Short-term profit vs long-term transformation — a “tale” of two firms.
tl;dr. — In short, a pre-IPO company called A abandoned its transformation plan and instead focused on increasing profits in response to a rising wave of demand in response to the COVID-19 pandemic. However, its competitor, company B, remained committed to a similar transformation plan and has since become the dominant player in the market. Now, A is contemplating filing for administration, all within the span of less than three years.
An IC meeting, an early exit
Just had our last investment committee meeting, and sadly, the IC (Investment Committee) had to reach an early exit decision on one of our star portfolio companies. Let’s call it firm A. This was a pre-IPO firm back in 2019, with a steady growth trajectory, and a cunning transformation plan to disrupt its target market (elite sport service sector, b2b). The management was so confident that they signed a VAM (Valuation-Adjustment Mechanism) agreement. Since early this year, firm A has failed its scenario KPIs in a few consecutive checkpoints, which had in turn, triggered the buyback term in the VAM. So founders had to use up cash and take on debt to pay back investors according to the VAM terms. It’s a disappointing situation for everyone involved. Of course, “cash is reality”, and this reality sucks …… so what happened?
Covid! and it’s not what you think…
In 2019, firm A approached us with a pitch for a pre-IPO investment to expand their emerging service opportunities and grow their business. As part of our due diligence, we evaluated market demand, refined their service offering, and developed a transformative business model. Both parties believed that an IPO was on the horizon within the next three years.
However, six months later, the outbreak of Covid-19 brought the global economy to a standstill. While some industries were severely impacted, others experienced a sudden surge in demand. Fortunately, firm A was in a position to capitaliee on the increased demand for one of their key product (not the service in the concern of our investment) and, as a market leader, orders began to pour in. The sudden success caused the management team to lose sight of their original vision on servisitation and abandon their transformation strategy.
Meanwhile, there is another firm…
A strong competitor, let’s call it firm B, was also considering transitioning from selling products to offering services. When the Covid-19 pandemic hit, their production and logistics capabilities were not able to keep up with demand. Instead of panicking, firm B took the opportunity to work closely with key clients to understand their value chain and develop a plan to address the gaps in their service offerings. This allowed them to serve their clients more effectively, even during the crisis. Additionally, it allowed them to test a model for addressing these missing pieces in their service-driven business model.
As lockdown measures began to ease in 2021, firm B’s staff hit the road to test their servitization model. They didn’t rush to get more orders, while firm A became even busier with production as they worked towards their IPO goals. By September, the entire industry was on its way back to “normal.” Clients of firms A and B became too busy servicing their own customers to focus on supply-side configuration, and instead shifted their focus to the demand side. This led to a reassessment of suppliers, and firms that could provide better value to the entire value chain, not just cheap products, stood out. Firm B, the former runner-up in the market, was the only one with a fully operational service model and traction with a few clients. As a result, clients began to move to buy services from firm B. Firm A was forced to resume its servitization plan, but now had to compete with the benchmark set by firm B. In the booming market and with fierce competition, clients were no longer willing to accept “trial” versions of services from firm A.
Approaching 2022
Firm B’s successful service offerings allowed them to secure a dominant position in the market, as they took on more and more clients from firm A. By the end of 2021, some of firm A’s numbers had begun to fall below expectations. Over the next two quarters of 2022, most of their key performance indicators were not met, leading to the triggering of a buyback term. In response, management focused on crisis management and developing a rescue plan. And here came to the IC meeting…
The boring stuff — 3 horizon transformation
In 2019, before making the investment, those involved (firm A leadership team and our PE team) had a clear understanding of the business life cycle and the three horizon models.
We all agreed that the first horizon had peaked, which made the need for servisitation model imperative in order to move to the second horizon. We developed a plan to execute this transition within 18 months, and an iteration plan to take us to the third horizon in three years, with the goal of transforming the industry plus IPO. However, the COVID-19 pandemic created a false signal that distorted the first horizon curve, making it appear similar to the second horizon at the 18-month mark. This, along with positive performance numbers, convinced leadership at firm A that the first horizon had not yet peaked, leading them to believe that there was still plenty of time to plan for the second horizon. As a result, the company continued to operate as usual and stopped the transformation.
Game theory — follow the follower
Let’s say misreading the signal above was a mistake that is hard to avoid. A second chance was allowed when firm B moved into servitisation. However, firm A thought it was only because B was in trouble, and left with no choice but to “take up some client work”.
Firm A made a second mistake when it did not execute the “follow the follower” strategy in response to firm B’s move. But the strategy was overlooked by firm A’s board. (in case you are interested in the “follow the follower” strategy American cup case, here is the extended reading — https://effectiviology.com/follow-the-follower-strategy/)
So in the end, firm B had the opportunity to implement its disruptive innovation, overtook the leaders in the industry through business transformation, and turned the industry upside down.
There are many more points I can list, but you get the main picture here. I thought this was such a shame, that having helped a few runner-up companies in other industries to overtake the leaders through business transformation, we didn’t land easiest case (firm A) well…..
Thought this is worthy of sharing with my fellow entrepreneurs.
