Letter to The CEO - Managing for Value
May 27, 2012
Managing for value is your primary mission.
That may sound self-evident, but it’s easier said than done. In our work with senior people in a number of companies, we see a clear fact emerging: the current business model will soon be invalid. As each firm renews and renovates its business model, the job will get done only in an atmosphere of innovation.
This article suggests a few dimensions of regenerating the business model for you to rethink. In our experience, these elements are essential if you are going to make it happen.
The value of any firm is the sum of the internal and external relationships of its people: their quality, strength, and diversity.
Acknowledging this statement will direct you to new frontiers you will find worth exploring.
Chapter 1: Corporate Governance Phenomena
Entire management practices nowadays are aimed at overcoming corporate governance phenomena: lines of reporting, financial statements, the budgeting process, the capex approval process, and the board of directors - to mention just a few.
When we distill the causes of corporate governance practice, we arrive at two basic human behaviors: (1) the agent phenomenon and (2) the free riders phenomenon.
There’s nothing new about the fact that we are endowed with two eyes, adding depth to our vision. This is exactly how we ask you, dear CEO, to look at each managerial event: equipped simultaneously with both (1) the agent lens and (2) the free rider lens. When you do so, you will be amazed by the quality and sharpness of the managerial picture you gain.
Assuming we agree that most corporate governance phenomena are devoted to dealing with the agent problem and the free rider issue, there are three ironclad but simple rules we must follow if we are to cure this condition:
(See our previous article at MIX.Managing in the 21st Century)
Chapter 2: What is the Real Value of the Organization?
The knowledge economy and Management 2.0 lead us to new insights concerning the value of an organization. We argue that the value of any firm is the sum of the internal and external relationships of its people: their quality, strength, and diversity. To test this premise, let’s consider two imaginary cases: (1) the case of the fire and (2) the case of the mass resignation.
Dear CEO: your company’s industrial plant was razed to the ground last Friday night. A huge fire demolished the entire infrastructure and all your machinery. Thank God there were no casualties. The damage is equivalent to the plant’s entire book value. Question: how long it will take you to relaunch the company’s manufacturing activity? Our assumption is that, by making wise use of subcontractors, you will be back on your feet within a few months.
On Friday night as they were leaving work, all the employees of your company left you a message: “Bye-bye, dear CEO - we are no longer working for you. We quit.” There’s nobody left, not even your loyal secretary. Question: how long will it take you to recover from this catastrophe? Our assumption is that you will never recover: the entire body of the company’s knowledge and knowhow will have been lost.
These two examples demonstrate that the real value of an organization is embedded in the mind and soul of its people. Book value (tangible assets) is worth nothing. Intangibles are the story.
Let’s take a look from another perspective: Stern Stewart, the consultancy firm, defines the difference between book value and market value as MVA: Market Value Added. Assuming that the difference is positive, this means that the managers have created value. In the case of a negative difference, the managers have destroyed value. So we might also define MVA as Management Value Added. This means that the managers have brought in a certain amount of money (“cash in”), managed the transformation process wisely, and created a premium on the initial investment. If the shareholders then sell the company (“cash out”), the premium can be monetized.
The Intangible Components:
The MVA (intangible) can be broken down into the following components: R&D, Brand, Human Capital, and Social Capital. Each of these components represents an item that accountants usually view as a cost rather than an investment. We do not need to convince you that these are among the ongoing concerns of the organization over the long term. The first three (R&D, Brand, and Human Capital) are already an accepted part of current managerial thinking. The fourth (Social Capital) will be elaborated in the next chapter.
Chapter 3: The Cohesiveness Phenomenon
Social Capital is the sum of the qualities and uniqueness of the entire workforce. It represents the ability of the organization to fuse and consolidate shared knowledge and relationships, both within the organization and relative to the outside world.
One can look at the organization in terms of the organization chart format: hierarchy, lines of responsibility, and lines of reporting. This perspective, however, says very little about the real competitive advantage of the firm. Ronald S. Burt, in his book Brokerage & Closure: An Introduction to Social Capital, observes the organization from a completely different angle:
External brokers - people who have many quality connections with the outside world;
Internal brokers - people who, regardless of their position, possess great diversity of knowledge and an understanding of the internal capabilities of the workforce.
These two types of brokers offer huge potential for the organization. The problem is that most senior staff consider them “troublemakers.” They can be difficult to manage - unpredictable, uncontrollable, hard to steer - and they insist on having a say about everything. In short, let’s get rid of them.
That would be a huge mistake, because these brokers are the main components of the organization’s DNA. Sure, there may be a few “rotten apples” that put the entire fabric of the organization at risk. We urge you to examine these people carefully, then encourage the good and get rid of the bad.
When you face a turning point down the road, it is these people who will bring you the best ideas and help move the company forward. Why? Because these brokers have acquired many insights and capabilities that nobody else recognizes as valuable assets. They are the core strength of the fabric of your organization. The brokers love changes. Their readiness for innovation is enormous.
Now, let’s explore how we can tie it all together.
Chapter 4: The HACK: the Avenue of Internal Governance
In their paper, “The Internal Governance of Firms,” Acharya, Myers, and Rajan describe a new way to govern the firm in light of the agent phenomenon. They claim that there is a lack of conventional governance (External Governance) to encourage the CEO to think and act for the long-term benefit of the firm. The time horizon of the CEO is by nature too short. After all, he can see many other opportunities out there. By contrast, the professional people (in our terms: the core people) see their horizon in a much longer perspective. Hence, the recommended remuneration scheme for the CEO should not foster short-sighted goals. It should instead be based on the performance of the core people who spend their time on long-term goals.
The program for implementing this method has been fully developed; however, for the purposes of this article, what matters is the principle: the entire remuneration schedule should be based on the long-term perspective of the organization.
The comprehensive concept we suggest here is designed to meet the challenges of the 21st century.
Internal governance, or management from within, is synonymous with managing less. Rajan and Myers put forward the idea of compensating the CEO according to the performance of the core people.
Looking at the managerial landscape through the two lenses of agents and free riders will provide the management team with a better understanding of what they see.
Three practices can help to mitigate the reality of agents and free riders:
This reflects the immeasurable importance of the intangible: let people manage themselves. From the corner-office perspective this will no longer be a problem: the people will feel like and act like owners.
The vital step is to recognize that the true value of the firm lies with an intangible: people. But recognition is not enough. The unique core people, the brokers, should be discovered and encouraged. Internal and external relationships should be developed by supporting these brokers in their efforts.
To enhance this concept we recommend the full-scale practice of internal governance. Base the compensation scheme on the performance of the core people. This will steer management practices as a whole toward a much longer view.
This is the essence of managing for value.
Managing for Value
Managing from Within