For companies planning to launch new initiatives during uncertain times, it’s important “to know from the start that the plan is wrong,” according to Ian MacMillan, Wharton professor of innovation and entrepreneurship and co-leader of Wharton Entrepreneurial Programs . Assumptions are what get most companies into trouble, MacMillan and co-author Rita Gunther McGrath, a professor at Columbia Business School, argue in their new book, Discovery-Driven Growth: A Breakthrough Process to Reduce Risk and Seize Opportunity. In an interview with Knowledge@Wharton, McGrath and MacMillan describe how firms tend to approach growth in ways that hurt them, and what they can do to make the most of new opportunities, even during the current downturn. It’s not failure that companies need to avoid, they say, but rather “failing expensively.”
An edited transcript of the conversation follows.
Knowledge@Wharton: Why don’t we start with a basic question about why so many good companies fail at growth?
McGrath: We see that a lot. We have a file that we used when researching the book, which I call my “flops file.” You have to lose your parent company at least $50 million to get into my flops file. The big dilemma is that [these companies] tend to use conventional approaches — that work very well when you’ve got a lot of knowledge — to try to get into new spaces. That sets in motion a really dysfunctional pattern of behavior. Here’s an example: You want to get money for a project. You put together a PowerPoint deck of 100 slides with all these back-up details and all these spreadsheets. You go to whoever has the resources and you make this big pitch. And then they say, “Okay.”
You set off, and in two or three months you discover that the market wasn’t exactly what you thought, and the service delivery requirements aren’t exactly what you thought, and maybe the product needs to be tweaked. Now, you’ve got this huge commitment that you’re supposed to live up to. So the first dilemma that we see in companies that causes them to fail so systematically is this presumption that you can be right in a world of massive uncertainty. That leads to these kinds of dysfunctional behaviors.
The second thing that companies do to get in their own way is insisting on financial metrics that make no sense when they are looking at a new business. A typical company will insist on, say, a net-present-value calculation or a discounted cash flow calculation … when, in effect, what you’re doing in many cases is buying an option value — you’re buying the right, but not the obligation, to continue to make further investments. Using these present-value, internal rate-of-return types of requirements almost sets you up for failure, because they build inflexibility into the system.
It’s not that planning for new businesses or planning for growth opportunities is undisciplined. That’s where people go wrong. They think it’s undisciplined. It’s not. It’s just a very different kind of discipline. It’s the discipline that, for example, habitual entrepreneurs use, or people who start multiple businesses involving a lot of learning, a lot of change, a lot of redirection use. And that’s actually okay.
Knowledge@Wharton: Based on what you just said, how should companies be thinking about growth at a time of uncertainty? And could you give any examples of companies that are doing it right?
McGrath: At a time of uncertainty, the first thing you need to do is stop panicking. The next thing is to take a look at your whole portfolio of activities. When times are good, to be honest, people get a little sloppy. Companies get a little sloppy, and it’s easy for things that are not value-added, or things that really aren’t going to be a route to your future, to kind of hang out there because they’re not doing anybody any harm, and maybe you’re historically affiliated with them and so on. So the first thing I would do is take a look at where resources could be freed up.
One concrete example is a company like Verizon getting out of the directory business. It’s not that it’s not a good business. It’s not that it doesn’t have great cash-flow, but if [the company is] going to make initiatives that will form its future, it has to get the resources from somewhere, and that’s one. There’s some talk right now, for example, that Time Warner should be selling AOL’s dial-up business because even though it’s generating cash-flow, it’s kind of distracting the company from the future it needs create. So the first question I would ask is: Are there places you can free up some resources — not a lot necessarily, but some resources — to get into some of these growth spaces?
The next thing I would do is set up a small group — not very big, but small or a couple of small groups — to really go out and look at where you could find growth relatively soon. So, in a nine to 10-month horizon, start to get some things going which could take you on a path towards higher growth areas. And recognize that if you don’t make those investments, it’s basically setting in motion a long-term negative for your company. It’s a bit like having credit card debt at an early age; it just sets in motion these inabilities down the road to do things.
And then lastly, in tough times, what you want to be thinking about is: “Am I creating enough option value to merit looking at these areas a little bit more?” You want to really be thinking about that even when times are tough. Now, who is doing it well? In the last few weeks, I visited wonderful companies like General Electric, IBM … and sure, they’re not happy with the way their stock is being treated, and they’re not happy with the fact that maybe sales that they were counting on haven’t happened. But that doesn’t stop them. They’re not paralyzed by it. Their basic position is that you can’t change your whole strategy. You can’t throw everything overboard because a year has been really bad. So they’re really looking more towards how to build the best innovation they can going forward.
Knowledge@Wharton: Let’s say a company wants to do exactly what you described. It wants to use discovery-driven growth and set up its own initiative. How should it go about designing that initiative?
McGrath: Designing it? Well, different companies will do it differently. But I think there are some principles in common. I think the first principle is that you can’t allocate growth projects to people who are already just screamingly busy. That is just dysfunctional and [those projects] won’t get the attention they deserve. So the first principle is that you need some kind of dedicated resource. Now, that can be associated with an established business. It can be set somewhat aside. But in general, we found that it has to be a group — probably a small group — that is really just focused on the new areas. That’s their main job. I think you also want to be thinking about what kind of company culture you have. Are you a top-down kind of company, where whatever the boss says goes and that’s what we do? In which case, [the group] better get the boss’s blessing and … be supported by the boss and so forth. At other companies, what we found is once you have this focal group set up, they actually work best by doing a lot of coalition building and a lot of brokering with other parts of the firm.
Some companies have actually restructured to create growth opportunities. At DuPont — a company we worked with for many years — they had almost religious dedication to the concept of the strategic business unit. The assets in the company and the revenues all went together in these strategic business units. And what they found out was that a lot of their great growth opportunities were falling in between their conventional units. So they created this growth group and then got people thinking about growth. They built the right toolkit for growth, but then actually created these growth platforms which create that cross-business connection necessary to get some of these growth drivers to occur. So I think the principles you want to think about are: dedicated resources, clear lines of sight to the top so that you’ve got that executive endorsement, and focus on a few key things that are going to be valuable possibly in the future.
I’m not a big believer in new business development or innovation groups being allowed to launch businesses themselves. It tends to become fiefdoms, and people then want to make a career out of it. You don’t want that. What you ideally want is your innovation group — or whatever you call it — to be a place where people come and spend a few great years, learn a lot, and then take that learning into your core business. It’s sort of an incubator of people as well as of business ideas.
Knowledge@Wharton: That’s very interesting. I wonder if you could go back to something that you said earlier when talking about GE and IBM. Obviously, it’s a tough business environment and the stocks are being hammered. Savings are down. Would you implement a growth strategy differently during a downturn of the kind that we have today than you would, say, in a boom period? How would you implement this strategy during a severe downturn?
McGrath: I think in a severe downturn, the concept of discipline becomes more important than ever. In fact, one of the benefits of this approach is that it gets more attractive when you have less resources. You just don’t have the money to do what I alluded to earlier — spend a lot of money and get yourself way down the track before you know what you’re doing. You would find this [approach] more attractive in a downturn than when there’s a lot of money floating around.
The other interesting thing about downturns is that they create a lot of discipline. [There will be] less tendency for people to go off on efforts which are not going to be successful. You’re also going to see more discipline around shutting things down that need to get shut down. And we’re seeing that now, even with companies that are very successful, like Google getting out of their radio ad business because they feel they’ve given it long enough and they haven’t really broken through.
So, the key message in a downturn is don’t lose your head…. Don’t be afraid to make some modest investments in exploring where your future might lie. One of the things we’re seeing that’s brand new is that people’s core businesses — businesses where they thought they had a lot of predictability, they thought there was a lot they knew — are kind of sliding over into that very uncertain space. And so another suggestion I would make is don’t assume you know what’s going on in your core business. Be prepared to do what we say in the book, which is stop, write down your most significant assumptions and see how they’re mapping against the changing realities that you’re dealing with right now. It’s a very useful discipline in both environments.
Knowledge@Wharton: And during a boom, how would that change?
McGrath: In a boom, it’s easier to get resources. And there are more segments of the economy that are fast growth. So I think in a boom it’s just easier. The barriers are lower. The problem with booms is that they produce a lot of stupid behavior. Companies can afford to make big mistakes, so they go ahead and do it. And there’s this sort of thought that: “Yeah, we can just spend the money because who needs to worry.” I won’t name them, but I have a client who makes a lot of money and there’s no discipline at all around their project process. Anybody that’s senior enough can get their pet project funded. There’s no kind of coherence in the corporation about what’s going on. So, booms have their downsides, too. But of course it does make it easier.
Knowledge@Wharton: If CEOs of Fortune 500 companies wanted to know what are some of the things that they could implement right away, what advice would you give them?
McGrath: I’d tell them first that a lot of strategy today is about learning. It’s not about sustainable competitive advantage. It’s not about the sort of stable industry forces that we’re used to thinking about when we’re thinking about strategy. I would encourage them to think of strategy as a very dynamic entity — that means changes in behavior on their part. They need to stop talking about being right all the time. Instead, what we want to talk about is being disciplined. You need to stop talking about how failure is bad. Instead you want to think about intelligent failures — low-cost intelligent failures that are rich in learning. That tone can only be set from the top. If you’re the kind of CEO who [says] “off with his head” the minute something doesn’t work out the way somebody predicted, I suspect you are going to have a lot of trouble in these incredibly dynamic, strategic environments.
Part Two: Interview with Ian MacMillan
Knowledge@Wharton: Ian, could you explain the concept of discovery-driven growth and how it differs from traditional ways of thinking about growth?
MacMillan: Let’s start off with the current mess we’re in economically. The world has become a lot more uncertain. Managers really need to begin to be able to make decisions in the face of uncertainty. When things are uncertain, you really don’t know what the outcome is going to be. In conventional planning, what you do is sort of project what the future should look like, and then you build a plan with a fair level of confidence because you have a knowledge base that you can use to do your projections.
In uncertain environments, you don’t have knowledge. You have to make assumptions. The key issue is to know from the start that the plan is wrong. That’s the only thing I know about the plan — that it’s wrong. So, how do I plan in such a way that I come out with the right solution but not necessarily know what it is at the outset? That’s what discovery-driven planning is all about. It’s a plan to learn. We don’t know. So what are we going to learn? What you really want to do is you want to learn cheap and you want to learn fast, and if it’s wrong you want to go and do something else or you want to redirect. That’s the idea.
Knowledge@Wharton: Could you explain the principal steps that a company needs to go through to create a growth framework?
MacMillan: The first important thing is to set a firm target about what you’d like to accomplish. You may come back later and change it, but you start off with something that you think is worthwhile. If you’re going to do something that’s really uncertain, then when you get to the end of the road you need to be able to look back and say that all that energy and effort was worthwhile. So you set a frame.
The second thing to do is to ask: If this is what I need to accomplish, what is the scope of what needs to be done? How much physically must happen? If I want to make a million dollars, how many buckets of stuff must I sell in order to get that million dollars? That gives you a sense of what the physical challenge is as well as the economic challenge. Step number two is to begin to say: What are the activities that I must undertake in order for me to be able to deliver this plan? How will people know that I have an offering? How will people search for that offering? How will they be able to buy whatever I’m doing? What processes must be in place for them to be able to receive whatever I’m delivering? How are they going to use it? How do I need to service it? Each one of these items — which we call a “consumption chain” — is the consumer or the customer experiencing your offering and your company.
Each one of those involves a cost or an asset commitment. So, you specify — what we call a deliverable specification — the physical things that need to be delivered in order for the financials to be delivered. So that’s the second step. The third step is to basically say: Well, I’m making assumptions about what these costs are going to be or what these assets are going to be. How am I going to test them? I document all the assumptions that I’m making. And then I test these assumptions. I plan to test these assumptions at checkpoints. So, for instance, I might develop a model of the product if it’s a product I’m making. I might do a market test. I might do some focus groups. But at each one of these checkpoints, what I do is come back and test whether my assumptions are right or not. To the extent that they are right, I continue. To the extent that they are not right, I shut down the project. So, I deliberately design checkpoints where I can learn.
The last challenge is to creatively invest only as you learn. In the beginning you invest very little so you can afford to be wrong. As you get more and more confident in your assumptions, which may change, and as you redirect the project you may make bigger and bigger investments.
Knowledge@Wharton: In your book, you also talk about creating reverse financials and an assumptions checklist. Could you explain those concepts?
MacMillan: Typically, what happens when somebody designs a conventional plan is they start off with the revenues they hope to get. They estimate what the costs are. They subtract the costs from the revenues and that tells them what the profits are going to be. A reverse income statement starts with the profits I must earn to make it worthwhile. I can then calculate what the maximum cost can be in order for me to make those profits, and then what the revenue should be in order for me to make the profits.
So, you start with the income statement at the bottom and you work up instead of starting at the top and working down. That’s what we mean by the reverse financials. Very rapidly, you may find that in order for you to be able to make the numbers that you plan to make in terms of profits, all you need is 5000% market share — at which stage you say, “Oops, let’s go and do something else.” You really don’t know, but it gives you a sense of what the scope is. And then the next step is to do the deliverables specification that I spoke about before. In order for me to get one dollar, one rupee, one ruble worth of revenues, I need to put something in a customer’s hand. The customer needs to say, “Yes, I want it. I’m going to pay for it.”
What does it take to actually get the object into the customer’s hand? That’s your deliverables specification. And then what we do is say: In order for us to deliver this business and this consumption chain that we’ve designed, what checkpoints are we going to use that allow us to drive down the cost of failure?
Knowledge@Wharton: Can you give an example of a company that has gone through this process?
MacMillan: The company that I think has been the most successful would be Air Products. What’s interesting about Air Products is that it is 60 years old, was established a long, long time ago, and built its profit streams on the basis of industrial gases, selling things like oxygen, nitrogen and carbon dioxide. They elected to start to look at diversifying what they were doing so that they wouldn’t find themselves constantly in a place where they had to cut price below cost and make it up on volume. They started to use discovery-driven planning to push them to new spaces.
And some of the things that they’re looking at now pretty aggressively is — since [they are] very good at being able to measure [using] telemetry to find out what the stocks are of various gases all over the country — why don’t we take our telemetry capabilities and begin to build businesses around that? So, for instance, one of the things they’re seriously looking at is [using telemetry] for tracking the status of patients with chronic illnesses so that you can constantly monitor what their level is — or whatever thing you’re trying to control. And it’s a very, very new business. And because it was so new and because it was so different, conventional planning would just not have worked.
Knowledge@Wharton: You also talk in your book about the art of disengagement. Could you explain what that means and why is that important for growth?
MacMillan: We recognize that because the world is getting more uncertain, managers will have to make investment decisions in the face of much greater uncertainty. We recognize that because of that uncertainty, the chances that you’re right are very low. That basically means that the normal condition is that you’re wrong. What you need to stop doing is obsessing about being right — because you can’t be right. Or, very rarely can you be right.
The real issue is: If I’m likely to be wrong, then how do I plan in such a way that the cost of being wrong is as low as possible? Also, if I go out there and I try to build this new enterprise or this new product or this new market, there will be people who are going to be disappointed. So, if I find that I must redirect and I can’t — because the most preferred alternative is to redirect the business to where there looks to be opportunity, but let’s say that doesn’t work — I need to plan ahead of time how I’m going to disengage from that project if it doesn’t work out.
And so a critical discipline — it’s kind of like planning our divorce case before we even get married — is to recognize you could be wrong. That basically means we may have to retreat. Let’s do it in such a way that as few people are damaged as possible — that we have really serious damage control. That means we need to plan how to disengage if we even begin to undertake it. If we find that we can’t disengage unless at great cost to people like customers or distributors or suppliers or employees, don’t go for it — because the cost of being wrong is just too high. Therefore, the fundamental rule — that you want to fail cheap because you can fail often — is now betrayed. You’ll find yourself failing expensively, and that’s what you don’t want.
Knowledge@Wharton: How would you implement discovery-driven growth during a severe downturn of the kind that we face today? And how does that differ from how you would think about it in a booming economy?
MacMillan: In a downturn, here’s the issue: There’s a legal condition of a business that’s called insolvency. And as you move into insolvency, all the rules change. You’re a very, very different company if you’ve been declared insolvent. So the most critical issue is to find ways of reducing the probability of insolvency. The typical response of many companies — and we see it right now — is that management comes in and says: “Fire the left half of the building. Cut costs across the board by 30%.” That’s just mindless cost cutting, and what you’re doing in many cases is you’re getting rid of people who are very, very valuable to you.
As uncertainty increases, it becomes more and more important to recognize that whatever moves you make are unlikely to be as successful as you would hope. So, the need to plan now starts to move towards what actions can we take to maximize cash inflow and minimize cash outflow. And what innovations can we do to the way that we run or operating business, with the full knowledge that even as we try we might find in three or four months that it’s not working? And, we better then do something to make sure that it does work, otherwise we end up in the bankruptcy court. So the focus here to me would be on how do we use discovery-driven planning to take out costs that don’t add value for customers, to reduce expenses and assets that are unnecessary for the ongoing part of the business. Yet, at the same time, take the people in the company who have time now freed up and use them as resources to be invested in building your position with your core customers.
And the definition of the core customer changes. Today, in this kind of environment, the core customer is not the person who brings me lots and lots of revenues. It’s the person who brings me lots and lots of cash flow. And they may not be the same. In this environment, we’re looking at enhancing cash flows and putting in place projects that significantly improve our cash flows and focusing on [those customers] whom we call the “cash darlings” — the people who are most responsible for creating cash flow for us. Pay attention to them and not to the ones who just place big orders and then don’t pay you.
Knowledge@Wharton: And in a boom, how does this change?
MacMillan: Here, what you’re looking at is: How do I expand my capacity to deliver to the customers who are going to give me future streams of revenues with the associated profit streams? You build revenues, but in the background, your stock’s value is not based on revenues. Your stock’s value is based on profit streams. So, I need to be thinking about the customers who give me increased revenues with a fairly high level of confidence that they will be accompanied by profit flows. But what I’m looking at now is how do I grow my asset base, and how do I deploy and grow my employee base in such a way that I chase only the very best customers?