The Innovator's Rule Book
Innovation -- when it occurs in companies at all -- tends to be random and unexpected. But at SRC, we've built a system of mechanisms that makes innovation happen like clockwork.
Wherever I go these days, I hear a buzz about innovation. The subject comes up in almost every conversation I have about how companies are doing, and it fills the business press. Even my bank has gotten into the act, sponsoring invitation-only conferences on innovation for the CEOs in its customer base. The sessions are packed.
You'd think that -- after all the hype about innovation during the Internet boom -- we'd be sick of the subject. So why is there suddenly such a sense of urgency about it now? I think the answer has to do with the current recession. During the 1980s and 1990s, much lip service was paid to innovation, and massive corporate expenditures on technology created the illusion that a lot of it was happening. But with the economic downturn, it has become increasingly clear that a lot less innovation has been going on than was commonly supposed. Rather than innovating, it turns out, a lot of companies have been caught in what you might call the optimization trap.
By optimization, I mean the process of taking something you already do and figuring out how to do it better, cheaper, and faster. It's about improving productivity, driving down costs, and reducing waste.
When you think about it, that's what we generally consider "management." In fact, optimizing has been the focus of just about every major management fad and business trend of the past 100 years, from Frederick Taylor's time-study engineering in the early 20th century to Michael Hammer and James Champy's reengineering in the early 1990s. It's all been geared toward helping companies become more efficient and productive, doing the old things better rather than doing anything new. The same can be said about the billions we've spent on technology.
Optimization defines our lives as managers. We spend virtually every hour of every workday trying to make those incremental improvements that will result in slightly better performance. We do that month after month, year after year, until we're ready to scream. We have no choice. You can't be successful in business without optimizing.
In the long term, however, optimization alone is not enough. Incremental improvements will take you only so far. If the leader in your industry earns 7% before taxes and you earn 6.5%, you no doubt have room for improvement, but the potential gain is not nearly as great as what you could achieve by coming up with a new product or marketing idea or an entire new business that would allow you to earn, say, 15% pretax.
More important, too much optimizing will leave you vulnerable to the dangers of the marketplace -- new technologies, new competitors, economic downturns, and so on. If you're focusing only on doing the same things better from year to year, you don't think about the big threats that lie farther down the road, and so you don't diversify. You don't make the investments required to come up with the new products, services, and businesses that can address your weaknesses and protect you when the day of reckoning finally arrives.
That's the optimization trap, and it's easy to fall into, especially during a period of sustained prosperity and expanding markets. As long as you get the annual improvements you need to remain competitive, you'll be satisfied. But when a recession hits, sales of your old products and services will drop, and you won't have new ones to pick up the slack.
Even worse, you may find that relentless optimizing has actually stripped out your capacity to innovate. To save money, you've gotten rid of engineering, market research, human resources, and every other support function, and you no longer have the people or the culture you need to come up with the breakthroughs that can save you.
There's only one way I know of to avoid that trap: you have to innovate and optimize at the same time. That takes a strong constitution. After all, you're under pressure to optimize 24 hours a day, but no one is pushing you to innovate. So somehow you have to develop your own mechanisms that keep innovation on the front burner, constantly showing you what you need to do, why you need to do it, and how far you need to go with it.
At my company, SRC Holdings Corp., we've managed to come up with a set of such mechanisms during the past 14 years. But before we were able to do that, we first had to change our whole perspective on business. For openers, we had to come to the realization that there's a lot more value in building companies than in building products. If you sell a pen, you can make a dollar. If you sell a pen company, you can make $10 million. When you play the game of business at the highest level, you understand that ultimately the company is your product, not the pen.
Once we made that leap, we began searching for opportunities to start new businesses. What did we find? They were all around us. So we developed a system that allowed us to start businesses using resources we already had and a minimum of capital. That system became our principal tool not only for growing and diversifying the company but also for generating a passion for innovation.
As it turned out, our experimental new venture would teach us a set of homegrown rules we would use to transform our company and make innovation an integral part of the way we would run SRC from then on.
In the beginning, however, we weren't looking for a system. I didn't even know that one existed. I was just trying to solve one of those annoying problems that drive CEOs nuts.
It was the summer of 1987, just four years after our founding. Our company was still called Springfield Remanufacturing Corp. back then, and our main business involved taking worn-out diesel engines -- or cores -- and remanufacturing them so that they ran almost like new. Every engine core that we brought into our plant in Springfield, Mo., came with a component known as an oil cooler, whose function was to keep the engine from overheating. Unfortunately, most of the coolers leaked so badly that we had to replace them.
That was costing us a lot of money. We were paying about $50 each for the leaking coolers as part of the overall price of an engine core. Whenever we threw a cooler away, we replaced it with a brand-new one at about $100 a crack. All told, we were spending more than $275,000 a year on an item that I believed should have been costing us about $60,000 -- in effect squandering almost 20% of our profits.
The situation was driving me crazy. I kept bugging our engineers about it, and they kept telling me that they were too busy to focus on it. They didn't have time. They had other things to do that were more pressing.
That just got me more angry and frustrated. I bitched and moaned, but our vice-president of manufacturing told me I was wasting my energy. He didn't think that, given our overhead, we'd actually save money by remanufacturing our own oil coolers. I didn't buy it. I thought there had to be a way. I believed we simply weren't trying hard enough. We were looking for excuses. Finally, I said, "Screw it. Let's settle this thing once and for all. We'll take the damn oil coolers out of our factory, set up an independent company, and give it the oil-cooler business. We'll get other people to fix the problem for us."
So a small group of us got together and started a business, Engines Plus, to remanufacture oil coolers for SRC. As it turned out, our experimental new venture would teach us a set of homegrown rules we would use to transform our company and make innovation an integral part of the way we would run SRC from then on.
Our plan was to start Engines Plus with a small amount of equity and a large amount of debt. There was, of course, a practical reason for limiting our up-front investment: we didn't have much money. But we were also curious to see if we could harness the power of leverage.
RULE #1: Use leverage when you can.
I'm referring here to the principle that the more debt and the less equity you use in financing a start-up, the greater will be the initial rise in the company's value if you're successful. We'd already had one dramatic demonstration of leverage with SRC, which we'd launched with $100,000 in equity and $7 million in debt, thereby fueling a 15,500% increase in our stock price in the first four years. But that had been an accident. At the time, we were just trying to get the company started any way we could, and the deal we wound up with was the only one available.
With Engines Plus, we deliberately applied the leverage principle. A small group of us put up $1,000 of our own money as an equity investment. Then we arranged a $50,000 line of credit from SRC. Engines Plus thus began with a 50-to-1 debt-to-equity ratio -- not quite as steep as SRC's, but close.
RULE #2: Protect the mother ship.
It's important to understand that the new business was an experiment. We didn't know for sure that the people we brought in would be able to develop a process for remanufacturing oil coolers or that the coolers they produced would meet SRC's specifications. We certainly didn't know whether they could run the business profitably.
So we made sure that this experiment wouldn't have negative repercussions for SRC. We didn't take people out of SRC to work on it. We didn't use SRC facilities or equipment. We'd didn't put SRC funds at risk. If things fell apart, SRC would be able to recover whatever capital it had advanced either from the assets of the business or from the partners.
The point is that we'd never done anything like this before, and so we wanted it to be a separate deal, at least until we had a better sense of the risks involved. Then we could modify our approach accordingly.
RULE #3: Find the right leader and strike the right deal.
We figured we would recruit someone to head up the venture, give him or her a significant equity stake, and devise a valuation formula that would encourage bootstrapping. As luck would have it, we had a strong candidate. His name was Eric Paulsen, and he was a vice-president at one of our competitors. We knew Paulsen was looking for a new opportunity, and he met all our qualifications. He had a good track record in business, with experience in accounting and in sales and marketing, and he could put together a start-up team. We also thought he'd be able to diversify the company once he got it up and running. Among other things, he had started a parts-distribution business for our competitor. We believed he could eventually start one for Engines Plus.
RULE #4: Find a cash-flow generator.
By that, I mean a customer who has a specific need and is willing to pay to get the need taken care of. In this case, it was SRC, which needed to stop wasting money on new oil coolers.
There are actually four things that will help ensure positive cash flow in the beginning: long payables (good terms from suppliers); a bimonthly payroll (good terms from employees); short receivables (fast payment from customers); and minimum inventory. Because SRC was both supplier and customer, it was able to help Engines Plus on three of those counts. To begin with, SRC could provide oil-cooler cores on consignment, allowing Paulsen to obtain most of his raw materials without actually spending any money on them. In addition, we could set up a line of credit with SRC at minimal risk. After all, the start-up would have a guaranteed market for its products, at least its initial ones.
RULE #5: Come up with an overhead absorber.
I'm talking here about a product that's going to meet the customer's need and that you can begin selling immediately. After all, as soon as you start the business, you're going to have overhead expenses: salaries, rent, electricity, telephones, and so on. You need to be producing something you can use to cover those expenses -- or absorb them, as we say in manufacturing. In the case of Engines Plus, the overhead absorber was the line of remanufactured oil coolers.
Once you put together a cash-flow generator and an overhead absorber, you have the most important thing a start-up needs: positive cash flow. As a result, the business is immediately viable, meaning that it can support itself on the cash it's generating internally. It doesn't have to rely on outside sources of capital to stay afloat.
RULE #6: Diversify, diversify, diversify.
Becoming viable, however, is just the beginning. You haven't maximized the value of your business as long as its cash flow comes from one product and one customer. Hence the next step: diversification. You need to be constantly looking for vulnerabilities you can address and opportunities you can capitalize on. In other words, you need to innovate, coming up with new products and services, new markets, maybe even new businesses, as you work on optimizing the ones you already have.
That was the basic formula, and it worked better than we dared to hope. Paulsen loved the plan and signed up immediately. We sold him 25% of the stock and agreed to a valuation formula that rewarded him for increasing the company's assets or reducing its liabilities, thereby giving him a powerful incentive to watch every nickel.
And he did. Indeed, Paulsen displayed many of the bootstrapping qualities I thought we were in danger of losing at SRC. He was resourceful. He was creative. He did all the clever little things you do when you're getting by on pocket change and know you're doomed if you run out of cash.
The business couldn't get going, for example, until the shop had worktables. So Paulsen and his buddies found some heavy crates used to ship engines. They cut out the saddle for the engine, came up with square metal tubes to use as legs, and added a top, and they were in business.
Then there was the oven needed to dry the rebuilt coolers before checking them for leaks. Industrial drying equipment could cost as much as $10,000. But Paulsen had worked in restaurants as a kid. He decided to look up a company that sold used restaurant supplies. There he found a pizza oven with just the right specifications. He bought the oven for $200.
That's what innovation is all about. It isn't glamorous, and it doesn't take place in corporate offices. It happens in cellars and garages and makeshift workrooms, and it mainly involves a lot of hard work. But the results can change lives.
Bit by bit, the pieces came together. It happened so fast we could hardly believe it. In February 1988, its third month in existence, Engines Plus shipped 350 to 400 rebuilt oil coolers to SRC. I'd spent two years trying to get our people at SRC to focus on developing a process for remanufacturing oil coolers. Paulsen and his people had come up with one in a matter of months. By the time the bugs had been worked out, moreover, they were able to remanufacture those oil coolers for a small fraction of what we'd been paying. SRC took them all -- and saved a lot of money.
We'd innovated our way out of one problem, but with one product and one customer, Engines Plus had barely begun to tap its potential market value. So Paulsen quickly moved on to the next step of the program, marketing automotive engines by direct mail. Within a year, however, a much bigger opportunity presented itself.
One of our major customers, known as J.I. Case back then, had a joint venture with Cummins Engine Co., under which the two companies manufactured and sold a couple of powerful engines used in agricultural equipment. Looking for opportunities to sell more engines, Case's president of parts operations, Robert Nardelli (now CEO of the Home Depot Inc.), came up with the idea of incorporating the engines into a new line of stationary power units, which farmers would use to pump water for irrigation. He inquired whether SRC would be interested in manufacturing the power units as a subcontractor to Case.
It was a nice offer, but it didn't really fit in with our main businesses. So we put the Case people in touch with Paulsen, who signed up on the spot. After looking at some power units made by other companies, he put together a quote, which the Case people accepted. They came back with a design of the unit they wanted. "Can you do it?" they asked.
"Sure," he said.
There was just one problem. He knew nothing about making power units. The Case people wanted him to exhibit a prototype based on their design at their big annual trade fair in Kansas City on November 1, 1989. Although Paulsen and his people had never built a prototype before, they somehow managed to pull one together in time. A couple of them stayed up the whole night before the trade fair, drying the paint with handheld hair dryers. When Paulsen returned from Kansas City three days later, he had orders for 200 power units, which Case would buy from him for $5,000 each -- $1 million in sales of a product that had never been tested, that he wasn't even sure would work.
It was one of those classic entrepreneurial situations. Even if the product passed muster, Paulsen didn't have a factory large enough to make the power units. For that matter, he didn't have the necessary machine tools, workforce, or raw materials. Worst of all, he didn't begin to have enough cash to finance the power-unit business -- either then or in the future. If Case bought as many units as expected, Engines Plus's sales could grow from less than $1 million to more than $11 million in three years. Where would the cash come from to pay for that growth?
The answer, it turned out, was Case.
When we sat down to negotiate with the Case people, we proposed a deal under which Case would pay Engines Plus for the power units in 30 days, and Engines Plus would pay Case for the engines in 90 days. (Remember, short receivables, long payables.) That way, Case would get what it wanted: the opportunity to record the sale of the engines as soon as they were shipped. And Engines Plus would get what it had to have: net positive cash flow for 60 days.
That was, in fact, the arrangement we agreed upon, and it allowed Engines Plus to develop the power units. At a production level of 66 units a month, the 60-day lag time was like getting an interest-free loan of $660,000 for the entire length of the contract. As a result, Engines Plus -- which had already paid off its note to SRC -- was able to grow for the next seven years without taking on any significant bank debt, and Case got a lower price, since there was no interest expense in the power unit's cost.
I guess you could call that an innovation as well.
If you sell a pen, you can make a dollar. If you sell a pen company, you can make $10 million. When you play the game of business at the highest level, you understand that the company is your product, not the pen.
The case deal was a turning point not only for Engines Plus but for SRC. It had always been our intention to sell Engines Plus to SRC at a bargain price if the start-up proved successful, so that the employees who own our company would reap the major rewards. On February 1, 1990, all the Engines Plus shareholders except Paulsen sold our stock to SRC, which -- for $24,000 -- acquired a 75% ownership stake in Engines Plus.
But the stock transfer was only the beginning -- because Engines Plus had clearly changed. It was no longer simply an experiment in innovation, nor even just a way for SRC to save money on oil coolers. With the Case deal, Engines Plus had become a real business, capable of generating a significant amount of cash flow from a mix of products and a mix of customers, both of which could be expanded in the future.
That change had enormous implications. To begin with, it meant that Engines Plus could be sold. We probably could have found a buyer right away if we'd had to. We would certainly be able to find one in the future if we did a halfway decent job of developing the business. By then the company might be worth a lot of money. It was by no means inconceivable that, in a few years, SRC could sell its stake for several million dollars.
That could prove critical if SRC wanted to remain privately held. As an employee-owned company, we were going to need a lot of cash in the future to cover our obligations to departing shareholders while we continued to grow the business. Engines Plus could be a significant part of the solution. (Last year, in fact, we received an offer from an outside investment group to acquire Engines Plus for $13 million. The terms weren't right, and so we didn't do the deal. Still, that wouldn't have been a bad return on a $1,000 investment.)
And if we'd had one successful start-up, why couldn't we have others? Why couldn't we keep right on building businesses that we could use to feed the liquidity of the parent company? Businesses that we could sell, if necessary. Businesses with higher gross margins and better cash flow than remanufacturing had. Businesses that would grow when our traditional markets were contracting. Businesses that would open up new opportunities when we'd reached the limits of optimization with the old ones.
The realization hit me like a thunderbolt. That was it! We had a model we could use to build whatever kind of company we wanted -- which was yet another innovation to come out of the Engines Plus experiment.
In fact, the success of Engines Plus changed the whole way we thought about growing the company. You need only look at SRC today to see the effect. Back in 1987, we were one business with two divisions. Now we are a diversified collection of enterprises and an ongoing business incubator.
Altogether there are 22 companies operating under the umbrella of SRC Holdings Corp. Some, like Engines Plus, are direct spin-offs of our engine-remanufacturing business, meaning that we started them to leverage expertise we already had. But we've also ventured outside remanufacturing to apply our ideas to other types of businesses.
Feeling the urge to spread our wings, we started a bank with a group of local investors a few years ago, partly because we thought it was a good investment but also because we wanted to see how our approach to management would work in an entirely different setting. In fact, the bank has been a phenomenal success, consistently outperforming most midwestern banks of its size in terms of return on equity, total assets, operating efficiencies, and just about every other measure.
More recently, we raised $6 million to launch a venture-capital firm, which operates out of our headquarters. Our goal there is simply to earn a better return on our capital. To date, we've invested in seven start-ups, three of which have gone public.
Since 1987, our sales have increased 300%, from $40 million to $160 million, and we've been profitable every year. In the same period, we've added 563 employees, bringing our total workforce to 871. And a share of SRC stock that was worth 10¢ in 1983, the year we started, and $13.02 in 1987, when we launched Engines Plus, had an appraised value of $81.60 as of our most recent valuation.
The success of Engines Plus changed the whole way we thought about growing SRC. Instead of one business with two divisions, we're now a diversified collection of enterprises and a business incubator.
And what if we had simply stuck with our original business and optimized like crazy? To tell the truth, I'm not sure SRC would even be around today. Both of the divisions we had back in 1987 got into trouble. One of them struggled for years until we finally sold it. The other has been hit hard by the economic downturn, although SRC as a whole has come through the recession unscathed. The new businesses have carried us.
We are also stronger in ways that don't show up in our financial statements. Back in 1990 we had a whole generation of managers and supervisors who had nowhere to go within SRC. They were the bright young stars of the company, people we'd been training for years. The problem was, they couldn't move up because the positions above theirs were taken. Without the new businesses, we no doubt would have lost a lot of them.
Instead, we held on to almost all of them. They became the leaders of the new businesses, where they kept learning and growing. As a result, they were able to take on ever greater challenges as time went along.
Then, too, when the young stars left their old jobs, they created opportunities for other people to move up, which in turn produced job openings for new recruits. So we kept training new leaders and never suffered from the talent shortage that plagued so many companies prior to the recession -- and that will return as soon as the economy recovers.
At the same time, we reduced our overhead in our established businesses, since the new people didn't earn as much as those they replaced. The subsidiaries have thus given us a way to cut costs without downsizing, without layoffs, and without undermining our culture. So we've been able to keep optimizing -- and remain competitive -- while retaining our capacity for innovation.
I don't mean to suggest that all our innovations have been successful. Of the 39 businesses we've started since 1990, 17 no longer exist. But there are always a lot of failures when you innovate. It goes with the territory. The point is, we've been able to experiment and innovate at minimal risk. If one of the businesses fails, the rest of the company is safe.
And yet, for all the obvious benefits of our system of innovation, I sometimes think that -- if we're not careful -- someone might come along and optimize it right out of existence. It's a feeling I often get when I'm showing around the visitors who come from all over the world to see what we've done and how we've done it. Almost all of them are impressed by the number and diversity of businesses we've created. People listen intently as I and my colleagues explain how important innovation is to our long-term success and how careful we must be to make sure we foster conditions under which it can flourish.
But afterward, without fail, two or three people will come up to me. It's great what you've done, they'll say, but wouldn't it be a lot more efficient to centralize a lot of functions? Couldn't you cut out a lot of waste by streamlining the organization? Yes, innovation is important, but how can you afford to keep operating the way you do?
My answer is, how can we afford not to?
About the authors
Jack Stack is the president and CEO of SRC Holdings Corp., formerly Springfield Remanufacturing Corp., based in Springfield, Mo. Bo Burlingham is the editor at large of Inc. They are coauthors of the best-seller The Great Game of Business (Doubleday/Currency, 1992), which is about the revolutionary system of open-book management developed at SRC. This article is adapted from their next book, A Stake in the Outcome: Building a Culture of Ownership for the Long-Term Success of Your Business, which will be published by Doubleday/Currency this month.
If SRC and Jack Stack sound familiar, they should. We have been following them since August 1986, when we published "The Turnaround," which chronicled the company's rise from the ashes of International Harvester and the invention of its system of open-book management, the Great Game of Business. Subsequently, Stack became an Inc contributor and coauthored, with Bo Burlingham, a series of groundbreaking management columns under the rubric of Critical Numbers. You can find the article, the columns, and more at www.inc.com/incmagazine/columns/numbers.html. You can also find interactive materials on innovation, as well as links to other resources, at www.inc.com/keyword/innovate.
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