Schumpeter and Search

As a student of economics, I have long been fascinated with economist Joseph Schumpeter's concept of "creative destruction" as described in his landmark treatise Capitalism, Socialism and Democracy, and its ramifications for the growth and development of industries. Per Wikipedia:

Creative destruction, introduced in 1942 by the economist Joseph Schumpeter, describes the process of industrial transformation that accompanies radical innovation. In Schumpeter's vision of capitalism, innovative entry by entrepreneurs was the force that sustained long-term economic growth, even as it destroyed the value of established companies that enjoyed some degree of monopoly power.

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There are numerous types of innovation generating creative destruction in an industry:

• New markets or products
• New equipment
• New sources of labor and raw materials
• New methods of organization or management
• New methods of inventory management
• New methods of transportation
• New methods of communication (e.g., the Internet)
• New methods of advertising and marketing
• New financial instruments
• New ways to lobby politicians or new legal strategies

Now you have to admit, this is one cool theory. And the beauty of Schumpeter's theory is that it both makes intuitive sense and requires one to ponder history for only a few seconds to come up with several examples that support his thesis, i.e., Xerox, Polaroid, Kodak and General Motors, to name a few. Why does creative destruction occur to companies that are seemingly leading-edge, have vast financial resources and market power and are poised to squash any competitor that stands in their way? Well, a few of the reasons that come to mind include:

1. Success breeds complacency, and by being so happy with yourself you lose the edge and intensity that got you where you are in the first place. This is bad for hard-driving, entrepreneurial people who want the edge and want to win. They lose touch with the company they once knew and the best people leave.

2. Big companies can be less fun than small companies, and the creative and entrepreneurial minds that developed the successful products and paradigms often don't have as much fun or function as well in large, developed bureaucracies. As with (1) above, the most entrepreneurial people will tire of being subjected to extra policies, procedures and processes that serve to inhibit creative thought and follow-through and will eventually leave the company.

3. The prospect of a big payoff is dampened by scale, as the meteoric rise in equity value naturally slows as it becomes harder to grow as fast across a larger base, new competitors enter and make the business less profitable and the equity incentive for employees loses its luster. Again, the best people will want to identify the next challenge and seek the rush and potential payoff of the new new thing.

And these three reasons only address part of the internal environment - how employees are effected when super successful companies get too big and successful. What about the external environment?

4. Arrogance often becomes a fixture of the super successful company, as they begin to believe that they can do no wrong and know what customers want without actually listening to them (I mean, how long were people really going to buy GM cars as long as they said "They'll buy what we build," which was a common refrain within the company during the 1950's and 1960's).

5. Squandered financial resources on either steps to diversify away from one's core competencies, or on irresponsible R&D projects that become "white elephants" and are not subjected to rigorous ROI analysis.   

Hmmm - complacency, less fun, diminished prospect of a big payoff, arrogance and wastefulness - this doesn't sound good. We saw it happen to the formerly great companies mentioned above. But surely we've all gotten smarter, right, and wouldn't make the same five errors I've just described? Some stuff you just can't help, like getting big by being successful. Bigness happens. Maintaining a breakneck growth rate is mathematically impossible beyond a certain scale. And the stagnant stock price necessarily comes to pass as the growth-stock aura is lost.

Have we seen any recent precedence to support my view here? Well, how about:

Microsoft. Remember them? Still a monster but not the monster it once was. Didn't they seem unstoppable for much of the 1990s? $600 billion market cap, super smart people, thousands of Microsoft Millionaires, and who thought the gravy train would ever end? Well, as the base became too large for organic growth to feed the beast we saw efforts at expansion into cable (AT&T, Comcast), telecommunications (Nextel) and other areas too numerous to mention. By in large, I'd say these efforts were a failure. Oh yes, and then there were all those smart people working to chip away at edifice Microsoft on initiatives like Linux and a panoply of other open source programs. Oops, I forgot Google. Oh, and they also spent hundreds of millions of dollars not to mention priceless management time fighting legal battles over their monopoly power instead of developing new products. So what happened? Stock price floundered. Lots of top performers left and took their money and ambition and went elsewhere. Still a great company, but not the unstoppable force of nature it once was. Creative destruction took its toll and is still doing so to this day.

So what of the three most successful internet companies founded in the 1990s, Yahoo!, Ebay and Google? Can they possibly fall prey to Schumpeter's theories? I'd say so, and I'd even go so far to say that Yahoo! could be shaping up to be the next Microsoft with Ebay nipping at its heels. While Google seems like they are still creating without being destroyed in the process, I also see areas where their seemingly impervious shell could be pierced by a legion of super-bright, highly motivated entrepreneurs who simply want to win.

Yahoo! and Ebay. A recent article in the Wall Street Journal specifically addressed the three internal indicators of creative destruction I mentioned above. A telling excerpt from the article is provided here:

While once workers left other companies to join Yahoo and eBay Inc., many employees are now leaving those firms to work at the newest wave of Web start-ups. The exodus -- the largest outflow, some say, since Yahoo and eBay went public in the late 1990s -- is a sign of how the two companies have matured. Part of the original groundswell of Internet firms, the two are grappling with the same challenge of how to retain employees that other mature tech companies, such as Microsoft Corp., have faced.

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Many are leaving eBay and Yahoo now because they have already grown rich from their stints there. And there is little financial incentive to stay: EBay and Yahoo shares have fallen significantly of late, buffeted by increased competition and their maturing businesses. In the past year, eBay shares have declined 42%, while Yahoo stock has declined about 20%. That has pushed many employee stock options underwater, making the potential of lucrative payoffs at start-ups even more attractive.

Again, great companies but indisputably falling prey to several of the indicators of creative destruction. Stock price weakening, employee retention become more of a challenge, switching from a focus on organic growth to one supplemented by acquisitions (which necessarily increases risk) - these are all signs of Schumpeterian destruction in action.

The good news: lots of new companies and technologies have emerged to augment and even improve upon what Yahoo! and Ebay deliver in the marketplace. This is something from which consumers can only benefit. The bad news: it is harder to manage and grow a company under siege from competitors and innovation on the outside and employee flight and massive cultural changes on the inside. So while the value pie (the asset) is expanding to the benefit of consumers, the shareholder pie (the equity) is being shifted from the incumbents to the upstarts. This is a healthy and natural process, but man, it must really suck when you see it happening to you.

So, what about Google, the glamour gal of the moment? Still pulling in great people, losing few top performers, innovating like crazy, focused on organic growth. So where are the chinks in the armor? As noted in a previous post, Google is really great at general search but pretty crappy at targeted, vertical search. Domain expertise is not their forte, and a massive industry has been born and is being nurtured around this idea of domain-specific vertical search. Depending upon how robust and specialized these search engines get, one can imagine that advertisers would be willing to pay more for eyeballs that have essentially self-selected by living on a particular vertical search tool versus surfing a generalized search tool. This could suck ad dollars away from Google and render their general search model a highly profitable but less rapidly growing enterprise.

This would not be good and would readily translate into a manifestation of creative destruction. While they have clearly created an innovation culture around Google Labs and fostered big-thinking by their employees, they need to turn some of this potential energy into kinetic energy if they are to maintain their growth trajectory, drive stock price and keep employees pumped and excited.

While it is hard to get to the top, time (and our friend J. Schumpeter) has shown that it is even harder to stay there.