Why Companies Fail (Part 1)

By Gary Homel

Published June 1, 2009 on WSJ

I grew up in Michigan, so the bankruptcy of General Motors strikes close to home. There was a time when GM made more than half the cars sold in the United States. But now, what was for decades the world's largest industrial company, is a ward of the state. GM's failure isn't the result of one spectacularly ill-conceived decision - the company didn't jump off a cliff. Instead, it meandered into mediocrity, one small short-sighted step at a time. Like a two-pack a day smoker, GM committed suicide in degrees.

Dodgy quality, a toxic labor environment, incoherent brand identities, clunky power-trains, adversarial supplier relations, and subterranean resale values - these were the chronic symptoms of a management model that regarded profits as the game rather than the scoreboard, that valued financial finagling more highly than inspired engineering, and elevated MBA-types to rule over the car guys.

A scan eight months ago, GM's then-chairman, Rick Wagoner, boasted that his company was "ready to lead for 100 years to come" - a comment that only could have been made by someone who was either naively optimistic or hopelessly delusional.

Ever since I can remember, GM's defenders have been arguing that the company was making progress; and they were right. GM has been getting better for a very long time - but it's been 40 years since it was the best. The Chevrolet Malibu and Corvette ZR1, the Buick Enclave and Cadillac CTS-V: these are exceptional cars by anyone's standards. Problem is, they are even more exceptional when judged against the persistent ordinariness of GM's other products. For years, excellence at GM has been an occasional aberration, rather than an all-consuming passion.

A company can coast for a long time when it starts with a dominant share of an enormous and hard-to-penetrate market in the world's largest economy - but given enough time, and enough incrementally myopic decisions, and it will eventually run out of momentum.

GM is not the only company that's sputtering right now. Motorola, Citi, NASCAR, Starbucks, Sony, United Airlines, EMI, Kodak, Alitalia, Sprint Nextel, the New York Times, Unilever, AOL and Chrysler - these are just a few businesses that seem to have lost their mojo. Truth is, every organization is successful until it's not - and today, there are a lot that are not.

How does this happen? How do yesterday's icons become today's also-rans? How does excellence degrade? What are the causes of corporate dysphoria? These are important questions. When an organization stumbles badly everyone loses: shareholders, employees and customers. Through the years, I've seen a lot of companies lose their way. Here's how it happens.

First gravity wins. There are three physical laws that tend to flatten the arc of success. The first is the law of large numbers. We all know that it's a lot harder to grow a big company than a small one. To grow a $40 billion company by 25% requires the creation of ten new billion-dollar businesses. To grow a $40 million company by the same percentage requires only one new $10 million business. In business as in biology, big things grow slower.

Then there's the law of averages. No company can outperform the mean indefinitely. During the last five years of Jack Welch's tenure at GE, the company's market value grew from just under than $140 billion to more than $400 billion. To maintain that torrid pace, Jeff Immelt, who took over from Welch in September 2001, would have had to grow GE's value to more than $1.2 trillion dollars by August 2006 - but that was never going to happen. As you lengthen the relevant timeframe from one year to five and then to ten, the probability of out-performing the average rapidly approaches zero. In the long-run there are no growth companies.

Lastly, there's the law of diminishing returns. The pay-off to any program focused on revenue growth or margin enhancement tends to shrink over time. Top-line growth slows as markets mature, and productivity growth slows as the knife scrapes closer to the bone. Over time, it takes more and more effort to produce less and less in the way of incremental returns. While these three laws aren't as unyielding as gravity, they're tough to overcome - and few companies manage it.

Second, strategies die. Like human beings, strategies start to die the moment they're born. While death can be delayed, it can't be avoided. Autopsies reveal three primary causes of death.

Clever strategies get replicated. Hewlett-Packard ultimately learned how to make computers as cheaply as Dell. JetBlue took a chapter out of Southwest Airlines' playbook. Cialis and Levitra intruded on Viagra's turf. And Facebook built on the social networking model pioneered by MySpace. While some strategies are harder to imitate than others (particularly those that yield network effects), most can be decoded by dedicated rivals.

Venerable strategies get supplanted. Digital cameras made firm obsolete. Downloadable music deflated the market for CDs. Skype allowed its users to sidestep expensive tariffs. And online news aggregators hollowed out newspaper profits. Sometimes newspapers improve on an existing strategy, but occasionally they shoot it out of the sky.

Profitable strategies get eviscerated. The internet has produced a dramatic shift in bargaining power - from producers to consumers. Armed with near perfect information, customers are able to batter down prices on just about everything. For many companies, well-informed customers are now a bigger threat to margins than well-armed competitors.

In life, death can come as a shock. In business, it never should. With the right metrics, strategy decay is largely predictable, though few companies bother to track it. And while a doddering granddad can't abandon his decrepit body for a young and vital one, a company can - at least in theory. Companies die when they can't escape the grasp of a dying strategy.

Third, change happens. Think of the number of things that have been changing at an exponential pace: the number of genes sequenced, the number of devices connected to the internet, the number of mobile phones in the world, CO2 emissions, the amount of bandwidth available globally, and the production of knowledge itself. In the past, there were many things that protected incumbents from the gale-force winds of creative destruction, including regulatory barriers, technology hurdles, distribution monopolies, and capital constraints. But in most industries these bulwarks have been crumbling. Discontinuities undermine old business models and create opportunities for newcomers. So not only do strategies die, they die quicker than they used to - and that's a fact. Over the past few decades, product- and technology-based advantages have become more fleeting. At the same time, the correlation between current and future earnings performance has become progressively weaker.

Fact is, most businesses were never built to change - they were built to do one thing exceedingly well and highly efficiently - forever. That's why entire industries can get caught out by change - industries like big pharma, publishing, recorded music and major U.S. airlines. In a world where change is shaken rather than stirred, the only way a company can renew its lease on success is by reinventing itself root and branch, before it has to - a feat that even the smartest companies have trouble pulling off.

Without doubt, the greatest threat to success is success itself. So next week: how success corrupts.