Strategic Deficit

March 14, 2019

Creative destruction involves the incessant creation and destruction of companies and is part of a well functioning economy. Some believe that the destruction of companies is accelerating. A much touted data point to illustrate this is the lifespan of the S&P 500. The 33-year average tenure of companies on the S&P 500 in 1964 narrowed to 24 years by 2016 and is forecast to shrink to just 12 years by 2027. 1

While this is simply one metric, I believe that this subject merits deeper reflection and understanding. I posit that the underlying reason for the decrease in corporate longevity is the evolution of the market – in other words how quickly the market moves. Ineptitude is not to blame but the speed of change that’s deadly.

To illustrate the point, let’s boil down a company to its simplest essence; solving problems and capturing value. Past the startup phase, a known problem is being solved and delivering value for a customer, from manufacturing automobiles to providing accounting services and so on. The people in that company attempt to continuously improve the way they solve that problem over time. The key issue that they face is the rate of change in the market versus their internal rate of improvement. If the delta grows too big, the company finds itself in a strategic deficit.

A strategic deficit occurs when the market evolves too rapidly for the company to adapt in an effective manner. As simply illustrated below:

The market here is defined as customer expectations, technology trends and the competitive environment. The gap between the market and the company’s value creation needs to stay within a respectable distance. If the market changes too quickly, the company will not be able to adapt.

This framework can be useful if properly measured and tracked over time. Individual metrics for each category (customer, technology, competition) will vary.

The decline of a company occurs when the gap grows past a point of no return. We can see this play out in multiple industries over time sometimes quite dramatically. Let’s take the retail sector an often-used example.

  • Technology: The technical capability to launch an ecommerce website followed a reverse exponential curve; it became increasingly easy and inexpensive to launch & operate an ecommerce company. Today, you can literally set up an functional ecommerce website within a day. In 1999, this required funding and a development team.
  • Customers: People prefer convenience and receiving goods directly at home in several categories. If you happen to operate a business in one of those categories where customers prefer online shopping, you cannot forego building out an ecommerce capability for your customers.
  • Competition: Over the past 15 years, hundreds of thousands entrepreneurs took a shot at building ecommerce companies. While many failed, the companies that survived stole market share from existing incumbents.

Traditional retailers found it extremely difficult to compete in these circumstances because the entire dynamics of the market shifted. The technological capability made ecommerce easy to do but expensive to profit from. Customers that shop at retail locations do their own picking and packing as well as their own shipping. Driving to and from a store and picking up your goods was friction in the transaction imposed upon customers. Software enabled shopping has allowed companies to remove that friction from the purchase process, the cost being passed on to the retailer. Traditional retailers were built for an era where it was more capital efficient in building physical locations and serving customers in that manner. The entire assumption of the market shifted and left many in the lurch. This was the catch-22. The profit incentive for retailers to make this shift towards ecommerce was not present but strategically they had no choice.

This is the essence of a strategic deficit; when an organization cannot adapt rapidly enough because it does not have the organizational capability to do so as well as the profit incentive.

Let’s examine another category, advertising. The advertising model is based on people’s attention. People watch television, listen to the radio, read newspapers and magazines. In the pre-internet era, a company that wanted to reach specific people was confronted with friction; how can they reach consumers across dozens of different media channels (TV stations, newspapers, etc.). This was the important role that the advertising agency used to play, act as a middleman and efficiently distribute ads across all relevant channels. The process was relatively simple. Create the message (brand), design the ad (creative) and distribute to the right channel (media). What the rise of connectivity did was take the channel problem and amplify it a thousand fold. People were not spending time across dozens of media channels but rather on thousands of websites across a variety of devices.

This is where the exponential impact of technology was felt. Despite the massive needle in the haystack problem that brands faced to reach consumers, technology enabled the centralization of advertising. The rise of the large technology players notably Google and Facebook have enabled the aggregation of people’s attention in a way that was unimaginable in the last century. Sophisticated tracking and software created the means to effectively target the right people with the right message – across the entirety of the connected population. We’ve moved from a world with several dozen choices for the purchase of advertising space down to essentially two. This now begs the question, why give away a percentage of your media spend in the form of a commission to a middleman? A company now has the means to acquire customers on their own. The relative value of the middleman centralizing a brand’s media spend has decreased significantly and it has impacted the market capitalization of all the major advertising companies. 2

I want to go back quickly to the simple framework from an advertising agency’s point of view:

  • Technology: the sophistication of online targeting has enabled a more effective and cost efficient form of advertising
  • Customers: people spend the majority of their free time on a connected screen instead of traditional media
  • Competition: digital agencies focused on maximizing an advertiser’s returns by working with the duopoly are stealing away market share

From a strategic perspective, many leaders are now re-evaluating how they work with agencies. To amplify the challenge, any new company created doesn’t automatically consider working with an agency. In fact most technology startups today are building out their advertising capabilities in house, as they should. Communicating to your existing and potential customers is a skill set that shouldn’t be outsourced. It is now a strategic imperative. The playing field for advertising agencies has rapidly shifted and most are facing a widening strategic deficit.

As a final example, I’ll use this framework to try to predict what might happen in the legal industry. Specifically, how might the market shift for law firms that provide legal services to businesses. A law firm’s business model is relatively straightforward. An entrepreneur wishing to obtain an incorporation, shareholder agreement or any other legal service will pay a law firm for said service. The economic units of the transaction are hours. The more time it takes to complete the service, the more it costs proportionally.

Law firms benefited from accreditation as a competitive advantage. This has provided a strong moat because legal services can only be provided by lawyers. The work delivered internally by law firms is based on human labor. An incorporation for instance is a set of prescribed steps that the certified professional sets out to accomplish. Upon completion of of this task, the number of hours are counted, an invoice is sent and the lawyer is on to the next client.

It is not difficult to foresee that software will shake up this market and in turn radically change customers expectations. Automation will be able to replicate these steps with software, particularly for tasks that are repetitive. In turn, legal tech startups will offer this as a service based on probably on a license fee at a dramatically reduced price. Let’s see how the market shift will occur:

  • Technology: the rise in automation will enable a radical decrease in the cost to deliver most legal services
  • Customers: business owners will expect a rapid delivery of the service and at a reduced rate
  • Competition: nimble technology firms that have lawyers embedded within them will start chipping away at the large firms that haven’t adapted

How this will exactly play out in the legal space is unknown as there are many possible futures. The underlying changes though are pretty clear. The dynamics of this service industry will undergo more change in the next five years than it has in the last fifty. It should come as no surprise then that the world’s leading law firms are investing heavily in technology and notably machine learning.

Most market changes don’t happen overnight. In fact, most happen over the course of years. A leader has to step back and evaluate what is happening regularly in their market. The goal of surveying the market is to be able to identify when to take action. There is no magic formula or software that can do this. This isn’t of course new, but what has changed is the speed of the market’s evolution. Surveying technology trends, customer expectations and competitive activity is not a once a year activity as it used to be, it needs to become a regular activity of a leadership team.

The framework provided is one of many possible ways to do this. It can be a powerful predictor of how a market will change in the future. As technology invades more parts of the value chain, it becomes even more important for every single organization to be aware of market changes on a continuous basis. The forces of technology and competition will erode any competitive advantage over time; adaptation and agility are critical. The shift to the information age will undoubtedly shift the very structure of certain industries. When this mutation occurs, the strategic deficit will be too great for some to overcome.

1. https://www.innosight.com/wp-content/uploads/2017/11/Innosight-Corporate-Longevity-2018.pdf

2. http://adage.com/article/agency-news/holding-company/312572/