Co-owners sharing business rewards do not need to take on the same mix of responsibilities; instead, to create more value, all can focus just on those responsibilities they are best able to discharge. In this article, Felix Barber and Michael Goold discuss that by sharing business ownership, executives can expand the pie so much that everyone does well – and the company is poised for future success.
In 2000, Cisco Systems did something very strange. One of its leading engineers, Mario Mazzola, was tired of working for the networking giant and had decided to retire. So Cisco gave him an offer he couldn’t refuse: his own company to work on new networking technologies. Cisco put up nearly all of the funding, $184 million, but accepted only a minority share of the equity. All it asked for was the right to buy back the company when Mazzola was ready to sell, at a price to be determined. Mazzola would have autonomy and independence from Cisco, and the company didn’t even mind when Mazzola took many of his favourite engineers from Cisco with him.
Four years later, when the startup developed a practical product but before its commercialisation, Cisco paid an additional $750 million to acquire the “spin-in”. Mazzola and his colleagues made hundreds of millions that, in a normal company, would have stayed in the treasury. But Cisco was so pleased with the arrangement that two years later, in 2006, it encouraged Mazzola to try again. This time the company put up $70 million, and bought the startup for $678 million more only two years later.
These first two ventures focused on storage and server technologies, which were complementary to Cisco’s main product. The third spin-in, launched in 2010, focused on developments in software-defined networking that threatened Cisco’s core. Rather than develop this technology in-house, they gave Mazzola $135 million to do it for them. Not surprisingly, morale at Cisco R&D took a hit. But two years later, almost by clockwork, the company happily paid $863 million to Mazzola & Co. Rather than being embarrassed at the failure of its internal R&D, Cisco has publicised the approach and attributed billions in sales to it.[ms-protect-content id=”9932″]
Directing and controlling the work is getting harder nowadays, as strategies depend more on innovation, sales growth, and large transformational projects – challenges with little routine. If you can’t specify what you want in advance, and your employees are in a better position to understand the marketplace and technology than you are, then you can’t rely on directing and controlling them to get results. You have to give them autonomy to figure out what to do – and then you have to motivate them to produce the results that most benefit you.
This is not a new problem, but the main solutions advanced so far have all proved unsatisfactory. Performance-management systems, which connect strategies to individual jobs and incentives, are too easy to game or too complex to administer, especially as strategies become ever broader and more complex. Another tack is to rely on charismatic, visionary leadership, but this is difficult for most executives to pull off. Many executives have thrown up their hands in frustration and relied more on outsourcing as the route to success – let someone else deal with the problem. But if you’re having difficulty defining what you want done, you’ll struggle to set up a robust contract with an outside supplier. You can’t outsource the risk when you outsource the work.
In recent years a number of companies, like Cisco, have tried new solutions. They have chosen a third path, between managing the work with employees and simply outsourcing the work to suppliers. They’ve formed relationships with “business partners” to whom they transfer quite substantial decision-making rights. By also granting these partners a good share of the income, they align their interests tightly with the company’s strategy. In short, these companies have been sharing ownership of their business. (See the sidebar Business Ownership and Ways to Share It.) Like Cisco, they’ve found this approach quite successful for implementing strategy where conventional approaches are failing.
For simplicity we can divide ownership-sharing approaches into two types. One focuses on boosting revenues, often through more innovation or faster expansion to new markets or categories. The other focuses on controlling costs, particularly of large transformational projects such as an IT system.
Let’s start with boosting revenues. The goal here is to surrender enough control and ownership to motivate the key people, but not so much that they stray from your intent or they capture most of the value. The basic approach is nothing new – just look at how book publishing has traditionally worked. Rather than hire employees to write books, or buy manuscripts from suppliers, publishers prefer to collaborate with independent authors. By sharing ownership with the authors – offering them royalties on their books – the publisher motivates an author to write books that will sell well. Because authors and publishers take on quite different responsibilities, sharing revenues may not sufficiently align interests. But simple contract provisions can close the gap. Publishers typically put some constraints on a book’s content, length and illustrations to ensure it fits the publisher’s brand and is not costly to layout and print. A similar dynamic takes place for Apple with its App developers.
Cisco’s spin-ins follow the same logic. If Cisco had relied on internal R&D to boost its revenue, it was going to have trouble generating products that would make it stand out in the marketplace. Many of its most talented engineers were already leaving to join networking startups that promised them greater ownership rewards.
Cisco could have simply waited to see what emerged on the outside and bought the most suitable technologies on the open market. It’s well known for doing that – since 1993 they’ve acquired more than 170 companies. But besides the premium necessary to buy a company in an arms-length transaction, there’s always the risk of the technology going to a major rival.
Similar experiments have been highly successful in other industries. In 1990, the UK hypermarket chain Asda was looking to boost its small clothing department. Rather than hiring internally to meet the challenge, they invited fashion designer George Davies’ firm to simply take over the department. For designing and buying the clothes, and laying out the department, ASDA gave Davies’ firm 25% of any increase in clothing profits. Asda also took a minority equity stake in Davies firm, because they knew the firm would use the contract to develop valuable capabilities in this area.
By 2000, the new “George at Asda” line was generating £600 million in annual sales. Walmart acquired Asda that year, and liked the George line so much it has rolled it out in the United States. As for George Davies himself, he decided to sell the line outright to Walmart. Within a year he was lured over to Marks & Spencer. The big department store had been a longtime leader in the UK clothing market, but after years of decline it was barely breaking even. Womenswear was the heart of the problem. Younger buyers, key to the company’s new strategy, were going elsewhere. The company had plenty of in-house expertise on fashion, but instead the executives gave Davies’ firm control over a large section of the women’s department. Four years later, Davies’ Per Una line was generating £300 million in sales, to a decidedly younger demographic. Davies then sold it to Marks & Spencer for £125 million. Though Per Una was only 20% of Marks and Spencer womenswear revenues, its boost to the company’s fashion image was seen as a key factor in the company’s overall turnaround.
While such ownership-sharing experiments are still rare in big high-tech or chain store retailers, they are becoming mainstream in pharmaceuticals. Until recently, Big Pharma companies maintained enormous R&D staffs exploring all sorts of promising drug compounds. But as all the most appealing compounds came to market, drug pipelines started drying up in the 1980s. With the odds of discovery falling sharply, an R&D team might go through an entire career and never work on an actual marketed drug. Top executives couldn’t find a way to increase their productivity. If the likelihood of success is low, and the personal reward from any discovery not so high in any case, it’s not surprising that many researchers were focusing instead on work that might win them attention in the scientific community.
With poor results coming from their own in-house R&D, big pharma companies have looked to an ownership-sharing model to fill their pipelines. They’ve been entering into strategic partnerships with small R&D companies. At most of these firms, managers and researchers hold much of the equity, so they’re highly motivated to develop commercially attractive compounds.
The usual model is for the big company to provide funding for specific R&D projects. If the funded compound merits commercialisation, then the company gains the marketing rights in exchange for a percentage of revenues; it often also takes a minority stake in the R&D firm. GlaxoSmithKline’s collaboration with Theravance from 2002, for example, generated a number of key products, such as Relvar Ellipta for asthma and Anoro Ellipta for chronic obstructive respiratory disease. Buoyed by these and other successes, Big Pharma now relies on strategic partnerships for a third or more of their overall pipelines.
All of these ownership-sharing arrangements discussed so far aim at jump-starting revenue by innovating in products or services. Another path is through rapid expansion into new markets, by relying on partners who are closer to those markets than you are. Shared ownership in this case – better known as agency, licensing or franchising – has been around since the 19th century. These businesses tend to attract little media attention because most franchisors stay private – after all, they rely on franchisees to invest the capital for expansion. Yet franchisors are coming up with increasingly sophisticated contractual agreements to motivate partners to maximise value for both parties, ensuring better alignment of interests. That is making them increasingly powerful competitors.
With over 100,000 agents, Keller Williams recently became the largest US residential real estate brokerage. An innovative ownership-sharing arrangement with agents, not just the franchisee, was an essential part of its growth. The typical real estate franchisee rewards a local agent only with a percentage of the commission on the sales made by that agent. But Keller Williams’ agents can also receive a share of the profits of the franchise they work with. Let’s say Sally recruits Bob to join their Keller Williams franchise. Sally gets a credit for all the sales that Bob brings in – and also for any sales brought in by people that Bob recruits as well. The more sales made by Sally’s recruits – all the way to seven links in a chain – the greater Sally’s share of the local franchise’s profits.
These profit shares can be quite substantial. Some agents use it to finance their kids through college. Agents who effectively recruit and mentor new agents can often retire with a steady passive income from the franchise. It even extends to agents recruited to join other franchises elsewhere.
This approach has even helped Keller Williams expand internationally. An agent from Texas was sightseeing in South Africa and decided to strike up a conversation with a top local realtor. After much encouragement, the latter went on to found the South African office of Keller Williams – and his mentor is now reaping the rewards.
The exhibit summarises the basic contract design to jump start revenue by sharing ownership as well as important requirements for aligning interests to make the partnership work. (see Exhibit 1, “Jump-starting Revenue by Sharing Ownership”)
Cutting Project Time and Cost
Executing a new strategy isn’t just about new products or markets. It often requires putting in place a complex production or information platform. If you are in a capital-intensive business, such as an oil company building an offshore rig, an electric utility with a distribution network to upgrade, or a bank with processing systems to consolidate, then the speed and cost of setting up the new platforms can be crucial to your success. Unfortunately, large construction and IT projects are renowned for overruns on time and budget.
Companies typically outsource much of the work on these projects to external suppliers. But they struggle to clearly specify what they want done. For construction projects, the traditional approach has been to develop a proposal, put it out to vendors, and use market competition to get a reasonably priced bid at a fixed price. But the low price is often an illusion. When you can’t clearly define in advance what you want, the vendor gains leverage. He can bid low to win the contract, and then, once work is underway and it’s hard to switch, negotiate high margins on the inevitable additions and changes. A confrontational relationship develops between the client, trying to keep costs under control, and the contractor trying to restore his margins. A great deal of effort goes into negotiating, and the delays add up.
As for the usual alternative approach, simply paying the contractor for time and materials, that’s even worse. Those contractors have little pressure to work efficiently or quickly.
Most important, before the work starts, each side signs a “pain-and-gain sharing” agreement. If the project runs over budget or late, both sides take a financial hit. If it outperforms, both sides benefit, all according to specified percentages. Client and contractor therefore share ownership of the business outcome.
In practice, target costs may turn out a good deal higher than in competitive bidding, but that’s largely because both sides have an incentive to be as realistic as possible. The final costs are usually lower, as both sides are aligned in seeking efficiency and limiting additions and changes. Clients concerned that the contractor may be sandbagging the budget can choose to employ a third party cost estimator to give them better information.
The trend to pain and gain sharing started in the early 1990s with offshore oil exploration. BP was eager to launch a strategically important expansion into the North Sea, but the harsh environment there, combined with low world oil prices, presented a hurdle. BP’s initial estimates for the project fell short of an acceptable return on investment, especially given the tendency for difficult projects to overrun on costs.
BP invited contractors to assess the project and offer bids, in case these companies had expertise that could lower costs substantially. Brown & Root led a group that improved on BP’s estimates, but then also allayed the fears of overruns by offering to share the pain and gain of the project’s results. This ownership sharing worked well, as the new rig came on line at a cost 35% below BPs original estimate and 22% below what the contractors had put forth. Other oil companies in the North Sea quickly followed suit, and “Alliancing” has since spread to construction projects on terra firma.
Utilities are embracing it as well, especially in the UK. Anglian Water, for example, is a privately owned utility supplying 5 million residents in southeast England. Their main construction partner for the last ten years has been the @oneAlliance, a collaboration of seven construction and engineering companies formed to work with Anglian. Not only did ownership sharing reduce costs substantially – by 20-30% over the past five years on projects value at well over £1 billion – but it also met targets for fewer accidents and reduced carbon emissions. Pain-and-gain-sharing even helped smooth out Anglia’s free cash flow, a major concern for the highly leveraged utility. It is owned by a few large pension funds eager to use Anglia’s dividends to meet regular pension obligations.
These experiences point to a key distinction for ownership-sharing. When the goal is to generate new products or expand sales, the relationship can be fairly hands-off. The initiating company needs to set general specifications and include constraints that keep partners from destroying value. But for large contracts where the goal is to keep down the costs of new infrastructure that will provide an important performance platform for the company, the partners need to collaborate, often on a day-to-day basis. They must decide jointly about additions and changes to original specifications, or how to address unforeseen risks.
Governance, therefore, becomes a major challenge. “No fault, no blame” clauses in the contract can help to limit squabbles over liability and force both sides to collaborate on reducing damages from mishaps. But preventing disputes from undermining the work often requires more than contractual safeguards.
For one global insurer, getting a new IT system up and running in five key country markets was critical to its strategy. They were reorganising their commercial lines business on a global basis in order to better serve multinational customers. But their old IT systems were country-based and lacked visibility into customers’ overall risk exposure.
Creative governance procedures were key to getting the new IT system in place quickly and efficiently. The contract allowed the insurer two change requests per quarter; beyond that number, the ERP vendor could raise its overall fee for the project. But for the vendor to do that, the insurer had to agree that the requested change would in fact raise costs. What if the two sides disagreed? In that case the matter would go to a steering committee made up of high-level executives from both sides, who would have to meet in person on short notice. Arranging such a meeting proved so painful for everyone that the two project leaders soon learned to reach agreement on their own. They managed to stay within the two-change request limit, bringing the project in on time and budget and letting the new global commercial lines business get to work.
The exhibit summarises the basic contract design to cut project time and cost by sharing ownership, as well as important requirements for making these partnerships work. (See Exhibit 2, “Cutting Project Time and Cost by Sharing Ownership”)
A New Paradigm for Productivity
It’s understandable that executives focus on their own organisation or potential acquisitions when they implement their strategy. That’s what they know, after all. Everything else is outside their control, an unknown territory that must be explored and negotiated. It’s also hard to allow outsiders a substantial share of the rewards from a successful strategy. In some cases an outsider could even make more money than the CEO that drove the strategy. But by sharing ownership, executives can expand the pie so much that everyone does well – and the company is poised for future success.
Sharing business ownership can be an excellent way to implement some of the most challenging components of your strategy, such as driving sales growth or completing major projects. Even when partners take on quite different responsibilities to earn their share of the business rewards, carefully designed contracts can do a good job of aligning interests.
Modern industry was born in the division of labour for standard tasks. By setting up specialised roles for employees, companies and economies boosted productivity enormously. Adam Smith’s “division of labor in pin manufacturing” still graces the face of the British £20 note. But with so much economic activity now centred on complex, unstructured tasks, future productivity gains depend as much on the motivational benefits of a sophisticated division of ownership as on gains from a division of labor.
About the Authors
Felix Barber (left) and Michael Goold (right) are directors at the Ashridge Strategic Management Centre and co-authors of Collaboration Strategy: How to Get What You Want from Employees, Suppliers and Business Partners (Bloomsbury, 2014).