As we move from an industrial economy to a digital one, many of the certainties that once held true are rapidly changing. In the industrial era, companies built up value by investing in assets. But in a digital world, the value that can be leveraged from those assets is hugely influenced by digital strategy — and the flexibility to react quickly to new circumstances. In this new world, established processes and the culture that surrounds them are no longer fit for purpose.
Sanjay Brahmawar, CEO of Software AG, recently hosted a discussion on this topic with Jim Whitehurst, the former CEO of open source giant Red Hat, who went on to become President of IBM after it acquired the company in 2019 for $34 billion. He left IBM two years later and became an advisor to private equity investor Silver Lake, which invested in Software AG a year ago and put forward Whitehurst to join its board. As someone who works with PE and VC firms and often advises CEOs contemplating acquisitions, Whitehurst is a keen observer of these trends. He observes:
For a long time, the core of competitive advantage was around driving variance out of processes, standardizing economies of scale. And so the technologies we used, whether it was ERP systems, whether it was the analytic tools we used at the time, were all about, how do we take a known state and make it better and better? ...
If we look at where we are now, we've honestly run to the end of this economies of scale ... Today, much more advantage is happening from companies figuring out ways to innovate around, I'll say, physical products.
Flexibility and innovation vs efficiency
The challenge that established companies face is that their operations, systems and culture were built for efficiency and are not optimized for innovation. Efficiency and reliability is still important — referring to his pre-Red Hat days at Delta Airlines, he observes that, "You definitely want Delta innovating and trying new things on their mobile app to make it move fast. You don't want people iterating or experimenting on the safety procedures for your flight." But innovation depends on different capabilities. The startups he works with are building for long-term flexibility rather than efficiency. He explains:
They're not at all thinking, I'd say, about classic efficiency. They're saying, 'How do I put processes in place, how am I going to put technology in place, so if I double or triple or quadruple, my costs are only going to go up 20%, 30%, 40%?' What that means is, they're not building very bespoke systems for today's environment, they're thinking about how do I build flexibility long-term?
Established companies are hard-wired very differently, which makes it very difficult for them to adapt this new approach. He continues:
The problem is, technology companies and IT shops, for 50 years, were focused on efficiency, which is saying, 'Let me look at the problem as it is today and let me build systems to fix that.' And so you get a system that does this — and, by the way, the data and the logic are together — and a system to do HR, and a system to do this piece of customer engagement, and this for this product.
You get all this stovepipe set of systems, number one, and then throw on top of that, the classic, I'll call it industrial model, was you drive efficiency via specialization. So you specialize and specialize — accounts payable does this, somebody else does this. You get these fragmented silos that also then build all of their stacks, whether that's technology or organizational.
The problem that you get with those things, as the world changes, those are very brittle, because you've optimized them very specifically.
Getting the data out
Ripping out those legacy systems isn't an option, and so companies have to find ways to access the data and connect more flexible processes across the existing stovepipes. He adds:
I can't just replace all those systems. If I could call a timeout and take five years and give me a ton of money — but companies can't do that. So the most important is, 'How I get the data out of that system?' ...
Getting data out and then be able to drive meaning across it are critically important for what I think of as larger traditional enterprises, to be able to move more quickly, to be able to innovate, to add new feature functionality, to compete with the digital natives, but without being so stuck in these legacy silos.
As well as the transactional data, gathering and analyzing data about how customers use the product makes it possible to find ways to add value around that usage. He elaborates:
You want to be able to take meaning out of your processes. You want to be able to say, 'I need intelligence at the edge in my products, to know how people are using my products and measure their behaviors to make those tweaks ...'
Companies that are able to do that, using technology, that can therefore move faster, are ones that are more likely to build competitive advantage, are more attractive [to VCs or corporate acquirers].
But many companies go about this the wrong way because of how they have historically organized data. He continues:
The industrial logic to do this is probably, 'Okay, well, I have all this data, what I really need to do is have it all together. So let me go spend hundreds and millions of dollars to do this mega data project to try to pull it off. Now I've got to put it in a pool somewhere.' By the way, that pool gets stale really quickly. And you spent a lot of money to do that versus saying, 'Well, the systems are running, how do I smartly just access the data when and how I need it?' ...
In five years, it's going to change again, so you spent too much money on it, building this massive data lake thing, that now the data is stale, and you can't pull it with the pace you need, versus a set of lightweight solutions around integration, where you spend a lot less money, you spend a lot less time, and you have a lot more flexibility.
How you move that over time, again, leads to companies that are more agile, therefore more able to react in a volatile world and therefore more able to create value.
Open source and culture
Given his history in open source software, Whitehurst believes this too plays an important role in enabling innovation, particularly at the infrastructure layer where it's been most successful. Whereas Red Hat's business model was built around supporting the open source lifecycle, he believes the pattern of offering that as a cloud service, espoused by the likes of Confluent and Elastic, has become "the second great open source business model." But he points out that open source creates even more value elsewhere:
I think that the biggest value that open source has created is not the value of those companies, but the feature velocity, and therefore businesses, that it's enabled to build on top. As an extreme, I don't know if Google could exist without open source. If they had to buy Sun servers for doing search, they probably couldn't offer search for free.
So I do think the value really is the externalities of the innovations that's been able to happen on top because of the speed of the innovation in open source and the freeness of it.
Having the right technology in place to become more flexible and innovative is important, but it's not the whole picture. Changing the culture is hugely important, too. He explains:
If you're not able to question your boss, if you don't have good, rich debate, you won't be able to get to the best solutions or to challenge the status quo — and change is always about that. I'm really passionate that, beyond technology, the flexibility there, you need to have an open culture as a way to build a capability that allows you to innovate at the pace or be able to make change at the pace that you need to win ...
I think more and more CEOs are realizing, this whole digital transformation thing ... is really more of a culture thing than it is a technology thing. I think that's a recognition around the importance of much more open cultures, which is hard in these top-down organizations that were all built around compliance to a set of plans, because that's how you drove variance out and got better standardization.
We're now saying that we actually want smart variance in, and it's hard to do that, specifically in processes, but it's much easier to do in culture.
Private equity's strategic advantage
Finally, one side-effect of the growing emphasis on strategy over assets is what Whitehurst believes is a permanent shift in favor of private equity owners over the public markets. He explains:
If you look at a totally private company, your ability to share more detail with owners just goes up dramatically. When you can do that, it becomes much easier for owners to be able to get deeper in how those things work, which does get harder in the public market ...
In my view, broadly, secularly, where we're going around investing is, in an industrial era, price-to-book mattered, so your asset base mattered and you had to collect massive assets to build big factories. The traditional capital markets worked pretty well, where you'd say, 'Okay, I'm gonna collect a lot from small shareholders, and, yeah, I can't share information with them, but they can see my balance sheet.'
In technology companies, frankly, the vast majority of the value isn't in your assets, it's in your future cash flows, it's based on your strategies, and not being able to talk to your owners about that without telling your competitors, does make it a little bit more difficult.
Some intriguing thoughts from Whitehurst, reinforcing many of the principles of Frictionless Enterprise we've written about at diginomica and the growing importance of continuous engagement with customer outcomes. With some interesting insights too into the impact of open source and the growing role of private equity.