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THE NEW ECONOMICS OF ORGANIZATION

26 THE McKINSEY QUARTERLY 1998 NUMBER 1

The idea is this: share ownership of assets with the managers

responsible for generating value from them

Then create greater transparency between markets and these owners

And make sure intervention is both dificult and expensive

Industrial venturecapitalism:

Sharing ownershipto create value

Industrial venturecapitalism:

Sharing ownershipto create value

OUR EMPLOYEES ARE OUR MOST VALUABLE ASSET, many companiesclaim. Are they right? Yes and no. Valuable, certainly; many businessleaders and management thinkers believe that only a small number of

people in every company are responsible for creating a major part of itswealth. But an asset? Not really; as economists would say, a corporation hasno rights of possession over its employees. And the corporate assets property, plant, and equipment that traditionally conferred power overworkers are less efective with knowledge workers, who carry most of theirtools with them when they walk out the door each day.

Rather, corporations and their top talent which doesnt just mean that at thetop of the hierarchy are engaged in a kind of joint venture or partnership,a relationship whose future both sides continually evaluate. As in anyrelationship, both sides need incentives if they are to cooperate. And evenin the closest partnership, there is competition to capture value.

The design of incentives,bothfinancialand non-financial, is therefore a criticalskill for tomorrows managers. In industries such as sotware and wholesale

banking, efective incentive systems and financial structures for deliveringincentives have long been recognized as an important source of advantage.

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Industries such as steel making, which appear to be less knowledge-intensivebut increasingly rely on the talent and energy of a few individuals to makethem profitable, will soon find themselves in the same position.

Strong incentives, devolved accountability, and credible performancemeasures are economic complements. Each reinforces the rest, and if one ismissing or weak, less value is created. Fortunately, organizational economicshas useful theory and practice to ofer companies keen to improve theirincentive design.

The industrial venture capital model

Until recently, enterprising individuals seeking substantial financial rewardshad little choice but to leave their employers and seek outside venture capitalto set up their own businesses. But new models are emerging that embed theinitiative of an entrepreneurial firm within a large corporation. We mightdescribe them as forms of industrial venture capitalism.

The industrial venture capital (IVC) company attempts to marry theenvironment of a small entrepreneurial start-up with the administrativeconvenience, scale economies, and risk reduction of a large corporation. Likeconventional corporations,IVC companies own assets that allow themtodeliverproductsorservices tocustomersin order tocreate valueforshareholders. Butthere are several fundamental diferences in the way they work.

Whereas large corporations tend to hold all assets in common (either in oneentity or through subsidiaries), IVC companies share the ownership of certainassets with the managers who are responsible for generating value from them.They find that managers who own a share in the business they are runningextract more value from it, just as workers who own their tools will tend totake better care of them

Large corporations can shelter unproductive assets or subsidize businessesthat destroy shareholder value; IVC companies, by contrast, subject many oftheir business activities to the direct scrutiny of the capital markets. Thislimits any tendency they might otherwise have to hold on to unproductiveassets. Indeed, IVC companies, like ordinary venture capitalists, are quick todivest an asset when they are no longer advantaged owners compared withother capital providers.

Becoming an IVC: The case of TAMC

The Asset Management Company (TAMC), a real but heavily disguised

company, has a market capitalization of US$5 billion and profits ater tax ofroughly US$300 million. Active in a wide range of retail and wholesale


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value in situations where businesses could not prosper within a large andbureaucratic corporation.

Finding that certain routes persistently turn in a loss, some airlines have soldthose routes to local management, only to see them become highly profitableunder their new ownership. Similarly, many oil companies have watcheddivested assets multiply in value as soon as they leave the managementprocesses and culture of a giant corporation. Had they adopted the IVCmodel, the sellers would have received a share of that value.

Other companies have used IVC approaches to take options on technologieswhose future value is uncertain. Talented researchers in industries such aselectronics, sotware, and pharmaceuticals oten have little interest in beingemployees in a giant corporation. The IVC model lets corporations use equitystakes to gain options on technologies should they become valuable, eitherby buying into small research firms or by setting up quasi-independentsubsidiaries in which the researchers can work.

These examples illustrate that there is no ideal way to act as an IVC company.Choosing an appropriate model is a critical strategic decision.

Making an IVC work

To succeed as an IVC, companies must overcome at least five challenges:

1. Secure the value

The IVC company must ensure that it captures a substantial share of thevalue that is created by its subsidiary.

TAMC faced the risk that its best fund managers might defect to competitors,taking their clients with them. To prevent them doing so, it tailored incentivesystems to make staying with the company more attractive than leaving.Managers stakes were structured so that their value was depressed in thefirst four years of the subsidiarys operation as a deterrent to moving on.

TAMC also uses policy and contractual mechanisms to retain its managers:

Non-compete clauses seek to prevent managers from working for acompetitor for a long period.

All client contracts are written with TAMC, not its subsidiaries, helpingensure that the company owns relationships with clients.

Spun-of subsidiaries continue to rely on the parent company in their

dealings with the capital markets and for accounting, back-ofice support,and risk management. As well as producing economies of scale, these shared



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services raise the cost of switching should the managers of a subsidiary wishto move to another parent.

TAMC controls marketing activities, ensuring that the corporate brandappears on all literature and is not subordinated to individual managersidentities.

2. Ensure knowledge is shared with the IVC

One of the key challenges for an IVC company is to ensure that as muchknowledge as possible is transferred from the subsidiary to the parent so thatits knowledge is constantly refreshed. Some companies use informationsystems to link subsidiary to parent. Others devise incentives to alignmanagers interests with the success not only of the subsidiary but also ofthe parent, thereby promoting knowledge sharing.

3. Devolve decision-making authority

A great temptation for the IVC company is to intervene in the management

of the subsidiarys business. If the full benefits of entrepreneurialism are tobe captured, IVC companies must devolve decision-making authority in acredible way.

To this end, TAMC executed a letter of intent with one subsidiary statingthat it would not intervene in the management of the business. Although notformally binding, the letter signaled TAMCs wish to act like a real industrialventure capitalist.

4. Minimize reputation risk

One of the costs of devolving decision-making authority is risk to theparent companys reputation. Fraud or deception in one subsidiary wouldharm TAMCs reputation and jeopardize the success of its other sub-sidiaries. To mitigate this risk, TAMC attempts to inculcate its own valueswithin its subsidiaries. It selects partner companies and managers withgreat care, gets its subsidiaries management teams to take part in its train-ing programs, and links some of their incentives to the performance of theparent company.

Through its majority ownership, TAMC maintains the right to remove asubsidiarys management team if it is acting against the interests of the parent.Such a move would be costly and dificult to carry out, and would be reservedfor serious regulatory violations, unethical behavior, or prolonged under-performance.

5. Optimize deal structure

A key success factor for an IVC company is the design of the contracts

between the parent and the managers of its subsidiaries. Every deal isdiferent, but some issues will apply to all:



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Determining the ownership split between the IVC company and themanagement of the subsidiary;* the type of equity, real or phantom; publicor private equity; and whether management has to purchase the equityor earn into it.

Determining how disputes should be formally resolved and ensuring thatcontracts are enforceable.

Defining the exit plans: exit triggers, valuation methods, and mechanismsfor asset disposal.

New mindset and skills

The transition from an ordinary corporation to an industrial venture capi-talist company is not a simple one. In particular, it calls for a new mindsetand new skills.

Readiness to exit. A true venture capitalist operates as a knowledge arbi-

trageur, buying assets that the market lacks the knowledge to value fully, andselling them as this knowledge asymmetry with the market evaporates.Venture capitalists therefore think about exit at least as much as they thinkabout entry.

An IVC must operate with a similar mindset. When it is no longer the naturalowner of a business because its information advantage or other form ofsynergy has disappeared, it withdraws capital from it.

Most corporations find this step dificult. In some cases, an internal mech-anism is needed: one oil company operates an independent investmentbank charged with selling assets for which the company is no longer thenatural owner. It has the power to sell over the heads of protesting businessunit managers. Other companies have used innovative financing vehicles securitization in particular to withdraw capital.

Management selection and development as the primary means of

intervention. Venture capitalists put a lot of energy into finding the right

manager or management team. Yet ordinary corporations all too oten act asthough managers are dispensable. The head of an IVC must become a skilledselector and developer of people. In many cases, this means giving managersmore scope than conventional personnel processes would allow.

The chief executive of one top energy company was concerned thathis managers were not ready to start operating in an IVC mode. But as he



The ownership split is oten a function of the strategic role of the subsidiary. IVC companiestend to hold small shares of subsidiaries whose primary role is to test uncertain technologies,

but retain a majority holding of those created in order to exploit a proven technology in a moreentrepreneurial environment.

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increased their freedom and exposure to market discipline, their performanceimproved so dramatically that they were targeted by headhunters as potentialchief executives for independent energy companies.

Making subsidiaries credible to the capital markets. As noted, an IVCneeds to give managers control of their spun-of businesses in a way thatboth managers and investors find credible. Investors will discount shares ifthey believe that the parent company can withdraw critical resources fromits quoted subsidiary on a whim. In most cases, intervention by thecorporate center is still possible because the parent owns a majority interestin the subsidiaries.

However, the disaggregated organization and finances of an IVC companymake intervention dificult and expensive. IVC parents typically run numer-ous subsidiaries from a lean corporate center whose staf have little time tomonitor and intervene in day-to-day management. Public shareholding, withthe financial transparency and stronger corporate governance it imposes,limits the parents right to withdraw capital, make radical strategic changes,and even reallocate key managers. Both subsidiary managers and investorsknow that the parent company will intervene only if the subsidiary acts in away that threatens the corporation as a whole. By publicly demonstrating thehigh cost and complexity of routine intervention, IVC parent companies canprovide investors in the subsidiaries with assurance that their fortunes will notbe unreasonably compromised.

Operating as an IVC company thus demands a wholesale change in theattitude of senior executives. In particular, it calls for a readiness to conferconsiderable responsibility on less senior managers. But, as many companieshave discovered, it can unlock hidden entrepreneurial energy and createsubstantial shareholder value.



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THE CEO AS ORGANIZATION DESIGNER

Twenty years ago, very few managers thought in terms ofdesigning a corporation. But the number is growing. Tworeasons lie behind the increase.

First, many organizations sense that things are no longergoing well. Consequently, many senior executives see thattheir primary role is no longer to exert direct control, butto educate their people. They may not be sure preciselywhat education is needed, but they have stepped away fromrunning everyday operations to lay the groundwork througheducation so that other people can make better decisions.

Second, many managers no longer find a computerfrightening. They have had experience with computers andare willing to apply them in new ways. We are moving towarda time when increasing numbers of corporate executives willbe ready to take on the role of corporate designers. To succeed,they must realize that redesigning a corporation will take evenlonger than designing, producing, and marketing a major newproduct. Corporate redesign can be a ten-year job.

Mark Keough and Andrew Doman, The McKinsey Quarterly, 1992 Number 2

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