I spent some of the recent break catching up on some reading I hadnt had a chance to get to, when I came across a favorite author of mine Bob Cringely (nom de plum).  He had written a great article on why startups are able to out innovate the big established companies (here).  When you think about it, it’s absurd that a company with billions of dollars of cash can get disrupted by “2 guys in a garage”.  It’s long been a question on my mind and Ive heard many answers: big cos aren’t nimble, they’re too focused on their core, management is distracted  on rewards tied to current business, etc.  All of these are very true, but I think at the heart of the dilema is one simple equation: risk vs reward.

Let me tell you more what I mean.  My background is in stock valuation and asset management.  There is an old adage on the Street, “you dont get fired for buying IBM”.  Very true, many incentives on the Street tend to have managers just retain their jobs and earn a GOOD bonus.  One could go for a GREAT bonus, but he could lose his job if he’s wrong.  So most play it safe.

The same is true in the executive / board ranks of companies as well.  Based on my years of conversations with top execs where we discuss missing buying “the next microsoft, Google or Facebook” one thing is very clear: managers / directors would need to put themselves on the line for something that may not even prove out for many years. Take for example $YHOO not buying $FBOOK, when it could have several years back for $1b, reportedly.  Could you imagine how shareholders would have reacted?  $1b for a company with almost no revenues?  Especially with MySpace leading the sector and user bases that seem fickle (ie Friendster)?  The CEO would likely get fired in the next 24 months or have so much pressure on him to produce revenues NOW, that he would have destroyed what Mark Zuckerberg had the patience to build (ie what happend to MySpace).  The board, would have been ridiculed constantly in the press and directors would get replaced.  There would be a $1b writedown and $FBOOK would not exist today.  The risk / reward is clearly not in management’s favor…

Therefore, I think that the only way to have true disruption, innovation, and long term forward thinking is to give a board and management the “freedom and time” to make those bets.  Could you imagine where $YHOO would be today if its leaders had that leniency?  If Mark Zuckerberg could have been given $YHOO’s vast resources and connections while NOT being pressured to change his approach, $FBOOK would be even bigger today – hard to imagine.

But shareholder (PMs at large funds need to hit year end numbers to get their bonuses) and therefore time pressure gets shorter on companies to perform NOW.  Some funds have longer horizons (Legg Mason, Dodge & Cox, etc.) and act as a nurturer of the companies they own – that’s why one sees companies trying to woo the most friendly shareholders.  But it’s tough to have all your shares placed with owners will allow big bets that may not pay off for years…and maybe that why disruption from startups will be inevitable for many years to come….

Hence, the risk/reward equation may be the entrepreneur’s best friend.

Robert Peck, CFA
President CoRise Co., LLC