CEO Quest Insights
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CEO Quest Insights

In The Loop—Chapter 12: Justifying Transformation Investments

As with the previous chapter, this chapter is for senior executives of a large enterprise facing generative and digital transformation.

As CEO of a large enterprise, your job is to reward investors by increasing the company’s market capitalization over the long run. This means you must improve the fundamentals of your business: increase earnings and free cash flow, and maintain a healthy balance sheet. Within the market sector you serve, you seek to command a stock price premium relative to your competitors. This requires superior financial performance.

Earnings and free cash flow can grow in the short term through cost reduction, but sustainable profit growth (and a healthy balance sheet) depends on revenue growth. Revenue growth occurs when you increase (and better communicate) the value you deliver customers. In other words, it depends on your generativeness. That’s why the generative imperative is always the first priority of an In The Loop leader.

In today’s fast-moving ecosystem, enterprise business models face continuous disruption from digital-first upstarts. As discussed in Chapter 11, to keep ahead, the large enterprise must become generative and digital at the core. This requires three types of investments:

  • Digital transformation investments
  • Innovation experiment investments (what Geoffrey Moore calls Horizon Three investments)
  • Acquisition(s)

For most large legacy businesses, these are big investments.

In a recent study, PWC found that 31% of companies globally are investing at least 15% of total revenues every year in digital transformation alone¹. Despite the high rate of spending, IDC has predicted that thirty percent of global businesses will fail in their digital transformation efforts².

As to the second type of investment, an enterprise serious about investing in innovation will devote at least five percent of its enterprise value to innovation experiments. This may be accomplished via an evergreen VC-like fund, with allocations to corporate venture investments, skunkworks experimentation initiatives (often tied to incubators and accelerators) and new product business unit investments.

I noted in Chapter 11 that to accelerate change, you will eventually need to make a big move that breaks the company’s death grip on the old way of doing things. A key strategic acquisition can play this role. For an acquisition to make this degree of impact, it needs to be large enough — I estimate at least five percent of enterprise value. Just like the other two types of investments, however, acquisitions are perilous. The acquisition failure rate is variously shown in research to be as low as fourteen percent ³, or as high as seventy percent or more⁴.

All three investments to drive the digital and generative transformation of a business, then, involve big dollar bets with high risk profiles. Which leads to two questions:

  • How do you make the case that these investments are the right use of enterprise cash (superior to alternatives such as paying shareholder dividends, or to reducing debt, or to buying back shares)?
  • What are the sources of and limits to cash available for such investments?

The Investment Case

Your board has a duty of care for the long term health of the enterprise. So the starting point for the investment case is to lay out the cost of not making these investments. You live in the digital era, where rising digital first competitors are disrupting every market of consequence on the planet. The pace of disruption is unrelenting. What will happen to your brand, relative product value, competitive position, pricing capacity and talent mix if you remain behind this digital and generative curve? What risks will you incur? The “do nothing” business case is a compelling starting point. In it, you share a five year estimate of revenue, profit, balance sheet and stock price. It won’t look pretty.

If you are absolutely committed to lead your company to become a digital-at-the-center, fit systems enterprise, then you are embarking on a multi-year journey. You will make a series of investments, some of which may have rapid payback but most of which won’t. Drawing from experiences of companies such as the New York Times, Walmart, Starbucks and General Motors, key transformational investments might play out over a five to ten year period. As the previous chapter noted, such investments might play out like this:

  • Phase 0: Consulting projects (small investment, one year)
  • Phase 1: Initial digital infrastructure projects, first innovation experiments (mid-to-large investment, one year)
  • Phase 2: Multiple investments in innovation experiments, rising investments in digital infrastructure, rising investments in bringing digital leverage to existing product customer experience and investments to increase operational resiliency, scalability and efficiency (large investment, two years)
  • Phase 3: All Phase 2 investments grow, plus a large acquisition (very large investment, one year)
  • Phase 4: Follow-on investments to accelerate digital transformation; continuously improve the customer experience; build out data infrastructure; strengthen and scale the acquired entity; drive operational resiliency, scalability and efficiency and support new product development (large investment one year)
  • Phase 5: Ongoing investments in infrastructure, customer experience, new product development and acquisitions (steady state investments, ongoing)

During the transformation period you may still have opportunity to take costs out. If business units are operating at a loss and don’t show promise, you can shut them down. Or perhaps some efficiency moves remain available to you. But it is likely the case for these investments will not be made on cost savings alone. In fact, cost savings is likely to only be a small portion of the overall investment case.

Digital and generative transformation investments don’t fit well into traditional investment assessment frameworks, such as ROI and payback time. Decision filters such as these work on the premise that the enterprise is a going concern, and that a “no investment” scenario is viable. The reality is that for many companies behind the curve, the decision not to make digital and generative transformation investments would inevitably lead to the breakup and sale of the enterprise. So the real comparison is between the breakup value of the enterprise now, versus the enterprise’s value six years from now when the generative and digital transformations of the enterprise has been accomplished. This estimated difference can be calculated, with discounts applied to adjust for risk and net present value. This will give you the collective ROI of all anticipated digital and generative transformation investments.

Of course, the individual projects will each need a business case.

Digital Transformation Investments

Digital transformation investments cannot be justified based on savings in IT alone. Too often this is the narrow standard against which such investments are measured. Yes, a move from the monolith to the cloud might increase uptime and speed development time by 7X or more. It might make engineers substantially more efficient and reduce compute costs. These IT related ROI benefits comprise just a fraction of the total enterprise value of digital transformation.

In its report, “What’s Your Digital ROI?” PWC shared an ROI framework. It identifies six areas that are positively impacted by the right digital transformation investments:

Source: Hirji, Nadir, and Geddes, Gale. “What’s Your Digital ROI? Realizing the Value of Digital Investments”. PwC Digital Services and Strategy &, October 12, 2016. ⁵

Digital transformation investments offer multiple sources of ROI — some more tangible and others more speculative:

  1. Reduction in IT capital costs due to shift from on premises to the cloud
  2. Reduction in compute and storage costs
  3. Reduction in IT maintenance costs
  4. Reduction in working capital (due to supply chain efficiencies and better inventory control)
  5. Operational cost reduction via automation of human steps
  6. Reduction in insurance costs due to improved risk profile (for instance in the area of cyber insurance)
  7. Increased revenue due to improved current-product customer experience (better customer acquisition, higher customer retention)
  8. Increased revenue due to digital extensions to existing products
  9. Increased revenue due to new digital products

Innovation Experiment Investments

For innovation experiment investments (corporate venture, skunkworks incubator / accelerator projects and business unit new product development initiatives), the math is well known in the venture community. It is a recognized rule of thumb that for a well managed firm, ⅓ of early stage VC investments will lose all or most invested capital, ⅓ will return back most of invested capital and ⅓ will return more than invested capital (hopefully including some ‘home runs’).

Industry Ventures has shown that for early stage funds, the IRR after accounting for carry and management fees is 20% or more, the target net multiple is 3X and the hold period is 10–12 years.⁶ These numbers guide the business case for innovation experiment investments.


Too often, acquisitions are justified or rejected based on whether they are accretive or dilutive to the acquiring company upon acquisition. But this is a faulty criterion. An accretive deal is one in which the ratio of purchase price to earnings of the company being acquired is lower than the P/E ratio of the acquiring company. Let’s say Company A acquires Company B, with a lower P/E ratio, with an all-stock deal. The earnings per share of Company A will rise as a result, but its P/E ratio will decline. In fact, setting aside cost synergies, the P/E ratio and the EPS will offset each other, creating no immediate incremental value.

A study by AT Kearney that accretiveness continues to be the primary factor in acquisition analysis, but other factors are also growing in importance:

Of course any successful acquisition will be accretive in the long term. It will power the enterprise to substantially higher earnings in the future than would be true without the acquisition. Good acquisitions can be initially dilutive, and bad acquisitions can be initially accretive. Especially for acquisitions tied to the generative transformation of the enterprise, the right assessment method is based on fundamentals:

  • Is it strategically sound?
  • Does it enhance enterprise core capabilities?
  • Are there revenue synergies?
  • Are there cost synergies?
  • Can the acquiring enterprise integrate the acquired company effectively given acquisition objectives, especially in terms of its culture and systems?

In valuing a prospective acquisition, executives consider absolute valuation, such as discounted cash flow and relative valuation, such as multiples of revenue or profit in comparison to benchmarks based on previous M&A transactions in the market sector.

Sources and Limits of Cash for Investments

There are five possible sources of cash for digital and transformation investments:

  • Cut costs to increase cash flow
  • Sell off a business unit
  • Raise debt
  • Reduce dividends
  • Issue new shares

All of these have tradeoffs and limitations.

Cut Costs to Increase Cash Flow

Of course, if bloat remains anywhere in the enterprise, you can free up cash by cutting out these excess costs. For most enterprises, this is a play they’ve been running for years now, and few opportunities remain.

Sell Off a Business Unit

A study by Bain & Co. found that across 2,100 public companies, the companies that engaged in a focused and active divestment strategy outperformed their inactive peers by 15% in total shareholder return over a 10 year period. Those that combined focused divestment with focused new acquisitions outperformed by 40%.⁷

A business unit makes sense to sell when:

  • It is not core to your strategy
  • It has been made attractive to buy (be sure to factor in the time it will take to position the unit for sale)
  • You have disentangled the business unit from core systems and operations
  • You have conducted reverse due diligence to confirm there are buyers who would gain significant leverage from its acquisition

Raise Debt

Debt can be a cost-efficient way to finance transformation investments, if your balance sheet can support it. Bankers will consider your liquidity ratios (current and quick), profitability ratios and leverage ratios (especially debt to equity and debt to assets). Many companies are already highly leveraged and can’t run this play. But if you have debt capacity, it may make sense to use it.

Reduce Dividends

If the enterprise has a history of issuing dividends, cash can be raised by cutting or eliminating the dividend. The challenge, of course, is that your company’s profile has attracted a certain type of investor. Investors won’t like it when the dividend payments stop. For that reason, it’s likely your board will resist this approach to raising cash.

Issue New Shares

You can also raise money in the equity markets by issuing new shares. If your stock price is depressed, however, this is an expensive way to raise money. Your board will resist, fearing an investor backlash. Issuing new shares only makes sense when the share price is trading high, and that’s unlikely if you are on the front end of a multi-year digital and generative transformation process.


Of course, you and your board will need to select the least expensive and least risky option available to you to raise the necessary cash for transformation. Build confidence that you have a well thought through multi-year plan. Stake out milestones along the way that enable you to prove progress before asking for the next tranche of investment. And when you face resistance, remind the board of the “do nothing” alternative. That should stiffen spines.

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  1. Hirji, Nadir, and Geddes, Gale. “What’s Your Digital ROI? Realizing the Value of Digital Investments”. PwC Digital Services and Strategy &, October 12, 2016.
  2. Frank Gens, SVP and Chief Analyst, IDC, as quoted in InformationWeek, “Digital Transformation Underway, and Many will Fail At It”, article by Charles Babcock, published November 3, 2016.
  3. “The State of the Deal — M&A Trends, 2018”, Deloitte.
  4. Christensen, Clayton M., et al. ”The Big Idea: The New M&A Playbook”, Harvard Business Review, March 2011.
  5. Hirji, Nadir, and Geddes, Gale. “What’s Your Digital ROI? Realizing the Value of Digital Investments”. PwC Digital Services and Strategy &, October 12, 2016.
  6. Swildens, Hans, and Yee, Eric. “The Venture Capital Risk and Return Matrix”. Industry Ventures, February 7, 2017.
  7. Allen, James. “Companies Hate to Sell Business Units. That’s a Big Mistake”. Bain & Company, November 3, 2017; previously published on



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