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Scale and scaleablity: a conversation with Erik Simanis

Erik Simanis is Head of the Frontier Markets Initiative at Cornell University. His work is published in leading management journals, including the Harvard Business Review and The Wall Street Journal. He also writes for The Guardian’s sustainable business , and is a core faculty member of the Intrapreneurship Lab.

His thinking is grounded in hands-on experience, advising companies and spending time among the communities that they are looking to engage as customers. I interviewed Erik recently as part of this month’s Practitioner Hub theme of ‘scaling inclusive business’, and I’m sharing a note based on our conversation in this blog.

TH: I think a lot of what you write about concerns scale. For example, the Harvard Business Review article you wrote with Duncan Duke last year was titled ‘Profits at the Bottom of the Pyramid’. However, you opened the article by explaining how many ambitious BOP initiatives started by multinationals are ‘destined to remain small’. I have always felt that the exciting thing about these huge companies developing products and services for low income consumers is that they would have to have impact at scale in order to be commercially sustainable. Do you agree?

ES: Absolutely. For a business case to succeed in a billion-dollar multinational, a venture has to get big. And that’s the beauty of business: if you can create and sell a product that creates enough value for consumers that they are willing to pay a price that covers all start-up and operational costs, and provides a minimum required return on capital, the business will get big on its own. Because of that, I see little reason in corporations investing resources creating so-called “social businesses” that don’t start with this profit objective. Creating a social business that requires donor capital to sustain or grow, be it from external sources like foundations or internal sources like CSR budgets, is a failed business in my view; it’s simply re-created what non-profits and government programs already know how to do (and, incidentally, do much better than companies, as they are built for that purpose). One of the motivations behind the HBR article was a growing trend, if you will, of corporations being distracted by social missions to the extent that they lose sight of business fundamentals and the priority that profits have to take. Once companies frame their goal as “we’re solving a social problem” rather than “we’re creating an investment-worthy project,” they stop thinking like business people and start thinking and acting like development professionals—and a donor-dependent venture inevitably results.

TH: so what does scale mean for a multinational?

ES: To answer that, we first need to clear up what the word “scalable” means. In my experience, many organizations and managers confuse “scalable” with “replicable.” Anything can be replicated, given enough time and money. In a business context, scalable means one simple thing: a venture has a positive net present value. In other words, the additional free cash flows generated within a defined period of time are high enough to repay the upfront investment costs and working capital that come with every replication of a business unit, and to pay the providers of that growth capital (i.e., shareholders of the company) a required return on their money.

What constitutes meaningful “scale” for a multinational, then, actually depends on where you sit in the company, as value creation responsibilities are divided up across units and departments. Different parts of the company are working with different size budgets, and under different time constraints to generate results. For a country office in East Africa generating sales of $5 million annually and tasked with 15% year on year growth, a venture that generates $250,000 in incremental sales at a 30% gross margin within one year is meaningful scale. For a VP overseeing $2 billion of sales across Developing Markets and responsible for an innovation pipeline that ensures long-term growth for the company, a venture’s revenue potential will have to be in the tens, even hundreds, of millions of dollars to justify investment. But the time frame within which it will be expected to achieve that will also be significantly longer, as much as 5-7 years out.

TH: why have we not seen or heard about companies making tens and hundreds of millions of dollars in the bottom of the pyramid? Why has the proverbial “fortune at the bottom of the pyramid” proven so elusive?

ES: It’s true. When we look at BOP markets, most successes have landed in the incremental sales category and have been managed by a country office. Unilever’s success with its Wheel laundry detergent in India is an often-noted case. What’s been hard to come by are scalable ventures that achieve profits that can move the needle at a corporate (i.e. global) level. The reason is threefold:

  • the significant upfront investment required to build new sales and distribution networks that are inevitably required for effectively reaching the BOP “mass market”;
  • the longer timelines required to reach significant numbers of BOP consumers due to the inherently small-scale size of the business unit; and
  • the high discount rates that accompany higher-risk projects in emerging economies.

It’s the interplay of these three factors that make it so tough. Even within a generous 5-7 year time frame (once proof of concept for a business model is established), there has to be explosive growth in the first few years of a venture to be NPV positive, because the cash inflows in later years are worth little once discounted and brought to present-day value. To crack this dilemma, it’s going to require business model solutions that enable rapid replication of the business unit. And that inevitably points us toward highly standardized, low-complexity business models using highly transactional customer interfaces and requiring minimal training of a sales force. This is the opposite of what most experts say is needed to be successful in this space!

Incidentally, I think this is where the argument for so-called “patient capital” is completely missing the boat about how the numbers work. Regardless of patient capital, a venture still has to realize the majority of its growth in its early years. Simply extending an investment period to 10 or 12 years doesn’t make most BOP ventures more attractive, because the present value of free cash flows in years 7 and beyond are worth a fraction of their face value. So until we solve this underlying business model issue, patient capital is not going to accomplish much on its own.

TH: you have also written about how BOP initiatives often get ‘stuck’ in a team that is far away from a core business unit and, therefore, never gets taken seriously by a company for that reason. I think that was one of your contributions to the WBCSD’s ‘Scaling up inclusive business: Solutions to overcome internal barriers’ report?

ES: That’s true. And I’ve been there and done that for sure, so I’m talking from experience. Generally speaking, most advocates of the ‘skunk works’ approach (including me, when I started in the BOP space more than 15 years ago) believe a carte-blanche scenario is needed. The belief is that any restrictions on the venture—whether in terms of spend, reporting, or deliverables—constrain innovation. And innovation is the key to cracking the BOP challenge. I agree about the importance of innovation. However, when it comes to constraints, I believe it’s the other way around. BOP teams invariably spin their wheels precisely because they aren’t working with a clear value-creation mandate, and aren’t subject to the rigorous routines and management expectations of a defined business unit in the company. Those boundaries actually provide valuable guidance to, and structure for, a team, not to mention cultural and operational integration. Clear boundaries also give managers a basis for determining trade-offs. If the need is for a longer time frame and the flexibility to explore new business models, there are units in every corporation that meet those criteria. The senior manager’s job is to make sure alignment exists between the venture and the sponsoring business unit.

TH: you and I are aware of initiatives that have not been successful because they could never find the right ‘home’ within a company. Is it that too simple? Perhaps these ventures were always too ambitious and could never have succeeded?

ES: I actually believe it has little to do with the venture and everything to do with management of the venture. In my experience, companies jump into (and managers push) ventures without first understanding the investment profile of their venture (i.e., the required capital, the required human resources, and the return timeline). As I mentioned earlier, companies are particularly prone to do this when they frame their venture’s objective under a “big-hairy social mission” (e.g., ‘eliminate water borne disease among the poor’). So they end-up running a project in the wrong part of the company, albeit with impassioned managers. But once that happens, you’re pushing the proverbial rope uphill, as the venture can’t effectively work within the parameters of the unit. And trying to move it over to another area once it has been incubated in another is equally unlikely, as the venture wasn’t run or designed to meet the other unit’s definition of rigor and success. That’s the problem with most skunk-works projects. At some point, that passion will turn to frustration, and an employee that once felt empowered can feel duped.

A classic symptom of this kind of failure is when managers try to justify continued resourcing for a venture using a “basket of value” logic: they agree that the project doesn’t meet a unit’s success criteria (the often heard complaint being that the unit is myopically focused on short-term sales), but argue that the project also creates some brand value, some PR value, some incremental sales, and some innovation insights. So the project’s aggregate value to the company makes the project worthwhile. Nice try, but that completely fails to appreciate my earlier point that corporations divide-up value creation responsibilities across a company. Yes, the project may create some brand value, but the manager in the brand department could have created 10x more brand impact using the same budget. So it doesn’t meet his/her needs. Same goes for the sales manager and the innovation manager.

Ultimately, to “find” the right home, you need to start in the right home. To put it another way, don’t go to a Japanese steakhouse and then complain about the limited vegetarian options on the menu.

TH: despite these challenges I don’t think you are saying that large companies should forget inclusive business or BOP ventures? It’s just that they need to be less ambitious about some of their ideas? You have also written recently that companies need to focus less on their social mission and get back to business fundamentals.

ES: It’s not a question of ambitiousness, but of being ambitious in the right way. Ultimately, to make social impact part of an MNC’s core business, managers need to translate their vision and passion and impact objectives into investment opportunities that create value equal to, or greater than, alternative uses of that unit or department’s capital. Social impact and sustainability are the lenses through which managers see the world and the unique business opportunities it holds, but the projects and ventures have to be brought back down to fit inside a corporation’s operational logic. We need to accept that an MNC isn’t going to achieve social impact the same way that a non-profit can, because it has different resources, different constraints, and different responsibilities. So the projects have to be framed and managed entirely differently. Ultimately, my core message to managers is that you have to respect and embrace your institution. Every institution has drawbacks. But that’s what it means to be a corporate entrepreneur – you figure out how to bring to life your vision using the tools you have available.

TH: thank you very much.

 

This blog is a part of our April 2015 series on scaling inclusive business. To view all the articles in this series click here.

Tom Harrison
Tom Harrison
I manage operations and projects for the Business Innovation Facility

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