All businesses share the same underlying foundation: a flow of money in and out. The money in has to cover the costs of the money out. It has to pay for the production of your product or service, and have enough left over to fund growth and expansion for the future. This is the basic equation whether you’re Amazon or General Electric or Tesla. Some businesses aren’t profitable (Tesla, as of when I’m writing this), but they still get money in. Their money comes from investors, in the form of loans or equity investment.
Some simple back-of-the-envelope calculations can help you understand a business. It’s most obvious in a small business. Say, a one-man business. Magician Evan Northrup and I sat down to talk about his business and how it works. He graciously allowed me to share the video. In the first half, we walk through the basic numbers of the business. In the second half, we ask how to make his product stand out from his competition.
The Chief Executive Officer is one of the most coveted titles, and least understood jobs in a company. Everyone believes that CEOs can do whatever they want, are all powerful, and are magically competent. Nothing could be further from the truth. By its very nature, the job description of a CEO means meeting the needs of employees, customers, investors, communities, and the law. Some of a CEO’s job can be delegated. But several elements of the job must be done by the CEO. Read on for the details of what makes a CEO.
What is intrinsic to the CEO’s job?
This isn’t a traditional job description; it’s an examination of the actual roles that a CEO plays (legally or de facto) within a company. A CEO’s job description includes a few important areas. Any individual CEO may take on any tasks that they wish, but these are the things that can’t be delegated:
While a CEO may get input for some of those duties, it is the CEO’s—and only the CEO’s—responsibility to perform those well. Being the CEO, they can spend the rest of their time doing whatever they decide they want to spend their time on. But ultimately, everything else about a given CEO’s job is optional.
Admit it. We all feel a touch of awe when someone has it: the CEO title. The power, the salary, and the chance to Be The Boss. It’s worthy of awe!
Too bad so few CEOs are good at what they do. In fact, only 1 in 20 are in the top 5%. Many don’t know what their job should be, and few of those can pull it off well. The job is simple—very simple. But it’s not easy at all. What is a CEO’s job?
More than with any other job, the responsibilities of a CEO diverge from the duties and the measurement.
A CEO’s responsibilities: everything, especially in a startup. The CEO is responsible for the success or failure of the company. Operations, marketing, strategy, financing, creation of company culture, human resources, hiring, firing, compliance with safety regulations, sales, PR, etc.—it all falls on the CEO’s shoulders. Being responsible means that the CEO is the one held accountable for the success of the company’s efforts, across the board. But of course, the CEO doesn’t actually do all that work.
The CEO’s duties are what she actually does, the responsibilities she doesn’t delegate. Some things can’t be delegated. Creating culture, modeling values, building the senior management team, financing road shows, ultimate approval of how money gets spent, and, indeed, the delegation itself can be done only by the CEO.
What is the CEO’s main duty? Setting strategy and vision.The senior management team can help develop strategy. Investors can approve a business plan. The Board can approve, advise, or ask the CEO to revise a business strategy. But at the end of the day, it’s the CEO who ultimately sets the direction:
Which markets will the company enter? Against which competitors?
What will the company’s product lines be?
How will the company differentiate itself? Will it be low cost? High service? Convenient Locations? Flexible financing? High-touch? Mass produced?
The CEO decides, sets budgets, forms partnerships, sells off incompatible product lines, makes acquisitions, and hires a team to steer the company accordingly.
Modeling and setting the company’s culture, values, and behavior
The CEO’s second duty is building culture. Work gets done through people, and people are profoundly affected by culture. A lousy place to work can drive away high performers. After all, they have their pick of places to work. And a great place to work can attract and retain the very best.
Culture is built in dozens of ways, and the CEO sets the tone. Her every action—or inaction—sends cultural messages (see “Life Under a Magnifying Glass”). Clothes send signals about how formal the workplace is. Who she talks to signals who is and isn’t important. How she treats mistakes (feedback or failure?) sends signals about risk-taking. Who she fires, what she puts up with, and what she rewards shape the culture powerfully.
This can not be emphasized enough! People imitate a CEO’s behavior when deciding how to act. The book Pre-suasion by Robert Cialdini, documents at length the ways in which, for example, a dishonest CEO makes employees feel as if they can cut corners, steal from the company, and generally behave according to those same standards.
A project team worked weekends launching a multimedia web site on a tight deadline. Their CEO was on holiday when the site launched. She didn’t call to congratulate the team. To her, it was a matter of keeping her personal life sacred. To the team, it was a message that her personal life was more important than the weekends and evenings they had put in to meet the deadline. Next time, they may not work quite so hard. The emotion and effect on the culture was real, even if it wasn’t what the CEO intended. Congratulations from the CEO on a job well done can motivate a team like nothing else. Silence can demotivate just as quickly.
If vision is where the company is going, values tell how the company gets there.Values outline acceptable behavior. The CEO conveys values through actions and reactions to others. Slipping a ship schedule to meet quality levels sends a message of valuing quality. Not over-celebrating a team’s heroic recovery when they could have avoided a problem altogether sends a message about prevention versus damage control. People take their cues about interpersonal values—trust, honesty, openness—from CEO’s actions as well.
Building and leading the senior executive team
Team-building is the CEO’s #3 duty. The CEO hires, fires, and leads the senior management team. They, in turn, hire, fire, and lead the rest of the organization.
The CEO must be able to hire and fire non-performers. She must resolve differences between senior team members, and keep them working together in a common direction. She sets direction by communicating the strategy and vision of where the company is going. Strategy sets the direction for the senior team, who in turn set it for the rest of the company. With clear direction that everyone understands, the team can rally together and make it happen.
Don’t underestimate the power of setting direction. In 1991, at Intuit’s new employee orientation, CEO Scott Cook presented his vision of Intuit as the center of computerized personal finance. Intuit had just 120 employees and one product. Ten years later, it’s a billion-dollar company with thousands of employees and dozens of products. Worldwide, it is the winner in personal finance, bar none. The success is due in no small part to every Intuit employee knowing and sharing the company’s vision and strategy.
Allocating capital to the company’s priorities
Capital allocation is the CEO’s #4 duty. The CEO sets budgets within the firm. She funds projects which support the strategy, and ramps down projects which lose money or don’t support the strategy. She considers carefully the company’s major expenditures, and manages the firm’s capital. If the company can’t use each dollar raised from investors to produce at least $1 of shareholder value, she decides when to return money to the investors. Some CEOs don’t consider themselves financial people, but at the end of the day, it is their decisions that determine the company’s financial fate.
Footnotes for Part 1
 Pay no attention to the math background peeking from behind the curtain… back
Measuring Success as a CEO.
Knowing the job description is a good first step for a CEO, but to know how she’s doing, she needs to design her own measurement system.
Unlike inconvenient lower-level jobs, no one tells the Chief Executive how she’s doing. Do managers let her know she’s undermining their authority, making poor decisions, or communicating poorly? Not likely. Even when a CEO asks for honest feedback, the fear is there: non-flattering feedback may stall a promising career. Even when a company uses 360-degree feedback, no one penalizes the CEO if she doesn’t act on the feedback.
The Board of Directors supposedly oversees the CEO, but they are far removed from day-to-day actions. Over time, they can evaluate performance, but they look mainly at share price and company strategy. They are rarely interested in—(or qualified to comment on!)—the CEO’s daily behavior.
But the CEO’s daily behavior will make or break the company! The CEO’s duties don’t change because they are unmeasured. Indeed, lax measurement makes it easy for the CEO to feel confident, even when she shouldn’t. Good feedback is the only way to know what’s working, but share price simply doesn’t do it. External measures measure the company, not the link between the CEO’s actions. A low share price tells her something’s wrong, but it doesn’t help her figure out what.
By measuring her performance based on her duties, a CEO can learn to do her job better. As explained in part 1, the CEO’s job is setting strategy and vision, building culture, leading the senior team, and allocating capital. The last of these is easy to measure. The first three are more of a challenge.
How does a CEO know she’s doing the vision thing? It’s hard. Having vision isn’t enough—that just takes a handful of mushrooms and a vision quest. Communicating the vision is the key. When people “get it,” they know how their daily job supports the vision. If they can’t link their job to the vision, that tells a CEO that her communication is faulty, or she hasn’t helped her managers turn the vision into actual tasks. Either way, a CEO can monitor her success as a visionary by questioning and listening for employees to link their jobs with the company vision.
Culture building is subtle, the culture a CEO sees may be very different from the culture of the rank-and-file. One company had a facilities policy that all equipment within 450 feet of the senior management offices was kept in top working order. Senior managers saw a smoothly running company, while everyone else saw neglect and carelessness.
Surveys about openness, values, and morale can be used to develop a measure of culture. The questions to ask aren’t rocket science. The book First, Break all the Rules gives a great questionnaire for measuring overall culture. Also, check turnover. When 95% of your workforce says they can’t wait to get to work, something is going right. If people rarely leave, and if it’s easy to attract top talent at below-market prices, you can be sure the culture plays a large role. If people leave (especially your top performers), again—look to culture. And don’t underestimate the power of walking around and counting smiles. If people are having fun, it will show.
The CEO’s success at team-building can often be measured through the team. Teams usually know when they’re effective. They can also rate their team using assessments that measure specific behaviors. For example, “I can trust my teammates.” “My teammates deliver their part of the project on time.” “Every member knows what is expected of them.” Regular team self-assessments can help the CEO track the team’s progress and hone her abilities to keep the team running smoothly.
Easiest to measure is a CEO’s capital allocation skill. In fact, financial measures are the ones made public: earnings and share price. But how can a CEO link those to her actual decisions? Working with her CFO, a CEO can devise financial measures appropriate to her business. Sometimes traditional measures are most appropriate, such as economic value added or return on assets (for a capital-intensive company). Other times, the CEO may want to invent business-specific measures, such as return on training dollars, for a company which values state-of-the-art training for employees. By monitoring several such measures, a CEO learns to link her budget decisions with company outcomes. Ultimately, the CEO’s should be creating more than a dollar of value for every dollar invested in the company. Otherwise, her best bet is to return cash to the shareholders for them to invest in more productive vehicles.
In startups, earnings begin low to nonexistent, and share price is more about salesmanship and vision than earnings. So the CEO gets almost no useful feedback about her capital allocation wisdom. She doesn’t know whether a dollar spent on a slightly nicer-than-necessary copy machine is wasted or is a wise investment in a long-term. Careful attention to the design and tracking of financial measures can help her prepare for the transition to an earnings-driven company.
 The CEOs don’t help the problem. Many of my CEO clients highlight the value of honest feedback from their coach. Yet they complain about employees who disagree with them, just don’t “get it” or don’t have enough information “to understand the real issues.” In a coaching call, they can hear feedback and consider it. At work, they treat disagreement as dissension, and then wonder why everyone’s a “Yes man.” back
 There are dozens of team effectiveness surveys. You can start by checking out http://www.cambriaconsulting.com,http://www.ccl.org, and http://www.pfeiffer.com.back
Pitfalls and Solutions for the CEO
A CEO can tank a company by not understanding their duties, or failing to set up good measurement systems. But it’s also true that the job itself can screw up the person, as well. It’s said that power corrupts, and few positions are more powerful than CEO. While the USA may be a democracy, our companies are legal dictatorships with the CEO calling the shots(1). While she may be having a great time playing Boss, the position may be taking a very human toll.
It’s all too easy for the CEO to become a …; jerk(2) …; without realizing it. They can forget—if they ever knew—what it was like to have a boss. They are free to ignore feedback that they don’t want to hear, and no one will call them to task for it. They can bypass the chain of command when they want to meddle. They can give themselves raises and genuinely believe they deserve it. And most dreadfully, they can forget what it is like to be “one of the little people”:
I have to leave early today.
To pick up my kids from daycare.
Oh… (looks genuinely perplexed) Why don’t you have your nanny do that?
I don’t have a nanny.
Oh…; wanders away with a mildly confused expression
The worker was an incredibly productive person. She worked harder than the CEO, got more done, yet couldn’t have afforded a nanny if her life depended on it. The CEO didn’t intend to be a jerk, but his lack of empathy didn’t win many supporters.
A CEO can become arrogant by externalizing blame
Having no day-to-day accountability for her actions can also turn a CEO sour. When things go wrong, she can blame everyone around her without facing her own shortcomings. “My employees just don’t get it,” proclaims the CEO, never thinking for a moment that she is the one who hired them. Did she hire incompetents? Or has she failed to communicate goals consistently and clearly? “Market conditions have changed.” she declares. A nice excuse, but isn’t it the CEO’s job to anticipate the market and position the company for success under a variety of scenarios? Without someone to keep her honest, she can gradually absolve herself of all responsibility.
Believing in a title can lead to overconfidence
Arrogance also threatens a CEO. “Because I am CEO, I must know the business better than anyone else.” It has been said, but it just isn’t true. No CEO can be an expert in all functional areas. A CEO who is doing her job is spending time with the big picture. If she knows the details better than her employees, she’s either hiring the wrong people or spending her time at the wrong levels of the organization. It’s appropriate for a CEO to manage operations if absolutely necessary, but she should quickly hire good operational managers and return to leading the whole business.
If she also comes to believe that the CEO title grants infallibility, watch out. Even the Pope is only infallible a couple of times each century. But CEOs can reinforce their delusions of grandeur by giving themselves higher salaries (surely she deserves it! After all, salary benchmarks show how underpaid she is) and more perks. Then when layoffs come, the CEO wants applause for having the moral strength to make “hard choices,” quietly overlooking how her own poor decision making led to the need for layoffs.
CEOs can stop learning well
Of course, once infallible, there’s no more to learn, and a CEO may quietly stop learning. Without daily oversight and high quality feedback on how she does her job, she can mistakenly believe her actions lead to success. In reality, she may be doing the wrong thing, but her staff may be working around the clock to cover for her.
Furthermore, sins of omission aren’t penalized. A CEO who does an adequate job, but far less than she could/should have done—goes unnoticed. In hindsight, XYZ Software(3) could have had a $1 billion market niche, and gone public with a valuation of tens of billions. Instead, it stuck to one product, had little understanding of its markets, and ignored competition. Yet it still went public in a $300-million IPO. Was management penalized for a lack of vision and market responsiveness? Hardly! The top managers walked off with $60 million apiece, reinforcing the notion that they had done a great job. Yet with a slightly grander vision, the company might have been 10 or 100 times its size.
Setting vision is the CEO’s job, but nothing tells her if her sights are too low. She isn’t penalized for missing the grander vision. Such sins of omissions are a CEO’s worst enemy. She can be lulled into mediocrity by not knowing what would have been possible. The four-minute mile was considered impossible…until Roger Bannister ran it. Now, it’s commonplace. Likewise, a CEO may limit herself by not realizing she can do her job better.
Though salary benchmarks are common, performance benchmarks are surprisingly rare. Quality learning demands a CEO benchmark herself against other superb CEO’s. Her central learning question is not “are you doing a good job?” but “are other CEOs doing a better job and if so, how can you learn to measure up?(4)“
Footnotes for part 3
(1) Ok, ok. Technically the Board of Directors has hire/fire authority over the CEO, but the Board can’t control day-to-day operations. And while there are certainly boards that replace inept CEOs, it takes sustained incompetence over a long time to move a board to action. So for practical purposes, the buck stops with the CEO. back
(2) Her employees may use less diplomatic terms. back
(3) Names are changed to protect the innocent. back
Coaching tips to stay sane and skillful at the top of the heap.
These coaching assignments will help an executive avoid some of the pitfalls of the CEO job. They are simple, easy, and won’t take much time. They’ll help a CEO stay connected with workers, keep herself humble, and increase her learning while becoming more successful. The suggestions strive to be quick and easy to do, while still producing real results.
Make Space to Practice These Assignments
Set aside 5 to 10 minutes, daily, to developing as a leader and human being. This will be the time you think about the below topics and set your mind for the day. Schedule the time if necessary. Just make sure that you do what’s right for your growth.
Pace yourself. Life is long. Adopt these suggestions one or two at a time, and practice until you make them your own. Then move on. Forcing won’t help; this is about developing at your own natural rhythm. Do one assignment for a few weeks, then move on to another. Keep the ones that work for you and drop those that don’t.
Staying connected with “the little people”
Cultivate an attitude of respect—your respect for them. The “little people” are the ones turning your vision into reality. Meditate on this for a few minutes and ask yourself whether you can their jobs as well as they can. If you can, then you’re not hiring the right people—go change that! Otherwise, once a day, go talk to one of your low-level employees—someone more capable than you in their area of expertise—and learn from them. Choose a different person each day. Get as close to the front line workers as possible.
Listen with an open mind and learn. Learn about their job. Ask what works for them and what doesn’t. Above all, listen to their comments without judgment. Your goal is to connect with their experience of the world, not impose your own. Learn about their life. Find out what motivates them. Why did they come work for you instead of somewhere else? Simply by spending a few minutes understanding their life, you can greatly increase your appreciation of how they’re different (and similar!).
Share your vision and job with them, from a position of service. Pretend that your job is to make this person a success. Ask them how their job fits into the work the company does. If they don’t know, take on the responsibility of helping them understand how their job links to the vision. Clarify any confusion they may have about where the company is going. And ask them what you can do to help them succeed at doing their best. Then do it.
Acknowledge, often! Without your employees, your dreams and plans wouldn’t amount to much. Take every available opportunity to acknowledge the contribution of those around you and give them credit, especially in public. Feedback is rare in most companies, and positive feedback is rarest of all(1).
“Get” that it’s all your responsibility. When things don’t go the way you want, take responsibility—whether or not it’s your fault. The mindset of responsibility will put you in a much more powerful place than the mindset of blame. Regularly review circumstances asking, “What could I do differently (or stop doing) to make a positive difference?” Identify the action and then take it. You’ll be surprised how much more power you have over externalities, operating from responsibility rather than blame.
Gather honest advisors to hold you accountable for your behavior. Sometimes a Board of Directors will give honest feedback, but they are removed from your day-to-day behavior. Actively solicit feedback from third parties: friends, peers, associates. Share your issues and how you’re handling them, and ask for an honest assessment. Everyone in a company is accountable to someone for their behavior, except the CEO. Make yourself accountable as best you can.
Identify your limits. Ask, “can someone else in the world do my job better than I am currently doing it?” If the answer is Yes, seek out that person and ask for their guidance in getting better. If the answer is No, validate that answer by asking your advisors, competitors, suppliers, customers, and employees. Many companies have crashed and burn because they believe they were the best, for no good reason but pride and ego.
Create measurable performance criteria for your executive team, including yourself. Make sure people within the organization know your goals, and know what you can be counted on to do. Hold yourselves accountable. If you don’t meet your goals, withhold your bonus, take no raise, and treat yourself exactly as you would treat an employee who missed their targets. It sends a powerful message to the company that you’re serious about performance.
Ask your direct reports, your Board of Directors, and anyone else you work with for feedback a couple of times a year. You can use a 360-degree feedback process or simply ask in an e-mail. It’s a lot easier to hear feedback on your performance if you’ve explicitly asked for it.
Videotape yourself receiving bad news. Watch the videotape and decide whether or not you would want to work for that person. If the answer is No, learn to chill when you hear bad news.
Study excellent CEOs. Call a CEO you admire and invite them to lunch. Exchange tips and adopt tactics that others have found useful. Read books like First, Break All the Rules, which are broad-based studies of habits of top-performers. Adopt at least one new habit a month.
Create systems for gathering feedback. Interview customers, competitors, analysts, and others in your industry to know how your company and products are perceived. Make sure you’re gathering feedback that will disconfirm your beliefs about the world, as much as confirms it. For example, if you think you’re #1 in your market, don’t just ask customers why they like your products. Ask what other products they use, and how your products fall short.
Spend time learning about the fundamentals of a CEO’s job:
Setting strategy. The strategy and vision for the company determine where everyone will focus their efforts. Find a vision and strategy and use it to align your entire company.
Creating the corporate culture. Your culture will determine what people do and don’t try, who will stay, who will leave, and how business will get done. Culture starts with you. Decide how you want people to act and start modeling the behavior publicly.
Capital allocation. Every dollar you raise and spend should produce more than $1 of return for the company, or it’s a waste of money. Learn how to make these judgements.
Hiring and Firing. The job of executives is primarily team and culture building. Hiring and firing are must-have skills. Read, take classes, and review past hiring successes and mistakes. Do whatever you can to hone your abilities.
Raise the Bar
Hold yourself to higher standards next year than you did this year. Challenge yourself to learn to get more done with fewer hours and fewer resources while creating a more balanced life for yourself.
These are just a few of the things you can do to increase your chances for success as a senior executive. I also believe in working with a coach to identify and overcome (or compensate for) blocks in your performance. Success can be had with many different skill sets. The more you learn about yourself and your capabilities, the better you will be able to shape a job that works for you. The more you learn about the capabilities of those around you, the better you will be able to build teams that produce spectacular results.
Do Great Things!
Footnotes for Part 4
(1) Social psychology has shown that rewarding desired behavior is far more effective than punishing bad behavior or non-performance. For reasons that aren’t entirely clear, our culture has evolved around using punishment as the main way of controlling behavior. Unfortunately, punishment doesn’t work very well. Interestingly, animal trainers have known this for years. For an excellent book on the subject, check out Don’t Shoot the Dog by Karen Pryor. back
I just returned from Black Rock City, NV, better known as Burning Man. Burning Man is an annual event where 70,000 artists, engineers, performers, and makers descend on the Black Rock Desert in Nevada. In one week, they build and inhabit a city made of interactive art. Then they dismantle it and “leave no trace.” They take every bit of refuse home with them, leaving the desert the way they found it.
You know what’s even more amazing? It’s all done by volunteers. Think about that: 70,000 people, paying to attend the event, cooperatively pitching in to build and run a city. (Yes, it’s the size of a city. I once thought it was just called that. Nope. It’s a city.)
Burning Man started as a party with a dozen people on Baker Beach in 1986. As someone who loves growing organizations, it fascinates me. So many organizations struggle with growth. How did Burning Man scale from a beach party to an actual city?
Scale requires different people.
The people you need to run a small organization are different from the people you need to scale. In a small organization, everyone knows everything that’s happening. People can pitch in as needed. They may still have different jobs, but if the situation warrants, you might ask the accounts receivable person to handle a customer service from someone they know. You need generalists.
As the organization grows, jobs shrink. The original crowd at Burning Man handled all aspects of what was, then, basically a camping trip. Each person would be part of choosing where tents would go and how things would run. Generalists make the small event run.
With a city-sized event, just laying out the street grid requires dozens of people. Each person will spend every day, all day planting flags at the corners of streets that will later guide the city construction. The best people for the job are those who enjoy focusing on this one task, and doing it superbly.
Scale requires uniform processes.
When you’re small, you can get away with everything being ad hoc. If Ozzie Obstacle (the most annoying of your 12-person party) is pitching their tent in the wrong place, you can yell over, “Hey, Oz! Move your tent ten feet to the right!”
When tens of thousands of people are pitching their tents, you can’t just do everything by the seat of your pants. If you yell “To the right!” while someone yells “To the left!”, poor Oz’s head will explode. And at Burning Man, that could mean literally.
Getting large requires that people be able to coordinate at a distance. Doing the same things, the same way lets people coordinate when the ad hoc approach no longer works.
Scale requires explicit process.
It’s not enough for processes to be uniform. People have to know them, which means they need to be documented and communicated. Sometimes this is done informally, through mentorships or apprenticeships. But often, it’s done via classes, checklists, and explicit instruction.
With 70,000 people constructing a city, the behind-the-scenes organizations (the Rangers, the Department of Public Works, camp Placement) not only have uniform processes, but they have extensive training and reference resources to teach those processes. They have classes, certifications of skill levels, Wikis, and gatherings to explore and deepen the shared understanding of what gets done and how.
When your organization is successful, you’ll reinvest for growth. But pay attention carefully to the changes that scale requires. You’ll need to change who you hire, how they do their jobs, and how they get trained. It changes the nature of the work, but if done right, you’ll be laying the foundation for great success.
The economic playing field has gotten complicated enough that it’s foolish to step on the field without some idea of how you’re going to win. In sports, you have a playbook, which lists the plays you can make. In business, we call these “tactics.” You also need a strategy, a way to combine those plays so you win the game. While it’s possible to win without a formal strategy, having a good strategy can often give you a leg up. You’ll form the best strategy by looking both inward and outside.
For example, you may have invented an electric car that you sell to shipping companies. That’s given you expertise in creating electric cars, and you have expertise selling to shipping companies. You can grow your business by concentrating on bringing your technological expertise (electric cars) to new markets. You can also grow your business by developing new products to sell to shipping companies. In the first case, you’re organizing your strategy around your technology. In the second, you’re organizing around a particular set of customers. Which you decide to do is entirely up to you.
When I worked at Babson College in the team formulating the strategy of the school, Babson was ranked the #1 school for entrepreneurship, world-wide. This gave us an explicit decision: do we ignore the ranking, and (try to) build some other brand for the school, or do we concentrate in entrepreneurship. Babson chose to continue building on entrepreneurship. It didn’t have to, however. Making the choice explicit led to initiatives that would never have happened without that self-examination.
Look outwards to the environment
Great resources aren’t enough. You might have the biggest bank account in your industry, but if your competitor also owns your industry’s largest distributor, you’re going to get creamed. Your landscape determines which (if any) of your resources can help you win.
The most famous model for understanding the strategy landscape for crafting your business strategy is Michael Porter’s “Five Forces” model. My favorite is a later extension of Porter’s model, the “value net,” presented in the excellent book Co-opetition by Adam Brandenburger and Barry Nalebuff. With a value net, you look at the world around you: competitors, substitutes, suppliers, customers, complementors, and barriers to entry. You design your strategy taking into account what each part of your value net brings to the table, and how that meshes with your business goals.
For example, your industry might be dominated by two or three suppliers. That gives the suppliers tremendous negotiating leverage, and the ability to cut you out of the market if you don’t agree to their demands. Furthermore, it makes your business vulnerable if one of the suppliers encounters a disruption, since you don’t have many alternatives.
Good business strategy sometimes happens by magic, but you don’t want to bet the farm on Tinkerbell being in the right place, at the right time. Formulate your strategy by deciding how you can best deploy your internal resources given how your industry’s value net looks today. Times change quickly these days, and an integrated approach to keeping your strategy current will keep you at the top of your game.
How ICOs and Cryptocurrencies Work for Entrepreneurs and Investors
With Bitcoin and cryptocurrencies all the rage, I was recently invited to participate in an ICO (an “initial coin offering”). Warren Buffett made his fortune by limiting his investments to businesses and investments he understood deeply. That seems sensible, so I’ve been delving into the ICO world to understand if it’s for real, if it’s a scam, or if it’s something genuinely new.
Much to my surprise, it doesn’t seem to be a complete scam. ICOs are a fund-raising play for a business. Coin-based entrepreneurship has aspects of equity, and aspects of … something new. It decouples the value of the organization from profit. If it’s sustainable, coin-based organizations could become a way to create markets whose bottom line is genuine societal value. The “triple-bottom line” could be an actual market reality. That’s exciting!!
Or, it could turn be unsustainable, and a fancy way for unskilled or unethical entrepreneurs to walk away with lots of investor cash and no obligation to do anything with it.
As you’ll read below, while the ICO mechanism has been invented in the context of crypto currencies, there’s no inherent reason that this has to be done with cryptography. The same structures could be put in place in the physical world, without needing to buy into blockchain or virtual currencies.
What I’ve Learned so Far About ICOs
Here’s my current understanding of “coins” and initial coin offerings (ICOs). While the concepts are being developed in the context of crypto currencies, as I mention below, they can be (and have been) implemented in ways that are totally independent of crypto, or even computers.
PLEASE CRITIQUE AND COMMENT! This understanding is about two or three hours old, so it’s my very first attempt to understand.
ICOs make a different bet than stock investments
The ICO model is fascinating. Instead of betting on the success of a company, as you would with a traditional corporation, you’re betting on the creation of a market. The entrepreneur is then pitching their ability to create a market for the coin, which can be done in many different ways, depending on the company issuing coins.
This means that an ICO has two cases to analyze. While a traditional startup only needs to make a business case, an ICO needs to make a case for the creation of the coin market, and a case for the success (however that’s defined) of the organization being funded with the ICO.
There must be a market-making mechanism
The entrepreneur needs to present a compelling case:
that their endeavor can create a market
that the market created makes sense (that there’s a reason want the coin)
that there’s a way coins are exchanged for dollars or other value that is valuable enough that people will want to trade the coins
The primary function of the business being financed with the ICO is to create a market for the coins, rather than to make an economic profit. For example, an organization issuing an ICO may not do anything on an ongoing basis, as long as they can kick-start the market for their coin.
(There’s no inherent reason that any of this has to involve blockchain or crypto, by the way. You could be issuing frequent flyer points that are tracked in a spreadsheet in an “IFFPO” and it would basically be the same thing.)
For example, an airline could simply rename their frequent flyer points as “coins” and sell a bunch of those coins rather than issuing stock. People would want the coins because they could be exchanged for flights. If the only way to fly were by paying in frequent flyer points, then the market for the points would be created by anyone who wants to travel by air. Frequent flyer points would then be convertible to and from dollars based on the price in coins the airline charges for a flight, and the overall market demand for air travel.
But the airline would not rise and fall based on its ability to generate a profit; it would rise and fall based on its ability to keep the market for FFCs boosted. It would then presumably pay its employees in FFCs, which they could convert to cash.
Coin-based financing may resemble ongoing equity financing
This scenario resembles a company that is financing itself on the strength of its equity, by selling stock to pay any ongoing expenses, rather than financing itself on its underlying business fundamentals.
For an airline, which needs to pay salaries and has high ongoing expenses, it probably wouldn’t work. But as Amazon shows, a company can consistently generate lackluster business results and have its “coins” (shares of AMZN stock) continue to be valued quite highly.
Coins can fund one-time projects as long as they create ongoing markets
The thing about coins is that the organization that did the ICO might not be an ongoing business at all, but a one-time fund raise, as long as it kick starts the market. For example, if the coins created are done so as the only currency that can be used to access some resource, like time on the Hubble telescope, then one organization can create the coins and the protocol that requires them, while completely separate organizations accept the coins and thus generate demand for them.
[One historical example that comes to mind is the currency of green stamps, which survived for decades but eventually failed. An ICO could be likened to an Initial Green Stamp Offering.]
Coins dilute … the market
Coins are like equity in that issuing additional coins dilutes the value of the coins already in circulation. The one ICO I’ve seen closely puts a cap on the number of coins that can ever be issued, to preserve the coin scarcity. That makes sense for an ICO that finances a one-time, transient organization. But if coins will be used, rather than profit, as an ongoing source of an organization’s funds, then having a hard cap on the number of coins will put a cap on the total amount the organization can raise over its lifetime.
In the social enterprise world, coins could be issued to finance social good, as long as there were some mechanism to drive the demand and market for the coins. Rather than having social enterprise rely on constant begging, a social enterprise could drive demand for their coins by striking agreements with businesses or other organizations to use the social coins as a currency. To fund a social enterprise for years on coins, however, would require a substantial initial ICO or the ability to keep issuing coins when funds are needed, so the coin used for the funding probably shouldn’t be capped.
It’s fascinating! And I have no idea how to value a coin, or whether this will prove to be sustainable in any meaningful way.
Often, a company’s business model constrains what it can and can not do. That, in turn, gives it strengths and weaknesses. Learning to spot business models, and do quick back-of-the-envelope calculations on them, will help you become a ninja at spotting opportunity.
When you see a hot pretzel vendor at a ballgame, ask yourself: what’s that person’s business model? How do they make money? How much product or service do they need to sell to make that money? How much does it cost them to make it? Is it a good business? Hot pretzels being one of my favorite foods as a college student, I was astonished to learn that the hot pretzel vendor cleared a six-figure income.
When you pass the neighborhood bookstore, ask how they stay in business? What’s their business model? Why does it work for them, and not for the bookstore down the block that went out of business five years ago?
When you use Facebook, ask and consider: what’s their business model, and what does that imply about the actions they’ll take? Or eBay? Or Uber?
Business models give policy insights
In a recent Facebook flame war, we were discussing different kinds of health insurance systems. Understanding the business model of an insurance company might give you some insight into their incentives and potential actions:
Health insurance companies make money through underwriting profits (premiums minus payouts and expenses) and investment income on the premiums they collect.
Insurance must ALWAYS be priced higher than needed to pay out because all that administrative overhead, salaries and buildings, needs to be covered.
Furthermore, a for-profit insurance company wants to grow profits. That means raising revenues and/or cutting costs.
How can they cut costs? By streamlining operations and finding ways to avoid paying out on existing policies.
How can they raise revenues? By increasing premiums above what’s necessary to pay out on their pool of premiums.
Now, when we formulate our own opinions about healthcare policy (which we all do, rather than simply parroting our favorite pundit, right?), we can at least understand that the business model of insurance companies constrains their actions.
Every time you interact with a business today, ask yourself:
How do they make money? Where does their cash come from?
In order to make that money, how much do they have to spend, and from where?
What are the levers that their business models allows? What are the risks and benefits of their model?
Pretty soon, you’ll discover you can spot opportunities to bring business models to places they’ve never been used. Often, you’ll discover there’s a reason they weren’t used there. But other times, you’ll find that a shift in business model just might make you the next PayPal.
If you want to read more about [my thoughts on the insurance example implications, keep reading…
Health Insurance Business Models Drive Policy
IMPORTANT DISCLAIMER: This is intended as an example of how understanding a business model leads to confidence in predicting the behaviors of people who use that model. This post reflects my layman’s understanding of insurance business models. If anyone knows better, please please correct me.
For you gentle readers who also don’t know the inner workings of the industry, read this to understand how a business model leads to predictions of behavior. Do not read this for accurate information about the insurance industry.
For-profit health insurance companies must overcharge
I’m guessing that competition will not produce efficient health insurance. Health insurance companies make money only two ways: through underwriting profits (premiums minus payouts and expenses) and investment income on the generated float.
Insurance will always be priced higher than needed to pay out because all that administrative overhead, salaries and buildings, needs to be covered.
Furthermore, as long as we have a market that defines “healthy” profits as profits that grow yearly, there will be ever-increasing pressure to raise profits. That means raising revenues and cutting costs.
You can only cut costs so far on the admin side. But you can reduce your payouts by writing ever more complicated policies that in fact cover less and less. You can also challenge payouts, make the reimbursement process deliberately more cumbersome, lower the ceilings of what you will cover, etc.
And of course, regulation caps permitting, you can always raise revenue by raising premium prices.
Every year, due to the market expectation of continually growing profits, all these forces will come into play. (Premium prices will rise, and people will blame Obamacare or the lack of Obamacare or greed or whatever. It’s just the way growth-oriented markets work.)
Any for-profit insurance company will feel all those forces as a simple matter of doing business. So any for-profit insurance company in a competitive market will be pressured over time to do these things.
Even if their investment income is reliably positive, they can’t control that nearly as quickly, easily, and reliably as all these other forces. And if the company is heavily invested in derivatives (which Warren Buffett calls “Weapons of Mass Destruction”), well, at some point there may be a “correction.”
There are competitive pressures at play, as well. Price wars. When a competitor lowers premium prices below the actual rational value for a given policy, a company is pressured to match that pride and write unprofitable policies in order to compete … resulting in pressure to make up profits from one of the other sources1.
That’s why private mutual insurance companies are a good thing. They still have these pressures, but at least the policyholders own the company so the company’s goals are more aligned with the goals of its members.
This is one source of Warren Buffett’s wealth. When he acquire an insurance company, he gives them permission to stop pricing policies below expected payout values, even if there’s a competitive price war going on. ↩︎