Archive for September, 2010

Investor vs. Investor

September 29, 2010

Internal start-ups have all of the usual new business challenges.  They need products, customers, and a profitable way of getting customers to pay for the products.  But above all, they need cash, because even the best strategy will crash and burn if money runs out too soon.

[Production note: at this point investors should enter, corporate investors stage left, venture capitalists stage right]. They speak the same language and are genuinely interested in incubating  great new businesses, but don’t let that fool you.  They are from different worlds.

promised to talk about some of the things that doomed the Bellcore internal start-up which I briefly led.  There is no way of  knowing whether a VC-funded company would have fared any better. In fact, one of the companies that we might have merged with was a venture-funded operation that lasted only a few months longer than we did.  Nevertheless, we did learn a lesson or two about corporate sponsorship of start-ups:

Corporate sponsors of new ventures and VCs have different belief systems.  They are fundamentally incompatible, and without early, explicit steps to stop it, corporate attitudes, practices, and beliefs will overwhelm the fragile culture of the start-up.

Let me set the stage a bit.  In 1999, Bellcore (now Telcordia Technologies) was a small company (revenue creeping up on two billion dollars) that was trying to ride the internet wave, but it had inherited a corporate style from its previous owners that was, well, hierarchical.  Big deals dominated the business mix, and internal investment decisions were obsessively analytical.

Bellcore’s new owner was SAIC, a big company serving a hierarchical marketplace that was paradoxically entrepreneurial. Bob Beyster, SAIC’s founder, had insisted on a flat corporate structure in which managers were encouraged to develop independent business.  When my little start-up failed, I  made my wrap-up presentation to the CEOs of both companies.  One of them tended to believe that Bellcore’s internal investment machinery was the right way to grow a new business.  Here’s how it went.

  1. We spent a lot of  money on extensive analytics to gauge market potential.  It was how the investment decisions for Bellcore’s big operations support systems were made and every new round of funding was based on a rosy prediction of a complex market study. In reality, market behavior was unpredictable.  We should have evolved our concepts in the market.
  2. Except for the few top  technologists that I could steal from my own research staff, corporate investors would not permit top talent to be redirected from existing projects — where the  big customers were —  to this risky venture with uncertain prospects. Once both scale and success were clear, we could recruit internally, but until then, we had to rely on good-natured volunteers to help us out.  The only thing we could do was hire externally, but there was little upside to attract the kind of business team that we needed.  A VC sponsor would have known that new ventures do not succeed without a highly talented team.
  3. Speaking of success: the corporate sponsors were only interested if the likelihood of success was high, so we spent a lot of time on the success factors that would be convincing to them.  An angel investor or a VC would have known that, since the likelihood of success of a given venture is quite low, it is better to fail earlier rather than later.
  4. Corporate culture was a culture of ownership, so many business planning meeting focused on patents and intellectual property rights that would build walls around the business.  It was an unfortunate mindset.  This was a time of open standards and sharing, but shared ownership was not part of the equation for our start-up.
  5. Internal sponsors wanted to see scale.  Niche markets were simply not interesting. The business had to embrace all of telecommunications, so part of the operating strategy was to place many product bets simultaneously, a disastrous choice given the meager resources for product development and the lack of real experience on the part of our business development team.  A VC would have told us that a narrow, easily explainable, product focus was key to success.
  6. The corporate sponsors were all senior Bellcore executives, and they were focused on building the core businesses.  They believed that value creation had to be demonstrated by earnings. A VC would have told them that the market recognizes value well before earnings are even possible — it’s the single most obvious characteristic of early-stage investors to constantly seek those kinds of  market signals.

There were ways through this thicket.  That is one of the lessons for corporate leaders who want to launch internal start-ups: avoid colliding worlds by choosing the right corporate role.  Corporate sponsors need to be responsive to the needs of the new venture, but proactive support is just one more opportunity to infect the start-up an alien culture.  An internal start-up needs to be managed, but managing for value makes much more sense than managing to artificial revenue and earnings targets. And freaking out over the possibility of failure is also not helpful.  New business creation is a portfolio game, and any corporation that does not take a portfolio approach is betting against high odds.

An overlay to the story of every internal start-up is corporate machinery.  The milestones that mark the calendar for corporate sponsors are timed to fit the needs of much larger — and more visible — core businesses.  No billion dollar company can afford make its processes dependent on external business and market events.  But that is exactly what a start-up needs to do.  So, even if the new venture survives the Investor vs. Investor duel, it needs protection from the calendar, the  topic for my next post.

The Internal Start-up

September 22, 2010

I had a conversation the other day with a senior executive — let’s call him Bob —  of a Fortune 10 company about their “internal start-up” culture. It seems that they are looking for breakthrough product ideas that do not align well with their core business.  The solution seems obvious: let’s create the same kind of  exciting, market-driven environment that you would find in a start-up!

Everything sounded fine for a few minutes.  They thought that the most creative people in the organization needed to have elbow room that would be difficult to achieve in the risk-averse culture of a hundred billion dollar company.  So how did they plan to achieve that?

  • Freedom to break some rules:  the start-up can use its own  product roadmaps and sales strategies
  • Freedom from process-driven corporate calendars and budgets: the leadership of the start-up is not bound by the revenue and earnings goals of their parent
  • Freedom to take risks: they have permission to fail

It didn’t take long for the discussion to go seriously off track.  When I started in with questions about how they were going to actually pull this off, Bob said: “Look, I’m in charge of new technology and platforms and I’m going to be the venture capitalist funding a new product, so that when it succeeds we’ll be able to fold it back into our current business.” I had seen this movie before.  It’s called When Worlds Collide. When I suggested that Bob lives on a different world and would make a terrible venture capitalist, things got a little heated. As I recall it, Bob said, “In your ear!” A surefire way to put a fine point on your argument.

Bob lives on a planet where the scale of his business creates a climate for successful development of new products that can be sold to familiar customers using existing channels and tried-and-true processes.  Above all, in Bob’s world, it is possible to make big bets. The examples are impressive. Everything from HP’s inkjet printing to the Boeing 777. Unfortunately for Bob and his start-up, none of those things matter.  The start-up lives in a world of new markets, which means new customers, new channels and new processes.

Even though Bob has all the talent he needs for market success,  the likelihood of failure is high. The Newton and the Factory of the Future did not fail because  because Apple and GE could not innovate.  They failed in large measure because corporations foster a system of beliefs that is fundamentally incompatible with  taking capabilities to new markets. When I asked Bob  how the start-up employees were going to be recruiteed and rewarded, whether they had a safety net for returning to the company in case of failure, and how many simultaneous bets he was willing to place, the answers were not encouraging.

I immediately did a deep dive into my archives, hoping to find traces of a long-forgotten venture that I helped steer into the ground.  In the late 1990s Bellcore was poised to enter the online services business, hoping to attract newer, smaller customers than the seven  Regional Bell Operating Companies who accounted for most of the company’s revenue.  This was a time when Bellcore’s Applied Research group was generating a blizzard of patents in e-commerce and software, technology that I have talked about before. We were as smart and nimble as any West Coast start-up, and best of all we had the cash to fund a new venture, the talent to staff it, and the power of an existing sales team to go after those new customers. I was asked to lead the new company.  We would be funded just like a VC-backed start-up…

When the dust settled and I reported lessons learned to the Bellcore’s CEO Richard Smith and later to Bob Beyster, CEO of SAIC,  Bellcore’s parent company, the first thing I said was that there had been no structural reason for failure.  A team from McKinsey had already given us the range of possibilities. We could have set up an independent business unit or spun 0ut a company in which we retained minority ownership.  Setting up a new incubator would have required more time than we thought we had, and, in any event,  Applied Research was already in the incubation business. We had chosen to bypass corporate reporting structure and create a company-within-a-company with direct oversight by a CEO who was committed to our success.  It was exactly the Hughes DirecTV model.

There are three reasons that internal start-ups like ours tend to fail.  Bob was not in the mood to listen because he is banking on success, but the topic comes up in every large enterprise, so I thought it might be a good time to repeat the conclusions here:

  1. Failure is common: Building new business is a portfolio game in which 90% of the returns come from 15% of the investments.  It is fundamentally unlike product development. A “big bet” strategy only succeeds when there is high degree of confidence in your ability to sort out winners and losers.  In a new market, that just never happens.
  2. Market-driven milestones drive success in new ventures.  An internal start-up — even one with strong support at the top — cannot divorce itself from processes that are timed to fit corporate needs.
  3. Corporate sponsors of new ventures and VCs have different belief systems.  They are fundamentally incompatible, and without early, explicit steps to stop it, corporate attitudes, practices, and beliefs will overwhelm the fragile culture of the start-up.

I want to spend the next several days elaborating on these ideas.  I hope Bob is reading.

Damaged Pipelines and the Future of Innovation

September 6, 2010

One of the strongest arguments for shoring up the nation’s public universities, increasing graduate offerings, and expanding the role of expansive research plans in determining institutional priorities is the effect that investments like these have on America’s ability to innovate. It’s an argument that rings true, but as facts accumulate, it is beginning to look like public universities are not doing much to secure the future of innovation in the United States.

The nation’s supply of scientists and engineers is fed by a pipeline that extends from the undergraduate programs of colleges and universities to the graduate programs that educate the next generation of PhDs.  The massive investment in research at public universities should have had some impact on the health of this pipeline, but it has not.

A couple of weeks ago, I cited a depressing  CCAP ranking of universities that placed many of the country’s most highly respected research universities near the bottom of value-oriented rankings.  Now there is a new survey from UCLA’s Higher Education Research Institute that adds more details to this portrait of failed priorities.

On a per capita basis the schools whose undergraduate programs are responsible for the most PhDs in the STEM (Science, Technology, Engineering, Math) disciplines are the ones that are also highly regarded by students and alumni for the value they deliver.  There are only three public institutions in the top fifty: UC Berkeley (39), William and Mary (45), and a surprisingly strong 15th place showing for tiny New Mexico Tech.  Who is at the top? Caltech is number 1.  Private research universities like MIT, Princeton, and Chicago are also in the top ten. But so are schools with virtually no research funding.  Harvey Mudd is ranked number 2.  Reed, Swarthmore, and Carleton — all liberal arts colleges — are among the top ten as well. Many in the top fifty are small, but there are a couple of  large institutions like Berkeley (35,000) and Cornell (21,000).  About half enroll between 10,000 and 15,000 students.  All are highly selective, but so are the most of the public universities that are members of the AAU.

In a recent post, I asked “Why universities do research?”  This data makes the question even more pointed. The largest consumers of federal research dollars should be directing their energies to insuring the health of the STEM research pipeline.  All of the schools in the top fifty manage to do it — some with little or no help from the federal government.  So it makes perfect sense to ask what is going on at the other institutions.  I have my own ideas — and I talk about them in my book — but I am also interested in hearing your thoughts.  Is this another indication of a damaged pipeline?


September 1, 2010

In Where’s the money….? I described for you the Department of Education’s assessment of the financial health of the nation’s private universities:

The U.S. Department of Education issues a regular report on the financial health of  degree-granting colleges and universities.  It is a sort of test of financial strength.  When I started tracking the course of these institutions for my book, there were about a hundred non-profit colleges  that failed the test.  By 2008, that number had risen to 127.  The Chronicle of Higher Education has just reported that 150 non-profits now fail the Education Department’s test.

Now we have picture of the toll that the financial meltdown and runaway expenses are exacting on America’s public institutions as well. Moody’s Investor Services has just issued its report on the liquidity of public universities: “U.S. Public University Medians for Fiscal Year 2009 Show Tuition Pricing Power Amidst Rising Challenges.”  The report is available only to Moody subscribers, but Goldie Blumenstyk, writing in today’s Chronicle of Higher Education, summarizes the key findings as follows:

The median level of debt for 200-plus public institutions rated by Moody’s—$176.9-million as of the end of the 2009 fiscal year—has grown by 31 percent over four years. That’s notably greater than the rate of revenue growth (25 percent), total financial resource growth (15 percent), and enrollment growth (13 percent) during that same period…For the first time, colleges’ debt per student ($13,665) exceeded their financial resources per student ($12,893).

As a consequence, operating margins are at or near all-time lows for public institutions and are negative for many.

Tuition is rising at many public universities, but the cost to students is not being converted to increased educational value.  In many cases, tuition increases simply service expanding debt obligations. While the liquidity of top-ranked public research universities is worse than their private top-ranked counterparts, the public medians have the ability to convert a larger share of their assets to cash in the near term.  What Moody’s doesn’t say is where the liquid cash comes from.

The lack of transparency in public funding of higher education matters.  A public university has a public budget, and we all know that in most states funds slosh back and forth between spending categories without regard to the rules of arithmetic that most of us have to live under.

One large eastern state delayed paying university employees until the start of the next fiscal year.  Another one routinely delays most raises until the start of the next calendar year.  Still another allows cash to flow freely between major athletic programs and major academic obligations in the hope that a great athletic season might generate enough private donation to repay internal mortgages. Cost-sharing contributions are shifted, research cost recovery is murky, and personnel obligations are sometimes backloaded for months and years.

Even in good times, generating cash for operations in a public university is an exercise in juggling future payments.  With zero operating margins, administrators are the unlucky Monopoly™ player who has just landed on Park Place and realizes that the only way to pay the rent on the three hotels is to mortgage all of his properties. He spends the rest of the game hoping that he can keep his meager wages. Hope is not a strategy.

That is why the ability to raise tuition is so powerful.  But, as Moody’s new report makes clear, tuition increases are like passing GO.  New tuition dollars fill budget gaps. They do not change a university’s finances. It is only a matter of time before students figure that out and go for the e-pill.