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The Five Paths to Business Ownership

There may be “50 ways to leave your lover,”2 as the song states, but there are only five ways to get into small business management:

?          You may start a new business. ? You may buy an existing business. ?        You may franchise a business. ?    You may inherit a business. ?            You may be hired to be the professional manager of a small business.

Although everyone gets into business by one of these five paths, the specific details of going into business are unique to each person.3 Start-ups may be deliberate, well planned, and financed. On the other hand, many start-up businesses “just happen.” Often a compelling hobby slowly morphs into a profitable business, or a chance occurrence leads to a new busi- ness venture. Purchases of existing businesses may occur in any number of ways, from cash purchases to “earn-outs” in which the business is bought over a period of time with money earned from the business. Franchises may range from “turnkey,” in which every part of setting up the business is handled by professionals, to those in which the only thing that is franchised is the right to use the business name. Some business managers work their way to the top from a beginning part-time employee position. Other professional managers are recruited to become the chief executive. It is common for hired management to use leveraged buyouts or employee stock option plans to purchase the firms for which they work. This chapter examines the details of these paths of entry into small business: start-ups, purchasing, franchising, inheritance, and professional management.

Starting a New Business

Starting a new business is at once the most risky path into business and the path that promises the greatest rewards for success. The success rate of start-up businesses is a matter of some controversy. As we note in Chapter 1, while the Small Business Administration (SBA) reports that 66% of new employers survive two years or more, 50% survive at least four years, and 40% survive more than six years,4 those businesses that get help last much longer. Eighty-seven percent of start-ups that begin in business incubators are still in operation five years later,5 and the survival rates for students from entrepreneurship programs and entrepreneurs seeking help from Small Business Development Centers are about twice that of businesses in general.6 Even for those who get help in starting their business, one must admire the courage and optimism of a person who chooses to start a new business (see Figure 6.1). Despite the rather high failure rate, creating a start-up is not, as some maintain, a triumph of hope over reality. Many businesses that end do so not because they failed, but because the owner took advantage of a better opportunity.7 The rewards, both financial and personal, of starting a successful new business can be most impressive.

Advantages of Start-Ups

There are many reasons that people choose to start a new business rather than purchasing an existing business, franchising, or being an employee:

start-up

A new business that is started from scratch.

buyout

The purchase of substantially all of an existing business.

LO2

Compare the rewards with the pitfalls of starting a new business.

?

A start-up begins with a “clean slate.” There are no existing employee problems, debts, law- suits, contracts, or other legal commitments that must be satisfied.

?          A start-up provides the owner with the opportunity to use the most up-to-date technologies. There are no “legacy” locations, buildings, equipment, or software that can hamper productivity. ?    A start-up can provide new, unique products or services that are not available from existing businesses or franchises. Existing businesses and franchises exist because of their success in

providing proven products and services. ? A start-up can be kept small deliberately to limit the magnitude of possible losses. A

purchased business or franchise requires immediate and constant cash flows to meet ongoing obligations.

Disadvantages of Start-Ups

Offsetting the advantages of starting a new business are several disadvantages:

?          A start-up business has no initial name recognition. An existing business or franchise has in- vested in developing its market. The brand rights can guarantee immediate acceptance of the business.

? A start-up will require significant time to become established and provide positive cash flows. An established business or franchise has built-in customers to provide immediate cash inflows.

?          A start-up can be very difficult to finance. Established businesses and franchises provide im- mediate assets, sales, and cash inflows that can be used to obtain financing for the business. ? A start-up usually cannot easily gain revolving credit from suppliers and financial institu- tions. An existing business or franchise often has lines of credit that transfer with the business. ?        A start-up may not have experienced managers and workers. Established businesses and fran-

chises provide experienced workforces, training, and management support.

Creating a New Business

The vast majority of start-up businesses are “me-too” enterprises. The business idea is simply to create another occurrence of a common business: a beauty shop, a restaurant, a bar or lounge, a rock band, a sign company, plumbing service, yard care, and so on. Starting a copycat business provides some protection from business failure. It is not necessary to define the business to the market be- cause everyone knows what a beauty shop, restaurant, or lounge provides.

On the other hand, this type of start-up can be very difficult to differentiate from other similar businesses. Often, the only competitive advantage may be the location of the start-up. This is why owners of common businesses go to so much effort to try to make a difference between their busi- ness and other, essentially identical, firms. An example is how Morton’s of Chicago and the Ruth’s Chris steak houses operate. Careful sampling of each firm’s steaks reveals no significant difference in price, quality, tenderness, size, or taste. The restaurants have similar menus and wine lists. Each, however, has distinctive interior decorating and presentation of their meals. Morton’s brings a selec- tion of huge uncooked steaks to each table for patrons to make their choices. The cooked steaks are served on oversized china plates. Ruth’s Chris provides equally large steaks, selected from a printed menu, served on plates that are heated to a high temperature to create the trademark “sizzle.”

Amy Conti, of San Antonio, provides an example of an accidental business start-up. She initially did babysitting for a few friends. When demand for her services exceeded her available time, she began having some of her friends, whom she knew to be competent, sub contract for her. She re- quired her “subs” to have advanced Red Cross first-aid certification and she closely supervised their sitting engagements. Her strict standards and ability to pay for standby sitters has made her service unique. The high reliability of her service and the confidence that parents have in the abilities of her sitters have made a business that is usually considered to be a part-time thing for the girl next door into a professional and profitable business for its founder.

The specific concept that leads to a start-up business usually comes from the experience of the person starting the business. Two-thirds of all start-ups are based on ideas from prior work experience, hobbies, and family businesses.12 These businesses are generally more likely to succeed than are businesses based on ideas from other sources. Research into the indicators of successful start-ups shows that one of the best predictors of success is the level of experience of the founders. Random events, suggestions from friends and associates, and specific education courses are the sources of only a relatively few start-up ideas.

Increasing the Odds of Start-Up Success

The probability of creating a successful start-up is increased greatly when the founder has certain attributes and when the founder takes certain actions. Doing the following things has been shown to be the most effective route to success (see Exhibit 6.1).

?          Start the business in a business incubator: A business incubator is an organization that pro- vides financial, technical, and managerial help to start-up businesses. Most incubators are asso- ciated with economic development agencies and are integrated into the community. Incubators provide access to angel investors, public grants for seed money, and technology support.

Business incubators are created to strengthen the local economy by helping create jobs through the establishment of successful small businesses. But incubators do much more than just create new jobs. They aid in the commercialization of new technologies, the revitaliza- tion of distressed neighborhoods, and the creation of wealth. The best incubators provide inexpensive office space with full-time on-site managers who can assist the entrepreneur in many ways. Incubator participants share common office services, such as telephone answer- ing, and production and copying of documents. Perhaps most important, incubators pro- vide legitimacy by furnishing the business with a location and with established business processes.

?          Take part in a mentoring program: Successful business owners and corporate executives do well by doing good. They can, by helping others, in a way repay the many people who helped them achieve success. Executive volunteers contribute their time and energy to assist- ing start-up and struggling small businesses as a public service. Because of their experience, mentors can help you avoid mistakes and make good business decisions.

?          Have a detailed start-up budget: The start-up phase is usually the most difficult time you will have in business. You are required to make myriad decisions concerning location, prod- uct, target market, promotion, sales, and all the facets of starting and operating a business. And you must juggle all these demands while simultaneously seeing that you have enough cash. A detailed start-up budget provides a road map for necessary spending during the start- up phase, when cash inflows are likely to be small or nonexistent. Companies that carefully plan their start-up activities and avoid any unnecessary spending are much more likely to succeed.

?          Produce a product or service for which there is a proven demand: It is an unfortunate fact that most new products and services fail to gain acceptance. NewProductWorks of Ann Arbor, Michigan, maintains a “failed product museum” that contains samples of over 73,000 items, all of which were commercial failures. During the dot-com bubble of 1998–2001, many busi- nesses started with novel and completely untested products and services. Examples are Beenz .com, which was started to facilitate Internet transactions; webvan.com and yourgrocer.com, both of which sold groceries online for home delivery; and estamp.com, which offered online purchasing of U.S. postage, to be printed on the user’s printer. All four of these businesses failed to gain success with their products. None of these businesses survived the “dot-com” bust of 2001, although the domain and patents of e-stamp.com were purchased by the cur- rently operating company, stamps.com.

Large corporations, such as Procter & Gamble or Sony, spend millions of dollars annu- ally testing the market acceptance of new products. Despite their huge resources and years of experience, they regularly introduce products that fail. (Are you old enough to remember “New Coke”?) Your start-up business will not have either the experience or the resources to absorb the loss from product failure. By producing a product or service for which there is a proven demand, the risk of product failure can be reduced or eliminated.

?          Secure outside investment: Securing outside investment accomplishes two things: First, the process of obtaining investment funds means that your business will be critically examined by outsiders who have no vested interest in your idea, product, or service. Second, the fact that you were able to convince outsiders to invest in your business indicates a level of belief in the business and you that provides legitimacy.

? Start with more than one founder: Starting with more than one founder provides the business with more experience, skills, and resources than can be furnished by a single indi- vidual. Having more founders in the business also provides an opportunity for synergy, in which the business results are greater than the sum of the input. Multiple founders can also provide a forum for examining ideas, evaluating information, and making good business decisions.

?          Have experience managing small firms: Managing a small business requires attention very much like that displayed by a person spinning plates on sticks. As a performer must move quickly from plate to plate, many demands of small business management require that you have the ability to quickly move from task to task, without allowing any task to ultimately go uncompleted.

The process can be overwhelming for inexperienced managers. Those entrepreneurs who have experience in small business management are more likely to be able to meet the many simultaneous demands of guiding a successful start-up than would a person new to small business.

?          Have industry experience: Each industry has its own peculiarities. Only through experience can you learn the methods, sources, and markets for any specific one. Even simple tasks, such as buying necessary material, can be nearly impossible without industry knowledge.

For example, suppose that you plan to start a quality steak house, similar to Ruth’s Chris or Morton’s of Chicago. Where do you buy prime beef of the required cut and quality? How do you cook the meat? Or, consider making high-tech, lightweight bicycles. Where can you buy titanium tubing? What does it cost? What do you need to cut, shape, and weld it? How will you sell the bikes? Are bicycles sold through wholesalers? Are they sold directly to bicycle shops? Or maybe you want to start a sign company to make sand-blasted signs. Where will you buy the resist material to protect the wood you don’t want blasted away?

The less you know about something, the easier it appears to be. A true expert makes a task seem effortless. Watching Tiger Woods play golf might lead you to believe that it is an incredibly easy game. Just stand up, hit the ball, and watch it fly to the green. Sure it’s easy: So why do fewer than 2 percent of golfers ever make a course par? The same is true of busi- ness. Businesspeople, such as Michael Dell, Scott McNealy, and Warren Buffet, make the process of succeeding in business seem effortless. But if you have been in the business, you know better. Being experienced won’t make your start-up easy, but at least you have firsthand knowledge of how your industry works that will make your task easier.

? Have previous experience in creating a start-up business: “Nothing succeeds like suc- cess.” In the 150 years since Dumas made this famous statement, it has come to be an un- questioned part of our language. It is just succinct enough, just truthful enough, to seem like a universal truth. For entrepreneurs, it is fortunate that the statement is also not completely true. Although one may learn from successes, most learners acquire expertise through a process of repetition, which only occasionally results in successes. One study of entrepreneurs who had successfully created a start-up business found that on average an entrepreneur suffered three start-up failures before achieving success. Thus it is more nearly correct to state that no entrepreneur succeeds without having prior experience in failing.

? Choose a business that produces high margins: High margins, the amount by which sales prices exceed product costs, provide a buffer for lots of mistakes. The single greatest hurdle to a successful start-up is obtaining and maintaining sufficient cash to support both operations and growth. When margins are low, loss of any one sale or customer has an

immediate effect. However, the problem of replacing the lost margin is much easier if you have to make only one or two sales or get one or two new customers to make up for the lost business.

?          Start the business with established customers: When you start with established customers, you know that you will immediately have cash inflows. There are basically three ways that you can go about obtaining committed customers prior to start-up: (1) You can start your new business as a spin-off from your current employer’s business. (2) You can start a business to specifically go into competition with your employer. (3) Or, you can start a business to sub- contract services to your employer or to other established businesses.

(1) Creating a spin-off is a regular business practice that is done by businesses of all sizes and at all stages of development. Some spin-offs are created to get rid of “noncore” activities. By disposing of the noncore activity, the parent firm reduces capital requirements and pro- vides a tighter focus for management on the remaining businesses. Other spin-offs are created when the parent lacks either the interest or the resources to pursue the opportunity. By being spun off, the start-up can gain access to resources other than those of the parent.

(2) Going into competition with your current employer is also a common practice. Of course, this almost always results in resentments and often ends in lawsuits over issues of trade secrets, rights to intellectual property, and abridgment of contractual provisions. You will have to make difficult ethical decisions. From a legal point of view, the contract be- tween employer and employee is satisfied when all wages and other benefits have been paid in return for you accomplishing the tasks for which you were hired. Absent a specific con- tract providing otherwise, neither party, employer nor employee, is obligated beyond this exchange. However, not so easily answered are the questions: (1) Is it ethical to use your employment to build relationships with customers that subsequently can be used to start a new business? and (2) Is it ethical for you to use knowledge and skill received through training and education furnished by your employer to go into business competing with your employer?

(3) Subcontracting services to an existing business is somewhere between doing a spin-off and starting a competing business. Services that are often contracted include sales, janitorial services, accounting, research, and product development. It is a common, accepted practice for the contractual relationship to be created prior to starting a business.

? Build trust in your “story”: Building trust is essential to the success of all start-ups. You must be able to convince suppliers, employees, and, most importantly, customers that the business is now successful and will be in the future. Not only is there an understandable reluctance for people to be associated with a potential “loser,” but customers, vendors, and employees all take risks by doing business with an unknown and unproven start-up.

Suppliers are often reluctant to deal with start-ups, even if you make your purchases in cash. Most new businesses are small compared to established businesses in the same industry. There is a good reason why you, as the owner of a new business, would prefer to make numer- ous orders of small quantities of the goods and services you need. Doing so reduces cash flow requirements and reduces the risk of your being stuck with old or obsolete inventory. For the vendor, however, accepting your frequent small orders greatly increases the cost of providing goods and services to you. Most vendors, especially wholesalers, work on very small margins. The cost of accepting and filling numerous orders for a new customer may well make such business unprofitable. It is, therefore, essential that the vendor believes in your eventual suc- cess and that you will become a valuable customer in the future.

Employees take on significant risks when they go to work for a start-up business. Not only may the start-up fail, but frequently the cash flow problems of start-ups cause payments for wages to be late or missed entirely. This is one reason why so many start-ups offer stock options and stock bonuses to employees. The start-up doesn’t have enough cash to pay high wages right now, but if it’s successful, employees will share the rewards in the future.

Customers can similarly be at risk when purchasing from a start-up business. In the event that the start-up fails, there is no recourse for warranty problems, for maintenance, or for up- grades to the product. This risk is especially acute when the product or service of the start-up affects the core business of its customers. For example, the San Antonio Bed & Breakfast

immediate effect. However, the problem of replacing the lost margin is much easier if you have to make only one or two sales or get one or two new customers to make up for the lost business.

?          Start the business with established customers: When you start with established customers, you know that you will immediately have cash inflows. There are basically three ways that you can go about obtaining committed customers prior to start-up: (1) You can start your new business as a spin-off from your current employer’s business. (2) You can start a business to specifically go into competition with your employer. (3) Or, you can start a business to sub- contract services to your employer or to other established businesses.

(1) Creating a spin-off is a regular business practice that is done by businesses of all sizes and at all stages of development. Some spin-offs are created to get rid of “noncore” activities. By disposing of the noncore activity, the parent firm reduces capital requirements and pro- vides a tighter focus for management on the remaining businesses. Other spin-offs are created when the parent lacks either the interest or the resources to pursue the opportunity. By being spun off, the start-up can gain access to resources other than those of the parent.

(2) Going into competition with your current employer is also a common practice. Of course, this almost always results in resentments and often ends in lawsuits over issues of trade secrets, rights to intellectual property, and abridgment of contractual provisions. You will have to make difficult ethical decisions. From a legal point of view, the contract be- tween employer and employee is satisfied when all wages and other benefits have been paid in return for you accomplishing the tasks for which you were hired. Absent a specific con- tract providing otherwise, neither party, employer nor employee, is obligated beyond this exchange. However, not so easily answered are the questions: (1) Is it ethical to use your employment to build relationships with customers that subsequently can be used to start a new business? and (2) Is it ethical for you to use knowledge and skill received through training and education furnished by your employer to go into business competing with your employer?

(3) Subcontracting services to an existing business is somewhere between doing a spin-off and starting a competing business. Services that are often contracted include sales, janitorial services, accounting, research, and product development. It is a common, accepted practice for the contractual relationship to be created prior to starting a business.

? Build trust in your “story”: Building trust is essential to the success of all start-ups. You must be able to convince suppliers, employees, and, most importantly, customers that the business is now successful and will be in the future. Not only is there an understandable reluctance for people to be associated with a potential “loser,” but customers, vendors, and employees all take risks by doing business with an unknown and unproven start-up.

Suppliers are often reluctant to deal with start-ups, even if you make your purchases in cash. Most new businesses are small compared to established businesses in the same industry. There is a good reason why you, as the owner of a new business, would prefer to make numer- ous orders of small quantities of the goods and services you need. Doing so reduces cash flow requirements and reduces the risk of your being stuck with old or obsolete inventory. For the vendor, however, accepting your frequent small orders greatly increases the cost of providing goods and services to you. Most vendors, especially wholesalers, work on very small margins. The cost of accepting and filling numerous orders for a new customer may well make such business unprofitable. It is, therefore, essential that the vendor believes in your eventual suc- cess and that you will become a valuable customer in the future.

Employees take on significant risks when they go to work for a start-up business. Not only may the start-up fail, but frequently the cash flow problems of start-ups cause payments for wages to be late or missed entirely. This is one reason why so many start-ups offer stock options and stock bonuses to employees. The start-up doesn’t have enough cash to pay high wages right now, but if it’s successful, employees will share the rewards in the future.

Customers can similarly be at risk when purchasing from a start-up business. In the event that the start-up fails, there is no recourse for warranty problems, for maintenance, or for up- grades to the product. This risk is especially acute when the product or service of the start-up affects the core business of its customers. For example, the San Antonio Bed & Breakfast Association contracted with a start-up business to develop and maintain a web-based avail- ability and reservation service for the association’s members. The start-up failed during the dot-com bust of 2001. When problems with the system subsequently developed, there was no one to fix them. The system was complex and the source code incomprehensible. As a result, the association lost a core service that provided value to its members.

The issue of building trust in your story is a catch-22. If customers, vendors, and employees do not have trust in the entrepreneur and in the business, quite simply, there is no business. How- ever, there must be a business, or you don’t need customers, vendors, and employees. There are several ways for a start-up business to build trust and legitimacy, and these are detailed in Chap- ter 2. Specific examples for the kinds of businesses discussed in this chapter include obtaining a performance bond that will pay vendors and customers if your business fails. Restaurants, lodging establishments, barbers, beauty shops, and other businesses that deal with issues of cleanliness as a business requirement can obtain licenses and join industry groups that perform inspections. Displaying licenses and certificates of inspection provides assurance that you are at least meeting minimum standards. Manufacturing businesses and construction businesses may hire engineers to certify design and construction details. Warranty service can be contracted to an independent company that specializes in providing such services. Rigorously maintaining business procedures that ensure on-time delivery of products and services and on-time payment of bills, wages, and loan payments will, in time, result in the start-up being trusted.

Many businesses have been successfully created which lacked one or more of these indicators. It is also true that many start-up businesses have failed, despite having all these characteristics. No one knows what makes the difference between such successes and failures. Some have speculated that the one indispensable trait of people who create successful businesses is determination to make the business work.

“LEAN” Entrepreneurial Methods

You may have read or heard about the currently popular idea of the “lean start-up.” “Lean” is the lat- est name for a set of tried-and-true methods that can lessen the capital requirements and, as a result, reduce the financial risk of a start-up. We discussed the similar concept of bootstrapping in Chapter 5. You remember that bootstrapping includes methods for “finding ways to achieve desired business goals and objectives when start-up capital is limited.” Both lean operations and bootstrapping are based on and share three underlying ideas:

1.         Waste not, want not. That this thought appears in a 1576 book when Shakespeare was a mere 12-years-old tells you how old this latest fashion is. Avoiding waste is one obvious way to achieve this, but so is borrowing something rather than renting it, and renting rather than buy- ing. Making do with an older but free laptop would be another example, as would saving every penny you can.

2.         Create, standardize, repeat. About the same time as Shakespeare, shipbuilders in Venice created a ship made of standard parts. It made creating subsequent ships much faster and easier. You do this when you make a form letter to solicit customers, when you create a cell phone app that thousands of people can download, or when you buy in bulk to save money. Some firms standardize their most important characteristics so customers get the same result wher- ever they buy, for example, in franchise restaurants. If your most important characteristics are built uniquely, you can still benefit from standardizing by applying it to the supporting, repeti- tive aspects of your business.

3.         Keep in touch. Central to the lean start-up is being close to your customer. It helps you know if your product or service is doing its job. It alerts you to problems earlier so you can correct them, and it is just a good business practice in general. Customers and their needs change, and to keep up, you need to keep in touch. As you learn what is needed, adjust your product or service to op- timally fit needs. Most cell phone apps get updated every few weeks. This is because as the app makers find out about bugs or glitches, they can fix them and get the fixed version out to users.13

Today’s lean start-up and bootstrapping stress the need for creativity and innovation in all aspects of business start-ups and operations. Eric Reis, the modern father of the lean start-up writes that

start-ups should attempt to produce the “minimum viable product,” ship it to paying customers, measure its success, apply what is learned to improving the product. There is an older quality control model that checks for problems before the product leaves the firm, and where safety is an issue, that is the best way to go. But for many other types of products or services, the minimum viable product approach is a better one.

Thomas Caldbeck, whose story introduces this chapter, exemplifies many aspects of the lean approach. He did not start into business until after he had mastered the basic management skills needed for success. His garage, van truck, and a spare bedroom in his home became his business location. He expanded into additional areas of business only after a customer had been obtained for that service. This way Tom relied on revenues to provide funds for growth. He maintained close contact with customers to ensure that they were satisfied with the work he was doing. He used his own funds for the start-up and leveraged their value by using bank financing for his truck and equip- ment. Part-timers and subcontractors who are paid only for work actually completed, met the need for employees.

Your current employer may provide assistance if your new venture is not going to be a direct competitor. Often, a new product or service idea arises from the work being done in the current employment of the start-up founder, as in the case of UltimateKeychains.com. The employer may, however, have no interest in pursuing the opportunity. In such cases, the start-up may well proceed with the employer’s active support.

Buying an Existing Business

The second most common way to enter small business management is to purchase an existing busi- LO3 ness. Buying an existing business has important advantages over creating a start-up. However, pur- chasing a business has its own, unique set of risks.

Advantages of Purchasing an Existing Business

There are some advantages to buying an existing business:

? Established customers provide immediate sales and cash inflows. Because the business is already successful, it has proven that there is sufficient demand for its products and services to operate profitably.

?          Business processes are already in place in an existing, operating business. This eliminates the need to hire employees, find vendors, set up accounting systems, and establish production processes.

?          Purchasing a business often requires less cash outlay than does creating a start-up. The seller will often provide financing that makes it possible for you to buy the business.

Disadvantages of Purchasing an Existing Business

Disadvantages to buying an existing business include:

?          Finding a successful business for sale that is appropriate for your experience, skills, and edu- cation is difficult and time-consuming.

?          It is very difficult to determine what a small business is worth. The value of a small business can never be known with certainty. You must rely on analyses, comparisons, and estimates.

? Existing managers and employees may resist change. It can be very difficult to convince employees to adapt to new business methods, procedures, and processes that can provide increased profits.

?          The reputation of the business may be a hindrance to future success. Sellers are usually reluc- tant to tell you about problems that the business has. Business owners are especially sensitive about discussing past disputes and lawsuits with vendors and customers.

?          The business may be declining because of changes in technology. ?           The facilities and equipment may be obsolete or in need of major repair.

You will greatly increase your chances of finding the right business by using multiple sources. Make some calls: Contact business brokers and ply your own network. You should be actively read- ing advertising of businesses for sale in newspapers and magazines and on the Internet. You might consider asking your employer if his or her business is for sale. Keep in mind that every business is for sale at a high enough price. If you hear of a business that is interesting, contact the owners and ask what it would take to buy it.

Brokers advertise and facilitate the sale of businesses for a fee, most usually a percentage of the ultimate selling price. Most states have laws that require brokers to work solely for the interest of the seller and to obtain the highest selling price possible. This creates a conflict of interest between the broker and you. The broker is trying to get the highest price. You’re trying to get the lowest.

The quality of broker services ranges from excellent to outright rip-offs. Only a few states have any education or licensing requirements, although some, such as Illinois, do require business bro- kers to register by filing a simple form. Accusations of misrepresentation and fraud by brokers are common in the business press.

Networking is an excellent way to find businesses for sale. While most businesses are for sale at any time, for competitive reasons most owners do not want to say so explicitly. Because customers, vendors, and employees are likely to feel threatened, openly advertising a business for sale can lead to the loss of revenue, credit from vendors, and key employees. For these reasons, it is common for business owners to make their intention to sell known only to trusted confidants in the industry and in the community. Attorneys, bankers, accountants, and insurance agents all will provide you with information only if they know that they can trust your discretion. You can usually get solid leads just by telling other businesspeople that you’re interested in buying a business.

There is a trade journal for every industry that exists. People in the mortuary business bone up with Embalmer and American Funeral Director. The replacement window industry looks through Fenestration. The electric sign industry is energized by Signs of the Times. The folks who process dead and decomposing animals into useable products digest Render magazine. The construction industry digs Rock and Dirt. No matter what type of business you might be considering, there is a magazine for it. They all have advertisements of businesses for sale.

The Internet also has numerous sites that advertise businesses for sale. A search using Google with the keyword “business” and the phrase “for sale” resulted in over 38 million pages listed. None of the advertisements that were inspected during the research for this book provided the name or the exact location of the advertised business. Rather, the sites have various ways you can obtain ad- ditional information. Some provide a link by which you can request more information. A very few listed phone numbers you can call. Others require becoming a member and paying a fee for access.

Your current employer is probably a ready source of information about businesses for sale in your industry. Most managers of small businesses are members of formal and informal groups of businesspeople, for example, the Chamber of Commerce, Rotary, Kiwanis, and other groups that have meetings and provide resources. Also, your employer probably has information about competi- tors and vendors in the area. Don’t forget the example of UltimateKeychains.com—your employer just might be interested in selling his or her business, as well.

Investigating Entrepreneurial Opportunities:

Performing Due Diligence

Suppose you’ve actually found a business you’d like to buy. Your job has just begun. Finding an appropriate business is merely the first, and easiest, step in the process. Buying a business is a lot like getting married—it is easy to get into, but if it turns out bad, it’s very hard to get out. Now that you’ve found that “perfect” business, you must make an exhaustive investigation to tell if it is re- ally suitable. Unlike residential real estate, which is highly regulated in the United States, sellers of businesses are not legally required to make disclosures of impairments or deficiencies. If you are outside the United States, your laws may be different. For example, in Canada, sales of businesses for a price less than $200,000 are tightly regulated. Sales for amounts greater than $200,000 are not regulated at all. As in the United States, it is your responsibility to fully investigate the business and to come to your own independent evaluation of its value.

Due diligence is the process of investigating to determine the full and complete implications of buying a business. During the process of due diligence every aspect of the business is examined in exacting detail. Nothing is taken for granted. No statement is accepted without evidence. Evidence is, itself, substantiated with sources external to the company. Properly performing due diligence minimizes the risk of failure and maximizes the probability of success by identifying the strengths and weaknesses of the business.

When a business is acquired, there is a clear order of steps that should be followed:

1.         Conduct extensive interviews with the sellers of the business. 2.      Study the financial reports and other records of the business. 3.           Make a personal examination of the site (or sites) of the business. 4. Interview customers and suppliers of the business. 5.       Develop a detailed business plan for the acquisition. 6.            Negotiate an appropriate price for the business, based on the business plan projections. 7. Obtain sufficient capital to purchase and operate the business.

The first five steps together make up the process of due diligence.18 A basic tenet of business law is caveat emptor, or “let the buyer beware.” This does not mean

that a seller can freely lie to you about the business. Deliberate misrepresentations can lead to law- suits and may be prosecuted as fraud. However, except for specific representations by the seller, you are responsible for understanding the condition and the facts of the business. It’s kind of a “don’t ask—don’t tell.” If you don’t ask the right questions, the seller has no obligation to tell you the right answers. Thus, as the buyer, you must determine how the business is currently being operated, and you must substantiate (or disprove) representations made by the seller regarding the existence and value of assets, liabilities, financial performance, and the condition of the business.

Due diligence has two primary goals. First, you are attempting to find any wrongdoing: (1) fraud committed by the owners or managers; (2) misrepresentations of the sellers, such as improperly recognized revenues or expenses; and (3) missing information, including pending or threatened xes. Second, you are trying to find any inefficiencies, unnoticed opportunities, waste, and mis- management. The first goal is information that greatly affects the value of the business and the advisability of purchasing it. The second goal is how you, as a new owner, can make changes to increase its value. Both goals can give you a negotiating advantage.

The first information that you get is usually a set of financial statements. There are four reasons why this is so: (1) the seller usually has financial statements available and incurs little added cost in providing them, (2) you, as a business person, are most likely familiar with financial statements and can extract useful information from them, (3) financial statements are accepted as representative of the business by bankers and investors, and (4) financial statements are considered to be indicators of future business results.

Financial statements should include (1) a balance sheet, (2) an income statement, and (3) a state- ment of cash flows. You should also examine the federal and state tax returns for at least the last five years. Information forms for partnerships, corporations, or limited liability companies should be examined also. Any financial statement prepared by or for the seller must be treated with skepti- cism. Some financial statements that you see will have been subjected to rigorous examination by professionals outside the business; some will have been dashed off by the owner at midnight on April 15. To be believable, the statements must be substantiated by external sources.

When you examine the income statement, you should focus on corroborating the amount and timing of revenues and expenses. Be aware that the income statements of small businesses are com- monly misstated. To avoid taxes, owners often charge personal expenses to the business, such as cars, country club memberships, travel, and even home office expenses. On the other hand, when preparing to sell the business, owners are motivated to overstate revenues and understate expenses to show the highest profit.

Balance sheet items that are likely to be misstated are intangibles, that is, things that have no physical existence, but rather are legal rights and obligations. Intangibles include accounts receiv- able, patents, licenses, and liabilities. Assets claimed on the balance sheet must be examined to ensure that they exist and that the stated value is reasonable. Because liabilities are legal require- ments to give up economic value in the future, such as debts for borrowed money or merchandise purchased on account, your risk is that there will be liabilities that are not disclosed. Your problem is that you are attempting to prove the absence of something. Once the examination is complete, you should adjust the amounts, contents, and format of the statements to reflect what you have discov- ered through due diligence.

During due diligence you should also try to answer many nonfinancial questions. Why is the business for sale? Who are key employees? What is the extent of obsolescence of equipment and key technologies? What are the prospects for the firm’s products and services? What opportunities can the firm reasonably expect to have in the near future?

1. According to this chapter, what are the 5 ways to get into small business management?

2. According to this chapter, what are the 12 ways to increase the chance of business start-up success?

3. What is the predominant method by which entrepreneurs open new businesses?

4. What is the greatest advantage of a franchise?

5. According to this chapter, what magazine is a good source of franchisors eager to sell you a franchise?

6. Before you as a potential franchisee sign on the dotted line what two documents should you study carefully?

C++ Data Structures:

Use Huffman coding to encode text in given file (Pride_and_Prejudice.txt).

TO_DO:

Define a struct for Huffman tree node. This struct contains links to left/right child nodes, a character, and its frequency.Define a function for file reading operation. This function should take in a filename (string type) as parameter and return a proper data structure object that contains characters and their frequencies that will be used to generate Huffman tree nodes.The construction of Huffman tree requires taking two nodes with smallest frequencies. Select a proper data structure to support this operation. Note this data structure object could be different to the object from step 2.

Design a function that takes in the root of Huffman coding tree, prints, and returns the encoding scheme in a data structure object.Design a function that takes in the encoding scheme and filename (string type), output encoded content (bit-string) to a file named pride.huff

Pride_and_Prejudice.txt:

Chapter 1

It is a truth universally acknowledged, that a single man in possession of a good fortune, must be in want of a wife. However little known the feelings or views of such a man may be on his first entering a neighbourhood, this truth is so well fixed in the minds of the surrounding families, that he is considered the rightful property of some one or other of their daughters. “My dear Mr. Bennet,” said his lady to him one day, “have you heard that Netherfield Park is let at last?” Mr. Bennet replied that he had not. “But it is,” returned she; “for Mrs. Long has just been here, and she told me all about it.” Mr. Bennet made no answer. “Do you not want to know who has taken it?” cried his wife impatiently. “You want to tell me, and I have no objection to hearing it.” This was invitation enough. “Why, my dear, you must know, Mrs. Long says that Netherfield is taken by a young man of large fortune from the north of England; that he came down on Monday in a chaise and four to see the place, and was so much delighted with it, that he agreed with Mr. Morris immediately; that he is to take possession before Michaelmas, and some of his servants are to be in the house by the end of next week.” “What is his name?” “Bingley.” “Is he married or single?” “Oh! Single, my dear, to be sure! A single man of large fortune; four or five thousand a year. What a fine thing for our girls!” “How so? How can it affect them?” “My dear Mr. Bennet,” replied his wife, “how can you be so tiresome! You must know that I am thinking of his marrying one of them.” “Is that his design in settling here?” “Design! Nonsense, how can you talk so! But it is very likely that he may fall in love with one of them, and therefore you must visit him as soon as he comes.” “I see no occasion for that. You and the girls may go, or you may send them by themselves, which perhaps will be still better, for as you are as handsome as any of them, Mr. Bingley may like you the best of the party.” “My dear, you flatter me. I certainly have had my share of beauty, but I do not pretend to be anything extraordinary now. When a woman has five grown-up daughters, she ought to give over thinking of her own beauty.” “In such cases, a woman has not often much beauty to think of.” “But, my dear, you must indeed go and see Mr. Bingley when he comes into the neighbourhood.” “It is more than I engage for, I assure you.” “But consider your daughters. Only think what an establishment it would be for one of them. Sir William and Lady Lucas are determined to go, merely on that account, for in general, you know, they visit no newcomers. Indeed you must go, for it will be impossible for us to visit him if you do not.” “You are over-scrupulous, surely. I dare say Mr. Bingley will be very glad to see you; and I will send a few lines by you to assure him of my hearty consent to his marrying whichever he chooses of the girls; though I must throw in a good word for my little Lizzy.” “I desire you will do no such thing. Lizzy is not a bit better than the others; and I am sure she is not half so handsome as Jane, nor half so good-humoured as Lydia. But you are always giving her the preference.” “They have none of them much to recommend them,” replied he; “they are all silly and ignorant like other girls; but Lizzy has something more of quickness than her sisters.” “Mr. Bennet, how can you abuse your own children in such a way? You take delight in vexing me. You have no compassion for my poor nerves.” “You mistake me, my dear. I have a high respect for your nerves. They are my old friends. I have heard you mention them with consideration these last twenty years at least.” “Ah, you do not know what I suffer.” “But I hope you will get over it, and live to see many young men of four thousand a year come into the neighbourhood.” “It will be no use to us, if twenty such should come, since you will not visit them.” “Depend upon it, my dear, that when there are twenty, I will visit them all.” Mr. Bennet was so odd a mixture of quick parts, sarcastic humour, reserve, and caprice, that the experience of three-and-twenty years had been insufficient to make his wife understand his character. Her mind was less difficult to develop. She was a woman of mean understanding, little information, and uncertain temper. When she was discontented, she fancied herself nervous. The business of her life was to get her daughters married; its solace was visiting and news. Chapter 2 Mr. Bennet was among the earliest of those who waited on Mr. Bingley. He had always intended to visit him, though to the last always assuring his wife that he should not go; and till the evening after the visit was paid she had no knowledge of it. It was then disclosed in the following manner. Observing his second daughter employed in trimming a hat, he suddenly addressed her with: “I hope Mr. Bingley will like it, Lizzy.” “We are not in a way to know what Mr. Bingley likes,” said her mother resentfully, “since we are not to visit.” “But you forget, mamma,” said Elizabeth, “that we shall meet him at the assemblies, and that Mrs. Long promised to introduce him.” “I do not believe Mrs. Long will do any such thing. She has two nieces of her own. She is a selfish, hypocritical woman, and I have no opinion of her.” “No more have I,” said Mr. Bennet; “and I am glad to find that you do not depend on her serving you.” Mrs. Bennet deigned not to make any reply, but, unable to contain herself, began scolding one of her daughters. “Don’t keep coughing so, Kitty, for Heaven’s sake! Have a little compassion on my nerves. You tear them to pieces.” “Kitty has no discretion in her coughs,” said her father; “she times them ill.” “I do not cough for my own amusement,” replied Kitty fretfully. “When is your next ball to be, Lizzy?” “To-morrow fortnight.” “Aye, so it is,” cried her mother, “and Mrs. Long does not come back till the day before; so it will be impossible for her to introduce him, for she will not know him herself.” “Then, my dear, you may have the advantage of your friend, and introduce Mr. Bingley to her.” “Impossible, Mr. Bennet, impossible, when I am not acquainted with him myself; how can you be so teasing?” “I honour your circumspection. A fortnight’s acquaintance is certainly very little. One cannot know what a man really is by the end of a fortnight. But if we do not venture somebody else will; and after all, Mrs. Long and her nieces must stand their chance; and, therefore, as she will think it an act of kindness, if you decline the office, I will take it on myself.” The girls stared at their father. Mrs. Bennet said only, “Nonsense, nonsense!” “What can be the meaning of that emphatic exclamation?” cried he. “Do you consider the forms of introduction, and the stress that is laid on them, as nonsense? I cannot quite agree with you there. What say you, Mary? For you are a young lady of deep reflection, I know, and read great books and make extracts.” Mary wished to say something sensible, but knew not how. “While Mary is adjusting her ideas,” he continued, “let us return to Mr. Bingley.” “I am sick of Mr. Bingley,” cried his wife. “I am sorry to hear that; but why did not you tell me that before? If I had known as much this morning I certainly would not have called on him. It is very unlucky; but as I have actually paid the visit, we cannot escape the acquaintance now.” The astonishment of the ladies was just what he wished; that of Mrs. Bennet perhaps surpassing the rest; though, when the first tumult of joy was over, she began to declare that it was what she had expected all the while. “How good it was in you, my dear Mr. Bennet! But I knew I should persuade you at last. I was sure you loved your girls too well to neglect such an acquaintance. Well, how pleased I am! and it is such a good joke, too, that you should have gone this morning and never said a word about it till now.” “Now, Kitty, you may cough as much as you choose,” said Mr. Bennet; and, as he spoke, he left the room, fatigued with the raptures of his wife. “What an excellent father you have, girls!” said she, when the door was shut. “I do not know how you will ever make him amends for his kindness; or me, either, for that matter. At our time of life it is not so pleasant, I can tell you, to be making new acquaintances every day; but for your sakes, we would do anything. Lydia, my love, though you are the youngest, I dare say Mr. Bingley will dance with you at the next ball.” “Oh!” said Lydia stoutly, “I am not afraid; for though I am the youngest, I’m the tallest.” The rest of the evening was spent in conjecturing how soon he would return Mr. Bennet’s visit, and determining when they should ask him to dinner. Chapter 3 Not all that Mrs. Bennet, however, with the assistance of her five daughters, could ask on the subject, was sufficient to draw from her husband any satisfactory description of Mr. Bingley. They attacked him in various ways—with barefaced questions, ingenious suppositions, and distant surmises; but he eluded the skill of them all, and they were at last obliged to accept the second-hand intelligence of their neighbour, Lady Lucas. Her report was highly favourable. Sir William had been delighted with him. He was quite young, wonderfully handsome, extremely agreeable, and, to crown the whole, he meant to be at the next assembly with a large party. Nothing could be more delightful! To be fond of dancing was a certain step towards falling in love; and very lively hopes of Mr. Bingley’s heart were entertained. “If I can but see one of my daughters happily settled at Netherfield,” said Mrs. Bennet to her husband, “and all the others equally well married, I shall have nothing to wish for.” In a few days Mr. Bingley returned Mr. Bennet’s visit, and sat about ten minutes with him in his library. He had entertained hopes of being admitted to a sight of the young ladies, of whose beauty he had heard much; but he saw only the father. The ladies were somewhat more fortunate, for they had the advantage of ascertaining from an upper window that he wore a blue coat, and rode a black horse. An invitation to dinner was soon afterwards dispatched; and already had Mrs. Bennet planned the courses that were to do credit to her housekeeping, when an answer arrived which deferred it all. Mr. Bingley was obliged to be in town the following day, and, consequently, unable to accept the honour of their invitation, etc. Mrs. Bennet was quite disconcerted. She could not imagine what business he could have in town so soon after his arrival in Hertfordshire; and she began to fear that he might be always flying about from one place to another, and never settled at Netherfield as he ought to be. Lady Lucas quieted her fears a little by starting the idea of his being gone to London only to get a large party for the ball; and a report soon followed that Mr. Bingley was to bring twelve ladies and seven gentlemen with him to the assembly. The girls grieved over such a number of ladies, but were comforted the day before the ball by hearing, that instead of twelve he brought only six with him from London—his five sisters and a cousin. And when the party entered the assembly room it consisted of only five altogether—Mr. Bingley, his two sisters, the husband of the eldest, and another young man. Mr. Bingley was good-looking and gentlemanlike; he had a pleasant countenance, and easy, unaffected manners. His sisters were fine women, with an air of decided fashion. His brother-in-law, Mr. Hurst, merely looked the gentleman; but his friend Mr. Darcy soon drew the attention of the room by his fine, tall person, handsome features, noble mien, and the report which was in general circulation within five minutes after his entrance, of his having ten thousand a year. The gentlemen pronounced him to be a fine figure of a man, the ladies declared he was much handsomer than Mr. Bingley, and he was looked at with great admiration for about half the evening, till his manners gave a disgust which turned the tide of his popularity; for he was discovered to be proud; to be above his company, and above being pleased; and not all his large estate in Derbyshire could then save him from having a most forbidding, disagreeable countenance, and being unworthy to be compared with his friend. Mr. Bingley had soon made himself acquainted with all the principal people in the room; he was lively and unreserved, danced every dance, was angry that the ball closed so early, and talked of giving one himself at Netherfield. Such amiable qualities must speak for themselves. What a contrast between him and his friend! Mr. Darcy danced only once with Mrs. Hurst and once with Miss Bingley, declined being introduced to any other lady, and spent the rest of the evening in walking about the room, speaking occasionally to one of his own party. His character was decided. He was the proudest, most disagreeable man in the world, and everybody hoped that he would never come there again. Amongst the most violent against him was Mrs. Bennet, whose dislike of his general behaviour was sharpened into particular resentment by his having slighted one of her daughters. Elizabeth Bennet had been obliged, by the scarcity of gentlemen, to sit down for two dances; and during part of that time, Mr. Darcy had been standing near enough for her to hear a conversation between him and Mr. Bingley, who came from the dance for a few minutes, to press his friend to join it. “Come, Darcy,” said he, “I must have you dance. I hate to see you standing about by yourself in this stupid manner. You had much better dance.” “I certainly shall not. You know how I detest it, unless I am particularly acquainted with my partner. At such an assembly as this it would be insupportable. Your sisters are engaged, and there is not another woman in the room whom it would not be a punishment to me to stand up with.” “I would not be so fastidious as you are,” cried Mr. Bingley, “for a kingdom! Upon my honour, I never met with so many pleasant girls in my life as I have this evening; and there are several of them you see uncommonly pretty.” “You are dancing with the only handsome girl in the room,” said Mr. Darcy, looking at the eldest Miss Bennet. “Oh! She is the most beautiful creature I ever beheld! But there is one of her sisters sitting down just behind you, who is very pretty, and I dare say very agreeable. Do let me ask my partner to introduce you.” “Which do you mean?” and turning round he looked for a moment at Elizabeth, till catching her eye, he withdrew his own and coldly said: “She is tolerable, but not handsome enough to tempt me; I am in no humour at present to give consequence to young ladies who are slighted by other men. You had better return to your partner and enjoy her smiles, for you are wasting your time with me.” Mr. Bingley followed his advice. Mr. Darcy walked off; and Elizabeth remained with no very cordial feelings toward him. She told the story, however, with great spirit among her friends; for she had a lively, playful disposition, which delighted in anything ridiculous. The evening altogether passed off pleasantly to the whole family. Mrs. Bennet had seen her eldest daughter much admired by the Netherfield party. Mr. Bingley had danced with her twice, and she had been distinguished by his sisters. Jane was as much gratified by this as her mother could be, though in a quieter way. Elizabeth felt Jane’s pleasure. Mary had heard herself mentioned to Miss Bingley as the most accomplished girl in the neighbourhood; and Catherine and Lydia had been fortunate enough never to be without partners, which was all that they had yet learnt to care for at a ball. They returned, therefore, in good spirits to Longbourn, the village where they lived, and of which they were the principal inhabitants. They found Mr. Bennet still up. With a book he was regardless of time; and on the present occasion he had a good deal of curiosity as to the event of an evening which had raised such splendid expectations. He had rather hoped that his wife’s views on the stranger would be disappointed; but he soon found out that he had a different story to hear. “Oh, my dear Mr. Bennet,” as she entered the room, “we have had a most delightful evening, a most excellent ball. I wish you had been there. Jane was so admired, nothing could be like it. Everybody said how well she looked; and Mr. Bingley thought her quite beautiful, and danced with her twice! Only think of that, my dear; he actually danced with her twice! and she was the only creature in the room that he asked a second time. First of all, he asked Miss Lucas. I was so vexed to see him stand up with her! But, however, he did not admire her at all; indeed, nobody can, you know; and he seemed quite struck with Jane as she was going down the dance. So he inquired who she was, and got introduced, and asked her for the two next. Then the two third he danced with Miss King, and the two fourth with Maria Lucas, and the two fifth with Jane again, and the two sixth with Lizzy, and the Boulanger—” “If he had had any compassion for me,” cried her husband impatiently, “he would not have danced half so much! For God’s sake, say no more of his partners. Oh that he had sprained his ankle in the first dance!” “Oh! my dear, I am quite delighted with him. He is so excessively handsome! And his sisters are charming women. I never in my life saw anything more elegant than their dresses. I dare say the lace upon Mrs. Hurst’s gown—” Here she was interrupted again. Mr. Bennet protested against any description of finery. She was therefore obliged to seek another branch of the subject, and related, with much bitterness of spirit and some exaggeration, the shocking rudeness of Mr. Darcy. “But I can assure you,” she added, “that Lizzy does not lose much by not suiting his fancy; for he is a most disagreeable, horrid man, not at all worth pleasing. So high and so conceited that there was no enduring him! He walked here, and he walked there, fancying himself so very great! Not handsome enough to dance with! I wish you had been there, my dear, to have given him one of your set-downs. I quite detest the man.”

Please read the article and answear about questions.

Strategy in the Small Business

Strategy is the idea and actions that explain how a firm will make its profit. Whether you know it or not, all small businesses have a strategy. The strategy may be a blueprint for planning or a standard to compare actions against. Either way, strategy defines for you, your customers, and your competi- tion how your business operates.

Good strategy leads to greater chances for survival and higher profits for a small business. What makes a strategy good is its fit to the particulars of your business and the resources you can bring to it. In this chapter, we consider how strategy can be created and applied to help your business be its best.

Strategy in small business is special because most small businesses are more imitative than inno- vative. If you are opening a home day care center, a machine shop, an Italian restaurant, or an online collectible figurine store, these types of businesses already exist. You can find examples, books, and often even magazines to study, as well as trade and professional associations to join. There are special strategies that aim to help imitative businesses be successful.

Getting to the useful strategies for a small business is a four-step process. Figure 7.1 shows the strategic planning process for small businesses. The first step involves reviewing and confirming the goals that define your firm and knowing your magic number. The second step is where you consider your customers and the benefits you want to offer them and plot these out in a procedure called perceptual mapping. The third step is to study the dynamics and trends of your industry using a technique called industry analysis in order to identify the best way and time to enter busi- ness. The fourth step involves building on the prior three steps to determine the best strategic direc- tion and strategy for the firm. After this four-step process, there is a continuing effort called post start-up which aims to refine your firm’s strategies and tactics in order to maintain a competitive advantage.

As you can see in Figure 7.1, strategy builds on four key types of decisions you make about your firm. These may be made formally or informally in your opportunity analysis or feasibility analysis. These decisions are:

1.         The major goals you set for your firm. 2.       The types of customers you seek and what benefits you plan to offer them.

3.         The stage and trend of your chosen industry. 4.         The specific generic and supra strategies you choose to pursue.

Goals: The First Step of Strategic Planning

Before getting into industry analysis, you as the entrepreneur need to make some very basic deci- sions about your goals for your prospective business—you, your idea, and your firm. These goal decisions will set the stage for the kind of business you will have and are the foundation for further analyses. There are five initial key goal decisions:

1.         As owner, what do you expect out of the business? 2.           What is your product or service idea (and its industry)? 3. For your product or service, how innovative or imitative will you be? 4.           Who do you plan to sell to—everyone or targeted markets? 5.    Where do you plan to sell—locally, regionally, nationally, globally?

Owner Rewards

For a small business that is starting out, all strategy starts with the owner. As owner, what do you want out of your business? In Chapter 1 we introduced the rewards sought by entrepreneurs from their businesses. Some, like flexibility, personal growth, and a solid personal income, were pretty universal. Skill Module 7.1 looks at how you can determine your magic number, which is the income you personally seek from the business. Knowing that number from the start, you are better able to evaluate if your proposed business can deliver on that very basic need that everyone reports needing. Other rewards like great wealth and developing a new product or service was mentioned occasionally, while recognition, admiration, power, and family tradition get mentioned least often of all rewards. For EnableMart, the original reward was to generate the wealth necessary to bring Mindnautilus to market, and also provide a service that made it easier for America’s 54 million disabled to get the products they need to make their lives better.

Whatever the reward or rewards you seek—it is fine to want more than one—it should be central to your creating the business. In a very real sense, what you want from the business is the core of your and your firm’s strategy. It is the “why” which drives the process of entrepreneurship.

in Chapter 5. Either way, the idea gets made real as a product (something physical a customer buys) or a service (activities undertaken on a customer’s behalf). It is possible to combine products and services, like a GM auto that comes with the OnStar cell phone service. You can learn more about that in Chapter 9.

If you have in mind a product or service, you also have an industry. Industry is the general name for the line of product or service being sold. Examples include the restaurant industry, the computer consulting industry, and the collectible doll industry. In addition to a name, industries have numeric codes, called SIC or NAICS codes,3 which are discussed below. Industry is vitally important to your core strategy decisions because simply put, there are industries that are more profitable than others.

In fact, picking the right industry is key to the success of your small business. Stanley and Danko,4 in The Millionaire Next Door, point out that two-thirds of all millionaires are self-employed. They say that the key to being successful is selecting an industry that offers good potential for making a profit and attractive opportunities to work with a minimum of risk and competition. These industries are described as having high industry attractiveness. Stanley and Danko were surprised to discover that most millionaires who owned businesses are in industries like scrap metal, coal mining, and dry cleaning. It turns out that industries that are attractive from a profit-making sense may not be the industries thought of as attractive places to work. But choosing one of these attractive industries can do a lot to help your firm survive and you to be successful.

Industries which do well in good times and poor historically include financial firms tied to bank- ing, health-related firms, insurance firms (especially related to health), and business consulting.5 When talking about the small business myths in Chapter 1, other occupations that came up included bookkeeping, credit counseling, and tax preparers.6 Figure 7.2 gives information about a number of industry sectors and some popular individual businesses to help you get an idea of the relative attractiveness of industries (based on their profitability), and the expected level of sales.

If you know the industry’s code number (see Skill Module 7.2 to find out how to do this), you can find out a tremendous amount of information about the industry. This is because most informa- tion is coded using the industry number. From the work done by marketing researchers Stanley and Danko7 as well as BizMiner.com and others, we know there are between 15,000 to 30,000 different industries in the United States.

There are two major classification systems that code industries: the new NAICS (North Ameri- can industry classification system) and the better-known standard industrial classification system, or SIC. SIC codes have four digits; NAICS have six. NAICS covers more industries and more of the newer types of industries. Skill Module 7.2 gives you help in finding the NAICS and SIC codes for the industry for your business. The Skill Module is also on the Online Learning Center.

The key to finding information about industries is knowing how to check the information, and NAICS and SIC codes are essential to that. It is also important to know that there are no “safe” industries. In much the same way that families and societies are living things—things that are born, mature, and can die—industries can be considered living too. Ten years ago, coffee shops were a dead industry in most of the country. However, today, with Starbucks, Panera Bread, Seattle’s Best, and a host of independent coffee shops blanketing the country, the industry has been revived through franchises, company-owned stores, and innovative independents.

Imitation and Innovation

This chapter’s subtitle is “Imitation with a Twist.” The idea reflects the fact that for most small busi- nesses, the owner wants to be a lot like others in the industry, but not exactly like them. Owners who elect to imitate their competitors still want to have something that distinguishes them from the oth- ers—something that makes the owner’s firm special and better. That special and better element—that innovation amid a lot of imitation—gives us the kind of entrepreneurial thinking behind the chapter title.

The choice between imitation and innovation is truly important and often overlooked. Busi- nesses, especially new firms, can do more or less what others are already doing—an imitative strategy—or they can start doing something that is very different from what others do—an innovative strategy. Imitation is the classic small business strategy. We know from the PSED that almost two-thirds of people starting businesses today plan to use imitation as their approach.8

There are several advantages to using an imitative strategy.9 You benefit from being able to buy existing technologies, such as industrial grade washing machines for a laundromat, web servers for a hosting service, or calligraphy pens for greeting card publishing. Architects, builders, real estate

agents, zoning boards, equipment manufacturers, equipment servicing companies, and banks are more likely to understand the industry and what is expected. Because of this, they can give you firm estimates of costs and schedules. With imitative approaches, there is also the possibility to buy existing businesses.

Perhaps the key benefit of an imitative strategy comes from your customers. Chances are they already know about the kind of product or service you are offering. This means your marketing ef- forts can focus on the benefits you offer instead of explaining the product itself.

When you elect an innovative strategy, you have the benefit of making your business precisely fit your own ideas and preferences. Take the example of snowboards. When Dimitrije Milovich built the first modern snowboard in 1969, he not only had to have the product available for purchase, but he also had to inform the customers that such a product existed and how it could be used. With highly innovative businesses, there is often not much opportunity to sell the business, and the owner spends a lot of energy in creating the processes and markets as well as informing suppliers, resellers, and investors about the new product or service.

In practice, most firms use imitation plus or minus one degree of similarity. Imitation minus one degree of similarity would be the business equivalent of cloning. It is franchising, first dis- cussed in Chapter 6, in which you purchase a precise and complete copy of an existing busi- ness from the franchisor. Imitation itself involves patterning a business on existing firms and processes. Your imitation is not likely to match the precision or completeness of copying seen in franchising, since you are unlikely to have all the information about the model businesses or processes. You may also adapt your business to fit local situations or your current situation. You might pattern your new Italian restaurant after the Olive Garden, but you end up buying your equipment and food from different sources and add local favorites, such as toasted ravioli in St. Louis, barbeque pizza in Memphis, or deep-dish pizza in Chicago. This approach is called parallel competition.

Imitation plus one degree of similarity is where you look at existing businesses and pattern yourself after them, with the exception of one or two key areas in which you seek to do things in a

new, and hopefully better, way. This is called incremental innovation and is second only to par- allel competition in frequency. You have seen it in the fast-food business where Burger King told customers “have it your way.” This approach was bettered by Wendy’s, which offered custom-built hamburgers that were, in addition, “hot and juicy.” Hardees moved into the fray with supersized custom burgers. Each company makes custom-built hamburgers, but each added a small innovation to differentiate it from its competition. Small businesses do the same thing, whether they are offer- ing haircuts or golf clubs.

The last type is pure innovation, also called a blue ocean strategy, which results in a new product or service. These situations are rare. Typically with a new product or service, you also have a unique setting. For example, Philadelphia chef Joseph Poon was one of the early developers of a food style called Asian Fusion, which combined Asian food with contemporary American and nouvelle cuisine elements. His restaurant reflected the Asian Fusion theme with light woods, simple lines, and oriental details. Other Asian Fusion restaurants, such as Roy’s of Seattle or the E&O Trading Company in San Jose, California,10 added different wines, beers, and liquors, and even new types of mixed drinks developed to complement the food. After all this, the Asian Fusion chefs had to convince diners to try these new combinations of flavors.

These ideas lead to a simple set of strategic moves that can help you think about how to compete better as an imitator. Think of the case of the upstart Netflix, which became a major player in the video rental business, but was a relative latecomer.11

?

?

Parallel Innovation ? Use the standard-setter’s approach for lower start-up costs: Blockbuster set the standard, so

the software and basic inventory for video rental existed. ? Don’t make the mistakes the leader is making: Blockbuster customers complained about

lack of selection, and out-of-stock movies, so Netflix had a larger selection and arranged to

avoid stock-outs. Incremental Innovation ?   Take it to the next level: Pick one area important to customers to do much better than the

pioneer. You can be easier, cheaper, or offer higher quality. Netflix offered avid movie

renters a better financial deal and better selection. ? Borrow from Outside: If another industry has a solution that works (and people know about

and like), imitate that idea in your home industry. Netflix married the book clubs’ use of mail and the video rental model of Blockbuster.

Remember that a lot of research shows that imitators do better than pioneers in the long run.12 For example, we know Boeing, Microsoft, and Google, but these are all imitative companies. The pio- neers in their industries were companies like Wright or Curtis (airplanes), Digital Research (PC operating systems), Wandex (web searching), and Overture (keyword ad sales). When you do imita- tion well, it can do well by you.

Markets

A market is the business term for the population of customers for your product or service. If you know your market inside and out, you are likely to know much of the key information for how to be successful in your line of business. There are two market decisions you need to make early in the process of going into business. One of these is the scale of the market, which is the size of the market—whether you plan to aim for a mass market or a niche market. The other is the scope of the market, which defines the geographic range covered by the market—from local to global. manufacturers in your city. Niche markets are specific and narrow, and in a niche market approach, you try to target only customers in the niche.

Most industries have both mass and niche markets. For example, the greeting card industry has mass-market giants like Hallmark and American Greetings, which advertise nationally on TV (a sure sign of a mass marketer). However, the industry is also full of niche markets. For example, Maria Peevey and Lisa Bicker started SimplyShe with greeting cards targeting women going through try- ing life experiences such as breaking up, motherhood, or weddings. Having identified their niche and its needs, they market their cards through specialty fashion boutiques such as Henri Bendel, as well as online.13

Scope: Local to Global

Market scope is related to market scale. Market scope refers to the geography of your target market. It can be local (like a neighborhood or a city), regional (e.g., a metropolitan area or a state), national, international (usually meaning two to a few countries), or global (meaning everywhere). Owners of the businesses studied in the PSED14 were asked how much of their business they thought would come from each of the geographic categories. Overall, they estimated that 58 percent of sales would be local (within 20 miles), 30 percent would be regional (from 21–100 miles), 22 percent would be national (from 100 miles out to the rest of the United States), and only 4 percent would be interna- tional (outside the United States).

Market scope is important for two reasons. First, knowing your market scope helps you decide where to focus your sales and advertising efforts. The second benefit is that knowing your target market gives you a way to determine which potential competitors you need to worry about most, namely those also in your market scope.

In the Goal step, the key is to bring together the decisions that underlie the business you hope to own. This starts with you and the rewards you seek; the product or service you plan to offer for sale to achieve those rewards; and the industry and markets with which you and your firm will plan to deal. Armed with this basic understanding of your firm, you are ready to begin developing a strategy to achieve your goals. Very often, it starts with a closer consideration of your potential customers and what you can do with your product or service to best catch their attention.

Customers and Benefits: The Second Step of Strategic Planning

In this second step of the strategic planning process, the focus is on the kind of customer to whom you want to sell, and the benefits that will attract them. Just as there are industries that offer better and worse opportunities, there are customers that entrepreneurs prefer. Customers who offer the kinds of rewards you are seeking are generally those you are most likely to view positively. If you are interested in great wealth, having customers who are themselves wealthy and not very sensitive to price issues would be seen as rewarding. If growth is your goal, having customers from whom you can learn and who expect things to be constantly new and improved will help you meet your goal.

There are also some types of customers often seen as particularly attractive. These include:

?          Corporate customers: Look at Figure 7.2 and compare the B2B (wholesale) to B2C (retail) sales. Selling to other businesses may produce greater profits.

? Loyal customers: Loyal customers return and are already presold, making your life easier. They also refer friends, another source of revenue.

?          Local customers: This was originally true because as the owner you could keep tabs on the sat- isfaction of local customers more easily than distant ones; but in the digital age, it is less about geographic proximity than about you taking the time to stay in touch with your customers.

?          Passionate customers: People who are not just loyal but are likely to rave about your business are likely to generate more potential customers than any other type.

There are literally dozens of beliefs about the best customers. Most of them have at least a germ of truth about them. You can learn about the types of customers in your intended line of business by

talking to other entrepreneurs already in the business, and by researching the business in the trade press (to find these, refer back to Skill Module 3.1). Look for terms like “customer profile” and “preferred customers” as well as articles about “loyalty programs” and “repeat customers.” These articles are most likely to have information about the most prized customers in your proposed line of business.

The point is that thinking ahead about the kind of customer with whom you want to deal is the best way to orient your strategic planning process toward finding those customers when you get to picking a strategy. As you decide on the type of customer you want to encounter, your next step is thinking about the kind of benefits you can offer them to help meet their needs with your product or service.

Value and Cost Benefits

Benefits are characteristics of a product or service that the target customer would consider worthwhile, such as low cost or high quality. The best way to identify desirable benefits is through potential customers. You can do this directly through interviews, focus groups, or ques- tionnaires (see Chapter 12 for more details on how to do this), or indirectly through reviewing websites using the techniques given in Skill Module 7.3. Ratings and complaints for products

and companies can give you valuable information on what benefits people want, and might want more of. Usually the benefits focus on value added to the product or service or on the cost of the product or service.

Benefits are usually characterized as value benefits or cost benefits. A value benefit displays characteristics related to the nature of the product or service itself. Things like quality, fashion, and reputation are elements that give a product or service value in the eyes of the customer. A complete list is given in The Thoughtful Entrepreneur box on value and cost benefits.15 Value benefits are important because they are almost always what lead to higher prices and higher prof- its. For example, McDonald’s Big Mac often costs $2 more than their double cheeseburger. The difference between them are some sesame seeds, a third piece of bun between the top and bottom patty, the “special” Big Mac sauce, and some lettuce. Both have two all-beef patties, two buns, and cheese, which you would figure (correctly) are the major costs of the sandwiches. But people pay far more for the Big Mac and pay it far more often. Next time, ask your friends why they do that. The answers you will get will tell you a lot about value benefits, and how much people will pay for them.

While value benefits refer to what the customer senses in the product or service, cost benefits refer to the ways by which a firm can keep costs low for the customer. These include scale and scope savings, and a full list is given in the same Thoughtful Entrepreneur box. It is often important for customers to know one of these cost benefit reasons why a product or service has a low price so that they do not erroneously conclude that your firm has cut price by cutting quality.

Benefits are central to how you appeal to your target customer base. Picking benefits customers find attractive makes your firm attractive to them. Picking customer-desired benefits that your com- petitors do not offer is a powerful way to make your firm stand out from the competition. Benefits drive your firm’s offering to its customers and influence every part of the strategy process. As we will see later, benefits can be combined to offer themed strategic packages.

Offering the benefits your customers want opens up the possibility of your being able to charge a premium price and make higher profits, since people are willing to pay for value-based benefits they desire. Having cost-based benefits can also increase profits by lowering your cost of doing business, and thereby increasing your margin relative to your competition’s. Therefore, it is easy to see how benefits help you select a strategy that improves your firm’s profitability.

As you decide what benefits to offer, you open up the possibility of using a powerful strategic analysis tool called a perceptual map. Perceptual maps are a graphic display of products, services, brands, or companies evaluated in two or more ways at once. Very often one of these ways is cost or price or one of the cost-related ideas from the Cost Benefits list in the Thoughtful Entrepreneur box, since most consumers have ideas about what they are willing to pay. So price becomes one of the dimensions of your perceptual map.

The other dimension can be what you think you or your customer will think is most important. It could be the stylishness of an item of clothing, the speed of a cell phone app or car, any of the Value Benefit ideas mentioned in the Thoughtful Entrepreneur box. You are not limited to one idea. Entrepreneurs often make different perceptual maps to find a benefit that the competition is

not delivering on, but their own company could. That kind of opportunity is the goal of perceptual mapping—a combination of Value and Cost benefits your firm provides and makes your firm stand out from others in your industry or market. Skill Module 7.4 takes you through developing a perceptual map.

Industry Dynamics and Analysis: The Third Step of Strategic Planning

Industry refers not only to your product or service, but also to all the firms also selling that product or service, in other words, your competitors. In setting strategy you need to look at your competitors in order to best position your firm, but you also want to look at the changes in competitors, sales, and prof- its in your industry—what are called the industry dynamics—to make sure it is a good time to enter it.

It turns out the fortunes of industries move in a predictable way. Figure 7.3 shows the two ways the number of firms in an industry change.16 Most industries’ introduction stage starts with only a few firms. These firms elected to be innovative in their approach, making a new product or offering a new service. The number of firms typically grows slowly at first. Sales are probably small, and most customers are largely unaware of the offering. When enough customers have bought the product so that it begins to draw the attention of the general public, there are two possibilities for the growth stage. Most products and services tend to grow at a regular rate, one at which the growth in the num- ber of firms more or less meets customer demand. However, some products or services turn out to be extremely popular or “hot” and grow very rapidly. In these cases, the original firms are unable to keep up with consumer demand. Other firms jump in to take advantage of the growth; this stage is often called the boom. Firms begin to compete on features and price, and there may seem to be an explosion

of choices. Eventually, all such booms come to an end, and there is a stage called the shake-out in which many of the firms close down. This phase ends as the rapid die-off of firms stops.

Whether through slow and steady growth or a boom and shake-out cycle, the industry eventually reaches a relatively stable number of firms, with minor variations and a slow drop in numbers. This is called the maturity stage. Eventually mature industries begin a decline stage. Some industries face death, while others find new life in a process called retrenchment. We will look at those later stages later in this chapter.

Starting early is not always a guarantee of eventual success. Consider cars—the original car com- panies were small businesses. Charles and Frank Duryea, brothers who created a family business, made the first production car in the United States in 1893. Firms from the start-up stage included Duryea, Winton, and Studebaker as well as Olds, Cadillac, and Ford. The boom started in 1905 and went to 1915 with over 75 auto manufacturers, many of them still small businesses. In the shake-out during World War I, the number dropped into the teens, settling into the maturity phase of the Big 3 (GM, Ford, and Chrysler) who survived into the 21st century.

Industry dynamics are important in telling you and potential partners or investors about the pros- pects for the industry as a whole. Obviously it is easier to sell people on your business when the whole industry is growing. But if the industry is not growing there are still ways to be successful, but as a start-up you need to have worked these through ahead of time. As mentioned before, the market relinquishment in the declining airline industry after 9/11 opened up opportunities for new small airlines in the cities abandoned by the major airlines. Remember, there are small businesses started in every industry at every stage of the industry life cycle. Knowing where your industry is in the life cycle helps you to craft the best strategy for success.

Tool: Industry Analysis

Armed with the concepts and preliminary information about the product/service and the market, you are ready to do a preliminary industry analysis. Industry analysis (IA) is a research process

that provides the entrepreneur with key information about the industry, such as its current situation and trends. Most entrepreneurs initially do an IA to find out what the profits are in an industry in order to better estimate possible financial returns. Taking this one step further, finding out how those profits are generated often makes the difference between success and failure. Armed with this information, the entrepreneur can tell if the industry is growing, stable, or in decline and what the degree of competition is. Skill Module 7.5 provides a how-to description for gathering the key types of information needed to perform an industry analysis. It also explains how the information is use- ful. For a complete example of an industry analysis, see this chapter’s appendix.

What are you looking for in your industry analysis? You want a business that can help you meet the magic number you determined earlier in the chapter. In looking at the other numbers in the industry

analysis, you may see ways to cut costs, or leverage friends or expertise or other resources available to you to make your business more profitable than the average one. That can be a tremendously useful finding.

Knowing the stage and trend in the industry is important to thinking about how you will enter the industry. Going into an established industry means it is easy to find locations, equipment, and experienced people (think pizza parlors). Going into an industry early may mean you have to spend more time and money doing things for yourself. It is better to know these things early. If the analysis tells you that you are facing a lot of competition, you want to pay particular attention in building or rebuilding your perceptual map to find a set of benefits that will help your firm stand out. All in all, an industry analysis is central to your plotting of your firm’s strategy.

Table 7.1 provides a listing of many of the key databases used in assembling industry analy- ses. Some are online, while others are in book form and available in local libraries. Armed withthe information from your industry analysis, you are in a better position to decide if the industry meets your needs for income (which comes from profits and operating revenues), financial growth (depending on the trend of the industry as a whole), and competitive challenge (depending on the number and concentration of competitors). It can also help you determine if you have or can get the expertise needed to run a profitable business (comparing how profits are made to how you would run your business if you started now). If the IA outcomes do not look promising, there are thousands of other industries to try, and it is time to think about what you can offer to attract customers to your business.

Strategy Selection: The Fourth Step in Strategic Planning

There are three classic strategies for businesses of all types—differentiation, cost, and focus.17 Because they are so widely applicable, they are called generic strategies. Differentiation strategies are aimed at mass markets—situations in which nearly everyone might buy your product or service. With this strategy, you try to show how your firm offers some combina- tion of value benefits that is different from and better for the customer than those offered by competitors.

Relatively few small businesses use differentiation strategies, because it is hard for small busi- nesses to have the resources to pursue mass markets. It happens most often when a small business offers a mass-market product or service locally. For example, a gas station offers a mass-market service, but its sales are naturally limited to a particular location. This business reality sets boundar- ies for where the firm competes, which help target advertising and pricing.

Cost strategies are also aimed at mass markets. In a cost strategy, you try to show how your firm offers a combination of cost benefits that appeal to the customer. Small businesses in a va- riety of industries make use of mass-market cost strategies. Typically, this comes when the small business can pursue a very low cost operation. For example, one gravel supplier in Memphis, Tennessee, was the undisputed low-cost provider. His secret? A farmer by trade, he discovered gravel under one of his farm fields. He sold directly to the users, cutting out intermediaries and their costs.

Focus strategies target a portion of the market, called a segment or niche. Instead of selling mass-market gravel for everyone, a focus strategy might target people seeking decorative gravel. For example, Scott Stone Company in Mebane, North Carolina, offers eleven different types of gravel that differ in color, stone size, and durability. By ensuring the quality and consistency of the gravel and knowing which types work best in specialized settings, such as oriental gar- dens or waterscapes, Scott Stone offers customers products and expertise not readily available elsewhere.

Small businesses often use a combination strategy that can use aspects of differentiation or cost approaches that are reformulated for the niche market. You identify a focus or combination strat- egy by figuring out what benefits your market most wants. This can be done by asking customers outright, through surveys, or by looking at what is working among your competitors locally or in more advanced markets. Often you will find that your market seems to want several benefits at once.

Building from this, strategy researchers such as Dean Shepherd and Mark Shanley as well as Mi- chael Porter have identified classic benefit combinations which they call supra-strategies 18 which are given in Exhibit 7.1. All are designed to work where there are many small businesses in an industry, along with a few larger firms.

Tightly managed decentralization can also work in more conventional firms too. The Men- love family mastered the auto business in southern Utah with a Dodge dealership that started in 1962. Family members opened a Toyota dealership in 1986, and a Mitsubishi-Subaru dealership in 2002. Each one is highly rated in customer satisfaction and sales volume.19 Part of the un- derlying reason for their success is their ability to transplant the skills they mastered in the first dealership. Armed with these strategic choices, it is possible to profile the most typical strategies for new businesses. Table 7.2 shows four types of start-ups and outlines how they align with the scope, ge- neric strategies, imitiation/innovation choice, and supra-strategies discussed above.

It might help to think about how Table 7.2 applies in a particular industry. Let’s look at Italian restaurants (part of NAICS 72211). There are probably several Italian restaurants where you live or go to school. If you think about it, the vast majority offer the same sorts of dishes. They are funda- mentally imitators of one another. Most of them differentiate themselves based on one or two menu items (one has cannoli, another has Italian wedding cake, etc.). That is their craftsmanship. Another may differentiate on the basis of atmosphere (i.e., best place to take a date) or location (close enough to walk to from class). They probably have nearly identical kitchens and bought most of their furni- ture and serving ware from the same restaurant supply store. That is their formula facility. Together, these restaurants are classic imitators.

There is also probably another Italian restaurant known as the place to go toward the end of the month, when money is tight. The menu has the same sort of items, but the quality of the ingredients may be less (e.g., more like institutional food) or the de?cor may be nothing to look at, but the prices are always low. That restaurant is your classic cost leader.

Last, think about the Italian restaurant that has the most different menu. It may be hard to find a marinara sauce on the menu. The de?cor may look more at home in a Scandinavian restaurant, and the menu may change with the season and what looks good locally. Here you have a firm pursuingan innovator strategy. It may appeal only to a few individuals. Because the food varies so much, they are more willing to tweak recipes to fit the customer’s wishes. Some of the equipment in the kitchen or the seating area will probably be different from what the other local Italian restaurants have. That too is part of the innovator strategy. Innovators either grow enough to become mainstream, or they die out fairly quickly.

Innovators may also come along as drivers of the retrenchment of an industry. The growth of northern Italian cuisine (Italian without red sauce) revitalized the Italian restaurant industry by ex- panding the menu and reenergizing bored customers to come back and learn about new dishes. The growth of the wine industry in the United States also led to a revitalization of Italian eating. The Internet version of the Italian restaurant is the online ordering system pioneered by big chains like Pizza Hut, but is now available for small restaurants everywhere. The food is the same. The prices are the same, but the difference is the ability to order online. For some other businesses, the online inventory may be larger than the one at the store, because the entrepreneur can fill an online order through their supplier, without adding to their own inventory. So it is possible to be more comprehensive online than in the store.

Most of the time your preferences for a particular type of business or industry and the industry analysis you perform are closely tied together. But there are times when opportunities pop up unex- pectedly, and suddenly you can find yourself trying to decide if the opportunity is the right business and industry for you. This ability to quickly pivot is one of the classic strengths of the entrepreneur. Retired entrepreneurship professor Karl Vesper21 named these opportunities entry wedges, and he identified seven that come-up again and again:

? Supply shortages: Supply shortages occur when a new product is in demand. The target audience is leading-edge buyers who are willing to pay a premium to be the first to have the product. This is a short-term market and one that changes rapidly. The key benefits are deliv- ery, shopping ease, and style.

?          Unutilized resources: Unutilized resources can be a physical resource like gravel in a farm field or even entire inner cities (see Small Business Insight: Initiative for a Competitive Inner City). It can also be a human resource. Tax Resources, Inc. was started in 1988 by people ex- perienced in dealing with the IRS in order to advise taxpayers on legal strategies to minimize their taxes or handle audits.22 The key benefits are lower costs, scale savings, or organizational practices.

? Customer contracting: Customer contracting occurs when a customer, most often a busi- ness, is willing to sign a contract with a small business to ensure a product or service. Because big businesses frequently downsize, they have ongoing needs to outsource work. Former em- ployees are often the preferred source for independent subcontractors. The key benefits are quality, delivery, technology, shopping ease, brand/reputation, and assurance. Style and per- sonalization are often factors too.

?          Second sourcing: Second sourcing seeks out customers who are already being serviced by another firm. The strategy is to offer customers a second place to obtain goods or services. Often the advantage the small business offers is being locally based. Second sourcing pro- vides the customer with greater certainty of supplies or services, and at its best provides a competitive pressure to keep both suppliers providing the best service and prices. Like cus- tomer contracting, the key benefits are quality, delivery, technology, shopping ease, brand/ reputation, and assurance.

?          Market relinquishment: Market relinquishment occurs when business firms leave a market. Since the 9/11 terrorist attacks, the major American airlines have dramatically scaled back their service. For small commuter airlines, these market relinquishments have been opportuni- ties to expand and provide ongoing service to smaller airports. Key benefits are place, shop- ping ease, quality, delivery, and service.

?          Favored purchasing: Favored purchasing occurs because government agencies, government- sponsored commercial contracts, and many big businesses have policies that provide for set- asides or quotas for purchases from small businesses. You can find out more at the SBA’s online government contracting site. Key benefits are quality, delivery, service, assurance, place, and belonging.

?          Government rules: Rule changes by the government can help small firms compete. For ex- ample, when the Environmental Protection Agency let small construction firms out of some of the water pollution treatment requirements that large firms must face, it gave the small businesses a savings of $1.5 billion, which made them more competitive. The Regulatory Flexibility Act of 1980 drives many of these rule changes in government.23 Key benefits here are technology, service, personalization, lower costs, and organizational practices.

The industry analysis helps confirm that you have chosen the right industry, and also where your competitors are and the current industry stage. That and your own decisions earlier about the scope of your business and whether you plan to pursue an imitative or innovative strategy give you the fundamentals for deciding the type of small business strategy that makes the most sense for your start-up. With that information in mind, it is time to think about how you will set up your firm to implement the strategy.

Post Start-Up Tactics

The goal of strategy after the start-up stage is to maximize profits (or any other reward you specify as meeting your criteria for success) and protect your business from the competition. To secure suc- cess, there is a step you need to take past picking and implementing the right strategy. It is the step of securing competitive advantage. Competitive advantage is the particular way you implement your customer benefits that keeps your firm ahead of other firms in your industry or market. Com- petitive advantage is your firm’s edge in meeting and beating the competition.

It can be harder than it looks. Why? In part because most small businesses face a lot more forms of competition than they initially realize. Strategy guru Porter25 identifies five different threats of competition for any business, see Figure 7.4. Imagine you plan to start a web development firm in Pocatello, Idaho.

The first place to look at for competitive threats are existing firms in your industry. Pretty much all the other web developers in the Pocatello vicinity pose the threat of rivalry. Since web development is even being taught in high schools, another potential competitive threat will be potential entrants, other web development firms that open after yours. If you think about why people come to a web developer, you realize that there is a very broad threat of substitutes with which you compete. Prepackaged website templates are offered by many hosting services, com- panies like monstercommerce.com and Amazon.com sell whole e-commerce sites already laid out using templates, and people can buy their own templates from companies on the Internet like websitetemplates.com or even freewebsitetemplates.com. But customers can substitute whole other approaches, so you compete with free blogs from Blogger.com and Wordpress.com, and the growing possibility of running a company site from MySpace.com and other social network- ing sites.

Part of what will make your web development firm special might be the advanced services you offer. Perhaps you licensed one of the large archives of photos to include in your customers’ Websites. If your supplier of photos raises prices, your profits could take a hit. Similarly, if your customers have done their homework and checked out what other local developers offer and are charging,

These five—rivals, entrants, substitutes, suppliers, and customers—are aspects of your industry which can change your profitability and give an edge to any of the many types of competitors you face. The major ways you cope with these competitive pressures is by undertaking some combi- nation of strategic actions and tactical actions. Exhibit 7.2 shows some of the best-knownProduct/Service Idea and Industry

Along with this pursuit of rewards, there is often an idea for the business. Recall in Chapter 4 we saw that 37 percent of businesses start with an idea which energizes the entrepreneur to start a firm. For 42 percent the idea of starting their own business comes first, while for 21 percent the idea and the desire to start a business are simultaneous.2 EnableMart was one of those cases where the idea (Mindnautilus) came first. This is an example of a pivot, described in Chapter 1. The feasibility study Nick and Dennis did showed that it would take time to bring this product to market (and for customers to be able to use it easily). Then came the idea for a business to sup- port Mindnautilus, which became EnableMart. Whichever applies in your case, the fact is that the idea for a product or service and the idea to start a business to earn rewards make up the core of strategy—what you plan to do and why you are doing that. The process for evaluating ideas, called the feasibility study, was detailed in Chapter 4. For the purposes of this chapter, we will assume you know your idea is feasible.

Some entrepreneurs may start a firm to get the product or service out, while others may create the product or service and have agents find firms to use it, which is the consignment process described

Post Start-Up Tactics

The goal of strategy after the start-up stage is to maximize profits (or any other reward you specify as meeting your criteria for success) and protect your business from the competition. To secure suc- cess, there is a step you need to take past picking and implementing the right strategy. It is the step of securing competitive advantage. Competitive advantage is the particular way you implement your customer benefits that keeps your firm ahead of other firms in your industry or market. Com- petitive advantage is your firm’s edge in meeting and beating the competition.

It can be harder than it looks. Why? In part because most small businesses face a lot more forms of competition than they initially realize. Strategy guru Porter25 identifies five different threats of competition for any business, see Figure 7.4. Imagine you plan to start a web development firm in Pocatello, Idaho.

The first place to look at for competitive threats are existing firms in your industry. Pretty much all the other web developers in the Pocatello vicinity pose the threat of rivalry. Since web development is even being taught in high schools, another potential competitive threat will be potential entrants, other web development firms that open after yours. If you think about why people come to a web developer, you realize that there is a very broad threat of substitutes with which you compete. Prepackaged website templates are offered by many hosting services, com- panies like monstercommerce.com and Amazon.com sell whole e-commerce sites already laid out using templates, and people can buy their own templates from companies on the Internet like websitetemplates.com or even freewebsitetemplates.com. But customers can substitute whole other approaches, so you compete with free blogs from Blogger.com and Wordpress.com, and the growing possibility of running a company site from MySpace.com and other social network- ing sites.

Part of what will make your web development firm special might be the advanced services you offer. Perhaps you licensed one of the large archives of photos to include in your customers’ Websites. If your supplier of photos raises prices, your profits could take a hit. Similarly, if your customers have done their homework and checked out what other local developers offer and are charging,

These five—rivals, entrants, substitutes, suppliers, and customers—are aspects of your industry which can change your profitability and give an edge to any of the many types of competitors you face. The major ways you cope with these competitive pressures is by undertaking some combi- nation of strategic actions and tactical actions. Exhibit 7.2 shows some of the best-known

examples of each type. Generally strategic actions require more time, money, and specialized expertise (which collectively are known as your firm’s resources) than most tactical actions. That means a tactical response is most often your first response, with strategic actions building behind the scenes.

From all this, you can see that strategy represents the way by which an entrepreneur plots a path to success. For strategy to work, it needs to draw on most of the elements discussed in the chapter. When Nick and Dennis were putting together the idea for Mindnautilus.com, they were trying to strategize the right way. You know by now that they did an industry analysis that led them to see that Mindnautilus faced significant threats, and at that time, the partners lacked the strengths, especially financial strength, to overcome the threats. They kept thinking through what they could offer and eventually found an innovative option, creating EnableMart, which was ultimately a very successful firm.

Long term or short, every small business has a strategy, and successful small businesses have strategies that fit their industry, market, and resources. Strategy is one of those areas in which you can take charge and think through the options available to you and your firm. For all the ideas on which strategy touches, in the end there are some straightforward ways to help you decide on strategies, such as industry analyses and perceptual maps. These analysis techniques can help you narrow down your choices to a model of strategy that can help you succeed. For the vast majority of small businesses, the most powerful technique is to pursue an imitative strategy. By following the industry standard practices, with only one or two innovations to differentiate your firm from others, you can gain many of the benefits of established businesses and industries and still benefit from the power of innovation along smaller lines, which can make a real difference for your customers. For many owners, strategy is the grand game of business, but it is a game in which winning can make a major difference in the success of your firm and your life.

1. What are the three classic strategies for businesses of all types?

2. According to this chapter, what are the 7 entry wedges specific to small businesses pursuing an imitation strategy?

Let Chaos Rein, and then Rein in Chaos – Repeatedly: Managing Strategic Dynamics for Corporate Longevity describes types of dynamics that confront a corporation and how they may destroy their corporate longevity. Linear dynamics are characterized by rule abiding strategic actions from industry competitors that are easy to respond to and have foreseen consequences. Nonlinear dynamics are characterized by rule changing strategic actions from industry competitors that are difficult to respond to and have unforeseen consequences. A case study of Intel from 1968 to 2005 is presented that describes their response to both P-independent and P-controlled dynamics in terms of leadership style and leadership strategy.

QUESTIONS

What is the balance of exploitation and exploration that will maximize a company’s survival chances when confronted by nonlinear dynamics?

How can a company’s strategy making process be designed as to maximize both fitness and ability to evolve?

How can both P-controlled and P-independent dynamics be rule changing?

What is strategic style? How is strategic style different than strategic leadership?

How does strategic style guide strategic leadership?

READINGS

Combining longitudinal field research and executive experience, we propose that corporate longevity depends on matching cycles of autonomous and induced strategy processes to different forms of strategic dynamics, and that the role of alert strategic leadership is to appropriately balance the induced and autonomous processes throughout these cycles. We also propose that such strategic leadership is the means through which leadership style exerts its influence on corporate longevity. Our findings can be related to organizational research on structural inertia, learning and adaptation, as well as to formal theories of complex adaptive systems. They also contribute to resolving the seeming contradiction between a study of corporations that attributes exceptional long-term success to leadership style, and the more common proposition that strategy is the determinant of long-term performance.

INTRODUCTION

It is generally acknowledged that relatively few companies survive as independent entities for very long periods of time. For instance, of the top100 US-based industrial companies listed in Fortune magazine in 1965 only 19 remain in the top 100 in 2005, 15 fell out of the top 100, and 66 were acquired or disbanded.1 We think that an important reason for this lack of institutional longevity is that most of the time companies operate in a stable industry structure and develop a strategy-making process geared toward coping with linear strategic dynamics, which are relatively easy to understand and predict (e.g., Porter, 1980); but at some times in their evolution they face nonlinear strategic dynamics that overwhelm their capacity for strategy-making. Nonlinearity is described as “the property that the magnitude of an effect or output is not linearly related to that of the cause or input” (Oxford English Dictionary, Supplement). Such nonlinear transformations of inputs into outputs are governed by positive feedback loops in the interactions of the components of complex social systems (Arthur, 1989), and their outcomes are difficult to understand and predict.

Nonlinear strategic dynamics come about as industry participants - sometimes incumbents, but probably more frequently new entrants - change the “rules of the game:” normative rules based on laws, customs, and administrative principles; technological rules based on available technical solutions; economic rules reflecting existing bargaining power relationships among the industry players (often captured in contracts); and cognitive rules that are widely shared judgments about key success factors (a kind of “industry recipe” (e.g., Spender, 1989)). Whether implicit or explicit, the rules of the game usually remain unchallenged for extended periods of time (Grove, 2003), thereby engendering a strong tendency toward strategic inertia among the industry incumbents.

Organizational ecology researchers have provided empirical evidence (e.g., Hannan and Freeman, 1989) and deductive theoretical support (Hannan, Polos, and Carroll, 2004) of the value of inertia for organizational survival. They point to the conundrum leaders intending to improve organizational performance face, for instance through what they call “architectural change”(e.g., form of authority, pattern of control relations, and so on): “Surely some architectural changes do improve performance and thereby reduce mortality hazards. Just as surely, others have the opposite effect. Should we assume the beneficial case as a default? We think not.” (Hannan et al., 2004: 229). Attempted changes are hazardous because the organization-specific contingencies on which the success depends are very difficult to assess a priori; many changes are imitative, simply reflecting fads and fashions; and changes often lead to unforeseen and unintended consequences (Hannan et al., 2004: 229-230). Similarly, leading researchers of organizational learning and adaptation warn about the potential dangers of change associated with exploratory activities, because while the upside of correct decisions is very high, the downside of wrong ones can “…lead to major disasters…” (March, 2006:

205).

Yet, while organizational change may be potentially hazardous for corporate longevity, equally dangerous is what we call the “creosote bush conundrum,” using a metaphor coined by Craig Barrett, Intel Corporation’s former Chief Executive Officer. The creosote bush is a desert plan that poisons the ground around it, preventing other plants from growing nearby. Accordingly, the creosote bush conundrum refers to the strategic inertia that a successful core business experiences as it gets locked-int its product-market environment. This makes it difficult to explore and exploit new business opportunities that are not directly related to it (Burgelman, 2002). To the extent that corporate longevity depends on the capacity of a company to enter into and exit from businesses in the face of changing strategic dynamics (Burgelman, 1994), this too is a serious conundrum of strategic leadership.

Nonlinear dynamics are systematically discussed in mathematical theories of complex adaptive systems in the physical and biological sciences (e.g., Prigogine, 1980; Kauffman, 1993; Gould, 2002), and increasingly also in social science (e.g., Axelrod and Cohen, 2000) and history (e.g., Gaddis, 2002). Management scholars have also attempted to introduce some of these theoretical ideas into administrative science (e.g., Burgelman, 1983; Thietart and Forgues, 1995; Brown and Eisenhardt, 1997; Levinthal, 1997; McKelvey, 1997; Anderson, 1999; Tsoukas and Chia, 2002; Meyer, Gaba, and Colwell, 2005). Discussing some of the original theorists’ work Gould, however, cautions against“… any pure theoretician’s claim that success in modeling logically entails reification in nature” (2002: 927).

We heed Gould’s caution. Grounded in a combination of longitudinal field research and executive experience at Intel Corporation, we construct a conceptual framework of strategic dynamics situations and examine the various nonlinear ones that the company has faced. Since the challenges posed by nonlinear strategic dynamics unavoidably need to be addressed by a company’s strategy-making process, we examine the role of induced and autonomous strategy processes (Burgelman, 1991), and associated developmental resource allocation that Intel has managed throughout its evolution.

We arrive at the same fundamental questions as posed in formal theories of complex adaptive systems: What is the balance of exploitation and exploration that will maximize a company’s survival chances in the face of different nonlinear strategic dynamics situations? (March, 1991; Axelrod and Cohen, 2000). How can a company’s strategy making process be designed to effectively maintain such balance so as to maximize both “fitness;” that is, adaptation to the current environment, and “evolvability;” that is, ability to adapt to a changing environment and/or to seek out new viable environments? (Kauffman, 1993; Gould, 2002). We propose to show that different nonlinear strategic dynamics situations require different balances of induced and autonomous strategy processes, and that balanced cycles of these processes are at the heart of corporate longevity.

These important questions, in turn, raise another fundamental one about the role of strategic leadership: How can the importance of designing a strategy-making process capable of simultaneously maintaining fit and evolvability be reconciled with the observation that strategy does not play a decisive role in the evolution of companies that make it from “good to great” in the long run, but that what matters is a certain leadership style (Collins, 2001)? Our single case study of Intel Corporation, described in more detail below, allows us to examine the role of strategy-making in great depth, and as a result we propose that strategic leadership - how top management designs the strategy-making process - is the means with which leadership style exerts its influence on corporate longevity.

Research method

Combining longitudinal field research and executive experience. We draw on longitudinal field research of Intel Corporation’s evolution between 1968 and 2005 to highlight some of the strategic dynamics situations the company has faced and the role of its strategy-making process in managing them. Our research design for this paper is thus comparative with respect to time: We compare Intel’s strategy-making approach in successive strategic dynamics situations over the course of its evolution. Our research design is also consistent with recommendations of scholars studying nonlinear change (Meyer, Gaba, and Colwell, 2005): we situate Intel’s evolution in the context of the highly dynamic industries in which it participates and focus on the periods when these were in flux, away from equilibrium, and discontinuous changes were taking hold.

The longitudinal field research has involved formal and informal interviews with many hundreds of Intel managers since 1988, the observation of strategic planning meetings, and the study of company documents (Burgelman, 1991; 1994; 1996; 2002a, 2002b). We augment relevant findings of this research with insights about managing Intel’s strategic dynamics gained through more than thirty-five years of experience in top executive and governance positions at the company (Grove, 1996). With the help of senior Intel finance staff, we also tried to reconstruct the developmental resource allocation related to induced and autonomous strategy processes throughout the company’s evolution. While dollar amount allocation alone does not fully reflect resource deployment, it provides a first approximation of the corporation’s efforts to cope with strategic dynamics.

Limitations. The usual caveats associated with case study research apply. Our combination of academic research and executive experience has provided a lens through which various strategic dynamics situations in Intel’s evolution could be studied comprehensively and in unusual depth, but it unavoidably contains a subjective element. Also, the personal computer industry is somewhat special because of the importance of increasing returns to adoption (Arthur, 1987), which creates conditions leading to winner take-all outcomes. Intel benefited from these conditions during part of its history. These limitations require caution about the extent to which our analysis can be generalized.

CONCEPTUAL FRAMEWORK

Strategic dynamics situations

We examine the various ways in which a focal company’s strategic actions can interact with the environment. Call this focal company Pi and the environment E, which includes the other players, Pj, that constitute the traditional industry forces (customers, suppliers, competitors, complementors, potential new entrants, and substitutes), as well as exogenous forces such as technological change, government regulation and deregulation, and major fluctuations in the capital markets. While E’s boundaries are relatively well defined at any given time, in a dynamic world other industries or newly emerging environmental segments may potentially affect E at some time. Call these other industries or emerging segments e, and consider (E, e) the relevant environment for our further discussion of strategic dynamics. Both Pi and other players in (E, e) most of the time engage in rule-abiding strategic actions: Actions that are consistent with the prevalent normative, technological, economic, and cognitive rules that determine how Pi and the other players in (E, e) compete and that have guided them toward achieving a relatively stable industry structure. Alternatively, they can seek to turn the basis of competition in the industry decisively to their advantage by engaging in rule-changing strategic actions. Note that (E, e) are never identical across a set of Pi comprising an industry; and, given that different Pi have different positional and competence characteristics, it matters which

Pi tries to change the rules.

Game theorists note that relatively small changes in the rules can produce enormous changes in outcomes (Brandenburger and Nalebuff, 1996); on the other hand, some rule changing behavior, such as switching from Cournot (simultaneous) to Stackelberg (leader-follower) strategic action, can lead to quite stable equilibriums (e.g., Saloner, 1991: 126). Organization theorists warn about unanticipated and unforeseen consequences (e.g., Hannan, Polos, and Carroll, 2004). Complexity theory suggests that small changes in the interaction pattern of a large number of rule-abiding agents can have

big effects (e.g., Gleick, 1987). In light of these observations, the criterion we adopt for distinguishing rule-changing from rule-abiding strategic actions is that rule-changing actions by one of the players materially changes the competitive context for the other players and thereby the expected outcomes of their strategic actions (Axelrod and Cohen, 2000: 8; Gaddis, 2002: 97; Grove, 2003). We view rule-abiding strategic actions as additive and producing linear and fairly predictable change. For instance, assume that competing by offering rebates has been part of the industry tradition. Typically, the advantage of a rebate given by one competitor is canceled out when another competitor offers a similar or slightly larger one, and the effect of these competitive moves is fairly predictable. Rule-changing strategic actions, on the other hand, are multiplicative and produce strategic dynamics that are nonlinear and more difficult to predict. For instance, when one competitor starts using innovative lean manufacturing to achieve lower costs and offer lower prices, the other competitors may continue to respond by giving rebates, but this may reduce their cash reserves and may make it more difficult to catch up with the innovative competitor, leading the other competitors to offer even larger rebates in the next round of competition and falling farther behind; in this situation it is harder to predict what the new equilibrium will be.  

Determining a priori whether a strategic action by Pi (or one of the other players in (E, e)) is rule changing - e.g., negotiating a new type of contractual arrangement with customers or suppliers, introducing a technological innovation, successfully lobbying the government, and so on - will often not be possible. Pi’s capacity for “strategic recognition” (Burgelman, 1983) of the rule-changing implications of a strategic action after it has been taken but before others see them seems critical. Such strategic recognition requires a mental state of constant alertness – metaphorically called “paranoia” (Grove, 1996) – widely distributed among P’s leadership, which could be measured, for instance, by Pi’s reaction time to changes in (E, e).

Most of the time Pi’s strategic actions are rule abiding because Pi does not have the resources necessary to try to change them or because Pi anticipates that the other players can respond in kind. For the same reasons, the other players in (E, e) also engage in rule abiding strategic actions. Our example of matching rebates with rebates illustrates this situation (see above). The interplay of rule-abiding strategic actions on the part of Pi and (E, e) preserves a stable industry structure, even though the industry participants compete vigorously. The competitive context facing the various players is not materially altered and the distribution of the potential industry earnings (PIE) (Saloner, Shepard, and

Podolny, 2001) is fairly predictable, with relatively small shifts one way or the other over time that are reversible. Some scholars have called this “Red Queen” competitive dynamics, as it evokes the image of the Alice in Wonderland character running as hard as she can just to stay in the same place (Barnett and Hansen, 1996).

Sometimes players in (E, e) engage in rule-changing strategic actions that adversely impact Pi. Such rule-changing strategic actions produce P-independent industry change, which significantly reduces Pi’s power relative to (E, e). P-independent industry change is nonlinear and disruptive (from Pi’s point of view): the rule-changing actions by players in (E, e) and Pi’s inertial rule-abiding actions combine multiplicatively to materially and unfavorably change the context from Pi’s perspective. This is likely to be reflected in Pi’s decreasing relative share of the PIE. Our example of a competitor responding with rebates to another competitor’s lower prices based on a new manufacturing strategy illustrates this situation (see above). In this case, Pi is rule abiding in the face of rule changing by others in (E, e). Conversely, sometimes Pi is able to engage in rule-changing strategic actions while the other players in (E, e) continue to engage in rule-abiding strategic action. Pi’s successful rule-changing strategic actions produce P-controlled industry change, which significantly increases Pi’s power relative to (E, e). P-controlled change is nonlinear and complex: Pi’s rule-changing actions lead the other players in (E, e) to respond defensively, which multiplies their effect and materially changes the context to Pi’s advantage. This is likely to be reflected in P’s increasing relative share of the PIE.

Rule-changing strategic actions may be planned, but probably more often are unplanned and depend on strategic recognition of an opportunity that arises in a more or less fortuitous way. Forces driving toward commoditization, for instance, may change the rules (e.g., lead customers to expect lower price and higher quality) so that manufacturing process rather than product innovation becomes the new basis of competition (e.g., Utterback and Abernathy, 1975); or, a “disruptive technology” (Christensen and Bower, 1996) becomes “good enough” to change the basis of competition. In other cases, increasing returns to adoption (e.g., Arthur, 1989), such as in the personal computer industry, and digitization of content, such as in the music industry, may make changing the rules possible. These sorts of technological developments, as well as some regulatory developments (e.g., the deregulation of the telecommunications industry), may engender P-independent industry change or make P-controlled industry change possible. Sometimes both Pi and other players in (E, e) engage in rule-changing strategic actions simultaneously. Such compounded rule-changing strategic actions lead to runaway industry change. Runaway industry change is nonlinear and can be characterized as chaotic. In contrast to complexity, “… chaos deals with situations such as turbulence (…) that rapidly become highly disordered and unmanageable…”(Axelrod and Cohen, 2000: xv). Accordingly, the rule-changing strategic actions of players in (E, e) with Pi’s rule changing action interact multiplicatively and change the context in ways that are difficult to anticipate. While a runaway industry is the least stable situation and will eventually revert back to one of the other situations, it is difficult to predict which one. In the mean time, it is unclear whether Pi’s rule-changing strategic actions will ultimately be to its advantage. Technological or regulatory forces driving the convergence or collision of different industry segments (e.g., Internet computing and desktop computing), or of entire industries (e.g., computing, communications, and consumer electronics), create conditions for runaway industry change.

Internal ecology of strategy making

The co-evolving interactions of Pi and (E, e) constitute an ecological system (e.g., Hannan and Freeman, 1989). We propose that Pi’s fate in this dynamic system depends, at least in part, on its own internal ecology of strategy making (Burgelman, 1991). Consequently, we view Pi as an ecological system within which strategic initiatives emerge in patterned ways and compete for Pi’s limited resources through two distinct processes. Through the induced strategy process Pi exploits opportunities in its familiar environment. To do so, Pi’s top management sets the corporate strategy and induces strategic actions by executives deeper in the organization that are aligned with it. The induced strategy process limits actions that deviate from the corporate strategy for at least two reasons. First, Pi survived environmental selection by satisfying its customers and other constituencies in reliable ways and wants to continue to abide by the rules. This reactive propensity constitutes a rational source of strategic inertia (Hannan and Freeman, 1989). Second, Pi successfully changes the rules and aligns all the forces at its disposition to reshape the environment to its advantage, but this proactive propensity results in co-evolutionary lock-in and becomes another rational source of strategic inertia (Burgelman, 2002a).

Through the autonomous strategy process Pi explores new opportunities that are outside the scope of the existing corporate strategy, relate to new environmental segments, and are often based, at least in part, on distinctive competencies that are new to the company. Autonomous strategic initiatives usually, but not necessarily, originate at operational or middle management levels. They often come about fortuitously and somewhat unexpectedly as a result of Pi’s dynamic capabilities (e.g., Teece, Pisano, and Shuen, 1997) that co-evolve with (E, e). To overcome the selective effects of the company’s structural context, which is set up to support initiatives that are aligned with the current corporate strategy (Bower, 1970), the initiators of these autonomous initiatives try to activate a process - which we call strategic context determination (Burgelman, 1983) - to convince top management to amend Pi’s corporate strategy, thereby integrating them into the induced process going forward. The key role of the autonomous process is to extend the boundaries of Pi’s competencies and opportunities and/or to help Pi prepare for disruptive technologies. On the other hand, resources can be spread thin if P supports too many autonomous initiatives (and halts too few), perhaps at the expense of its core businesses. Most dangerously, autonomous initiatives may undermine Pi’s existing competitive position without providing a secure new one.

In general, the effectiveness of Pi’s internal ecology of strategy making depends on maintaining Pi’s ability to exploit existing opportunities through the induced process, while simultaneously maintaining Pi’s ability to pursue new opportunities through the autonomous process.

MATCHING STRATEGY-MAKING AND STRATEGIC DYNAMICS:

OBSERVATIONS FROM INTEL’S EVOLUTION

P-independent industry change: Intel’s exit from DRAM

The entry into the dynamic random access memory (DRAM) industry of several large, vertically integrated Japanese companies, which were supported by the Japanese government in their quest for dominance of the DRAM industry, fundamentally changed the rules: As DRAM products became commoditized, customers demanded consistently high quality and low prices. Hence, it took manufacturing competence to win. Intel’s competence, however, was circuit design and process technology. For several product generations Intel’s inertial induced strategy process led the company to engage in strategic actions based on its existing distinctive competencies, which increasingly undermined its ability to compete in the changed DRAM industry.

Intel’s induced strategy process became unhinged, with stated strategy and strategic action in the DRAM business diverging, as middle-level product planning managers gradually allocated scarce manufacturing capacity away from DRAM products to other, higher-margin products, including microprocessors. These actions were consistent with Intel’s generic strategy of differentiation and product leadership, which favored specialty products over commodities. But it exacerbated the decline of Intel’s ability to compete in the DRAM industry. As a result of these external and internal forces, Intel’s share of the DRAM PIE declined rapidly.

The availability of new business opportunities associated with microprocessors facilitated exiting from the DRAM business and highlights the importance of Intel’s autonomous strategy process. Intel’s microprocessor business had emerged in the early 1970s outside the scope of the company’s official corporate strategy (focused on semiconductor memory products) and in relation to a set of new market segments (electronic calculators and other embedded applications). The growth of microprocessors as specialty products drove further development of Intel’s distinctive competencies, especially in circuit design; and by the mid-1980s, Intel had moved from a silicon-based distinctive competence in memory products to a distinctive competence in implementing design architectures in logic products. As long as they remained niche products, however, top management was not ready to embrace microprocessors as its new core business because the sum of these relatively small niches was not viewed as equivalent to the large DRAM business. Hence, between 1982 and 1985 Intel’s induced strategy process remained in disarray as top management was uncertain about how to proceed. The rapid growth of the

IBM PC business, however, facilitated top management’s decision to exit the DRAM business and focus the company on microprocessors. By 1985 top management officially adopted microprocessors for the PC market segment as Intel’s new core business. P-controlled industry change: Intel’s sole source strategy. It was not until after Intel had provided the first two generations of microprocessors for PCs (8088 and 286) under cross-licensing arrangements imposed by IBM, Intel’s largest original equipment manufacturer (OEM) customer, that top management realized that it was in effect giving away its designs to the competition (second-source agreements had generally been a strong industry legacy practice). Intel funded the development of next generation processors and the cross-licensees expected to get those designs for free from Intel because the OEM customers basically demanded it. Hence, Intel’s rivals got a free ride. And, in spite of its innovative design work, this arrangement made it difficult for Intel to take a significant share of the PIE. When Intel tried to change the arrangement, asking for compensation from second sources, these rivals declined. Rivals were ready to wait until the Original Equipment Manufacturer (OEM) customers would browbeat Intel into giving the designs away. Consequently, Intel insisted on becoming sole source supplier to the OEMs. This strategic action was rule-changing because it fundamentally changed the balance of power between Intel, its OEM customers, and its competitors. Fairly quickly this led to a major shift of influence toward Intel in terms of its ability to set industry-wide standards and to appropriate a rapidly increasing share of the PIE.

It worked because of the emergence of new patterns of behavior in the PC market segment associated with increasing returns to adoption and the “horizontalization”

(Grove, 1993; Farrell, Monroe, and Saloner, 1998) of the computer industry. These new patterns favored Intel because of the strong product-market position it had achieved as a result of IBM’s efforts to create a large installed base for its PC product in the emerging personal computer market segment, whose users demanded backward and forward compatibility (they wanted to be able to continue to use their application software). This motivated independent software developers to write new applications running on Intel microprocessors, creating thereby a fast growing ecosystem around the Intel Architecture. The resulting “virtuous circle” - based on increasing returns to adoption (Arthur, 1989) - favored Intel (and Microsoft), even though it had been caused by IBM and not by Intel (and Microsoft), because Intel (and Microsoft) owned the key technological components of the PC and were free to license these technologies to other OEMs (IBM had not insisted on exclusive licensing arrangements). Consequently, Intel didn't buckle under pressure to continue to cross-license its technology.2

During 1987-1997, Intel successfully maintained P-controlled industry change. The “Intel inside” marketing campaign, another rule-changing strategic action that changed the relationship with its OEM customers and solidified its leadership position, was instrumental in this. Still another rule-changing strategic action involved the bottom-up development and championing of Intel’s chipset business around a new technology coming out of the Intel Architecture Labs. Traditionally, specialized companies and the major OEM customers developed most of the chipsets for Intel’s microprocessors. Top management initially wanted to introduce the new technology into the industry through a consortium effort. The general manager of Intel’s declining chipset division, faced with highly mature products, however, successfully engaged in an autonomous strategic effort to turn chipsets into a major Intel business. Having gained strategic control of the chipset business turned out to be extremely important at the time of the ramp-up of Intel’s new Pentium product line.

Potential runaway industry change: The battle of RISC versus CISC within Intel

Reduced instruction set computing (RISC) had been developed in IBM’s research labs in the early-to-mid 1970s, but it was MIPS Computer Systems, a Silicon Valley startup that attempted to commercialize this alternative microprocessor architecture in the mid-1980s for workstation computers. Soon thereafter several other companies, including Sun, HP, IBM, and DEC began work on their own RISC architectures. During the late 1980s, the workstation market segment had settled on RISC-based machines, and many technologists had become convinced that the performance advantage of RISC would eventually make complex instruction set computing (CISC) obsolete. Intel’s vice president of corporate marketing, for instance, confirmed that in the late 1980s Intel, whose microprocessor architecture was CISC based, was perceived as a technology laggard and that this hurt the company’s growth in the workstation market.

In the late 1980s, Intel's official corporate strategy had been not to enter the RISC business, but rather to focus its induced strategy process on its x86 (CISC) architecture.

The sole-source strategy for the 386 processor was highly successful, and with the upcoming 486 microprocessor Intel was poised to further strengthen its position as the architectural leader in the early 1990s. Intel top management called RISC “the technology of the have not.” Operating autonomously, however, a young engineer had been attempting to get Intel into the RISC processor business ever since joining the company in 1982. He ventured to sell the design for the i860 processor to top management as a co-processor for the 486 rather than as a stand-alone processor. By the time top management realized what their "co-processor" was, he and two other champions had already lined up a workstation customer base that was different than the companies who purchased the 486 chips. Thus the i860 team could argue that they were broadening Intel's business rather than cannibalizing it. Even though top management had not officially sanctioned its development, Intel did in fact introduce the i860 as a standalone RISC microprocessor in February 1989. At the time, a top-level executive pointed out that RISC was still viewed as relatively less important than CISC in Intel's strategy, but that its availability made it possible for Intel to be a strong competitor in what might become an important new market.

The threat of RISC, however, took a different form than envisaged by the RISC supporters within Intel. Some industry observers interpreted the introduction of the i860 as a signal that Intel was endorsing RISC. But this could confuse Intel’s existing PC OEM customers, who might fear that Intel would reduce support for the x86 architecture in the future. That fear was not unfounded. The RISC team within Intel had created a strong following. Distinct CISC and RISC camps had formed and they were competing for the best engineering talent of the company. The RISC effort siphoned off hundreds of people just on the marketing side. By 1989, RISC-based processor development had begun to absorb about one third of the total resources allocated to microprocessor development. The two camps were also trying to gain allies in the industry (Microsoft encouraged the i860; Compaq opposed it). The battle between CISC and RISC within Intel had turned into “civil war.” RISC proponents prepared a development trajectory showing the Intel Architecture transitioning to RISC after the 486 and wanted to rename the i860 processor 486r to facilitate the transition. But in response to serious concerns by

Intel’s VP of Marketing and other senior executives, top management decided that the i860 could not be re-named 486r. Eventually, the i860 was not successful because demand for it petered out as every workstation vendor decided to develop its own RISC processor. By 1993, most of the technical people of the i860 team had left Intel. Intel, however, succeeded in retaining many members of the team who had honed skills in ecosystem development.

Looking back, this was a confusing period for Intel. The i860 was a very successful renegade product that could have destroyed the virtuous circle enjoyed by the Intel Architecture. Intel was helping RISC by legitimizing it. Yet the company was dabbling, trying to be the best of the second best. A key lesson was that not all purported “paradigm shifts” are in fact paradigm shifts. Another key lesson concerned Intel’s strategy-making process. Positively, it looked like a Darwinian process: Top management lets the best ideas win, adapts by ruthlessly exiting businesses, provides autonomy and is the referee who waits to see who wins and then re-articulates the strategy, and matches evolving skills with evolving opportunities. Negatively it looked like Intel is reactive, lacks focus and has no constancy of purpose. It looked like chaos – ready to reigned in. And so it was. Having concluded that RISC did not constitute a paradigm shift, top management determined to fully exploit Intel’s favorable strategic position by vectoring everybody in the same direction through the induced strategy process. Intel’s subsequent success with its highly focused strategy during 1991-97 then created “co-evolutionary lock-in” (Burgelman, 2002a) with the PC market segment. However, the associated strategic inertia then impeded the company’s autonomous strategy process. As a result, when the PC market segment growth started to slow down by 1998, the company experienced difficulty in extending itself into new directions for continued profitable growth. New P-controlled industry change: Intel’s “right hand turn”

As described above, during 1987-1997 Intel grew very successful by developing new microprocessors along the performance dimension, mainly by increasing clock speeds. Their success informed the expectations in the market for market processors, a clear example of P-controlled industry change. However, toward the end of the decade the market was beginning to place less value on high performance (customers still liked higher speed but were reluctant to pay for it). Also, by the early 2000s Intel’s traditional rival had begun to catch up on the speed dimension. Intel had in some ways come full cycle. It faced a second stable industry structure situation, this time in the core microprocessor business. It was a favorable one given its market segment share, but nevertheless one in which competition had become narrowly defined in terms of bringing out the faster microprocessor the fastest in the newly tightened race with the traditional competitor. Consequently, Intel began to broaden its view of microprocessor performance along different dimensions, primarily power consumption and communications capabilities. Top management referred to this as a “right hand turn,” and indeed it did signal a major course change for the company and provided the opportunity for a repeat of P-controlled industry change.

A key ingredient in this right hand turn was the acquisition of communications capabilities. This came about as a result of moves by Intel’s new CEO, who felt the need to turbo-charge the company’s autonomous strategy process. In 1998, top management concluded that the microprocessor business by itself would not be able to sustain the company’s future growth objectives. During 1998-2001, top management encouraged and supported initiatives in many different directions and spent many billions of dollars on acquisitions. Most of these ventures failed. However, some of them did significantly augment Intel’s distinctive competences in communications technologies, which was important in view of the rapid convergence of the computing and wireless communications industries.

It is important to note that in spite of the sharp declines in Intel’s revenues and profits during the early 2000s information technology slump, the Board of Directors decided to let top management maintain cash reserves sufficient to cover one year of R&D and one generation of capital investments. Maintaining sufficient financial reserves gave the company enough resources to fully pursue the existing opportunities in the induced strategy process through continued heavy capital and technology investments, and a time buffer to decide which new strategic direction to take.

At the time of the “right hand turn,” Intel’s Mobile Computing Group (MPG) had already begun to work autonomously on developing a Pentium processor architecture optimized for the mobile PC. In late 2002, the group launched a project codenamed “Banias,” a new mobile PC microprocessor featuring an entirely new micro-architecture. The Banias project was designed to provide PC makers with ingredients to build mobile PCs with extended battery life, improved performance, reduced/varied form factors, and easier-to use wireless connectivity. A PC based on Banias would include Wi-Fi capability through a communication device codenamed “Calexico,” which contained the first 802.11 chips made by Intel.  

It is important to note that the performance dimensions that the MPG sought were in conflict with those that had driven Intel's success in the past, particularly in the desktop market segment. One of the leaders of the group said: “Being located in Israel both helped and hurt the effort to convince the company to pursue mobility. The Israeli team has a ‘renegade’ culture, so we were very open to the idea of mobility in the first place.

However, being in Israel, far apart from Intel’s HQ, made it difficult to convince the company to move toward mobility. It took blood, sweat and tears.” He also said, however, that the effort was greatly helped by the fact that top Intel executives were concerned that the microprocessor was starting to use too much power, particularly in power-sensitive environments like mobile PCs, and that the CEO found the idea of a low power microprocessor very appealing (Burgelman and Meza, 2003).

In early 2003, Intel publicly launched Banias by for the first time branding a combination of technologies under the “Centrino” name. Intel decided to bet on Centrino and subsequently spent several hundred millions of dollars helping develop the “hot spot” infrastructure necessary for mobile users to take advantage of the Centrino capability in places ranging from airports to Starbuck coffee shops. The company also invested several hundred millions of dollars in 2003 and 2004 marketing Centrino. The investment paid off. Not only was Intel able to successfully launch a new, system-level brand, but Intel’s laptop and notebook computers with the Centrino capability increased the worldwide market segment for these types of computers, commanded higher average sales prices, and increased Intel’s share of the product’s bill of materials. In 2005, the success of the mobile group’s initiative was helping drive Intel toward becoming a “platform” company.

STRATEGIC LEADERSHIP OR LEADERSHIP STYLE - WHAT DID WE LEARN?

Our longitudinal study of Intel’s evolution focused on turbulent periods in the company’s history, when the existing equilibriums between it and its environment became undone, and strategic dynamics were nonlinear. Our framework of strategic dynamics helped identify the challenges that different nonlinear dynamics situations pose for top management. We were able to link these to our framework of induced and autonomous processes, and our findings suggest that the most important contribution top management can make is to appropriately balance induced and autonomous strategy processes to meet the challenges of different strategic dynamics situations.

Accumulating resources

Our research also attempted to track Intel’s developmental resource allocation to get an indication of how the company managed the balancing of induced and autonomous strategy processes throughout its evolution. We found that it was difficult to find information about conscious and formal decisions about developmental resource allocation to autonomous initiatives. This should perhaps not be surprising given that such initiatives, by definition, are not “planned.” Based on the second author’s executive experience and with the help of Intel’s senior finance staff, however, we were able to roughly estimate the percentage of developmental resource allocation to induced and autonomous strategy processes at critical times in Intel’s evolution.

We can see that most of the time a surprisingly large proportion of the company's developmental resources have been deployed in autonomous activities. It seems that companies naturally generate a “portfolio” of autonomous initiatives. Autonomous initiatives tend to emerge as middle managers search for opportunities to sustain their business in the face of internal and external selection pressures, and find resources that are not completely absorbed by the induced strategy process and use them for their initiative. For example, in the P-independent industry change situation, middle level managers allocated manufacturing capacity away from DRAM to microprocessors (even though the official corporate strategy was still focused on memory products); in the P controlled industry change situation, the chipset business development was initially funded by the general manager of a division that was on the decline with cash generated from its very mature products; in the potential runaway industry change situation, the RISC team was able to get almost a third of the company’s microprocessor development resources even though top management had not made a corporate-level strategic decision to pursue RISC; In a recent P-controlled industry change situation, Centrino grew out of a design team in Israel that faced disbanding, and the project was helped by the autonomous development, also in Israel, of a specialized chipset.

It is instructive to follow this development. What started as an autonomous initiative with Centrino during the tenure of one CEO became the driving force of the induced strategy process - by the name “platformization” - under the next CEO in early 2005. With the autonomous initiative of the last several years having become the driving force of the new induced strategy process, a new cycle of autonomous initiatives emerged; for example an effort to develop digital products for health care applications, which by year end represented about 2 percent of development spending.

Companies might be engaging in significantly more autonomous activity than is generally believed. This may surprise many management experts, who, as March (2006: 211) points out, tend to presume that the level of “exploration” is usually less than would be optimal. Yet, most of them don’t contribute significantly to the longevity of the company. This has several important implications. Most likely it is far more difficult for strategic initiatives to be truly effectively induced by the corporate strategy than is generally understood. And, it poses distinct challenges related to resource allocation and top management control.

Scaling up and vectoring resources

In order to take advantage of the portfolio of autonomous initiatives we propose that it is necessary for top management to adopt an approach of experimentation-and-selection with novel ideas that initially require only small bets (e.g., Burgelman, 1983; March, 1991, 2006). Such an approach implies that middle managers must be able to engage in autonomous initiatives before they actually have formally obtained resources to do so. However, since autonomous initiatives start small they need to scale-up in order to be relevant from the corporate strategy point of view. Scaling up depends on the capacity of middle-level executives to build on the initial success of an initiative by combining it with other autonomous initiatives from different parts of the company (often existing there as “orphan” projects), and/or with relatively small acquisitions. Such activities require “strategic context determination,” which, however, is beyond the purview of middle management. It is top management, who must evaluate how these initiatives fit into, or reshape or even radically change, the corporate strategy going forward.

We also propose that as an autonomous initiative gains impetus in the strategy-making process, a critical top management strategic role is to evaluate first, the extent to which the autonomous opportunity has been validated (through the process of strategic context determination), and second, the extent to which available cash reserves are sufficient to protect the company from disaster in case the scaled-up autonomous initiative ultimately fails. This suggests four possible strategic choices: (1) “safe bet:” validated opportunity and sufficient cash reserves; (2) “bet the company:” validated opportunity but insufficient reserves; (3) “wait to bet:” not-yet-validated opportunity and sufficient cash reserves; and (4) “desperate bet:” not-yet-validated opportunity and insufficient cash reserves.

Even though Intel lost almost 200 million dollars in 1986, when top management decided (in 1985) to give up on the DRAM business and re-focus the company on microprocessors for the PC market segment it was already a “safe bet;” while if done a few years earlier, it would have been a “bet the company” move. Having sufficient cash reserves but not yet being sure about the potential competitive threat of RISC, Intel decided to “wait to bet” for a while, but put restraints on the autonomous initiative (for example, no renaming of the i860) until strategic context determination took its course (the autonomous RISC initiative died out). Intel’s decision to move to a platform strategy based on the success with Centrino is another example of a “safe bet.” (So far, Intel has not faced a “desperate bet” strategic choice.)

Strategically balancing induced and autonomous processes

Based on our analysis of Intel’s evolution, we propose that different strategic dynamics situations call for different balances of induced and autonomous strategy processes. In the base case of limited industry change, Pi must continue to exploit the opportunities associated with the current corporate strategy, which is achieved through the induced strategy process. Pi’s sustained profitable growth, however, depends on being able to continue to develop new business opportunities to replace declining ones over time, which requires an active portfolio of autonomous initiatives and a commensurate degree of accessible uncommitted resources and looseness of managerial control. Hence, top management should watch evolving growth opportunities and marginally re-balance resource allocation to the induced and autonomous processes.

In the case of P-independent industry change, the autonomous strategy process becomes key. As other players are able to engage in rule-changing strategic action, Pi’s induced process does not readily respond to these changes because of strategic inertia. But even if Pi could adapt to the changing basis of competition it is unlikely that it would be better than an also-ran. Ultimately, Pi is better off pursuing new opportunities created by the autonomous strategy process that continue to capitalize on the company’s distinctive competencies. Hence, top management should significantly increase resource allocation to the autonomous strategy process to generate a higher rate of new initiatives in the portfolio, and gradually increase resource allocation to winning initiatives before existing opportunities in the induced process wither away.

In the case of P-controlled industry change the induced process becomes key. While opportunities for Pi’s potential rule-breaking strategic actions often can be traced back to initiatives that started in the autonomous strategy process, P-controlled change requires that Pi align the internal and external forces to its advantage and massively increases resource allocation to the induced strategy process. As a result, however, successful P controlled change may make it difficult to pay attention to future new business opportunities. Hence, top management should continue to allocate a minimum amount of resources to keep the autonomous process viable and maintain at least a limited portfolio of autonomous initiatives.

The extreme uncertainty of runaway industry change creates a resource allocation conundrum because Pi cannot support both processes at increased levels simultaneously. Top management must decide between two different courses of action with respect to the balance of induced and autonomous processes. If Pi already has a validated new opportunity to make a “safe bet” or “bet the company,” the induced strategy process is key to impose a new strategic direction. If Pi does not yet have a validated new opportunity and decides to “wait to bet,” the autonomous strategy process is key for discovering a viable new strategic direction. Figure 3 summarizes our proposed appropriate balancing of the induced and autonomous strategy processes for each of the strategic dynamics situations.

IMPLICATIONS AND CONCLUSION: STRATEGIC LEADERSHIP AS THE

EXPRESSION OF LEADERSHIP STYLE

Collins (2001) defined great companies as those 11 that for a period of 15 years after a major transition were able to achieve average cumulative stock returns at least 3 times those of the overall stock market.3 He and his research team found that such enduring greatness depended on “level 5” leadership style: “a paradoxical blend of personal humility and professional will.” Such leaders “get the right people on the bus before they figure out the best path to greatness;” are willing to “confront the brutal facts without losing faith;” pursue a fairly simple core business in which they can be the best in the world, feel passionate about, and get tremendous profits on a carefully chosen denominator (the “hedgehog concept”); develop a culture that combines discipline with entrepreneurship; and pioneer the use of carefully selected technologies to accelerate their profitable growth. Rather than the result of dramatic transformations, the process that generates greatness is metaphorically described as “…relentlessly pushing a giant heavy flywheel in one direction…” (2001: 14).   

While academic researchers have pointed at potential weaknesses in Collins’s methodology, for instance, the fact that “long leads in random walks” may produce sustained interfirm performance differences based on chance only (Denrell, 2004), this is not our concern here.4 We do, however, note that Collin’s large sample study, while thorough and capably carried out, did not examine the role of balancing cycles of induced and autonomous processes in the long-lived success of the companies studied, and thus may have missed a deeper and primal reinforcing relationship between leadership and strategy-making process.

The strategic management field has long been interested in developing a truly dynamic theory that explains how superior competitive positions are attained longitudinally (Porter, 1991). While Collins’s study finds, surprisingly, that strategy does not play a decisive role, we think the paradox is resolved if what sets apart such leaders is the ability to design a strategy-making process that is capable of effectively balancing induced and autonomous strategy processes to meet the various strategic dynamics situations that their companies unavoidably face as they evolve. Like the phenotype is the expression of the genotype in biology, we propose that strategic leadership is the expression of Collins’s level 5 leadership style in organizations.

Alert strategic leadership is cognizant of the important role of both induced and autonomous processes in strategy-making, tolerates a sufficient level of uncommitted resources and looseness in control to continue to maintain a portfolio of autonomous initiatives, and is able to select at the right time those that need to be converted to the discipline of the induced process in order to cope with nonlinear strategic dynamics. We think that our framework of different strategic dynamics situations may help top management to better identify the associated challenges and match the dynamics of the internal machinery of strategy making - characterized by the balance of induced and autonomous strategy processes – with the dynamics of the external ecology in which the company operates. Our fundamental proposition is that corporate longevity depends on the coincidence, at different key moments in a company’s evolution, of such alert strategic leadership and the complex, on-going cycles of induced and autonomous processes that renew the organization and keep it viable.

Our confidence in this fundamental proposition is bolstered by the fact that it parallels insights from formal theories of complex adaptive systems. Prigogine (1980: 128), for instance, observes that the continued evolution of complex adaptive systems depends on “mutations” and “innovations” occurring stochastically (in our terms: generated through the autonomous process) and becoming integrated into the system by the “deterministic relations prevailing at the moment” (in our terms: becoming part of the induced process). Similarly, it parallels the idea of “adaptation at the edge of chaos,” (Kauffman, 1993) which suggests, in Gould’s succinct translation “… that a system must be adaptive, but that too much (and too precise) a local fitting may freeze a system in transient optimality with insufficient capacity for future change. Too much chaos may prove fatal by excessive and unpredictable fluctuation, both in external environments and internal states. (…) Adaptation at the edge of chaos balances both desiderata of current functionality and potential for future change, or evolvability.” (2002: 1273-74).

Achieving such a balance by design as compared to evolution is difficult and requires the juggling of opposing tendencies. Lining up potentially diverging strategies and keeping them lined up through the induced strategy process is itself a demanding task. Yet, as we have seen in the Intel case, the company must also prepare itself for the next big opportunity by continuing to let middle management experiment with, and then select, new strategic initiatives through the autonomous process before converting them to the discipline of the induced process. The appropriate balance of induced and autonomous strategy processes at different times in a company’s evolution may be thought of in terms of linear combinations of the two processes, with varying weights on each of them over time, but with none of the weights ever becoming zero. Finding the right weights for each time period is the supreme challenge of top management. The process of changing these weights can be characterized by the exhortation that during times of nonlinear change, management should let chaos reign, then rein in chaos -- but, as we have learned, never quite completely.   

NOTES

1 These 19 survivors of the top 100 of 1965 are: General Motors, Exxon Mobile, Ford Motors, General Electric, IBM, Chevron Texaco, Boeing, Procter & Gamble, Lockheed Martin, Conoco Philips, United Technologies, Dow Chemical, Caterpillar, DuPont, International Paper, Honeywell International, Alcoa, Coca Cola, and Weyerhauser.

2 It is interesting to note that IBM probably lost its power because it did initially not recognize the enormous growth potential of the PC market segment (neither did Intel). This is probably why IBM did not insist on an exclusive technology licensing agreement with Intel. IBM was of course interested in keeping prices for microprocessors low and did insist that Intel cross-license its technology to other manufacturers. Without the constraint of an exclusive licensing agreement with IBM, Intel could sell its microprocessors to other PC manufactures, such as Compaq. Hence, if IBM did not want to bring to market PCs with the next generation Intel microprocessor, these other manufactures could; and given the importance of backward compatibility to customers (they wanted to continue to use the application software they had bought for the previous PC generation). This created the “virtuous circle” that gave Intel the power to adopt a sole source strategy as of the 386 microprocessor generation, and IBM little choice but to go along.

3 Intel was not part of the set of great companies. As Collins put it, “Most technology companies were eliminated from consideration because they are not old enough to show the good-to-great pattern. We required at least thirty years of history to consider a company for the study (fifteen years of good results followed by fifteen years of great results)… Intel, for example, never had a fifteen-year period of only good performance; Intel has always been great. … ”(2001: 213).

4 Since 2001, of the 11 “good-to-great” companies, two were acquired (Gillette by P&G, and Wells Fargo by Norwest); six have underperformed, or performed at the level of, the S&P 500 (Circuit City, Fannie Mae, Kimberly Clark, Kroger, Philip Morris, ands Pitney Bowes); and three have continued to outperform the S&P (Abbott, Nucor, and Walgreens).

ARTICLE

ILINC The founding, growth and eventual acquisition of the ILINC Corporation is a typical small example of technological entrepreneurship. ILINC was founded in 1993 by a professor (the author) and two students, Degerhan Usluel and Mark Bernstein, at Rensselaer Polytechnic Institute. Later the name was changed to LearnLinc to match the name of its popular product and eventually LearnLinc entered a triple merger in early 2000 with Gilat Communications and Allen Communications to form the Mentergy Corporation (NASDAQ). The Research: It all began with an idea, and that idea eventually became a research project. In the late 80’s and early 90’s, my scientific colleagues and I were working on the application of computing and communication technologies to science and engineering education. After producing several multimedia projects, I turned my attention to the management of large quantities of educational materials on networks. The early focus was on the modularization of materials and the ability to store and retrieve those modules in an object oriented fashion. I had served as an IBM Consulting Scholar and was a frequent speaker at conferences on multimedia on networks. At one point I was invited to present my vision of the future of networked multimedia education to a group of executives that included several key executives from AT&T. That speech led to an invitation to Bell Laboratories to discuss potential cooperation and to present my vision to a broader and more technical audience. Apparently the speech was a great hit with the audience, because the AT&T Executives asked me to create a prototype of the vision -in partial collaboration with scientists from Bell Laboratories. The negotiation of the contract for this work took longer than most since I felt I had a significant interest in the pre-existing intellectual property and also wanted to maintain the rights to derivative work from the earlier work. This required some careful legal negotiations. Eventually an agreement was reached which granted rights to AT&T for all software newly created for this project, but it protected the earlier work I had done and allowed me to make further developments based upon it. The contract was written as a contract with deliverables and due dates rather than as a “best efforts” grant. The contract and deliverables caused several faculty members I invited to decline to participate because of the difficulty of working under the pressure of deadlines in an academic environment. Nevertheless, Rensselaer and I entered the contract with AT&T and began work on the project. The resulting prototype would allow distant learning on networks by using ISDN video conferencing and by using the same ISDN lines to network the distant learning sites. My team of students and staff and I also managed to make several of the pre-existing multimedia education projects work in this environment. I was pressed into service for presentation after presentation to AT&T executives, engineers, and customers over the next few months. At the same time, the Bell laboratory engineers began to Figure 1 D. Usluel-M. Bernstein-J. Wilson port the code into potential AT&T products including the WorldWorx project. Later the WorldWorx product was released in a global introduction, but (as we shall see) the product never caught on since the technologies were moving so quickly that it was out dated upon its release. The Opportunity: No technical person is ever satisfied with the first version of any software product, and I was no exception. So much had happened in computing and communications over the course of the project and the ensuing months, that I became convinced that it needed to be done quite differently in order to take advantage in the advances in object communication and multicasting - just to name two items. I went back to my colleagues at AT&T and proposed that we start all over from scratch to create a different kind of prototype that would take advantage of all the new things. I was easily able to get the technical staff at Bell labs excited. They could see exactly what I was talking about, but the proposal went absolutely nowhere with the business units. They wanted to focus on getting out product, and (in their opinion) they had what they needed. The Rensselaer and Bell Laboratories technical staffs commiserated and schemed, but no further options presented themselves, and I moved on into other projects while continuing to work on the preliminary design - adding new features with each advance in computing. One of the other projects in my laboratory, The Design and Manufacturing Learning Environment (DMLE), had a bright young graduate student, Degerhan Usluel, working on it, and he became fascinated with my plan for a network of educational objects -all communicating across the internet and distributing voice, video, and data to every site. Degerhan Usluel had been an undergraduate electrical engineering student who decided to come back for an MBA in entrepreneurship. As a student he had already founded one computing company that he turned over to his father before leaving for graduate school. Young, brilliant, naïve, and fearless, Degerhan was the ideal person for discussions about the future of collaboration on networks. One day, Degerhan showed up in my office to announce that he was beginning to plan for his upcoming graduation and that he wanted to share that plan with me. He explained that he did not want to go to work for a large company and that he wanted to start a business in software and that he wanted to do that in collaboration with me. It came as a bit of a surprise when he told me that he wanted to start up his own company rather than go to work for one of the big companies recruiting him. When I asked him what kind of company he wanted to start he told me "Something in the computer and network field, but I am not sure exactly what, but I want you to be the President." Moreover, he had recruited one of his classmates, Mark Bernstein to join him in the venture. Mark had been a “Top Gun” salesperson for Computer Associates prior to joining some friends in a startup computer disaster recovery firm called CPR. The firm had been a reasonable success, and Mark’s sales skills were certainly a factor. After discussing several different possibilities, I pulled out a file that I had been keeping with the details of the design for a distributed learning environment that would run on the internet and utilize communicating objects on students and faculty machines in a peer – to peer architecture. I also pointed out that we could use multicasting to distribute the video and audio while using the multi-casting and agent technology to manage the bandwidth on the network. This was needed to keep bandwidth requirements from getting out of hand as more and more sites were added. I did not point out to Usluel that no one had really been able to make multicasting work reliably and that most of the Internet did not support it anyway. I was confident (foolishly) that these were all solvable problems. The fact that several major computing companies had tried and failed did not dissuade us. The Team: Thus ended the opportunity recognition portion of the formation of LearnLinc. The team building portion began immediately thereafter. Usluel, Bernstein, and I vowed to start a company and began meeting regularly in my basement and sunroom. Usluel’s assignment was to build the software from scratch. Bernstein took the lead in the opportunity evaluation phase as he looked at the market and identified competitors and potential competitors. Fortunately, there were no actual competitors using the technology they envisioned! Unfortunately, no one had ever made the underlying technology work reliably! I served as President and mentor while Usluel became Vice-President for Technology and Bernstein became Vice President for Sales, Marketing, and Business Development. I began serving as a part time President and full time Chairman of the Board using my 20% consulting time from Rensselaer, my weekends, my evenings, and my holidays. It was agreed upon up front that at the end of 1-1.5 years, I would either quit Rensselaer and join ILINC LearnLinc or step down as President and CEO, recruit a replacement and serve on the board. The decision would be a joint decision of the Founders. Working with local attorneys, they created a Founder's agreement that granted 40% of the founder's stock to me and 30% each to Usluel and Bernstein. The agreement provided for potential future situations -such as a founder leaving. They also incorporated as the ILINC Corporation, obtained a Federal Tax ID, registered with the State, obtained the ILINC.com domain name, and opened bank accounts. The Exit Agreement: Deciding what their exit strategy would be was one of the easiest tasks that they had to accomplish. It took about ten minutes to decide that all three founders wanted to create a successful public company, that would define a new category of software and change the world. They were not interested in creating a "lifestyle" or a "hobby" company, and did not think they wanted to keep it as a privately owned company. They wanted to build a company, Figure 2 Mark Bernstein, Jack Wilson, and Degerhan Usluel accept one of the many awards given to ILinc go public or be acquired, and then go on to doing other things. If only the other tasks were as easy. Now they had to create a prototype, develop the pitch, and raise the money. The Prototype: The prototype was created out of bits and pieces of my work augmented by some new materials prepared by both Wilson and Usluel. Bernstein worked on the pitch with lots of kibitzing from Wilson and Usluel. Start-Up Funding -A Bootstrapping Process: Funding was a tougher problem. After discussion with a number of other successful entrepreneurs, such as William Mow, founder of Bugle boy industries and Mike Marvin, co-founder and Chairman of MapInfo corporation, Paul Severino , founder of Bay Networks, industry executives (especially from GE and IBM), and with lots of encouragement from Mark Rice, then Assistant Professor and Director of the Center for Technological Entrepreneurship, the founders decided to try to fund the company by bootstrapping the company through the sales of software for future delivery. With Wilson’s contacts and Bernstein’s passion and sales experience, they felt that they had a chance to do this without having to go to venture capitalists at an early stage. Wiser and more experienced executives (such as Warren Bruggeman, GE Executive and Chairman and primary investor in MapInfo) counseled them on the futility of this approach, but they decided to give it a try anyway. Bernstein’s passion and Wilson’s persistence carried the day. They obtained enough contracts for future delivery of software to fund the company in the early days of growth. First customers included IBM, AT&T, GTE, Sprint, Office Depot, and Harper Collins Publishing (News Corp.). An article in Success magazine later described our improbable success story as a variation on the old story of Pop-eye the Sailor Man’s friend Wimpy. Wimpy would wonder around asking folks for hamburgers while promising them that he would “gladly pay you Tuesday for a hamburger today.” In our case we promised that we would gladly give them software next year for a $300,000 (give or take) payment today. Although that does not sound like a compelling offer, we had many takers. Early customers included IBM, AT&T, GTE, Sprint, Office Depot, Aetna-United Healthcare, and Harper Collins Publishing (News Corp.). Building the Product: They were now to step eight of the entrepreneurship path. They had to do it. For that they turned to Usluel, because he had to build the product that I envisioned and Bernstein promised. And he did. When the software was delivered, it managed to satisfy all but one of the early customers and eventually even that customer grudgingly conceded that ILINC LearnLinc had delivered what they had promised, if not quite exactly what the company wanted. First Round of Venture Capital: ILINC then entered a rapid growth phase with very little working capital -depending upon cash flow to finance the each new step. When the monthly “burn rate” (the amount of cash spent each month) reached about $100,000 per month, the founders decided that it was finally time to visit the venture capitalists. Because the company had no track record, the founders were financing the shortfalls in the cash flow with bridge loans against receivables, but these had to be personally guaranteed by the founders. Signing monthly personal guarantees of $40,000 or so began to make them all a bit nervous, because none of them had the income to really handle this and only I had any assets! They went to a local venture capital firm called Exponential Investors who helped to arrange several hundred thousand dollars of financing in cooperation with some New York State business development funds. It was also time for me to decide. My partners encouraged me to come in full time, but I decided that it would be better to go back to Rensselaer and recruit a more experienced CEO for the company. I felt that I would be able to continue to help with the vision and direction, but that the company would benefit from someone with past experience in creating new ventures. A new CEO, Jim O’Keefe, was recruited who had just completed another start-up that had been acquired. The Next Two Rounds: The next few years saw ILINC grow substantially, if not painlessly, and two more rounds of financing in single digit millions brought investments from GeoCapital Investors and the Intel Corporation. The multi-million dollar investment from Intel was one of the turning points for ILinc. Intel had a video card, the ProShare card, that could be inserted into micro-computers to allow one to play live video and do video conferencing. They also partnered with Microsoft to create a software/hardware solution for video-conferencing on networks. They were building servers that would receive the video streams from several computers in a conference setting and then compose that video and send it to all participants. The problem was the factorial increase in bandwidth as additional computers were added. (Bandwidth scaled as n! or n*(n-1)*(n-2)*(n3)*(n-4)........). Thus if one went from two participants in conference to ten, the bandwidth scaled from 2x to 3,628,800x. This essentially made it impossible to serve more than a few computers in a conference. The ILinc architecture, which I had developed and Degerhan Usluel implemented and perfected, managed all this video bandwidth by keeping unused video off the network and introducing concepts now common in all conferencing systems -such as the ability to "Raise a hand" to request attention from the leader and the server. Intel heard that ILinc had solved the scaling problem, but perhaps did not believe it fully. They sent a representative to our office for a confidential demonstration covered by non-disclosure agreements. I asked them how many simultaneous participants they were able to serve and they suggested that it was less than ten. At one point an Intel representative asked me how many simultaneous sites ILinc could link up with video, audio, and screen-sharing. Since we did not have the resources to equip many sites, we really did not know for certain. The mathematics told us that we should be able to do a very large number of sites, but we had not done it. The Intel representative then asked whether we could do more than 50 sites, and I said “sure.” Under my breath I added –“probably.” Intel then cobbled together a large number of sites which was less than the 50 but more than 20 and we were asked to do a demonstration. It worked. At that point Intel told us that they were willing to invest, but that we had to have a side-by-side venture capital partner that would make a matching investment –which we quickly (but not easily) accomplished. We were also invited to develop a presentation for then CEO, Andy Grove, to do at a major software conference. According to many of my friends, Andy Grove was even more difficult and demanding to work with than Steve Jobs. Having worked with Jobs earlier in my career, I knew this was a high bar. They asked that I fly out to Santa Clara and meet with Grove to do a demonstration and answer his questions. I took the trip with some trepidation, but also knowing that the investment was already a done deal. His staff set me up in a demonstration room in which we had several computer simulating multiple remote locations. I was told that “Dr. Grove will come in at 11:15 am and then you will do the demonstration for precisely 15 minutes. At 11:30 he will begin to ask you questions. At 11:45 he will promptly depart for another meeting.” They sternly instructed me not to depart from the script and not to engage in small talk. The instructions were consistent with everything I expected. Sure enough, at precisely 11:15 Andy Grove came in and introduced himself. We sat down together at a computer, and I began to demonstrate the product. I did not get too far until he asked his first question about our screen sharing protocol. Then he followed up by asking how we had been able to do so many simultaneous video sites when his folks only were able to do eight or so –and that took a big fast server to pull off! I explained that it was not really all that hard. We simply recognized that only two video streams at any time were necessary and we used agent technologies to shut off those streams that were not going to be used. We shut off those streams at the source, while standard multipoint video conferencing solutions dealt with them all at the video-conferencing server level. We set up a simple protocol of hand-raising that would allow any participant to ask for the floor –much as legislators ask for the floor in congress. That prompted another question and then another. 11:45 came and went but Andy Grove was still sitting at the computer asking me to demonstrate one point after another and firing off questions like he was giving a doctoral candidate an examination. That put him on my turf, and I was enjoying myself immensely. His staff got more and more nervous, but they were quite careful not to interrupt him. They kept giving me dirty looks, but Andy Grove just kept on asking questions and clicking on buttons. It was nearly 1 pm when he left with a smile and a big handshake. I could not have found him to be a nicer or more interesting guy. When he delivered his speech, my partner Mark Bernstein was there to provide his support. It was one of the highpoints of our early years. Figure 3 Andy Grove, CEO of Intel, and Mark Bernstein when Andy presented LearnLinc to thousands of attendees at a major national convention after Intel invested millions in ILinc and also adapted its software to some Intel products. As noted above product development and financing went through several cycles as ILINC released new versions of LearnLinc and arranged new rounds of financing. Fortune described ILINC as: “Interactive Learning International Corp. (ILINC), a two-year-old company in Troy, New York, has shown what's possible in today's world of limited telecommunications bandwidth. ILINC's interactive training programs can be transmitted to users' PCs over local- and wide-area networks, as well as high-speed communications links such as ISDN (integrated services digital networks). A live instructor can appear in a window on the screen and address students in dozens of locations. He can launch video and audio clips for all the "class" to see and hear. And at discussion time, a student can click on a "raise hand" icon to get the floor.” 1 In 1998, the Wall Street Journal said: "'It's great -- by using it, we've cut our travel expenses substantially,' says Gary Schweikhart, a spokesman for Office Depot, an office-supply company in Delray Beach, Fla. Office Depot first took its corporate training sessions online in May 1996. It was one of the first customers of Interactive Learning International Inc., or ILINC, a Troy, N.Y., maker of distance-learning software. Since then, about 1,500 Office Depot employees have completed online training, on everything from how to write a business letter to how to use the company's proprietary order-taking system. 'We were in a situation where we were doing a lot of training of trainers' in order to have enough qualified instructors to teach employees at 629 stores and 68 sales offices across the country, says Doug Kendig, the company's manager of training technology. 'We had to deputize a lot of people [to train employees], and you don't always get the best results that way.' But now Office Depot uses the ILINC software for about 20% of its training, with classes in Florida, California and Texas using just six instructors. 'I think it's fantastic,' says Jeannette Perez, who works in Office Depot's commercial credit-card department. 'It just holds my attention more, because you're interacting with the computer.' 2 1 REPORTER ASSOCIATE Alicia Hills Moore Copyright © 1996, Time Inc., all rights reserved 2 Wall Street Journal –Thursday August 6, 1998. Figure 4 Wall Street Journal; Aug. 6 1996. The Plot Thickens: The company was becoming successful but experiencing growing pains and pinched financing. Moreover, they now had some very significant competitors. Without patents on the underlying technology, the fast followers were able to reverse engineer the LearnLinc product. Although their earliest efforts were crude and unreliable, there was no reason to believe that they would not get steadily more powerful. These competitors were also much better funded. ILinc was founded in 1993 by people who knew the “old rules” of entrepreneurship. They focused on revenues, tried to achieve positive cash flow, and minimized the acquisition of venture capital. Their competitors were living in a “new-new world:” the dot-com era of the tech boom. They raised ten times the venture capital and thus had a far more powerful sales and marketing enterprise. There were times that the LearnLinc product was only being discovered after one of its competitors had gone into a company and sold them on the concept. For big companies like Aetna-United Health Care, there was a process to evaluate competitors for big purchases. After Centra had sold them a pilot, LearnLinc was chosen as the corporate provider. In general, it is difficult to rely on your competitors to sell your product. Going Public: By the summer of 1999, the founders felt that it was time for LearnLinc to raise much more funding and to grow substantially. The new CEO had been replaced by an interim CEO, Mike Marvin, and then by Degerhan Usluel. I continued to serve as Chairman. The Board decided to hire an investment banker (Michael Kane and Associates of California) and met with a selection of other entrepreneurs to decide how to best go forward. They identified three potential paths: ? Do an IPO. ? Get acquired by a complementary company ? Enter a partnership with (and receive an investment from) a complementary company that would build upon their joint strengths and allow them to grow faster. From the beginning, the group leaned toward some kind of business alliance or acquisition. Although the excitement and financial reward of the IPO was attractive, they felt that the glory might be short lived. They knew that LearnLinc needed a much larger sales force and needed to be much larger financially to crack the very large enterprise accounts that could allow them to reach the next level of development. Although they had sold product to IBM, AT&T, Lucent, MCI, Computer Associates, Aetna, United Health Care, Boeing, Flight Safety, and many other large accounts, these tended to top out at less than million dollar accounts. In order to grow and dominate the market, they needed to be able to crack that barrier. An IPO could bring them the funds necessary to grow, but it would take time and management attention to hire the people and create the systems needed to handle the growth. The company’s advisors suggested that an IPO would likely value the company at $100 million to $200 million. Perhaps it could be more, but that would depend upon timing and market excitement. They also suggested that an acquisition would probably only bring about $50 million, but that the acquisition might leave the company better positioned to grow over the coming years. Given the anticipated lock-up periods for founders stock, the founders tried to evaluate the options as they would look one year into the future, rather than at the transaction date. The Triple Merger - LearnLinc becomes Mentergy: Eventually we decided to agree to be acquired by Gilat Communications. The deal closed on February 29, 2000. Gilat paid 1.5 million shares (gross before commissions) for LearnLinc. On February 29, Gilat closed at $35 per share making the value of the deal $ 52.5 million at closing. Because of the use of bootstrap start-up funding, venture capitalists held less than 50% of the company at the close. During the same period, Gilat acquired Allen Communications from the Times Mirror group for $23 million in cash. Over the next six months, the three companies were blended into one company - known as Mentergy. The companies had a complementary set of strengths. LearnLinc was the market leader in live-on-line eLearning. Allen Communications had an impressive established customer base, a large skilled sales force and specialized in web and CD-ROM based CBT. Gilat brought expertise in satellite communications and interactive learning over satellites. The plan was to create a blended learning approach that was “technology agnostic” and could provide the best eLearning solutions for a variety of different learning needs. The target market continued to be corporations and corporate training. At first the market loved the combination. By March of 2000, Mentergy had a market capitalization of over $500 million. Plans were developed for a secondary offering both to cover the expenses of the triple merger and to provide additional development and marketing resources, but the declining stock market made that a difficult task. The situation was complicated further by a misguided effort to create a headquarters for Mentergy in Atlanta, Georgia (when most of the employees were in New York, Utah, and Israel) and by management confusion caused by the difficult communication process with key management personnel and the Board Chair in Israel. Wilson, Usluel, and Bernstein had agreed to remain involved for at least six months after the merger. I severed my ties in frustration as soon as allowable. Usluel and Bernstein persisted longer in a futile attempt to get the company back on track. By 2002, Mentergy was in bankruptcy. The company was broken back into several pieces. The ILinc portion was purchased by EDT Learning from Arizona. They renamed themselves ILinc in honor of their successful product, which continues to be used in many major American corporations. In hindsight, there would be many things that might be done differently if we had to do them over again, but I hope that the reader can see how we were thinking as we made each decision.A new venture is expected to be attractive, timely, durable, and anchored in a product or service that creates or adds value for the buyer. How did ILINC fit with this description? How did ILINC fit with trends in economic forces, social forces, technological advances, and political and regulatory changes? ARTICLE ILINC The founding, growth and eventual acquisition of the ILINC Corporation is a typical small example of technological entrepreneurship. ILINC was founded in 1993 by a professor (the author) and two students, Degerhan Usluel and Mark Bernstein, at Rensselaer Polytechnic Institute. Later the name was changed to LearnLinc to match the name of its popular product and eventually LearnLinc entered a triple merger in early 2000 with Gilat Communications and Allen Communications to form the Mentergy Corporation (NASDAQ). The Research: It all began with an idea, and that idea eventually became a research project. In the late 80’s and early 90’s, my scientific colleagues and I were working on the application of computing and communication technologies to science and engineering education. After producing several multimedia projects, I turned my attention to the management of large quantities of educational materials on networks. The early focus was on the modularization of materials and the ability to store and retrieve those modules in an object oriented fashion. I had served as an IBM Consulting Scholar and was a frequent speaker at conferences on multimedia on networks. At one point I was invited to present my vision of the future of networked multimedia education to a group of executives that included several key executives from AT&T. That speech led to an invitation to Bell Laboratories to discuss potential cooperation and to present my vision to a broader and more technical audience. Apparently the speech was a great hit with the audience, because the AT&T Executives asked me to create a prototype of the vision -in partial collaboration with scientists from Bell Laboratories. The negotiation of the contract for this work took longer than most since I felt I had a significant interest in the pre-existing intellectual property and also wanted to maintain the rights to derivative work from the earlier work. This required some careful legal negotiations. Eventually an agreement was reached which granted rights to AT&T for all software newly created for this project, but it protected the earlier work I had done and allowed me to make further developments based upon it. The contract was written as a contract with deliverables and due dates rather than as a “best efforts” grant. The contract and deliverables caused several faculty members I invited to decline to participate because of the difficulty of working under the pressure of deadlines in an academic environment. Nevertheless, Rensselaer and I entered the contract with AT&T and began work on the project. The resulting prototype would allow distant learning on networks by using ISDN video conferencing and by using the same ISDN lines to network the distant learning sites. My team of students and staff and I also managed to make several of the pre-existing multimedia education projects work in this environment. I was pressed into service for presentation after presentation to AT&T executives, engineers, and customers over the next few months. At the same time, the Bell laboratory engineers began to Figure 1 D. Usluel-M. Bernstein-J. Wilson port the code into potential AT&T products including the WorldWorx project. Later the WorldWorx product was released in a global introduction, but (as we shall see) the product never caught on since the technologies were moving so quickly that it was out dated upon its release. The Opportunity: No technical person is ever satisfied with the first version of any software product, and I was no exception. So much had happened in computing and communications over the course of the project and the ensuing months, that I became convinced that it needed to be done quite differently in order to take advantage in the advances in object communication and multicasting - just to name two items. I went back to my colleagues at AT&T and proposed that we start all over from scratch to create a different kind of prototype that would take advantage of all the new things. I was easily able to get the technical staff at Bell labs excited. They could see exactly what I was talking about, but the proposal went absolutely nowhere with the business units. They wanted to focus on getting out product, and (in their opinion) they had what they needed. The Rensselaer and Bell Laboratories technical staffs commiserated and schemed, but no further options presented themselves, and I moved on into other projects while continuing to work on the preliminary design - adding new features with each advance in computing. One of the other projects in my laboratory, The Design and Manufacturing Learning Environment (DMLE), had a bright young graduate student, Degerhan Usluel, working on it, and he became fascinated with my plan for a network of educational objects -all communicating across the internet and distributing voice, video, and data to every site. Degerhan Usluel had been an undergraduate electrical engineering student who decided to come back for an MBA in entrepreneurship. As a student he had already founded one computing company that he turned over to his father before leaving for graduate school. Young, brilliant, naïve, and fearless, Degerhan was the ideal person for discussions about the future of collaboration on networks. One day, Degerhan showed up in my office to announce that he was beginning to plan for his upcoming graduation and that he wanted to share that plan with me. He explained that he did not want to go to work for a large company and that he wanted to start a business in software and that he wanted to do that in collaboration with me. It came as a bit of a surprise when he told me that he wanted to start up his own company rather than go to work for one of the big companies recruiting him. When I asked him what kind of company he wanted to start he told me "Something in the computer and network field, but I am not sure exactly what, but I want you to be the President." Moreover, he had recruited one of his classmates, Mark Bernstein to join him in the venture. Mark had been a “Top Gun” salesperson for Computer Associates prior to joining some friends in a startup computer disaster recovery firm called CPR. The firm had been a reasonable success, and Mark’s sales skills were certainly a factor. After discussing several different possibilities, I pulled out a file that I had been keeping with the details of the design for a distributed learning environment that would run on the internet and utilize communicating objects on students and faculty machines in a peer – to peer architecture. I also pointed out that we could use multicasting to distribute the video and audio while using the multi-casting and agent technology to manage the bandwidth on the network. This was needed to keep bandwidth requirements from getting out of hand as more and more sites were added. I did not point out to Usluel that no one had really been able to make multicasting work reliably and that most of the Internet did not support it anyway. I was confident (foolishly) that these were all solvable problems. The fact that several major computing companies had tried and failed did not dissuade us. The Team: Thus ended the opportunity recognition portion of the formation of LearnLinc. The team building portion began immediately thereafter. Usluel, Bernstein, and I vowed to start a company and began meeting regularly in my basement and sunroom. Usluel’s assignment was to build the software from scratch. Bernstein took the lead in the opportunity evaluation phase as he looked at the market and identified competitors and potential competitors. Fortunately, there were no actual competitors using the technology they envisioned! Unfortunately, no one had ever made the underlying technology work reliably! I served as President and mentor while Usluel became Vice-President for Technology and Bernstein became Vice President for Sales, Marketing, and Business Development. I began serving as a part time President and full time Chairman of the Board using my 20% consulting time from Rensselaer, my weekends, my evenings, and my holidays. It was agreed upon up front that at the end of 1-1.5 years, I would either quit Rensselaer and join ILINC LearnLinc or step down as President and CEO, recruit a replacement and serve on the board. The decision would be a joint decision of the Founders. Working with local attorneys, they created a Founder's agreement that granted 40% of the founder's stock to me and 30% each to Usluel and Bernstein. The agreement provided for potential future situations -such as a founder leaving. They also incorporated as the ILINC Corporation, obtained a Federal Tax ID, registered with the State, obtained the ILINC.com domain name, and opened bank accounts. The Exit Agreement: Deciding what their exit strategy would be was one of the easiest tasks that they had to accomplish. It took about ten minutes to decide that all three founders wanted to create a successful public company, that would define a new category of software and change the world. They were not interested in creating a "lifestyle" or a "hobby" company, and did not think they wanted to keep it as a privately owned company. They wanted to build a company, Figure 2 Mark Bernstein, Jack Wilson, and Degerhan Usluel accept one of the many awards given to ILinc go public or be acquired, and then go on to doing other things. If only the other tasks were as easy. Now they had to create a prototype, develop the pitch, and raise the money. The Prototype: The prototype was created out of bits and pieces of my work augmented by some new materials prepared by both Wilson and Usluel. Bernstein worked on the pitch with lots of kibitzing from Wilson and Usluel. Start-Up Funding -A Bootstrapping Process: Funding was a tougher problem. After discussion with a number of other successful entrepreneurs, such as William Mow, founder of Bugle boy industries and Mike Marvin, co-founder and Chairman of MapInfo corporation, Paul Severino , founder of Bay Networks, industry executives (especially from GE and IBM), and with lots of encouragement from Mark Rice, then Assistant Professor and Director of the Center for Technological Entrepreneurship, the founders decided to try to fund the company by bootstrapping the company through the sales of software for future delivery. With Wilson’s contacts and Bernstein’s passion and sales experience, they felt that they had a chance to do this without having to go to venture capitalists at an early stage. Wiser and more experienced executives (such as Warren Bruggeman, GE Executive and Chairman and primary investor in MapInfo) counseled them on the futility of this approach, but they decided to give it a try anyway. Bernstein’s passion and Wilson’s persistence carried the day. They obtained enough contracts for future delivery of software to fund the company in the early days of growth. First customers included IBM, AT&T, GTE, Sprint, Office Depot, and Harper Collins Publishing (News Corp.). An article in Success magazine later described our improbable success story as a variation on the old story of Pop-eye the Sailor Man’s friend Wimpy. Wimpy would wonder around asking folks for hamburgers while promising them that he would “gladly pay you Tuesday for a hamburger today.” In our case we promised that we would gladly give them software next year for a $300,000 (give or take) payment today. Although that does not sound like a compelling offer, we had many takers. Early customers included IBM, AT&T, GTE, Sprint, Office Depot, Aetna-United Healthcare, and Harper Collins Publishing (News Corp.). Building the Product: They were now to step eight of the entrepreneurship path. They had to do it. For that they turned to Usluel, because he had to build the product that I envisioned and Bernstein promised. And he did. When the software was delivered, it managed to satisfy all but one of the early customers and eventually even that customer grudgingly conceded that ILINC LearnLinc had delivered what they had promised, if not quite exactly what the company wanted. First Round of Venture Capital: ILINC then entered a rapid growth phase with very little working capital -depending upon cash flow to finance the each new step. When the monthly “burn rate” (the amount of cash spent each month) reached about $100,000 per month, the founders decided that it was finally time to visit the venture capitalists. Because the company had no track record, the founders were financing the shortfalls in the cash flow with bridge loans against receivables, but these had to be personally guaranteed by the founders. Signing monthly personal guarantees of $40,000 or so began to make them all a bit nervous, because none of them had the income to really handle this and only I had any assets! They went to a local venture capital firm called Exponential Investors who helped to arrange several hundred thousand dollars of financing in cooperation with some New York State business development funds. It was also time for me to decide. My partners encouraged me to come in full time, but I decided that it would be better to go back to Rensselaer and recruit a more experienced CEO for the company. I felt that I would be able to continue to help with the vision and direction, but that the company would benefit from someone with past experience in creating new ventures. A new CEO, Jim O’Keefe, was recruited who had just completed another start-up that had been acquired. The Next Two Rounds: The next few years saw ILINC grow substantially, if not painlessly, and two more rounds of financing in single digit millions brought investments from GeoCapital Investors and the Intel Corporation. The multi-million dollar investment from Intel was one of the turning points for ILinc. Intel had a video card, the ProShare card, that could be inserted into micro-computers to allow one to play live video and do video conferencing. They also partnered with Microsoft to create a software/hardware solution for video-conferencing on networks. They were building servers that would receive the video streams from several computers in a conference setting and then compose that video and send it to all participants. The problem was the factorial increase in bandwidth as additional computers were added. (Bandwidth scaled as n! or n*(n-1)*(n-2)*(n3)*(n-4)........). Thus if one went from two participants in conference to ten, the bandwidth scaled from 2x to 3,628,800x. This essentially made it impossible to serve more than a few computers in a conference. The ILinc architecture, which I had developed and Degerhan Usluel implemented and perfected, managed all this video bandwidth by keeping unused video off the network and introducing concepts now common in all conferencing systems -such as the ability to "Raise a hand" to request attention from the leader and the server. Intel heard that ILinc had solved the scaling problem, but perhaps did not believe it fully. They sent a representative to our office for a confidential demonstration covered by non-disclosure agreements. I asked them how many simultaneous participants they were able to serve and they suggested that it was less than ten. At one point an Intel representative asked me how many simultaneous sites ILinc could link up with video, audio, and screen-sharing. Since we did not have the resources to equip many sites, we really did not know for certain. The mathematics told us that we should be able to do a very large number of sites, but we had not done it. The Intel representative then asked whether we could do more than 50 sites, and I said “sure.” Under my breath I added –“probably.” Intel then cobbled together a large number of sites which was less than the 50 but more than 20 and we were asked to do a demonstration. It worked. At that point Intel told us that they were willing to invest, but that we had to have a side-by-side venture capital partner that would make a matching investment –which we quickly (but not easily) accomplished. We were also invited to develop a presentation for then CEO, Andy Grove, to do at a major software conference. According to many of my friends, Andy Grove was even more difficult and demanding to work with than Steve Jobs. Having worked with Jobs earlier in my career, I knew this was a high bar. They asked that I fly out to Santa Clara and meet with Grove to do a demonstration and answer his questions. I took the trip with some trepidation, but also knowing that the investment was already a done deal. His staff set me up in a demonstration room in which we had several computer simulating multiple remote locations. I was told that “Dr. Grove will come in at 11:15 am and then you will do the demonstration for precisely 15 minutes. At 11:30 he will begin to ask you questions. At 11:45 he will promptly depart for another meeting.” They sternly instructed me not to depart from the script and not to engage in small talk. The instructions were consistent with everything I expected. Sure enough, at precisely 11:15 Andy Grove came in and introduced himself. We sat down together at a computer, and I began to demonstrate the product. I did not get too far until he asked his first question about our screen sharing protocol. Then he followed up by asking how we had been able to do so many simultaneous video sites when his folks only were able to do eight or so –and that took a big fast server to pull off! I explained that it was not really all that hard. We simply recognized that only two video streams at any time were necessary and we used agent technologies to shut off those streams that were not going to be used. We shut off those streams at the source, while standard multipoint video conferencing solutions dealt with them all at the video-conferencing server level. We set up a simple protocol of hand-raising that would allow any participant to ask for the floor –much as legislators ask for the floor in congress. That prompted another question and then another. 11:45 came and went but Andy Grove was still sitting at the computer asking me to demonstrate one point after another and firing off questions like he was giving a doctoral candidate an examination. That put him on my turf, and I was enjoying myself immensely. His staff got more and more nervous, but they were quite careful not to interrupt him. They kept giving me dirty looks, but Andy Grove just kept on asking questions and clicking on buttons. It was nearly 1 pm when he left with a smile and a big handshake. I could not have found him to be a nicer or more interesting guy. When he delivered his speech, my partner Mark Bernstein was there to provide his support. It was one of the highpoints of our early years. Figure 3 Andy Grove, CEO of Intel, and Mark Bernstein when Andy presented LearnLinc to thousands of attendees at a major national convention after Intel invested millions in ILinc and also adapted its software to some Intel products. As noted above product development and financing went through several cycles as ILINC released new versions of LearnLinc and arranged new rounds of financing. Fortune described ILINC as: “Interactive Learning International Corp. (ILINC), a two-year-old company in Troy, New York, has shown what's possible in today's world of limited telecommunications bandwidth. ILINC's interactive training programs can be transmitted to users' PCs over local- and wide-area networks, as well as high-speed communications links such as ISDN (integrated services digital networks). A live instructor can appear in a window on the screen and address students in dozens of locations. He can launch video and audio clips for all the "class" to see and hear. And at discussion time, a student can click on a "raise hand" icon to get the floor.” 1 In 1998, the Wall Street Journal said: "'It's great -- by using it, we've cut our travel expenses substantially,' says Gary Schweikhart, a spokesman for Office Depot, an office-supply company in Delray Beach, Fla. Office Depot first took its corporate training sessions online in May 1996. It was one of the first customers of Interactive Learning International Inc., or ILINC, a Troy, N.Y., maker of distance-learning software. Since then, about 1,500 Office Depot employees have completed online training, on everything from how to write a business letter to how to use the company's proprietary order-taking system. 'We were in a situation where we were doing a lot of training of trainers' in order to have enough qualified instructors to teach employees at 629 stores and 68 sales offices across the country, says Doug Kendig, the company's manager of training technology. 'We had to deputize a lot of people [to train employees], and you don't always get the best results that way.' But now Office Depot uses the ILINC software for about 20% of its training, with classes in Florida, California and Texas using just six instructors. 'I think it's fantastic,' says Jeannette Perez, who works in Office Depot's commercial credit-card department. 'It just holds my attention more, because you're interacting with the computer.' 2 1 REPORTER ASSOCIATE Alicia Hills Moore Copyright © 1996, Time Inc., all rights reserved 2 Wall Street Journal –Thursday August 6, 1998. Figure 4 Wall Street Journal; Aug. 6 1996. The Plot Thickens: The company was becoming successful but experiencing growing pains and pinched financing. Moreover, they now had some very significant competitors. Without patents on the underlying technology, the fast followers were able to reverse engineer the LearnLinc product. Although their earliest efforts were crude and unreliable, there was no reason to believe that they would not get steadily more powerful. These competitors were also much better funded. ILinc was founded in 1993 by people who knew the “old rules” of entrepreneurship. They focused on revenues, tried to achieve positive cash flow, and minimized the acquisition of venture capital. Their competitors were living in a “new-new world:” the dot-com era of the tech boom. They raised ten times the venture capital and thus had a far more powerful sales and marketing enterprise. There were times that the LearnLinc product was only being discovered after one of its competitors had gone into a company and sold them on the concept. For big companies like Aetna-United Health Care, there was a process to evaluate competitors for big purchases. After Centra had sold them a pilot, LearnLinc was chosen as the corporate provider. In general, it is difficult to rely on your competitors to sell your product. Going Public: By the summer of 1999, the founders felt that it was time for LearnLinc to raise much more funding and to grow substantially. The new CEO had been replaced by an interim CEO, Mike Marvin, and then by Degerhan Usluel. I continued to serve as Chairman. The Board decided to hire an investment banker (Michael Kane and Associates of California) and met with a selection of other entrepreneurs to decide how to best go forward. They identified three potential paths: ? Do an IPO. ? Get acquired by a complementary company ? Enter a partnership with (and receive an investment from) a complementary company that would build upon their joint strengths and allow them to grow faster. From the beginning, the group leaned toward some kind of business alliance or acquisition. Although the excitement and financial reward of the IPO was attractive, they felt that the glory might be short lived. They knew that LearnLinc needed a much larger sales force and needed to be much larger financially to crack the very large enterprise accounts that could allow them to reach the next level of development. Although they had sold product to IBM, AT&T, Lucent, MCI, Computer Associates, Aetna, United Health Care, Boeing, Flight Safety, and many other large accounts, these tended to top out at less than million dollar accounts. In order to grow and dominate the market, they needed to be able to crack that barrier. An IPO could bring them the funds necessary to grow, but it would take time and management attention to hire the people and create the systems needed to handle the growth. The company’s advisors suggested that an IPO would likely value the company at $100 million to $200 million. Perhaps it could be more, but that would depend upon timing and market excitement. They also suggested that an acquisition would probably only bring about $50 million, but that the acquisition might leave the company better positioned to grow over the coming years. Given the anticipated lock-up periods for founders stock, the founders tried to evaluate the options as they would look one year into the future, rather than at the transaction date. The Triple Merger - LearnLinc becomes Mentergy: Eventually we decided to agree to be acquired by Gilat Communications. The deal closed on February 29, 2000. Gilat paid 1.5 million shares (gross before commissions) for LearnLinc. On February 29, Gilat closed at $35 per share making the value of the deal $ 52.5 million at closing. Because of the use of bootstrap start-up funding, venture capitalists held less than 50% of the company at the close. During the same period, Gilat acquired Allen Communications from the Times Mirror group for $23 million in cash. Over the next six months, the three companies were blended into one company - known as Mentergy. The companies had a complementary set of strengths. LearnLinc was the market leader in live-on-line eLearning. Allen Communications had an impressive established customer base, a large skilled sales force and specialized in web and CD-ROM based CBT. Gilat brought expertise in satellite communications and interactive learning over satellites. The plan was to create a blended learning approach that was “technology agnostic” and could provide the best eLearning solutions for a variety of different learning needs. The target market continued to be corporations and corporate training. At first the market loved the combination. By March of 2000, Mentergy had a market capitalization of over $500 million. Plans were developed for a secondary offering both to cover the expenses of the triple merger and to provide additional development and marketing resources, but the declining stock market made that a difficult task. The situation was complicated further by a misguided effort to create a headquarters for Mentergy in Atlanta, Georgia (when most of the employees were in New York, Utah, and Israel) and by management confusion caused by the difficult communication process with key management personnel and the Board Chair in Israel. Wilson, Usluel, and Bernstein had agreed to remain involved for at least six months after the merger. I severed my ties in frustration as soon as allowable. Usluel and Bernstein persisted longer in a futile attempt to get the company back on track. By 2002, Mentergy was in bankruptcy. The company was broken back into several pieces. The ILinc portion was purchased by EDT Learning from Arizona. They renamed themselves ILinc in honor of their successful product, which continues to be used in many major American corporations. In hindsight, there would be many things that might be done differently if we had to do them over again, but I hope that the reader can see how we were thinking as we made each decision.

Question : A new venture is expected to be attractive, timely, durable, and anchored in a product or service that creates or adds value for the buyer. How did ILINC fit with this description? How did ILINC fit with trends in economic forces, social forces, technological advances, and political and regulatory changes?

Describe the potential social, economic, and cultural implications associated with the Baby-Friendly Hospital Initiative.

Describe how the registered nurse can overcome the obstacles to make the Baby-Friendly Initiative a success.

250 words or more please

The Baby-Friendly Hospital Initiative (BFHI) is a program developed by the World Health Organization (WHO) and the United Nations Children's Fund (UNICEF) to promote breastfeeding in hospitals and birthing facilities worldwide. Since the program was launched in 1991, breastfeeding initiation, duration, and exclusivity have increased globally, a trend largely attributed to changes in hospital policies and practices brought about by the BFHI. This article provides an overview of these practices and policies, the institutional benefits of achieving BFHI certification, and the process through which health care facilities can do so. All nurses—whether they work in maternity care or another nursing specialty in a hospital, ambulatory, or community setting—can play a role in promoting societal health through their support of long-term breastfeeding as recommended by the WHO and UNICEF.

It is well documented that breast milk is the best choice for newborns and infants, providing protection against many common causes of infant morbidity. Exclusively breastfed newborns and infants have lower rates of otitis media, respiratory infection, gastroenteritis, urinary tract infection, conjunctivitis, and thrush than those who receive only partial or no breastfeeding.1, 2 Breastfeeding has also been found to reduce the risk of type 1 and type 2 diabetes, childhood leukemia, overweight and obesity, and necrotizing enterocolitis.3-5 There is also evidence that breastfeeding is positively and significantly associated with a child's intelligence (as measured by IQ score) at all ages, even when birth weight and such parental factors as intelligence, educational level, social class, and age are statistically controlled for.6        

Figure. Photo by Mon... Opens a popup window               Opens a popup window Opens a popup window

Although obstacles to long-term follow-up have hindered efforts to document the maternal benefits of breastfeeding, there is evidence that breastfeeding for one year or more reduces the mother's risks of breast and ovarian cancers, cardiovascular disease, and type 2 diabetes.4 An analysis of data from the National Institute of Child Health and Human Development on more than 1,300 families found an association between breastfeeding and positive changes over time in “maternal sensitivity,” or heightened responsiveness to infant cues.7 Likewise, exclusive breastfeeding is inversely associated with postpartum depression.4, 8, 9 While depression during the third trimester (as measured by the Edinburgh Postpartum Depression Scale) is associated with lower rates of breastfeeding, exclusive breastfeeding at three months postpartum is associated with significantly decreased depression scores.8 Such findings, which suggest that breastfeeding may reduce depressive symptoms, underscore the importance of recognizing prenatal depression as a risk factor for early breastfeeding cessation and of offering extensive breastfeeding support to new mothers who show signs of depression. Achieving breastfeeding self-efficacy within the first week postpartum is positively correlated with both breastfeeding exclusivity and duration through six months postpartum.10, 11

Taken together, the benefits of breastfeeding are enormous. A 2010 cost analysis used pediatric disease data collected by the Agency for Healthcare Research and Quality, 2005 breastfeeding rates (the most recent available at that time) calculated by the Centers for Disease Control and Prevention (CDC), and 2007 dollars to estimate the potential health and financial benefits of breastfeeding. The analysts concluded that if the proportion of U.S. mothers who followed the medical recommendation of exclusively breastfeeding their infants for at least six months after birth were to rise from 12.3% to 90%, it would prevent more than 900 deaths per year and save the United States approximately $13 billion in annual health care expenditures.12 Despite evidence of the pediatric and maternal benefits of breastfeeding, however, many countries, including the United States, have low levels of breastfeeding, with the CDC reporting that only 22.3% of U.S. mothers were exclusively breastfeeding through six months in 2016.13 This article describes the Baby-Friendly Hospital Initiative (BFHI) developed by the World Health Organization (WHO) and the United Nations Children's Fund (UNICEF) to promote breastfeeding throughout the world. It discusses the hospital policies the BFHI advocates and factors that contribute to breastfeeding success. It explains the BFHI certification process (in which hospitals that complete the process are designated as “Baby-Friendly”), institutional benefits associated with certification, and the practices through which all nurses can support long-term breastfeeding and associated societal health.

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THE INTERNATIONAL BFHI

Launched in 1991 by UNICEF and the WHO to increase support for breastfeeding in facilities that provide maternity care, the BFHI is the global standard for hospital support of breastfeeding. Mothers who deliver at institutions that follow BFHI practices are more likely to initiate breastfeeding and continue breastfeeding their infants for at least six weeks postpartum than mothers who deliver at institutions that do not.14-17 The BFHI was founded on 10 evidence-based practices for promoting breastfeeding (see The Ten Steps to Successful Breastfeeding).     

Box. The Ten Steps t... Opens a popup window Opens a popup window Opens a popup window

Institutional factors can promote or impede breastfeeding. Perrine and colleagues analyzed data from the Infant Feeding Practices Study II, which surveyed 1,457 women who had given birth to a single healthy child in a U.S. hospital between 2005 and 2007 and intended to exclusively breastfeed for periods ranging from less than one month to more than seven months.18 The women answered survey questions during their third trimester and approximately every month after giving birth for about 10 months. Initially, more than 85% of the women surveyed planned to breastfeed exclusively for three months or longer, but only 32.4% of the women met their intended breastfeeding goal, and 15% had stopped exclusively breastfeeding before hospital discharge. When the researchers investigated hospital practices, they found that the percentage of women who breastfed for as long as they intended rose with the number of BFHI practices the hospital followed. When hospitals followed none or only one of the Ten Steps to Successful Breastfeeding (Ten Steps), only 23.4% of the women met their intended breastfeeding goal, compared with 46.9% of the women whose hospital followed six of the Ten Steps. Successful breastfeeding was nonsignificantly associated with breastfeeding within one hour of giving birth, not giving the infant a pacifier, and rooming-in (mothers and infants remaining together throughout the hospital stay), and cessation or disruption of breastfeeding was significantly associated with administering formula to healthy breastfeeding infants.18 Similarly, a Hong Kong study found that policies prohibiting hospitals from accepting free formula from manufacturers reduced in-hospital formula supplementation and increased both in-hospital exclusive breastfeeding and breastfeeding duration.19

Unfortunately, institutional adherence to BFHI guidelines is not optimal even among hospitals that have achieved BFHI certification. In a study of 915 mothers who gave birth at four BFHI-accredited birthing facilities in Maine, only 34.6% of the mothers reported that their hospital followed all seven of the BFHI practices the researchers investigated, and 28.4% reported receiving a gift pack containing formula—a practice prohibited by the BFHI because of its association with breastfeeding cessation.15 In a study from the United Kingdom that included 1,130 mothers, fewer than 18% were happy with the breastfeeding information they received during pregnancy from health care professionals, fewer than 50% reported receiving adequate information on how to find breastfeeding support after birth, and more than 92% of those who stopped breastfeeding by six weeks postpartum said they would have liked to have continued beyond that point.20

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THE BREASTFEEDING REPORT CARD

National breastfeeding data are collected by the CDC and documented in the Breastfeeding Report Card, which provides information on breastfeeding practices in all states, the District of Columbia, and Puerto Rico. This report card is published every two years, most recently in 2016 (

www.cdc.gov/breastfeeding/pdf/2016breastfeedingreportcard.pdf

).13 The report card indicators are based on the breastfeeding goals outlined in the U.S. Department of Health and Human Services (DHHS) Healthy People 2020 initiative. For health care facilities, the aims are to reduce the proportion of newborns who receive formula in the first two days of life and to increase the proportion of live births that occur in facilities that provide recommended care for lactating mothers and their infants. The results of the last report card are positive, showing that U.S. breastfeeding levels continue to rise incrementally, with 2013 rates exceeding those of 2011 for the proportion of newborn infants who started to breastfeed (more than 81% versus 79%), were breastfeeding at six months (nearly 52% versus 49%), and were breastfeeding at one year (nearly 31% versus 27%).13, 21 But despite these improvements, Healthy People 2020 targets for breastfeeding duration and exclusivity are not yet being met (see Table 1). In 2013, the Healthy People 2020 targets of at least 60.6% of infants still breastfeeding and at least 25.5% of infants still exclusively breastfeeding at six months were met in only 12 and 16 states, respectively.13 In addition to breastfeeding rates, the report card includes data on such “breastfeeding support indicators” as the percentage of live births that occur in institutions receiving Baby-Friendly designation, the number of international board-certified lactation consultants per 1,000 live births, and the number of La Leche League leaders per 1,000 live births.      

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In 2015, the CDC reported that policies and practices of maternity units had improved nationally since 2007, but that more work was needed to ensure that all women receive breastfeeding support and education during their hospitalization.22 According to this report, the percentage of U.S. hospitals that incorporate the majority of practices recommended in the Ten Steps increased from 29% in 2007 to 54% in 2013, but of the 3,300 maternity hospitals in the United States, only 289 had been certified as Baby-Friendly.22

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BABY-FRIENDLY CERTIFICATION

When institutions achieve Baby-Friendly status, not only does it help them meet Healthy People 2020 targets and improve national health outcomes, but the certification process can strengthen the organizations’ leadership and increase staff competence. When a hospital commits to the work involved in achieving this designation, it can stimulate new ways of thinking among all nursing staff, the maternity team, and the facility's administration. In addition, with Baby-Friendly certification, a facility meets the Joint Commission's maternity care standards for exclusive breastfeeding.23

Baby-Friendly certification is awarded when a facility has successfully implemented the Ten Steps and the International Code of Marketing of Breast-Milk Substitutes.17 The 13-page BFHI Self-Appraisal Tool, which a facility uses to appraise its current practices as part of the certification process, breaks down each of the Ten Steps into several substeps in the form of yes–no questions. For example, step 1—“Have a written breastfeeding policy that is routinely communicated to all health care staff”—is followed by 11 substeps, such as, “1.1 Does the facility have a written breastfeeding/infant feeding policy that establishes breastfeeding as the standard for infant feeding and addresses all Ten Steps to Successful Breastfeeding in maternity services?” (The BFHI Self-Appraisal Tool is available online at

www.breastfeedingor.org/wp-content/uploads/2012/10/using-bfhi-self-appraisal-tool-2011.pdf

.) It is important to note that these policies should take effect on pediatric units, EDs, medical–surgical units, ambulatory surgical units, outpatient units, and any others in which a mother or infant may be admitted for care.17

Training of maternity nursing staff is formal, consisting of 20 hours of instruction, including 15 sessions required by UNICEF and the WHO and five hours of supervised clinical experience to ensure clinical competence.24 Other health care providers (physicians, midwives, physician assistants, and advanced practice RNs) involved in labor, delivery, maternity, or newborn care require at least three hours of breastfeeding management education and should thoroughly understand the benefits of exclusive breastfeeding, the physiology of lactation, and which medications are safe to use while breastfeeding. Health care providers who are unable to describe or demonstrate breastfeeding skills are expected to provide mothers with appropriate referrals to others who can.24 To practice in accordance with the International Code of Marketing of Breast-Milk Substitutes, institutions must not accept free or reduced-cost supplies of breast milk substitutes and feeding supplies. In addition, any educational material given to mothers must be free of commercial identifiers, such as logos. Staff members are forbidden to receive gifts in the form of nonscientific material, equipment, money, or meals from producers of breast milk substitutes or artificial nipples and bottles.24

A prospective cohort study of 2,560 mother–infant pairs in public hospitals in Hong Kong investigated the effects of the BFHI guidelines on breastfeeding rates for 12 months following birth or until the cessation of breastfeeding.19 A total of 1,320 mothers delivered before and 1,240 delivered after the hospitals had implemented the guidelines. Investigators found that the proportion of mothers exclusively breastfeeding during hospitalization rose from 17.7% before guideline implementation to 41.3% afterward, and median duration of breastfeeding increased from eight to 12.5 weeks. Increased formula supplementation was associated with higher rates of breastfeeding cessation.

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THE ROAD TO BABY-FRIENDLY STATUS

In the United States, implementation of the BFHI occurs in four phases, called the “4-D Process.” The four phases are as follows 25:

* The Discovery Phase is the first phase, in which staff learn what BFHI practices include and all that they entail. In this phase, the facility or institution must register with Baby-Friendly USA (BFUSA) and submit a completed BFHI Self-Appraisal Tool, a letter of support from its chief executive officer, and a completed facility data sheet (a sample of which is included in the online BFHI Self-Appraisal Tool). It should be noted that all forms must be completed online by one of two facility personnel authorized to use the BFUSA portal.

* The Development Phase is the planning phase, in which the facility plans how to implement and sustain the Ten Steps. In this phase a committee is formed to oversee the process, including policy development and staff training. There are specific time frames associated with each task in this phase and, starting at this point, phase fees are required. (A fee schedule is available at

www.babyfriendlyusa.org/get-started/fee-schedule

.)

* The Dissemination Phase is when all facility staff members who may be affected by this policy receive an orientation. Facilities must establish a breastfeeding education program for pregnant women and new mothers and begin collecting breastfeeding data from patient medical records and audits of maternity care practices.

* The Designation Phase occurs after the facility submits a “Request to Move Letter” to BFUSA. This must include data demonstrating that the facility has met the specific guidelines.

According to the BFUSA website, as of June 9, 2017, 440 U.S. hospitals and birthing centers had been designated as Baby-Friendly (for a regularly updated list, see

www.babyfriendlyusa.org/find-facilities

). In 2007, only 2.9% of U.S. births occurred in facilities with the Baby-Friendly designation, and this figure has grown to about 21.5%, exceeding the Healthy People 2020 target of 8.1%.

Bumps in the road. The process for achieving Baby-Friendly status may seem simple, but implementation can be difficult. A qualitative study that included 31 participants, representing midwifery, medical, nursing, and ancillary staff from six Australian maternity hospitals, found that the understanding and personal views of staff, as well as a “bottle-feeding culture,” were often at odds with BFHI objectives.26 Unpaid education time further impeded the goals and stressed staffing levels. A San Francisco hospital found it took eight years to achieve Baby-Friendly status, with challenges including health care providers with limited breastfeeding knowledge, hospital practices that did not support rooming-in or skin-to-skin contact between mother and infant, and little breastfeeding education overall.27

Hospital policies and lack of breastfeeding education on the part of staff are not the only impediments to achieving Baby-Friendly status and improving breastfeeding rates. Population characteristics such as language barriers, homelessness, substance abuse, and poverty can present challenges as well.27

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ACHIEVING SUCCESS

The Guided Infant Feeding Technique (GIFT), an educational program based on the Ten Steps, was introduced to 1,086 participants from 35 Louisiana hospitals between November 2008 and February 2012.28 Within 30 months, the number of hospitals that had achieved GIFT certification rose from nine to 24. Subsequently, Louisiana's breastfeeding rates, as documented in the CDC's Breastfeeding Report Card, increased from 50.7% ever breastfed in 2007 (the year before the program was introduced) to 60.9% ever breastfed in 2016, though this rate is still well below the Healthy People 2020 target of 81.9%.13, 29 Similarly, among mothers giving birth in a large multicenter medical institution in Chicago, rates of exclusive breastfeeding throughout the hospital stay rose from 38.6% to 53.5% over a four-month period after nurses completed a 20-hour BFHI education program.30

Other facilities that achieved Baby-Friendly designation noted that the following factors contributed to their success 31:

* involvement of all staff, not only nurses

* financial assistance in the way of grants, which help offset educational fees

* ongoing technical assistance with data collection

Maintaining momentum. Once an institution has been designated as Baby-Friendly, it is important to maintain the momentum that was involved in attaining that status and to continue practicing in accordance with the BFHI. A study that included 915 women who gave birth in one of four Maine hospitals that were BFHI accredited either before or during the study period found that adherence to the Ten Steps was not optimal. Only 34.6% of the women reported that the hospital followed at least seven of the steps, with 35% of the women who gave birth at hospitals working toward Baby-Friendly status and 28% of the women who gave birth at hospitals that had already achieved Baby-Friendly status reporting that they had received gift packs containing formula upon discharge.15 As the number of BFHI-accredited hospitals grows, follow-up on practices will be an important area of continued nursing research.

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SUPPORT FOR BREASTFEEDING

Health care facility programs. The DHHS has included the promotion of breastfeeding in its Healthy People 2020 objectives since 1990. Professional organizations, including the Association of Women's Health, Obstetric and Neonatal Nurses, the American College of Obstetricians and Gynecologists,32 and the American Public Health Association,33 encourage health care facilities that serve childbearing families to maintain programs that support the successful initiation and continuation of breastfeeding.

One of the difficulties women and families face in continuing to breastfeed after hospital discharge is lack of support, and it has been shown that support after discharge can increase continued breastfeeding rates. For example, in one study, 27 first-time mothers received weekly telephone calls from a lactation consultant for three months after discharge, and then once monthly for the next three months or until the infant was weaned. At six months postpartum, 73% of the women were still breastfeeding exclusively, compared with the hospital's baseline breastfeeding rate of 38%.34 In a larger study conducted in Italy, 114 first-time mothers were randomized into two groups: an intervention group receiving weekly structured telephone counseling by a midwife for the first six weeks postpartum, and a control group having routine postnatal visits with a physician at one, three, and five months postpartum. Overall breastfeeding rates in the intervention group were significantly higher than those in the control group, and postpartum rates of exclusive breastfeeding were consistently higher at one month (76.4% versus 42.4%), three months (54.5% versus 28.8%), and five months (25.5% versus 11.9%).35

Peer counseling is also effective in promoting breastfeeding, as demonstrated in a study of 990 women who were receiving services from Michigan's Special Supplemental Nutrition Program for Women, Infants, and Children. Women who participated in a peer-counseling breastfeeding support program in addition to receiving prenatal services were significantly more likely to initiate breastfeeding and to continue it for six months than were those in a control group who received prenatal counseling but no peer counseling.36 A systematic review of 31 qualitative studies found that the mere presence of a supportive person who is available to assist with breastfeeding and with whom the mother has a trusting, sincere rapport can increase rates of continued and exclusive breastfeeding.37

To be effective, breastfeeding support must be culturally appropriate, thorough, specific, consistent, and delivered both prenatally and postpartum. In a qualitative study in Maryland, women reported that, though they were encouraged to breastfeed because of the benefits it offered, they were not given specific oral or written information.38 Only one of the 75 women interviewed reported having received consistent information and support both at the hospital and from the pediatrician after discharge. She was also the only one interviewed who, at 10 months postpartum, reported never having given her child formula.

Workplace support is also essential in promoting continued breastfeeding. Although many women stop breastfeeding when they return to work, participation in a workplace lactation program is associated with exclusive breastfeeding at six months.39 Furthermore, Section 4207 of the Affordable Care Act amended the Fair Labor Standards Act to require employers to provide time and space for new mothers to express breast milk for their infants for up to one year after birth.40 Informing patients of this protection may substantially increase the likelihood that they will continue breastfeeding after returning to work.

Public perception. Others’ negative attitudes about breastfeeding in public spaces can discourage exclusive breastfeeding. In a survey conducted by the New York City Department of Health and Mental Hygiene, more than half of the 1,979 respondents believed women should breastfeed in private only.41 Patients should be informed that breastfeeding in public is sanctioned by laws in 49 states (all except Idaho), as well as the District of Columbia and the U.S. Virgin Islands.42 For more information on state breastfeeding laws, visit the website of the National Conference of State Legislatures at

www.ncsl.org/research/health/breastfeeding-state-laws.aspx

.

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CONCERNS ABOUT BFHI ENFORCEMENT

While most health care providers would agree that the BFHI can help improve outcomes for mothers and infants, the initiative has faced criticism that it is, in some cases, too rigidly enforced and may even interfere with nursing judgment. Some have expressed concerns that, with strict enforcement, mothers who have had an operative delivery may not be provided adequate time to recover before being encouraged to initiate skin-to-skin contact with their infant and begin breastfeeding.43 Some nurses have expressed the belief that hospitals need to reduce rates of cesarean section before embarking on this initiative. The BFHI prohibition against pacifier use has also been questioned, because pacifiers have been associated with a reduced risk of sudden infant death syndrome.43 Finally, some articles in the popular press have suggested that new mothers are being made to feel guilty if they cannot or choose not to breastfeed, and some nurses, midwives, and physicians echo this sentiment, voicing discomfort with hospital policies that prohibit infant formula from being provided without a medical order.

Whether following an operative delivery or a long labor and vaginal birth, it's clearly important for exhausted mothers to be carefully observed during the postpartum period when engaged in skin-to-skin contact, breastfeeding, or bottle feeding.44 The BFHI does not prevail on mothers to breastfeed when it is unsafe for them to do so, and with appropriate observation, infants will be moved to a separate sleep surface if the mother is drowsy. Regarding pacifier use, since it is associated with shortened duration of both exclusive breastfeeding and any breastfeeding, the American Academy of Pediatrics recommends delaying the introduction of pacifiers to healthy infants born at term “until breastfeeding is well established,” generally at three to four weeks after birth.44 While BFHI practices support new mothers with breastfeeding, offering them the assistance of lactation consultants, midwives, and nurses, it is important that mothers who choose not to breastfeed are never made to feel guilty or uncomfortable.

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RECOMMENDATIONS

At Jacobi Medical Center in New York City, before mothers give birth, we host “Baby Showers” for patients and their families. At these showers, we provide gifts, food, and extensive breastfeeding education. RNs and nursing students from a local university have been active participants in organizing and presenting at these events. Such experiences are invaluable. At a time when so much clinical learning occurs in simulation, this is one area in which hands-on learning is best.

Upon discharge after childbirth, breastfeeding mothers receive written information that includes telephone numbers they can call for support. We also invite new mothers to participate in a breastfeeding clinic within a week of giving birth. At the clinic, the mothers are evaluated by a lactation specialist, and the infants are weighed and examined by a pediatric health care provider. The lactation counselor observes breastfeeding, offering assistance as needed. This visit incorporates a support group, led by a health educator, in which mothers are encouraged to share what has helped them with breastfeeding. In addition to educating the mothers and families, the clinic provides an opportunity for medical and nursing students to participate and learn more about breastfeeding. Both RNs and local nursing students have led some of the groups.

Although the data suggest that the numbers of women breastfeeding exclusively are increasing, significant improvements must be made if we are to meet Healthy People 2020 targets. All nurses can help promote breastfeeding in their practice and in speaking with their friends and neighbors (see Implications for Nursing Practice). We must also work to include breastfeeding education in the curricula of nursing and medical education programs.

n October 2010, Tom Chong was on his way to his office and thinking about several issues he would have to deal with in the coming weeks. Chong was Jextra Stores (Jextra) country manager for the Neighbourhood Markets Division in Malaysia. One issue involved a conversation with the mayor of Klang, a town near Malaysia’s capital city of Kuala Lumpur. Chong had been seeking to expand to Klang for some time. The mayor surprised Chong with an offer to help with land zoning if Jextra would help finance a new primary school (or at least Chong thought that was what he had been asked for).

The second issue involved the job performance of Arif Alam, Jextra’s top-performing buyer. Alam, a buyer of fresh fruit and vegetables, consistently negotiated better contracts than Jextra’s fifteen other buyers and, Chong believed, better than Jextra’s competitors. The contracts negotiated by Alam certainly contributed to the excellent financial performance of Jextra Malaysia. Nevertheless, Chong could not help wondering if there was more to the picture than he was aware of. The retail industry in Malaysia was notorious for buyers accepting money and gifts from suppliers. A few days ago, Chong had accidentally overheard two of his accounting employees speculating that Alam must be accepting gifts, or even taking bribes—how else could he get such good contracts?

Chong was not sure what to do. Should he con- front Alam? Or, to use one of his English colleague’s

favorite expressions, should he let sleeping dogs lie? Chong knew that his boss expected him to aggres- sively grow the business, so perhaps it would be best to accept the mayor’s offer and deal with Alam later.

Jextra Malaysia

Jextra Stores, a large Asian retailer, was based in Hong Kong and was owned by Sim Lim Holdings, a large publicly traded industrial group. Sim Lim Hold- ings was traded on the Hong Kong and London stock exchanges. Jextra operated retail stores in Hong Kong, China, Philippines, Viet Nam, Malaysia, Thailand, and Singapore. The company operated supermarkets, hypermarkets, and convenience stores.

Jextra entered Malaysia, a stable and prosperous nation of 28 million multi-ethnic people, in 2005 and was very successful. The company operated super- markets in Malaysia using the name Neighbourhood Markets. There were now ten Neighbourhood Mar- kets, and breakeven had been reached quickly. Jextra was planning to enter the Malaysian convenience store sector in a few years. Although other Asian and European retailers were entering Malaysia, Tom Chong saw plenty of growth opportunities for super- markets, and his boss in Hong Kong had approved an aggressive five-year investment strategy.

Tom Chong

Tom Chong, a Hong Kong native, had been in his posi- tion for eight months, and expected to remain there for another two to three years. Malaysia was Chong’s first assignment as country manager. Prior to moving to Malaysia, Chong held various positions in corporate headquarters in Hong Kong, and then moved to Malay- sia as finance director. After two years in finance, he moved into his current role as country manager for Neighbourhood Markets. His new assignment in Malay- sia was his first experience with real operational issues and proft and loss responsibilities.

Chong reported to a Regional Operating Officer responsible for Singapore, Malaysia, and Thailand, and was in constant contact with the CEO and the CFO of the Supermarket and Hypermarket Divisions of Jextra in Hong Kong. Chong was evaluated based on various financial measures, including Economic Value Added. As a country manager in a young market, the number of new stores opened was an important element in his overall evaluation, and a factor in deter- mining his career prospects. In a fast-growing market like Malaysia, a failure to open new stores would be viewed negatively at corporate headquarters. The number of new stores opened would also be a factor in determining his discretionary bonus. In recent years, Chong’s performance had been among the best for Jextra managers of his age and experience.

A New Store in Klang

Jextra was doing well in Malaysia and actively seeking to expand. Chong and his team had identified a poten- tial site in Klang for a new Neighbourhood Market. Klang, a town located about 30 km west of Malaysia’s capital, Kuala Lumpur, was growing and was viewed as an attractive location for a new store. Although the potential site was not zoned for retail and commercial purposes, it had good road access and plenty of space for parking. Chong knew that several other retailers were also interested in expansion in Klang, especially with the opening of a new highway connect- ing Klang to the southeastern edge of Kuala Lumpur.

At a recent meeting between Chong and the mayor of Klang:

Chong: As you know, we have identified Klang as one of the most attractive cities in Malaysia for Jextra investment. We are interested in opening a Jextra Neighbourhood Market there.

Mayor: We are pleased that you are considering our city for your next investment. Klang is a growing community, and the new highway makes our city much more attractive as a place for families to live and commute to the capital. Where does your investment analysis stand?

Chong: We have done some preliminary work. We have identified some potential sites. There is one site of interest near the new sports arena, and we have had some conversations with your offcials since the land is currently not zoned for commer- cial use. Unfortunately, our previous investments in Malaysia have all encountered diffculty with land development. Our newest store was delayed by more than eight months because of zoning issues. We hope that will not be a problem in Klang.

Mayor: We have a unique community in Klang, and want to protect our cultural heritage. We scrutinize

all proposed real estate developments very carefully. With your store, perhaps we can help each other.

Chong: Can you be more specific?

Mayor: Our community is growing quite rapidly, and we have a lot of young families moving in. We des- perately need a new primary school. Without it, families may choose to live elsewhere. People do not want to live in a city with inadequate school facilities. Unfortunately, our school budget is quite tight, and we may not be able to build the school for at least two years. If Jextra were willing to consider supporting a primary school development fund, I am sure I could speed up the land zoning process.

Chong: Interesting....Can you tell me a bit more about the primary school project? Do you have any preliminary estimates of the cost?

Mayor: My Director of Schools has told me that we need about 350,000 ringgit to make up a budget shortfall for a new primary school. Jextra’s support would greatly help the community. Also, if you were to build your store on the proposed site, road and electricity developments would be necessary. A fly- over at the intersection of Jalan Mantin and Jalan Subang on the east side of the site would be nec- essary to ensure smooth traffic flow. We would, of course, expect Jextra to help pay for the flyover. I understand one of your competitors in Shah Alam [a community close to Klang] helped pay for a new fire truck when they entered the market. This is quite normal for new investment in Malaysia.

Chong: Well, Mr. Mayor, thank you for your time. We will continue with our analysis, and certainly hope that we can do something that is good for Klang and good for Jextra.

With that, Chong left the meeting. The conversa- tion with the mayor had caught him by surprise. The mayor’s zoning proposal was unexpected, but could certainly speed up development. However, Chong was not sure what he asked for. Was he being asked to pay the entire 5 million ringgit or just a part of the cost? Would he pay for it before the pri- mary school was built, or after? Would he pay the city or a contractor? If he said no, would that mean a denial of the zoning change?

Chong made a few calls, and learned that the mayor’s sister was on the school board and was one of the major supporters of a new primary school. Chong also learned that planning for the flyover had started several months before Jextra had ever expressed an interest in the nearby site. In addition, Jextra had already determined that traffic to and from the store parking lot would be routed through the west side of the lot, using a lightly used commercial street and not on either of the roads close to the planned flyover. Chong wondered about the mayor’s motives in asking Jextra to pay for the flyover.

Jextra Business Conduct Code

Jextra’s Business Conduct Code was very clear: employees could not offer benefits to third parties in connection with business matters (see the Appendix for excerpts from the Code). If Jextra were to contrib- ute to a primary school, the benefit would be a contri- bution to a school development fund, and the benefit would go to the school and the community, not indi- viduals. Chong had discussed a hypothetical situation with a Malaysian friend who was also a lawyer (he did not reveal the specifics of the mayor’s request). He was told that Malaysian law was unclear in the area of business payments for social purposes made spe- cifically for regulatory approval. He was also told that although not widespread in Malaysia, the practice of businesses contributing to city projects was common in Klang and other areas around Kuala Lumpur, and the local mayor prided himself on being able to obtain these payments for schools and roads in particular.

Jextra’s corporate office in Hong Kong had a small group of employees that managed the Jextra Social Fund. The Jextra Social Fund provided funding for various social and educational programs, mainly in Hong Kong. One of the fund’s specific initiatives was providing university scholarships in Hong Kong for children of lower-income families. As Jextra expanded in Asia, the fund was slowly looking at ways to contribute to more local programs.

However, Chong knew that recently there had been some concerns in the Philippines involving the Jextra Social Fund and some funds for a community center in a city in which Jextra planned to build a store. Chong did not know the details, but the rumors were that much of the money went to local politicians instead of the community center. Not long after the incident, Jextra’s country manager in the Philippines was transferred back to Hong Kong to a position that looked like a demotion.

Legal in Malaysia?

Chong thought that the primary school contribution could be illegal in Hong Kong if it circumvented the

Jextra Social Fund. But, perhaps this was normal practice in Malaysia. Chong’s friend said that some local lawyers would probably advise him to make the payments, but to keep the school and flyover pay- ments independent, which would blur the line as to whether the behavior was indeed illegal. Complicating the issue was the question of the expected outcome from the primary school payment. If the school pay- ment speeded up the development process, it could be legal; if it was necessary to make the payment solely as a prerequisite to obtaining the permit, it could be considered a bribe. If the payment was made after the store was built and went directly to a school board budget for future operating expenses, would that be illegal? Chong did not know the answer to these questions.

Various scandals involving alleged bribes and cor- porate contributions had contributed to the recent“retirement” of various elected officials in Malaysia. Both state and federal politicians were using “clean government” as part of their political platforms. The State Investment, Trade and Industry Committee Chairman said that his government would separate itself from the historically tight ties between business, government, and political campaign contributions. At the federal level, the government had promised that foreign direct investment in Malaysia would become transparent, and that giveaways to foreign investors would stop (exactly what giveaways he meant were never specifically identified).

Chong knew that, in the last year, there had been several foreign investors who were rumored to have helped fund different government programs in exchange for favorable treatment. So far, there was no evidence that any of these efforts were illegal or even of much interest to voters and legislators. When a European electronics company opened a new plant in Malaysia, there were many rumors that the company paid a substantial amount of money to a government“education fund.” Chong’s teammate from his football club told him confdentially that the company had paid 2.5 million ringgit to the fund, and that the fund was controlled personally by the Industry and Development Minister, a well-known businessman turned politician, whose wife was dean of the Communications School at the Malaysian Institute of Technology.

Jextra’s Competitors and the

Mayor’s Offer

Chong was aware that Super-Value, one of Jextra’s competitors, was also actively looking at Klang for a new store. Would the mayor make the same offer to Super-Value as he had made to Jextra? If so, when would the offer be made, and would Super-Value be willing to accept it? Perhaps Super-Value was inter- ested in the same site as Jextra. Before Chong could even consider agreeing to the mayor’s primary school request, he needed to think through the details. How would he get the money for the school? Would he identify it in the investment proposal, or try to hide it with other items? Should he get legal advice on his possible criminal liability in Hong Kong? What if he went ahead with the payment, and the money ended up not going to the school? If the press found out, Jextra and Chong could be in big trouble.

Perhaps the best approach would be to decline the mayor’s offer and work through regular channels to get the zoning approval. If that was successful, he would worry about the fyover request later. On the other hand, he did not want to lose access to a prime retail site, and his boss, who was aware of the Klang site, wanted an update on the project next week.

Category Management

A very simplified view of Jextra’s category manage- ment and buying process is as follows. Category managers (CMs) were responsible for driving cate- gory direction and leading an operationally efficient category team to deliver the budget within the frame- work of the corporate goals. A key area of responsi- bility for category managers was working with suppliers to determine the products to order, together with their negotiating prices. For a new supplier, establishing a relationship with a category manager was crucial in getting its products listed by Neigh- bourhood Markets. Category managers negotiated contracts, rebates, equipment, placement, incentives, and other financial and logistical arrangement for their category. Neighbourhood Markets in Malaysia had category managers for product lines such as fruits and vegetables, meat, frozen foods, and beverages. Product buyers managed the bundling of orders and actual buying from suppliers at the negotiated prices. Over and above this organizational setup, there were few defined processes, leaving a fair amount of lee- way to the category managers because they decided what to order and what not to order.

Arif Alam

Arif Alam was 32 years old, and had been with Jextra in Malaysia since the company entered the market. He had worked his way up from a sales apprentice position to category manager for fruits and vegeta- bles. His responsibilities included building and man- aging contacts with suppliers, listing suppliers and products, negotiating prices, and working closely with buyers to ensure that the supplier relationship was smoothly managed.

As Alam’s boss, Chong had a reasonable under- standing of how the Malaysian buying process worked, but he did not know all the details, and cer- tainly was not involved in day-to-day activities. What Chong had learned over the past few months was that there were ample opportunities for CMs to exploit the system for personal gain. One typical scheme involved company samples and rewards. Most suppli- ers provided CMs with a large supply of product sam- ples that could be sold on the grey market. CMs and their spouses often traveled extensively to product presentations of certain suppliers. These events usu- ally took place at luxury hotels, and often in resort set- tings. Since Alam was a CM for fruits and vegetables, he might be provided with other products, such as small appliances like toasters or coffeemakers. Another typical scheme was for suppliers to provide rewards tied to performance and sales. These could range from household appliances to expensive jewelry and watches. These rewards could be kept or sold. There were even cases where companies owned by relatives of CMs had to be paid by suppliers in order for the suppliers to get their products sold by Jextra.

Besides his suspicions that Alam was accepting gifts, or even taking bribes, Chong had heard rumors about a scheme between Alam and his father-in-law. Alam referred suppliers willing to be listed for a new product to his father-in-law who, as a side job, ran a trading agency that “established contact to Jextra Stores.” The agency received a commission of 0.5 percent for all goods covered by the agency agree- ment. It was rumored that Alam rarely listed suppliers and products not covered by the agency.

Bribery

The bribery issue was particularly troubling. Bribery of retail buyers was as old as the retail industry itself. The bribery process works as shown in the following exam- ple. A buyer who paid 50 ringgit for a pair of blue jeans the previous year negotiates a 45 ringgit price based on a larger order. Another clothesmaker offers the same pants for 42 ringgit each. In order to retain the big order, the first vendor matches the 42 ringgit price and gives the buyer 2 ringgit for each pair of blue jeans. The bribe is undetectable, because the buyer sets up a phony company that serves as a middleman in the transaction. The vendor bills the retailer for 42 ringgit a pair and funnels the 2 ringgit to the buyer through the dummy corporation, calling it “an agency commission.” After the deal is done, the vendor keeps the order and the retailer pays less for the pants than a year ago. The buyer looks good because the price paid was lower than a year ago. The buyer believes,“I deserve the money because I am helping the com- pany.” For a few years, the retailer may benefit by hav- ing lower costs. Longer term, the retailer’s costs may increase because the buyer has an obligation to the vendor and may end up paying less-competitive prices. The retailer may also end up with merchandise that is inferior in quality and difficult to sell because it was purchased by a corrupt buyer.

Chong’s Decision

Chong had a dilemma. Although he suspected that Alam was involved in “dirty” buying, how could he find out? His colleagues might know, but they could be involved in the same activities. Jextra was doing well and, as far as Chong knew, except for bribery, most of the behaviors were not criminal in Malaysia. What if he set up an investigation? If he found noth- ing, he could alienate his people and lose personal credibility. He might find that large parts of his prod- uct category management were engaged in similar actions. What should he do then? The whole busi- ness might be at risk if he were to shut it down. He could lose his top CMs and disrupt supplier relation- ships. Plus, how would he actually investigate the CMs—hire an outside investigator? Talk with suppli- ers? Find a disgruntled employee? Spy on his employees? This was all new to him.

Proving any of his suspicions would be difficult. Alam was a respected member of the team. Aside from rumors and hearsay, Chong had no real evi- dence of bribery or kickbacks. Alam’s lifestyle did not seem out of the ordinary. Chong would need clear evidence, and an outside investigator would mean added cost. The investigation could take months, or even years, and Chong might be gone from Malaysia by the time the process was com- pleted. In addition, this would take a lot of his time, and he was already working almost 60 hours a week.

Chong needed to keep growing the business and meet his financial targets. It was critical for him to deal with the mayor’s proposal appropriately and ensure that Jextra’s chosen site did not end up with one of his competitors. Maybe he should wait before doing anything about Alam.

Appendix: Excerpts from Jextra’s Business Conduct Code

Summary

Jextra is an international company with a strong rep- utation for providing quality products. We continually seek to deliver the best results for the Company the highest return to our shareholders, and the most beneficial service to our customers.

Ethical conduct is defined as conduct that is mor- ally correct and honourable. To maintain our valuable reputation and to build on our success, we must conduct our business in a manner that is ethical as well as legal. This Business Conduct Code estab- lishes Jextra’s commitment to following ethical busi- ness practices. It details the fundamental principles of ethical business behaviour, and defines the responsibilities of all directors, officers, associates, and Company representatives.

Jextra is committed to conducting business lawfully and ethically. Every associate is obligated to act at all times with honesty and integrity. We expect you to bring good judgment and a sense of integrity to all your business decisions. While it is not possible to list all policies and laws to be observed, or all conflicts of interest or prohibited business practices to be avoided, this Business Conduct Code details the company’s expectations for associate conduct, and helps associ- ates make the right decisions. Associates are expected to know the company’s policies and comply with them.

Applicability

Associates who supervise others have an important responsibility to lead by example and maintain the high- est standards of behaviour. If you supervise others, you should create an environment where employees under- stand their responsibilities and feel comfortable raising issues and concerns without fear of retaliation. If an issue is raised, you must take prompt action to address the concerns and correct problems that arise.

You must also make sure that each associate under your supervision understands our Code and the policies, laws, and regulations that affect our workplace. Most importantly, you must ensure that employees understand that business performance is never more important than ethical business conduct.

As a Jextra employee, you are expected to comply with both the letter and the spirit of our Code. This means you must understand and comply with all of the company policies, laws, and regulations that apply to your job, even if you feel pressured to do otherwise. Our Code also requires you to seek guidance if you have questions or concerns, and to cooperate fully in any investigation of suspected violations of the Code that may arise in the course of your employment.

Bribery

It is illegal to pay or receive a bribe intended to influ- ence business conduct or behaviour. Our guideline goes beyond the standard set by the law, and prohi- bits any activity that creates the appearance of any- thing improper, anything that may embarrass the company or anything that may harm our corporate reputation. No assets of the company or other funds may be used to bribe or influence any decision by an officer, director, employee, or agent of another company, or any governmental employee or official.

It may be acceptable to entertain or provide minor gifts to guests or suppliers, as long as the expenses are reasonable, consistent with good business prac- tices, and do not appear improper. Any gift, enter- tainment, or benefit provided must be modest in scope and value. You should consult with your super- visor if you have any questions about whether any gift-giving activity is appropriate. Never provide a gift, entertainment, or benefit that contravenes any applicable law or contract term or that is large enough to influence, or appear to influence, the reci- pient’s business decisions.

Associates should not accept money, gifts, or excessive entertainment from any guest, contractor, or supplier at any time. For more information on gifts, entertainment, and related issues, see the Conflicts of Interest guidelines.

International laws strictly prohibit giving, promis- ing, or offering money, or anything else of value, directly or indirectly, to officials of foreign govern- ments or foreign political candidates in order to obtain or retain business or any improper business advantage. Never give, promise, offer or authorize, directly or indirectly, any payments to government officials of any country.

Conflicts of Interest

Associates must avoid any situation in which their personal interests conflict with the interests of Jextra. If a circumstance arises in which your interests could potentially conflict with the interests of Jextra, it must be disclosed immediately to both your supervisor and Human Resources for review. Associates should be vigilant about recognizing potential conflicts. You must always consider whether your activities and associations with other individuals could negatively affect your ability to make business decisions in the best interest of the company or result in disclosing

nonpublic company information. If so, you may have a real or perceived conflict of interest. Below is a list of potential conflicts of interest.

l Owning a substantial amount of stock in any com- peting business or in any organization that does business with us.

l Serving as a director, manager, consultant, employee, or independent contractor for any organisation that does business with us, or is a competitor—except with our company’s specific prior knowledge and consent.

l Accepting or receiving gifts of any value or favours, compensation, loans, excessive entertain- ment, or similar activities from any individual or organization that does business or wants to do business with us, or is a competitor.

l Taking personal advantage of a business opportunity that is within the scope of Jextra’s business—such as by purchasing property that Jextra is interested in acquiring.

Related Party Transactions

Employees and immediate family or household mem- bers may not serve as a supplier or customer of the Company, or otherwise engage in business dealings with the Company, without the written consent of a member of the Executive Management Team. You or a member of your immediate family or household may not accept business opportunities, commissions, or advantageous financial arrangements from a cus- tomer, supplier, or business partner of the Company. You may not purchase for personal use the goods or services of the Company’s suppliers on terms other than those available to the general public or estab- lished by Company policy. You may not take advan- tage of any business opportunity that you learn about in the course of your employment.

Questions:

1.What cross-cultural differences may be at play in the Jextra case? What factors are motivating the key players in this case?

2. Regarding the requests for roads and schools, does Chong understand exactly what the Mayor has asked of him? Is he correct to assume that this may be a request for a bribe? What are Chong’s options as to how to proceed? What are your concerns for Chong going ahead with a contribution to the school? What are your concerns for Chong refusing to contribute?

3. Considering the need to be a manager with a global mindset, what should Chong do with his suspicions regarding Alam?

On April 2, 2017, Elon Musk announced that Tesla produced 25,000 cars in the first quarter, setting a new company record.1Within two weeks, Tesla’s market value zoomed past Ford Motor Company (which manufactured more than 1.5 million cars per quarter) and General Motors (which made more than 2.5 million cars per quarter) to become the most valuable U.S. car manufacturer.2Elon Musk used the occasion to needle his naysayers, writing on Twitter: “Stormy weather in Shortville.”3By most measures, Elon Musk was on a roll: Beyond promising to scale Tesla by a factor of 10 between 2015 and 2018, Musk was vowing to deliver fully autonomous driving and an automated car-sharing service.4To support hisaggressive plans, Tesla was constructing a giant battery factory in the desert outside Reno, Nevada. Everything about the factory was massive: when complete, it would be the largest building in the world.5This so-called “Gigafactory”would require $5 billion in investment and would ultimately produce 105 gigawatt hours (GWh) of battery cells per year, more than the entire capacity of the world’s li-ion(lithium ion) production in 2015.6Musk also wanted to turn Tesla into a renewable energy company.In the fall of 2016, Musk made another big bet by orchestrating Tesla’s acquisition of the rooftop solar installerSolarCity, where Musk was the chairman and largest shareholder. While the automotiveand solar businesses were starkly different, Musk insisted that they were part of Tesla’s goal of “accelerating the advent of sustainable energy.”7The Gigafactory plus SolarCity would transform Tesla from an automaker into what Musk called the “world’s only vertically integrated energy company offering end-to-end clean energy products to our customers.”8In his spare time, Musk wasalso the CEO of the commercial space flight company SpaceX. Musk insistedthat SpaceX would begin transporting people to Marsby 2025, achieving his stated goal of making humanity a “multiplanetary species.”9Transforming transportation, pushing forward renewable energy generation and storage, and colonizing Mars: such was the scope of Musk’s ambition. Little wonder that a former colleague said that “Elon thinks bigger than just about anyone else I’ve ever met.”10Even though Tesla and SolarCity were unprofitableand burning cash, for Musk the question was always: what’s next? For Musk’s board and shareholders, the question was different: was Musk, as his biographer put it, “a being sent from the future to save mankind from itself or a slick businessman dragging foolish investors along on grand cash-burning bets?”11This document is authorized for use only by Alex Waterman ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. 717-431Elon Musk’s Big Bets2Elon Musk’s VenturesElon Musk was born and raised in South Africa, and made his way to Canada in 1989 at the age of 17. Staying with relatives and working odd jobs, Musk enrolled in Queen’s University in Ontario and then transferred to the University of Pennsylvania, where he earned degrees in economics and physics. He began a PhD program in applied physics at Stanford, but dropped out in 1995 to start an online map and directory firm called Zip2 with his brother. They sold the company to Compaq for $300 million in 1999. Musk used the money from the sale to launch another startup called X.com, an online bank. In 2000, X.com merged with Confinity, another startup,which ran a money transfer service called PayPal. The combined firm took the name PayPal in 2001 with Musk as the CEO and largest shareholder until the firm was sold to eBay for $1.5 billion in 2002. SpaceXNot content with founding and selling two successful startups, Musk founded Space Exploration Technologies, better known as SpaceX, in 2002. He told a reporter in 2003 that “I like to be involved in things that change the world. The Internet did, and space will probably be more responsible for changing the world than anything else.”12Reaching Mars was the long-term goal, and Musk claimed in 2012 to be on track to get a manned spacecraft to Mars in 10–15 years. In the shortterm, however, SpaceX concentrated on the commercialization of near-Earth exploration.13Musk invested some $100 million of his own money in SpaceX and nearly lost it all when SpaceX struggled to achieve a successful test launch of its first rocket. By 2006, SpaceX had won contracts to take commercial and NASA satellites into space despite not yet launching a rocket. Its first three launch attempts ended in failure. By September 2008, SpaceX was on the brink of collapse. As a colleague recalled, “Everything hinged on that launch. Elon had lost all his money, but this was more thanhis fortune at stake—it was his credibility.”14The launch succeeded, however. Then, in July 2009,SpaceX had its first successful paying mission.15In May 2012, SpaceXbecame the first commercial firm to successfully dock a vehicle with the International Space Station (ISS), and later that year it delivered its first load of cargo to the ISS.16In late 2013, SpaceX carried out its first successful launch of a commercial satellite. SpaceX achieved another milestone in December2015, when it successfully landed a rocket after launch.Musk saw reusable rockets as an essential step toward making spaceflight truly affordable. SpaceX executives estimated that reusing rockets could cut its launch prices by 30%, from around $61 million to $43 million per launch.17SpaceX advanced further toward this goal in March 2017, when it successfully launched and landed a previously flown Falcon 9 rocket. Elon Musk was not the only high-profile technology entrepreneur to pursue ventures in space. Amazon founder and CEO Jeff Bezos, the second-richest person on Earth, founded spaceflight company Blue Origin, which directly competed with SpaceX. In November 2015, Blue Origin was the first company in history to successfully launch and land a rocket during a mission to space, proving to the world that reusable rocket technology could work.18As of March 2017, Blue Origin was focused on launching its first crewed flight into space and building heavy lift rockets to further compete with SpaceX. In order to ensure the company had enough money to accomplish its goals, Bezos pledged to sell $1 billion of his Amazon stock each year to finance Blue Origin.19Despite these successes, launching rockets into space remained a risky activity, and SpaceX had lost a few rockets and payloads over the years. On September 1, 2016, a SpaceX rocket exploded on the launch pad at Cape Canaveral. While no one was hurt, the loss was a particularly high-profile one This document is authorized for use only by Alex Waterman ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. Elon Musk’s Big Bets717-4313because the satellite on board was to be used as a part of Facebook’s effort to bring Internet access to regions of Africa, the Middle East, and Europe.Such setbacks had a significant financial impact on SpaceX: in 2015, SpaceX’s revenue declined 6% after multipleyears of strong growth, and the company recorded a wide operating loss of $260 million following multiple years of small but positive operating income (see Exhibit 1). An early 2015 funding round valued SpaceXat approximately $12 billion, making it oneof the most valuable venture-backed private companies in the world.20Meanwhile, the revenue generated by SpaceX’s success in near-Earth missions provided the capital to continue working toward the ultimate goal of regular space travel to Mars.While SpaceX sought to address Musk’s dreams in the stars, he also had great ambitions for revolutionizing travel on and under the Earth’s surface. The Hyperloop, The Boring Company, and Neuralink In August 2013, Musk announced his idea for yet another revolutionary mode of transportation, dubbed the Hyperloop, which Musk claimed would be a faster and cheaper replacement for high-speed rail. Inspired by pneumatic tubes once used to shuttle documents around offices, it would transport passengers at speeds of more than 700 miles per hour in pods enclosed in underground steel tubes under near-vacuum conditions. Given his other obligations, Musk did not attempt to commercialize the idea, but published an open-source white paper describing the technology. A few startups picked up the idea and began developing the technology. One of them, a firm called Hyperloop One, held a demonstration in the Nevada desert in the spring of 2016, propelling a sled one-half mile down a test track at speeds of over 300 miles per hour. The startup had raised $150 million for the venture through January 2017.21At the end of 2016, Musk tweeted the launch of a Hyperloop-like venture called The Boring Company, which would build underground tunnels to combat traffic. Days after the tweet, he boughtthe website BoringCompany.com and staffed a SpaceX engineer to oversee the new venture.22Finally, in the spring of 2017, Musk started yet another company, called Neuralink, which sought to merge the human brain with computers. Musk planned to be CEO of both new startups. TeslaAlthough Elon Musk was the face of Tesla, he was not one of its founders. The company was started in 2003 by Silicon Valley engineers with the goal of producing a high-performance electric sports car. Musk joined the company in 2004 (two years after launching SpaceX) as its chairman and led its fundraising efforts, which netted $7.5 million in its first round. Musk became CEO in 2008, by which time he had invested $55 million of his own money. The company raised $260million in its 2010 IPO, the first American car company to go public since Ford in 1956.23At the end of 2016, Musk remained the largest shareholder in Tesla with a 20.8% ownership stake in the company. By March 2017, Tesla had raised over $9.3 billion in financing (see Exhibit 2a). Musk articulated a grand vision for Tesla and the broader electrical vehicle (EV) industry as the key to sustainable transportation, in the context of the looming disaster of climate change. As he put it in 2011, “[I]n order to change the infrastructure such that we avoid having some sort of catastrophic situation [acentury from now], we must act now, because we’re talking about changing what will probably be 2 billion cars. You don’t just change that overnight. A whole industry has to be born.”24Musk saw Tesla’s role as bringing that industry into being, with the long-term goal of creating an affordable electric vehicle. Because the cost of electric vehicle technology, particularly battery technology, did not permit the construction of an appealing mass-market electric car in the early 2000s, Tesla and Musk decided to enter the market at the high end and move down-market over time. Musk, tongue-in-cheek, revealed This document is authorized for use only by Alex Waterman ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. 717-431Elon Musk’s Big Bets4Tesla’s “secret plan”in 2006: “1. Build sports car; 2. Use that money to build an affordable car; 3. Use thatmoney to build an even more affordable car.”25True to the plan, Tesla’s first production vehicle, released in 2008, was a high-performance and high-priced sports car called the Roadster. Tesla only manufactured 2,500Roadsters,but it demonstrated that an electric car could deliver superior performance. The 300 horsepower Roadster went from 0to 60 in 3.7 seconds, had a top speed of 125 mph, and sold for about $110,000 in 2009. Tesla’s next vehicle was a luxury performance sedan called the Model S that was released in 2012 and designed to compete withMercedes, BMW, and Audi. It was priced starting at $70,000, although optional features (such as a larger battery to provide longer range) could push the price well past $100,000. While not by any means a truly “affordable”car, total Model S sales rose from under 5,000 in 2012 to150,000 by September 2016.26Initial reviews for the Model S were very positive. In 2013, Consumer Reportsgave the first model its highest rating ever, a 99 out of 100, and Motor Trendnamed the Model S its Car of the Year. Two years later,Consumer Reports gave an all-wheel-drive version of the Model S a score of 103 out of 100 for its combination of power and efficiency, prompting itto rescale itsscoring systemto bring the Model S down to a perfect 100. Surprisingly, reliability problems with the Model S led Consumer Reportsto revoke its recommendation in late 2015, citing “a worse-than-average overall problem rate”based on a survey of 1,400 Model S owners.27Tesla’s reputation suffered a further blow when threeTesla vehicles were damaged by battery fires in 2013, caused when the battery pack, which was installed in the car’s undercarriage, was damaged by striking roadway debris. Although no one was hurt in the accidents and Tesla pointed out that fires happenedat a far higher rate in gasoline-powered cars, the fires raised potentially damaging concerns about battery safety. Tesla’s stock fell nearly 4% on the news,and the National Highway Traffic Safety Administration (NHTSA) opened an investigation. In response, Tesla announced in early 2014 that it would modify the Model S to raise its ground clearance at highway speeds and that it would reinforce the vehicle’s underbody armor in order, in Musk’s words, “to bring this risk down to virtually zero.”28The NHTSA subsequently closed its investigation, saying that “a defect trend has not been identified.”29Safety concerns were renewed, however, when a Model S caught fire while charging at a supercharger in Norway in January 2016, completely destroying the vehicle. Tesla, which ultimately traced the cause to a short circuit, insisted this was an isolated incident and pointed out that vehicles had been charged at supercharging stations 2.5 million times without incident. Norwegian officials concluded that it represented an isolated event.30Tesla released its next vehicle, an SUV called the Model X, in late 2015, and it had sold and delivered about 37,000of the vehicles by March 2017.31Like the Model S, it received rave reviews for its performance, but also faced quality issues in the early months after its release, including problems with the vehicle’s unique falcon-wing rear doors and, more seriously, a faulty seat latch that in some cases allowed the rear seats to fold forward during a collision, which led to arecall of 2,700 vehicles in 2016.32Shortly after the launch of the Model X, Tesla announced the availability of a package of self-driving features, which it called “Autopilot.”The system used cameras, radar, GPS, and other sensors to provide semi-autonomous highway driving, keeping the car in its lane, changing lanes when necessary, and maintaining a safe following distance.Musk and Tesla described the system as a “public beta,”recommending that drivers keep their hands on the wheel and remain alert and readyto take control at all times. It soon became clear that drivers were not heeding such warnings, posting videos of themselves reading or watching videos while letting the car drive itself.33In May 2016, a Tesla driver was killed while driving in Autopilot mode when neither the car’s sensors nor the driver detected a tractor-trailer crossing the highway and the vehicle collided at full speed with the trailer. The Tesla driver was reportedly watching a movie at the time of the crash.34Tesla responded by releasing This document is authorized for use only by Alex Waterman ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. 717-431Elon Musk’s Big Bets102016, it had a range certified by the EPA at 238 miles and an estimated sale price of about $37,500.87In 2015, Audi, Mercedes, and Porsche announced plans for electric luxury vehicles that would compete with the Model S and Model X.88EV manufacturers faced unavoidable trade-offs between cost and rangeof batteries. Tesla had, with the Model S and Model X, chosen to maximize range by equipping them with a large battery:a 70 kWh or 85 kWh battery delivered an EPA-estimated range of 240 to 265 miles,respectively, on a single charge. In 2016, Tesla announced the availability of 100 kWh battery packs for both vehicles, pushing the estimated range of the Model S over 300 miles.89But that range came at a cost: the size of the battery contributed heavily to the vehicles’price, which could be as high as $135,000. Other manufacturers had opted to sacrifice range to cut costs. Nissan’s Leaf, for example, originally came with a24-kWh battery that gave the car a range of 84 miles per charge, while BMW’s i3 had a 22-kWh battery that delivered a range of 81 miles.90Offerings from Volkswagen and Mercedes similarly had smaller batteries with ranges between 70 and 90 miles. Tesla and other automakers partnered with major technology companies, including NEC, LG Chem, Samsung SDI, and Panasonic, to supply battery technology for their vehicles. Early in its history, Tesla had made the choice to construct its battery from existing industrial-grade li-ioncells manufactured by Panasonic, rather than build or outsource a battery specially designed for its vehicle, as other EV manufacturers had done. The form factor cells used by Tesla were slightly larger than an AA battery and were commonly used in consumer electronics. Tesla worked with Panasonic to optimize the cells for its vehicles.Energy StorageIn addition to electric vehicles, energy storage for residential, business, and utility use was a major potential market for battery technology. The widespread adoption of renewable energy sources such as wind and solar would require significant increases in storage capacity. Falling renewable energy costs(the cost of solar panels had fallen over 85% between 2007 and 2014)had led to increaseduptake around the world.By 2015, the world was adding more renewable generating capacity than that of gas, coal, and oil combined. In many European countries, wind and solar accounted for over 20% of electricity generation, and Germany had set a target of getting 80% of its energy from renewables by 2050.91To reach such goals, renewable energy generation would have to be paired with large-scale storage capacity, most likely in the form of batteries, allowing energy generated by solar panels or wind turbines to be stored for use when the sun was not shining or the wind was not blowing. As well as facilitating renewable energy use, load-balancing for electric utilities was another potential application; massive batteries could permit utility companies to avoid the necessity of firing up so-called “peaker” power plants to meet peak demand. Instead, utilities could draw power from batteries at times of peak demand and recharge them when demand was low. As Musk put it in 2015, “you can basically, in principle, shut down half of the world’s power plants if you had stationary storage.”92Tesla saw this as an important secondary market for its batteries; in fact, Musk estimated in 2015 that the long-term capacity demand for stationary energy storage would be roughlydouble the demand for batteries for electric vehicles.93Indeed, in September 2016, Southern California Edison announced it would purchase 20 megawatts of Tesla batteries to plug into one of its substations, charging them up during times of low usage and discharging them at times of high demand.94To take advantage of the energy storage market, Tesla announced in early 2015 its Tesla Energy suite of battery packs, designed to provide stationary storage for residential, commercial, and utility-scale applications. The residential product, called Powerwall, was designed for load-shifting (charging This document is authorized for use only by Alex Waterman ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. Elon Musk’s Big Bets717-43111when rates werelower and discharging when rates werehigher), to provide backup power during outages, and to be used in conjunction with rooftop solar applications, storing surplus solar energy for use when the sun was not shining. The Powerwall battery pack provided 6.4 kWh of energy storage, at a price of approximately $3,000. Multiple battery packs could be installed together for greater capacity if needed.In October 2016, Tesla unveiled the Powerwall 2, along with solar roof-top panels that integrated directly with the energy storage system, at an event in Los Angeles. The new Powerwall for residences had more than double the capacity of the first edition (14 kWh) and contained a built-in power inverter (a previously needed separate piece of hardware). The second edition was also priced higher at $5,500. Although the residential system garnered the most attention, Tesla executives anticipated that commercial and utility-scale applications would be much larger; Musk estimated that 5–10 times more capacity would be deployed at industrial and utility scale than at the consumer scale. A few months after the launch of Tesla Energy, Tesla CTO Straubel said that about 70% of reservations had been for the industrial-scale Powerpack and 30% for the residential-scale Powerwall.95Musk claimed the demand for Tesla’s energy storage solutions had been “staggering”in the first few months after announcing the product. By the end of the second quarter of 2015, Tesla reported that it had received more than 100,000 battery reservations, worth $1 billion if they turned into sales (whichMusk admitted they might not).96Musk insisted that, in order to realize the goal of transitioningthe world’s electricity generation to renewable sources, Tesla hoped other battery companies would join Tesla in building “Gigafactory class operations of their own.”He also said that Tesla would continue its policy of “open-sourcing”its information technology related to the Gigafactory and battery manufacturing.97The opportunity to manufacture batteries for various energy storage solutions, whether targeted for electric vehicles or renewable energy, demonstrated such great potential to Elon Musk that he made the bold move to further vertically integrate Tesla by merging the electric vehicle and battery manufacturing company with SolarCity, an alternative energy sourcing and storing company.Tesla’s Renewable Energy Division: Solar CityTesla and SolarCity haddeeply linked histories and close ties. SolarCity’s founders, brothers Lyndon and Peter Rive, were Musk’s cousins;and it was Musk,by all accounts,who encouraged them to look into the solar energy business in 2004. Musk became chairman and a major financial backer when SolarCity was founded in 2006,and was its largest shareholder when it went public in 2012. He remained chairman and the largest shareholder in 2016. In addition, Tesla CTO Straubel sat on SolarCity’s board, and the firms shared one additional board member.98For most of its history, SolarCity positioned itself as a solar energy provider; it purchased solar systems and installed them for residential, business, governments, and ultimately utility companies. It covered the cost of the installation and maintenance of the system and charged customers for the energy produced by the system. Residential customers could pay as little as zero for the installation and pay a monthly fee for the electricity produced by the system, typically ata cost lower than that charged by the local utility.99The option to transition to solar power with no up-front costs had spurred adoption, and the number of SolarCity installations grew rapidly, with the installed customer base reaching 300,000 by the time Tesla acquired the company in November 2016.100Revenues had also increased significantly, from $60 million in 2011 to $538 million for the year ending June 30, 2016. Despite rapidly increasing revenues, SolarCity’s debt levels grew at a much quicker pace (see Exhibit 6 for SolarCity financial data).This document is authorized for use only by Alex Waterman ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. 717-431Elon Musk’s Big Bets12Since SolarCity had not historically manufactured solar systems, it had benefited from the falling price of solar panels, which had enabled the cost of its rooftop installations to decline from $4.73 in 2012 to$2.84 per watt of generating power in 2016. In 2014, however, SolarCity acquired panel maker Silevo. The acquisition made SolarCity, in the words of Peter Rive, “the most vertically integrated solar company in the world.”101To that end, SolarCitybegan construction on a $750 million factory in Buffalo, New York,where it would manufacture solar panels in 2017. SolarCity officials claimed that the new panels would be as much as 30% more efficient than the commodity solar panels it was currently purchasing. These efficiency gains, combined with a simplified manufacturing process and the scale of production, had the potential of even further reducing the cost of residential solar installations to $2.50/watt.102Declining costs for producing solar translated into greater competition for SolarCity. The residential and commercial markets for solar installation were both highly competitive. According to one analyst, the top 10 residential solar installers in 2015 represented 58% of the market, with SolarCity leading at 35% (Vivint Solar was second at 11%). On the other hand, the top 10 producers in the commercial market represented only 42%, with SolarCity leading at 14% (SunPower was second at 7%). “The fragmented commercial developer landscape is largely the result of bottlenecks in the customer origination process that make it difficult for any individual player to consistently grow,” said noted one research analyst. SolarCity would need to defend its lead position among two different sets of competitors,while at the same time, barriers to entry were falling.103To do so required high spending; SolarCity’s sales, administrative, and research costs were $438 million in the first half of 2016, 42% greater than revenue of $308 million.104Such a high level of spending meant that SolarCity needed to find a solution to its continuing need for financing. Further indicating its commitment to the renewable energy business, Tesla first announced in June 2016 a proposal to acquire SolarCity. The acquisition offer was all-stock, in which each share of SolarCity would be exchanged for a fraction of a share in Tesla. This exchange ratio of stock represented a value of $26.50–$28.50 per share of SolarCity and a total equity value of $2.6–$2.8 billion. Tesla’s shareholders did not react positively to the announcement; the next day Tesla’s stock price fell by 10.5%, while SolarCity’s stock price rose 3.3%.105In the context of the SolarCity acquisition, Musk pointed out that renewable energy generation had long been a part of Tesla’s vision. “The point of all this,”he wrote in July 2016, “was, and remains, accelerating the advent of sustainable energy.”Indeed, the original “master plan”written by Musk in 2006, though focused on Tesla’s EV business, included the goal of becoming “energy positive”by providing “zero emission electric power generation options,”partly through partnership with the then newlyfounded SolarCity.106SolarCity had begun offering home energy bundles including solar panels and battery backup using Tesla’sPowerwall battery packs earlier in the year, and for Musk the merger was a natural progression. Musk argued that there was considerable overlap between the two companies’ potential customer bases, that Tesla’s design and manufacturing experience would benefit SolarCity’s solar panels, while SolarCity’s sales, distribution, and installation capabilities could serve Tesla customers.107Tesla claimed $150 million in cost synergies that would be unlocked in the merger (see Exhibit 7). JP Morgan’s research reporton the initial offer cast doubt on the customer overlap: “Absent a detailed explanation (at this time) we are struggling to see brand, customer, channel, product or technology synergies.”108(See Exhibits 8 and9.) Several analysts criticized the proposed deal as adding to Tesla’s already daunting challenges of scaling battery and vehicle production, but Musk insisted that Tesla would benefit from creating a “smoothly integrated and beautiful solar-roof-with-battery product. We can’t do this well if Tesla and SolarCity are different companies, which is why we need to combine and break down the barriers inherent to being separate companies.”109In anticipation of the completion of the merger, Musk announced a new solar roof product which replaced a traditional roof with glass tiles that contained This document is authorized for use only by Alex Waterman ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies. Elon Musk’s Big Bets717-43113power-generating solar cells. Musk later claimed that Tesla’s solar roofing material would cost less than traditional premium roofing materials, even before factoring in savings from electricity generation.110SolarCity’s financial struggles also contributed to skepticism aboutthe proposed acquisition. The company struggled to become profitable and its operating losses were mounting—totaling nearly $980 million for 2014–2015, leading to considerable doubts about merging two companies that were steadily burning through cash, to the tune of an estimated $2.5 billion combined in 2016.111(See Exhibits 3b and6b for Tesla and SolarCity cash flow data.) The Wall Street Journal wrote that “Tesla latching on to SolarCity is the equivalent of a shipwrecked man clinging to a piece of driftwood grabbing on to another man without one,” while Forbes wondered how the already-indebted Tesla could carry SolarCity’s $5 billion long-term debt load.112Some critics argued the acquisition was aneffort to save SolarCity from its debt obligations, which grew 13x from 2013to 2016. “This deal has everything to do with debt. Call it a bailout, call it what you will....SolarCity is one bad economic downturn away from going belly up,” said one analyst.113Musk and Tesla responded by pointing out that SolarCity’s debt position and cash flows appeared to be worse than they really were because SolarCity used debt to finance rooftop installations that generated revenue over time through long-term leases and power purchase agreements.114Tesla revised its offer for SolarCity on August 1, 2016, in part due to SolarCity announcing that its 2016 forecast for megawatts installed would be 10% lower than previously expected. The new acquisition offer was about $300 million lower than the initial offer at $25.83 per share, representing a $2.6 billion equity valuation.115This price for SolarCity was 10x higher than the average revenue multiple of SolarCity’s publicly traded peers (see Exhibit 10). On the other hand, $25.83 per share was well below SolarCity’s all-time-high closing price of $86.14 set in February 2014 (see Exhibit 11).Corporate governance issues were also debated. The required number of shareholders from both companies to approve the merger was considerably lower than normal. JP Morgan’s research remarked: “The proposal requires the majority approval...from shareholders accounting for 39.44% of economic interest in Tesla(50% of shareholders excluding Elon Musk’s interest of 21.12%) and 38.73% of economic interest in SolarCity(50% of shareholders excluding Elon Musk’s interest of 22.54%).”116Due to conflicts of interest, several board members of both companies had to abstain from voting on the merger. On the Tesla side, Elon Musk and Antonio Graciasrecused themselves because they served on both boards. On the SolarCity side, five of eight board members recused themselves given their various connections to Elon Musk and Tesla. This left two independent board members, Donald Kendall and Nancy Pfund, who were solely responsible for approving the merger on behalf of the SolarCity board.117In the end, investors sided with Musk against the skeptics. After the boards of both companies approved the proposed merger in August, shareholders overwhelmingly approved the acquisition in November, with over 85%of Tesla shareholders voting in favor of the deal.

What are the key environmental challenges Elon Musk saw as opportunities? How did he address those challenges in different businesses?

Why do you think that Tesla, with a shorter history, significantly smaller sales and virtually no history of profits was valued higher than the other American car makers? Should there be different performance metrics for startups, such as Tesla?

How are the different businesses of Elon Musk related or unrelated to each other? Would it make sense for Elon Musk to put different businesses into one corporate umbrella or would he be better off running them separately?

If Elon Musk had to divest one of the various businesses, which would you recommend him? Why? How would this divestiture help him increase performance and investors’ confidence?