As analysts, one of our favorite areas of exploration is how companies fail. We have long felt that big companies each carry their own pathology of decay and decline. In this post, we want to explore one particular sub-category – how big companies always seem to crush new business units. This is a topic that has been pressing on us for a while, so we thought we would put it in writing.

In Business schools today there is already a rich vein of analysis about how big companies stifle innovation. The canonical work on this topic is Clayton Christensen’s “Innovator’s Dilemma“. However, much of this focuses on ‘disruptive’ technologies, those that end up threatening the company’s core business. Less well understood, at least in Technology, is how companies fail to diversify. In the Tech press and blogosphere, it seems to be just understood that big companies cannot innovate. There are millions of posts about how particular start-ups fail, but less time is spent looking at how large companies fail. The one exception to this is the study of how Motorola, Nokia and RIM all got sent to oblivion by Apple, but there is far less of an understanding about what happened to Lucent, or seems to be happening to IBM.

When large companies look to enter new areas, they typically consider two options – Buy vs. Build. Most companies tend to prefer the former. Buying a successful company is seen as much less risky. There is also a vocal contingency of bankers and investors pushing for acquisitions (maybe, possibly because they have other interests in mind). However, building a new business unit carries its own set of risks.

First, is the general problem that starting a new business is always full of risk. This is as true for large companies as it is for start-ups. In Tech, there is real engineering risk: Can the new business unit actually develop the product? And all the associated problems of customer acceptance, distribution and support.

Large companies also have to worry about how the new product will fit in with the rest of the company. Will it operate independently, which risks duplication of overhead. Or will it rely on the parent’s infrastructure, which then risks getting bogged down with integration problems. We see all of this as execution risk.

Secondly, there is investment risk. All companies face a finite amount of capital. Start-ups have to worry about their ability to continuously raise money. Large companies have to consider whether they are better off investing in some new business or investing in more in the core business, or just returning their cash to investors through dividends and stock buy-backs. Dedicating capital to some new project is much riskier than those alternatives.

Third is the problem of management risk. How do you motivate employees and managers of the new business. Most companies in tech use their stock as a powerful incentive to keep everyone aligned. For new business units, this fails because the stock price is much more likely to be driven by the results of the core business, over which employees of the new business unit have no influence.

One insidious off-shoot of this problem is the way that decisions end up getting made inside the new business unit. In most companies management bases its decisions on what is best for shareholders. This is manifested through the Board of Directors, or by the company’s share price. However, in new business units of large companies, the dynamic is very different. Since their actions tend to have no impact over the larger company’s share price in the near-term, managers of business units tend to make decisions on a different basis. In this case, the source of funding for the business is parent company management, and only indirectly, through those senior managers, the capital markets. So business unit managers end up making decisions that are entirely focused on what their management teams want to hear. At some companies, Facebook being a notable example, new businesses can enjoy the benefit of an executive team that can focus very sharply on a new business, but these are the exceptions. In most cases, new business units tend to be poorly understood by senior management. They operate in new industries where the parent company managers may not be familiar with industry dynamics. These new business units are also relatively small operations, and so management teams tend to allocate less time to them, focusing more on ‘big’ problems in the core business, and Parkinson’s Law of Triviality takes hold. .

Managers of new business units thus end up focusing on the wrong problems. Rather than think about their operation as a business in its own right, they instead end up focusing on company politics. One of the most important things we advise teams in this situation is to think of their business from a ‘Corporate’ perspective, try to think of your business as a company in its own right. Treat parent company management as shareholders, that is outsiders who have certain rights but should have no say over the day to day operations. Avoid getting caught up in the parent company’s politics and planning cycles. Insist on a healthy degree of independence, but then also push hard to maintain that distance from the parent. Unfortunately, the incentive structure for this independence rarely exists. Business unit managers care about promotions and bonuses, and those get determined to a large degree by those ‘shareholders’, which creates all kinds of problems.

A while ago, we were working with a client who was such a new business unit. One year, they were preparing for their participation in the larger company’s annual review process. The local management team insisted on making some wild promises about their prospects. Those of us working on the company’s go-to-market were alarmed because we knew there was no way to deliver on those promises. The business unit was doing fine from the perspective of a new company, but the management team wanted to convey something different to the executive team. So the leadership team insisted on moving going down this path. Later, it turned out that the executive who was sponsoring the business unit had his own performance reviewing coming up. This review was tied to a massive stock grant. If the new business unit had reported ‘honest’ numbers, it would have likely resulted in him being denied a large portion of that payout. And the head of the business unit himself was hoping to get promoted up and away from the business unit. So the business unit made its promises, then promptly failed to deliver them. By that time the senior sponsor had his retirement package and had left the company, leaving no one to sponsor the business unit when the day of reckoning arrived.

We recognize that declaring independence from the parent company is nearly impossible. That being said, to have any hope of success new businesses units need to operate as if they were independent and make decisions that correspond as closely as possible to their own operations.