The Creative Destruction of Business

The fall of Goliath and the distributed nature of… everything.

In short

We are entering an age where the nature of the firm, business and work in general is being reinvented. Textbooks should be re-written. Consultants’ slide decks redrawn. MBAs updated.

Technological, cultural and economic developments will result in the decentralised nature of work, the firm and markets.

To become a sustainable business in the era of ‘always on transformation’, organisations will need to reinvent themselves.An IT infrastructure that supports continuous development and modularity, facilitating integration with new partners.An operating model and structure that balance efficiently delivering value today while also introducing market forces within the organisation.

A culture that empowers employees to make decisions, focused on delivering value to customers.

The essence of a company will be its product and brand. All layers of the organisation will exist as part of a wider ecosystem. Organisations will be designed and managed as distributed systems. This restructure allows companies to continuously evolve the organisation and pursue new and cannibalise old business models.

The large organisations that have built up huge amounts of technical and organisational debt, that have become bloated and lost focus on creating value, will not last. Many have already fallen victim to early stages of a new paradigm shift. More will follow unless they truly understand what ‘digital transformation’ requires.

Controlling an ecosystem will require much more capital expenditure and employees than in the past. Organisations must understand where they fit within an ecosystem, but remain focused on delivering value.

The Evidence

In 1942, Joseph Schumpeter wrote “Capitalism, Socialism and Democracy”, in which he introduced the concept of creative destruction, a concept that “describes the process of industrial mutation that persistently revolutionises the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”The premise of this essay is the destruction of business and the nature of the firm as we know it. Driven by the diffusion of new technology and the rise of entrepreneurs across the globe, we will reconfigure and transform the nature of business and firms. The centralised nature of the firm, markets and the economy will shift to decentralised, distributed networks.

Every aspect of the firm will become a distributed network.

• Employees are moving away from silos sitting next to one another, and instead becoming distributed teams scattered across the globe;
• IT infrastructure is moving away from a monolith architecture to microservices;
• Data management is moving from ‘warehouses’ to ‘lakes’;

The metaphor of the Cathedral (high centralization) and the Bazaar (no centralization) is not new, particularly in software development, but will spread to all aspects of an organisation.

In 1937, Ronald Coase published “The Nature of the Firm”, explaining why successful companies grow larger and at some point, begin to level out. When the transaction cost of doing business within a firm exceeds the benefits of outsourcing, then it makes sense to bring the function in-house. The new paradigm of IT infrastructure, ubiquity of software, a connected world and independent workforce has meant transaction costs decrease and now everything can be delivered ‘as a service’. This in turn will lead to ‘enterprise as a service’ and be the driving force behind restructuring organisations.

The firm is now over 300 years old. From the dawn of the Dutch East India Company, it made sense for organisations to grow and scale. Operational excellence was achieved by lowering marginal costs and growing distribution globally, both of which required significant investment. The market was also slow to change. The products delivered were simple and evolved slowly over time. Corporate culture focused on performance and acquisition at all cost. This meant we needed laws to protect the world from this philosophy (child labour laws, environmental protection, etc.). This thinking has now changed. Not only have organisations taken greater responsibility towards the world in which they exist, they perform better by doing so (see Porter’s concept of shared value and my previous post on purpose).Technology is having an even bigger impact. Technology is lowering the drawbridge allowing new entrants to cross the moat that once protected large empires. Research by Foster and Kaplan found that on average, an S&P 500 company is now being replaced about once every two weeks. 89% of companies listed on the S&P 500 in 1955 no longer exist, and the average lifespan of S&P 500 companies has fallen from 61 years in 1955 to 17 years in 2015. Firms are not just disappearing but struggling to compete. Between 2000 and 2009, over half of publicly traded firms with a market capitalisation of greater than $1bn shrunk their revenue by 10% or more in one of those years. Competitive advantage of traditional incumbents is disappearing.

Malcolm Gladwell reframes the story of David and Goliath. David didn’t beat Goliath despite his size, lack of experience and rudimentary weaponry, but because he was better prepared for the battle and Goliath failed to see the threat. In the age of the ‘fourth industrial revolution’, the ‘second machine age’ or whatever you want to call it, Davids (small businesses) have the potential to dismantle Goliaths (large incumbents).

The hypothesis: companies will be become smaller (in terms of employee numbers) and able to scale as part of a broader ecosystem. The essence of a company will be its product and brand. Competitive advantage will be achieved from a firm’s operating model and the ability to maintain a Founder’s Mentality. This will provide firms with the ability to adopt and integrate new technology and maintain a clear purpose. This completely changes the nature of the firm as Ronald Coase knew it, and is the ‘creative destruction’ of business.

Welcome to the stage ‘Digital Transformation’

Digital transformation is at the top of the agenda for most CEOs across industries, though I believe many underestimate the scale of change required for their organisation. Charles Koch, an American businessman, has trademarked the term ‘market-based management’ (MBM), stating that market signals should operate just as vigorously within an organisation as between them. This ability to create a culture and infrastructure that allows an organisation to continuously evolve and create new business models is becoming a competitive advantage in creating a sustainable business. BCG has published an analysis of today’s ‘always on’ transformation that captures the salient points of Charles Koch’s MBM.

Bain’s concept of Founder’s Mentality articulates that ‘growth creates complexity and complexity kills growth’. It’s startling how often companies try to manage complexity with complexity. Additionally, as companies grow they often lose what made them great. Entrepreneurs start with a passion to solve a problem, but as they scale, the conversation changes. No longer are they using passive data to observe the world, but active data to evaluate their products and performance. Then, as they scale and establish themselves as an incumbent, the conversation turns to efficiency, costs, etc. Firms lose what made them great; they lose that connection to the value they are creating. The analysis from Christensen’s disruption theory found that managers failed and businesses struggled to adapt precisely because they were well run in the traditional sense. They miss the next big thing because margins are good and customers are happy.

In their book ‘The Innovation Illusion’, Erixon and Weigel argue that creative destruction is dead, that modern capitalism does not allow us to adopt and spread the use of innovative products and services. I believe this is short-sighted. Those expecting a revolution will be disappointed. The structure and management of companies referred to is not sustainable. The seeds for the ‘second machine age’ are just being planted.

The following is not an exhaustive list, but an indication of the forces that are reshaping organisations and the nature of work. These are cultural, technological and economic forces allowing Davids to stand on the shoulders of Goliaths.

· The price of being big. Complexity and layers of bureaucracy slow decision-making and create an environment inherently resistant to change. Big corporations are traditionally slow. The time needed for each decision increases as a factor of the number of people involved in the decision process. Peter Thiel uses ‘mimetic theory’ to conclude that you also end up with the lowest common denominator, rather than the best decision. Traditional hierarchies and slow decision-making are infuriating. The FT found 89% of independent consultants left large organisations to avoid rules and bureaucracy. 63% of business leaders think their company responds too slowly to technology-enabled opportunities. ‘Technical debt’ is the accumulation of old code and short-term solutions that collectively burden the performance of an organisation’s technology over time. ‘Organisational debt’ is the accumulation of changes that leaders should have made, but didn’t; rather, they chose to make no decision. All these issues make large organisations less competitive; the problem is not being big, but continuously evolving large organisations.

· Innovation is no longer top down. Software has eaten the world. Innovation no longer follows the single pattern of being adopted by those that can afford it and then trickling down. This is still true in some cases, particularly in new hardware, robotics and quantum computing. However, software is no longer only available to large corporations, who then bring in consultants to configure that software. Well-written software combined with large computing power and machine learning can create powerful businesses in a much shorter time than previously possible.

· Computing is powerful and cheap. Moore’s law has slowed down in recent years, making processers cheaper, essentially free. “Digital gear is now finally both fast and cheap enough to enable” a host of new innovations (e.g., machine learning, factory robots, self-driving cars, virtual reality).

· Tomorrow comes sooner. The challenge is balancing today and the future. As the pace of change accelerates, this amplifies the problem.

· The renaissance of IT infrastructure. Primarily driven by the rise of cloud computing and the importance of software, the cost of launching a start-up has fallen 1000% in 10 years (Up Front Ventures). What other industries have experienced that degree of deflationary pressure?

· Open source. The biggest information product in the world, Wikipedia, is maintained by 27,000 volunteers for free (GitHub, RedHat, Linux).

· The ubiquity of mobile. Everyone having a supercomputer in their pocket is something we already take for granted. Mobile has created an entirely new ecosystem, new consumer behaviours, new systems, new workflows and new products. This allows companies to reach much greater scale, meaning the addressable market is huge.

· Machine learning — it works! The prominence of machine learning and ‘bots’ in an organisation will drastically change the nature of work. New use cases are being identified and capability breakthroughs achieved at a startling pace as we enter the early stages of machine learning. True cognitive A.I. has some way to go. Rather than automate all the jobs and create mass unemployment, our work will become more closely integrated and reliant on machines doing the heavy lifting. The most successful chess teams have not been humans or machines, but machine and human teams working together. This will change how organisations operate and the nature of work we do. We will continue to find higher ground as “human needs and wants are infinite”. 20 years ago, if you had told a farmer that his son would be a web designer or social media manager, he would have given you a very puzzled look — those jobs simply didn’t exist.

· Everything is connected. Everything has sensors. You can program the world. Companies are now driving the shift from an economy that is powered by natural resources and physical labour to one in which knowledge and the mind have become the dominant means of production.

· The cult of entrepreneurism. Three start-ups are launched every second. In 2016, more than 640,000 new companies are expected to launch in Britain, up from 440,600 in 2011.

· Rise of cloud computing. The worldwide public cloud services market is projected to grow 17.2% in 2016 to $208.6bn, the highest growth coming from infrastructure services (infrastructure as a service). In 2016, spending on public cloud Infrastructure as a service hardware and software is forecast to reach $38bn, growing to $173bn in 2026. Cisco expects cloud traffic to grow 3.7x from 2015 to 2020.

· Abundance of capital. The 20th century worked, the industrial revolution made us all richer. There is a significant amount of money floating around looking for a return, willing to invest in new business. 2015 saw the highest venture capital activity in nearly two decades — $148bn invested in 8,381 deals — but there is still room for growth. Share buybacks in Q1’16 amounted to over $160bn. The value of negative yielding bonds in August 2016 reached $13.4tn. This money could start to make its way into the private market.

· The nature of work. Business can exist as entirely virtual organisations using a distributed workforce. With VR, real-time translations, etc., people can work together seamlessly throughout the world. This is already the case; when GitHub launched in 2008, it had a handful of employees who communicated mostly through instant messenger. “Chat was our office.” Today, GitHub is roughly 600 employees distributed throughout the globe, with 20% of its workforce outside the US. The number of workers who telecommunicate across industries doubled between 2005 and 2014, up to 3.6 million workers. The emerging suite of technologies, particularly in augmented and virtual reality, will dissolve the boundary between digital and physical worlds.

· Rise of the freelance economy. As of May 2015, 15.5 million people in the US were self-employed. The Intuit 2020 report estimates that 40% of the American workforce or 60 million people will be independent workers. In the UK between 2011 and 2015 there was a 22% rise in the number of freelancers. Stephen DeWitt, CEO of Work Market, predicts that by 2040 every skilled worker will be their own enterprise. Talent matching platforms such as PeoplePerHour and CoMatch are looking to capitalise on finding skilled labour work. UK official statistics show that 55,000 of 175,000 management consultants and business analysts are now self-employed. Less than half of the 29,000 people who joined this category between 2011 and 2016 were self-employed. PWC has responded by creating a ‘talent exchange’, their own talent matching platform.

· Blockchain. Blockchain becomes the protocol layer for exchanging value. The technology has the ability to fuel decentralised market economies.

It is important to state that none of these factors happened in isolation; in fact, they are closely intertwined. Culture and technology are becoming more closely integrated.What does digital transformation look like? What does the firm of the future look like?

Operating Models. The art of execution.

Organisations become ecosystems not value chains. In 2001, Nokia described manufacturing as a core competency. 75% of Nokia phones were made in 8 Nokia factories. In 2016, The iPhone has 189 suppliers with 789 locations, none owned by Apple.The essence of a company will be its product and brand. Enterprise functions will be delivered ‘as a service’ using a network of partners. HR will no longer be a function that sits in a silo within the organisation, but will be delivered through a variety of software partners, and one person within the firm will be accountable for the welfare of people. The same goes for finance, sales, marketing, security, analytics, etc. — no silo is safe. Traditionally in large organisations these silos acted as internal monopolies. A new platform structure allows organisations to introduce market forces to all areas of the business.

Cloud migration is an inexorable trend and is seen as the first step on the road to digital transformation. But for incumbents, a shift to cloud does not make you fit for the digital tsunami of the second machine age. In fact, it changes very little if you don’t rethink how your tech infrastructure operates and how the business uses and adopts new tech.Using CB Insights trends, between 2012 and 2016 there was a more than 600% increase in the use of the word ‘platform’. Midia research has dubbed 2017 ‘the year of the platform’. This is principally driven by the new business models seen with the likes of Uber and Airbnb. In the age where strategy and execution become more closely connected, the operating model on which companies are built becomes a competitive differentiator. This requires an IT infrastructure that connects to many distributed systems — e.g., Hadoop and Spark for distributed databases, blockchains that provide distributed ledger for exchanging value. The concept applies to every business; it is about connectivity. Metcalfe’s law states that the value of a network as a whole is proportional to the square of the number of participants. This world requires a modular, plug-and-play infrastructure, and on which the focus is on integration and interoperability.Gartner’s 2016 CIO report articulates that “a platform provides the business with a foundation where resources can come together — sometimes quickly and temporarily, sometimes a relatively fixed way — to create value. The value comes largely from connecting the resources, and the network effects between them.”

According to Heraclitus, a Greek philosopher of the 5th Century BC, “change is the only constant in life.”Platforms and ecosystems will not reach a steady state, but constantly morph.

A platform structure allows the organisation to continuously evolve, following Koch’s theory of introducing market signals within the organisation. It allows the organisation to quickly develop new capabilities and cannibalise products or services that are no longer relevant. Most large companies today charge a premium, not because their product is superior, but because they have these bloated infrastructures. Digital business models collapse this paradigm. To date, business models have evolved faster than operating models.

Companies such as Tesla and Monzo are disrupting their industries by reinventing what is means to be a car manufacturer or a bank. They are creating new ‘back-ends’ rather than layering digital technology onto existing infrastructure. Industries such as healthcare, education and energy have yet to see the same level of disruption as other industries due to their nature; that is to say, they are large-scale integrated systems that require multiple parts of the system to be changed simultaneously. Across industries, incumbents have the ability to reinvent themselves, but they must design their business and operating model to fit within a completely new ecosystem, designed for new customer behavior and a new way of working.You don’t change things by fighting the existing model — you change things by making the existing model obsolete.

The conglomerate model of the likes of GE and Procter & Gamble allows those companies to kill off one business unit and build another. Google’s shift to Alphabet is evidence of the discipline this model brings at scale and allows each business to focus on core capabilities.

Culture. The invisible advantage.

“Control what you must, not what you can.” Traditional management dictates that failure to deliver results is due to either a failure to plan adequately or a failure to execute properly. However, success often requires some level of failure, though I would argue the pendulum is swinging too far in embracing failure. There must be a culture that allows employees to take control and have the confidence to pursue ideas and experiment on a small scale. With a smaller core team, the best organisations won’t have to compromise on quality of staff. A study from Gensler found that the most important factor in determining whether a company was innovative was trust. “Innovative companies exercise trust with employees”. Many large organisations today have created layers of complex bureaucracy to protect themselves; often the smallest changes get sent up the command chain and lost amongst the complexity of running such an organisation.

The ability to balance today and tomorrow. The ability to deliver value today as efficiently as possible and the ability to continuously evolve. Culture that maintains that focus on the purpose of the organisation. That allows you to cannibalise the business. A culture that not only doesn’t resist this change but encourages it. Employees see how the problem is changing and the opportunities presented, and they then feel empowered to act rather than protect their silo or profit and loss statements within the organisation. All stakeholders must recognise that to be sustainable and successful the business must deliver value. Google published their values (’10 things we know to be true’) and ‘an owners’ manual for Google shareholders. Both documents help create a culture that supports a sustainable business, maintaining focus on the customer, creating an environment where employees are empowered to take risks and continue to invest in long-term strategic plays.

Gillian Tett, in her book ‘The Silo Effect’, looks at how organisations must create a social structure that influences the way people think, organise and integrate. The norms, values, symbols, measures and processes within a firm all inhibit or support a culture of innovation.

The use of corporate venture arms and accelerators is becoming increasingly common as change agents. Incumbents are able to use start-ups as outsourced R&D, identifying the early tremors of an earthquake. Most importantly is perhaps getting staff to work alongside start-ups, distilling the culture of focused problem-solving back into the organisation.

Data. The fuel of business.

Data is the oil of 21st century business. “Data is the new oil. It’s valuable, but if unrefined it cannot really be used. It has to be changed to create a valuable entity that drives profitable activity; so, must data be broken down, analyzed for it to have value.” — Clive Humby. This is echoed in KPMG’s 2016 survey where 80% of CEOs were worried about their data quality. Kasparov, who became the first world champion to lose a chess match to IBM’s Deep Blue, talks of human ‘strategic guidance’ versus computers ‘tactical acuity’. The most successful chess teams are now a combination of machines and humans. In fact, since Google’s DeepMind won at AlphaGo, humans have learnt to become better players. What this means for organisations is that they must utilise the new tools at their display to work. Machine learning can find patterns in a variety of new data sources at mass scale for use cases we haven’t imagined yet. Benedict Evans’ latest presentation looks at the impact this will have on retail, shifting from buying to shopping online.

I mentioned earlier how as companies scale the conversation changes, moving away from passive data. Companies that maintain focus will have the ability to utilise new alternative data sets as they scale. Data will drive investment decisions, and understanding customers will allow organisations to make investment decisions better than their rivals.An interesting shift taking place is linked to the IT architecture of an organisation and the rise of microservices. Typically, data has been organised using warehouse principle, providing each silo of the business with historical data relevant to their area. We are now seeing the rise of ‘data lakes’, where organisations store as much raw data as possible in one pool. Any area of the business can then request that data with some element of purification and bottling. This data is provided in real-time to aid every decision made, no longer providing just a rear view mirror but predictive analytics. This becomes the basis of a new enterprise stack and operating model.

Incumbents are currently sitting on valuable data that needs to be liberated from disparate legacy systems. At the same time, new data sources from social media, nanosats, etc. are providing opportunities to take advantage of better insights to customer behaviors and desires.When a business’ sole focus becomes the constant evolution and execution of new ideas, they create a sustainable business. Particularly in today’s world where new ideas are commoditised so quickly, brand and the ability to continuously deliver more value than your competitors is vital.

Big is clever

Michael Mandel of the Progressive Policy Institute believes that today’s economy favours big companies. The conventional wisdom that small companies are more suited to innovation is a gross simplification. He is absolutely right.Making this essay big versus small allows me to use the analogy of David versus Goliath, but reality is far more complex.

Schumpeter himself stated that large scale firms were the most powerful engine of progress. Ecosystems need to be managed by a core company that has the scale and skills to provide technological leadership. Looking at the tech giants of today supports this notion. Tech giants are facing the same challenges as many incumbents, but have the skills, scale and capital to adapt; they also have less organisational debt.Annual capital expenditure of Amazon, Facebook, Apple, Google and Microsoft has increased from $1bn to $34bn since 2000. In the same period, the number of permanent employees at these firms increased over 5x. Tech giants are using their current lucrative revenue streams to expand their capabilities, creating ecosystems that commoditise core capabilities that were once the foundation of firms. By aggressively expanding into new areas, they are creating new moats. This is most evident in the creation of ‘monoclouds’ — a singular cloud provider that satisfies all of a customer’s needs. Moving from infrastructure to applications. The race for AI is heating up as the world moves from ‘mobile first’ to ‘AI first’.Seems as though corporatism is here to stay with new set of players in town.

If the problem is not a lack of innovation but scaling ideas, what is the best approach?

American firms with 5,000 or more people spend more than twice as much per worker on R&D as those with 100–500 employees. The likes of Google and Facebook reap colossal rewards from being market-makers rather than market-takers. Historically, Nobel Prize winners have usually done their award-winning work either in academia or at the largest of companies — ones that can afford to support high-level research.

Undeniably, businesses are having to undergo large scale transformation and there has been a changing of the guard. The question is, was that all it was? I believe there is a more fundamental shift on the horizon. Large and small organisations will continue to co-exist. The important change will be the rise of distributed networks of businesses — a complex web — at all layers of the traditional enterprise.

‘The Fourth Transformation’ notes that the real magic isn’t in the smartphone, but the network. Similarly, 20 years after Thomas Edison invented the light bulb in 1879, only 3% of US homes had electric lighting. The creative destruction of business and reinventing the firm is enabled by networked resources and organisations.

Parting thoughts — The ripple effects

In this new reality, every industry is ‘unbundled’. This leads to sector convergence, which we’ve already seen, but more is coming. Driven by expanding platforms, building new features and commoditising what has gone before, these mega platforms expand across the entire customer journey. The winners will be those that own the customer relationship.

Genevieve Bell, an anthropologist at Intel, highlights that the Frankenstein anxiety of new technology is nothing new. The concerns raised around robotics and AI echo the worries we had regarding cars and electricity. ‘Humanity’s greatest fear is about being irrelevant’.

There are potentially more profound impacts of us all becoming more connected and exchanging ideas. Clive Gamble refers to the fact that humans used the same tools for thousands of years, despite their brains developing. The most important factor of developing new tools was in fact social interaction — when a network of humans that were able to exchange ideas grew to a certain level. Could this dawn of technological and cultural change lead to a period of rapid brain growth and be a critical point in human evolution?

The secondary order effects:

• What are the implications on policies, supporting industries and financial valuations?
• The support for businesses: VCs, PEs, Consultants, all impacted.
• Regulation.
• Tax.
• Pensions.
• Society changes.
• Market valuations.

This is not a new idea or completely revolutionary, but the creative destruction has arrived. We should not artificially hold on to the old, but instead make success of the new.

Originally published at www.mrogers.london on January 8, 2017.