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How Companies Evolve

As investors, we're interested in companies that can sustain growth over a long period of time. Successful businesses must navigate through many challenges as they grow larger and more unwieldy, and for investors to benefit from a buy-and-hold approach, they should consider the different stages that public companies move through as they evolve from small firms into huge, successful corporations.

In this series of articles, originally published as several Fool on the Hill columns last fall, we take a look at three stages that successful businesses experience, as described by author Robert X. Cringely in Chapter 12 of his book Accidental Empires. In addition, we discuss different ways investors can think about these stages when evaluating companies. For example, when are companies more likely to experience successful mergers and acquisitions? What are some ways that larger companies try to manage creative employees? These are just two examples of how investors can use the "three waves" discussed below in their own investing research.

Commandos, infantry, and police
Cringely -- who also writes a monthly column for Worth magazine -- argues that businesses grow from start-up to conglomerate in three distinct phases, each of which is driven by a different type of person. The differences and conflicts between these waves of activity help explain why so many small companies self-destruct as they grow, and why so many large companies are so bad at doing anything new.

In addition, Cringely's book includes an excellent analogy between the growth of a company and a military operation. He uses this analogy to discuss the three waves of expansion, each with its own characteristics and each driven by people with very different sets of skills.

The first wave to hit the beach when entering new territory consists of commandos. These are people who, in Cringely's words, "Work hard, fast, and cheap.... Their job is to do lots of damage with surprise and teamwork, establishing a beachhead before the enemy is even aware that they exist." Simply put, they create something out of nothing, turning an idea into a product. A commando can literally do the work of a hundred normal employees when they've got the right problems to work on. A start-up without commandos will have nothing to sell.

The second wave consists of infantry, exploiting the opportunity created by the commandos. These are the people who turn a promising start-up into a profitable business with systematic development, manufacturing, and sales efforts. They provide structure to a company, which allows it to grow beyond an activity shared by a half-dozen friends into a real business. As Cringely says, "While the commandos make success possible, it's the infantry that makes success happen."

The third wave consists of police. Once the business has grown into its market niche, the third wave is an occupying force intent on holding territory. Author Eric Raymond describes middle managers as "conservators of the stability of the organization," which makes the presence of middle management a clear indicator that the third wave has arrived. A middle manager's job is to say no to ideas that don't originate from on high, somewhere near the CEO. This prevents the enormous size of the company from tearing it apart. A mature third-wave corporation is full of bureaucrats defending the empire, approximately as interested in reducing expenses as growing sales. Third-wave gains come from economies of scale, incremental growth, and by simply remaining profitable quarter after quarter.

Working together, or not
Although infantry and commandos can work together, there is some natural tension between the two groups. The founders of many companies leave after the IPO, as commandos look for fresh challenges rather than settling down to nurture old ideas. On the other hand, infantry can take much of the non-creative load off of commandos, giving them a protected environment in which to work free from distractions. We see this in situations where company founders are relieved of day-to-day management in order to focus on bigger-picture concerns, as Yahoo!(Nasdaq: YHOO) has done with co-founder Jerry Yang.

The third wave is fairly exclusive. Agents of change and facilitators of change don't mix with opponents of change. The only place second-wave people can survive in a third-wave company is at the executive level. The only way dynamic individuals can survive middle management is by outranking it. The problem here is that the company cannot promote from within easily. Middle management stifles visionaries, who leave the company or give up their creative ambitions. The company must hire executive talent from outside the company, or wind up as a paralyzed, reactionary zombie. This fate nearly befell IBM(NYSE: IBM) and many other large companies that gave middle managers executive power to suppress all change within the company.

Commandos categorically cannot stand middle management. A third-wave company cannot keep commandos around. Period. Commandos create change, middle managers prevent change. When "the suits" take over, the commandos are outta there. The bureaucrats often don't value commandos during the brief time they have access to them (often in the brief period of time between buying a promising start-up and killing it). The commando's idiosyncratic nature, even outright unreliability, may be a minor price to pay to receive the benefits of their brilliance, but the unpredictability is all the bureaucrats can see, and it gives them hives.

Usually, commandos leave long before the third wave. When the second wave becomes too prominent, and building upon existing successes becomes more important to the company than creative new directions, the commandos simply get bored and leave. This isn't a "lack of discipline," this is just the way creative people are. Steve Wozniak of Apple(Nasdaq: AAPL) and Steve Jobs when he couldn't be CEO of a second-wave company are examples. Others include Mitch Kapor at Lotus, or Netscape's Jamie Zawinski. The list is endless.

The right mix
Healthy companies need to mix the various waves. As they grow, they need to survive the transition from first wave to second wave, and later from second wave to third wave. At all costs, they need to isolate any commandos they have on staff from middle management. The case of the launch of IBM's PC is an instructive example of how a third-wave company can do this. (This is covered both in Accidental Empires and Clayton Christensen's The Innovator's Dilemma -- both perspectives are valuable.)

As investors, we tend to focus on second- and third-wave companies. First-wave companies usually aren't publicly traded, and most start-ups fail because the commandos can't handle the details of running and growing a business, yet won't hand it off to competent infantry. Second-wave companies are Rule Breakers, most lucrative early in the second wave with plenty of room left to grow along their current lines. Third-wave companies with second-wave upper management are Rule Makers, stable and profitable with the potential for steady growth. Third-wave companies with third-wave executives are, in short, probably not good investments.

Continue to Part 2: Berkshire's Sustainability »


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