10 September, 2015

Executable strategy: Sweat more in peace, bleed less in war

Tolstoy famously opens "Anna Karenina" by stating that
"Happy families are all alike; every unhappy family is unhappy in its own way."

Peter Thiel ended on this theme in his September 2014 WSJ article "Competition is for losers"
Business is the opposite.  All happy companies are different: Each one earns a monopoly by solving a unique problem.  All failed companies are the same: They failed to escape competition.
Go read Peter's thoughtful essay.  Then come back and I'll build on what Peter said by turning it back on itself:

  • Happy companies are all alike: they solve problems for their customers in a way that leaves enough leftover for themselves
  • Unhappy companies are all unhappy in their own way: They are solving customer problems in ways that fail to ensure value accrues to the company in a sustainable way - sometimes by taking too little, other times by taking so much it provokes a reaction that leaves it with net less

This post is in three parts at a general level, and finishes with a coda looking at the financialization of taxi medallions that seems relevant and timely - and a bit fun given our Uber conversation.

Like many of my other posts, it could probably have been broken into several pieces if I had the time to make it shorter.

1.  Solving a real problem for customers is hard, whether you're a startup or have a billion dollars in annual revenue.

In May, Business Insider repeated a joke that "SF tech culture is focused on solving one problem: what is my mother no longer doing for me?"  Presso (India) seems to be adapting that in India, from Washio's playbook.  Kodak has been reduced to making selfie sticks, possibly for people whose mothers aren't there to take their picture anymore.

I'm not making a red/blue ocean distinction for executable strategy - in "red ocean," a company is already serving existing customers and much of its near-term strategic options are constrained by current business realities.  Particularly in the "red ocean," stray too far afield and it's unlikely that your business is the natural owner.

Many "red ocean" companies benefit from back-to-basics and earning the right to grow into those nearby opportunities - I've seen one spectacular failure and several near-misses from up close; all were self-inflicted failures of executable strategy rather than a result of a brilliant competitor move

"Blue ocean" moves have much more latitude for imperfect execution - but they still have to be good enough!

In fact the execution bar may be net higher as buzzwords and underdeveloped concepts can obscure when trendy ideas are ignoring an age-old fallacy that has been forgotten by incumbents and not noticed by newcomers.

Dan Davie's "Cynic's Guide to FinTech" is a fun way to think about exposing the core concepts behind a strategy.

The Financial Times' Alphaville page enjoyed Davie's post so much it launched a series in homage - beginning with an observation that AndersonHorowitz star Transferwise's
greatest achievement to date seems to be acquiring marketshare from incumbent retail players through the highly innovative strategy of spending shed loads on marketing — most of it focused on negative campaigning tactics against banks, cheap publicity gimmicks involving scantily-clad women and, most crucially, rebranding FX matching models as “peer-to-peer” businesses.

Technology is great - in the past bad ideas could persist through sheer inertia.  Today, a good idea can take over the world quicker than ever before.

So can a bad one - often while losing money because it's "functioning as designed."

2. Once you solve a problem, ensuring enough value accrues to your company is even harder...

In the first dot-com boom, it was clear most managers realized the internet would change everything.  It was also clear they had little idea how.  MIT's magazine published an article on the widespread absence of viable dot-com strategies in April 2000, noting
Although most managers are cognizant of impending changes, the business landscape is fuzzy and fast-changing. We are navigating in uncharted waters.
How should companies develop effective strategies in such a situation? Four interrelated issues are useful in orchestrating conversations about the dot-com agenda. Effective strategizing for the dot-com business operation requires the management team to consider these issues together, not in isolation.
Too often, companies focus on one dominant issue and let it be the driving force while paying scant attention to the other issues only to realize the ramifications and conflicts much later.
Many of the dot-com failures weren't failures in a good way - reasoned bets about likely futures that went bad.  They were common failures of understanding, by people who feared missing out (FoMO) but had access to capital.  Many succumbed to the Dunning/Krueger effect - they didn't know what they didn't know.

Jeff Bezos famously credits his regret minimization framework to launching Amazon.com, although he was much better with numbers than many self-professed "big picture thinkers" (Amazon went public after a single funding round of $8m)

One of the "Lessons of History" is "The men who can manage men manage the men who can manage only things, and the men who can manage money manage all" (sic, 1968.  men=people).  People who manage money understand executable strategy.

Where I like to engage is, given that your organization has selected a goal as worthy of accomplishment, how should it go about accomplishing that goal in a manner consistent with the economic constraints of the world around it?

And how should a CEO stay mindful of creating the kind of world the business would want to live in, not one which accidentally recreates past fallacies in a new context?

In short, how do you build a strategy that doesn't (solely) rely on something that cannot go on forever?

If your business amounts to picking up pennies in front of a steamroller, you should at least understand that as a (the) explicit risk.

3. This failure to capture value from solving customer problems is clear at all levels of business

"Buying" customers is an age-old problem.  M&A value has historically accrued to the target, rather than the buyer - in part because of over-estimation of revenue synergies in "deal fever" (cost synergies tend to be much more accurate, although subject to distribution negotiation).

The problem may be magnified in startups because buying customers is a legitimate part of the early playbook in businesses that are expected to exhibit network effects; (S)aaS companies need to finance legitimate sales expenditure growth through the medium-term because of the nature of cash flow in that business model; and operations with scale economies must be built out ahead of demand.

I suspect that many companies find it hard to (a) realize when they are actually buying, not earning, business; (b) determine when buying business is no longer appropriate; and (c) operationally draw the line for transitioning themselves off that crutch.

If there's also a belief of a winner-takes-most market, there's a particularly strong temptation to just keep reaching a little bit farther than the current grasp, believing the holy grail is almost within reach.

Zirtual shutdown and fire sale

Zirtual shut down in early August 2015, with a $400k/month burn rate after pivoting from a contractor-based business to an employee-based business.  It lacked the funding to complete the pivot; the CEO blamed her outsourced CFO, though a Fortune article interviewing that CFO seemed to indicate he had stopped working with Zirtual well before the fundraising.

Bottom line seems to be that funding at a $38m pre-money valuation became impossible because of the cash crunch, and the value went (almost) to zero.

With $11m run-rate revenue (900k/month) and $400k/month expenses, it's not clear why the former CEO believes $3m of bridge funding (7.5 months of expenses at zero revenue) was derailed by two missing pay periods (<1 month) in the financial projections.

Zirtual was apparently acquired by one of its customers, in hopes of keeping at least part of it running.

Good Technologies acquisition by BlackBerry

BlackBerry, the company formerly known as Research In Motion (RIM), acquired Good Technology for $425m in August 2015.  Dealbreaker jokingly called this a proof-of-life for RIM.

TechCrunch paints this as a loss for GoodTech:
Good Technology, a long-time IPO candidate with reams of public financial data, was snapped up by BlackBerry this morning for $425 million. You might think that the number isn’t too bad. It is: The company raised $291 million from investors. So its sale is nearly certainly a down-exit, compared to its late private valuations...
Good did what I would call the correct things to get its offering off the ground: Show an ability to grow its revenue and lose less money in the process...
Instead of raising more private capital, going public, or merely borrowing more money to keep the lights on, the company sold for a head-scratching price. I don’t care who you are. With more than 30 percent revenue growth, selling yourself for just over twice your trailing revenue is strange...
...Good’s exit makes a touch more sense when you examine its cash position. The startup wrapped 2014 with $24.5 million in cash and equivalents, down from $42.1 million the year prior. That’s not a lot of cushion, given the scale of Good’s operations and expenses.
But that could have been solved by a public offering, which could have brought in quite a lot of capital — its initial S-1 noted a standard, placeholder $100 million expectation.  Sans that, Good could have felt a growing pinch regarding its operational funding. 
The IPO, however, is the key nugget. Its lack of existence I think helps us better understand where both private and public currently stand. I pinged one of my favorite venture capitalists on the matter, and they essentially mirrored our prior analysis regarding cash shortages, but also made an interesting comment: “Numbers weren’t there to IPO. [The] IPO bar is pretty high, actually.”
That fact, paired with the implied fact that external private capital sources were tapped out, Good would have nearly no doors left to open, sans, of course, a sale. 

As an aside, overvaluation triggering dilution in the next funding round isn't bad in and of itself - but may represent a missed opportunity to spend equity, resulting in an increased pressure on cash flow

Set aside for the moment the real emotional demoralizing factor of a down round.  Equity is the most expensive form of capital.  But sometimes it's appropriate to use it as currency.

A lot of recent press focuses on the tension between big valuations and small print.  All else equal, though, this seems fair - if a down-round (say, between B round and IPO) triggers dilution of the pre-B owners, this is little different than if the B round had been more reasonably priced from the beginning - that money would have bought a greater share of the company back then, so it ends up with some portion of that greater share now.

The people who are actually out of pocket are the people who accepted shares at the B-round price - ISOs or stock used to acquire companies - that is now worth less.  To me, this seems to be the more relevant danger of overpricing in a business model sense: reducing the credibility of stock puts increased pressure on cash flow.

And as we saw with Zirtual and Good Tech above, a highly valuable business without the cash it needs to fund ongoing operations becomes worth a lot less, very quickly.  Uncredible valuations may also increase cash compensation requirements for direct hires, or prevent desired M&A activity (such as Uber's failed attempt to acquire Nokia's map business)

TechCrunch has been publishing an annual learning from billion dollar companies more popularly known as "unicorns" (or even "decacorns"). 

Some interesting observations TechCrunch makes suggest a lack of executable strategy is becoming more common as startups increase:

  • "IPO is the new down round"
  • Capital efficiency of startups is consistently dropping
  • The potential for "unicorpses" seems to exist

Coda: Who will reap the gains from the elimination of taxi medallions?

A valuable lesson from my first project as a consultant was that it wasn't enough to help a client create a new way of doing business, even if it created billions of dollars in value.  The client had to do it in a way that ensured enough upside would accrue to the (client) company, particularly considering the costs involved.

In short, we had to advise the company as if we owned it.

Synergies can exist when two parties come together (and may be over/underestimated) - but who gets what piece of them is a wide open conversation that sometimes keeps any gains from taking place at all (see also poison pills and golden parachutes).

Which is why I'm puzzled so much about how much Uber is spending relative to the value of the underlying business that will accrue to its strategy.  We've talked before about the value of a user (passenger) to Uber.

Let's flip that on its head for a bit and ask about the value of the right to drive passengers point-to-point.  Here's a great primer on taxi medallions from Priceonomics.

There's tremendous money involved with disrupting the taxi industry - There are 13,437 TLC medallions in NYC alone, each (recently) worth well over $1m apiece and representing the value of being able to charge "above-market" prices - over $13.5b in collective medallion value

  • 175m rides at at average fare of $13.40 is $2.35b in taxi revenue each year
  • Taxi revenue varies between $26 and $44/hr, and amortized lease of the cab is $9.58-11.58/hr
  • This implies the cab lease is to 26-37% of the taxi revenue, a max of $870m/year accruing to medallions (likely less due to car costs)
  • Taxi medallions trading more than 15x annual revenues seems absurd.  The Priceonomics piece above describes extortion "fees" the medallion mafia is charging off-the-record, it's difficult to believe these would make up the difference

Medallion value decline caused by on-demand ride hailing is triggering credit defaults and reposessions

Uber's actions in NYC seem set to transfer most of that $13b to the citizens of NYC if the taxis don't manage to defend those assets through re-regulation.  Uber would keep only a small fraction for itself.  The taxi "box" revenue has begun to decline, though not as much as I'd have expected.

  • Today, asking price for NYC medallions appears to be $600-800k, down from $1-1.2m about a year ago.  It's not clear how many are owned outright vs loaned.
  • Citigroup foreclosed on 89 medallion loans in June
  • Crain's reported on Sept 8th that 78% of Melrose Credit Union's $2b loan portfolio is in NYC taxi medallions
    • 1/3 of those loans - $400m worth - are delinquent or troubled
    • No taxi medallions have traded hands since two Feb 2015 sales at $700k
    • Other credit unions (Lomto, Progressive, Montauk) also have significant taxi medallion loan portfolios in NYC and have joined Melrose in court seeking an injunction against Uber

That apparent $6.5b drop (~$500k on ~13,000 medallions) in NYC medallion value is less than Uber's total global investment so far, and *significantly* less than Uber's NYC investment.

How much of that drop (plus induced upside) will accrue to Uber is another way to frame the question I've been asking.  My current answer is - not as much as their current valuation suggests, and possibly not enough to earn the cost of capital on Uber's existing investment, especially in the long run.

Disintermediation is a good strategy, as long as you stand to benefit from the results.

A wacky thought about Uber's investors

It's possible that Uber's latest investors are investing on momentum, or structuring the investment to reduce downside risk to an acceptable level.  Also, just like no one ever got fired for buying IBM, Uber's popularity is so high right now that it's unlikely an investor would get dinged if the investment somehow went south.

Thinking out loud and assuming rational investors, what if the latest investors are financial wizards who found a way to use credit default swaps to bet against the loans underlying taxi medallions in the world's biggest cities?

The WSJ reported in Dec 2014 on the resurgence of these types of investments by event-driven hedge funds, being used to bet against businesses that can be forced towards bankruptcy.

I don't know how a trade like this would be structured, or even if it's possible or legal.  But the amount of money at stake is enough that I'm sure some smart people have at least considered it.

If it's possible (and legal) to bet against medallion loans, funding a company like Uber to drive down the medallion cost could make sense.  If Kalanick's strategy works in the long run, terrific.  But even if it doesn't, it's possible that he could be encouraged by smart investors... and be successful enough in the short term to cover the investors' bets against medallion value.

Such an investor could win regardless of Uber's end state:

  • Uber's cash flow/valuation situation means late stage investors will either own 
    • A "fair share" of Uber if it manages to become Google or Facebook, OR
    • A disproportionate share of Uber if it stumbles, which may be worth a little or a lot
  • ... AND the initial investment in Uber could be paid for by closing out the CDS position once it experienced a 30% drop 
  • ... AND it's likely that any re-regulation (if successful) would also positively impact the valuation of Uber if it won a tradeable "right" to operate

TL;DR A CEO's job is not only to set strategic direction, but also to ensure various stakeholders' interests remain aligned long enough to justify (preferably increase) the value held by shareholders.  

Some day I'll write a post on the challenges of second-best solutions, local maxima, and other things.

Today I'll finish with my favorite Upton Sinclair quote, included in the proposal for my first independent engagement in 2011:
It is very difficult to get a man to understand something, when his salary depends on not understanding it.

I like to think of this as "The lamentation of a consultant."  All of the success I've had in business has been when a client begins with a question that's already been puzzling her - part of her business isn't doing what she expected it to do, and her salary/stock value depends on figuring it out.

Often, my answer is to demonstrate that the organization is actually "functioning as designed."

My work often illustrates how the design has (often accidentally) recreated one business fallacy or another, and what the options are for resolving it: either change the design/execution/incentives, or change her expectations about results.

But the first step is that leadership at the company has to believe an issue exists that needs to be solved.  Even-keeled or overconfident leaders (and teams) don't want (need) help.

Leaders in growth mode sometimes want help, as long as you're helping solve a recognized growth-related challenge.  If capital efficiency isn't viewed as a constraint, if productivity improvements aren't seen as a needed reduction of pressure on the hiring pipeline, there's often little room for executable strategy to help here either.

Leaders who already recognize they are in trouble are (by definition) the ones most ready to find a solution - beginning with rallying their team around the "burning platform."

The earlier a leader can recognize that burning platform, and learn to sweat the executable strategy in peace, the less his company will bleed in war.

Thanks for reading,

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