms of competitor and marketing synergies, the most common relate to increases in market share, and improved realised prices or greater delivered value per customer. Clearly, benefits may also arise through ecosystem consolidation to improve pricing and purchasing power in addition to a generally greater control of resources against a reduced set of competitors. Resource synergies typically involve the rationalisation of facilities and assets, together with greater sharing of costs, and typically restructuring of activities to increase productivity. Resource synergies may also include the capturing of internal margins via backward or forward integration, and may involve reductions in uncertainty, for example in scheduling, which could reduce working capital or the costs of finance. Management synergies arise from business model modification and the extraction of greater rents. Where geographic replication occurs, value may be greater by the sharing of experience or operational economies including branding or sourcing. Technology adjacencies may liberate value through the exploitation of IP rents or through the application of existing technology to products or processes. Regulatory synergies may reduce the costs of information and the costs of compliance. Dynamic synergies are most evident in the case of innovative product or process development arising from the assimilation of new assets (including IP), skills or knowledge (mostly the S and the K of the framework). For example, by entering an adjacent ecosystem B, which has a distinct technological base, a business may find that this technology can be integrated with the technology in its base business A in such a way that innovative products and processes arise, which would not be achievable by incremental business development in business A or B alone. So, for instance, the combination of Internet content publishing and independent television production has led to the development of interactive subscriber-based fan communities that support merchandising, advertising and affiliation revenues. Whereas the arithmetic of static synergies is typically 1+1 ¼ 1.5, because of the ability to remove cost or increase sharing, dynamic synergies are the ones for which the traditional theorem is 1+1 ¼ 3. From a CASK perspective, business development via dynamic adjacencies often confers the ability to create entirely new ecosystems and to reconfigure the old ecosystem from which the development move originates. This reconfiguration may

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allow structural changes in the base business model because development into a new area has conferred new skills or the knowledge necessary for the reconfiguration.

Strategic Revision Strategic revision provides the opportunity to generate returns from new business development by replacing a deficient business model with a superior one. A number of years ago the major UK food retailers finally moved into the retailing of petrol after many years of deliberation. Their reluctance stemmed from the break-even economics of the retail operations of the oil majors. By co-location, generic purchasing, loyalty programmes and cross-selling with other goods, the food retailers have succeeded in gaining a major share of the retail market on a profitable basis. Similarly, the emergence of new insurance providers operating through call centres has significantly altered the business model in retail insurance. A number of newcomers have entered retail insurance from adjacent ecosystems of the banking industry. Their success is predicated less on the sharing of the costs or customers of their new insurance business with their existing operations (i.e. driven by synergies) and more on their ability to use new distribution methods to support a superior business model that eliminates the traditional retail broking intermediary (strategic revision) in a financial services ecosystem, which is adjacent to their existing business. Producing a compelling analysis of synergies that either lead to revenues, reduced costs or greater returns in the existing business requires considerable time and patience if the numbers are to be believed. Ideally, each of the identified adjacencies (competitor, marketing, resource etc.) should be worked through systematically to buttress an explicit compilation of year-by-year benefits. The sum of these benefits should then be calculated and discounted in the financial modelling of entry. A portion of them should be hard-wired into operating budgets. All too often though, new entry fever sets in, and blue-sky estimates are manipulated until they produce the level of returns that would make any investor switch her life savings into the new business without a moment’s hesitation. Similarly, the case for strategic revision is often the triumph of hope over experience. To mitigate against what others have called irrational exuberance, in those cases of business development where a fully developed new business entry plan is not forthcoming, as a minimum managers, for the purpose of comparison and critique, should explicitly map out the business models of (i) the new business (ii) the existing business, and (iii) the principal competitor in the new ecosystem. Asking a management team how they would act as the principal competitor against a new entrant can help considerably to anchor the expectations of synergy and market penetration. Exerting this kind of evaluative control is one of the principal functions of corporate managers in a multi-business company, and is discussed further in the next chapter. Supplementing this type of analysis one would typically carry out an evaluation of risks, returns and the impact on the existing businesses, items that are discussed further in Chapter 9.


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Summary 1. The key to development for a solo business is the exploitation of adjacent ecosystems (identified through the use of strategic ecology criteria and an audit of shared costs, activities, skills and knowledge) that give rise to opportunities for synergy with the existing business or that are amenable to strategic revision. 2. Strategic ecology, adjacency and synergy form a trinity of related strategic concepts that we can harness to design base, incremental and revised business models, which produce satisfactory financial returns on the resources available by exerting control over competitors. 3. Adjacency alone will not keep investors happy: new business initiatives need to generate adequate returns that arise from static and dynamic synergies or strategic revision in order to satisfy investors for the risks that they accept.

Questions 1. Can you compile a list of the ecosystems adjacent to your existing businesses? 2. What are the principal CASK elements of your existing businesses? 3. What synergies exist between your existing businesses and adjacent ecosystems, and are there sufficient static or dynamic synergies available to you to satisfy the financial requirements of investors? If not could these requirements be met from adjacent entry predicated upon strategic revision of the prevalent business models in the adjacent ecosystem?


Chapter 8

Corporate Strategy: Purpose The purpose of corporate strategy is to extract greater sustained economic rents from a set of businesses than the businesses would generate on a stand-alone basis or when directly owned by a common set of shareholders. If the extracted rents do not meet this test, then the corporate strategy fails to add value. The downsizing and restructuring of companies in the late 1980s and 1990s through buy-outs and spin-outs suggest that investors are a good deal more sceptical about the ability of corporate leaders to add value to businesses than they used to be. What grounds are there for continuing to think that corporate strategy has merit? The answers lie in the failures of markets and the scope for performance enhancement of businesses.

Market Failures One of the justifications for corporations is to reduce agency problems. These problems arise because owners and managers have different interests, and if owners are to see their wealth maximised, they must employ governance, monitoring and disciplining mechanisms to safeguard their interest.127 Often an individual shareholder will only own a very small percentage of the capital of a company. As a result the costs of monitoring and compliance may be very large in relation to the value of the holding. Where a shareholder is disappointed by the performance of the managers of a company in which she holds shares, the best remedy is typically to sell the shares. Some protection may be provided because institutional shareholders may be able to afford the costs of monitoring and policing, but the recent spate of corporate scandals reveals how easy it is for errant managers to profit at the expense of shareholders: what discipline there is, comes all too often too late. One way to mitigate this problem is to employ agents to manage the agents: poachers turned gamekeepers. Highly regarded agents of this ilk from the past include Harold Geneen (formerly of ITT), Lord Weinstock (formerly of GEC), Owen Green (formerly of BTR) and Lord Hanson (formerly of Hanson Trust). By exercising very tight control of cash budgets, operational managers were prevented from

127

In fact, one can argue that the whole basis for the existence of companies is to exert hierarchical control to prevent agency-type problems throughout the business: foremen prevent workers skiving, supervisors checkup on foremen, etc. The problem between shareholders and senior managers is one aspect of a wider set of alignment of effort, rewards and punishments.

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frittering away shareholder funds on marginal projects. By correcting perceived agency problems in the businesses they acquired, these CEOs created value for their shareholders simply by preventing others from destroying it. Unfortunately, there is only so much value that this corporate strategy can deliver: shareholder wealth can only grow by finding larger and larger agency problems to sort out, and eventually there are no ready candidates to acquire. The performance of each of these companies plateaued and declined because once waste was removed there was no additional leg to the corporate strategy, which supported value creation through growth and development. Keeping the agency problem under control adds a stable but non-growing element of value to shareholders, but investors are likely to expect more. Besides making sure our managers are not crooks or laggards, we need to get them to be good managers. One related aspect of the agency problem relates to business retention. Very often incumbent managers will passively retain businesses because of the disruption and uncertainty caused by their disposal. One value-adding skill of a good corporate strategist is to recognise when a business might be worth more to someone else than it is to its current owners. Understanding the shadow value of a corporation’s assets can help a corporation to make the right hold–sell decisions, safeguarding its own independence in the medium term. A second justification for the intervention of the corporate hand is the ineffectiveness or inadequacy of financial markets. Much research has been done on the efficiency of market transactions and the inability of short-term trading strategies to produce profits on a systematic basis. This research, however, overlooks the fact that securities may be mis-priced even if they are traded efficiently. At the time of the Internet bubble, a little basic arithmetic showed that valuations could not possibly stack up. Perhaps what we witnessed was locally rational speculation: a land-grab was underway but no one knew which the best plots were. Faced by ignorance, it was sensible to buy a small piece of each plot. As a result of the lack of fundamental understanding of strategic ecology and business models for the Internet, all the Internet-related share prices were bid up. The effect was a perverse prisoners’ dilemma. Normally, the payoff to the two prisoners is jointly best when they cooperate, but individually it is in their interest to betray their compatriot. During the bubble, it was in the interest of individuals as a whole not to speculate (i.e. not to cooperate with others), but individually the temptation was overwhelming to invest (me included). Individually (with a few rare exceptions), we would have been better off not to cooperate. During the bubble, a huge mis-allocation of resources occurred — over a hundred billion dollars of venture investment alone in the United States in 2000. The ensuing fall-out has been traumatic, sweeping away thousands of new enterprises often on an indiscriminate basis, wiping out good with bad. For those seeking to establish new businesses since 2000, largesse has been replaced by famine. A number of promising businesses have been held back, in some cases for good. The message to take away is the importance of psychology and timing in traded investment markets. Corporate owners can obviously mitigate these difficulties. One might object that bubbles are fairly rare occurrences, but we see that every day the specialisation of assets, resources and business models make it extremely


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difficult to establish accurate market prices in general at any given moment (even if we accept there is such a thing as the price). Remember financial markets are markets of expectations, and while coupling with the physical markets for goods and services in the longer term; the linkage between expectations and underlying business realities is fuzzy at best. We may take comfort in the fact that markets are typically selfcorrecting, but this does not remove the vulnerabilities businesses may suffer because of market perceptions and unfavourable timing. What bubbles signal is that mispricing is generally recognised as being so widespread that it has captured the attention of the general public: the day-to-day mispricing is out of hand. Corporations can provide a more consistent resourcing environment than more volatile public markets. This must in part be an explanation for the tremendous growth in venture capital and private equity. The general conclusion is that corporations may sometimes allocate resources more effectively than markets. Financial theorists recognise this implicitly when they talk of the value of insider information: this information, provided asymmetrically to managers relative to shareholders, would allow a corrupt manager to make abnormal trading profits. In financial jargon, we say that financial markets are not strongly efficient, because one could systematically make money based on insider trading strategies. That same knowledge can legitimately enable managers to overcome the capriciousness and volatility of markets in allocating resources to businesses within the corporate portfolio, more to some, less to others. The managers are putting the insider information to work.128 Besides these general asset-pricing problems, there are three particular types of market failure that warrant further discussion and buttress the claims that corporate strategies can add value. First, markets fail radical innovators. The reason is that the requirements for a market to function — for instance widely accessible information available at low cost on the assets that are traded in order to set prices — undermine the value of the innovation. Imagine you have invented the first three-dimensional holographic hard drive for a computer that uses optical processing and that your designs and technology, while exceptionally innovative, can be easily replicated. If you require money to develop products, it will be very difficult to raise money from financial markets because the provision of the information to validate your breakthrough will eliminate your ability to capture profits from it. The information required for the good functioning of financial markets is itself the confidential source of proprietary value: angels, venture capitalists and corporations have a role to play if this value is to be liberated discretely. Unfortunately, recourse to angels and venture capitalists gives rise to a second market failure that again plays to the advantage of corporations. In the United Kingdom there have been many investigations into the ‘‘equity gap’’, some dating from before World War II. The term refers to the difficulty developing businesses encounter in raising seed capital funds that fall between the typical deal

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These notions could be explored more systematically in a Williamsonian Transactional Cost Economics framework.

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Astute Competition: The Economics of Strategic Diversity Table 10: Seed Capital Example. Year 0

Revenues Costs Cash profits Investment 1 Investment 2 Investment 3 Rate 1 Rate 2 Rate 3 Value of Inv 1 Value of Inv 2 Value of Inv 3 Exit multiple Equity % 1 Equity % 2 Equity % 3 Owner Total Value

0.50 0.75 0.25 0.40

1 1.00 1.25 0.25

2 1.50 1.75 0.25

3

4

5

2.50 2.50 0.00

4.00 3.00 1.00

6.50 4.50 2.00

6.57 5.24 3.15 15.00 21.88% 17.48% 10.51% 50.13% 100.00% 30.00

0.80 1.50 75% 60% 45% 0.40

0.70 0.80

1.23 1.28

2.14 2.05 1.50

3.75 3.28 2.18

30.39%

24.45% 19.53%

24.45% 19.53%

69.61% 100.00% 1.32

56.02% 100.00% 4.10

56.02% 100.00%

21.88% 17.48% 10.51% 50.13% 100.00% 14.27

21.88% 17.48% 10.51% 50.13% 100.00%

thresholds of angels and venture capitalists (or banks) — currently between £ 250,000 and £ 1,000,000 in the United Kingdom. Successive governments have introduced a series of policy measures, often related to tax incentives, to facilitate this type of funding. For a number of fundamental reasons, however, it is most unlikely that this gap, which cannot be served by traded markets on a cost-effective basis, will be eliminated. Consider the following development path for a new business (Table 10). The trajectory is that of a fairly successful business enjoying Fibonacci-type sales development.129 The table shows the typical returns expected from two rounds of seed and one round of venture capital funding. The end result is that, after setting aside equity for the management team, the founders are likely to have a little less than the majority of the equity, and the seed holdings will have diluted to 22 and 17 per cent based on an assumed trade sale at fifteen times cash earnings in Year 6 (equal to approximately four and a half times revenues). Knowing the rates of return that investors will require (representative numbers have been used) allows us to work backwards to determine the equity participations at each round. To attract an initial investment of £ 0.40 M, the owners will need to give up just over thirty per cent of the equity, based on an implied pre-investment valuation of just under £1 M. Such a funding package is reasonably common today: 30 per cent of the equity for a

129

Sales this year are the sum of the previous two years.


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£ 400,000 investment at a pre-money valuation of a million. The problem is that very few businesses offer this good a trajectory. There are two possible responses: either demand greater equity or refuse to fund. Seeking greater equity is problematic for a number of reasons. First, the founders will not wish to yield a very large portion of their business to the funders when they consider that they do most of the work. Second, putting the funder into a majority position may lead management to abrogate their responsibilities (though the legal aspect of majority ownership can be overcome to some extent using preference shares etc.). Lastly, the high initial stake may prejudice later funding possibilities. Not surprisingly the usual response is to refuse to fund. Of course, the deal economics would change if we reduced the rate of return expected by investors: why are they so high? They reflect the high effective failure rate of start-ups, where it is possible to lose all the money invested or to be heavily diluted by unanticipated extra rounds of finance. The rates are also strongly influenced by the limited diversification of typical seed portfolios within a fund (often between eight and fifteen investments), and the established risk-return expectations for this asset class (relative to say equities, fixed interest or absolute return investments). To make seed funding work, there have to be occasional winner investments that deliver these high levels of return, and the funders start with the pre-investment requirement that whatever they invest in should be capable of this level of return. The result is that very few businesses get funded. Those that do not get funded undergo a Darwinian cull, so that those that do manage to survive are sufficiently derisked and robust to attract venture or bank funding at a later date on more acceptable terms. The equity gap is likely to remain, and one bona fide role of corporates is to help to fund these types of investment both internally through new business development within the corporation, and externally with third parties by joint development agreements, alliance funding and corporate venturing. Corporates also have a better chance of redeploying a new business idea or technology in response to market feedback, and failure seldom means a complete write-off of the resources deployed. The last market failure relates to people. In spite of the growth in the number of head-hunters, the allocation of talented people between businesses is haphazard and precarious. Most individuals only investigate other employment opportunities at moments of crisis. Then for a short period of time, an individual will initiate a deliberate but highly bounded search, frequently constrained by cost and by geography. Even where individuals do, over a longer period, identify attractive areas of opportunity, it is often difficult to obtain the resources necessary to train or educate for the new area. Timing of entry is often awry, and much is left to chance. Contrast this with the management development programmes of some of the top quartile corporations, and it is clear that gains are available from the systematic and sympathetic management of human resources within a corporate framework. In addition to addressing the market failures relating to innovation, funding and talent, it can also be argued that there is a further benefit to employing a corporate rather than a market framework. According to the proponents of transactional cost economics, firms exist because they can internalise complex, infrequent, specialised

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transactions at lower costs than markets.130 Operating at a higher level, the same transactional efficiencies may be available in the contractual coordination of a collection of stand-alone businesses in order to extract the greatest sustained economic rents from that collection of businesses. While this argument has some merit, it only offers a minimalist notion of what a corporation is about (you have heard this before in Chapter 1 in relation to a single business). It overlooks one of the principal benefits of a corporation: corporations, like businesses, get things done. The frameworks they establish for corralling businesses, pooling resources and pursuing shared advantages would be extremely difficult, if not impossible to replicate in market-based transactions between the entities. Corporations focus power and collective will to pursue narrow courses of action that managers hope will deliver acceptable returns to investors.

The Performance Enhancement of Businesses While the preceding pages dealt with some recognised market failures, corporate critics may feel that few of these failures are likely to apply to a set of well-established businesses. With sufficient critical mass each business within a portfolio may be fully capable of innovating, finding funding and managing its people well. Agency problems may exist, but who is to say that this is better dealt with by another layer of management within a corporation as opposed to a strong and effective board for an autonomous company. So what value, if any, might be attributed to a corporate strategy? The answer surely lies in the performance enhancement of the businesses themselves. Where corporate managers are able to extract greater sustained economic rents from the businesses than they would generate on a stand-alone basis, then the corporation has added value. How can corporations do this? In much the same way that companies may often make up for market failures, perhaps we can say that corporations make up for company failures. There are perhaps half a dozen main ways of enhancing the performance of a set of businesses, which we will discuss below: static and dynamic synergies, coordination, business model engineering, reinforcement, investment and pursuit of major initiatives.

Synergies In the previous chapter we have discussed the common sources of static synergies: competitor, market, resources, management, geography, technology and regulation.

130

Teece (1980: 229) came to a similar conclusion when he wrote : Besides technological knowhow, the transfer of managerial (including organizational) knowhow, and goodwill (including brand loyalty) represent types of assets for which market transfer mechanisms may falter, and for which the relative efficiency of intrafirm as against interfirm trading is indicated.


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We explained in particular how CASK analysis can be used to elucidate the resource linkages between businesses. Those synergies arising from the sharing of costs and activities may be systematically extracted by recurrent reviews of business unit cost structures and overhead value analysis. Higher-level synergies involving particular skills or knowledge may be exposed by the analysis of best-demonstrated practice on a systematic basis across businesses. Corporations vary in the way they conduct these reviews: transfers of personnel, swat teams and outside experts represent some of the more common choices of mechanism. Improvements in enterprise management software have also made it easier to carry out comparisons and analysis. In theory, businesses within a corporate portfolio might be able to effect these synergies without a corporate owner, but in practice there is much to be learned from the business practices of other members of a cohesive group. Dynamic synergies arise because entirely new opportunities arise from the ownership of a combination of businesses. Sometimes new combinations of assets and resources will permit significant product or service innovation, or the emergence of an entirely new business: Monsanto’s acquisition of seed breeding and biotechnology companies, for instance, has allowed it to develop entirely new activities in genetically modified crops. Such Schumpeterian breakthroughs may not occur frequently, but when they do they may be very disruptive and give rise to large innovator rents. More modest harnessing of skills, knowledge and technology often permits business renewal to occur, allowing continuing growth of value-added and deferral of eventual decline: many businesses show striking improvements in performance over very long periods from the embedding of new methods, skills and knowledge into existing processes. Successful exploitation of dynamic synergies does not require the mother of all new business initiatives — much of the value created is in small everyday parcels, and a lot of it is created serendipitously. To exploit innovative dynamic synergies, corporations nurture and support new internal and external ventures, overcoming some of the market failures we have discussed. This is not easy, and there have been periods when venturing and new business divisions have been in and out of favour. Companies like Intel and Xerox may claim some significant success, but there are no doubt other companies that are ill-suited to this role, who are nonetheless spending large sums on new ventures. In recent years, Hank Chesbrough and others have placed greater emphasis on the need for open innovation, based on collaboration, joint ventures and acquisitions.131 There is no simple recipe for success, but that does not imply that all corporate effort is wasted. Considerable value can be created from the directed application of innovative technology across new business areas, and from the steady nurturing of teams, business models and embryonic products and services, little of which might occur without a corporate backdrop. Often, it is only possible to manage the

131

See, for example, Chesbrough (2002).

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information involved in dynamic cross-business innovation through a hierarchical structure, which lends support to the need for a corporate structure.

Coordination Besides extracting synergies, corporations are able to create value from coordination, which harks back to the notion of coherence in a business strategy described in Chapter 2. Greater market, competitive and operational effectiveness may be obtained by marshalling the activities of a group of businesses in a way that facilitates their operation and cooperation, reminiscent of the coherence of a pulsed laser. Even where companies are not explicitly trying to increase coordination, it is evident: it may stem from such small things as organising management timetables so as to minimise conflicts and facilitate cross-working, but may extend to more significant areas such as the harmonisation of reporting, and the use of corporate PR, branding and logos. Where senior management are deliberately focused on improving coordination, there are a number of big levers to pull: encouraging cultural convergence, similarity of organisational design, consistent human resource strategy are some of the more obvious. Economists would consider many of these measures to be economies of scope. Often specific savings or benefits arise from shared tax planning, treasury activity and financial engineering, all of which would be hard to obtain transactionally between separate entities. Where collaborative working occurs between businesses, corporate ownership also provides a framework and mechanism for regulating the contribution of effort and reward between collaborators, something in principle undermined by market-based transactions when it is impossible to determine or price the contributions of the parties separately.132 What clearly needs to be borne in mind, however, and what has been the target of justified criticism, are the costs associated with management processes established to enhance coordination. Unless we are careful, we will need super-coordinators to coordinate the coordinators. Mind, this does not mean leaving individual businesses to decide the degree of coordination entirely by themselves: very few line managers will make the effort to coordinate with other businesses when left alone. Typically, they will focus their efforts on their own existing business, preferring to bring the entirety of any new cooperative activity in house. From their point of view this may be a worthwhile way to exploit economies of scale or scope. Successful cooperation requires both commitment and trust, and the latter takes time to create. This is human nature, and is part of the agency problem: it is not delinquency but local rationality, which able corporate managers may be able to correct, since they have the benefit of a wider perspective. I expect none of this is new, and all of it is common sense. But bland cooperation like political correctness is hardly likely to be the motor

132

See Coase (1937).


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of corporate value-added — something more aggressive and distinctive is required: business model engineering.

Business Model Engineering Business model engineering involves the creation, management and modification of the business models of the businesses that make up the corporation. Corporate managers typically request, examine and critique the strategies of operating units, which describe how the business models of the units are expected to change over time. We might consider an effective corporation as a sort of business model factory, creating, modifying and managing business models. With the right sort of intervention, corporate managers can improve, modify and often strengthen the strategies and underlying models of the units, to the benefit of the business managers, the corporation and its shareholders. What reasons are there for thinking corporate managers can do this more effectively than the businesses themselves? There are perhaps three: (i) knowledge, (ii) experience, and (iii) objectivity. Corporate managers may have better knowledge of outside market and competitive conditions, in part because of their detachment from operations, but also because they often have specialist resources to keep them informed (inside or outside the corporation). In addition, they often know about the operations of businesses that are adjacent to the businesses in question. This allows them not only to work on synergies and coordination, but also to have enough deep understanding to question line managers in the business about their choices. This need not be threatening or undermining; done well it can help the business managers to re-engineer their business model, or to make them more committed to it or to gain additional resources. The role is rather like that of an experienced non-executive director, or venture capitalist, roles that are recognised as often having a positive shaping effect on the development of a business. This strategic role is distinct from the budgetary, reporting and operational review roles that exist between the ‘‘centre’’ and the business. These roles are concerned with the delivery of what has been promised, (with its undertone of agency management and threat of a big stick), rather than with deciding what is and can be delivered on a sustainable basis from the business. The second reason, corporate managers may help to improve unit business models, is that often they have a lot more experience of analysing, modifying and crafting business models than the typical manager of a business. We see this in the serial success of leading venture capitalists such as Apax or Sequoia: they have a track record of systematically picking the winners from the losers, and part of that ability derives from the experience they have accumulated in the examination and review of business models. None of this rules out or diminishes the relevance of the experience of those in the business, but just as the managers of the business might expect to have greater experience with negotiating distribution contracts for their business, so they might also expect the centre managers to know a thing or two about what is or is not likely to work as a business model in a given ecosystem. Both sets of knowledge and experience can be set to work to hone and polish the existing model.

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Objectivity is a problem for any business if only because of the selection bias implicit in applying the things you know and excluding the things you do not know when you formulate plans, budgets and business models. Given that there is often asymmetry of information between the centre and the division, the inclusion of new, undisputed factual information is bound to alter the way the managers of a business think about it once they have been in discussion with the corporate sources of information. Obviously, other biases creep in: myopia, risk-aversion and ambiguity are non-conspiratorial sources of distortion. On top we have the much-discussed problems of wayward managers (fewer in number in my experience than the popular business journals would have you believe). These three grounds for thinking that corporates might add value are probably fairly unobjectionable. Where the real work takes place, however, is in figuring out the right sort of intervention. This can vary between corporate representation on devolved subsidiary boards in a holding company mode at one extreme, to line item monitoring by cost and profit centre within each business on a weekly basis at the other (the author has witnessed both). A lot depends on (i) the relative emphasis placed between the strategic role of the centre and the financial control of performance by operating units, and (ii) the balance between management by autonomy and management by direction. Like much in this book, there is no simple answer or recipe, and what works for a corporation at one time with a particular set of executives, may not work at a different time or with a different set of executives.133 Think politics: different countries favour different types of political system at different times. Just as there is no single superior form of political structure, so there is no single preferred form of corporate intervention. Cats aside, there is more than one way to skin a rabbit.

Reinforcement We can say, however, that the strategic axis of intervention will be particularly important where a corporation pursues a group strategy that involves the proactive management of a central thrust: perhaps defined in terms of core competences, or customers or technology. What underlies and makes potentially valuable each of these unifiers is adjacency: the corporate strategy creates extra value, corporate advantage, by exploiting collective strength in adjacent business ecosystems. Without adjacency to ground increased economic rents, there would be no particular purpose served by the central thrust. It would be rather like establishing a group of businesses

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We may dodge the disappointed reader by reminding him that this is a book first and foremost about strategy, not about strategic management (i.e. the way organisations are managed so as to behave strategically). Failure to offer prescriptive processes for strategic management, however, is not a result of laziness or ignorance. Rather, having reviewed the multitude of writings in this area, it is apparent that there are no general answers beyond what common sense and general business experience suggest. The situation is rather similar for parenting where there too we have no general book of rules. The lack of prescription, though, does not mean we have no understanding of what strategy is, any more than the lack of a parenting manual denies us a clear understanding of what parenthood is.


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that all involved shiny products, or which all began with the letter C, just as some people collect stamps that have birds on, while others collect stamps that depict trees. Reinforcement involves the single-minded exploitation of one or more major adjacencies across the businesses that comprise the corporation.134 Readers will recall from Chapter 7 that the most important adjacencies (mirrored in the criteria of strategic ecology) are competitors, marketing, resource, management, geography, technology and regulation. The key idea is that there is a high element of overlap between the constituent businesses in the corporation with regard to the adjacency that forms the basis of a corporate advantage. For example, one way to implement a corporate advantage based on a management synergy is to select constituent businesses that have very similar business models. Corporations exist or have existed that emphasise each one of these adjacencies as a source of corporate advantage — for example (in the same order as the adjacencies), we can cite: AirBus, Canon, Proctor and Gamble, Hanson Trust, Hudson Bay Company, Cisco and Price Waterhouse. Often a corporation’s mission statement points to the type of adjacency that is the predominant source of corporate advantage, which underpins the performance of the constituent businesses. It could be objected that this talk of adjacency as the basis for a central corporate thrust that confers advantage and thereby higher sustained rents, is nothing more than a restatement of the pursuit of synergies discussed above. There is a difference. We could pursue synergies, and cooperation, and business model engineering within a portfolio of businesses that are relatively heterogeneous as a whole. The pair-wise synergies that exist between different pairs of businesses might be quite dissimilar, so while synergy benefits could be extracted, the collection of businesses would not be held to have something strongly in common. This is not the case with reinforcement: the same adjacency is dominant across all the pair-wise combinations of businesses within the portfolio, and that adjacency confers something additional beyond the sum of the pair-wise synergies between the separate pairs of businesses, or beyond the benefits of coordination or business model engineering. Readers will recognise that this notion of reinforcement may overlap strongly with what Prahalad and Hamel call ‘core competence’. Imagine a stampede through the streets of Pamplona, compared to one on the open plain. If you get trampled on, you really know about it in Pamplona: so it is with competitors who get repetitively battered by the focused, reinforcing initiatives of a corporation that has a very strong emphasis on a particular adjacency as a source of advantage. This type of corporate coherence does not occur serendipitously. The central corporate thrust is the result of (i) proactive business model engineering to maximise the dominant adjacency across businesses (for example, implementation of a standard set of procedures and formats for businesses that are characterised by a common management adjacency; development of a key account CRM system to exploit a marketing adjacency; or new product development to incorporate a shared

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Prahalad & Bettis (1986) were thinking along similar lines when they coined the term ‘dominant logic’, as were Dierickx & Cool (1988) when they spoke of the interconnectedness of (strategic) asset stocks.

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technological platform), (ii) weeding out and elimination of those businesses and activities that are not adjacent — the ones that do not fit. One systematic way to do this is by implementing CASK profiling of the businesses within a corporation on a recurrent cycle every three or four years. What it comes down to is concentrating resources onto ecosystems that are narrowly adjacent to each other for maximal advantage, and getting rid of the corporate distractions that exist in other areas. It is the opposite of being a conglomerate.135 The starting point for the development of an adjacency-driven corporate strategy based on reinforcement is the diagnostic investigation of the existing portfolio of businesses, as described in the next chapter. The steps involve investigation of relevant strategic ecology, individual business model definition and then adjacency profiling between businesses resulting in a clear prioritisation and financial quantification for (i) synergies, (ii) coordination, and (iii) reinforcement. The scope for a common corporate emphasis on a particular dominant adjacency will emerge from this analysis. If the corporate advantage conferred by the common adjacency is significant, it may eventually erode the ecosystem barriers that distinguish different ecosystems. For example, the technological adjacency provided by the Windows platform has resulted in the assimilation of previously separate applications-driven ecosystems (databases, spreadsheets, word-processing) giving rise to a basic strategic ecology between a single enormous Microsoft-present PC software ecosystem, and a few nonMicrosoft-present niches such as anti-virus software. One could consider this the triumph of a corporate adjacency supported by scale economies over heterogeneity. Whether it lasts remains to be seen.

Investment and Major Initiatives These two items may be taken as a pair since they are closely connected. Corporations may create greater value than the stand-alone businesses they comprise through the process of investment by (i) ranking investment projects of different businesses in a common risk-return-timing framework; (ii) applying greater scrutiny and objectivity to investment proposals; and (iii) pursuing investments that build corporate adjacency through reinforcement, which might not otherwise be pursued. A particular form of the latter is the investment in a major start-up initiative, such as a new base technology, acquisition or long-term new organic business development.

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If one wanted to treat corporate models more explicitly one could develop matrix mechanics similar to those in the Chapter 3 to describe explicitly the corporate configuration that extracts adjacency benefits. We would develop corporate matrices C that provide coefficients for each type of adjacency that operate on the set of paired subsidiary business model matrices (BT1 C A2) to produce a matrix product, which could be diagonalised to reveal the principal axes upon which the corporate model is defined. In simpler terms, we would be able to see whether the common element across the corporation’s businesses related to common technology, common customers or shared competences. Corporate strategy would be defined as the change in the corporate model over time.


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This major initiative might be difficult to fund or to justify relative to other projects when considered from the perspective of any single member of a group of individual stand-alone businesses. Similarly, major corporate acquisitions fall into this category. Individual businesses are poorly positioned to establish investment priorities within a collection of businesses. Even if the businesses are well informed about each others’ prospects, it is very likely that a large element of quasi-democratic splitting of investment funds will occur, rather than a strict selection rule that funds some projects fully and declines other entirely: few business managers are known for their self-denial.136 The establishment of shared frameworks to evaluate risks, returns and timing is particularly important in dynamic environments where the opportunity costs of missed or failed investments are poorly captured by the relatively static and mechanistic tramlines of discounted cash flow, the usual decision rule for investment decisions within a single business. Scrutiny and objectivity with regard to investment are pertinent to the success, influence and credibility of corporate level managers. Corporate managers are well placed to demonstrate these traits for the reasons we explained above in connection with business model engineering. None of these perceived routes to adding corporate value is groundbreaking news. The difficulty resides in how to establish processes within the corporation that conform to these norms without undermining individual business initiative and without creating the temptation for large-scale corporate wishful thinking. Remember that where financial resources are pooled, CEOs and their team can feel under pressure to do something voguish with the money at their disposal, on a scale that often dwarfs the size of commitment that can be sanctioned by individual business heads. Much of my time as a strategy consultant working with senior managers of FTSE 100 and Fortune 500 companies was spent in dissuading them from pursuing some exciting, but value-destroying, initiative. Mondays were worst, following weekend rounds of golf or an interesting television documentary. By Friday sombre rationality had usually prevailed, but often not without several man-days of research to outline the weakness of an idea that was never used. As before, there is no obvious panacea: different organisations will cope with the benefits and drawbacks of corporate involvement in investment and initiatives in different ways.

Corporate and Business Model IP Drawing these various threads together, we can expect successful corporate strategy to extract additional sustained economic rents from the creation, management and modification of business models beyond what those models will independently deliver if separately owned. From this perspective, corporate managers can exercise considerable entrepreneurial flair in addition to ensuring that each business in the corporate pursues increased competitive control of resources within a strategic ecosystem through the sound execution of its business model. This is not dissimilar to

136

Good corporate managers can help to avoid both type I (reject the good) and type II (accept the bad) errors.

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the role played by venture capitalists or private equity specialists with regards to their funds.137 Where a corporation has developed implicitly or explicitly a recurrent means to extract these additional rents, we may regard that corporation as possessing a form of corporate IP in addition to the IP represented by the business models of its individual businesses. Like IP in general, the corporate IP may confer value if it is the basis for a competitive advantage that is hard to replicate that allows corporate managers to extract additional rents from the underlying businesses. This corporate IP may slowly evolve, may dissipate or may be enhanced by development. Chances are that it will be improved, strengthened and protected if it is made explicit and proactively managed. For the head of an individual business within the corporation, this perspective leads us naturally to regard the securing of resources for a particular business model as a type of marketing problem in a complex community. The business head needs to secure commitment to the IP represented by his business model in much the same way a technopreneur needs to win funding and support from a venture or development capitalist for technology IP in general. To do this, the business head needs to ensure that (i) the business model IP is valuable, scalable, defensible etc. (ii) the resources necessary to commercialise the business model IP are appropriate, justifiable, competitive etc., (iii) the resulting returns are sufficient to satisfy the corporate investor, and (iv) the funding and corporate resources required are sequenced against specific business milestones (see Chapter 10). Like venture propositions, generally, the proposals will need to be designed to meet the requirements and profile of the corporation to succeed. For instance, if corporate strategy is firmly based upon the pursuit of a particular dominant adjacency, then this will need to feature strongly in the proposal. Working out the needs of the corporation and then designing proposals to fit them that make use of business model IP introduces venture capitalist-type thinking to the process of business development within a corporate framework.

Recapitulation Corporations can create value for shareholders by extracting greater sustained economic rents from their constituent businesses than the businesses would generate on their own. They achieve this by (i) compensating for the inadequacies of marketbased solutions to problems of innovation, funding and talent; and (ii) by proactive management of their constituent businesses exploiting synergies, coordination and the reinforcement of adjacency advantages, together with the control of expenditure on investment and major initiatives. Whether corporations do deliver value will

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What is interesting and valuable in the VC/PE model is (i) the strict separation of funding and associated investor expectations from the activities and financial flows of the investee companies, (ii) the small number of committed investors, and (iii) the precise and fixed terms of carried interest to reward the fund managers. Perhaps this model may provide lessons for more integrated large corporations.


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depend upon their processes of intervention and central costs in addition to agency losses. In the next chapter we will review some of the techniques corporations may employ in order to make their intervention effective in generating additional value for investors.

Summary 1. The purpose of corporate strategy is to extract greater sustained economic rents from a set of businesses than the businesses would generate on a stand-alone basis or when directly owned by a common set of shareholders. If the extracted rents do not meet this test, then the corporate strategy fails to add value. 2. Corporations can add value by compensating for the inadequacies of marketderived solutions to problems of innovation, funding and talent; and by enhancing the performance of businesses by exploiting synergies, coordination and reinforcing adjacency advantages, together with the control of expenditure on investment and major initiatives. 3. Corporations are also business model factories where the principal task of corporate managers is to extract additional sustained economic rents from the creation, management and modification of business models beyond what those models will independently deliver. 4. The recurrent competence the corporate brings to its businesses may itself be regarded as a form of corporate IP. 5. Useful analogies may be drawn between the processes and behaviour of successful venture capitalists and private equity specialists and those of good corporate managers.

Questions 1. To what extent does your corporate business model focus on addressing market failures that relate to agency problems, technical innovation and the nurturing and development of promising businesses and talented managers? 2. Does your corporation have an explicit business model that describes and guides its value-adding activities? If so, what is the relative emphasis placed on synergies, coordination, business model engineering, reinforcement and major initiatives? 3. What distinguishes the way your corporation extracts greater wealth from its constituent businesses relative to its corporate peers, enemies and idols?


Chapter 9

Corporate Strategy: Techniques If corporations are to extract additional sustained economic rents from their constituent businesses, they need to be able to identify distinct businesses and their associated business models. Portfolio analysis can provide an accurate understanding of the portfolio of constituent businesses and their linkages. Once strategic options for the portfolio businesses have been crafted, they need to be evaluated and compared using a valuation framework. Often, acquisitions will have a part to play in the development of one or more of the constituent businesses, necessitating processes and techniques for target selection and evaluation. This chapter describes various portfolio, valuation and mergers and acquisitions (M&A) techniques that may assist a corporation in the value-effective management of its businesses.

Portfolio Analysis The first step in analysing a portfolio of businesses is to carry out a careful strategic ecology exercise in order to establish in which strategic ecosystem a given business competes (we will assume for the sake of clarity that each business occupies only one strategic ecosystem, though in practice this need not be the case). In Chapter 2 we described the empirical criteria that may be used to determine which ecosystem a business competes in. Let us assume that we have been able to apply these criteria and to settle the strategic ecology issues relating to the portfolio. For each business in the portfolio a strategic profile may be constructed. As part of the profile we will need to understand the factors that influence the magnitude and profitability of the value-added (resources) available within the ecosystem in which the business resides. The magnitude and profitability of the value-added will be affected both by factors outside and inside the ecosystem. Turning first to factors outside the ecosystem: typically the ecosystem will form part of an extended value chain that leads from raw materials or components to final products or services that are delivered to end user customers. Often the value-added chain will be taken to comprise an industry. For example, in the automotive industry we can observe a chain of activity that extends from the supply of raw steel through individual components to assembly, distribution and the after-sales service of vehicles. Within this chain of value-added, we may distinguish distinct strategic ecosystems — for instance, the ecosystem relating to the manufacture of catalytic converters. Pressures and changes that exist throughout the entire value-added chain that comprises the activities of the automotive industry will in part determine the growth and magnitude of value-added within the catalytic converter ecosystem. For

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instance, during periods of oversupply vehicle assemblers may attempt to rationalise their components supplier base and this may lead to pricing pressure reducing the magnitude of value-added available within specific component ecosystems. Downward pricing pressure will also affect margins within these ecosystems. As described in Chapter 2, we may carry out a Porter Five Forces structural analysis at the ecosystem level in order to isolate the effect of buyers, suppliers, substitutes and new entrants. Longer term and more pervasive influences will also be at work on the extended value chain. These may include secular growth or decline and the disruptive effects of new waves of technology. Understanding these factors will help to shape expectations of the availability of sustained economic rents and resulting resource margins from the ecosystems in which the portfolio businesses participate. Compounding these externally framed factors are the internal structural features within the ecosystem itself. The most important internal determinant of the attractiveness of the ecosystem is the behaviour of competitors within the ecosystem (reflected in the pricing environment discussed in Chapter 2), which will significantly affect the magnitude and growth of value-added (resources) within the ecosystem as well as the average level of resource margins. Depending upon the relative competitive position of the business within the ecosystem, it will enjoy higher or lower returns on resources than the ecosystem average. The historic development of relative resource margins will form an important item in the strategic profile of the business, together with the trajectory of relative market shares measured against ecosystem competitors. To complement financial and market performance data for the business, portfolio analysis will typically include an internal audit of the business that frames relative performance. At its best this will include an explicit specification of the business model using the matrix methods described in Chapter 3 (which may be further elaborated by CASK analysis), together with an assessment of business culture, relative capabilities compared to competitors, organisation and systems. The final data item for each business is an assessment of whether the fundamental economic value of the business is greater or less than its disposal or shadow value. For big corporations, this type of detailed profiling is typically carried only at times of CEO change or of crisis and is often allocated to outside consultants. For very small businesses, the profile is in the heads of the senior team. Equipped with the information provided by the four components of a business profile (ecosystem attractiveness, ecosystem position, internal audit and shadow value), it is possible to look at all businesses that comprise the corporation as a precursor to developing a strategy for the corporation. The following figures demonstrate some typical ways to present this information. Figure 16 shows a generic portfolio in which businesses are positioned according to their relative strength and future prospects. The motherhood-style imperatives that apply to quadrant positions will not surprise readers: after allocating current business activities into four quadrants (based upon attractive/unattractive, strong/ weak partitions), the priorities for business development are relatively clear. In those areas that are attractive and one has a strong competitive position, the priority is to


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Good

Evaluate development options

B

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Future Prospects (Attractiveness)

Figure 16: Generic Portfolio.

Invest

A

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Eliminate

C

D Low

High Strength

grow and to develop these businesses rapidly. In areas where one is weak and the business area is unattractive, one should exit as expeditiously as possible. In areas that are attractive where one is at a disadvantage relative to competitors, one that should evaluate options for development; and in converse situations, where one is strong but opportunities are few, the preferred strategy is to evaluate opportunities to withdraw. While these imperatives have a common sense origin, it is important in any portfolio investigation to avoid overly simplistic remedial action: for instance, withdrawal in one quadrant may undermine a promising position in another. As we will discuss later in this chapter, the attractiveness of a business is not determined solely by external ecosystem factors: the linkages to other businesses that are the basis of adjacency and corporate reinforcement need explicitly to be taken into account.138 For the time being, we may ask what we use as a measure of the attractiveness of future prospects. Figure 17 shows a disguised portfolio of technical businesses, where circle area is proportionate to sales. The annual growth and return on value-added (recall from Chapter 5 that we also call this return, the return on resources) for the ecosystems within which each of the businesses compete have been determined. As also discussed in Chapter 6, the growth of value-added and the return on value-added are the fundamental drivers of value, and hence they are taken to be the primary

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These linkages form part of the strategic architecture of the core competence of an organisation as discussed by Prahalad & Hamel (1990).

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Astute Competition: The Economics of Strategic Diversity Figure 17: Value-added Growth and Returns. G-Veh 20


Scale 15 10

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determinants of attractiveness. Note, the values are for the ecosystem, not the business itself, which might enjoy higher or lower values. Ideally, the values should also be prospective rather than historic values — because they arise from the industrial organisation structure of the ecosystem, these measures fortunately are often quite steady and robust, so historic values are often a reasonable proxy. The matrix allows us to home in on what are the most and least attractive ecosystems (compare G-Veh and G-Gw — the capital letter prefix indicates a particular division of the corporate). Besides considering the relative attractiveness of ecosystems within the portfolio, corporate managers will be particularly concerned with two aspects of the performance of the individual businesses: financial and market share performance. In Figure 18, we show a typical summary financial display that summarises various key financial performance measures for the businesses.139 The horizontal access shows return on capital employed, the vertical shows sales and the size of the positions is proportional to capital employed. As we have seen from Chapter 4 there are good reasons for looking primarily at resource margin performance for the individual businesses, but for the particular corporation concerned returns on capital were the primary yardstick. Again look at how well G-Veh performed.

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ROCE stands for return on capital employed, historically the benchmark measure for this corporation.


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Figure 18: Financial Performance. G-Veh 12

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Performance in terms of the share of value-added of the ecosystem is shown in Figure 19, where the growth for the individual businesses is contrasted with the growth of the ecosystem. Businesses that are above the x ¼ y diagonal are losing share; those below the diagonal are gaining share. For G-Veh, share has been maintained. Circle size is proportionate to capital employed but other measures such as resources (value-added) could equally well be used. With the aid of these displays we have been able to capture the attractiveness of ecosystems and the market and financial performance of businesses within the ecosystem, giving managers a comparative snapshot of the portfolio. What was striking for the corporation involved was the number and varied nature of the portfolio, which was typical of a conglomerate. This was not surprising given the corporation had been assembled over a number of years by acquisition based upon financial and availability considerations alone. As a result of this portfolio analysis under a new CEO, the corporation was refocused on one major and one supporting technical axis (relating to G-Veh and E-Comp), which were supported by reinvestment arising from the sale of peripheral businesses. Second level investigations can also be carried out: for instance looking at maturity (Figure 20), defensibility and other salient portfolio characteristics. The intention is not to be exhaustive but to show how comparative data can be displayed to foster serious strategic debate about the portfolio of businesses and how they should be managed. In addition to this cross-sectional view managers would also have more detailed information within the longitudinal profile of each business describing its business model and trajectory. Finally, managers may wish to aggregate information to produce a version of the generic portfolio, comparing attractiveness and strength. In Figure 21, the growth

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Astute Competition: The Economics of Strategic Diversity Figure 19: Market Momentum. 20

E-Sen

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and return on value-added have been added together to produce a composite measure140 of attractiveness, and strength is measured in terms of competitive multiples using a customary relative market share measure (ratio of share relative to the leader, or of the leader relative to the largest follower). PBIT stands for profit before interest and tax. The portfolio shows significant losses in ecosystems that are structurally not very attractive. Consultants often fall in love with the techniques they create, so it is important to keep the elegant Mondrianesque appearance of these analyses in perspective, and to focus on what they tell us that is of practical use. The portfolio techniques have diagnostic value, but simply compiling a list of businesses, ecosystems and their features does not guide action: How can the portfolio be changed, managed and developed to deliver greater sustained returns to investors? Once corporate managers have been able to assimilate and discuss the most important strategic features of the individual businesses and the portfolio as a whole,

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In traditional financial theory companies that are not externally financed can only grow at the rate of return on equity, assuming no dividend payout i.e. returns determine growth rates. Extending this to RMs suggests that we can attribute an extra percentage point growth in the resources of the business for each additional point of return generated on the existing resources, assuming this additional margin is reinvested to acquire additional resources. This suggests a simple composite measure of attractiveness: percentage growth plus percentage return on resources.


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Figure 20: Maturity — Life-cycle. Market Momentum 20

M-Ser

Segment Growth (Percent)

15

Key Embryonic

G-Ind

M-Mot

10

C-Con

C-Hone 5 0

M-Ted G-Av

E-Comp G-Gw M-Mar

C-Ala G-Mar M-Gear M-Eng

(5) M-Enc

Scale

(10)

10m

M-Feed (15)

Growth

E-Sw G-Veh

M-Sen

Capital Employed

C-Mar

(20) (20)

(10)

Mature

0

10

20

Company Growth (Percent)

Ageing G-Veh


Value Added 20 10 5

G-Av (Europe)

M-Sen M-Enc

M-Ted

0 (5)

G-Gw

G-Mar

(10) (15) (20) (20)

Scale

G-Ind

15

(10)

0

M-Eng 10m

E-Comp E-Sw

Sales

G-Av (USA) C-Ala M-Feed M-Mar C-Hone M-Gear C-Con 10

20

30

40

50

Return on Value Added (Percent)

three courses of action typically arise. First, the performance of individual businesses may be improved by reformulation or reinforcement of the business model to gain greater competitive control of resources (described in Chapter 4). The second set of outcomes usually relates to development: either organic growth within existing businesses, or the formation of new ventures or through acquisition (discussed in Chapter 7). Restructuring options constitute the third category of response. This may involve disaggregation of entities, financial engineering, M&A or divestment, all sharing the common goal of exploiting shadow valuation opportunities. As mentioned above, the result for the corporation shown in the figures was a dramatic shift in emphasis to

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Astute Competition: The Economics of Strategic Diversity Figure 21: Composite Portfolio Quadrants. SALES

Segment Attractiveness

60

Scale

50 40

£5M 25.7M

18.7M

30

Sales

20 10 7.6M

0

8.0M

(10) (20) 10X

5X

2X 1.0X .5X Relative Market Share

.2X

.1X

PBIT

60

Scale

Segment Attractiveness

50 40

£1M 3.4M

6.2M

30

Profit

20 10

(0.2M)

0.9M

0 Loss

(10) (20) 10X

5X

2X

1.0X

.5X

.2X

.1X

Relative Market Share

support G-Veh, which had not been previously identified and targeted, together with reinvestment in E-Comp, which had significant operating synergies from components with G-Veh. If the corporation is able to create a systematic advantage arising from a major recurrent adjacency across its businesses as described in the previous chapter, pursuit of this advantage will lead to a clear corporate thrust, which will delimit and dictate the prioritisation of the initiatives within the three categories. These initiatives will usually be reformulated to enhance as far as possible the benefits from the major adjacency. In order to prioritise initiatives within and across the three categories, financial and valuation modelling needs to take place (described below), which takes account of resource constraints that include finance, management, competitor responses and timing.


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Scenario-Based Retrospective Valuation Some strategists believe that strategy is a different discipline separate from finance and valuation. Notions of strategy are proposed, which are concerned primarily with positioning or out-manoeuvring rivals. Certainly we are able to judge a good from a bad strategy in terms of its coherence (whether all elements of the strategy reinforce each other and are aligned to a shared goal), and consistency (internally, between elements of the strategy and resource constraints, and externally in a compelling and complete understanding of competitor and market dynamics). But this is not enough. Business is about making money, and any strategic decision must ultimately be described in terms of a set of likely financial consequences for the organisation that can be gauged. Whether the consequences are oriented towards shareholders or employees is beside the point. Strategy without numbers is like flying without instruments — and at some time you have to take off and land. A number of articles have appeared over the years aiming to diffuse the apparent conflict between finance and strategy.141 For the practising strategy consultant, or corporate strategist, it is hard to understand how these two sets of considerations could ever be held to diverge. What is the human purpose of strategy if not to make money? Or, as we put it earlier less crudely: to appropriate sustained economic rents sufficient to satisfy the requirements of investors. The inseparability of finance from strategy is a clear consequence of the resource-based view of the firm. Money is one of the most important resources a firm has. How this money resource is applied and augmented is a critical determinant of corporate success. Each year the financial outturn will increase or decrease the financial resources available to a company, directly affecting the degrees of strategic freedom the company enjoys in the following year. This means strategy formulation requires the articulation of the financial consequences of resource allocation decisions. Funds provide access to other resources: people, IP, distribution. There is a basic inconsistency between believing both in the resource-based view of the firm, and the separability of strategy and finance. In practice, financial considerations, typically summarised by an NPV, are embedded at the heart of strategy proposals, together with questions of funding, tax and shareholder consequences. The process is often lengthy and iterative, as strategic and financial outcomes and assumptions are reassessed, modified and optimised. Risks and uncertainties are also evaluated, and incorporated in the discounting of future returns. Ideally, strategic options should be compared along three dimensions (assuming all the options are available to the current organisation): magnitude, return and risk, as summarised in Figure 22. The sloped line represents the corporation’s trade-off of risk and return. Strategic option A creates the largest expected value, but offers an insufficient rate of return for the risk incurred. Options B and C both compensate more than adequately for

141

CFOs and Strategists: Forging a Common Framework, Alfred Rappaport (1992); Must Finance and Strategy Clash? Barwise et al. (1989).

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Astute Competition: The Economics of Strategic Diversity Figure 22: Evaluation Framework for Strategic Options.

A

Risk

B

The circles are proportional to the value created C

Rate of Return

risk. B creates more value than C, but is at a shorter orthogonal distance from the trade-off line (smaller residual rates of return after attaining the threshold required rate of return as set by the trade-off line). The choice between B and C might be determined by considerations of the value created per pound of initial investment. Other factors (human, political and organisational) will also affect the choice. While the framework seems simple and elegant, it masks the deep complexities associated with the determinations of risk, rates of return, value, trade-offs and portfolio effects. Since this chapter is short, we will focus most on value.142 One observation on risk, however: little care is taken in finance or strategy to distinguish between risk and uncertainty. A useful distinction can be made between these two notions. Risk is captured by the distribution of future outcomes as the result of internal (endogenous) decisions and the action of external (exogenous) factors. This distribution of outcomes might, for instance, be described in terms of statistical measures such as the mean and variance of an NPV (see Figure 23 for example). Uncertainty, on the other hand, reflects our state of knowledge and relates to the variability in the estimates of this distribution of outcomes. Uncertainty is largely subjective. In principle, uncertainty can be reduced to as small a level as we like as we improve our knowledge — often strategy consultants use scenario modelling to reduce uncertainty. Risk, on the other hand, cannot be reduced, but it may be spread over a portfolio of risky projects. To make this clear, consider a fair die. The distribution of outcomes is known precisely, so uncertainty is minimal, but the risk associated with alternative outcomes is a constant. If in doubt, ask yourself whether you would prefer to possess one pound in cash or a ticket that allows you to

142

Readers interested in these other areas will do well to consult general finance textbooks (Brearley & Myers (1996), Copeland & Weston (1992)) as well as the work of specialists (e.g. Elton and Gruber (1995)).


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Figure 23: Value Probability Distribution.

Probability

Expected value

Net Present Value

participate in a game, where you win six pounds if you correctly predict the next throw of the die. Most people would prefer the pound (unlike the idealised investors of financial theory, we are undiversified and not likely to play the game for ever). In the proposed strategy evaluation framework, the risk axis does not include compensation for uncertainty. Instead, uncertainty is handled through scenario construction as described later in the chapter. That leaves us to resolve how we establish value.

Traditional Performance Measures (The following section repeats the critique of traditional performance measures that appeared in Chapter 6. For those readers familiar with this material, it makes sense to skip to the next section on real options.) Until the 1960s, the vast majority of strategic investment decisions were predicated upon an evaluation of the likely return on investment and the period by the end of which the investment would pay for itself (payback). These measures are flawed. Payback does not take account of the time-value of money, and leads managers to discard projects with a relatively lengthy payback period in favour of projects with a short payback period even if the lengthy project was likely to create much more value. Even when discounted for timing, payback continues to be an inferior measure of performance because it ignores all the value created after the initial investment has been repaid. A further difficulty arises because projects with the same payback period cannot be ranked relatively using this measure. ROI measures are also problematic. The results are highly dependent upon accounting conventions, producing differing annual values for projects producing the same economic return. These difficulties can be overcome in the case of a single project with known cash flows over a finite life, but otherwise there is no general method for relating accounting returns to discounted cash flows. Averaging accounting returns over a number of years produces anomalous results that fail to capture the time-value of money. To complete an ROI evaluation, the results also

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need to be contrasted with some benchmark ROI value, which is often based on historic levels of return, and captures miserably the opportunity cost of investment. Often financial managers will calculate instead the IRR for an investment. When carried out carefully, this method of assessing projects will coincide with NPV, but occasionally IRR will be misleading because of (i) more than one possible IRR values for a given set of cash flows, (ii) hidden assumptions about the lending and reinvestment of surplus funds, and (iii) IRR’s emphasis on the rate rather than the absolute size of return. The preferred method of valuation taught at business schools around the world is NPV. This measure takes account of the time-value of money and opportunity costs. It is also an additive for a series of investments. Relative to the other measures, it is clearly superior, and produces helpful answers in the case of simple, short-lived and well-defined investment projects. Unfortunately, choices of strategy seldom have these characteristics. When strategies are assessed according to their present values, future cash flow streams are discounted at a rate that compensates for both the time-value of money and for the ‘‘risk’’ (loosely a vague combination of uncertainty and risk) involved. This is the DCF. Experience has shown that significant problems occur in DCF forecasts of value for strategic options. These problems include: (i) predicting events that are many years away, (ii) sensitivity of the owner to the length of the event horizon considered, (iii) sensitivity to terminal value assumptions, (iv) sensitivity to discount rate choices, (v) insulation from external events, (vi) failure to incorporate credibly likely management action, (vii) failure to square with the actual value of transactions. If we accept that the problems with DCF cannot be brushed under the carpet, what can we do to overcome them? In recent years, the use of value-based planning systems among large corporations has increased significantly. Common to these approaches is the notion of a value-creating spread, where returns in a business exceed the returns required and expected by investors. Positive spreads result in increases in stock market value. These spreads are known as excess or residual returns (as discussed in Chapter 6) Much of the groundwork for this approach was laid by Bill Fruhan, a Harvard financial theorist, who looked at the return on equity of all US non-financial companies, and showed that the most highly valued companies generated returns in excess of the required rates of investor predicted by the CAPM. He summarised his conclusions succinctly: Managers who are successful in either shaping or simply taking advantage of the competitive environment so as to earn returns in excess of their capital costs create enormous wealth for their shareholders.143 He explained this phenomenon in terms of a simple economic valuation model, which showed how the ratio of the market to book value changes for a company as a function of the size of the spread it enjoyed, the number of years the spread lasted and the rate of growth of the company (determined by the level of retention of profits). Fruhan went on to explain how

143

See Fruhan (1979).


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spreads are grounded in microeconomic structure in terms of entry barriers building on the work of industrial organisation theorists like Porter. In terms of barriers, he identified unique products, scale economies, absolute cost advantages and capital requirements. Furthermore, high-spread companies focussed on a narrow number of product lines. If Fruhan is held to be the early pioneer of residual returns, it is Alfred Rappaport who made them familiar to the boardroom.144 His key insight was how to operationalise the notions of spread as a threshold operating margin after taking account of working capital and capital expenditures. In doing this he was much aided by the development of PC-based software, which allowed real-time modelling of businesses including the anticipated impact of management action on the creation or destruction of value. Typical inputs for the modelling are sales, margins and investment over the period when a positive spread is earned. Sensitivity analysis could easily be carried out: for example, the extra growth in sales required to produce the same strategy value for different levels of spread. The impact of capital efficiencies was immediately evident, and Rappaport’s approach provided a good way of looking at the critical operational drivers of value creation. Managers were required to take an integrated perspective on operations, considering both the profit and loss and balance sheet implications when planning a course of action. Furthermore, managers were also able to examine explicitly the stock market’s expectations of residual returns compounded in the current stock price relative to the likely level of residual returns in the business. Unfortunately, although we need only consider the period when residual returns are positive, this is often a lengthy period and Rappaport’s approach ultimately suffers the same fate as DCF — large variations in conclusions can be produced from small changes in input values. Rappaport’s software simply takes the pain out of calculation. What about the latest vogue — real options?

Real Options While this approach initially seems to have merit, further reflection reveals some deep-seated problems when carrying out a valuation. Why should we not add the options to re-enter a business after abandonment, to pre-empt, to enter later then exit if things start to go wrong? What about the options created by the option to abandon and do something else; and the option then subsequently to wait, invest, abandon and to do something entirely different? Without a rule to guide us in the choice of options, we are at the mercy of the creativity of strategy formulators and risk being mired in a technical bog of anticipated real options values, finally choosing those that suit our purpose, namely, to produce the financial answer we desire. In the absence of a general option selection rule (which is likely to be forever elusive), we must fall back on a decision tree analysis to evaluate which real options are of merit. But if we have the decision tree, why do we need the options? The

144

See Rappaport (1986).

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financial arbitrage upon which the options pricing formula rests is none other than DCF — the Black-Scholes formula is merely a combinatorially efficient method for dealing with an infinite number of future share price scenarios,145 and suffers the same problems of horizon, rate etc. as DCF in general. All too often, it seems that real options are introduced for reasons of expediency, but is this really any different from fiddling with the discount rate to achieve a desirable outcome? As with scenario models in general, in spite of the lack of foundation for the particular valuations produced, modelling of real options has heuristic value, but like most innovations in strategic valuation, it represents a slick representation of DCF methods and does nothing to address the inherent flaws of DCF.

Infinite Projections Given these difficulties, it makes sense to reflect on how they arose. We are encouraged by financial theorists to think that the value of a company should be equal to the endless stream of dividends we would receive from a share in that company, discounted at appropriate opportunity costs of capital. This method of valuation is captured by the infinite discounting formula: Pt ¼

1 X

E t ½divt Rt

t¼1

where Pt is the market value of a company at time t. E t ½Q represents the expected value at time t of variable Q. The R term is the discounting factor. This expression states that the value of the company is equal to the infinite sum of discounted future expected dividends. Is this valid given that no one has ever held a share for an infinite period? If we hold a share for a finite period, then sell it, we might think of its value today as the dividends we receive plus the value we sell the share for (appropriately discounted). But what is the value of the share at the end of the holding period? Traditional financial theorists will say that a person buying the share at the end of the initial holding period will carry out the same sort of valuation analysis, thinking about a second series of interim dividends and the value of the shares at the end of a second holding period. So the value for the original purchaser will equal the dividends received in the first two holding periods plus the value of the share at the end of the second holding period. Clearly, we can continue this analysis for all the subsequent holding periods. If we follow this logic, we will be led to conclude that the value today is, indeed, the discounted sum of an infinite series of dividends. Although this reasoning might satisfy the financiers, the argument is circular and question begging. The assumption that values in the future are determined by an infinitely discounted series of (then) future cash flows cannot be used as an argument when this very assumption of infinite discounting is in question. 145

It is straightforward to show that a decision tree binomial series of up and down price movements converges in the limit on the normal distribution used by Black and Scholes.


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It is perfectly possible that the value of the share at the end of the first holding period might not reflect the underlying performance of the company over the first or any later holding period. But, the traditionalists will say, this can only be a temporary aberration because arbitrage between physical and financial markets will require that ultimately the market value of the company will coincide with its economic value, which is set by the expected infinite stream of remaining dividends. This is not a winning counter-argument to the hold-and-dispose model of valuation: for significant periods physical and financial markets may be decoupled (witness dot.com speculation). This is not to say that financial markets are not transactionally efficient, in the sense that prices correspond accurately to investor expectations of price movements, even during periods when experts consider these expectations unrealistic. Fortunately, there is another way.

Retrospective Horizons If we adopt the hold-and-dispose model, and search empirically for performance measures, which explain how expectations are embedded in share prices, we will be able to develop a valuation method that restricts itself to a horizon that corresponds to management and investor holding periods, without running into the problems that arise from the traditional dividend-discounting paradigm. If we consider an event horizon of five years for which we can make credible forecasts, the alternative valuation paradigm might be expressed mathematically as in Figure 24. This means that under the alternative method of valuation, today’s value reflects our particular short-term projections for years 1–5, and the likely value investors will Figure 24: Holding Period Valuation.

Traditionally

Pt

= =

=

Alternative

Pt

= =

d1 (1+r) d1 (1+r) ⬁

∑ f =1

+ ... + + ... +

d5 (1+r)5 d5 (1+r)5

+ E (Pt+5)

+

d6 (1+r)6

+ ...

d1 (1+r)1

d1 (1+r) d1 (1+r)

+ ... + + ... +

d5 (1+r)5 d5 (1+r)5

+ E (Pt+5)

+ f (performance yrs 1−5)

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attribute to the company in year 5 given the performance trajectory of the company up to that point i.e. during years 1–5. This value in five years time is an exit value, and will be entirely familiar to venture capitalists and private equity managers. This alternative contrasts with the infinite discounting of traditional financial theory. To get the model to work we need a robust and well-validated strategic measure that provides linkages between the economic performance of a business and stock market value. In Chapter 6 we discussed RMs as a suitable strategic performance measure, and highlighted its superiority to, but consistency with, EVA. Statistical research146 shows that there is indeed a strong relationship between market to resources ratios (M/R) and the historic series of RMs. By predicting the level of resources in a business, and then the return made on those resources, we can then apply a statistically well-supported multiple to the resources in the ending year to determine a value for the business at the end of this credible management horizon. Employing this M/R measure within a hold-and-dispose model, we are able to value strategies and businesses within a time frame covering the few years relevant to performance assessment, for which we will have reasonably accurate projections. Such a time frame might last three or five years, coinciding well with the typical management tenure of a business position. In this way the model avoids the pitfalls of looking over either too short or too long a period. It incorporates three distinct features: (i) the right performance measure that has foundations in microeconomics and is captured by accounting systems; (ii) accurate short-term predictions of performance and of likely management actions; and (iii) empirical validation of the valuation scale for the performance measure (the M/R versus RMs model discussed in Chapter 6). We call this alternative approach scenario-based retrospective valuation or, alternatively, the c.v. view of valuation, as opposed to the crystal ball view of valuation that DCF represents. Consider the following employment analogy. In deciding how much to pay a person, theoretically one could calculate, using DCF scenario methods, the financial contribution the employee could be expected to make to the firm over the period of employment. This would require a tremendously detailed set of assumptions and scenarios about clients, wages, profits etc. over many years. In practice we do not do this: besides the effort involved, any answer would be considered very precarious. Instead we analyse the recent achievements of the applicant as described in the c.v. of the applicant, paying particular attention to the key elements that might have an impact on performance and thereby on remuneration. We effectively determine what sort of performance path the person is on: high, medium, low for instance. Implicitly, we then compare the performance of the candidate on these key performance elements (such as academic qualifications, roles, experience) to the performance of other personnel for whom we have pay information. We find someone comparable who is on a similar performance path. In this way we reach a conclusion about the general level of remuneration, which might be subject to some final negotiation.

146

See, for example, Johnson (2001a and 2001b)


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Figure 25: Scenario-based Retrospective Valuation. Scenario Modelling

Market Based Retrospection

Explicitly models possible states of the business over a credible time horizon

Looks at how the market actual rewards the shareholders according to financial performance

Shows how performance is valued

Models financial performance

Strategic Valuation

In like fashion, the author proposes that companies and strategies be valued through the extraction of measures of historic performance that are salient to valuation — in particular, RMs. Given that a company or business is on a particular performance trajectory, we can then ask how such trajectories are valued currently: just as we would ask what a particular c.v. might command. An understanding of the valuation metric for given trajectories will allow us to be able to predict over a sensible horizon, how today’s future performance will be valued retrospectively when the future arrives (say, in five years time). To see how this would work in practice, consider Figure 25. For a given business, scenario modelling is undertaken to capture the unfolding of different strategies over a credible time horizon (say three to five years, which coincides well with management tenure and investor holding periods). The modelling shows how the strategic performance measures that underpin valuation (the resource margin level and growth) would evolve over time. These forecasts are then combined with market-based retrospection, which looks at how the stock market actually rewards different levels and growth of resource margin performance. This scaling of reward for performance is determined empirically by multiple regression, rather like the Securities Market Line, which shows how risk is rewarded in the CAPM. From knowledge of likely future performance on the selected resource margin and resource growth measures, and knowledge of how performance is valued, we can determine the future value that will be created by the strategy. In constructing the scenarios, explicit account must be taken of the interactions between outside (exogenous) variables, management actions, including significant,

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possible decisions relating to the further development or retrenchment of the business. The basic business model captured by spread sheeting will need to change structurally over time as key milestones and critical events reshape the nature of the business activity. To be useful, the model will need to flex in response to shocks and the actions of competitors. It is rare, however, for such models to make precisely accurate predictions of the future performance of a business, and very often a simple model with few linkages is preferable to huge interlinked complexity. A large proportion of the value of a model is likely to be heuristic, helping managers to understand the causal linkages between product and service choices, operations and management of competitors. For example, the author helped to construct a basic model of a new business entry, which produced a surprising, and largely unanticipated need for a field service force, even when the product was considered to be relatively easy to install and reliable: it clearly was not that easy or that reliable. Using simulation techniques, modelling can be carried out, which gives probabilistic outcomes for the key performance measures (RMs level and growth) depending upon the distributions assumed for the key variables. The variability of the resulting values for the business can be summarised in traditional measures such as variance and standard deviation of RMs and resource growth to allow comparative assessment of investment options for different businesses. Alternatively, a modified Sharpe, Sortino or Calmar ratio can be calculated for the strategy given by the average level of residual RMs divided by the standard deviation of the RM over the years for which the scenarios are constructed.147 Among and within the strategic decisions that are entertained, particularly for larger businesses, are mergers and acquisitions, which are the subject of the next two sections of this chapter. To summarise: if the results of the scenario analysis are determined for various management decisions in terms of one or two key financial measures (preferably the level and growth of RMs) over a useful management horizon (three to five years), the financial trajectory described by these measures can be scaled by looking at how similar performance has been rewarded historically (in terms, for instance, of a market value to resources ratio) to produce an aggregate exit financial value that arises from managerial pursuit of this course of action. Choices can then be made between alternative courses of action as a consequence of the expected value of the business that results from the action taken. The retrospectively based valuation measures, while similar in motivation to DCF, avoid a number of the problematic sensitivities of this measure (horizon, rate etc.), are grounded in the structural microeconomics of ecosystem competition and empirically based scaling of rewards for performance.

147

The Sharpe ratio is the mean residual return divided by the standard deviation of the return; the Sortino ratio is similar to the Sharp ratio except it uses downside deviation as opposed to the standard deviation of the return; the Calmar looks at the annualised residual return over the past three years relative to the maximum anticipated drop in the value of the business during that period.


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M&A Business Logic Given the value of M&A transactions and their popularity as a means of corporate development, it is worth dwelling on this area, even though conceptually there is little from a strategic perspective to distinguish M&A from other forms of business development. Diversification is a seductive notion. Few businesses can be expected to continue indefinitely in their major business lines even if strenuous efforts are made to renew products and marketing strategy. Eventually, growth will plateau to be followed by a period of erosion, decline and decay. Faced by such dire prospects, small wonder is it that executives spend a considerable amount of time searching for new business opportunities to bolster the performance of their core business. Financial theorists, however, would have us believe that diversification, in and of itself, contributes no value to the shareholders of a company, given that those individual shareholders may on their own diversify their stream of returns by buying the shares of other traded companies (charitably we assume all these companies are traded). Where one sits on the issue will probably depend on what one counts as diversification. Does the sale of an enhanced version of a product or the latest upgrade to an existing customer count as diversification? What about an example that is perhaps more familiar to a manufacturer — of providing service support in addition to equipment sales? In both these cases the question of diversification or lack of diversification hinges upon the starting definition of the base business (and as we know, that brings us back to strategic ecology). To say that diversification has no value is in some sense at odds with the day-to–day evidence of our own eyes: business people continuously strive to push their products and enterprises into unfamiliar territory. But perhaps it is better to duck this definitional issue and ask rather what empirical evidence exists as to the relative benefits or disservice brought about by diversification. The general finding is that diversification is bad news. The results of a well-known study by Michael Porter published in the Harvard Business Review are typical. Porter investigated a large sample of new market entries.148 Approximately 70 per cent of the sample of 4,000 new entries related to diversification into areas outside the existing core business. Of these, 2,600 examples, some 70 per cent relate to business entry in the same sector as the business of the company. Approximately 80 per cent of these business entries were achieved by acquisition with approximately five per cent accounted for by joint ventures and the remainder by start-ups. In his study, Porter defined a measure of success given by the relative number of business retentions as opposed to eventual disposals for each method of new business entry. He found interestingly that the highest degrees of success were associated with start-ups, some 61 per cent, followed by joint ventures 53 per cent. Acquisitions might be judged a failure, in that 55 per cent of the businesses were subsequently disposed of. Looking further at the acquisition question, he also found that the success ratio was higher where acquisitions took place in the same sector as the core business

148

Porter’s results (Porter 1987) are consistent with the earlier seminal work of Rumelt (1986), Salter & Weinhold (1979). More recent studies, if anything, paint a slightly gloomier picture.

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(48 per cent success) compared to either new sectors related to an existing business (45 per cent) or in last, and distinctively inferior position, new business entry by acquisition into unrelated new sectors, where the success rate obtained was only 30 per cent. Porter found that start-ups generally work best because the linkages to existing businesses are most clear. Acquisitions by contrast have been less successful, though related acquisitions are much more likely to do well than those in unrelated sectors. Adjacency is key. So a conclusion that strongly follows from the work is that unrelated diversification should be approached with extreme caution. Over 70 per cent of unrelated acquisitions were subsequently divested within ten years. Diversification, in the widest sense of flights of fancy that stimulate the imagination of senior executives in the boardroom, is to be avoided. The emphasis placed on business development through adjacency contrasts strongly with the formal development methods used during the 1970s and 1980s based upon competitive portfolio planning. Such methods, first developed by companies such as General Electric, were popularised by consulting companies such as McKinsey and the Boston Consulting Group. Nearly all of the frameworks share the generic format discussed earlier: along one axis a measure of business attractiveness is defined and along the other axis a measure of relative strength is developed. A strength and a weakness of all these approaches is the strong emphasis on the external definition of the parameters that characterise the position and development prospects for individual businesses: the external emphasis is a strength because it focuses our attention on the competitive and structural characteristics of a given business; it is a weakness because it inclines us to think of each business entirely individually and ignores its interconnectedness. As a result, within this portfolio construct, there is limited scope for highlighting the business model and resource interdependencies and commonalities that exist across and within individual businesses and new ecosystems. It is possible within this framework that a company might contemplate buying an entirely unrelated ecosystem position provided that the cost of acquisition could be price justified. In a like manner, it is very easy using simplistic applications of portfolio techniques to justify the withdrawal from positions of slow growth and lessthan-leadership positions, as we have discussed above where we have expressed caution against undiscerning prescriptive orthodoxies. This caution is particularly warranted given that this latter quadrant accounts (by definition) for a very large proportion of all businesses, with the consequence that as a normative framework for diagnosing development possibilities, traditional portfolio frameworks are underdeveloped. While the portfolio frameworks as developed have been useful in resolving resource allocation problems within a company, it is clear that the thinking behind such types of approach has also subtly reinforced the move to unrelated diversification, if only because these approaches have under represented the systematic linkages that unite businesses and have ignored the binding competences or skills discussed in Chapter 8, which are at the heart of a corporation’s performance. In Chapter 7 we discussed how an individual business might approach the question of development beyond its existing ecosystem position. Emphasis was placed on adjacency, the converse of strategic ecology and on the need to satisfy investors either


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by exploiting synergies conferred by the adjacency, or through strategic revision. Very much the same is true of acquisition in a multi-business corporate: to justify the typical premium of a third over traded values, the new owners must be able to extract additional rents from synergies or a change of business model.149 In the case of a corporation, however, there are perhaps two additional considerations. First, as discussed in the previous chapter, the corporation may have been built on the benefits of dominant cross-business adjacency, for instance a particular customer focus or a particular technology platform. Evaluating the fit and additional benefits that arise from an acquisition from the perspective of a corporate adjacency will be an important step in assessing the merits of the acquisition. Second, the greater resources of corporations allow them to take advantage of market mispricing. Sometimes the greater insider understanding enjoyed by a corporate team may allow them to determine that constituents of an acquisition target are mispriced. Value may be created for the acquirer through restructuring the target and realising the value of its parts. For example, Hanson Plc established a strong reputation for spotting undervalued assets within corporates, and made a number of successful value-creating acquisitions. What they found more difficult, however, was managing the steady growth of acquired businesses once they had been restructured. Restructuring and value engineering are, however, difficult to do in public markets, and on average acquirers make no net gain, while sellers do handsomely. With private equity, there remains scope for value gains today in Europe, but in the United States, it is becoming increasingly difficult to generate distinctive returns in the buyout market, and the average returns are heavily skewed by the performance of a small number of firms that have enjoyed very exceptional returns. For most CEOs the dominant focus is and should be value creation from adjacency and strategic revision.150 How should this be approached? Often corporates initiate an acquisition investigation when they are prompted by an investment bank to consider making a bid for a company that is known to be in play or could be dislodged, or for which the bank has a sale mandate. In response, a hastily assembled corporate team will work against a ‘‘Mission Impossible’’ timetable together with teams of outsiders including lawyers, public relations companies and strategy consultants. The rush is fuelled by the supposed fleeting availability of acquisition targets. As in life generally, making important decisions in a hurry often results in a bad outcome. There is a better way. Corporations that have a clear understanding of their strategy should use their understanding of their businesses and the interconnections between them to formulate a corporate development strategy that includes relevant acquisitions. The

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Markides & Williamson (1994: 150) expressed this succinctly when they wrote: Relatedness, which opens the way for asset improvement, asset creation and asset fission, holds the key to the long-run competitive advantages of diversification. 150 It is pleasing to note that by the early 1990s even economists had come to realise this was so. Mahoney and Pandian, for instance, wrote: These empirical studies suggest that firm-specific resources and relatedness of activities are important variables in the diversification process. Companies grow in the directions set by their capabilities and these capabilities slowly expand and change (Mahoney & Pandian 1992: 367).

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corporation should study the acquisition candidates in advance of any deal prospect. Doing so allows the corporation to (i) gain a sharp understanding of its own strategy, competitive advantages and trajectory, (ii) test the value justification of proposed acquisitions, (iii) consider pricing, negotiation and tactics in advance, and (iv) take control and integrate the target. Objectors to this process often claim (i) it is expensive, (ii) it is not possible to develop a detailed understanding of candidates, and (iii) availability is the key consideration. These objections are ill-founded. The costs of investigation are high (millions of dollars a year for a large corporation), but this is very modest in relation to the scale of deal transaction fees, and even smaller in relation to the overpricing of deals that often occurs. Detailed analytical investigations can be undertaken by specialist boutiques, and there is very little about a target that cannot legally be discovered given time and patience: what one finds out is primarily determined by budget. The benefit of a sharp acquisition rationale that has been well tested and articulated is helpful even when a less than ideal candidate is available, and more importantly, a creative, thoughtful strategic case for an acquisition may directly influence availability, particularly in the case of private companies. One cannot imagine the evaluation of capital expenditure on plant of an equivalent amount being handled in the way that many acquisitions are. The author’s personal experience of a large number of acquisitions is that the benefits to a structured approach can be very significant and easily cost justified. In following a structured approach to acquisitions, a corporation will need to decide the balance between bottom-up business initiatives from divisions within a corporation and central initiatives that may often be larger. The balance will depend in part on the importance of a central corporate adjacency as a source of advantage, as discussed in the previous chapter. Devolved, centralised and mixed approaches can succeed provided that (i) they are consistent with the overall system of strategic management, and (ii) they are well understood and uniformly applied. Whatever the origination mechanisms, the principal issues to settle with regard to a candidate are: How attractive are the ecosystems in which the target competes? What is the target’s technological position? What is the target’s competitive position? How good is the target’s management? What opportunities are there for improving returns?

– – – – –

development static synergies dynamic synergies change of business model restructuring and rationalisation

How effectively can the target be integrated and managed? How much is the target worth?


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In order to answer the central question of improving returns, the target must first be analysed on an ecosystem basis. Ideally, this means producing a complete portfolio assessment of the type described earlier in this chapter. With the benefit of this strategic ecology analysis, it is then possible to build up painstakingly a specification of the opportunities for synergy or value creation by changing the business models of some of the component businesses of the target (see Figure 26). In the most detailed cases, the development of synergies involves a specific determination using CASK methods of resource and other adjacency overlap at the level of individual businesses, and also at the corporate level if the acquirer roots Figure 26: Valuation Model.

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Astute Competition: The Economics of Strategic Diversity Fig. 27: Valuation of Synergies. 400

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its corporate advantage in one dominant synergy (for example a particular set of customers or technology). For a large acquisition, this analysis may represent several man-years of effort. Restructuring and rationalisation projects can also be identified, together with a detailed plan for post-acquisition integration and management. The quantification of synergies needs to be integrated into a consolidated financial model that describes the future performance of the acquirer, and that of the restructured target. Management will then need to examine whether the business logic established by a detailed analysis of the integrated target generates sufficient additional returns to satisfy investors once account has been taken of the premium that may be payable to the seller. Figure 27 shows the valuation summary for an attractive US business that produced security labels. The dotted line depicts the pre-premium market value of the target’s shares. More often than not, however, the returns are insufficient to justify the likely asking price, and the deal should be rejected. Sometimes, though, there are acquisitions that are both strategically and financially sound that build upon the adjacency between the acquirer and the target. The basic message is that unrelated diversification is very often a waste of resources, but that a carefully crafted programme of adjacent acquisition can give rise to static synergies, dynamic synergies and strategic revision that support business renewal and innovation in a way that is acceptable to shareholders.151

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Montgomery & Wernerfelt (1988) similarly found that the further away a business moves from its base business to gain additional rents from its resources, the lower the marginal rate of return obtained.


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M&A Screening Once a business or corporation has established a satisfactory acquisition rationale or acquisition target characteristics, it may wish to screen target companies from both strategic and financial points of view. Figures 28 and 29 show typical screening tools. The purpose of the screen was to identify a long list of mid-sized UK-quoted companies that could be investigated for adjacency, fit and vulnerability. The summary strategic appraisal led the corporate acquirer to look in detail at companies D, I, C and H on Figure 29 to establish the scope for synergies or strategic revision. One of these companies was eventually acquired on reasonable terms and has been successfully integrated. On some occasions, ex ante financial prerequisites place considerable constraints upon acquisition selection requiring management to investigate closely premia and funding choices. The most common financial constraints are earnings dilution (in spite of the general criticism of this measure by financial theorists), and leverage (gearing). Working within these constraints acquirers need to justify the likely acquisition premium through the delivery of synergies that are realistic in the context of the earnings of the target. Since earnings dilution will depend upon the earnings Figure 28: Preliminary Financial Screen. All PLC companies

(1,500)

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performance of retained businesses when the acquisition contains non-cash elements, and because part of the funding for the acquisition may arise from disposals, it is often necessary to quantify the financial trade-offs by building an acquisition model as depicted in Figure 30. By using this type of model, it is possible to examine explicitly the financial consequences of acquisitions long before any deal is on the table. For large corporations, views often differ with regard to the size of an acceptable acquisition. Sometimes this can be settled by financial considerations. A typical pair of constraints is the wish to avoid initial earnings dilution, and the desire to achieve a medium-term, post-acquisition earnings target. By considering pro-forma acquisitions of different sizes (market capitalisation), which will require different types of financing as a function of size, it is possible to set some acquisition boundaries as shown in Figure 31. The light grey lines indicate the dilution and synergy outcomes for the acquiring corporation for different values of an all-cash acquisition. The slope changes because additional financing instruments were required as the prospective deal increased in size. The analysis reveals that an acquisition by X of a company costing more than £1B would lead to an unacceptable earnings dilution of ten per cent, while an acquisition of £250 M or less would require unrealistic levels of after-tax profit synergy in excess of one hundred per cent: the agreed target size was set at between £250 M and £1B. Figures 32 and 33 show some further examples of the type of analysis that can help to frame the strategic acquisition dialogue. Figure 32 shows how the setting of a leverage limit (35, 50 or 75 per cent) and hence the amount of debt finance


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Figure 30: Acquisition Model.

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Tax, Interest, Minority & Finance Calculations

determines the level of synergy (measured as a percentage change in the profits of a pro-forma target company), necessary to avoid earnings dilution and a threeyear earnings target for the acquirer as a function of the deal size. For instance, with a 35 per cent limit 40 per cent synergies are required to avoid dilution, but an unrealistic 75 per cent synergies to meet the acquirer’s earnings targets for a £60 M deal. In spite of the notoriety of earnings-per-share ramping by conglomerates in the 1960s in the US and the 1980s in the UK, CEOs and CFOs still find it necessary and important to massage the development of their earnings, particularly when making acquisitions. Typical earnings analysis is depicted in Figure 33, which shows the

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Astute Competition: The Economics of Strategic Diversity Figure 31: Acquisition Size Impact. EPS DILUTION AFTER ONE YEAR 20 Enhancement 10

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sensitivity of pro-forma deal economics to the price-earnings ratio of the target company. The impact of target PEs of 12 , 14 , 16 (calculated on a prospective, post-premium basis) on synergy requirements for different deal sizes are displayed. For example, for a £40 M deal, paying a 12 multiple leads to very modest initial required synergies of 15 per cent, and synergies of 40 per cent in year three to hit the acquirer’s target: not that hard to achieve perhaps, but the problem is that there are very few companies that are likely to be so lowly valued.


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Figure 32: Acquisition Sensitivity to Leverage Limit. SYNERGIES REQUIRED TO AVOID DILUTION

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The mix of financial instruments used to fund an acquisition will also determine the resulting earnings profile, and Figure 34 shows how financial trade-offs can be summarised into a set of feasible financings for a given acquisition. Mixtures of debt, equity and preferred shares that are used to fund the acquisition determine the triangular shapes in each of the financial years. Any point within the shape falls within the overall financial constraints set for the acquisition. The ultimate aim of these types of screening is to shortlist a small number of potential targets, which meet the screening criteria and which can be subject to an

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Astute Competition: The Economics of Strategic Diversity Figure 33: Acquisition Sensitivity to Target PEs. SYNERGIES REQUIRED TO AVOID DILUTION

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in-depth investigation of the business logic behind the acquisition as described in the previous section. Often practical considerations will also influence the eventual outcome: availability, pricing, timing, fit often play a part. Figure 35 summarises the most recurrent trade-offs. Businesses that fit really well are seldom available; it is often hard to identify value-creating acquisitions without ceding value to the seller; where a lot of value can


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Figure 34: Feasible Financings. Acquire 100%

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be added to justify acquisition, there will be risk associated with the implementation of a new business model. The trade-offs cannot be eliminated, but what is important is to try to analyse specific opportunities and to compare them using these types of criteria and trade-offs.

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Conclusion This chapter has highlighted a number of techniques employed by strategists to help corporations make informed strategic decisions that add value to their portfolio of businesses beyond what the businesses might achieve on a stand-alone basis. While these techniques have on occasion been very useful, it is important to realise that fancy analysis is no substitute for clear strategic thinking: most of the value of the tools lies in the concepts behind them, rather than in their numerically precise application. Carefully considering how improving the competitive advantage of the constituent businesses can create value is the starting point and first priority for corporate managers.

Summary 1. A number of tools can help corporations to add value to their constituent businesses: portfolio profiles, retrospective scenario-based valuation, M&A selection and valuation grids. 2. Portfolio analysis that incorporates the competitive strength and structural attractiveness of the businesses that comprise a corporation can be used to shape and evaluate corporate strategy so as to enhance the returns from the portfolio businesses and thereby deliver additional financial returns to investors. 3. Analysis of the strategic options for a corporation necessarily integrates financial considerations that relate to the creation or destruction of investor value. Retrospective scenario-based valuation methods deal with many of the deficiencies of traditional alternative valuation methods and ground questions of value within the typical time frames for management action and using observed valuation scales for financial performance. 4. Unrelated diversification is very often a waste of resources, but a carefully crafted programme of adjacent acquisition can give rise to static and dynamic synergies and business model reengineering that support business renewal and innovation in a way that is beneficial to shareholders. 5. To avoid the frequent pitfalls that have occurred in the past, corporate managers must base acquisition initiatives upon a systematic appraisal of whether sufficient additional value can be generated from the target acquisition by capturing synergies that arise through adjacency or strategic revision to justify the premium likely to be required by the sellers. 6. Techniques exist for the systematic appraisal of possible acquisitions that incorporate (i) the need to generate value through adjacency or strategic revision, (ii) financing choices and constraints, and (iii) the performance measures customarily used by the financial investment community such as earnings enhancement and leverage.


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Questions 1. Assuming that you have carried out an analysis of strategic ecology within your collection of businesses, and that you have constructed a business profile (ecosystem attractiveness, ecosystem position, internal audit and shadow value) for each of them, what are the structural, competitive and financial characteristics of the businesses that comprise your current portfolio of businesses? How do you expect each of these businesses to evolve over the next three to five years in market, competitive and financials terms? 2. What are the linkages, adjacencies and reinforcement that exist between the business models of the different businesses within your portfolio, and can you summarise or focus these advantages into a concise articulation of your corporate strategy? 3. What are the principal strategic options that you face with regard to the improvement, development or disposal of the businesses in your portfolio, and how will these options be valued in competitive and financial terms? 4. What methods and frameworks do you employ to investigate discrete acquisition options within the framework of the priorities established for corporate and individual business development? 5. What has been your acquisition track record to date, and how might your approach to acquisitions and other forms of development be improved?


Chapter 10

Start-up Strategy Many of the concepts developed in earlier chapters apply to the creation of new businesses: for instance strategic ecology, competitive control of resources and business development are as relevant for a start-up as they are for an established business. What distinguishes start-ups particularly from other businesses, however, are aspects of constitution and context. By constitution, we allude to the engine of business growth. Just as businesses are often a much more effective vehicle for action than markets, so entrepreneurs and their immediate team are often more effective than established businesses at getting things started: they are perhaps the appropriate, efficient transactional entity for managing the hub of activity that occurs at the outset of a new business. Although there are many sorts of entrepreneurs — boffins, buccaneers and wheeler-dealers often come to mind — the focus of this chapter will be largely on the professional entrepreneur who systematically exploits opportunities for profit to her own advantage by harnessing the resources of others. In this chapter we will mean a professional entrepreneur when we talk of an entrepreneur, unless this person exploits technology, when we might use the term technopreneur (and within a university environment perhaps we may even talk of dontrepreneurs — dons who are entrepreneurs). Very often the entrepreneur will own the majority of the business and will be constitutionally empowered to make rapid, occasionally unilateral, decisions on many important issues. Although these focal arrangements confer immediacy of action and a high level of deliberateness, they also place a premium on calling the right shots on many fronts simultaneously: technology, funding, personnel and marketing being the more obvious Turning to context, while there are a significant number of individual entrepreneurs, it is more common in the face of this challenge of omniscience to encounter a founding team comprising typically a CEO, CFO, CTO, VP Engineering or Operations, and VP Marketing or Sales. There is also good evidence to support the fact that teams are better bets than individuals. Given the prevalence of teams, it is clear that the goals, personalities and capabilities of this founding group strongly influence the development context of the embryonic business. The personalised context of the small founding group will determine the envelope of development: for instance the strategic options considered, the path chosen, the rate of progress and the surmounting of obstacles will all be strongly shaped by the preferences, performance and priorities of the founding group. The business will not at the outset have its own identity but will be an evolving composite of the many facets of the founders. Building a significant business that generates sustained economic rents is difficult to do, in spite of the endless success stories we encounter in the press. The results are

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very skewed: a tiny proportion of start-ups contribute the vast majority of sales, employment and profit. While failure rates for professionally managed start-ups can be reduced to less than thirty per cent in many instances, there remain a large number of new businesses that are not failures but are non-successes, in spite of the tremendous efforts made by those working in them. These businesses neither display sufficiently attractive growth and return on their resources to attract further backing nor do they perform so poorly that it is rational for the founders to abandon them in favour of some other opportunity. In the author’s experience the chances of top quartile success can be significantly improved by explicitly working on three critical aspects of the new business: the entrepreneurial concept, the strategy to build the business and the strategy of the business once built. The last is largely covered in earlier chapters; the other two concepts are unpacked here.

The Entrepreneurial Concept The entrepreneurial concept defines a development path for the start-up that reconciles the objectives of the founders with the financial needs of the business and the preferences of investors. Echoing earlier chapters, there are multiple possible routes for the development of a successful business, but each successful route requires consistency between these three sets of considerations. Much business and personal distress arises in start-ups because of the inconsistency that arises between these often conflicting demands. While not all inconsistencies can be prevented, certainly the successful elucidation of the entrepreneurial concept for a new business can reduce or mitigate major inconsistencies. Few start-up teams find the time to carry out this type of exercise, preferring to busy themselves energetically with the preparation of prototypes, the finding of premises or discussions with lawyers. Where some discussion takes place, more often than not it results in the generation of a basic financial package to appease investors, rather than a deeper dialogue concerning what the founders hope to achieve and how they will work together in a variety of different circumstances (Figure 36). Figure 36: The Entrepreneurial Concept. Founder Objectives

ENTREPRENEURIAL CONCEPT

Business Financial Needs

Investor Attributes

Start-up Strategy

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My own close experience of the early days of more than a dozen start-ups has led me to identify some principal elements of the entrepreneurial concept. The list is not comprehensive but has been useful in a number of situations over many years. It comprises: Success factors Personal goals and goal congruence Subordination of the business Models of development Ownership and control Investment and commitment IP and initial assets Legal structure Failure and dissolution Statement of principles.

Success Factors It is helpful for a founding entrepreneurial team to consider in detail the factors that they believe will determine the success of their new business, and also what they would use to gauge whether or not their business is successful. One critical success factor is likely to relate to leadership and management. Designing an effective team dynamic will require open discussion of individual goals and commitments, and how individuals will work together. The sorts of question to discuss explicitly include: (i) Who gives orders to whom, and how are disagreements settled? (ii) Who is really in charge? (iii) How will we deal with shifts of performance and expectations? (iv) Will people be rewarded differently? (v) How hard will we try if it turns out to be difficult to build the business? (vi) Just how good are the other members of the team, really? Managers who recognise the relevance of these topics to success, will then naturally move to an explicit discussion of their own thoughts and experience on how leadership and management are best exercised. A powerful aid to settling issues relating to leadership and management is for the team to develop and share an agreed entrepreneurial concept, since the working through of these topics makes perspectives about management and leadership surface in the context of a relevant debate about the business. While all this seems very sensible and obvious, very few start-up teams carry out this exercise, shyly preferring to cross their fingers and make some sketchy contingency plans if things go badly wrong. Not surprisingly half the founding team on average will have quit within the first three years of the business. A second key determinant of success is likely to be the clarity of vision and strategy for the new business. In order to select the most attractive opportunity or to

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focus development efforts in one of many directions open at the outset, the start-up team should specify criteria by which the selection must be made. Making these criteria explicit prevents business drift that may easily arise if the development path deviates from early expectations, and implicitly from the capabilities and goals of the team. Without an anchor it is easy to slide slowly into a strategy and business model, which at an earlier stage would have failed to meet the selection criteria. Sunk cost inertia can also lead a team to pursue a bad opportunity simply because the team has spent so much time investigating it. Sometimes the application of these criteria will involve screening more opportunities and analytical research. Often the criteria are needed in order to focus the application of a particular idea or technology to a given ecosystem. For instance, in the late 1990s a major university developed new organic materials for displays that stood to compete with liquid crystal technology. In spinning out a company to commercialise these breakthroughs, it was very important that the spinout articulated which customer applications it would target, because a poor choice would quickly have exhausted the available start-up resources. The bottom line output from this stage of visioning and strategic targeting is the crisp articulation of a business idea that can be summarised in a mantra, which the founding team jointly share: for example, low-cost flat projection displays for home entertainment. Once the business idea has been sharply articulated through a process of iterative revision, the team will benefit from the preparation of an explicit plan for the business. While actual business outcomes will differ from the plan, the plan may be regarded as a mental laboratory to test and analyse business ideas and their exploitation through marketing and distribution choices. A third success factor relates to the securing of adequate financial resources. The start-up team needs to know and discuss the likely magnitude of finance required to make the business successful, as well as the options available for raising this finance. When this preliminary quantification has taken place, the team can carry out research to identify possible sources of funding and calculate the timing and likely impact of successive rounds of finance (for example following the type of seed capital calculations shown in Chapter 8). The team will probably also wish to discuss how to select funders and how to handle the process of negotiation. Getting the right type of money is very important to success. The team needs funders who are empathetic, supportive but not dogmatic, and dependable when the going gets tough. Funders who look at start-ups on the basis of portfolio statistics or as a financial play are to be avoided. The best money comes from people who know and understand the business, and can provide concrete, practical solutions to the problems of development. It is important for the team to quantify and prioritise the sources of funding they seek, and to reconcile their choices with the desired competitive trajectory of the business. Such choices are often emotional and difficult. One business I know is struggling with the tension between a dislike of venture capital money because of prior bad experiences, and the genuine need to build an infrastructure to exploit the merits of its promising technology. The fourth factor strongly influencing success is likely to relate to the effective deployment of the necessary human resources to meet the milestones set out in the business plan. This will typically require the start-up team to undertake a skills audit

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and to develop a plan to fill resource gaps over time. Often resources are scarce in start-ups, and explicit discussion of how to attract and reward critical staff is needed. Fortunately, template models of equity and options structures are becoming more prevalent over time. Often, though, the start-up will depend on quite a large amount of unremunerated help from others, and this in turn requires considerable persuasive human resource skills. A further factor influencing human resource policy is the structuring of incentives particularly for early members of the organisation who were not part of the founding team, or of high capability, but who are nonetheless important parts of the organisational glue. Finally, well-articulated roles and responsibilities for the enlarged team will increase the chances of success. A fifth factor of success relates to control and infrastructure. The most important consideration is the effective management of cash during the early years of the new business. This will require the implementation of simple, but effective controls on expenditures and the necessary fiscal reporting systems to support good investor relations. Managing cash is a critical but miserable activity. Factor six: routes to market (RTM). Many companies succeed in developing the product or service that they originally intended but fail to build significant businesses because they are unable to develop adequate channels to market. The specifics of these arrangements will be different business to business, but if there is a recurrent theme to emerge from the recent entrepreneurial bubble in the late 1990s it is that too little time was spent by the founding team on the investigation and effective management of RTM. Recognition by the founding team that RTM is a key success factor is the first step along the route. Getting RTM thinking into the minds of all those involved in the early development of the business can shorten time frames and reduce the number of blind alleys that seductive technologies can lure founders into. Consideration of the factors of success would be incomplete without mentioning the very substantial element played by luck. Entrepreneurial activity involves risk and chance, and occasionally a serendipitous outcome will have a profound and unanticipated effect on the development of a start-up. Acknowledging the role of chance in enterprise can help start-up managers to avoid the depths of despondency, and the excesses of hubris. Personal Goals and Goal Congruence Members of the founding team should undertake an exercise to define explicitly the nature and magnitude of the goals that are most important to them. If it is possible, that ranking, and measuring their chosen criteria, can help individuals to identify the degree of congruence that exists between them and other members of the team. Typically, the goals may relate to a number of identified criteria shared by many managers (status, money, power, need to achieve, need to create, self-realisation, autonomy, lifestyle). In addition to these general criteria the founders should consider any personal individual factors particularly important to them, for instance the desire to work in a particular location. It is often interesting for the team to describe the personal goals of their colleagues. This type of group working can surface differences in outlook that can

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be discussed explicitly. But if the differences are hard to reconcile it is better for the business not to proceed since these differences will be sure to appear at some stage in the development of the start-up, often at a critical moment with very serious consequences. Frequently, teams paper over differences that exist between them in the hope that these differences will not be tested or that they will be able to deal with them at some future date. Usually, unresolved differences are harder to resolve once businesses are up and running and under threat than at the outset. Some differences may be helpful or even healthy, but it is important for the parties to have an understanding as to how they will get on together and how they will treat each other in advance of going into business together. Most people tend either to feel uncomfortable or vulnerable when these topics are broached, and as a result speak vaguely or in platitudes: ‘‘I’d like to make a decent return’’, ‘‘It’s important to me that I enjoy what I’m doing’’. This kind of dialogue is an unproductive waste of time. In my experience most people have a pretty sharp idea of what they want, or if not, certainly what they do not want. The kinds of questions the team need to answer include: (i) Exactly how much money will I receive and when? (ii) Exactly how many hours will I work a week and at weekends? (iii) Do we all fit together? (iv) Are these people like me? (v) Can I trust them? One ounce of frankness at the start is worth a ton of admission later if the business falls into a ditch. Subordination of the Business The start-up team should explore the extent to which the needs of the business in its own right should dominate the goals and aspirations of its leaders, together with the related question of whether the company is an extension or reflection of the character of the founders as opposed to being an independent person. In the case of some entrepreneurs one can say they are the business, and that is the way they want to keep it. For these individuals, their business is a way of leveraging their impact on and relationship to the world. This does not necessarily imply a small business: there are several personal entrepreneurial empires in Asia today each worth more than a billion dollars. For a professional entrepreneur, however, the needs of the business will come first, even to the point, in a number of cases, of the removal of the founding entrepreneur. One of the benefits of this professional detachment is that the problem of succession does not become a dominant and polarising issue as the founder ages and the business matures. Returning to this question of subordination from time to time may help the founding team to avoid sliding into a personalised reverie where over a number of years the objective development of the business may be compromised by incremental indulgence of the personal whims and preferences of the founders. A powerful external rudder may however exist in the form of outside shareholders, depending upon the path of development chosen for the business. Non-executive directors can also help the management team to calibrate the level of idiosyncrasy and inwardness of the business compared to the normative level of others.

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Models of Development The choice of the development path for the start-up will have a major impact on the way the business is managed and the way it grows, on both an individual and collective basis. Figures 37 and 38 highlight two possible development roads (most other routes comprise a mix of these two basic options). Very often a new business emerges from the prior or existing business activity of the founders. Often the founders may set up a new business using a relatively mundane contact-led new business initiative for which they provide some initial capital. The initiative might relate either to a new product development (NPD), or to the takeover of an existing business entity in conjunction with a willing vendor, who typically may provide part of the funding required to carry out the sale. For a new product, which addresses a set of customer requirements well studied by the founders, but is highly familiar, further funding from friends and family (FF), business angels and customers to support development and launch expenditures will often be necessary. Where the entrepreneurs have taken over an existing business, they will usually reorient the strategy of the business to improve its performance. The entrepreneurs

Figure 37: Organic Development Route. NEGOTIATED VENDOR PURCHASE MUNDANE / CONTACTLED / PRIOR EXP / BUILD

REORIENT STRATEGY

EXPANSION

OPS CASH FLOW

DEVELOPT & LAUNCH

NPD INITIATIVE

FOUNDER CAPITAL CUSTOMER FUNDS FF & ANGELS

Figure 38: Venture Development Route.

TECH-GEN IPR

FOUNDER CAPITAL

NPD INITIATIVE

FF & ANGELS

DEVELOPT & LAUNCH

VC RD 1 OR CUSTOMER

EXPANSION

VC RDS 2 & 3

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will also rely on operational cash flow to support either the new product or the reorientation of the business, perhaps leveraged by some term debt or overdraft funding. If the new product is successful, or the reorientation delivers good results the business will expand, often funded by retained earnings. Since this development route is typically incremental and modestly demanding of capital, expansion might be reached relatively quickly — two to three years is not unusual. This organic development route is much the most common, in spite of what we read about venture capital activities. An alternative development path is depicted in Figure 38. Here a founding entrepreneur will typically fund some garden shed activity through which she will identify some technology-generated IP. For example, an old friend has spent a large part of the past two years stabbing his thumbs as he perfected a new type of TENSbased painless injection.152 Once a preliminary design or prototype has been developed, the entrepreneur will solicit further funding from friends, family and angels in order to secure IP, form a technical team and start a formal period of new product development. Assuming technical hurdles are overcome, the entrepreneur will usually seek further funding from a sweetheart customer or venture capitalist. Over successive rounds of funding, the business team will be built, and will often comprise recognised professionals who have a track record of managing aspects of a start-up, as opposed to the early members of the founding team, who typically find themselves moved aside as the scale of the business expands beyond the domain of their proven competence. The typical time scale to reach expansion for a venture-backed business is four to five years (unlike the two to three years characteristic of Internet-related ventures funded in the last venture capital cycle). The look and feel of these two development paths is very different. The venture route will bring resources and early professionalism, but at the expense of additional stress, complexity and scrutiny. The organic route will often involve large amounts of bootstrapping, frustrated learning and usually slower growth. Both routes are viable, and the entrepreneurial team will need to make a choice between them that is consistent with individual and collective goals and the subordination of the business. Considerable tension and conflict are likely to arise within the team if the team has not maintained a steady dialogue relating to the development path. Ownership and Control The level of outside ownership and control will clearly be dependent in part upon the development route chosen. It is unlikely, for instance, that the founding team will ultimately own much more than a quarter of the equity if there are three or more rounds of external investment. Using a spreadsheet and a knowledge of how much the business might require at each round of funding together with the rates of return that external investors are likely to demand at each round, the founding team can

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TENS stands for transcutaneous electrical nerve stimulator.

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work backwards from an envisaged flotation at typical valuation multiples to calculate the ownership percentages for the providers of funds, and hence the residual equity left for them (see the simple example in Chapter 8).153 Based upon this type of modelling, the team can then package various funding deals, which will meet typical investor requirements and discuss the timing and magnitude of funding in order to achieve levels of outside ownership at different points in the development of the business with which they are comfortable. Besides the question of outside ownership, however, the founding team needs to settle how to reflect the early contributions made by the team of ideas, time, management and money. As a rule of thumb, at the angel/seed stage, one might expect the ownership to be split equally three ways between the business idea, the money and the management. Where an individual has made contributions to more than one category, then it may be helpful to allocate an overall equity percentage based upon a draw from each of these three pots. Further discussion will be necessary to establish the percentage of ownership to be ceded to employees, and outsiders (angels, consultants, non-execs), and conditions and mechanisms relating to the granting of these participations. Once the capital structure and its evolution have been rationally modelled, the stage is set for the real debate over the issue of control. This is almost always an emotive issue for the founding team, even when the team has a wall covered with certificates from the best business schools and universities. Sometimes it makes sense to recognise that this is a permanent feature of the emotional landscape and move on, but where possible an elucidation of the advantages and disadvantages of majority ownership needs to be aired. If control is important to individuals, perhaps because of prior business experience, recognising this and trying to work around any drawbacks this presents (for instance by using preference shares or other devices to separate aspects of funding from aspects of ownership) at an early stage can save time, expense and frustration later on. Often the holders of the majority of the equity overestimate the true control they can exert over their business. In reality, it is the economic weight of the various parties involved in the business that dictates many decisions: banks, funders, customers and employees constrain enormously the decision options open to the majority owners. The influence these groups have is largely unaffected by the relative standing of different cohorts of shareholders within the governance structure. Nonetheless, it is clear that majority ownership has more than a symbolic importance to some entrepreneurs, and this attachment may need to be respected. Investment and Commitment Related to the preceding discussion, the founding team will need to settle on a way to recognise historic investment and commitment other than through straight equity

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A simple set of IRR assumptions are 100%, 80%, 60% and 40% for seed, 1st, 2nd and 3rd round funding, respectively.

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rewards, and to agree future investment and commitment for a variety of possible business scenarios. During the period of soft start-up, where some team members will still be engaged in other businesses, the usual elements of investment comprise time, money and opportunity costs. Note that while the latter elements may enjoy substantive recognition within the team, outside they count for nothing: business angels often poke fun at those entrepreneurs who match the cash the angel is considering investing by calculating their investment contribution as the money they might have made doing something else instead of working on the start-up. Often the founding team muddles through these issues and does not record why things were decided in the way they were. This frequently leads to problems later, when further contributions are required and the basis for valuing those contributions appears inconsistent with what was done at the outset of the business. It is also useful to have established some metrics for valuing these items since others may join subsequent to the founding team. The discussion about commitment and investment also provides a suitable context to discuss the thorny issues of role and rank. If the team has been open and constructive in its self-appraisal, the allocation of positions and reporting lines in the new business will not be contentious, but on the more likely assumption that everyone has been afraid to spoil the party with some genuine frankness, what most often emerges is a set of fudged allocations, which have to be sorted out at a later date. In parallel with a discussion of the contributions made in the early history of the business, it is important to rehearse what individuals and the team will do if things turn out very differently from what the team expected at the outset. Establishing what individuals will do in extreme good and bad outcomes will help contingency thinking and build shared trust. When things turn out very well, the business can suffer because a key team member decides to do something else. When things go badly, it is important to know who will be there turning out the lights. If asymmetries exist between the principals, they need to be explored before they become realities. Very often businesses succumb to deteriorating circumstances not because the business could not survive but because the managing team disintegrates. Anticipating how each other may react allows the team to make better decisions in the light of events. Where individuals make known where their personal limits lie, roles and decision making can be discussed and agreed ahead of time, so that an unanticipated set of business circumstances does not throw the internal dynamics of the founding team into disarray. If further contributions of money or other resources could arise, it is important that the means to determine their value is pre-established, otherwise one party or another will feel aggrieved. Even though nearly all start-ups encounter one or more episodes of turbulence, few start-up teams spend time discussing these issues until it is much too late to handle them effectively and fairly. IP and Initial Assets One particular constituent of early investment and commitment that probably warrants individual treatment is IP. Auditing the IP and other initial assets (such as

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customer leads and software tools) is valuable both for establishing an initial valuation basis and for any subsequent determination of property rights. At the same time that this audit is carried out, the founding team may wish to settle general policies of IP ownership, as well as the allocation of the items in the starting inventory. It is also likely that some members of the founding team may leave the business to pursue other interests, which will give rise to questions of access, use and entitlement to elements of the IP. Working out a set of base principles as part of the entrepreneurial concept can make departures easier to handle and reduce IP distractions. In some cases the team may want to establish royalty rights for key innovators that survive departure. These discussions also provide a good background for discussing more broadly IP strategy for the new business, so that good practice is built in from the start. For instance, one can decide on technical log policies, the width and mechanisms of international coverage, the thickness required of the patent estate and the use of internal and external resources. Legal Structure Very often businesses incorporate before the founding team has even shaken hands. While this may be a sensible choice in a number of instances, it is important to realise that early choices of structure cannot be rolled back and as a result occasionally the owners suffer very adverse taxation consequences. If incorporation is not immediately necessary, there may be advantages to other trading arrangements, partnerships or trusts during the early days of the business. Traditionally, the trade-off has been tax reduction against increased personal exposure for liabilities. Personal estate planning and internationalisation are also issues to consider. Clearly there are some advantages to a very simple local corporate entity, but this is one issue where it may well be worth paying for some expensive tax and legal advice early on. Failure and Dissolution Failure and dissolution may occur at a personal or business level. For founders, issues of vesting and share buy-backs on departure are best sorted out upfront if at all possible, and included in the basic legal constitution of the business. Valuation is often a critical and uncomfortable area of concern both for legitimate departees and for those who remain. It is important to establish a method of valuation, and this will often involve an outsider. Mechanisms for payment and enforcement should be specified together with a non-legal means of resolving conflicts. At the business level, the limits of liens and guarantees should be established in advance, together with an agreement about how cash flow, debt and equity are defined. Certain levels of financial exposure may be contingent upon the attainment of clear operational milestones. It is important to try to scope out these exposures in advance. Some readers may object that it is not possible to predict a good set of medium-term outcomes for the business, because the path is too uncertain. Perhaps so, but if the founding team do not have a personal, practical sense of what business

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failure might mean and what it might feel like, they should not be setting up shop. If these questions are left to be determined by events there is a significant risk that even if the business survives a period of duresse, some members of the team may feel that their colleagues have been free-riding on their commitment to the business, to a degree that is hard to square with the shares of ownership in the business. This is dissolution one step removed. Statement of principles A sensible start-up team will put together a short statement of principles (three or four pages) that underpin the entrepreneurial concept, to which the team can refer from time to time. The principle might be organised under five headings: What are the shared personal goals of the founders and what constitutes achieve-

ment? This would cover the roles of the founders, how they spend their time. In addition, it is important to state explicitly their values and how they relate to each other. What business and financial risks are appropriate?

This would draw on the choice of development route, the investment and commitment discussion, and the boundaries set by failure and dissolution. How will other parties be involved and treated?

The other parties are usually providers of capital, ideas or skill. The principles established will be conditioned by views of development path, IP and control. How will the founders behave and treat each other?

The salient principles touch on (i) trust, integrity and openness; (ii) professionalism and formality; (iii) the resolution of conflicts and imbalances; and (iv) roles, reporting and responsibilities. What sort of company do the founders want to run?

This is the place to settle questions of culture, environment and style: lavish versus parsimonious, democratic versus. oligarchic, community involvement etc. The elements of the entrepreneurial concept are additive, so working on some aspects is better than doing nothing at all. In my personal experience, in the start-ups where the entrepreneurial concept has been well applied, the effort has been well rewarded. Where hard work has not taken place and has been replaced by blithe optimism, the teams have generally encountered significant later problems.

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The Strategy to Build the Business Most business plans weave together two distinct strategies: that of building the business, and that of the business when built. The symbiotic links between these two strategies can lead to a laissez-faire attitude to business evolution whereby the eventual strategy of the business is the direct consequence of whatever turns out to be the development path of the business. Relying on the vagaries of the development process alone to produce a successful business is a dangerous game to play when you have limited resources, and particularly when other people’s money is at stake. A more proactive approach may, however, be pursued, which can both help management to make key decisions and reduce the uncertainties the business faces, making it more attractive to investors. Let us suppose that we are confident that if a particular business can be physically established, its business model is sufficiently competitive for the business to generate adequate returns for longer-term investors. The process of building the business will then involve the progressive elimination of various risk factors that might prevent the establishment of the business, together with the completion of the product/service infrastructure and commercial networks to support the offering. The build process can be structured and managed around a blueprint that specifies a series of discrete modules characterised by major milestones, which mark the completion of key elements of infrastructure or networks or the elimination of a particular risk. The critical task for management is to obtain enough funding to pay for the resources to meet the next milestone. It sounds commonsensical, and yet quite often we read of start-up casualties that have failed to do this. Often failure to make the next milestone arises for one of four reasons. First, the team may have hit a genuine obstacle that could not reasonably have been foreseen, for instance an unknown technical hurdle. Second, engineers are often very tempted to increase the functionality of new products beyond what is strictly the minimum requirement for that stage of prototype development or meeting that development. A fluid and uncertain specification can be an insatiable consumer of resource. Third, the team may have underestimated badly the necessary level of resource to achieve the milestone. Or lastly, the team may be the victim of timing. The author for instance was involved in a California-based business where the principal funder of a new organic displays factory pulled out of the completion of a state of the art manufacturing facility after the events of September 11, 2001 when the facility was half built. The problem with falling between milestones is that any subsequent funding will always be on very poor terms, if it is forthcoming at all. Clearly some of the reasons for failing to make the milestone are down to the team. To the greatest extent possible, the start-up team must specify well scoped, achievable milestones in the business build blueprint together with the resources and funding necessary to deliver them. If the founding team has thought carefully about milestones, and in particular has defined milestones so as to allow business value realisation at that point, they and investors may enjoy greater returns from realisation than straining to raise the resources to meet the next milestone — at least they have a non-distressed option to realise business value. Correctly scoping each

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milestone is obviously very critical if the milestones are to be matched against resources and funding.Where the milestone relates to technical development of the product, the founding team may feel quite comfortable with the timeline, resources and budget they develop. If there is a bias in start-up thinking, however, it is to place too much emphasis on the relative importance of an innovative product over the need to establish RTM. As a consequence, the later milestones in business building that relate to RTM are often very weak, both on paper and in people’s heads. It is often assumed that if the product is innovative and well made, it will simply sell itself. Wrong! Just look at the large numbers of neat products that come and go, which fail to generate commercial traction. Conversely, look at companies that have very wellestablished RTM (for instance Microsoft), where the emphasis on radical, innovative products is often subdued. Experienced venture capitalists quickly perceive the lack of RTM thinking in the plans they receive: to win funding, the product or service has to have merit, but the founding team also have to have a credible route to actual customer sales. Getting individuals onto the team who have RTM experience in the ecosystems relevant to the start-up is an early priority. In the near term, non-executive directors or angels may be able to provide guidance. In a typical business build blueprint the following main risks are decomposed into steps of risk reduction, which are then aligned with particular milestones so that managers and funders can see the risks managed over time commensurate with the uptake of resources and funding. The blueprint provides a timeline against which these risks are reduced. Cutting across the timeline at any point will produce a crosssection where it is possible to see exactly what the state of each of the risks is, and what will be achieved in terms of risk reduction at the next milestone. The risks are described in product innovation terms but similar considerations relate to services. Technical Getting new products to work well and reliably often require the building of a series of prototypes: proof of concept, laboratory, engineering and manufacturing prototypes. Different technical considerations will be pertinent at each stage, captured by particular performance characteristics e.g. efficiency, functional quality, reproducibility, conformance and scalability. The technical milestones will co-incide with the ability to demonstrate that the product works, works well and can be made in the requisite quantities. Demand Sir Clive Sinclair, the British inventor, developed many innovative products over the years, including a revolutionary power-assisted bicycle, and electric car. Demand for these products has been very modest. A few years ago the venture capital community wondered if there would be any demand for organic light emitting diode (OLED) displays, in spite of the thinness and superior colour characteristics these displays offer relative to LCDs. Today there is very little demand risk for these new products.

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Sometimes it takes quite a while to determine the most valued application for innovative enabling technologies: prototyping and the parallel testing of different new product initiatives can help to resolve ambiguities surrounding the definition of products that make use of the technology. Resolution of the product ambiguity usually results in a value proposition that explicitly states what is the customer need or problem that the product addresses for which the customer is prepared to pay. Market research, panel testing, customer dialogue may all help to mitigate this demand risk. Key market tests and outputs will be incorporated in identified milestones for the business. Competition All too often pioneering innovators do all the legwork only to see some later entrant profit extensively from their innovation. In some areas patents can mitigate this risk, but often the best deterrent is successful rapid staged deployment of the new business ahead of others together with a well-conceived business model (all ideally documented in the business build blueprint). Monitoring competitors can help tactically to influence development plans. Forming development agreements, partnerships and joint ventures with businesses that possess complementary assets can leverage the competitive position of the start-up, but at the risk of erosion of returns: chaperones have their price. Key steps along the path of competitive control, including the legal granting of patents and licences, new product announcements, customer trials etc. will form part of the milestones. Human The starting team is seldom the commercialisation team, and the identification and filling of gaps is an important first step to reducing the risk that the team does not have the ability to deliver. Explicit planning for the introduction of replacement or supplementary resources well suited to later stages of development can also lower the risk of management failure. Changes in the configuration of resources will form part of milestone events in the plan for business build. Operational Once a manufacturable product or deliverable service has been developed and tested, considerable risks arise with regard to the procurement and operation of the necessary assets, facilities, resources, partnerships and contractual arrangements, particularly with regard to ramp-up and scaling (whether owned or contracted). Many of these individual risks will be specific to the business. Prototyping and pilot activities may represent stages in the process of scaling up. Very often the senior personnel capable of bringing operations on-line will not be in the business, resulting in search, remuneration and other human resources issues. Different volume thresholds and operational configurations will also need to be outlined in the milestones (e.g. different types of manufacturing process at different scale points).

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Financial Where the product can be supplied there may still be concerns about the costs of the product, including selling and after-sales support, particularly if costs have much volume dependency. Besides contractual supply arrangements and negotiation, careful cost modelling, in conjunction with material and equipment suppliers, may help to establish attainable cost and volume targets. Different milestones will cement key development step changes that secure the underlying economics of the business. RTM The risk remains that even if products can be made reliably at reasonable costs, product take–up may be slow. To handle this risk, the management team can develop a detailed understanding of channel economics, promotion and support. Based upon accurate knowledge of channel characteristics, management can identify a specific set of channel options that can be subject to limited testing. Detailed discussion and codevelopment of channel campaigns, inventory and sales policy can take place with channel partners and their advisors during the early phases of product development so that operational arrangements interface well with channel choices. What is very hard to figure out is not how to cooperate with channel partners, but how to sign early deals that do not give away an undue share of the upside. Underpinning the development of sales channels must be an adequately scoped level of sales and marketing resource that is competent to deal with the channels. The blueprint will highlight at which milestones the various channel uncertainties will be resolved. Funding This is the risk that the business will not be able to raise the sequential rounds of funding needed to meet specified milestones, or that investors or owners will not be able to realise their positions. Ironically, this risk is often foremost in the minds of the principal funders of a business: one might have thought these funders themselves would perceive that they as funders were in a better position than the management team to handle this particular risk. The best means that management has to get funding is a reliable record of meeting milestones on time and within budget (and this is not always sufficient). To the extent that the senior team can develop sources of funding and devote time to raising money, this risk can be lowered. It is also important to revise the blueprint from time to time to reflect the timing and preferences of the funding community. Depending on where we are on the cycle of initial public offerings, and the state of the portfolios of investors, the characteristics of attractive investments may change significantly in terms of magnitude, sector and types of acceptable risk. Timing is very important. In the second quarter of 2004 for instance there was a marked shift in sentiment towards certain early stage funding of start-ups following two years of drought. The key point is that the funding challenge for the management team is a type of marketing problem: they need to offer a package of return in a given sector that is of the right magnitude and comprising the right levels

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of risk factors that suit funders at the time of the funding need. Each of the packages should be tailored to one of the designated milestones where a step change occurs in one or more of the other risks. Designing and delivering these packages of funding also itself helps to reduce the funding risk itself, thereby making the business additionally attractive to investors. These risk factors are accentuated in the case of venture-backed new business development. Many of the factors may be considerably attenuated in the case of organic development, because of the knowledge, experience and more incremental nature of the founders’ business model. Sometimes the founders of an organic startup may be so familiar with the ecosystem within which their new business operates that much of their knowledge is tacit. Even then, however, there is value in the explicit setting out of the strategy for building the business for the benefit of employees, partners and funders. A full-fledged blueprint might be inappropriate, but a succinct executive summary comprising a few pages may usefully sharpen aspects of timing, execution and tactics.

The Strategy of the Business Once Built To determine an effective business model for the completed start-up, the founding team needs to identify the relevant strategic ecology for its product or service, how the actions of the start-up may effect the strategic ecology, and to study the business models for existing players in the ecosystem and any new entrants who might emulate the start-up ecosystem entry. Very often, founding entrepreneurs will state that there are no competitors to its innovation. While this might be strictly true in a very narrow sense — no one else does exactly what the start-up intends to do — it is exceptionally rare that the innovative product or service does not meet an existing need or demand that some other more basic product addresses simply because people have been around, largely unchanged, for a very long time. My initial reaction to the claim of non-competition is tremendous scepticism and likely loss of regard for the person making the claim. Armed with a detailed understanding of what currently occurs in the relevant ecosystem, one is at a good starting point for testing the viability of the new business model. The most important question to answer is why an individual would take hardearned cash out of her pocket and put it into the pocket of the entrepreneur in exchange for what is being offered that is different from competitors. The answer forms the kernel of the value proposition upon which the business model turns. Unless an entrepreneur can provide a compelling answer to this question, she has no starting basis for a business. One acid test is to try out the business model on trusted friends. It is often very revealing but painful to receive their comments. If the preliminary business model survives, the entrepreneur is then in a similar position to that of a corporate intrapreneur: in other words at the beginning of Chapter 7. We have assumed, throughout this explanation of what it is to provide a strategy for building a new business, that the business model of the new business is competitive and will produce sufficient returns to keep investors happy. It is very likely,

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however, that the process of building the business will yield insights into the business model, perhaps improvements, perhaps flaws. If the tension between what is revealed by the progressive attainment of milestones and the original business model becomes sufficiently great, it will make sense to reappraise the original business model. Even so, it still probably makes sense to separate analytically the revised business model of the ending business, and the strategy of building that end business, including the management of risks against milestones, resources and funding in the way described. Typically, however, the interaction between the two strategies (i.e. of building the business and of the business once built) results in iterative honing of both, new discoveries and thoughts in one area informing the other. For a powerful enabling new technology, the interaction of the efforts to build the business and of the efforts to define the business model may take months, even years, with false starts, twists and U-turns in a painful but intriguing journey of discovery: look at what is happening in wireless data services currently as a case in point. The purpose behind setting out these separate strategic elements is to provide methodological clarity; in practice, the analysis and investigative dialogue will be subtler, less mechanical and involve more judgement than this analytical road map suggests.

A Mnemonic: the Six T’s We may draw together the concepts developed and lessons learned over the last cycle of start-up formation in a checklist comprising the following six t’s: Technology — having an innovative business idea that could make money; Team — having the necessary people to develop and implement the idea; Talent — in the form of high quality individuals to lead aspects of the business at different stages of development; Timing — in relation to demand and investment cycles; Traction — early commercial indications that the business model will work; and Trust — between the founders, between the founders and their team and between the founders and the funders.

Summary 1. For start-ups, managers need to work through (i) the entrepreneurial concept that underpins the new business together with (ii) the strategy of how to build the business so as to deliver (iii) the strategy of the business once it has been built. 2. Start-up teams seldom set aside sufficient time to discuss the entrepreneurial concept that binds the team, nor to discuss explicitly the various distinct risks which need to be overcome during the process of business build. 3. There are clearly distinct development routes for a new business that have profoundly different implications for the role, rewards and expectations of individuals, yet these routes and differences are seldom discussed explicitly and managed by start-up teams.

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Questions 1. Have you been involved in any start-ups, and if so in what role? How does your experience relate to that of start-ups in general? 2. If you have started a new business what was the entrepreneurial concept that underpinned the start-up and how explicit and distinct was the strategy to build the business relative to the espoused strategy of the business once built? 3. How do you think professional entrepreneurs can improve their chances of successfully building a significant business that fairly rewards them?


Chapter 11

Summary, Observations and Conclusion For those readers who like to begin at the end before deciding whether to begin at the beginning, this chapter summarises the main themes developed in the book, points out some constraints on their application and highlights possible avenues for future development. It concludes that the concepts and techniques developed in this book will make a significant positive contribution to the objectivity, precision and rigour of strategy.

Executive Summary The content of the preceding 10 chapters may be summarised as follows: The centre of gravity of economics should shift to focus more on the activities of

diverse businesses rather than concentrate on extremes and idealisations such as monopoly or perfect competition. This could be accomplished by complementing the existing body of economic knowledge with a new area called the economics of strategic diversity (ESD). The elaboration and specification of strategies for heterogeneous businesses con-

stitute the focus of ESD. In practical terms, for a business within a given strategic ecosystem, a strategy is a

consistent and coherent pattern of action expressed through a business model leading to the appropriation of sustained economic rents. The critical first step to understanding the appropriate strategy for a business is

identifying its relevant set of competitors and the framing environment that surrounds the business — what we call the strategic ecology. Within a given strategic ecosystem, different businesses employ different business

models to pursue their individual strategies, each seeking to establish competitive advantages that deliver financial results that are acceptable to shareholders. Business models can be thought of, and using matrix methods explicitly described

as, types of business molecule or gene. To establish a competitive advantage, a business needs to pursue different sources

of advantage appropriate to its means, path and context. There are many routes to success but they require careful analysis and appraisal so that resulting actions within the business are consistent and coherent thereby conferring advantages that are hard for others to overturn.

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Businesses that enjoy competitive advantages generate economic rents above the

risk-adjusted cost of capital. Besides rents from monopoly, scarcity and innovation, businesses frequently generate opportunity rents. By offering differentiated products and services that are well valued by customers and protected by isolating barriers from immediate competitors, businesses can extract sufficient economic rents to keep their shareholders happy. Rents need to be calibrated against the resources required to produce them. If the

return on resources is higher than the risk-adjusted cost of the resources, shareholder expectations will be satisfied, and value will be created for them. The key to successful development beyond an existing base business is exploiting

adjacent ecosystem where competitive advantages can be carried over in part if not in their entirety. The transfer of competitive advantages gives rise to synergies, which, if sufficient, will warrant entry into an adjacent ecosystem, or to opportunities for strategic revision within an ecosystem. The purpose of corporate strategy is to extract greater sustained economic rents

from a set of businesses than the businesses would generate on a stand-alone basis. Corporations that comprise several businesses can deliver value to their share-

holders by compensating for market failures, exploiting synergies between the business units, coordination, business model engineering, reinforcing adjacency advantages, controlling investment and embarking on major successful initiatives. A useful corollary is to think of corporations as business model factories. A number of useful techniques, honed by practical application, are discussed to

distinguish and manage corporate strategic priorities, value strategic alternatives and assess the economics and strategic impact of acquisitions. In the case of new businesses, the founding entrepreneurs should clearly articulate the

entrepreneurial concept that unites them. In start-ups, it is also important to distinguish the strategy to build the business from the strategy of the business once built. Key elements of the strategy to build a new business relate to Technology, Team,

Talent, Timing, Traction and Trust.

Major Insights Sophisticated readers may correctly assert that others have said much of what has gone before, albeit using different terms, techniques and definitions. Where the book does introduce entirely new significant insights, however, is in three areas: strategic ecology, business models and the return on resources. For the purposes of strategy, it is absolutely critical to establish clearly the locus of competitive activity. This involves isolating some combination of suppliers, rival businesses, partners, distribution intermediaries and customers that all feature in the dance called competition. In the past, managers and strategists have tended to focus primarily on only one of these sets of participants when they have tried to identify the


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relevant perimeter for defining competitive activity. For instance, many businesses have designed strategies and action plans based on distinctions drawn between different groups of customer, different customer segments, imagining that the appropriate business models and associated competitive advantages or disadvantages that apply to the different customer groups are themselves distinct. This might or might not be the case: in general there is no logical requirement that different groups of customers should be regarded as strategically distinct, and hence requiring distinct business models. In a similar fashion, other managers and strategists have considered that different channels of distribution for a product or service characterise different competitive systems, each of which requires a distinct strategy and business model: online grocers versus off-line, for instance, or wholesale versus retail represent frequent distinctions that are drawn. Whether or not such differences in distribution or logistics are competitively relevant or not is a matter of fact in each particular case. Distribution is not necessarily the relevant basis for business model design and strategy formulation. One particular perspective that has had much influence on how strategists determine their set of relevant competitors has been the work carried out on strategic groups, where members of a given group share a common business model.154 If competition is defined on the basis of strategic groups, it follows conveniently for economists, that the differences in performance between different members of a given strategic group will be very largely explicable in terms of economies of scale, economies of scope and of relative efficiency (putting aside the other more extreme situations of monopoly and oligopoly). Why? Because all members of the group have the same business model in common. This does not square with experience. Quite often, businesses that compete with each other employ quite distinct business models in order to work with their suppliers, distributors and partners to satisfy the needs of their customers (whose needs might be quite varied and customer-specific). Competition is much richer between heterogeneous businesses within an ecosystem than economists have been able to capture. The standard models of microeconomics and the generic strategies of Michael Porter and other theorists of industrial organisation do not do justice to the diversity that exists between astute competitors within an ecosystem. As a result, the businesses defined as a strategic group may or may not form the relevant competitive set in any particular given situation. What we need is a valid means of establishing the strategic ecology that surrounds a business and shapes its ability to prosper. Chapter 2 specifies a set of important diagnostic questions that can be used systematically to determine the boundaries between distinct strategic ecosystems. While these questions have their origin in strategic consulting assignments carried out over

154 Thomas et al. (2005: 222) write: In the same way that there are segments on the demand side, there are groups on the supply side. We call these strategic groups. They represent some structures within an industry that enable us to identify groups of firms with similar strategies.

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many years for major international corporations, their foundation is underpinned by the elaboration of distinct business model elements described in Chapter 3, which encode the structural inter-relationships between a business, its suppliers, partners, distributors and customers. The diagnostic questions are reminiscent of the list of questions an entomologist might use in the field to establish whether or not two insects form part of the same ecosystem on the basis of their construction, behaviour and habitat. The questions key into whether there is engagement and overlap between the business models of different players resulting in competition. The prime insight is that the key to strategy formulation is an accurate identification and understanding of the strategic ecosystem in which a business is situated, and that identification and understanding is a matter of empirical investigation, not of definition or imposition. The second major insight to be gained from this book is that it is possible to provide an explicit formal description of what the business model is that any given competitor adopts to implement its strategy. Up to this point there has been much discussion in an informed and imaginative way by managers and investors concerning the business models adopted by different competitors in different markets. As far as the author is aware, nowhere has this intuitive understanding of what a business model is been made explicit. By using matrices it is possible to describe accurately in any given case precisely what the business model of a competitor comprises. Not only does this allow managers and strategists to be more accurate and explicit in their strategic discussions, but it will also allow a taxonomy of business models and competition to emerge, dubbed business genomics. This approach will allow strategists to tackle the enormous diversity that exists between competitors within an ecosystem, and to figure out what types of business model there are and which of them work well in a given ecosystem. Equipped with the ability to describe the business models of competitors and how they are modified over time, economists will be able to investigate, describe and theorise concerning the competitive behaviour of different businesses in different circumstances. The use of matrix methods will allow both practitioners and academics to develop a common set of metrics for the quantitative description of the application of business models to competitive dynamics. It is possible to envisage a fertile future period comprising both extensive empirical investigation of business models and the development of an associated theoretical framework. The result will be an adequate and working account of the economics of strategic diversity. The final major insight relates to the use of the return on resources as the appropriate measure of strategic performance. Chapter 6 describes the venerable origins of this measure in the work of economists who investigated the links between the profit arising on net output in different structural competitive contexts — what is now broadly called industrial organisation by economists. The return on resources measure allows us to compare the performance of quite distinct businesses on the basis of the risk-adjusted returns they provide to investors on the resources they consume. The advantage of using this particular measure is that it allows managers and strategists to integrate their strategic choices straightforwardly with financial markets theory, as typified by the CAPM. When combined with the explicit matrix


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mapping of business models, it is possible to investigate for the first time the microeconomics of heterogeneous competition in the different structural situations that arise in distinct strategic ecosystems. A deeper understanding of the linkages between different strategic ecosystems, business models and financial markets will lead to better resource allocation within businesses, between businesses within a corporation, and provide greater insight for regulatory supervision.

Constraints and Practice Although many managers may nominally sign off a general acceptance of the concept of a strategic ecology defined in the way we have described, it is possible that the use of such concepts may prove awkward because it is difficult to answer accurately or unambiguously the diagnostic questions used to established ecosystem boundaries. More likely, though, is that managers will fiddle the answers or their weighted combination to produce the answers they seek to justify their preconceptions. Just look at what happens when internal teams are asked to assess their own and competitors’ strengths, weaknesses, opportunities or threats. Who, other than someone intent on career hara-kiri, ever chooses to answer these questions with the frankness they deserve. Other constraints may impact the use of explicit matrix methods for business models. This may just prove to be too complicated for anyone other than a specialist, just like foreign currency inflation accounting for subsidiaries. Perhaps a PC-based software tool that presented the business models as molecules viewable from different perspectives might help with the internalisation and discussion of what the business model comprises and how it could be changed. It might, though, simply be too complicated to look at as a whole. Perhaps the side-by-side comparison of key elements compared to those of principal competitors would better elucidate discussions of options for change, development or reinforcement. A general problem for a lot of what is discussed is that understanding and applying the concepts and techniques will either imply a lot of money or, worse still in many cases, a lot of time. Given managers are often represented as having a primordial need for achievement, action also speaks louder than words, especially those that are written. As a result many managers much prefer to cut out the thinking and get on with the doing. After all, correcting just means more (un) doing later. What is required is an evangelist, like a Du Pont, GE or Shell, to embed the thinking. The optimists among you will see this as just a matter of time, the pessimists will think of it as likely as a flat unitary rate of tax for individuals in the UK or the US. In the case of performance measurement and valuation, it may turn out that the advocated measure of return on resources has little take-up because business managers and financial market participants are locked in to a set of well-known alternative measures that form part of the common language of business. Being better does not ensure prevalence, as IBM’s experience with OS2 as an alternative to Windows and DOS demonstrates. In finance classes students are taught the superiority of cash flow over unreliable earning-based measures such as P.E.’s, but the research of

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analysts is dominated by these well established though inferior measures. The same might well turn out to be the case of the return on resources.

Future Research Irrespective of the immediate problems or constraints, a number of distinct research paths arise immediately from the foundations laid by the earlier chapters. They include: Empirical research to test, hone and improve the investigative techniques used to

identify distinct strategic ecosystems. These improved techniques could be put to good work in compiling, first, the rudiments and, then, the general detail of a comprehensive list of recognised distinct strategic ecosystems, rather similar (as has been mentioned) to the SIC used to categorise products and services, but at a much finer level of competitive interaction. In a similar fashion, further investigation and critical testing is warranted of the

application of matrix methods that encode the specifics of the business models of different competitors. This work might result in the adoption of one or more standard schemes that describe business model architecture and configuration. The application of quantitative methods to the matrix formulation of business

models will give rise to more general theories of competitive interaction called Strategometrics. As has been described in the addendum to Chapter 3, it may be possible to develop explicit testable laws and theorems regarding business model mechanics, and competitive dynamics. The end result might be a generalised theory of heterogeneous competition similar to mechanics, where dynamic competitor system operators are applied to competitive state functions described by interaction vectors that are in turn derived from business model matrices according to some well-defined calculus. Equipped with a standard classificatory matrix tool, extensive field research might

be undertaken to catalogue, sort and organise the distinct categories of business model, which researchers encounter in practice. This would comprise the primary work of the new field of business genomics. Further statistical research is required to validate, modify and extend the use of the

return on resources as a strategic performance measure in different strategic ecosystems. This research might involve generalised econometric and auto regressive statistics. The integration of the research on strategic ecosystems, standard business model

architectures and the return on resources would allow a new field concerned with the linkages between context heterogeneous competition and performance to emerge. This new field would complement the existing body of knowledge established at a more aggregate level in industrial organisation, and would form the core of ESD.


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Conclusion An adequate account of how businesses compete with each other is long overdue. Using the methods, techniques and concepts developed in this book, business folk and academics may make the first steps in the elaboration of the economics of strategic diversity. The benefit of making business models and competition explicit would be similar to the benefits that the world has enjoyed since Marshall and Keynes formulated and explained the foundations of modern macro- and microeconomics. It is likely that fewer mistakes would be made in the design, adoption and implementation of business models. If this were the case, fewer resources would be wasted and businesses, their customers and wider society might benefit from a higher resulting productivity of resources. A higher level of strategic dialogue might also enable businesses to conceive and develop with greater confidence innovative business models, elements of which have seen good service in other, but relevant, strategic contexts. In so far as it might be possible to share a common language to describe business model architecture and taxonomy, it would allow the learning of less fortunate and less developed areas of the world to accelerate and to avoid some of the costly mistakes, which are otherwise likely to arise on their path to eventual economic emancipation.

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Further Reading Bettis, R. A., & Prahalad, C. K. (1995). The Dominant Logic: Retrospective and Extension. Strategic Management Journal, 16, 5–14.

Further Reading 221 Boudreaux, D. J., & Holcombe, R. G. (1989). The Coasian and Knightian Theories of the Firm. Managerial and Decision Economics, 10, 147–154. Bowman, C., & Ambrosini, V. (2003). How the Resource-Based and the Dynamic Capability Views of the Firm Inform Corporate-Level Strategy. British Journal of Management, 14, 289–303. Conner, K. R. (1991). A Historical Comparison of Resource-Based Theory and Five Schools of thought within Industrial Organization Economics: Do We have a New Theory of the Firm. Journal of Management, 17, 121–154. Dixit, A. K., & Pindyck, R. S. (1994). Investment Under Uncertainty. Princeton: Princeton University Press. Economist. (1991). The Best Companies, September 7. Ehrbar, A. (1998). EVA: The Real Key to Creating Wealth. NewYork: Wiley. Financial Times. (1996). How the Experts Value Blue Sky Forecasts, February 24. Goold, M., & Campbell, A. (1987). Strategies and Styles. Oxford: Blackwell. Grant, R. M. (1991). Contemporary Strategy Analysis: Concepts, Techniques, Applications. Oxford: Blackwell Business. Grossman, S. J., & Hart, O. D. (1980). Take over Bids, the Free Rider Problem and the Theory of the Corporation. Bell Journal of Economics, 11, 42–64. HBS (1982). Note on the World Auto Industry in Transition, 0-382-122. Boston: Harvard Business School. Henderson, B. D. (1984). The logic of Business Strategy. Cambridge, MA: Ballinger. Johnson P. (1999). An Investigation of Clean Surplus Value-Added Pricing Models Using Time Series Methods for the UK 1983–199. Oxford Financial Research Centre Working Paper, 1999-FE-05. Johnson, P. (2000). Beyond EVA: Resource Margin Accounting. In: T. Dickson (Ed.), Mastering Strategy. London: Pearson. Kay, J. (1991). Economics and Business. The Economic Journal, 101, 57–63. Kay, J. (1993). Foundations of Corporate Success. Oxford: Oxford University Press. Keane, S. M. (1990). Can a Successful Company Expect to Increase its Share Price?. Journal of Applied Corporate Finance, 3, 82–88. Kim, W. C., & Mauborgne, R. (2005). Blue Ocean Strategy. Cambridge, MA: Harvard Business School Press. Kwong, M. F. C., Munro, J. W., & Peasnell, K. V. (1994). Commonalities Between Added Value Ratios and Traditional Return on Capital Employed. Lancaster Working Papers in Accounting and Finance, 94-007. Luehrman, T. A. (1997). Using APV: A Better Tool for Valuing Operations. Harvard Business Review, 75(May–June), 145–154. Mahajan, V., & Wind, J. (1985). Integrating Financial Portfolio Analysis with Product Portfolio Models. In: H. Thomas & D. Gardner (Eds), Strategic Marketing. New York: Wiley. McGee, J., & Thomas, H. (1986). Strategic Groups: Theory, Research and Taxonomy. Strategic Management Journal, 7, 141–160. Mintzberg, H. (1994). The Rise and Fall of Strategic Planning. New York: Prentice-Hall. Mintzberg, H., Ahlstrand, B., & Lampel, J. (1998). Strategic Safari. New York: Free Press. Mintzberg, H., & Quinn, J. B. (eds). (1995). The Strategy Process: Concepts, Contexts and Case. Englewood Cliffs, NJ: Prentice-Hall. Moore, J. I. M. (1992). Writers on Strategy and Strategic Management. London: Penguin. O’Hanlon, J. (1994). Clean Surplus Residual Income and Earnings Based Valuation Methods. Lancaster Working Papers in Accounting and Finance, 94/008.

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O’Hanlon, J. (1996). The Time Series Properties of the Components of Clean Surplus Earnings: UK Evidence. Journal of Business Finance and Accounting, 23, 159–183. Porter, M. E. (1981). The Contributions of Industrial Management Organization to Strategic Management. Academy of Management Review, 6, 609–620. Porter, M. E. (1996). What Is Strategy? Harvard Business Review, 74(November–December), 61–78. Porter, M. E., & Teisberg, E. O. (2004). Redefining Competition in Health Care. Harvard Business Review, 82(June), 64–76. Ricardo, D. (1821). On the Principles of Political Economy and Taxation. London: John Murray. Seth, A., & Thomas, H. (1994). Theories of the Firm: Implications for Strategy Research. Journal of Management Studies, 31, 165–191. Utterback, J. M. (1994). Mastering the Dynamics of Innovation. Boston: Harvard Business School Press. Varaiya, N., & Kerin, R. A. (1987). The Relationship Between Growth, Profitability and Firm Value. Strategic Management Journal, 8, 487–497. Whittington, R. (1993). What Is Strategy — and Does It Matter? London: Routledge. Wilcox, J. W. (1984). The P/B-ROE Valuation Model. Financial Analysts Journal, 40, 58–66. Williamson, O. E. (1981). The Economics of Organisation: The Transaction Cost Approach. American Journal of Sociology, 87, 548–577. Williamson, O. E. (1985). The Economic Institutions of Capitalism. New York: Free Press.

Subject Index Adjacency Criteria, 129 Link to Strategic Ecology, 136 Link to Synergy, 136 Alchian, A. A., 5 Alexander, M., 17 Ambiguity, 24 Andrews, K. R., 29 Astute Competition Conclusion, 217 Constraints and Practice, 215 Executive Summary, 211 Further Research, 216 Major Insights, 212 Bain, J. S., 113 Barney, J. B., 69, 74, 86 Besanko, D., 5 Bettis, R., 18, 151 Bhide, A., 95 Booz Allen, 82 Borden, N., 88 Boston Consulting Group, 78 Bowman, C., 81 Brandenburger, A. M., 95 Business Objective Function, 20 Optimisation, 11 Business Genomics, 65 Business Model CASK Aspects, 70 Components, 73 Eigenvectors, 71 Formalisation, 53 Matrices, 55, 65 Mechanics, 71

Businesses Role of, 6, 7 Buzzell, R. D., 38, 75, 80 Campbell, A., 17 CASK Framework, 70, 132, 136 Categories, 23 Causality, 89 Caves, R. E., 39 Chan Kim, W., 78 Chandler, A. D., 91 Chesbrough, H. C., 60, 147 Coase, R. H., 5, 148 Competition Contexts, 83 Modes of, 78 Themes, 79, 82 Competitive Advantage Examples, 85 Routes, 73 Consumer Surplus, 100 Cool, K., 24, 74, 108, 151 Cooper, C., 40 Co-opetition, 95 Corporate Advantage As Intellectual Property, 153 Business Model Engineering, 149 Coordination, 148 Investment, 152 Major Initiatives, 152 Market Failure, 141, 146 Reinforcement, 150 Synergy, 146 Cost, 49

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Subject Index

Demsetz, H., 5 Dierickx, I, 24, 74, 108, 151 Dilution, 184, 187 Discounted Cash Flow, 112 Dixit, A. K., 30 Dontrepreneurs, 191 Dranove, D., 5 Drucker, P. F., 94 Duhem, P. M. M., 26

Hamel, G., 37, 53, 68, 74, 151, 159 Hart, O. D., 5 Hatten, K. J., 40 Head-hunters, 145 Henderson, B. D., 39, 78 Heterogeneity Business, 9 Holism, 22

Economic Value-Added, 118, 119 Economics Characteristics, 41, 47 Dynamics, 48, 51 Laws, 21 Phenomenological Laws, 25 Taxonomies, 21 Theories, 21, 26 Entrepreneurial Concept ,192, 202 Failure and Dissolution, 201 Intellectual Property, 200 Investment and Commitment, 199 Legal Structure, 201 Models of Development, 197 Ownership and Control, 198 Personal Goals, 195, 196 Statement of Principles, 202 Success factors, 193, 195 Exchange Characteristics, 104 Idiosyncratic, 100, 103

Jackson, F., 23 Johnson, P., 70

Faulkner, D., 81 Foss, N., 68 Foss, N. J., 8, 13 Fruhan, W. E., 78, 113, 169 Gale, B. T., 38, 75, 80 Gavetti, G., 66 Goldberg, V., 101 Gould, M., 17 Governance Agency Problems, 142 Grossman, S. J., 5

Idealisation, 5

Kay, J., 6, 7 Koch, R. J., 31, 129 Leask, G., 65 Mahoney, J. T., 9, 11, 15, 86 Market Failure, 141, 143 Marketing Mix, 88 Markets Deficiencies of, 7 Marshall, A, 106 Mauborgne, K., 78 McGahan, A. N., 41 McGee, J., 30, 31, 34, 39 Mergers and Acquisitions Business Logic, 175, 177 Screening, 181, 188 Mintzberg, H., 13, 15, 29, 40, 92 Mobility barriers, 31, 33 Model Integrated Strategic, 89 Montgomery, C. A., 99, 180 Nalebuff, B. J., 95 Nelson, R., 8 O’Hanlon, J., 118 Ohmae, K., 87 Open Innovation, 147

Subject Index Pandian, J. R., 9, 11, 15, 86 Parnell, J. A., 65 Path Dependency, 92 Peasnell, K. V., 118 Penrose, E. T., 79 Performance Enhancement Portfolio Businesses, 146, 153 Performance Measures Internal Rate of Return, 112 Net Present Value, 112 Payback, 111 Price Cost Margin, 115 Return On Investment, 111 Personal Career Analogy, 11, 75 Peteraf, M. A., 69, 102 Pisano, G., 7, 93 Porter, M. E., 9, 33, 37, 39, 41, 88, 108, 113, 116, 175 Portfolio Analysis, 157, 164 Market Momentum, 162 Power Buyer, 43 Supplier, 44 Prahalad, C. K., 18, 37, 53, 69, 151, 159 Price, 49 Competition, 10 Pricing Environment, 45, 46, 116 Profit Maximisation, 19 Pruett, M., 30, 31, 34, 39 Putnam, H., 14 Rappaport, A., 113, 169 Real Options, 169 Reductionism, 23 Relationships Business, 7 Relative Advantage Cost, 79, 82 Price, 79, 80 Product, 79, 80 Rent Economic, 6, 99–106 Opportunity, 99

225

Resource Margins, 114, 124 Statistical Testing, 120, 123 Resources Competitive Control of, 86, 94 Retrospective Valuation Risk, 166 Scenario Based, 165, 174 Uncertainty, 166 Ricardo, D., 99, 115 Rivkin, J. W., 66 Roberts, J., 5 Rumelt, R., 5, 8, 9, 17, 26, 36, 41, 102, 116 Russell, B. A. W., 94 Schendel, D. E., 40 Schmalensee, R., 41 Schumpeter J. A., 93, 99 Seed Capital Example, 144 Shanley, M., 5 Shuen, A., 7, 93 Stalk, G., 50 Start-Up Risks and Milestones, 204, 207 Stern, C. W., 50 Stern Stewart, 118 Stock Market Bubble, 142 Strategic Ecology, 30, 34 Examples, 34, 35 Link to Adjacency, 136 Link to Synergy, 136 Notions, 36 Strategic Heterogeneity, 40 Strategic Revision, 131, 137 Strategometrics, 69 Strategy Coherence, 29 Consistency, 29 Meaning of, 12 Pattern of Action, 29 Start-up Build, 203, 207 Success Key Factors, 87

226

Subject Index

Suppes, P., 53 Synergy Dynamic, 137 Link to Adjacency, 136 Link to Strategic Ecology, 136 Static, 136 Technopreneurs, 191 Teece, D. J., 7, 73, 93, 146

Teisberg, E. O., 37 Thomas, H., 30, 31, 34, 39 Value Added, 41–47 Wernerfelt, B., 27, 99, 180 Williamson, O. E., 5, 100, 143 Winter, S., 8

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