STRATEGY ONLINE

ENTROPY, ENERGY AND THE IMPLICATIONS FOR CHANGE IN FAMILY BUSINESSES

A SERENDIPITOUS INTERSECTION

The “trivia” question posted in a Caribou Coffee shop asked, “Which retailer first offered a money-back guarantee: Sears, Woolworth, Penney, or Montgomery Ward?” I answered—correctly it turned out—and received my discount.

At the time I had been reading The Advent of the Algorithm, a fascinating chronicle of the evolution of mathematical logic and computational processes. A passage lurking deep in the book resurrected a concept I hadn’t thought about for awhile: Entropy.

My “blink” reaction to that word was what one should expect from most thermodynamics students of the last 140 years—a teeth-mashing grimace. Most would remember struggling with an enigma, seemingly illusive to touch and feel.

What is entropy anyway, in everyday language? Purely a mathematical contrivance, or something of broader, even philosophical significance? Is entropy good or bad? Should anyone care?

These reflections first brought me back to that list on the coffee house blackboard and realizations that (1) each had begun its existence as a family business, and (2) only one still exists as a stand-alone entity seemingly capable of generating consistent returns to its owners ¼and it’s long-since not a family business. Then came the unflattering statistics familiar to all FFI members about the decaying probabilities of family businesses remaining so as generations advance. Then, thinking about my own experiences with family businesses over 27+ years, that “grimace” soon turned to a smile.

CHANGE AND DISORDER

“en.tro.py. (1) a measure of a system’s capacity to undergo spontaneous change. (2) a measure of the disorder in a system.” --Webster II, New Riverside University Dictionary ----

All businesses with their external environments are complex systems - - Family businesses can be more so. Effective change management is critical; the struggle is how best to accomplish it. Popular wisdom has often touted revolutionary change, bold out-of-the-box initiatives and institutionalized disorder – “high entropy” characteristics according to the above definitions -- as essential to long-term business health. But actual evidence taken from my family business client experiences appears inconclusive.

  • Northwest Cathodic (“NWC”), a family-controlled proprietary technology and process development enterprise, was compelled to pursue one such “bold, out-of-the-box initiative” as regulatory changes increased demand for the company’s core technology. Management pushed a “big-leap” strategy: forward integration into actual operations of a new plant designed and built by itself. But, overly optimistic assumptions, lack of critical knowledge and expertise, and inadequate financial systems and controls doomed this strategy from the beginning. The life-threatening liquidity crisis hit, seemingly without warning.
  • Electronics Innovation, Ltd. (“EIL”), a late first-generation manufacturer of automotive aftermarket components, had embarked upon an aggressive acquisition program involving both forward and backward integration and international expansion. Revenues jumped by 50%. Complementary product lines and marketing channels were added, along with a strategic beachhead in Asia. The Founder and his second-generation management team were lauded in the industry. Within six months, a twenty-year record of strong financial performance had turned to losses. EIL found itself out of cash, within three weeks of the expiration of a “forbearance agreement” imposed by the senior lender, with its impeccable reputation with long-standing customers under attack.
  • Amidst ambitious dreams of a regional franchising empire, Creative Health, Inc. (“CHI”), an entrepreneurial boutique of health food retailers, also found itself blindsided by a survival crisis. This time a gross overextension of company resources was exacerbated by legal conflicts and divisions among family Directors. Once again, a “big leap and creative disorder strategy” had threatened the life of what had been a promising family enterprise.
  • A sixth-generation manufacturer of high technology machine tools, usually under international license, Precision Machines, Ltd (“PML”) was already a family business “exception.” From customers’ commentaries - - “honorable,” “responsive,” and “talented” - - to employees who would “walk through a wall for that family,” the company’s reputation for excellence and integrity stretched far and wide. And while there had been some financial strains over a century-long existence, the business was currently doing well. But changes in corporate governance requirements imposed by leading licensors had presented the families’ owners with an unwanted crisis not of their own making. To maintain alliance relationships critical to the business’s future would demand radical changes in an ownership structure that otherwise was not broken.
  • Heritage Airflow (“HA”), an early third-generation regional family wholesaler serving segments of the construction industry, seemed more and more in no-man’s land as the pace of industry change was accelerating. Tradition and entrenched fiscal conservatism anchored a strong resistance to change, stretching from the Board down to branch employees. Most believed a strong work ethic and past reputation would continue to carry the day, even as profits declined, all growth stalled and employee turnover mushroomed. The real obstacles to successful change were failure to accept the need for it and fear of the unknown.
  • One thing that made the founder of Tidewater Developers (“TD”) so special was that he sought help regarding the future of his company, including succession, without being forced. The business had been unusually successful by “sticking to its knitting,” combining a legendary client service ethic with superior execution skills and well thought-out extensions of products and channels. But a recent market diversification was threatening to become a mini-crisis. Moving successfully into the next era would be a challenge.

DISSIPATED ENERGY

These brief situational family business vignettes hint that a “high entropy” approach to strategic change can, under certain circumstances, result in unintended and potentially severe consequences, leaving behind scars that may not easily heal. It turns out there is a third definition of entropy: the energy dissipated (and unrecoverable) in a total system undergoing change(1).

Put another way, “entropy” also represents the dissipation of energy -- that portion of energy not available to do something useful in a family business system undergoing change. Thus, to better assess the question of how much (and what kind of) change a given family business can successfully undertake within acceptable risk parameters, we need to understand something about the business’s “energy.”

THE CORPORATE ENERGY/ENTROPY MATRIX TM

Consider Corporate Energy as the sum of strategic and organizational attributes that make a business strong. These can include size, physical mass, speed, intensity of effort, infrastructure and technology, brands, market position, special or dominant core competencies, management depth and discipline, exceptional human resource development and financial capacity (Exhibit 1).

Characteristics of Corporate Entropy might include propensity to change quickly and/or in great leaps, high risk tolerance, a tendency to randomness or unstructured organization, undisciplined style, contrariness, exceptional creativity and “broad” business unit diversity (Exhibit 1).

It stands to reason that Corporate Energy, essential to long-term business success, is always best in high doses. The same, however, cannot be said about Corporate Entropy. Clearly too much is bad, with consequences ranging from wasted energy, squandered opportunities and costly distractions in an otherwise well-positioned enterprise, to catastrophic failure in an organization lacking basic strategic, human capital and operational fundamentals.

If too much Corporate Entropy is bad, is very little good? It’s not that simple. Too little is perhaps even more dangerous, risking corporate inertia, complacency, denial, missed opportunity, lack of innovation and, ultimately, even permanent loss of competitive viability.

Exhibit 2 displays the Corporate Energy/Entropy Matrix TM, proposing the strategic positioning of a business based upon its energy/entropy combination at a point in time. This presentation posits the High Energy/Medium Entropy position as the most advantageous, with Low Energy combined with either High or Low Entropy the most dangerous.

DETERORIATING PATHS, NEW LIFE

Exhibit 3 depicts the six family businesses highlighted earlier as they might have been placed at the important decision times presented (see solid-lined “ovals”). In all but one (PML), the dashed arrows track the old paths of deteriorating strategic health. In hindsight, three of the four most notable declines depicted (EIL, NWC and CHI) had come about as the direct consequences of flawed strategies, ill-fated from the outset (whether from naiveté, inadequate human talent, shaky financial underpinnings, mediocre competitive strengths or some combination).

The fourth, HA, represents the inevitable outcome for a business mired in the past, extremely resistant to change and blind to advancements being implemented all around it in a dramatically changing industry.

The good news for these businesses (and readers of FFIPractitioner) is that all six are not only still here, but prospering in some form. Three ¼PML, TD and, most remarkably, HA ¼are still family businesses.

  • The independent Directors on HA’s Board spoke up in time. In less than three years, the underlying fundamentals ¼marketing segmentation, product lines, information systems, logistics and vender management, staff development and branch operations ¼were strengthened. A new non-family CEO brought a renewed spirit, coupled with more disciplined accountability. Today, third-generation family members remain in middle-level positions with ownership still “all in the family.”

The other two were easier.

  • With just a little encouragement, the Founder of TD followed his instincts. The distraction of the one product diversification was discontinued. A new non-family COO was carefully recruited, followed by strengthening the financial function. With project management and sales functions fine-tuned, the Founder was able to concentrate on strategic direction and more focused growth.
  • For PML, the decision process was remarkably easy as “doing what’s right” was second nature. Selfish alternatives were never considered, and would have been summarily dismissed if presented. With agreement on two basic objectives (do what’s right for the business, and try to keep it in the family), a plan was developed for a small group to buy out all others. No fighting, no arguing, no pettiness; just unanimous approval (of twenty-seven shareholders) and a smooth closing. The “Juggernaut” rolls on today.

The remaining three examples are no longer family businesses, two of which by choice.

  • NWC’s Board, comprised of very talented third generation descendents of the three founding families, reasserted itself. Realizing that excessive Corporate Entropy had outstripped the company’s underlying capability, and sensing an unacceptable level of risk, the Board moved swiftly to position Northwest Cathodic for sale to a strategic buyer with the missing expertise and adequate resources. The Board acted in time and shareholders received attractive value.
  • The process took longer at EIL. Over eighteen months, an interim CEO directed the unwinding of the two ill-conceived acquisitions, strengthened the third (in Asia), returned operations to profitability and reduced and refinanced debt, while mentoring two members of the second generation. One became CEO at the process’s conclusion. Less than three years later, the family seized an opportunity to sell to a strategic buyer that coveted the Founder’s original creation. EIL had come a long way back.
  • The CHI operating business thrives today, but no longer under family ownership and control. Too much time had gone by, with the cumulative weight of the business’s problems too great to solve in time by any way other than a sale. The good news for employees, franchisees, and customers was the commitment and resources of the new corporate owner. The brand and concept lived on and expansion resumed within fifteen months.

A CONCEPT EASILY GRASPED

We’ve found the Corporate Energy/Entropy Matrix Ô to be easily grasped by groups crafting strategic plans in family businesses. In the six years since introducing the concept to business clients (family and otherwise), in discussion teams ranging from six to twenty participants, we’ve observed the following:

  • There is always someone who raises his/her hand to the question, “Who knows what ‘entropy’ is?” The definition given is accurate, if not complete.
  • Participants readily grasp that the overall implication of Corporate Entropy (Exhibit 1) as representing “the propensity and capacity to change.”
  • Teams have no trouble volunteering attributes of Corporate Energy (Exhibit 2).
  • People quickly see that the higher the energy the better. Regarding entropy, someone will always stop and think before suggesting that the optimum is in the middle.
  • A collective assessment of where their business currently lies almost always produces a tight cluster around a specific region of the matrix. The exercise adds a new perspective to the next subject, “Where do we go from here?”

TIME MOVING FORWARD

Conceptual roots of entropy reveal certain other implications: (1) change is constant and unrelenting, and (2) all natural processes are to some degree irreversible. In simple terms, this means there are no mulligans. A family business can’t go back and start over and expect the surrounding world to be just as it was. Denial and delay are not benign, with potentially tragic consequences for the perpetuity of a family business (remember CHI).

A progressive family business knows its position on the Energy/Entropy Matrix is constantly in flux; forces driving movements are continuous. It understands the natural tendency of things to come apart, and thus fixes things that aren’t broken (PML, TD) or at least before it’s too late (EIL, NWC). And, unlike the fleetingly successful (e.g., Montgomery Ward and its guarantee!), it knows that one good idea never lasts forever.

ENERGY GAPS IN FAMILY BUSINESS

Family businesses are certainly prone to lying at the undesirable extremes of the Corporate Entropy spectrum. Ponderous decision processes, complex financial or tax constraints, or just simple pain-avoidance can characterize Low Entropy. Excessive diversifications that distract and overextend the business to satisfy objectives of particular family members suggest High Entropy. But while neither is good, these tendencies are neither confined to nor necessarily more pronounced in family enterprises as opposed to businesses as a whole.

Attractive paths for change in most businesses revolve around increasing and enhancing attributes of Corporate Energy (e.g., moving up on the matrix and staying there). So, FFI Practitioner(s) advising their clients should pay special attention to the critical components of building and sustaining Corporate Energy.

Creating and enhancing those things that make a business special, keeping it vital and competitively strong, is a difficult and never-ending process. Consistent success demands that (1) talented people occupy all functions of the business; (2) a culture of accountability; and (3) leadership focused first on what’s best for the enterprise itself.

Perhaps pressures to deviate from such a disciplined philosophy can be greater in a family versus a non-family business(2). A lesson of the Energy/Entropy Matrix is that the stronger the business to begin with (i.e., its Corporate Energy), the wider its options and better its odds of success during the inevitable periods of change.  

 

 

 

The six vignettes are disguised adaptations of true situations. Though all company names are fictional, as are some of the industries, all were clients of Norelli & Company at the time.

(1) Proposing his new function in 1865, Rudolph Clausius noted an interrelationship to energy so important that it influenced the name he chose: “I have designedly coined the word entropy to be similar to energy, for these two quantities are so analogous in their physical significance that an analogy of denominations seems to me helpful.” “Entropy: The Origin of the Word.” www.es.ucsc.edu/~smf/entropy.html.

(2)“Unfortunately, the family business that survives the Founder – let alone ¼prospers [in] the third generation ¼is still the exception. Far too few ¼accept the one basic precept that underlies all ¼[success] ¼Both the business and family will survive and do well only if the family serves the business. Neither will do well if the business is run to serve the family.” Drucker, Peter F. August 19, 1994. How to Save the Family Business. The Wall Street Journal.

 

 

 

EXHIBIT 1: THE CORPORATE ENERGY/ENTROPY PROFILE

Attributes of Energy :
Attributes of Entropy:
  • Size, physical mass, scalability
  • Propensity to change quickly and/or in great leaps
  • Speed, intensity of effort
  • High risk tolerance
  • Infrastructure, technology
  • Tendency toward random, fluid structure
  • Brands, market position and power
  • Undisciplined style, susceptibility to distractions
  • Special or dominant core competencies
  • Contrariness, out-of-the-box thinking
  • Management depth; focus
  • Exceptional creativity
  • Disciplined and exceptional human resource development
  • Broad, perhaps unrelated, product and business unit diversity
  • Financial strength, access to capital
 

 

 

 


 



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