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146. Luca Dellanna on the Power of Adaptation: Adapt or Die

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Ceaseless flux. Those are words Ludwig von Mises used to describe the perpetual change in business conditions that entrepreneurs experience. The consequent need, he told us, is for a process of constant adjustment. The current word for that process is adaptation. Economics For Business talks to Luca Dellanna, a leading business expert who advises companies of all sizes on managing the challenge of continuous adaptation.

Key Takeaways and Actionable Insights

Adaptation is a necessary capacity of all businesses.

Adaptation is a necessity. The marketplace changes, customers change, technology changes. Change is the norm. Firms that don’t adapt will suffer and potentially die, so adaptation must become the norm for business. In complex systems theory, adaptation is the selection of strategies or actions that enhance survival or any other measure of success (or fitness, as its sometimes called) amidst swirling change. In business, adaptation means choosing your degree and pace of change.

Change will be externally imposed if it is not internally embraced.

Businesses can influence the level of change impact. They can critically examine their mental models, and assess their products, processes, beliefs, and people, to evaluate their fitness for adapting to market change. To avoid change being imposed from outside the firm — to avoid negative natural selection, in the evolutionary metaphor – all layers of the firm must embrace change, and proactively adapt. Eliminate unfit products and processes, pursue the development of new ones that are better adapted, and upgrade people resources through thoughtful hiring and active learning.

Adaptation is different than responsiveness — it’s embracing harm.

We talk a lot about a business’s responsiveness to customer wants and preferences, especially when those preferences are fluid and incompletely articulated and require interpretation. Responsiveness is critical — but it’s different from adaptation. It’s response to an external signal. Adaptiveness is embracing change inside the firm.

Luca Dellanna has a striking way of communicating this: he advises his clients to deliberately expose themselves to what he calls “harm” — new problems never before encountered. The exposure must not be to a problem that could overwhelm the firm, but one that can be addressed at a subsidiary level or component level or via adjustment in a shared mental model. Luca calls this “small harm” — specific problems (e.g., the price of a product or service compared to the customer’s willingness to pay). Proactively probe the problem, e.g., in a high pricing test, generate feedback and actively use the learning to adapt. Another word for “small harm” is stressors: situations that put stress on the firm. Set up systems to seek out these stressors so that adaptation is deliberate, and can be enculturated, rather than wait for a crisis that requires an emergency response.

Lack of discomfort is a problem to avoid.

Identify the leading indicators that describe the conditions that will change the future.

Lagging indicators — such as revenue — are metrics that describe the past. There are leading indicators available such as number of customer contacts (describing what the pipeline might look like in the future), and satisfaction scores (describing future repeat sales). Luca recommends pairing one lagging indicator with one leading indicator to develop a metrics system.

This is not the same as popular consultant-proposed metrics systems such as OKR (Objectives and Key Results). Objectives are not leading indicators. The best leading indicators are behaviors, because these can be easily adjusted if observed to be in need of change. Falling behind on objectives does not yield an actionable response if not linked to a causal factor. Inadequate behaviors (e.g., conducting a sales call without following the proven process) can be addressed, especially if they are clearly linked to positive outcomes.

This is the same principle as Amazon’s focus on what they call controllable inputs, and Amazon knows a lot about driving business growth.

There are several strategies to pursue adaptation.

Redundancy (having more than needed): A focus on efficiency and “no waste” can be detrimental to adaptation if it leaves no resources for experimentation and exploration. Employees need time to work on new things, not just on current tasks and issues.

Bottom-up initiatives: Central command and control can’t run everything, anticipate every harm, or plan every experiment. Ensure entrepreneurial empowerment of front-line employees and functions so that they can initiate learning.

Avoid game-over: In experimenting, calibrate the risk to ensure that a negative result is not overwhelming, and, in regular operations, be aware of any possibility of a major crisis — a Black Swan event — and be sure that it will not destroy the firm or deliver a setback from which it will be hard to recover.

Never stop exploring, in a culture of anti-fragility.

Nassim Nicholas Taleb famously coined the term “anti-fragile”. The company that has the most well-developed capacity to learn from problems and harm is the most anti-fragile. The culture of anti-fragility is always to surface problems when they are encountered and address them at the source. Luca stresses that culture is built when everyone in the company can see a consistent set of actions in which the trade-offs of addressing problems are consistent with the stated vision. For example, a culture of safe operations will be reinforced when safety precautions are taken even when the cost, in time or money or both, is high.

The leading indicator is that every individual and every operation and sub-operation is following safe practices, and that the company readily commits resources when a new safety procedure or installation is proven to be effective. If the trade-off is made that the new procedure is effective but too expensive to install, the culture will be punctured because the company has acted contrary to its declared vision.

Additional Resources

“The Power Of Adaptation” (PDF): Download PDF

Read Luca Dellanna’s book, The Power Of Adaptation: Download PDF

Another application of adaptation, Teams Are Adaptive Systems: 12 Principles For Effective Management by Luca Dellanna: Download PDF

Visit Luca Dellanna’s website to find more resources: Luca-Dellanna.com

E-mail Luca at luca@luca-dellanna.com

145. Christopher Habig: How Understanding Subjective Value Will Revolutionize the Medical Care Industry

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The field of medical care is so ripe for new entrepreneurial solutions. As is always the case, solution design begins with understanding subjective value, both for customers (patients) and providers (doctors) Christopher Habig of Freedom Healthworks (FreedomHealthworks.com) joins Economics For Business to explain how an Austrian, subjective-value focused approach is bringing market freedoms to medical care.

Key Takeaways and Actionable Insights

Step 1: Like many entrepreneurs, Chris Habig started a revolutionary business from a place of familiarity and existing knowledge.

The so-called effectual process in entrepreneurship begins with two straightforward questions: what do I know and who do I know? Chris Habig grew up in a family where both parents are physicians. This vantage point gave him the opportunity to observe the critical doctor-patient relationship first hand, as well as the way in which modern bureaucratized medicine imposes obstacles and complexities that strangle the value generation potential of that relationship.

Step 2: Assessing the subjective value gap.

From his Austrian analytical perspective, Chris was able to identify the subjective value gap. For customers (patients) it is the loss of the positive feelings that they associate with the doctor-patient relationship. Chris summarizes them as advocacy, access and affordability: my doctor is on my side and looking out for me; my doctor is always available to me; I will not be excluded for economic reasons. These feelings are negated by bureaucratic medicine.

There’s a subjective value gap on the physician side, too. Research shows that doctors are stressed, and no longer find fulfilment in their work. Their mental health declines and there is an increasing rate of defection (leaving the industry) and even suicide. It’s a sign of a dysfunctional system to exert such an effect on its human capacity.

Step 3: Identifying the barriers to remove.

Value generation often consists in the removal of barriers to the realization of the desired experience. Chris identified two major barriers: insurance and government. The current approach to medical insurance actually hampers the market for what customers truly desire, which is the positive feelings of the doctor-patient relationship. Now it’s a patient-insurer relationship: will my visit / test / procedure be covered? Will there be a big bill in the mail?

And, of course, the participation of government to enforce the current system through legislation and regulation perpetuates the barriers.

Step 4: The entrepreneurial solution.

The solution is to free the system from its constraints through entrepreneurship. The physician is the entrepreneur on the supply side. Via a new business model called Direct Primary Care (DPC), the physician-entrepreneur creates a new value proposition for customers. Access is provided via a subscription model, and this financial innovation enables the thriving of a practice composed of a small number of patients to whom the physician can devote more time per visit, more attention, and more personal and individualized care. The physician is networked into a web of complementary secondary and specialist services that can be orchestrated for the individual patient’s need. All the associated business services are clustered around the DPC practice, and the physician does not need to be bound by a hospital system bureaucracy.

The new financial model enables the customer to take charge of their medical expenses, paying cash for current needs and reserving insurance for catastrophic events, which is the way it should be used. Consumer prices are lowered throughout the system.

Lives are improved on both sides of the doctor-patient relationship.

Step 5: The support system for the entrepreneurial model.

We live in an age in which distributed entrepreneurship can be embedded in an enabling system of digital infrastructure. Part of the innovation that Freedom Healthworks brings to the renaissance of the doctor-patient relationship is the platform on which the DPC business model can run.

Chris has identified 158 steps for the set-up, operation, and maintenance of a DPC business model. These can all be hosted, enabled, and implemented on the physician’s behalf. Finance, technology, operations, marketing, and vendor relationships can all be systematized and partially or fully automated. The doctor can focus on the relationship component of interacting with patients.

Step 6: Scaling.

Can entrepreneurs build out a fully-functioning cash-based direct care system to rival and ultimately replace the government-insurance company nexus? It’s already happening. As each DPC practice proves itself, more entrepreneurial physicians will make the transition and momentum will build.

DPC is an important example of the future of entrepreneurial economics.

Additional Resources

“Enabling A Direct Primary Care Practice” (PDF): Download the PDF

“FreedomDoc Launch Process” (PDF): Download the PDF

Healthcare Americana podcast: View Podcast Archives

Visit FreedomHealthworks.com and FreedomDoc.care

144. Joe Matarese on Expectations and Building a Culture of Continuous Innovation

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Every company starts as an innovation. Thereafter, the unceasing challenge is to keep innovating because the market continues to change, technology continues to advance and, crucially, customer expectations continue to rise. Economics For Business speaks with Joe Matarese, Executive Chairman of Medicus Healthcare Solutions, about how to build a culture of continuous innovation and overcome the countervailing forces of the status quo.

Key Takeaways And Actionable Insights

Every company starts as an innovation. The challenge is to continue — and ideally accelerate — innovation without pause.

As Joe Matarese puts it, innovation gets you into the game. It’s how every company starts. There’s the identification of a gap in the marketplace and the operationalizing of a new innovation to fill the gap, better than any other competitor or rival entrant.

Innovation is seldom a great new invention or unprecedented leap. It’s more often the day-to-day incremental changes and improvements in products and processes to meet customers’ changing expectations.

The great challenge is to continue or even accelerate innovation as the company grows and expands.

Continuous innovation combines mindset, processes, technology, empathy, and organizational empowerment.

The world is complex and ever-changing. Innovation is necessary for all businesses to keep up or even move ahead. Innovation is not simple, and it’s not easy — in fact it’s a continuous struggle against opposing forces. Joe Matarese has directed innovation from three vantage points: big corporate, startup, and large growth company. To achieve the goal of continuous innovation requires attention to multiple factors:

Mindset: Innovation must be the commitment for everyone in the company. That means always asking the question, “How can we do better?” Such a mindset requires both tolerance of discomfort — since there’s never any rest — and humility in the face of feedback. Innovative companies hire people with these characteristics and cultivate constant vigilance throughout the firm.

Processes: Things get done through the implementation of processes. Innovative are always seeking to improve their processes — make them faster, lower cost, and more efficient in their use of inputs, especially the use of people’s time. Innovation itself is a process, and process improvement is a form of innovation.

Technology: Irrespective of how innovative any one company may be, technology is progressing at an increasing rate of change with potential to render all processes faster, lower cost, and capable of higher quality and fewer errors. One way to ensure continuous innovation is the rapid adoption and early implementation of new technologies as they become available.

Empathy: Even more powerful than technology is the capacity to tap in to customers’ expectations. This is the source of knowledge about future requirements. Customers are experiencing new technology, are absorbing innovation from other firms in the market (whether they are firms that are competitive to yours or simply adjacent), are experiencing change, and their expectations are changing and becoming more demanding by the moment. By sensing their changing expectations, the innovative firm is in position to be a first responder or an innovator before the expectation has even hardened or matured. Being ahead of expectations is a powerful place to be.

Empowerment: People in front line sales and service functions are closest to customers and their expectations. Line operatives are closest to process implementation. Supply chain managers are closest to business partners and vendors. It is these front-line positions that are best placed to deliver information about expectations and what’s changing. They are also best placed to sense dissatisfaction and unease, and to make real-time changes and adjustments. If they are empowered to make changes and to both suggest and implement improvements — even if what they try doesn’t work — they will be more highly motivated and more likely to serve as an internal engine of innovation.

Tools: Joe shares how his company, Medicus, has developed tools for innovation. Internally, all employees have access to communications tools that ensure the customer data they collect, and the ideas they generate as a result, are widely circulated and responded to. Externally, doctor whom Medicus reimburses for services have access to a tool to record their time that is administratively simple and generates fast payment, addressing two measures of unease.

Our Econ4Business.com platform curates many tools for entrepreneurs. One example relevant to this episode is the “Continuous Customer Expectations Monitor” (see Mises.org/E4B_144_PDF2). It guides entrepreneurs through the continuous process of tracking and keeping up with changing customer expectations.

There is a constant counterforce to innovation that the innovative company must recognize and overcome.

There is an innate human resistance to innovation and change. Consider this from a leading brain scientist and psychologist:

When information streams in through our sensory systems, it first stops off at our amygdalae, which are there to ask the question, “Am I safe?” We feel safe in the world when enough of the sensory stimulation coming in feels familiar. When something does not feel familiar, however, our amygdalae tend to label that unfamiliar thing as dangerous, and they respond by triggering our fight-flight-or-play-dead fear response. —Jill Bolte Taylor, Ph.D., Whole Brain Living (Mises.org/E4B_144_Book)

It’s natural in humans to resist change. It may not be safe. It may threaten my job, or my comfortable routine, or generate unwanted uncertainty. Fear of change is real. The function that exercises the fear response in companies is bureaucracy. Bureaucracy exists to ensure compliance with existing rules, and their consistent and uniform implementation. Bureaucracy is anti-innovation.

When a business leader commits to improving a product or process, he or she is undoing what someone else in the firm had championed and nurtured and maintained. It’s a constant battle that must be waged between change and the maintenance of the status quo.

The adoption of new technologies is an effective technique of innovation, but it can also trigger a fear response.

Technology is the continuous innovator’s weapon. It advances at its own pace, as a form of evolutionary advance. Every technological innovation spurs new applications in the marketplace. The adoption of these new technology applications is a catalyst for continuous innovation in the firm, supporting both product and service improvements and the incremental efficiency of processes — faster, leaner, lower cost.

The fear mechanism exhibits itself as employees worrying about their jobs. Perhaps the application of technology will reduce the number of people supporting a particular process from 5 to 4 to 3 or 2 or even one or none. They fear that progress will punish them. They adopt a defensive mindset. The innovator’s goal is to change the mindset to one of anticipation of rewards for progress.

Basic economics tells us that resources which are no longer utilized in a process that is rendered more efficient are thereby released for higher and more productive uses. Innovation leaders can communicate that, and make sure employees know they will be rewarded for progress via new and better opportunities for them to contribute more through the higher productivity that innovation brings.

The greatest resource for continuous innovation comes from customer intimacy and empathy that senses customers’ escalating expectations.

When we talk about a changing marketplace, we are really talking about customer expectations. Innovation elevates customer expectations and thereby triggers the next round of innovation in a never-ending cycle.

For example, now that many people carry iPhones and other smartphones, they’ve become used to unprecedented levels of convenience, interconnection, functionality, and intuitiveness. Their expectations for every other piece of technology they encounter, and every interface they navigate, are raised to a new level. There’s a marketplace of expectations and every new technology raises the bar.

The way to keep pace, and to have any chance of anticipating and meeting the next level of raised expectations is to get as close to the customer as possible, to be with them when they’re using your product or service or technology and listen and empathize when they express a wish (or expectation) that the experience could be easier, better, faster, less frustrating, more enabling. “I wish it were as easy as my iPhone” is the expression of an expectation that everything should be as easy as the iPhone.

Innovating firms build in mechanisms that make continuous innovation not only possible but likely.

There’s a quote in the book Working Backward, about continuous innovation at amazon, to the effect that “Good intentions don’t work, mechanisms do”. The intent to improve a process or product is not enough; people already had good intentions in the first place. Mechanisms turn intentions into actions and achievements. Some of the mechanisms Joe Matarese recommended are:

Mechanisms for taking in data from and about customers: Customer intimacy has a mechanism, in the form of frictionless and unstructured data collection. Give front line employees and the technology they use the unfiltered capacity to gather customer information about their dissatisfactions and report it back.

Let people experiment: The E4B technique of explore and expand applies to everyone in the organization. Elevate experimentation over compliance. That’s the way learning happens.

Eliminate bureaucracy that is not mission-supportive: Every company eventually builds bureaucracies in order to support consistent application of business rules. Innovators differentiate between bureaucracy that is mission-supportive and bureaucracy that is mission-obstructive. HR is often a department where bureaucracy grows. If HR is helping to recruit talented people who will contribute to innovation, then the bureaucracy is mission-supportive. If HR imposes rules that unnecessarily impede innovation, then that part of the bureaucracy should be shut down. The goal is to liberate the value-generating creativity of everyone in the organization, and not to impede it.

Decentralization and entrepreneurial empowerment: Decentralization is a mechanism of innovation. The goal is for your organization to consist of hundreds of individuals thinking creatively and solving problems for customers. You want them all to think and to learn! They must know that the firm cheers them on for doing so.

Additional Resources

“Designing An Organization For Continuous Innovation” (PDF): Download PDF

“Continuous Customer Expectations Monitor” (PDF): Download PDF

Medicus Healthcare Solutions: MedicusHCS.com

Econ4Business.com

Whole Brain Living: The Anatomy of Choice and the Four Characters That Drive Our Life by Jill Bolte Taylor: Mises.org/E4B_144_Book

143: Per Bylund: How Austrian Entrepreneurs Succeed

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Successful entrepreneurs are Austrians, they just don’t know it yet. This is a famous assertion from Dr. Per Bylund, and we dissect its meaning in the latest Economics For Business podcast.

Key Takeaways and Actionable Insights

Success starts from a deep understanding of subjective value (see Mises.org/E4B_143_PPT).

What’s the value of a successfully completed Google search? What’s the value of the feeling of satisfaction that results from having cooked an excellent meal enjoyed by your family? What’s the value of the PowerPoint template you utilized to make a well-received boardroom presentation that may boost your corporate career?

Austrian entrepreneurs know not to ask the question in that form. First, value is not measurable; it’s a feeling or experience in the mental domain. It may have great intensity, it may have long duration, but it can’t be measured in dollars or with any other number.

Yet the generation of customer value is the entrepreneur’s goal. How can the goal be achieved when the understanding of value is so challenging and its measurement is impossible? This is the brilliant advantage of the Austrian entrepreneur.

The customer learns what a value experience feels like.

A customer can’t describe the value they are seeking or what goods and services will deliver it. The value process is not one of demand and supply. As Ludwig von Mises understood, customers feel a sense of unease — “things could be better” — and begin to explore possible avenues to relieving their unease. Of course, this exploration takes place within a complex system of needs: individual and personal goals, family comfort and security, job success and economic status. Customers sort through possibilities with incomplete information and in the context of uncertainty. The gap between feeling unease and finding the best good or service to address it is large. They might try multiple potential solutions with varied cost/benefit profiles before they arrive at one that seems best, or better than alternatives. In other words, they learn: value is a learning process.

The entrepreneur helps their customers to learn.

The customer’s value thinking is constrained: in the present, they can’t imagine a solution that they haven’t yet tried or that has not been available to them. The entrepreneur innovates around the constraint, by providing and communicating new means that the customer could utilize in the future.

Entrepreneurs can’t directly shape the customer’s choice. It’s a fallacy to believe that advertising or promotions or presentation of features and benefits can accomplish that. The customer’s context is too complex for such a simple mechanism to work. The entrepreneur creates a tomorrow in which the customer will feel better off, and provides the means to facilitate the experience, a means for the customer to learn what a better tomorrow feels like. They meet customers in a market that doesn’t yet exist.

Austrian entrepreneurs have a unique value generation tool.

The complexity of the customer’s value system — all the components of value interacting and changing in time — can be simplified with the use of a key that Austrians call the hierarchy of values. Every individual has a set of goals or values they pursue in life. Some of these are more important than others — we call them the highest values. For example, people who engage in sport and athletic activities may have several values for doing so: for fitness and health, for social reasons, for self-improvement, and so on. One value may be the most important in their own individual hierarchy — for many people it is the sense of achievement. By improving their speed or time of running or bicycling, by winning a tournament or a league or playing on a winning team, the individual can experience a sense of personal achievement that is rare, valuable, and fulfilling.

It is a commercially strong behavior to appeal to this highest value among customers. Nike does this for example with its “Just do it” appeal. To simply undertake the athletic activity is achievement: you’ve done something. And, of course, Nike wearables help the process of experiencing the highest value.

All entrepreneurs can appeal to customers’ highest values, and the Austrian entrepreneur has deeper insight into this action.

Austrian humility is a success factor.

So much of business success is projected as heroic implementation of superior strategy. Austrian entrepreneurs do not suffer from such hubris. They take a humble approach to business, understanding that the customer is often engaged in searching and learning without a clear outcome in mind, and that, therefore, the entrepreneurial business cannot be certain of any future results. Entrepreneurs humbly follow, letting the searching customer take the lead, and accepting the customer’s terms of service.

This is how entrepreneurs learn how to facilitate value — often from the harms they suffer from getting their value proposition out of alignment with the customer’s preferences. If the value proposition is wrong, or the price is too high, or the convenience not to the customer’s liking, then no transaction is made, and the entrepreneur must — humbly — adjust. The most successful entrepreneurs are able to maintain their attitude of humility at all points in the value cycle.

Austrian entrepreneurs take the role of fitting in to the customer’s value system. It’s a flow, not a plan.

Conventional business planning is anathema to Austrian entrepreneurs. The linear process of producing and selling to generate transactions with the goal of meeting a targeted volume or revenue in a fixed period of time is not appropriate for the humble, learning, exploring business of entrepreneurship.

Entrepreneurial success stems not from good planning but from adaptively fitting in to the evolving value system we call the market — a system that is different for every individual customer, and into which many overlapping and competing entrepreneurial value propositions are also trying to fit.

Planning is not a good tool for this purpose. Creativity, imagination, and adaptiveness are called for. The dynamic of learning from the customer and adjusting to changing signals calls for responsiveness not plans. The entrepreneurial journey with the customer is a flow, sometimes through white water. In this context, the Silicon Valley concept of pivoting is appropriate, although not quite as the West Coast gurus see it. Their pivot is a one-time major shift in direction, perhaps to a new business model when the original one proves inadequate. The Austrian pivot is continuous and flowing, adjusting the boat to the subtle and frequent signals sent by customers.

Explore, Realize, Then Keep Exploring.

We’ve talked in the past about an “explore and expand” model for entrepreneurial value generation. The entrepreneur co-explores various paths to value with the customer, and when one emerges as productive of significant value, the entrepreneur can expand the allocation of resources to that path and drive revenue growth, through selling more to the same customers, or recruiting new customers or both.

Professor Bylund added some nuance to this: the entrepreneur never stops exploring. When an exploration results in substantial value realized, there remains a lot of further exploration to understand the value experience of the customer in greater depth and detail, and continuous monitoring of changes and adjustments in the customer’s system and value network. The entrepreneur is continuously tested.

The entrepreneurial ethic is an ethic of service; profit is a shared outcome of consumer and producer choices.

Entrepreneurial firms are in business to serve customers. This principle may be appropriately expressed via mission statements and expressions of purpose; it remains the core of all entrepreneurship. Profit is an outcome of two collaborative choices: the exchange price the consumer is willing to pay for the value they anticipate receiving, and the choice of costs the entrepreneur considers proportionate to the value he or she expects to generate for the customer. There are many entrepreneurs in the market for resources bidding on costs at the same time, and so the individual entrepreneur’s choices are conditioned by those made by others. Profits emerge from this system.

Cash flow is a better indicator of the capacity of the entrepreneur’s business model to convert resources into exchange value for customers (although not the artificial cash flows of engineered P&L’s — rather, the true cash flow of the customer’s eagerness to exchange for the newly produced offerings from the entrepreneur).

There’s a distinctly Austrian approach to entrepreneurial business.

In a famous paper called “Inversions of Service-Dominant Logic,” professors Stephen Vargo and Robert Lusch called for inverting “old enterprise economics or neoclassical economics” in favor of a new perspective. One of their proposals was an inversion of “entrepreneurship and the view that value creation is an unfolding, emergent process” to a position “superordinate to management”. Business schools, they stated, teach a management discipline rooted in the industrial revolution. There’s an emphasis on centralized control and planning. Vargo and Lusch sought to replace this approach with value creation as “an emergent process within an ever-changing context, including ever-changing resources; it is, by necessity, an entrepreneurial process”.

The distinctive Austrian entrepreneurship approach captures and expresses the emergent process, and provides entrepreneurs (and managers) with the tools and methods to help them shape thriving businesses as they discover new solutions to relieve customer unease.

Additional Resources

“Explore and Realize (and Keep Exploring): How Austrian Entrepreneurs Generate Value on the Path to Business Success” (PowerPoint): Download Slides

“Inversions of Service-Dominant Logic” by Stephen L. Vargo and Robert F. Lusch (PDF): Download_PDF

141. Bharat Kanodia: How Subjective Value Generates Valuation In Business

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All value is subjective. But often, when an exchange is to be made, a numerical value is required. It’s a special kind of economic calculation, what Bharat Kanodia terms “a subjective opinion based on objective facts”.

Bharat has built a career on valuations, from 2-founder garage start-ups to the Eiffel Tower. He shares his knowledge, experience, and insights with the Economics For Business podcast.

Key Takeaways And Actionable Insights

Valuations start with a “what?” and a “why?”

What is the subject of the valuation? Is it a building but not the land it’s sitting on? Is it a patent? Is it a monetized patent or just an approved patent? Is it the assets of a business or is the going business? All these definitions and classifications of what’s being valued clearly make a big difference to the outcome.

What is the purpose of making a valuation? It might be a step in buying a business. Or in selling a business. It may be a valuation of an asset for insurance purposes, or for estate tax estimation. The valuation may be a tool for raising capital, or an assessment following a capital raise. The same asset can have different valuations for different purposes.

That’s why it’s important to start with the what and the why.

The most challenging business valuation is for a start-up.

Two founders working from a garage have a business idea and some code but no customers and no revenue. The business needs a valuation in order to raise capital. It makes no sense to value it on the basis of discounted future projected cash flows. They’re imaginary.

The business is going to be valued based on the story the founders tell, and a rule of thumb valuation that works backwards from the percentage of the business the founders are willing to give to a seed investor.

Most 2-founder garage pre-revenue businesses are deemed worthy of a $1 million valuation, because an investor can be given 20% of the business for a $200,000 investment, which are reasonable heuristics for both parties. Bharat advises founders not to haggle too much over this valuation stage — if the business is successful, this initial financial structure is largely irrelevant for the founders.

In subsequent post-revenue investment rounds, operations have more impact on valuation than future revenue projections.

Even once there’s revenue and a validated business model, projected future revenues are seldom the basis for valuation. There’s usually a hockey stick projection, or a long list of unverifiable assumptions. It’s more important to investors — and valuers — to examine operations, and specifically whether the business owners have a valid, detailed, and convincing plan to scale up. This kind of operations planning demands great rigor, both for purposes of implementation and for convincing investors.

Often, it’s the quality of storytelling that underpins the valuation.

With a detailed operations plan in place, the selling business founder or proprietor can build a persuasive story about future growth and potential. Here, emotion plays a big part. Can the business owner communicate how intensely the need is felt by potential customers? Can he or she communicate the passion they feel to deliver a solution to those customers? And the deep emotional commitment to the years of hard work it will take to attain appropriately ambitious goals?

The story, well-executed, validates the valuation.

For businesses like CPA firms, medical practices, and construction, 2 major factors have an outsize influence on valuations.

When an investor buys a mature service business, especially a local one, they are generally seeking hassle-free cash flow. They’re not looking to buy problems to fix.

Two factors stand out for these kinds of buyers. One is reliable recurring revenue from loyal customers. It must be revenues that are fully attributable to the service, and unlikely to be cut when there is a change of ownership.

The second is automation or established smooth-running and self-maintaining operations mechanisms. Bharat’s advice to sellers of these kinds of businesses is to automate everything you can, with reliable control software wherever possible.

These kinds of service businesses may have high levels of reputation and trust based on surveys and qualitative data, but those intangibles must be backed up with the behavioral reliability of the customer base.

In today’s markets, followers are a highly valued asset.

In many ways, recurring revenue is a metric to quantify followership. Ryan Reynolds has a followership. Nike has a followership. Tom Cruise has a followership. These followers are all monetizable as buyers of goods or services or movie tickets associated with these personalities and brands. Your personal brand has value if you have followers and if the followership can be monetized.

Every asset can be assigned a valuation — even the State of Hawaii and the Brooklyn Bridge.

Bharat has been called upon to give valuations of the Brooklyn Bridge, the Atlanta airport, and the state of Hawaii, among many other famous places or things. Sometimes, the valuation is for insurance purposes, sometimes for accounting. In all cases, there’s a number (or a range).

Once the what and the why are established, there is a mechanism for valuation that can be applied to any asset or stock or flow.

Additional Resources

“Pathways To Business Valuation” (PDF): Download PDF

“How to Double Valuation?” (Video): Watch Video

“What’s Pre-IPO Worth?” (Video): Watch Video

128. Matt McCaffrey: Austrian Business Strategy (Part 2): Principles

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Austrian economics helps entrepreneurs to develop and implement more effective business strategies, and to open up streams of continuous innovation. As Joe Matarese, CEO of Medicus Healthcare Solutions, said about Austrian economics in relation to business: It just works.

In episode #127, Matt McCaffrey outlined the Austrian strategy process of Explore and Expand, and its logic development. This week, he helps us dig deeper to identify the principles of Austrian economics that underpin our distinctive approach to business strategy.

Key Takeaways & Actionable Insights

Realism: real people, real markets, real entrepreneurs in real firms.

Mainstream economics has never been able to help business, because of its focus on math, models, and prediction. Real people and their decisions and interactions and motivations and emotions can not be captured in equations and mathematical functions.

Austrian economics has carved out a particular area of focus in the behavior of real people in its study of entrepreneurs and entrepreneurship. Austrians examine real entrepreneurial decision-making day-to-day; they highlight real people experiencing value and entrepreneurs’ role in generating that value. From this base, Austrian economics investigates how individual actions and choices and interactions lead to the formation of markets.

Dynamism: The market is a process.

Austrian realism sees the market as a dynamic process, continuously unfolding in interaction and innovation and change. Mainstream economics, with its preference for the greater mathematical tractability that comes with abstraction, has no capability of dealing with this real-world dynamism. The embrace and study of dynamic processes gives Austrian economics much of its applicability in business. The business world is never static. It can’t be understood in abstractions. It’s real and messy and changeable and unpredictable.

Uncertainty and complexity: embrace emergence.

Uncertainty is a keyword for Austrian economists. It’s a term that describes the real world in which entrepreneurial businesses operate. They can never know for sure what comes next; they can’t anticipate all of the interactions between competitors, changing customer preferences, technological advances and social and economic trends. There is no sure-footed way to plan for the future. Austrians recognize uncertainty and help businesses think about how to cope with it, how to narrow it, how to accumulate knowledge to lighten it, how to weigh decisions in the environment of uncertainty.

The new scientific term for uncertainty is complexity: in any system, the interactions are so many and their results are so unpredictable that modeling and forecasting are impossible, and outcomes are defined as emergent (i.e., outputs happen in a way that is not predicted by merely combining inputs). Austrian economics helps businesses deal with emergence.

Subjectivism: People are people, both as consumers and as providers.

One of the realistic principles of Austrian economics is to deal with people as people: we are all subjective in our valuations and judgments and emotions. We are not homo economicus: perfectly rational (in the mainstream economists’ definition of rational) in objectively weighing benefits and their opportunity costs. If all we are doing in producing goods and services for consumption is trashing the planet, then we can’t be rational, in their eyes.

In order to understand business and understand entrepreneurship, it is absolutely necessary to begin with subjectivism. Consumers’ subjective values ultimately determine what is produced; if consumers don’t value something, producers won’t make it. On the producer side, entrepreneurs’ subjective valuations of the resources they have available to them to assemble in a production process affect the value of their business.

It is entrepreneurs’ subjective evaluation that results in the identification of new uses for a resource, and the introduction of new innovations. Subjective values lie underneath every new business relationship with customers, from streaming movies to google searches to online travel booking. Subjectivism is everywhere in the economy and in business.

Time: How to plan in the present to satisfy customers in the future.

Austrians are unique in their understanding of the economic role of time in business. Entrepreneurs deal in future time. They imagine better futures in which customers enjoy greater satisfaction, and then they imagine how to bring it about and act on their imagination. Production — getting from imagination to consumption — takes time. Entrepreneurs are dealing with buying decisions in the present (such as hiring and buying inputs) for selling decisions in the future. They can’t know future prices or future customer preferences, so it’s a bet.

The consumption decisions customers make today reflect entrepreneurial decisions that were made weeks, months, years or decades in the past. Austrian economics helps entrepreneurs manage the contingencies of time.

Time makes the customer the boss.

Austrians utilize the concept of consumer sovereignty as an analytical tool. It means that consumers are the ultimate decision-makers in all economic systems, because what they buy or don’t buy determines what is produced. Their power is a result of the time it takes to produce. The value of resources that entrepreneurs assemble today depends on what consumers think and feel in the future.

Forecasting is tricky and best avoided, but patterns can be recognized.

A consequence of time and consumer sovereignty is the fragility and inaccuracy of forecasts. How is it possible to forecast consumer tastes in the future? There are some exceptional entrepreneurs who get it right. What’s their secret? Austrians’ understanding of dynamics and complexity can help point to the processes most likely to be associated with success, without attempting to forecast it.

One alternative to forecasting is pattern recognition. Jeff Bezos said that consumers are unlikely in the future to ask for higher prices, lower quality or slower delivery. That’s pattern recognition. It’s generalized and broad based and lacking in precision and specificity. But there is a consistency to some patterns that entrepreneurs can recognize and act upon, adding their own idiosyncratic insights and guesses to shape the actual value propositions they will make to consumers.

Out of all this emerges the Austrian entrepreneurial method.

We’ve all been educated in the scientific method. It’s utopian: experiments conducted with strict controls will yield the truth.

The entrepreneurial method is different, but with equal status, and greater applicability in open — i.e., human — systems where control is not an option.

It’s a bit messy and hard to characterize with precision, but it’s nonetheless real. It starts with imagination — imagining a future in which customer dissatisfactions are addressed and resolved. Their world is made better. This is proactive creativity on the entrepreneur’s part, triggered by existing highly dispersed knowledge, including tacit knowledge, held by the entrepreneur and others.

The entrepreneur designs a business model that might be able to resolve the identified customer dissatisfactions in the future and assembles resources that he or she believes, in the right combination, could accomplish the task. There’s no correct way; the entrepreneur draws on the realism of Austrian economics to best understand the challenges and how to address them.

The entrepreneur then advances with her or his own form of experiment. It’s not controlled in a closed environment. It’s a hard commitment of resources in a definite format to make a value proposition to customers. The experiment consists in ascertaining the customer’s response: like or dislike, buy or not buy, use and enjoy or use and reject? The experiment does not end there. It is continuous — receive the result, decide on how or whether to change the proposition, and try again.

Gut feeling or intuition or personal subjective heuristics all have roles to play in entrepreneurial decision making. Austrian economics captures these phenomena in the concept of judgment under conditions of uncertainty.

Organizing for the exercise of judgment.

Since judgment is the ultimate generative energy in producing value for customers, and since it’s personal and individual, how do firms grow? If judgement rests with a single entrepreneur, such as a founder, growth can’t scale, and will quickly reach its limits. Austrians have the organizational design solution: delegated judgment. Austrian leaders are able to design and implement non-hierarchical organizations in which every employee is empowered to exercise entrepreneurial judgment.

They do so by substituting value codes for authority. Value codes are the unwritten codes (although they might be found in the employee handbook) and conventions of “how we do things around here”, how we generate value for customers, the mission and purpose and internal methods of the firm.

Additional Resources

“Austrian Entrepreneurial Principles” (PDF): Download PDF

Austrian Perspectives on Entrepreneurship, Strategy, and Organization by Nicolai J. Foss, Peter G. Klein, and Matthew McCaffrey: But It On Amazon