What do investors want? This question concerns many entrepreneurs seeking to raise venture capital. The answer is not simple. The ability to model the unofficial expectations, the decision-making process, and what happens behind the scenes is not something that can simply be conveyed within a slide in a presentation. The following article is part of a series of articles that will reflect a number of essential parameters in the way of quality investors think and evaluate companies.
Quality Investors use several key investment attributes to identify businesses and trends that are likely to survive, flourish and create great returns in a dynamic economic environment while populating their portfolio with an optimal balance of Resilience and Optionality.
The first several characteristics that can address these two parameters revolve around the quality of the management team in terms of guiding the organization toward long-term thinking, helping foster a culture of innovation, empowering employees through the decentralized decision making, and building a company that adapts and evolves.
The importance of long term thinking and adaptability represent key themes running through the length of this article. To some, these might seem contradictory, but here I find another duality: management teams should clearly state long term intentions and act in a way that goes beyond optimizing for the quarter AND management teams should develop detailed plans but be ready to abandon them when the world throws them a curveball like it's happening right now within the context of COVID-19. Long term thinking and adaptability are two sides of the same coin.
By long term, I mean focusing on customer needs over time – both what will change in customer needs, and more importantly what will NOT change, partially or at all. Long term thinking, and, perhaps more importantly, avoiding what I call “short-termism” are critical to the ability of a company to evolve, adapt, and learn. Often a successful company will balance a focus on what will NOT change for their business with a strong ability to anticipate the evolving needs of its customers. A long-term focused company will generally make value-creating investments and thoughtfully approach decisions. I find these companies tend to be product and customer-focused rather than sales and marketing or competitor focused.
They tend to have highly empowered employees, usually structured in small teams, and decentralized decision making. Incentives are also aligned with long-term thinking, i.e., they avoid an emphasis on quarterly and annual results. A lot of companies believe they think long term, but, in reality, are too wrapped up in short term incentives to make the right value-creating decisions.
Let's take Jeff Bezos, CEO of Amazon, as a man prides himself on long-term thinking. The team at Amazon regularly thinks about their business 5-10 years into the future, but they do it in a surprising way. They think about what’s NOT going to change over that time period. For example, while Amazon has no better idea what changes the future may bring over 10 years than anyone else, they can say with some degree of certainty that 10 years from today customers will likely want cheaper products, more selection, and faster delivery. This is an important lesson. Resiliency teaches us to plan for the future based on what’s NOT going to change. At the same time, Amazon loves to experiment – some of these, like the Kindle or Amazon Web Services, become major successes. Amazon offers a great example of Resilience and Optionality working together in a complementary manner at the company level.
Companies that successfully think long term and evolve are masters at balancing their own Resilience and Optionality they tend to thrive and accelerate in the face of new competitive challenges or economic uncertainty. The optimal combination of Resilience and Optionality will depend on the nature of the industry in which the company operates. In a dynamic industry, a company too focused on Resilience is likely to become entrenched in one particular ideology and fail to adapt quickly enough to changing trends. On the other hand, a company overly focused on experimentation (Optionality) leaves itself vulnerable to shocks to the system if they don’t have stable platforms (Resilience) to fall back on. This is the ability to adapt and evolve.
Almost every business operates in one (or multiple) complex adaptive systems. As a consequence, most companies should be managed for an optimal balance of Resilience and Optionality. The appropriate amount of each will likely depend on the dynamics of the competitive industry structure, the needs of the customers, the pace of technological change, and the stage of such change. Management should focus their efforts less on strategy and competitive threats. Competitive actions and product or business model disruptions follow power-law math, trying to correctly anticipate them is generally a waste of time.
Instead, businesses should be built to adapt, evolve, and learn. Innovation should be a key cultural attribute. The incentives and structure of the company should align to create an environment inside the company that promotes adaptability. Companies that focus more on what will not change over the long run, rather than what will change, are much more likely to make the right decisions in the present. Complexity teaches us that as we harden the edges of the network through formalization, we make the system less adaptable and thereby more fragile. Although it appears counterintuitive, the system remains robust because the edges of the network are open to change. The silver bullet is that there is no silver bullet, only the willingness to try something new.
Companies that tend to thrive in complex adaptive systems operate increasing returns platforms with strong network effects. These companies build strong ecosystems in which their customers usually benefit more than the companies. They tend to enable other companies and customers, generating a win-win environment for everyone involved with the platform. Companies that create value while extracting low tariffs (charging as little as possible) on their ecosystem, especially in the Internet age, will be the biggest winners.
Businesses will likely have certain products, services, or processes that can be optimized for Resilience. These are generally high return on capital, high incremental margin, recurring revenue, cash generative businesses that should be used to fund a series of Optionality investments around the core or adjacent competencies. In the Resilient part of the business, the emphasis is more on stability through economic cycles, margins, and free cash flow optimization.
In the Optionality part of the business, the organization should be highly focused on innovation, pioneering, and experimentation driven by small, decentralized, agile, cross-disciplinary teams consisting of product, sales, and marketing people. Here, the organization should be centered on the unmet needs of the customer base while keeping in mind what is likely to not change over the long term.
If the company is overly focused on Resilience, they are highly likely to be disrupted by new technology, or, even worse, a competitor attacking with an entirely new business model. If the company is overly focused on Optionality, they may not withstand a shock to the system and live to fight another day. Management should therefore focus on 1. determining the right balance of Resilience and Optionality based on the dynamics of their specific industry and product lifecycles, 2. optimizing the resilient part of the business, 3. empowering innovation and experimentation in the Optionality part of the business, 4. incentivizing long term thinking across the business, and 5. under-promising and over-delivering to customers, employees, and investors. This is Decentralized Decision Making.
Decentralization is essential to a company’s ability to adapt and evolve. Interestingly, decentralization is NOT a characteristic we find in most companies. Instead, the most typical structure we find is one of tight central control over day-to-day operations from a hands-on management team (in particular a hands-on CEO). Often times, the centralized/decentralized structure boils down to how the management team understands their role. To oversimplify, CEOs need to do two things well: manage the business operations efficiently and successfully deploy the cash generated by the business.
In my observation and experience working with teams the vast majority of CEOs focus on efficiently managing daily operations – decentralization tends to make them uncomfortable, so the focus is turned toward tighter central control. This action gives employees less authority. A typical response is to take less responsibility in return. This is obviously not the right way to lead and manage.
However, a few CEOs understand their primary responsibility to be capital allocators, while business operations are given over to business unit managers. This has the effect of decentralizing operational control while centralizing cash and thereby capital allocation. Decentralized control gives mid-level managers more authority over day-to-day decisions, which yields a feeling of greater responsibility and creativity, and allows the management team a right to ask for accountability: because only when accountability is married with authority can it legitimately be expected.
This fundamental understanding of a CEO, allocator versus operator, represents a key variable to understanding a great long term investment. A decentralized organization run by a small group of people at headquarters tends to be the fingerprint of a management team that understands their role to be capital allocators. In other words, a decentralized company can react quickly and effectively to changing business conditions, while the management team adheres to tight parameters around what types of businesses the company will be involved within the first place. This places decision making closer to customers and future products or services.
Management teams with the maturity to turn over daily operations to business unit leaders and let them run the business as their own are rare. Management teams skilled at capital allocation are rarer still. They intuitively grasp flat S-curves, non-zero-sum, and Resilience/Optionality. This is where interviewing management becomes so vital -- answering this most important question: Does the management take on a role as a capital allocator or an operator?
Finally, because complex adaptive systems are best explained by power laws and thwart our ability to predict, the best way to figure out how to experience large gains is to make as many mistakes as possible for the least possible cost per mistake. By definition, decentralization distributes mistakes while centralization focuses on them. However, we should expect some centralized, option-at-the-top type companies to thrive out of luck. Over short periods of time, luck and foresight are indistinguishable.