Two approaches to hedge against disruption – using McKinsey’s third horizon

I’m getting a lot of clients talking about disruption at the moment. Both in the business world and in the not-for-profit world. The question on a lot of people’s lips is: “How do we hedge ourselves against disruption?”

Now, I am open to the idea that a question like that puts you on the back foot immediately. I hear a lot of rhetoric about “are you defending the castle, or are you building the new city?”. But let’s be honest, if you’re running an existing business, in an existing market, and you’re looking around at the media industry, the accommodation industry, and the taxi industry (to name but a few), I think it’s OK to ask yourself, “How can I hedge my risk?”

So, in this post I want to suggest two approaches to hedging against being disrupted. Both of these approaches hang within the third horizon of McKinsey’s framework. But I would add these hedges might still be pretty brutal. While I don’t subscribe to the “create your own future” palaver, I would say that any hedge against disruption at least has the risk of disrupting the host business.

Let me say that more clearly: If you think you can protect against disruption, and your strategy doesn’t itself entail at least the chance that you’ll end up disrupting your own business as part of that protection, then you’re dreaming. I suspect that in the long run the only way to stop others disrupting you is to disrupt yourself.

So let’s get going.

McKinseys three horizons model of organic growth

I will take it as read that you’re familiar with McKinsey’s three horizons model. If not, have a read here. In summary, this model is a great way of thinking about growth. Basically, a business should have “sub-businesses” that pay-off across three horizons of time: now; next (2 – 5 years); later (after 5 years, if at all). (That 5 years figure might be a bit long these days.) The key to the model is: if you want your business to continue to grow tomorrow, you have to work across all three horizons today. The horizons are a “time to pay-off” not a “time to execution”. In particular, the traditional reading of the model would say you should act across these horizons as follows:

• Horizon 1 – Protect and defend your H1 business(es). They may not be giving you a lot of growth, but they’re throwing off cash.
• Horizon 2 – Build your emerging businesses. These H2 businesses might have low revenue today, but the growth trajectory is stellar. And in a few years they’ll be your next H1 businesses.
• Horizon 3 – Build your options for your H3 businesses. These are “experiments” – they may work, or they may not.

In this day and age, I suspect the most important focus for leaders is on H3. These are the experiments that are going to hedge you against disruption.

But, I think there are at least two approaches you need to take to H3 businesses, in contrast to the traditional single approach to H3. And I think these approaches are in some sense in tension – but I think you need to have the wisdom to adopt both.

A bit more on H3

Before getting on to the two approaches I have in mind, let’s talk a bit more about H3 in the McKinsey model. The original idea for this horizon is that you should always have a portfolio of start-up businesses. They should be real businesses. But they are in a very real sense experiments as well. Some may fail. The ones that don’t fail should go on to be H2 businesses in a few years. The traditional approach to these businesses, what I would now call “Approach 1”, is to “fail fast and fail cheaply”.

Approach 1 – Fail fast and fail cheaply

One way to hedge against being disrupted is to put multiple H3 options out there in the market – and see what the market does. The traditional approach would say: put these options out; but make sure that if they are going to fail you realise they are failing quickly; and minimise the costs associated with finding all this out.

This is still a valid approach and one that I think any business should be undertaking. (It’s just that I think there is now another approach that businesses need to consider, see “Approach 2” below).

What does “failing fast and failing cheaply” look like? Here are some suggestions:

• Risk a pre-determined amount of money. And when it’s all gone, kill the idea (assuming there are no pay-offs). This is a classic entrepreneurial strategy. Decide what you’re going to risk: a stated amount of money. Put it out there. And see if it works. If it doesn’t, don’t keep throwing good money after bad. Kill the thing. Of course, the key risk here is the sunk cost fallacy.
• Put a minimal viable product (MVP) out into the market and see what happens. Don’t waste time getting it all perfect. Put the minimum out and test it in the real world. So, if you’re a big company, be happy to launch a product with manual systems or old systems supporting it, just with a nice front end. See if customers are responding. Then pick the pieces up later if they are (nice problem to have!). But if they aren’t, you haven’t wasted a load of effort and a load of time.
• Use customer-centred-design as you build your new product/business. One of the great things about the discipline of design is that its prototyping approaches act to “pull failure forward”.

In a sense this has been the traditional approach to take in H3. And I still want to commend it. But, now, I think there is also another approach, kind of the opposite, that you also need to consider.

Approach 2 – Pursue “optionality”

Approach 2: pursue “optionality”. I could name this approach more succinctly – “Approach 2 – create options”. But this kind of misses the point. I’m not talking about options in the usual sense, as in “choices”. Instead I’m talking about options in the financial markets sense. That is, buy Put Options – cheap “insurance policies” that are unlikely to pay-off, but if they do, if the market “falls”, they will pay off at scale. Hugely.

This idea of optionality comes from Nassim Nicholas Taleb, and he talks about it in a lot of his books, but treats it well in “Anti-fragile“. Basically, Taleb’s approach to risk is to make a number of low cost “bets” that will pay off non-linearly if a “black swan” event hits you. In the world of business I can imagine that this could involve a number of approaches:

• Take an investment position in a start-up potential disruptor in your industry. If the disruptor is successful, your investment pays off non-linearly for you, even as the rest of your business is being disrupted.
• Put a product out in the market that is potentially disruptive, and leave it there, waiting for “its time to come”. If its time does come, you’re positioned well in the market while others are scrambling to catch up.

Approach 1 v Approach 2

As you can see, Approach 2 is the opposite of Approach 1. In Approach 1 you need to make the call on your new project quickly and “fail fast and cheaply”. But in Approach 2, you’re actually sitting on the investment. The key is the investment needs to be low cost (so that any eventual failure is still “cheap”). But the failure may well be “slow”. In fact, this kind of optionality almost requires that you are sitting on a number of options that are essentially doing nothing for a long time. But maybe, at some time in the future, one of them may pay off spectacularly. Approach 2’s very essence is ongoing slow failure, while waiting for a “black swan” of huge eventual pay-off.

So, which Approach to use? I’m afraid that calls for wisdom in the particularity of the situation. For some industries and businesses, some strategies will call for Approach 1. In others, it will be Approach 2. And in others it will be a combination. I still need to do further reflection on all of this: and I would welcome your comments below. I’m finding this approach of putting ideas out there and getting feedback from you, the reader, to be really beneficial in formulating my thinking.

 

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