Chapter 1: Survival and Performance in the Era of Discontinuity

Of all the companies listed on the Forbes 100 list in 1917, 61 of them no longer existed 70 years later. Only 18 companies had managed to stay in the top 100, and none of these 18 were very good performers. Looking at the S&P 500 over the last 50 years shows similar results: few companies survive in the long haul, and those that do aren’t great performers.

The market always does better than the individual company. All companies underperform eventually, and all old companies underperform. This idea, that underperforming companies are continuously failing and being replaced, was tagged “the gales of creative destruction” by Schumpeter in the early 20th century.

Discontinuity isn’t a new thing, but the pace of discontinuity has increased, especially because of changes in technology. Companies have to adjust to the new paradigm.

Markets function better than companies. Take, for example, the S&P 500 index. A set of rules guides the composition of the S&P — if a company underperforms, it’s removed from the index, no questions asked. Businesses, on the other hand, are emotional. If a product underperforms, there are all sorts of emotional reactions that get in the way of correct action. In short, markets accommodate discontinuity better than businesses do.

Managers think the challenge lies in keeping their existing operations running smoothly while fostering an environment where new ideas can flourish and old ideas can be put down. But they cling too tightly to the idea of continuity. The world has changed; continuity is no longer as important as innovation.

Some companies won’t make needed changes even when there are obvious threats to their existence. This “cultural lock in” is a clear sign that a company is in decline. Cultural lock in happens because companies have built in mental models and unexamined assumptions that can keep managers from accurately understanding what is happening in the market. Companies that are not responsive to the market are doomed to fail.

The arc of a company’s emotional growth is quite a bit like that of a person’s. They start out passionate and ambitious, eventually maturing to a more rational mindset. In time, however, they get old and cranky. They don’t respond well to threats; they become fearful and overprotective. They are afraid to make way for new developments; they worry about customer conflict; and they absolutely don’t want to make acquisitions that could dilute their earnings.

Not all companies suffer from this problem, for example private equity firms and venture capitalists buy and sell investments without emotions clouding their decisions. These types of firms are sometimes able to outperform the market for long stretches of time.

Corporations must be redesigned to behave more like markets. They need to eliminate cultural lock in and accept the business world as a discontinuous place.

Chapter 2: How Creative Destruction Works: The Fate of the East River Savings Bank

Venerable institutions are the ones that are the most vulnerable to destruction. On Amsterdam and West 96th Street in New York City there is an imposing old building that originally housed a branch of the East River Savings Bank. The bank was founded in 1848, and it prospered and survived the Depression. It continued into the 1970s at which time it was bought out. The building was owned by a succession of financial institutions until 1998 when it was purchased by CVS and became a drugstore. This is creative destruction.

There are any number of causes for discontinuity. Basically, change happens. Change is not new, but the rate of change has been accelerating in the past 90 years or so.

Creative disruption is inherent to capitalism. Discontinuities create under and over performance. Companies need to keep up with change in the market in order to outperform it.

New companies perform better, so do new industries. Looking at the S&P, the process whereby old companies are replaced by new ones has increased. Entrants to an industry have an advantage over the established firms: they perform better, and they bring innovation. Generally, long lived companies don’t outperform their industries. The few that do are clustered in industries with high rates of change (software, for example). And as companies rarely outperform their industries, industries rarely outperform the economy. They may do so for a short while, but ultimately, they fall back into the range of performance that’s normal for the economy at that point in time.

Discontinuity comes from a wide range of sources. Technological changes have disrupted the computer hardware and software industries. International competition drives changes in the oil industry. Changing government policies impact the defense industry. And these changes are usually difficult, if not impossible, to predict.

Investor expectations are what create value in the public stock market. If investors think a company will do well in the future, the share price will go up. The only real value and growth are things that exist in the minds of the investors. Share price is a reflection of the confidence investors have in a company. Because decisions are made based on expectations, forecasting is important. Forecasting, however, becomes more difficult in an environment of rapid change, so investors make errors. Misforecasting will likely increase in the future, as creative destruction increases.

The only companies that manage to generate sustained higher than average returns are new companies. And they can only succeed in doing this for a limited period — at most 10 years. If we look at the companies that beat their industries and the industries that beat the economy, we can learn some valuable lessons that can lead to greater long term performance. The key is to master continuous change. Companies that are unwilling or unable to address change will most likely meet the same fate as the East River Saving Bank.

Chapter 3: Cultural Lock-In

Mental models are the biggest obstacle to change. While such models are useful, they can be liabilities. Our model of the world is based on experience, meaning it is backward looking. When change happens, we are working from old models. So sometimes we have to change our models. It can be hard to get rid of the old beliefs (people do all sorts of things to avoid seeing what they don’t want to see), but persisting with an incorrect model is a big mistake.

Mental models have a big impact on the various elements of corporate architecture. The mental models of senior management significantly affect information systems. The type of data that’s gathered is dependent on how important a manager thinks the information is to the job of running the company. For example, if executives believe that performance is mostly determined by sales margins, the monthly P&L statements will likely be rich with information on sales and costs, while capital employed might not be referenced at all.

The decision making process includes elements like planning systems, calendar management, agenda setting, decision criteria and so forth. These systems need to be consistent with mental models. For example, consumer retailers typically make decisions based on seasonal considerations, deciding when to increase inventory and when to lower prices to decrease inventory. Mental models also determine how staffing decisions are made, impacting how many employees are required to meet the company’s goals, as well as what kind of expertise and experience are needed from staff.

Control processes include things like operational control processes, compensation systems and capital allocation. A company with slim margins will strive to control costs on a day-to-day basis. A company that relies on innovation is likely to give more rein to engineers and scientists as they develop new products.

These elements constitute the architecture of the company, and they are collectively known as MIDAS (Models, Information, Decisions, Actions and Systems of Control). Corporate architecture changes as companies age and mental models change, and there is a pattern to the natural evolution of corporate architecture.

These stages of growth are similar across companies and across industries.

Chapter 4: Operating vs. Creating: The Case of Storage Technology Corporation

Since the dawn of the first industrial revolution, companies spend their energy and other resources on production, logistics, selling and billing. These are the activities that are supposed to make the company run smoothly. Managers are focused on operations, sometimes because they don’t know what else to do. This strategy wasn’t so bad back in the day (attending to operations has helped thousands of companies over hundreds of years), but times have changed. The tools and requirements of an innovative corporation are different than those needed in an environment of continuity.

Many people lump “innovation” into a single category, but this is a mistake. There are different kinds of innovation:

It’s important to understand what kind of changes are happening in order to decide how to address a particular problem. Each level of innovation has different managerial requirements.

There are two factors that indicate the level of innovation that is occurring: how much wealth it generates and how new it is. Incremental innovation doesn’t feel new; it doesn’t make a big change to the life of the consumer or the producer. Substantial innovations bring change to the consumer or the producer, and they can have a significant economic impact. Transformational innovation can bring vast changes, and it can generate immense wealth.

There are two ways to discover things: divergent thinking and convergent thinking. Divergent thinking means zooming out to look at the big picture, examining the entire context of a problem. This process includes three phases.

Convergent thinking is a process of immersion in details. The situation is broken into its smallest components to find novel ways of bringing the pieces back together again — or perhaps to switch some of the components for new ones.

Creativity is the foundation of all innovation, and environment is important in fostering creativity. Creative people need conversational skills, observational skills and reflective skills (collectively known as COR skills). It’s not easy to blend these skills — in some ways they are in opposition with each other — and ultimately some people are just more creative than others. Creativity isn’t usually cultivated in the environments typical of most companies. It’s a challenge to foster creative destruction and operational excellence at the same time.

Chapter 5: The Gale of Destruction

It’s upsetting to drop the ax on a company or a department; it almost always means layoffs. All too often, these tough decisions are avoided, and firms are left with divisions that drag them down.

Change requires us to change our mental models. But it can take companies a long time to overcome cultural lock in. Adjusting to corporate change is like adjusting to terminal illness — the psychological process is similar. There is a sequence of emotions, including denial, anger, bargaining, depression and acceptance, and these emotions interfere with the ability to analyze a situation accurately. And so poor decisions are often made.

Destruction and creation often come together. Mythology from all over the world teaches this wisdom. Many cultures and religions have figures that combine facets of death and rebirth, and philosophers have pondered the deeper meaning of this. At its most elementary, however, when old things die, they make room for new things.

“Destruction” makes us think of chaos and disorder, and especially of death, but it is an appropriate word for what happens. Companies that don’t meet their challenges with creativity will inevitably face mortality. The market sees the continual destruction of companies.

There are a lot of dinosaur companies that hang in there for a long time. They might generate a lot of cash, but they do not grow. They maintain the status quo, and the employees become comfortable with the way things are. These companies don’t generally attract much in the way of new talent. They can last a long time, but while they continue doing what they’ve always done, the rest of the world grows and advances. Eventually the market will overtake them and they will die.

Individuals should consider what this means for their careers. Their company, or even their entire industry, could become stuck in the mud. People should structure their lives so they have the tools to be professionally successful in a world of constant change. They should aspire to continuous education; they should stay alert to signs of ossification in their firms; and they should be ready to make changes in their career direction as needed.

Like innovation, destruction can be incremental, substantial or transformational. Companies face incremental change on a regular basis. Substantial destruction carries risk, but it must be dealt with to remain competitive. Transformational destruction alters the entire firm, leading to permanent change.

Destruction is a normal part of capitalism. Companies that harness the power of destruction can stay fresh.

Chapter 6: Balancing Destruction and Creation

Companies mostly start out full of creative energy. Eventually they become more rational and make decisions based on careful analysis. At some point, however, they slip into denial that prevents them from seeing that they are becoming uncompetitive. But this trajectory isn’t inevitable. Some companies have successfully escaped from this trap.

In 1864, Amory Houghton bought the Brooklyn Flint Glass Company. He relocated it to Corning, New York and changed the name to the Corning Flint Glass Company. Corning produced consumer goods like thermometer tubes, so when Thomas Edison needed a glass bulb for his new electric light, he looked to Corning for help. The lightbulbs were originally hand blown, but over time, a method for making bulbs from molds was developed and productivity soared. Corning also pursued joint ventures and successfully partnered with Pittsburg plate glass, fiberglass makers Owens-Illinois and Dow Chemical. Through all of this, Corning was more concerned about stock performance than they were about controlling their partners.

They expanded into international markets after World War II, manufacturing specialty glass that could endure big changes in temperature and selling products like laboratory equipment. Eventually, Corning developed the consumer kitchenware that would become their flagship product line. Their research into improving the technology for making glass tubes made it much less expensive to manufacture televisions, and so televisions became affordable to the middle class. This brought Corning considerable profits.

In the 1980s, they looked beyond consumer goods and bought some laboratory service companies. They also partnered with companies like Mitsubishi and Samsung, they got into the fiber optics business and in 1993 they signed a contract with AT&T to provide materials for underwater cables. They sold off the consumer products division and expanded telecommunications, also acquiring a number of telecommunication manufacturers.

Throughout its history, Corning has done a great job of eliminating those things that no longer brought growth to the company. The company is a shining example of creative destruction.

When companies mature and focus on operations, they should put some of their attention to innovation and destruction. Some companies do this a little too fast and end up harming themselves, but doing it too slowly will ultimately be just as harmful.

Companies think the name of the game is continuity, when they should really embrace discontinuity. The trick is to balance continuity and change, pursue destruction and creation at the same time. It’s hard to get the balance right, and people in the company, the board and the shareholders will resist the destruction of legacy products and departments, at least until it becomes clear that the strategy is a rewarding one.

To perform as well as the market does, it’s necessary to create new things and destroy unsuccessful old things at the same scale and pace that the market does. Companies must be destructive to thrive. But it’s hard for companies to get good at destruction, just about as hard as it is to become skilled at innovation. There are emotional ties to the old ways; there is resistance to change. And there’s denial.

Chapter 7: Designed to Change

To survive in this rapidly changing environment, companies must act like the market. Not only do they have to change as quickly as the market, but they also must broaden the decision making processes to include more of the collective wisdom of the company. Companies should sustain multiple mental models at one time. There’s more than one thing going on in the market at any given time, after all.

By way of example, private equity firms are different from publicly traded companies. These private companies don’t have to meet the same requirements that public companies do. (The assumption is that someone investing in these instruments is savvy, so they don’t need quite so much protection from making bad decisions.)

There are two kinds of private equity firms: venture capital firms, which invest in the early part of a company’s life, and principal investment firms, which invest in mature companies.

Broadly speaking, private equity firms have features that make them more suitable for discontinuity. Their investments are only for a limited period, after which they sell the investment and realize the profit (or loss). An exit strategy exists from the onset of investment. They also have small management staffs. Operational decisions are made by the companies in which the equity firms have invested, with contracts that specify the details of these arrangements. Private equity firms are decentralized; each subsidiary firm has its own management.

The business incubator is a new type of company. They try to generate new companies in the hopes of spinning them off at a profit. Unlike venture capital companies, they provide a great deal of resources and expertise to young enterprises.

Every type of company needs to master creative destruction to achieve good performance over time. There are enough good examples out there that we need not operate in the dark.

Chapter 8: Leading Creative Destruction

Management committees are often dominated by routine. They believe their mission is to keep operations running smoothly. They look at proposals for new ideas that are brought to them, but they don’t come up with any initiatives of their own.

Managers need to understand the environment in order to see opportunities and dangers. They have to know where the market is going, but it’s not easy to predict future consumer behavior. It’s also not easy to take care of operations and manage change all at once. Between these two, innovation management suffers.

When times get bad, people turn to authority for direction, protection and a sense of order. This works well when there are obvious solutions to problems. But in situations of ambiguity, for example with markets, which are always ambiguous, this is insufficient. Instead of authority, people need leadership. Leaders ask hard questions, and they teach people to reframe their expectations and take responsibility for finding solutions.

This is a huge change for managers. They must change their mindset, and if they do not, the company as a whole cannot change. Corporations tend to address problems by breaking them down into chunks that can be dealt with through authority, but this cycle needs to be broken. The CEO and the management committee must establish the balance between creativity and operations. Management has to be adaptive.

It’s easy to avoid adaptive work. People do a lot to ignore problems. They go into denial, they skirt important issues, they fake it, they shift the attention to other issues. Managers have to understand the importance of adaptive work, and management must design a process that allows adaptive work to flourish while operational control continues. There needs to be space to develop new ideas that doesn’t impinge on operations. Often, these processes are informal, for example, meetings and free periods for thinking and talking about alternative ideas.

These issues are much the same for different kinds of organizations. (Private equity firms, however, are better at adaptation because they’re used to an environment of change.)

Chapter 9: Increasing Creation by Tenfold

Established companies that want to stay innovative must master divergent thinking. This is the key to creativity. The objective is to find new ideas at the pace and scale of the market. It’s a process of discovering unmet needs and potential solutions. And it helps to look to the periphery for new ideas, seeing what competitors at the boundaries of your market are doing. Usually innovation occurs out on the edge.

The design of the strategic planning process will help a company find creative solutions. The overall process design needs to be planned. Management should select several issues that they want discussed, and they should spend a day conferring on these. Each manager should bring a handful of ideas about the opportunities and issues they’d like to address. Creative destruction should be a component of all the ideas.

To prepare the team for discussion on one of the issues presented, you might need to do some fairly deep research. For example, managers at Nike go to basketball games or visit schools and meet street basketball players. These activities allow them to understand the needs of their customers so they can bring that understanding with them into the discussion.

The discussion itself should usually take place over two days for a select issue. Since the emphasis is on dialogue, the agenda should be somewhat thin. There should be clear goals for the meeting, potentially including things like deciding the best opportunities to pursue, determining the order in which opportunities will be pursued and deciding what steps should be taken next.

There are several tactics that can be used to help stimulate discussion. For example, you can change the context, looking at the problem from a different angle. One way to do this is by including a mix of participants with unique perspectives, perhaps inviting managers from different divisions or even different countries. It’s always good to bounce ideas off someone. You might consider an exercise where the group breaks into pairs and talks over their ideas. Look to create synergy by pairing people together who have different roles and backgrounds.

And consciously slow down. Don’t try to rush through the process. Instead, dig in deeper. Slowing down is probably outside the experience of many executives. Sometimes, however, it’s necessary, especially when immersion in lots of details is required.

After the discussion is complete, it’s important to take time to reflect and make decisions. The dialogue leader should summarize the results for top management to review. Some time for reflection might be needed before any decisions can be made.

After the first issue has been tackled in this manner, the rest of the issues can be taken on one at a time, following the same process.

Chapter 10: Control, Permission, and Risk

Corporations have all kinds of control systems, elements that make sure things stay on track (for example, rules and processes, standards, checklists). The control systems in a company can be complex, and can sometimes come in conflict with one another. Control systems can also inhibit performance by reinforcing a tendency towards denial, encouraging simplistic thinking and suppressing creativity. Capital markets don’t behave like this — they meet change without trying to establish dominance over it.

The opposite of control is permission, which means being able to make decisions and act without having to check with upper management. Managers need the freedom to take risks and explore new solutions. But to give permission is to give up control, so it’s hard for people to do, even when they say they’re going to do it. It’s always something of a challenge to strike the right balance between control and permission, but it’s important to find this balance.

If change is considered more valuable than continuity, then change will happen. Venture capital companies are one example of an organization type that embraces change. If it’s believed that change will bring less value, then continuity is embraced. Many corporations follow this path. If the values of change and continuity are perceived to be roughly equal, then the tendency is to follow the status quo. Strong leadership, however, can make the case for change.

Leadership is the key for establishing the balance between continuity and change. Leaders can help set the pace and scale of change, ensuring that it matches the rate and scope of change in the market. This is what private equity firms do — by investigating and understanding opportunities, they reduce their risk while increasing the pace of change. Old, ossified corporations have trouble taking risks.

Here are some guidelines to make changes work:

This is a starting point for understanding what the company might be like if the assumption of continuity were replaced with the assumption of discontinuity.

Chapter 11: Setting the Pace and Scale of Change

Johnson & Johnson is a well-respected company. They’ve had impressive growth in the past 10 years, entering fields, such as blood glucose monitoring, and discontinuing products, like disposable diapers. They have made good decisions regarding their products and the arenas in which they participate. They’ve succeeded in setting the scale and pace of change to meet the market.

To understand Johnson & Johnson’s success, the authors recount an experience that occurred in the 1990s. Chairmen Ralph Larsen was concerned about changes in the healthcare industry and worried about his company’s ability to keep up. He put together a team including executive Roger Fine, members of the management committee and the authors of this book. This team had a meeting with the management committee, explaining the perils of inaction.

This was to be a design meeting, which would provide space for issues and ideas to be raised. It was held offsite, so participants could devote all their attention to the task at hand without any distractions. The participants felt that the dialogue was productive, and by the end of it, they had decided on several critical issues they wanted to address.

The team developed a template for future meetings which included three phases. The first phase, Discovery, included not only information gathering, but also time to reflect on that information. The Forcing Event came next, providing a deadline when all of the participants’ opinions were brought together into a unified corporate vision. The final step, Synthesis, came after the meeting concluded, and in this phase, the decisions generated by the discussion were acted on.

Over time, J&J had quite a few of these sessions. Themes that emerged from the early sessions included understanding new consumers, reducing costs and improving innovation. Pursuing these goals helped the team understand that while creation is good, when coupled with destruction, it became an extremely powerful agent for change. In time, the dialogues became integrated into the normal institutional functioning of the company. Johnson & Johnson enjoyed substantial change. Certainly, there was resistance to change over the years, but it was largely overcome.

Despite the occasional bumps in the road, the process was overall extremely successful, in part because the process had the strong support of management. This support ensured that resistance to change didn’t derail the process. Ultimately, the sessions weren’t sustainable over time, so the company eventually settled into a slower pace, to allow the company to absorb all the changes that were being generated.

There is a tendency to evaluate things too quickly, but the Johnson & Johnson executives understood that they needed to be patient. Projects were allowed to develop and mature before their impacts were evaluated.

J&J is a model of the success that comes from harnessing creative destruction.

Chapter 12: The Ubiquity of Creative Destruction

John Keynes was rivals with Schumpeter, the economist we met back in Chapter 1 who talked about the “gales of destruction.” During the Great Depression, Schumpeter’s talk of entrepreneurship didn’t seem as helpful as Keynes’ proposals for strong fiscal policy. But that was then and this is now.

Countries have followed Keynes for a long time, but conditions are quite different now than they were during that time. There was a lot more continuity back then — companies sustained on the S&P for 50 years, even longer. Companies more recently are lucky to last 20 years on the S&P. The rate of change might cool down a little from today’s frenetic rate, but it’ll never go back down to pre-1970s levels.

We are living in Schumpeter’s world now. Each technological advance that drives the economy sets the stage for the next technological advance. We are at the beginning of a new paradigm that will last for the rest of our lives. The internet is one example of how this plays out; it has started to permanently change all industries. And we are nowhere near the end of these changes. New technologies like wireless and broadband will accelerate the rate of change.

The path won’t always be smooth. There will be bumps in the road; there will inevitably be loss. Hedging our investments will be more important than ever. Ultimately, however, an immense amount of new value will be created.

There’s been lots of innovation at different times and different places, but only in 20th century America do you really see sustained creative destruction. Our transparent capital markets, our trade policies and our governmental policies all favor creative destruction.

It’s important to figure out how we will deal with the costs of destruction. We need to be sure people are not left behind. There has to be a strong social safety net to help people weather change. There’s currently no agreement on how to do this, but we should focus on identifying some solutions.

Creative destruction is inevitable. Institutions can benefit immensely from embracing the process. Failure to do so will cause immense harm to companies, institutions and society at large. And what is true for institutions is also true for individuals. Divergent thinking and remaining open to change are difficult, but people need to meet these challenges. They need to change at the pace and scale of the environment. We must all be willing to recognize and accept our tumultuous environment. We can’t wish for the old days — this is the world now. We have to adjust to change. We have to embrace creative destruction.

Additional Resources

Review of Creative Destruction by Knowledge@Wharton

Review of Creative Destruction by Publishers Weekly

Review of Creative Destruction by Fast Company

Review of Creative Destruction by CNN

Review of Creative Destruction by Soundview Executive Book Summaries

Buy Creative Destruction on Amazon

Summary of Creative Destruction by McKinsey Free