The TV show The Wire is an incredibly instructive lesson on how the modern world works (besides being a great work of art). The recurring theme is how individuals with good intentions are stymied by large institutions. As the show’s creator says:
The Wire is a Greek tragedy in which the postmodern institutions are the Olympian forces. It’s the police department, or the drug economy, or the political structures, or the school administration, or the macroeconomics forces that are throwing the lightning bolts and hitting people in the ass for no reason. In much of television, and in a good deal of our stage drama, individuals are often portrayed as rising above institutions to achieve catharsis. In this drama, the institutions always prove larger, and those characters with hubris enough to challenge the postmodern construct of American empire are invariably mocked, marginalized, or crushed. Greek tragedy for the new millennium, so to speak.
What’s amazing about the show is you see in a very realistic and compelling way how, say, 1) the well intentioned mayor needs to get the crime numbers down to get his school reform passed so 2) he pressures the (well-intentioned) police chief to do so, 3) who in turn cuts off a (well-intentioned) investigation that wasn’t going to yield short term metrics, 4) which emboldens the gang leader being investigated, 5) who recruits a sympathetic high school student into a life of crime. And so on.
This blog is mostly about startups so let me tell a true Wire-like startup story. There is a large, publicly-traded company we’ll call BigCo. BigCo has a new CEO who is under heavy scrutiny and expected to get the stock price up over the next few fiscal quarters. Wall Street analysts who follow BigCo value the stock at a multiple of earnings, which are driven by Operating Expenses (“OpEx”), which are ongoing expenses versus “one time” expenses like acquisitions (called “CapEx”). (If you read analyst reports, you’ll see that stocks are generally considered, correctly or not, to have key financial drivers. The stock price is often those drivers times a “multiple” which in turn is often determined by the company’s expected growth rate). The “smart money” like hedge funds may or may not believe these analysts’ models, but they know other people believe them so place their bets according to how they think these numbers will move (see Keynes on the stock market as a “beauty contest”). (Financial academics who believe in “efficient markets” would say none of this is possible but anyone who’s actually participated in these markets knows the academics are living in fantasy land.)
All this means the CEO is fixated on growing BigCo’s revenues while keeping operating expenses down. A great way to do this is through acquisitons, which analysts consider one-time expenses (CapEx). Let’s say BigCo is currently growing at 20%, but their multiple suggests they need to grow at 30%. So the M&A team goes out and looks for companies they can acquire growing at, say, 50%, to get the average up. BigCo spends lavishly to buy these companies since the costs can be considered CapEx. They even have elaborate dinners and incur other large expenses that can be counted as part of the acquisition. Once the deal is closed they immediately start planning how to cut operating expenses from the newly acquired company. They decide the best way is to move the engineering offshore. This rips the heart out of the engineering-driven culture and as a result morale drops, product quality falls, and key people quit. But the short term revenues are up and operating expenses down, so BigCo’s CEO keeps her job and makes a lot of money off her stock options.
The winners here are the people who understand the system and play it cynically (hedge funds, BigCo’s CEO & board, perhaps the acquired company’s founders & investors). The losers are everyone else – the company’s customers, the employees who lose their jobs, and the stock market investors who don’t understand the game is rigged.
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[...] Institutional Failure (cdixon.org) [...]
Great analogy to the Wire. Perfect actually.
The larger the organization the more things/people there are for others to hide behind. It gets easier for people to be cowards or just lazy and not take a stand for doing the right thing (in business, morally, etc.). I think some of the clusterF stems from people playing the system as you point out. No doubt about it.
But I also think some of it is just organizational behavior that tends to happen on its own as things get big unless there are genuine leaders who won't allow it. I don't think people realize the culture they're creating until it's too late.
I agree. Sometimes I think maybe we just need much smaller institution…. small pieces loosely coupled..
I think the bigger overlying problem is what people define as “innovation” – unfortunately, much of corporate culture looks at it from the myopic view of cutting costs and making more money. Of course, the most dangerous incarnations are when it intermixes with poor diligence and unethical behavior.
Sure, a lot of these “BigCo's” with the budgets to snap up innovative startups will just let them die – but I don't think there are any winners from what you described. Yes, those are the guys and gals that make money in the short term, but once your corporate culture fades to the point where innovation isn't rewarded on actual merits – it's probably only a matter of time until things fall apart completely.
I agree… well said.
The notion of “too big to fail” is actually “too big not to fail” I think. There are obvious advantages of scale. There are less obvious disadvantages.
this very scenario happened to me on the SonicWALL acquisition of Lasso Logic…. I'm am sales however, so they always consider you expendable if you don't grow your sales QoQ 117%. Nice article… weren't sure where you were going but by the 3rd paragraph it was clicking for me! Nice.
I think elements of this story are true for most acquisitions.
Great shout-out to The Wire. I can't imagine a better show coming along. That it wasn't more critically acclaimed is probably a moral in itself.
It struck me in the situation you brought up that the enabler of this happening is when people are reduced to a role and just playing within the forces of the incentives of the institution structure they are in. Something to keep in mind if you're in a position of control…
The CEO in your tale would have been replaced until the CEO was found who would do exactly what happened – it's built in (rigged, as you said).
So if you have a company and take VC money instead of growing organically – you have to be aware of the institutional forces that is going to put you under I think. Same for going public or getting acquired.
I'd imagine the happiest people in business are the ones that are able to stay independent and grow their business under their terms – where they define the forces of their own institution essentially.
I think you meant to say the company is valued at a multiple of Operating Income or EBIT which moves up when OpEx comes down.
yes, that's right. I was assuming fixed revenue and of course oversimplifying a lot etc.
oh i see i actually said “multiple of opex” which is clearly false. what i meant is earnings where opex is a key variable. corrected it. thx
Great post though.
also love the wire!
excellent illustration of why CEOs are fixated on growth. in effect, the CEO's boss is the shareholder/investor, and they put enormous pressure on the CEO to keep delivering steady growth. pursuing deals that are accretive to earnings is almost an easy way out (inorganic vs organic growth).
minor quibble- i think these transactions hits the balance sheet (cash, goodwill, etc.) more than the income statement. after the transaction, there is an impact on the income statement since all the future earnings are summed, but the costs of acquiring those earnings is mostly reflected in the balance sheet.
Cool – that said, as a young entrepreneur, one of my biggest fears is that I unassumingly create a culture that isn't innovating or is not rewarding good ideas.
Maybe in a future post you could highlight some of the questions you ask yourself and your portfolio companies to make sure that things are on track and moving forward (other than what the balance sheet says). I think that advice is portable to the BigCo's of the world.
Also – what do you think are the best mechanisms for rewarding people? Obviously startups can't/shouldn't write out big bonus checks (nor do I think that throwing monetary incentive is the best reward). There are already so many intrinsic rewards to startups and maybe just fostering that culture and the belief that you're doing something that will positively change the world is enough.
Also – watched Obama's Q&A this morning from the Baltimore (ironic give The Wire theme here…) retreat this week, and he repeatedly points out the incentive gutting American politics – politicians in constant campaign mode. Keeps them from being statesmen instead of politicians.
Congress is looking like our biggest institutional failure to me.
But – the Q&A itself, fielding questions from Republican congress members, is a glimmer of hope. I hope President Obama keeps up the chastising of both parties.
Yours is an argument against short-term management compensation, not against M&A per se.
I'm definitely not against M&A. Things I think would help: Longer term equity compensation for management (5 years), longer term investors (why not make short term cap gains 80% and long term 0%?), better accounting rules.
I like the cap gains idea – but it's hard to implement. It would be a nightmare for funds (indexed and ETFs in particular) who frequently are forced to re-balance their holdings.
As for compensation and accounting rules, as you know these are huge, complex topics. Another time….
Freudian slip: BigCo’s CEO keeps her job
So we are talking about HP and Carly Fiorina here?
or deliberate misdirection?
Dude.
If you ever want to start a blog specifically tying together lessons from The Wire/Homicide (and he's got a new show coming) to entrepreneurship you just found your first writer.
Sheeeeeeeeeeeeeeeeeeit.
LOL
Great post, Chris. I've been thinking about big vs. small a lot lately. I believe the Information Age will see (is already seeing?) a return to “cottage industry.”
These early “cottage” enterprises were small organizations characterized by close relationships where workers' social identity was inseparable from their work and their organization. People even took on surnames to reflect their work (i.e., Fisher, Weaver, Baker, etc.) Workers didn't need financial incentive or regulation to behave appropriately because they saw their work was a reflection of who they were.
During the Industrial Revolution, factories used the efficiencies of scale to put cottages out of business. People became cogs in a machine. Treated poorly by their foreman, people had little incentive to do more than the minimum required.
Big organizations today are still shaped under the logic that economies of scale mean bigger is better. Certainly that is still true for organizations like Wal-mart. But for many organizations in today's Information Age, we've automated or outsourced anything that benefits from scale (manufacturing). What remains are “knowledge workers.” Scale actually hinders–not helps–that sort of work (http://j.mp/85HaHd).
Today's tech startups are lot like cottages. In high margin, knowledge-centered industries (like software), cottages have speed, flexibility, and passion that will win over factories.
(P.S. Products that benefit from network effects, like social networking, search, operating systems, etc. are another exception where scale trumps everything else.)
Hey don't burst my bubble. I thought I had it all figured out
.
On a more serious note. Big companies problems can be described in 3 areas/systems (I like to think about it as systems, since the interact and influence each other).
1. Compensation (see your post)
2. Organization (strict hierarchical system are reactionary. Opposite “smart system” brain structure and plasticity, in economy start ups).
3. Over reliance on data. (From CYA to “be wary of Geeks bearing formulas” to my play on it “be wary of CEOs bearing golden parachutes”).
All of these interact and pretty fast create an inflexible system by itself unable to react to the market or anything else. Just optimized to serve one purpose, increase influence and income at the top.
Does BigCo. starts with a Y? if yes, you can add “replacing engineers with accountants”
Chris, this is a great post. I agree, and I think the answer goes far beyond just lengthening management incentives. I can't possibly summarize my thoughts in a comment, but “Life, Inc” is a good start, from D. Rushkoff; approaches the idea of corporate self-cannibalization pretty thoroughly, and in ways that resonate with the short-term gains you're referring to. I think there's a ways to go (also, love the Wire, great analogy).
Absolutely true. In a prior life I was at a private equity fund specializing in “roll-ups” — buy a company that does boring service or product X, get good management that can handle a larger scale, and set out to buy all the little companies doing X that you can. (GTCR is probably the most famous of the companies that do this.)
The investment thesis is that the bigger company, with better scale, mgmt, costs of doing business, brand, etc., can actually make all the little companies worth more.
The cynical view is that the market with pay a higher multiple for larger companies, so if you buy 20 companies doing $10 mm in revenue at 5x EBITDA, you can smush 'em together into a larger company doing $200 mm in revenue and float it on the markets at 8x EBITDA.
Good insight and nice hook with the Wire intro
[...] story of cynicism and institutional failure in corporate America. (Chris Dixon also The Reformed [...]
I think, in the long term, this type of pressure will not matter much anymore. Most typical large companies will one way or the other evelove and disappear. The only companies who will survive are those that a) don't care about Wall Street, see Amazon or b) are managed by a founder / founder like personality, again Amazon, Apple, even Microsoft.
Startups culture, speed of innovation and execution will become more and more critical in the future adn only large companies that are in effect large startups will survive; old style BigCos, in most sectors, will continue to struggle and gradually completely change their structure and their priorities or die.
That's some f'ed up repugnant sh&t.
From one guy who cares about real value.
Yes. Millions of tiny micro businesses super focused and well rewarded for creating real value. Not delusionary share price boosts.
If you want an organization that absolutely owns their work, you have to be willing to share equity. Founders and investors that own 80-90% of a company that profess that motivation is based on making a change are in most jeapordy of hypocracy.
[...] From cdixon.org [...]
Chris, the aspect of offshoring engineering caught my attention. We're working on products oriented around mobile, which means dealing with heavy device fragmentation issues that challenge our ability to scale and use capital effectively. In your experience, can core engineering be offshored in a startup? Or perhaps, in our case, the porting from primary to secondary device platforms. Interested in your thoughts… Worried about the trade-offs between execution risk (coordination and collaboration hurdles) and execution scale (cost, time to market).
[...] This post was mentioned on Twitter by howardlindzon, David Crow, Marc Angelico, Jesse Farmer, David Shen and others. David Shen said: gotta play the system, the world is not a fair place: Institutional failure http://ds.ly/dCG72y /via @cdixon [...]
The Wire should almost be a mandatory watch!
Great comparison and reference.
Jm from France
Hey chris,
great article… this might interest you:
A close-up look at the hedge fund environment of Argentina. Speaking with managers of two of the largest funds operating in the region, Alternative Latin Investor looks at the capital markets, politics and economics, which affect the operation of hedge funds.
http://www.alternativelatininvestor.com/hedge2.php
Never watched the Wire but now I'm gonna have to. Thanks for the tip.
Not sure I agree with the moral implications of your BigCo story.
This same scenario could be described differently: BigCo, with a strong balance sheet and operating scale, buys a smaller high-growth company. The deal positions BigCo for growth in its competitive global market. BigCo uses its scale to expand distribution of SmallCo's assets, while reducing costs to optimize operational performance and simultaneously enable the purchase premium paid to SmallCo's investors. (Assume the premium is very high given SmallCo's 50% growth rate; the early investors and founders have a fantastic exit.)
The public markets, and M&A arbitrageurs, who are more sophisticated than you imply, will make a call on true value; i.e.: is this a repeat of the 1960's EPS buying game or an EPS-accretive smart strategic move? Public market investors will decide and either reward or punish BigCo's share price – a fine check & balance on a fine capitalist endeavor.
Mark: Absolutely, everyone on my team has a meaningful equity stake and contributes significant mindshare in the evolution of the product as well.
That's a great motivational architecture. It incentivizes the entire team to critical evaluate what they're doing, and how it relates to the success of the startup.
Good luck Aniq! Working on first hire and equity split now before pursuing external funding. It detracts from productivity time though.
Andrea, I hate to sound overly cynical, but I am keen to understand what you think is changing to support this shift. You say “anymore,” and “more and more…in the future” but I am not sure that the majority of the GDP is in line with what you're saying or that there has been any cultural shift away from what Chris is describing.
I am a red-blooded entrepreneur like any other, so I love what you're saying, but I am not sure that most large organizations feel the need to behave like start-ups, or that one group is dying off any faster than the other. I don't know–
It's a shame that we all recognize the inefficiencies, disadvantages and costs of listing on a public market/being an acquisition target. Yet in the search for an exit, VCs fast-track portfolio companies towards these outcomes – undoubtedly with a strong preference for the method that monetizes the investment the quickest. Venture Capital is very much part of the system that is broken and requires some fresh thinking.
Anyway, for anyone that loves the Wire check out Jason Policastro's blog. He's an independent journalist in Baltimore providing a glimpse into the stories behind the city's politics, crime and culture. http://www.jasonpolicastro.com/wordpress/
[...] story of cynicism and institutional failure in corporate America. (Chris Dixon also The Reformed [...]
[...] as startups at creating new products. The bigger the company, the more likely it suffers from agency issues, strategy taxes, and myopia. But most of all: nothing is more motivating and inspiring than the [...]