On the Eve of Destruction?

It is one of the defining strategic questions of the new economy: How do you build a company that excels over the long term, but that is also capable of reacting quickly to massive shifts in technology and markets? A new book offers a carefully argued study of that urgent question.

Book: Creative Destruction: Why Companies That Are Built to Last Underperform the Market -- And How to Successfully Transform Them
Authors: Richard Foster and Sarah Kaplan
Publisher: Currency
Price: $27.50

Who's the poster boy for this postmillennial, hyperspeed, shock-a-minute economy? Why, that would be Joseph Alois Schumpeter, the Austrian-born economist who died in 1950. He was the "gales of creative destruction" guy who observed that a market economy ensures growth by allowing new, better companies to topple the old. In his own day, his notion played second fiddle to John Maynard Keynes's "general theory." Now Schumpeter's da man.

Consider this: Of the companies that comprised the Standard & Poor's 500 index in 1957, just 74 were still on the list in 1997. Destruction to go! Even more startling: Of those 74 survivors, just 12 outperformed the index over that 40-year period. "The corporate equivalent of El Dorado, the golden company that continually performs better than the markets, has never existed," write Richard Foster and Sarah Kaplan, authors of Creative Destruction: Why Companies That Are Built to Last Underperform the Market -- And How to Successfully Transform Them. "In the long run, the markets always win."

Foster, a McKinsey & Co. senior partner, and Kaplan, who has since left McKinsey to study at MIT, pored over 38 years of results from 1,008 companies in 15 industries. This effort, they say, took them a decade and the assistance of more than 50 McKinsey colleagues. (Does it take that many to change a lightbulb?)

Here's what they found: Companies that are "built to last" (note the dig at Jim Collins's 1994 classic) can't possibly sustain competitive advantage. The very characteristics that help organizations survive -- processes and systems that allow for order and control -- ensure that organizations will underperform the market. "Corporations are built on the assumption of continuity; their focus is on operations," Foster and Kaplan write. "Capital markets are built on the assumption of discontinuity; their focus is on creation and destruction."

The business world is discontinuous and becoming more so. Dramatic declines in capital costs, the increasing efficiency of capital markets, and the rise in national liquidity, Foster and Kaplan write, will force more economic disruption in the next two decades than ever. "The survivors will have to be masters of creative destruction -- built for discontinuity, remade like the market."

That is, to sustain advantage, organizations will have to emulate market behavior. The market is fearless. It abandons subpar performers. It welcomes innovation from the periphery. And it is completely flexible, unconcerned by threats of cannibalization, channel conflict, or earnings dilution. Companies, likewise, "must stimulate the rate of creative destruction through the generation or acquisition of new firms and the elimination of marginal performers -- without losing control of operations."

Most companies don't do that because they're trapped by their own success, plagued by "cultural lock-in" that prevents them from changing even in the face of clear market threats. Managers, rewarded for what was important yesterday, grow satisfied with operational excellence and incremental innovation. Harvard professor Clayton Christensen made the same point in the 1997 hit The Innovator's Dilemma (Harvard Business School Press) -- but let's face it: That book, rooted in a gray study of disk-drive manufacturers, was tough to wade through. Foster and Kaplan offer a much better read.

How can companies combat cultural lock-in? Some attempt simultaneous large-scale internal creation and destruction. Corning Inc., for example, experimented throughout the 1980s with investments outside its core consumer-goods business. It invested heavily in optical-fiber technology, a completely new arena. Eventually, it sold the consumer division, which had accounted for 50% of sales. "Corning has a bright future based on the assumption of discontinuity, not the comfort of continuity," Foster and Kaplan conclude. "So far, Corning has been a master of the game."

Likewise, private equity firms have created a model that places creative destruction above managing operations. Venture-capitalist company Kleiner Perkins Caufield & Byers, leverage-buyout firm Kohlberg Kravis Roberts & Co., and the recent explosion of incubators identify orders-of-magnitude opportunities. All of them apply strict rules dictating the life of their investments and expected returns; and they operate in a highly decentralized fashion, retaining control over operations through clear contracts.

Those firms, Foster and Kaplan argue, have succeeded at managing the conflict between "adaptive" work and "technical" work. Technical work is that of maintaining present excellence. Adaptive work is exploratory, requiring management to "ask expert questions rather than to fall into the more familiar pattern of providing expert answers." Adaptive work, the authors write, is the fundamental responsibility of management.

Safeguard Scientifics, they propose, is a model that merges the adaptive impulses of a private equity firm with the technical excellence of a public operating company. Since 1977, Safeguard has invested in emerging technology companies, spinning them off as independent public companies when they achieved solid footing. Safeguard continually gives up control, profits from its transactions, and then moves on to the next opportunity. It is "a clear example of how a firm can operate as the creator, operator, and trader of options."

Fair enough. Safeguard certainly presents an intriguing model for future organizations. Here's the problem, though. In the few months since Foster and Kaplan finished writing Creative Destruction, Safeguard has taken a calamitous tumble, both because of its dotcom investments and because of a breakdown in its investing discipline. Likewise, Corning has been hamstrung by slowing demand in its core fiber-optic business. Incubators? Suddenly, they're so 1999.

It took two years for critics to debunk some of the model companies proposed by then McKinsey consultants Tom Peters and Robert Waterman in their 1982 classic, In Search of Excellence. Two decades later, it seems, the half-life of competitive advantage has been whittled down to a matter of months. And for Foster and Kaplan, that's entirely appropriate. Ironically, Creative Destruction's own irrelevance may be the best endorsement it could hope for.

Sidebar: Defining the Periphery

A key to creative destruction is identifying new opportunities at the periphery of your market. In Creative Destruction, authors Richard Foster and Sarah Kaplan offer a template for considering such change:

  • Which companies define the periphery of your industry today?
  • What business strategies are they pursuing? Which offers the greatest potential? Which represent the greatest threats?
  • What new benefits do companies at the periphery bring customers? When will those benefits become economically viable?
  • Which current competitors are most vulnerable to attack from the periphery? How and when will those attacks happen?
  • Which competitors, both existing and at the periphery, are likely to succeed? Which are likely to lose?
  • What are the economic implications of a new competitive order in terms of market share, prices, profits, talent, and value creation?
  • What are the implications for your company? What options do you have?

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