Improving the Odds of Success for Corporate Transformations
Looking back upon my long career, one of the major factors shaping my views of strategy and innovation are the powerful transformational forces that I saw buffeting the IT industry over much of that time. It’s frankly sobering how many once powerful IT companies are no longer around or are shadows of their former selves. The carnage might be more pronounced in the fast-changing IT industry, but no industry has been immune. It’s all part of what Joseph Schumpeter called creative destruction over 75 years ago, - “the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”
For a startup a transformative innovation is all upside, an opportunity to take-on established companies with new products that offer significantly better capabilities and/or lower costs. Startups hope that their compelling new offerings will help them establish a foothold in the marketplace and, over time, become leaders in their industry.
But change is often difficult for established companies. Over the years, they’ve amassed a number of valuable assets and extensive organizations. Already consumed with managing their existing operations, - e.g., products and services; supply chain and channel partners; sales and marketing; revenues, profits and cash; - they may see a transformative innovation as more of a threat or distraction than an opportunity.
Darwinian principles seem to apply in business almost as much as in biology. The similarities between business and biological ecosystems was examined in The Biology of Corporate Survival, a 2016 paper published in the Harvard Business Review (HBR) by Martin Reeves, Simon Levin, and Daichi Ueda.
After analyzing the longevity of more than 30,000 public US firms over a 50-year span, the authors found that companies are disappearing faster than ever before. “Public companies have a one in three chance of being delisted in the next five years, whether because of bankruptcy, liquidation, M&A, or other causes. That’s six times the delisting rate of companies 40 years ago.”
The paper noted that “companies are dying younger because they are failing to adapt to the growing complexity of their environment. Many misread the environment, select the wrong approach to strategy, or fail to support a viable approach with the right behaviors and capabilities.”
Corporate mortality is further exacerbated by three broad trends: a more diverse, harsher and less predictable business environment; the faster pace of technological innovation which forces companies to adapt to new business cycles at about twice the rate as 30 years ago; and the increasing integration of business ecosystems and global markets, which while good for economic vitality, adds to the risks of system-wide shocks.
The subject was further examined in The Truth About Corporate Transformation, - published earlier this year in the MIT Sloan Management Review by Martin Reeves, Lars Fæste, Kevin Whitaker, and Fabien Hassan. The paper took an in-depth look at the risks inherent in corporate transformations and suggested concrete steps that companies should take to increase the odds of a successful transformation.
The authors developed methods for identifying companies with a demonstrated need for transformative programs, including the analysis of financial and nonfinancial data of all U.S. public companies with $10 billion or more market cap between 2004 and 2016. Their analysis identified more than 300 companies across different industries with a demonstrated need for fundamental change because their total shareholder return had deteriorated over 10 percentage points or more over two years relative to the industry average.
Patterns of Transformation
“Considering the increasing pace of technological change and volatility in many industries, the patterns suggest that the need for transformation is rising, while the chance of successfully achieving it is falling,” was the study’s overriding conclusion. But surprisingly given the stakes involved, there’s been little research on the design and execution of corporate transformations. Corporate transformation are often guided by anecdotal beliefs rather than by empirical evidence of what has and has not worked in the past. Other key findings include:
Leaders must be ready to transform their companies. At any given point during the 12-year study period, a third of large US companies were going through a severe deterioration in total shareholder value, - the leading impetus for transformative projects.
Successful recovery is the exception, not the rule. Only about 25% of the companies in the study were able to arrest their decline by 2012 and outperform their industry average over the long run; 30% were able to do so in 2001.
Both the need for transformation and its associated risks were higher when digital disruption was involved. The need was strongest in the fast changing technology industry, with over 40% of companies suffering severe shareholder value deterioration. In addition, technology companies were among the least likely to succeed in their corporate transformation.
The more severe the downturn, the worse the results. Over 95% of the companies with the most severe downturns, - defined as a decline of over 20% of shareholder value, - became stuck at a lower level or continued to decline further. Leaders must recognize the performance deterioration in their companies and act before it’s too late.
Patterns of transformation differ across industries. Companies in industries going through rapid change (37%) were more likely to require corporate transformation than those in more stable competitive environments (30%). Their transformations were also more likely to fail.
Factors for Transformation Success
Based on the empirical evidence, the authors suggest several factors that will help companies improve the odds of succeeding in their transformation.
Costs cutting and positive investor expectations are key to success in transformations. While cutting costs is necessary in the early part of a transformation, it’s not sufficient. To be successful, companies must regain the confidence of investors with credible operating plans.
Revenue growth is the key driver of long-run success. Successful transformation cannot focus solely on short-term operational improvements. To be successful in the long run, a firm must articulate a new strategy for growth that challenges the previous business model that got the company in trouble.
Success requires a long term strategy supported by adequate R&D investments, especially in rapidly changing environments. Companies with an above-average long-term orientation in their strategic and R&D investments outperformed those with a below-average orientation by almost 5 percentage points.
New, external leadership improves the odds of transformation success. Almost 25% of the companies involved in a transformation program changed CEOs, compared with almost 19% of all companies in the study. New CEOs performed worse than incumbent CEOs in the first year of recovery. But over the long term, companies that changed CEOs outperformed those that didn’t, with external hires performing somewhat better.
Formalized transformation programs perform better on average, as long as they have sufficient scope and scale. In the short run, formalized transformation programs boosted investor confidence. In the long run they led to sustainable improvements in the business. The most successful programs were ambitious, with a scope of at least five years.
When used jointly, these various factors yield an additional impact, - one that is greater than the sum of their individual parts. “This suggests that the optimal playbook for transformation should involve combining several success factors, such as reorienting strategy for the long term, investing in R&D, redesigning the leadership team, bringing in external perspectives, and formalizing the change program.”