Google’s Dominant-Logic Problem

Google has announced that it will become Alphabet, a conglomerate—that old-fangled complex corporate structure popular in the 1970s.

Could the conglomerate structure, as Google is defining Alphabet, represent the boldest and most innovative move yet within the entire class of super-tech companies?

Google is not the first company to confront the dominant-logic problem, which can cause successful companies to self-destruct, but it is doing so in a way that both challenges and appeals to Wall Street.

The Catch-22 of doing what the Street wants a publicly traded company to do

Google just had its best quarter ever; the announcement led to the biggest stock gain in a day in history. When Google unveiled the new conglomerate structure, the stock bumped up yet again. In just one month the company’s market valuation has increased by more than $100 BILLION dollars (as of today). Take that, unicorns.

But prior to this breakout quarter, Google’s stock had suffered 18 months of flatlining.

A flat stock was a real danger. Google’s senior management was being lured away to better performing companies, like Facebook, and newly formed private companies with mere billion-dollar valuations but more promise of upside.

What was going on during these 18 dismal months? It looked like Google was following the business-school playbook in organizing to capitalize on its core competency, but then got dinged in the process.

While Google has made a number of high-risk “moon-shot” bets—self-driving cars, autonomous drones, life-extension projects, and more—it had put most of its financial and human capital into the cash-generating part of the business. Even back in 2008, as it began making riskier bets, it acknowledged that “we don’t put many people on those things; 90% work on everything else. So that’s not a big risk.”

But that wasn’t reassuring enough for Wall Street, which likes clean valuations and highly predictable revenue.

The Street was discounting Google’s core business because of the moon shots.

There is a reason that Silicon Valley suffers from IPO phobia.

Wall Street was telling Google to stick to its knitting—to keep doing what it was already good at, to stay with the “dominant logic.” But just doing what you are already good at can kill you in the long term.

The dominant-logic problem

Dominant logic is the disease that killed Kodak, Blockbuster, and Nokia, and it threatens every successful large-scale company facing disruption—which is all of them, including Google. The danger isn’t so much the disruption itself, a product of fierce new competition and shifts in the technology landscape; it’s the faulty mindset that hampers senior management when it’s preparing for and responding to non-linear change.

“Dominant logic consists of the mental maps developed through experience in the core business and sometimes applied inappropriately in other businesses.”—C.K. Prahalad, The Dominant Logic: a New Linkage Between Diversity and Performance (paywall).

Prahalad was researching the failure of diversified conglomerates in 1986, when voguing was in vogue and conglomerates were all the rage, when he reached that conclusion. He found that a top executive group’s ability to manage a diversified firm is limited by the dominant general-management logic it already knows.

If the companies in the conglomerate are similar in type and from the same industry, as, for example, at P&G, then this logic—applied to spending on R&D, product development, marketing, and organizing and incentivizing employees—can work to its advantage. But when the companies in the conglomerate are deeply diversified, the situation gets complicated.

As Prahalad observed, “Typically, the dominant logic in diversified firms tends to be influenced by the largest business or the ‘core business’ which was the historical basis for the firm’s growth. The characteristics of the core business, often the source of top managers in diversified firms, tend to cause managers to define problems in certain ways and develop familiarity with, and facility in the use of, those administrative tools and are particularly useful in accomplishing the critical tasks of the core business.”

When management’s mind-set favors the core business at the expense of preparing for technological, market, and social/cultural change, its dominant logic can undermine the company’s chances for survival.

Anyone working in the innovation department of a Fortune 1000 company knows in their bones that the dominant business model can kill breakthrough growth ideas.

The thinking goes like this: “You can tinker with our product, spend countless hours investigating corporate ethnography, or design thinking exercises, drum circles, and lean-start-up experiments. That’s fine. But as soon as you mess with the way we’ve been making money, you will be escorted swiftly out of the building.”

Prahalad also foresaw what had begun to happen at Google: the management team that grew up around search tended to favor product-development ideas that made the core business stronger.

Google X and the moon-shot wagers amounted to little more than rounding errors in the company’s financial results, mere experiments with uncertain outcomes or upsides for the employees involved.

This strategy was never enunciated outright by Larry Page and Sergey Brin, who were in fact the biggest proponents of the moon-shot investments. But the very organizational design of housing these experiments within Google, where the dominant-logic problem reigned, made everything else pale in comparison.

Perhaps the founders simply weren’t satisfied with Wall Street’s definition of success: mastering the shift in advertising to web and mobile. The uppermost limit for Google was a larger share of the advertising pie.

“If you’re changing the world, you’re working on important things. You’re excited to get up in the morning.”—Larry Page

I can empathize with billionaires who find advertising limiting as a life’s pursuit. I can see why it would be hard to get up in the morning when that’s your only goal.

How Alphabet addresses the dominant-logic elephant in the room

Google’s newly hired CFO, Ruth Porat, likely had a heavy hand in creating the new structure, which separates YouTube, Android, and Google’s core search business from all the other riskier, less profitable companies. Wall Street is happier because now it can properly value the entire structure.

Dealbreaker said that splitting up these businesses “is akin to injecting steroids into Google’s P/E ratio.” (That’s price/earnings ratio, the prediction of a company’s future value based on its current earnings.) “It is A) The kind of thing that Silicon Valley doesn’t really do, and B) The kind of thing that Ruth Porat can think up in her sleep.”

Alphabet is the ultimate homage to pension managers and hedge funders. “We also like that it means alpha-bet (Alpha is investment return above benchmark), which we strive for!” Larry Page wrote on the Google Blog on August 10.

Google Glass, the drone-mounted wind turbines, and other experiments will no longer have to justify themselves as adding revenue to the core business. Hooray. The potential upside =for those working on the experiments, with a number of CEOs building quasi-independent companies, will makes it easier to attract and retain talent.

To be sure, this new structure might create more problems than it solves. There have been predictions of infighting among top talent as newly minted CEOs within Alphabet vie for their share of the investment pie.

The comparison to Berkshire Hathaway notwithstanding, Page and Brin now have to develop an operating style, financial controls, and rules for this new game board. Warren Buffett sets up financial filters for Berkshire Hathaway’s acquisitions, then stays completely out of the way and lets the companies run on their own. Will Alphabet adopt this approach?

Organizational design is a start, but it’s not enough. Google will have to address the investment criteria, structure, and valuation of its innovation portfolio. Its famous hiring processes and its HR management will be put to the test; so will the operational practices for which the company has become famous.

But by addressing the dominant-logic elephant in the room, Google may have pulled off the most pro-innovation bet that a leading tech company has ever played.

How about you? Are you inside a company struggling to innovate in the grip of a dominant logic? Are you in a start-up seeking to disrupt an industry ruled by dominant logic? How has dominant-logic thinking hampered your creativity or limited your success?

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