This mantra is so popular that it’s taken as a universal truth. But every big corporate was once an innovative start-up. As an investor, I’ve always been fascinated by the change in behaviour as a company scales up, and why some are able to escape this curse and continue to innovate (e.g. Amazon, Alphabet) while others fail (e.g. Kodak, Nokia).
“Loonshots” represent the high-risk, early-stage ideas that propel start-ups to success. In his thought-provoking book of the same name, Physicist Safi Bahcall, applies the science of phase transition to explain such sudden changes in behaviour within complex systems, and the importance of organisational structure in sustaining innovation as organisations scale. This refreshing and insightful read gives me a useful framework for analysing businesses on top of the strong emphasis we already place on culture and management at Baillie Gifford.
Phase transition is a key concept in Loonshots. Imagine a glass of water. At room temperature, it remains liquid, but as the temperature drops below zero, it freezes and becomes solid, although the water molecule is still the same. That’s phase transition. This phenomenon holds true for teams and companies. Under different conditions, the same team can behave completely differently; they can flip from protecting wild ideas to killing off risky projects as conditions change.
Every company faces an inherent tension between growing the already-successful part of the business (the franchise) versus developing high-risk early-stage ideas (the loonshots). To sustain success and innovation in the long term, a company needs to do both tasks well. However, just like water cannot exist as both liquid and solid at the same time, Bahcall asserts that a company cannot be in two phases simultaneously, because nurturing loonshots requires patience and creativity to support experimentation, whereas managing franchises requires discipline and operational excellence. However, there are exceptions. At exactly zero degrees celsius, water is right on the edge of a phase transition and ice coexists with liquid in a dynamic equilibrium. So how can one replicate that delicately balanced structure of melting ice in an organisation? Below are some of Bahcall’s suggestions:
• Separate the phases: Separate the ‘artists’ who are responsible for developing loonshots from the ‘soldiers’ who oversee the franchises. Tailor incentive structures and working environments to each group.
• Create dynamic equilibrium: Separation is the easier part; the more challenging task is keeping the two groups connected so that there is a continuous feedback loop and translation of loonshots into products and services. Without the translation, one could end up with an ‘innovation landfill’ where great ideas never made it to market. But there’s also another trap. The ‘Moses trap’ happens when a leader falls in love with loonshots and advances them with little regard for business strategy. During his first run as CEO of Apple, Steve Jobs clearly favoured the artists; he himself was an inventor, and he referred to the soldier group developing the Apple II franchise as ‘bozos’. This created dysfunction within the organisation. On his comeback, Jobs had realised his mistakes and learned to love both artists and soldiers equally. This change in leadership style enabled Apple to become one of the most valuable companies in the world.
• Spread a system mindset: Keep asking why the organisation makes certain choices, how they are made, and what can be done to further improve the design of the two phases.
• Lower the freezing point: All phase transitions happen because of the tug-of-war between two competing forces. In any organisation, there’s a conflict between ‘stake’ and ‘rank’. In small groups, stakes are high and everyone works towards the collective goals. But as groups grow larger, ranks become important and the focus starts shifting towards careers and promotions instead of doing what’s best for the projects. This phase transition is inevitable, but there are parameters one can control to shift the curve or delay the transition. For example, having fewer management layers and fewer steps in the career ladder will reduce the return on ‘rank’, while minimising the salary step-up and increasing the equity bonus tied to one’s project will increase ‘stake’. There is no one-size-fits-all structure, but it’s important for senior executives to think thoroughly about the structure of the organisations to best serve their visions and strategies.
As someone with a special interest in healthcare investing, I find the notion of phase transition particularly useful when analysing biopharmaceutical companies. For young biotechs, there is a distinctive and quite literal phase transition when the first drug program makes it from R&D (loonshot) to commercial (franchise). But the challenge for many biotechs is that they do not have the resources and financial strength to carry out both commercialisation of the franchise and investing in early-stage ideas at the same time. As a result, from time to time we see how the pipeline of loonshots gets abandoned, not by choice but by force.
On top of the framework that Bahcall sets out for analysing the leadership and structure of an organisation, another important question that I ponder is whether a company can afford to be in two phases at the same time. That alone can be a source of competitive edge.