a16z Podcast - a16z Podcast: The Business of Continual Change

Episode Date: February 18, 2018

Every large company -- especially ones that have been around for a long time -- goes through multiple cycles of change. But how do you know where to go next, and when, and how? The management literature is full of case studies, research, and of course, advice... but what if you borrowed from the principles of scientific and social progress instead? In fact, that's what Charles Koch, chairman and CEO of Koch Industries (one of the largest private companies in the U.S., with over $100B in revenue as estimated by Forbes), did in thinking about how to evolve their business. They systematically grew their capabilities from oil and chemicals; to polymers, fibers, and related consumer products; and then into forest products, glass, steel; and now, electronics and software. But this kind of "continual transformation" (and even stated company values) observes Marc Andreessen, sounds obvious; "every company must do that, every company must seek to be the partner of choice to all of its constituents, every company must seek to continually improve". So how did it all work in practice, from strategy and management to incentives and compensation? And is this a new kind of conglomerate business model? This episode of the a16z Podcast covers these questions and more, touching briefly on policy and also sharing a bonus reading list at end. The conversation is based on a Q&A from our annual Summit events, which bring together large companies, finance investors, academics, and startups to talk all things innovation.

Hi, everyone. Welcome to the A6 and Z podcast. Today's episode features a Q&A with Charles Koch, chairman and CEO of Coke Industries, one of the largest private companies in the U.S. with over $100 billion revenue, as estimated by Forbes. Coke also invests philanthropically in mostly education and communities, as well as in politics and policy, which we touch on briefly in this episode. The interview conducted by Mark Andreessen covers everything from measuring talent and risk to the business of conglomerates, change, and innovation. The conversation took place in November 2017 at our annual summit event. Other talks in the series can be found on our website at A6NZ.com slash summit. You went to MIT in the 1950s

received three degrees, general engineering, nuclear engineering, and chemical engineering. Why did you decide to study those fields? I didn't think I was good at anything, and I found at early age I was good at one narrow field, and that was math and logic. And so I wanted to go to a school that had math as a language. And I decided, okay, that I needed to learn a technical skill, and that'd give me a better chance of being successful as an entrepreneur than just studying business. I got MIT, and I quickly found out that, yeah, I was good at math and concepts, but I wasn't very good at applying them to, like, operate devices or create devices. So I maximize courses that were in science and math or theory. And I became fascinated

with the history of science, the philosophy of science, the scientific method, and the principles of scientific improvement. That was really the foundation for everything I've done. And I learned innovations come from mixing existing ideas in new ways. And later learned, learned something from Bologna called the Republic of Science, which was that there is a scientific community that you all learn from each other, but there can't be anybody in charge that dictates to the other or destroys the ability to make innovation. So it's what he called is an authority of the community, not of any individual. And as he put it, that you exercise this authority in general to bring about not its destruction, but its modification in the particular. And you use

that to keep challenging the old theories. And it's what Einstein said, the best fate for any theory that any theory can hope for is that it remains as a limiting case for the new theory. So a lot of people, when they talk about these ideas and they learn these ideas in school, and especially at a place like MIT, they think about them with respect to, yes, for sure, this is the cornerstone of the scientific method for developing and advancing science. This also works for the development of technology. Every engineer knows that you need to have free and open criticism and debate around what's going to work technologically.

Like the rocket's either going to fly or it's not, and you need to be able to have open debate without authority figures. And then however you're doing it can be improved. Right, right. So that needs to be your state of mind. But a lot of people don't then sort of take that into things like improving businesses. As I got into business, I said, well, this is great and this is critically important. But I also need to understand the principles of social progress.

So I started reading everything I could in the social sciences, whether that's philosophy, sociology, economic, psychology, and so on. And what was really fascinated with me is the principles of social progress were almost identical to the principal. of scientific progress. So that really got me going on, I got to apply this stuff because when you see all these different disciplines that come to the same point, there's got to be some truth in it.

And when you see them applied in history and they determined whether a society was prosperous or miserable, it gives you a few clues, or it did me anyway. After earning your degrees, you ultimately moved back to Wichita and went to work for your father's energy firm,

I believe, in 1961. and then took the firm over in 1967. Why did you decide to do that? Well, actually, after I finished at MIT, I went to work for Arthur D. Little, which then was a leading consulting company. And I was, as I say, looking for the opportunity to go in business for myself.

So I pushed myself around to different groups. I worked in product development, process development, then management services got to consultant strategy at age 25. Well, because when you're 25, you have a lot to teach big companies and how to us. I can really teach them. I didn't know what I was talking about, but I believe that's how it works. I learned a lot. And then I got to work in a group that consulted on innovation to help companies with their innovation process and commercializing their, their innovations. And after I'd been there a little over two years doing this, my father called me and he wanted me to come back and join his firm.

And I turned him down because I wanted to be in business for myself. And about a month or so later, he called me. He says, son, as you know, my health is poor. His blood pressure tended to run 2.30 over 120. So he said, I can't really run the company anymore, and I don't have long to live, and either you come back to run the company, or I'm going to have to sell it. Our main business was a crude oil gathering system in southern Oklahoma, and then we had a company that made internals for distillation columns. And then we had a one-third interest in a small refining company in Minnesota named Great Northern Oil Company.

And so I'm saying, well, I've been looking for an opportunity to apply all these ideas. What was it like to take over the company? Did you know that you wanted to preserve? And what in the company did you know you wanted to change? Well, I wanted to change everything because it was stagnant. And he was mainly focused on saving enough liquidity, enough cash to pay for his death taxes. So I started changing things, and believe me, applying these principles from society and science in how to run an organization, it isn't as obvious as you might think.

I had a lot of trial and error, mainly errors. As a matter of fact, the first thing my father said to me when I arrive, he said, son, I hope your first deal is a loser, otherwise you'll think you're a lot smarter than you are. I didn't disappoint him. You were able to accomplish that objective, yeah, yeah. That's one thing I lived up to my commitment. Is that right, right? To just put one straight in the ground?

Yeah. And then after the races after that. So walk us through, how have you thought about the evolution of the company over the last 40 years? Like, was the goal to get gigantic or did you think about it in some other way? Well, no, the goal was to, matter of fact, I plotted out after I got there, here's how much we can grow. Some things worked, I just didn't. But overall, it caused us to grow. I had developed this philosophy, perpetual or continual transformation, and that has basically

two elements, and one is to become counterparty of choice. And not only with our customers, but with all our other constituents, employees, partners, our communities, our regulators, and society as a whole. So how do we do that by focusing, first of all, not how much money we were making, but how do we use our capabilities to create value for these constituents? And then the second part is to believe however well we're doing as a company or however well we're performing as individual employees to realize it's not good enough, that if we don't improve and improve faster than our competitors, both existing and potential competition, competitors, we're not going to stay in business. So each one of us has to be lifelong learners that is constantly searching for new and better ways to create value.

And so using that philosophy then in 1969, we were able to buy the rest of this refining company. We start with, okay, what capabilities do we have? And then what are the best opportunities where these will create the most value? And then to constantly improve and add to these capabilities, which then opened a new opportunity. And then that calls for us to build additional capabilities. That opens a new opportunity. So the way I look at it, it's an endless cycle of creative destruction.

After we had acquired the rest of the Great Northern Oil Company, we had three sets of capabilities. We had crude oil gathering, which was starting to grow. We had process equipment in the mass transfer or distillation equipment. And we had chemical processing, which is refining it's a form of chemical processing. So here's what we did. Applying this philosophy, then we grew crude oil gathering business to become the largest in the U.S. in Canada. Then we did the same thing in gas liquids and natural gas, and then we got into natural gas distribution. We became the largest in asphalt distribution and got into ammonia distribution, which then took us into the fertilizer business.

Then we did the same thing in process equipment and built that a thousandfold. We now call it our chemical technology group. Then we built that many times its size. And then these capabilities then got us into chemicals, polymers, fibers, and related consumer products. And we got into wood pulping, other forest products, glass, steel, and now electronics and software. Let's pull out the key thread in there, which is, so, right, once upon a time, the conglomerate model, right, was very popular. And the idea was that companies should be in many different businesses because the different business, you know, the cycles of different businesses cancels each other out. And so if your real estate brokerage isn't doing very well, then maybe your TV network will make up for it or vice versa.

And then that turned out not to work well because those unrelated businesses are actually hard to manage under one umbrella. That then swung toward, you know, most of the business world towards very deliberate focus. And in the sense of like we're in a business and then we need to get bigger and better in that business. But we will not be allowed or permitted by our shareholders, investors, whatever, to be able to go on unrelated businesses. It sounds like this is a third approach, which is not so much based on what business are we, in. It's more based on what capabilities do we have. It's centered around our management philosophy, which we call market-based management. And we believe we have six core capabilities, and that's commercial excellence, operation excellence, talent, innovation, trading mentality, and public sector.

And all the businesses then share what they're doing with the others. You identified two core principles, so counterparty of choice. which is to say, to be the best partner, in essence, to all the constituents of the business, and then the other continual transformation, get continuously better at what you do. Those sound like apple pie. Those sound obvious. Those sound like every company must do that. Every company must seek to be the partner of choice to all of its constituents.

Every company must seek to continually improve. But how can you? I mean, if you're focused on your quarterly earnings and more worried about that than creating value for others, and how many companies are really dedicated to creating value for your employees, I mean, I speak at business schools, and one of the students there said, well, isn't that kind of naive? I mean, you've got to be focused on your profits. I said, well, don't you think it's naive that people are going to want to do business with you or want to work with you unless you're creating value for them? Now, it's got to be a system of mutual benefit.

You've got to be compensated for that. And to want to create value for an employee, they've got to be creating value for you. And that's the atmosphere you want. me, this works. We've developed an investment structure, and that's why we're a preferred counterparty, because we don't go, okay, this is the way it has to be or not. No, we say, what do you value? What do you want for this? And then we'll structure it any way you want, but the more risk you want us to take, then the more compensation we need. And so we work it out to mutual benefit. A lot of CEOs have written books. They talk about the values of the company. They talk about the

principles. They're up on the wall. They've got little cards that go on the wall. And then you're actually, when you actually go inside the company, you're like, well, no, that's not what they believe at all. And if you ask the employees, after a couple of beers, I'll tell you, no, that's not at all what it's like. So how do you get it to stick? How do you go from the abstract principles through to implementation, especially for a company with over now 100,000 employees? Like, how does a line manager? 120,000? 120,000.

This is major information disclosure going on right here. Over 120,000 employees. Like, if I'm a line manager at the company, and I've never met you, and I don't know you, and how, what do the principal stick with me? Well, I mean, we've got different kinds of principles. We have the general president, and then we have what we call our guiding principles. And as you say, a lot of companies have this list of principles. These principles are who we are as a company. They guide everything we do.

Who we hire, we hire first on values and second on talent. And when I say talent, I'm not talking about credentials or what's cool. We couldn't care less. I mean, it's like the NFL. They don't first select a quarterback that has the best statistics. They select a quarterback who has the best physical and mental capacity to lead the team to victory. And so when we're talking about talent, what potentiality do you have, and we'll make sure you fully develop, but the starting point is values.

When I talk to our people, I say, gosh, if you're going to hire somebody with bad values, don't be hiring somebody smart. harm stupid and slow, because they will do less damage. You look at the company's led by really smart people with bad values, and they're all broken. So if I'm a line manager at Cook Industry, it's like, what are my incentives? How does the incentive system support the values? Well, there are lots of incentives, and they're monetary incentives, but they're also incentives is, am I developing?

In any organization, particularly, there's what they call, of course, an agency problem, that the goals of the company and those of the individual are in conflict. And there's always going to be a certain conflict because individual goals and motivations are different for a company. So we try to do the best job of overcoming this agency problem. Most acquisitions we have is they have had an incentive program that's designed by consultants and it's a point system or something. And that doesn't work for us because what we want to do,

is having an incentive system that motivates an employee to maximize the long-term value. You know, the Silicon Valley way of trying to align long-term value and defeat the agency issues is stock options, right? Equity ownership in the company. Because of how you're structured, right, the overwhelming majority of your employees, by definition, aren't shareholders. Basically, what you're trying to do is how people think like owners, have your employees think like owners, even though they're actually not owners.

But owners who want to maximize the long term. How do you do that with cash compensation? How do you get the cash comp system to work like equity would work? We work awfully hard at this, to understand what an individual employee has contributed to increasing the long-term value of the company in harmony with our principles. Okay, what did you contribute to this year profits? What did you do to help our culture to make sure we were living up to our guiding principles? What did you do to help our competitive position?

What innovations do you bring that might pay off in the future? So it's a combination of objective measures and subjective measures. And so every supervisor is expected to go there, and we have the 360-degree evaluations of everybody, including me. I get feedback on my improvement plan every year, and it's a long list, so I won't bore you with all that. But the good thing is that you don't need to be precise, but you need to be directionally correct.

If I'm an employee at your company, can I make more money than my manager makes? Oh, absolutely. I mean, and why shouldn't we? Does LeBron James make more than his coach? What's the max? Is there a maximum on how much more I can make than my manager makes?

It has nothing to do with how much your manager, although we get some of the credit for you performing well. But there's no max. We want everybody to make all they can based on the value they're creating. So would you rather have an employee? employee risk a project with a 50% chance of success, 50% chance of failure, and a $10 million payoff, or a 90% chance of success and a $1 million payoff?

If you never have a failure, you're not trying anything new. And so we expect failures, but we don't want stupid failures if you have a correctly designed experiment, so you gain knowledge from it. And it's like Edison said, after it had 9,000 failures trying to develop a new battery, His friend says, gosh, Thomas, I'm so sorry you've had all these failures. He said, I haven't had any failures. I've learned 9,000 things that don't work. This is Popper's scientific method.

Science has falsification. When you come up with a theory, you want to try to falsify it as quickly as you can. If we got a bad deal or we're on a wrong track, we want to know quickly. So any of us, like any idea I come up, we ought to do, I get, I say, okay, what are the key drivers of these? Who's going to be best at each one of those, get together a meeting, and I say, okay, now point out the flaws in this

and challenge me. And every time we go through that kind of discussion and debate, come up with a better answer than I had myself. I've never understood this. People are so protected, their ideas, defensive about it. When somebody's pointing out the flaw, you need to thank them.

What if you had based your career on that, on a faulty proposition, and they let you do it. They're not your friends, they're worst enemy. Like you're driving a car toward a cliff at 100 miles an hour. Oh, you're doing a great job, Chuck. Keep it up. I've never understood that. The interesting thing about what you just said is that it's very much in alignment

with a lot of how Silicon Valley operates, both in terms of the venture capital model of funding startups where we're looking for similar high-risk, high-return outcomes. It's also what a lot of the big companies in the Valley have figured out, which is right. You need to take these big bets. You need to take that's a significant chance of loss to get the big wins. Failure is okay, but run the experiment, fail fast, right?

And then learn and move on to the next idea. A critique that gets applied in the valley is that some companies will take it too far to failure is good. And there's some dividing line between fail fast, learn from your failures. Failures are an essential element of this whole thing to failure is good. To the point, I'll just say an example, there's a large tech company. I wouldn't name by name, but they actually will throw a big party when a project fails. I don't know if maybe it's a Midwestern enemy where I'm just like, I can't quite reconcile myself with actually celebrating failure.

So how do you think about preserving this attitude of risk and experimentation, but still having a culture of performance and accountability and things do have to work at a certain point? We pay on the value created. And so if we've had a failure, but it was done very economically, and we've learned quite a bit, that could be a net positive. Okay. You had an experiment that showed that something we were going to do. didn't work so that won't be held against you maybe a positive usually it's a net negative but

if we learn something then that's on the positive side so let's say somebody had three or four failures with experiments and it was a voice so that won't be uh deducted whereas if you had a dumb failure and you lose 10 million you made 20 million or you made 25 million over here you get credit for 15 so we net it out So if I'm an executive at your company, like, how many times can I fail before you start to ask the question? If that were used on me, I'd be long gone. All we care is, are you contributing both in terms of our culture, our current, and for the long term? How many companies at scale in the world do you think have this kind of approach to management?

For example, this level of risk tolerance for new ideas and new ventures? Like, how many would be fundamentally capable of it? A number of years ago, one of the big banks, we did a lot of business with, asked me to come in and put on a one-day seminar. And so I said, do you know what's involved in applying this? It's not a cookbook. The leadership has to understand and live by the underlying principles. I mean, it's like with your kids, if you preach one thing and you act in another, they're going

to do the opposite because they know it's a bunch of BS. Yes. So the management has to understand these principles and see whether the procedures, the mechanics are violating the underlying principles. One of the interesting things about your company is you reinvest, I believe, is it 90% of earnings? 90% of earnings every year. So I think most companies at scale would consider that to be impossible. There just can't possibly be that many productive opportunities to play capital. Have you found, has it gotten, it must have gotten harder at scale? Why are you convinced that that's the right number as opposed to 50% or 20%?

Well, it's our shareholders have agreed. Is that right? Yeah. That's the right number. And the reason is, I think one is being private because we have a small number of shareholders outside of employees. And they've seen that we can earn a higher return than they can personally investing. And they have seen that we are large enough that paying 10% gives them all

the money they need to do what they do. So those are the key ingredients for our being able to do that. So let's move on to policy and politics now. So you've, in addition to becoming very well known as a CEO, you're better known as a policy activist. I see as the trajectory of this country is moving toward a system, what I call a system of control, dependency, and cronyism that's undermining progress and pitting people against each other. And what I'd like to move is toward, as I've been talking about, this system of mutual benefit, where people succeed according to the value they create for others. And so that involves policy, but it also involves helping people go through this self-transformation. That's only where you're going to change society,

electing a better politician or something. We're not going to solve the political problem with more politics. We've got to solve it at the grassroots level with individuals. and helping them see opportunities, and there are two sets of obstacles. One's an internal obstacle that people don't believe they can learn, contribute, and succeed. So you've got to overcome that, and then you've got to help them find what they would be good at, develop a valued skill, and then use that to create value for others. The amount of capital that you're deploying is large. How do you think about the productive deployment of that much money into both politics, but also the non-political efforts?

Perception is this is all about political action, and that you seem more interested. in intellectual action? The political part is more defensive. So we at least have free speech, open inquiry, some decent immigration, and free trade. I am a total free trade of this business on maximizing exports and minimizing imports is backwards. I mean, that's the old mercantilist deal, right? We're going to export everything and pile up all this money.

Meantime, the people starve. That's what Mao did to build up this military. and what makes people better is not more money stash somewhere, but goods and services that make their lives better. So I've never understand how they get that so backwards. So the current discussion climate in the U.S. and around the world is, let's just say, extremely negative at the moment and maybe has been for quite a while. What are you the most optimistic about? Innovation. We need to get rid of this protectionism and have what we call permissionless innovation and that is have the burden of proof on the government that what you're doing is really

unsafe so they can get a quarter or shut you down rather than have to go mother may I on everything and some things it takes like for a new drug it might take 10 years and cost 2 billion so the drug prices are much higher than they did and this is not just true for for new drugs but it's from on generic jobs you've got to get improved as well And then finally, you're famously an extensive and maybe even chronic reader. Give us two or three out-of-the-ordinary books that aren't on the normal reading list that you would recommend that people read. Well, let me give you some essays.

I would read Michael Plano's essay, Republic of Science. I would read Carl Popper's essay, Science's Falsification. I would read a couple of Hayak, that competition as a discovery procedure and the use of knowledge in society. I would read a chapter in Matt Ridley's book, The Evolution of Everything, called The Evolution of Technology. I would read D.D.R. McCloskey's op-ed in May 2016, Wall Street Journal, called How the West and the Rest got rich.

And then I would read Charles Murray's book in pursuit of happiness and good government. So you want more? That's an excellent homework assignment. Thank you. Thank you. Great. Thank you.