185. Jessica Fialkovich On The Business Of Selling Businesses

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Every business should have an exit plan in mind from Day 1. Why? Because it’s impossible to control the timing of an exit or the changes in circumstances that might precipitate it. Venture capitalists know this, and build in their exit formulas at the time of their initial funding. Entrepreneurs should think the same way. And, like any business process, selling a business is a knowledge-based process that repays an investment in learning its techniques and critical success factors. Economics For Business talked to Jessica Fialkovich, a successful business builder in her own right, who founded Exit Factor, an advisory firm that helps entrepreneurs get the most from selling their businesses.

Key Takeaways and Actionable Insights

Entrepreneurship provides better career control and security than corporate life.

Jessica climbed the corporate ladder, investing effort and skill into being a great employee. But she was just a name on a list when the GFC came along – a list of those to be let go when Lehman Brothers (her employer’s funder) collapsed.

She realized that entrepreneurship provided her with great security. There’s uncertainty, but the entrepreneur decides what their future is, takes responsibility for those decisions, and accepts the accountability.

She built a successful business through hard work and the discovery process of identifying target customers and finding new and better ways to bring them value. Her chosen business was in wine sales to wine-loving customers, many of whom were connoisseurs. She developed many specialized services including finding rare wines for collectors, and her clientele spanned the globe. She incorporated the latest technologies and innovated in marketing techniques. She worked long hours, talking to customers across 16 time zones from Japan to California.

Then she decided to sell.

Entrepreneurs experience a lot less support when selling a business than when building it.

When you’re successfully growing a business, everyone wants to help, providing you with business services and supplies, and advice and ideas. What Jessica found when she came to sell was that she was on her own. It was hard to find expert help, or the requisite resources, or pretty much any kind of support infrastructure for a transaction of the size she was planning. For big business, there’s investment banking. For the 99.9% of businesses outside the Fortune 500, there was nothing similar. There were some so-called business brokers, but they were not dedicated specialists, not professionals in the specific process of selling, unreliable and poor at client service.

As an alert entrepreneur, Jessica understood that this finding signaled a market need.

The first step to design for an under-served market is to draw on relevant experience from parallel markets.

Business development always starts with first principles: is there a market to be served, in that some potential customers feel an unmet need or have a meaningful problem to be solved? Jessica had first-hand knowledge of the problem, and talking to entrepreneurs in similar situations reinforced her confidence in the market’s potential.

The comparison market Jessica chose was investment banking, which can be thought of as selling businesses of a larger scale. There’s an established investment banking process and a timeline of steps and milestones from preparing an evaluation, to developing the pitch deck, to the identification of the best buyers and the tailoring of a marketing plan for them. Jessica’s husband had some relevant investment banking experience which enhanced the knowledge transfer from one field to another, and provided a reality check for the process design.

Business-to-business services development and execution has its own set of rules; the most important one is the nurturing of relationships.

A business brokerage is a high-intensity B2B service bundle requiring a lot of in-person customized relationship management. There’s pitching the potential customers in the first place, customizing the service tom their particular business and to meet their specific needs, with a big need for staff training to deliver these specialized services. B2B service providers must be both sales experts and process experts. That requires a lot of human capital.

Jessica’s answer was to design and build a system-based model that, once in place, could be repeated and reproduced via well-trained staff with the right IT support.

She has found B2B services to be even more demanding than sourcing rare wines for connoisseurs. Selling a business is somehow more personal and individual. A client’s perception of what their business is worth may be quite different than the market’s perception. It’s the nurturing of relationships that smooths out the potential jagged edges in these transactions.

Some insights for entrepreneurs selling their business.

  • Identify your exit options from Day 1 of your business. Since it’s impossible to control exit timing – which may be due to unforeseen changes in circumstances – it’s best to lay the runway from the start. Plan to run a salable business, as well as one that’s profitable and growing. Don’t have a fire sale or panic sale or be unprepared.
  • Tailoring your selling process to the size and type of your business is important. There are different influences on what moves valuations up or down depending on business size, but, in all cases, it’s a process with a beginning, a middle and an end to be planned for in advance. You’ve got to know how to find buyers, how to source offers, and how to keep your business in good shape for due diligence.
  • Conduct regular health checks for evaluation. Always know what your business is worth. Find out how businesses are valued in your industry or sector. Make sure your business shows well on the criteria that are applied in your field.
  • EBITDA multiples are the dominant valuation metric. You may read in the Wall Street Journal about businesses being acquired for brand value, or for technology integration, or for other reasons of corporate M&A strategy. For small and medium size businesses, EBITDA multiples remain the dominant metric. There’s some art regarding what the precise multiple may turn out to be, but it’d within a range and is not going to vary wildly.
  • There is some room for qualitative factors and subjective valuation. Jessica listed subjective factors ranging from the degree of business involvement of the owner (and the worry that their future absence might be detrimental) to the perceived quality of the brand and its imagery and reputation.
  • The ultimate asset is a proven and scalable business model. If you can demonstrate that your business model returns increases in revenue and profit growth for additional investments in capital or people or marketing, then you are most likely to find an eager buyer. Make sure you can model your business in this way and that the data are clean and credible.

Additional Resources

Getting The Most For Selling Your Business by Jessica Fialkovich: Mises.org/E4B_185_Book

ExitFactor.com

Jessica on LinkedIn: Mises.org/E4B_185_LinkedIn

No-One Understands How Systems Work.

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You may have been listening to economists debating and arguing about the state of the economy and the future of inflation. Are we in a recession or not? What will the economy look like next year? What causes inflation? Will the rate of inflation increase or decrease? What can be done to alter the future direction of change?

There is no shortage of opinions, but a total lack of certainty, of confidence, or even of sound theory.

You probably find the same phenomenon when engaged in discussions about business – about how firms can do a better job of creating customer value, to grow and succeed. How can they achieve a rise in stock price? What are the most critical constraints? What’s the best process for driving innovation? What’s the best way to manage and incentivize employees and to build a strong culture? Those are the kinds of words and phrases business consultants and business school professors use – your own peer conversations are probably more to do with increasing sales, or lead generation or your P&L, or whether all the ingredients you need will be delivered. 

But the challenge, in all these cases is the same. No-one knows anymore how these systems actually work. We can extend the list to climate as a system – some scientists claim they know how it works and can forecast the future, and another set views it as unpredictable and unmanageable. 

We saw during the so-called pandemic that virologists and infectious disease experts and pandemic modelers got their predictions – and their policies – hopelessly wrong, and it cost millions of lives and billions if not trillions of lost economic production. We can see the might modeler Ph.D.’s at the Federal Reserve make the same hubristic mistakes with their models of money supply, inflation, employment, and economic growth. The only thing they’ve ever been is wrong.

In fact, there’s a whole new science of not understanding systems which is called complexity theory, which overlaps closely with chaos theory. It says the following: A system is a collection of elements, components, parts, pieces, or, generally, agents. In an economic system, the agents might include individuals, families, and firms. There are additional elements like processes, government and institutions, norms, traditions, and a whole lot more. These elements and agents interact with each other and with inputs and outputs. There is further interaction after feedback loops establish themselves – agents react to outcomes and results they didn’t expect or anticipate. There are so many variables – individual decisions and preferences, group behaviors, trends, technological changes, money supply changes, etc, etc – that the interaction is described as complex, which means beyond understanding, unpredictable, and non-linear (it goes off in directions and at speeds that no-one expects).

Complexity is science throwing up its hands and saying, we don’t understand these systems anymore, can’t predict them, can’t control them, and can’t manage them. We don’t even have any ideas on how to do so.

There are many fancy new words that come out of this science. One, for example, is emergence. Systems have emergent properties, meaning s*** happens that we can’t account for and couldn’t even imagine in advance. Emergence is a kind of magic.

Another new term is self-organization, which means that the system will evolve and develop as it likes without any input -or despite any input – from the scientists.

Don’t worry, there are lots of government grants being given for the study of complexity, lots of papers and journals, lots of conferences, and lots of sabbaticals being taken to contemplate future studies and grant applications. There is money in complexity.

What’s the alternative? Pragmatism.

When the system (of life, of business, of health, of the economy) is complex to the point of incomprehension and unpredictability, there is only one action: do something and see if it works or it doesn’t work. In business, it takes the form of what is called today A/B testing. Try two different actions (without any prediction or bias or even desire as to which outcome will result) and choose one that works, i.e. moves in the direction you feel is better. Then do another test and another and another until there’s a string of results. Expand the actions so long as they keep working. Start a small store and keep expanding it unit by unit until there’s a big store. Be prepared for things to change without notice. Go back to square one if they do. 

There are fancy terms for this too. Economists call it entrepreneurship. Constantly trying and re-trying, combining and recombining, testing and re-testing. If a promising pattern is established, pursue it and reproduce it, but only so long as the pattern holds. Drop it as soon as it becomes erratic. Start another one. Creativity is the required skill set, and the whole point about creativity is unpredictability. 

Creative entrepreneurship doesn’t try to study complexity. Entrepreneurs face it every day and they take action rather than studying it. 

184. Rick West: When B2B Goes Click-To-Cart

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Do the principles of customer value generation that we espouse in our Economics For Business program apply equally for both B2C and B2B businesses? The answer is emphatically yes. B2B customers are seeking subjective value and a value experience just as B2C customers are. They have a clear sense of the things that matter to them, and those include emotional and personal values as well as price and functionality and performance.

In fact, trends that begin in the B2C domain often quickly begin to influence the B2B domain, and the alert entrepreneur can track those trends in B2C and establish an early advantage by exploring them for their business customers. Rick West has done exactly that with his business services company, Field Agent.

Key Takeaways and Actionable Insights

In addition to identifying a meaningful problem, and providing an effective innovative solution, entrepreneurs in today’s B2B market must offer the right service delivery platform.

Rick West created a company called Field Agent to provide B2B customers with a meaningful service: monitoring their retail stores and shopper behavior and collecting in-store data about the interactions of shoppers, stores, shelves, displays and products. This kind of information is high value for both the retail operators (like Walmart) and the companies that sell products through retail stores (such as Procter and Gamble or The Coca-Cola Company). The set of services often goes by the terminology of “shopper marketing”.

Typically, such business service offerings have a long and cumbersome sales cycle. The service provider and the service client get in contact, there are meetings, prices are negotiated, and contracts are prepared and signed. Then, once the service is executed, there are more steps in analytics and preparation of presentations of findings, and another big meeting to discuss the findings and recommendations. Lots of meetings, lots of travel, lots of time, lots of lawyers.

Is this the right service delivery platform? It’s been virtually institutionalized over time. But it’s not a good fit with modern business models and the modern technology-shaped environment.

The Amazon effect.

Think about purchasing on a shopping platform like amazon.com. The customer first self-educates. If there’s a complex product to buy – such as an expensive flat screen HDTV with internet connectivity and interaction with all the latest entertainment ecosystem devices like Roku and streaming services like Apple TV – the customer might search for information via google, might visit some ratings sites, do some comparison shopping, and generally collect information to get to the point where they are confident of making a purchase. They don’t need to speak to an HDTV salesperson or a “customer success manager” or to sign a paper contract.

Or think of a slightly more complex transaction such as buying a car on Vroom. There are some contracts to be signed via DocuSign, but confident shoppers are comfortable with self-educating, making their decision, committing, and experiencing the delivery of the car to their home, perhaps with the added service of taking away their old one.

This is the world of services and service delivery we live in today. Your B2B customer also has a life as a consumer and an internet shopper, and is fully aware of the efficiency, convenience, and safety of these kinds of transactions. Call it the amazon effect: customers becoming comfortable with the “click-to-cart” experience, without interpersonal interaction with a salesperson or other service personnel.

Why not in B2B services?

Click-to-cart has arrived in B2B services.

Rick West’s customers for Field Agent services can purchase them on plumshop.com. A full array of shopper marketing services is offered via pull-down menus in categories such as Audits, Marketing, and Insights. Under these headings are Display Photography, Price Check, Shelf Management, Price Sensitivity Study, and dozens more, all in the language of shopper marketing that’s well understood by the knowledgeable B2B service buyer.

Clicking on any one of these takes the client to a price list and a detailed description of the service and its output, all in the colorful and engaging presentation style of an e-commerce site (like amazon.com!) The client can create an account online and make a transaction just as easily as buying a TV on amazon (and probably easier than buying a car on Vroom).

Self-educated buyers know exactly what they want, and the description and designation of the services are crisp and clear. Clients can check out testimonials, comparison shop, and take all the steps any smart B2B service purchaser would take to get themselves to the point of confidence and trust.

Some customized services will always be a client requirement, but there will be a rapid shift to more and more self-service.

Some clients and some projects will always require a custom, tailored response, and Rick’s company has both custom service and automated service capabilities. One point he makes is that a first project might be customized and accompanied by in-person client service, while for the second or repeat purchase, the client will be comfortable with the click-to-cart process.

Rick’s guessing a 70:30 split for automated versus customer services over time in his field, especially as the interface software learns and becomes better and better at responding to client needs and preferences.

B2B entrepreneurs are trend-spotters in the B2C domain.

People are people. Economic behaviors that we can observe in consumer shopping and buying are bound eventually to show up in business-to-business markets. They’re the same people – your B2B client is a consumer when not at work. Smart B2B entrepreneurs keep an eye open for B2C trends that can be expected to transfer to B2B and jump on them early.

Additional Resources

Field Agent: FieldAgent.net

Plum: PlumShop.com/fa/shop

Rick West on LinkedIn: Mises.org/E4B_184_LinkedIn

The Road To Stagnation: Why Government Is The Enemy Of Economic Productivity.

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The federal government is planning to hire an additional 87,000 IRS agents. Some of them may be armed. This is not the action of a friend or partner. It is central to government’s anti-economic behavior. But now that behavior has shifted to beast mode.

Federal income taxation of companies and individuals is an act of extraction from the economy – the seizure of what has been produced. Government produces nothing – all production occurs outside government. Say’s law stipulates that we must produce first in order to be able to consume. This law does not apply to government, who must extract and confiscate first in order to be able to spend. If they spend some of the confiscated funds on production by others, such as arms producers and vaccine manufacturers, they can be counted on to be inefficient, and they don’t subject themselves to the trade-off analysis of alternative and better uses of those funds.

Taxation, of course, is not the only enemy action producers must face. Government regulation is the other major imposition on production. We’ve reported here on the one million Federal regulations the typical large firm faces. These regulations are designed both to suppress activity and to divert spending from productive to non-productive channels. Compliance requires an administrative staff, lawyers, form-filling, and reporting. Regulations often require specific investments by firms – software to interface with government systems, special safety installations and equipment, government-required training regimens, and more inefficient processes. And today, there’s the added imposition of diversity requirements in employment that replace meritocratic hiring and slow down productivity and reduce functionality.

Federal agencies are designed to impede and impose upon productive firms, and their bureaucrats enjoy – and are rewarded for – doing so. That’s how incentive systems work. If a bureaucrat is to be promoted in the SEC or OSHA or FDA or IRS, they must demonstrate the work output of large numbers of successful prosecutions. They must haul in revenues from fines or settlements. Those who get to the top are not the ones that hold back. 

The third army of the enemy assault on economic achievement is the Federal Reserve. By intervening to distort market interest rates, this army creates hard-to-manage financial uncertainty for business firms. Private investments in future asset-building must include a guess – that’s impossible to get right – about the whims of the Federal Reserve’s committees and Ph.D.’s. The Federal Reserve also regulates and controls all other banks, thereby placing their heavy hand on the scale of financing of business undertakings – for example, their location, the qualifications of their recipients, and their preferred projects.

And by destroying the value of the currency – the US dollar has lost more than 96% of its purchasing power since 1913 when the Federal Reserve was formed – the Fed forces pricing, squeezes profits, and removes economic incentives for growth and innovation. There’s less incentive to earn devalued dollars. 

The only way for firms to stay at least half a step ahead of the government bureaucrats is to innovate, to come up with better and better customer services that generate the reward of the marketplace, resulting in growing revenues and profits that can be used to pay off the confiscatory taxes. Happily, America’s innovative firms have been reasonably successful. But, more and more, innovative action is going to be diverted in the direction of new ways to file tax forms, or to do accounting, or to design a multi-national organization that avoids excessive US taxes. Corporate innovation activity will gradually be drained off (which the government loves because then they can use it as an excuse to increase the budget of the Pentagon and NASA and the NSF and other government R&D grant givers).

Eventually, firms will give in. The enemy will win. It’s unlikely that all firms will become publicly owned, but they’ll just sidle up closer and closer to the government and ask, “Just tell us what to do and we’ll do it.” There’s plenty of evidence that that’s already happening. Microsoft and Apple bid on massive government defense contracts. Digital companies execute the surveillance and suppression of open speech that governments prefer. Banks make the loans that government wants them to make. Companies do what it takes to sell satellites and pharmaceuticals and delivery services to the government. They don’t want to be excluded or to miss out.

Why is government the sworn enemy of business and business firms and their productivity and service to customers? It’s a matter of control. Government must be able to exert unchallenged control over the citizenry, and the innovation and service ethic of business threatens to rival that. If customers are loyal to service provider businesses, they might recognize the superior alternatives on offer. Government can’t allow that. Therefore they are committed to outnumbering and outspending any opposition. The federal employee roll of over 2.8 million civilian workers easily takes care of the outnumbering part. The array of lawyers, inspectors, and compliance officers in government can easily overwhelm any private sector firm.

And government expenditures (($6.8 trillion in 2021) easily dwarfs any private sector firm’s spending capacity.

When all this personnel and spending power are arrayed against individual firms, there’s no contest. The firm must comply, hand over the sums that the government says they must cede, hire people and allocate time to engage with all the regulations that they face, and find ways to abandon the activities of which the government disapproves, while finding new ways to innovate to try to get ahead of the inspectors and agents. It’s a race to stagnation.

183. Ahmed Elsamadisi: The Stories Data Can Tell Us If We Ask The Right Questions

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How do companies make decisions? Data certainly don’t make decisions, nor do analytics, nor do the computers they run on. Human begins make decisions — the human factor is crucial. Subjectivism is paramount, even in the age of big data and A.I. The key still lies with the people who are interacting with the data to generate human insights.

Ahmed Elsamadisi is one of the leading data scientists in the world. He’s worked on self-driving cars and nuclear defense and some of the biggest business challenges on earth. He believes that it is the stories we tell from data that drive business success. We are privileged to interview him at Economics For Business podcast, and he gave us a lot of useful advice we can all use every day in managing our businesses.

Key Takeaways and Actionable Insights

The data community has made data and algorithmic analysis far too complex, to the point where it’s no longer useful for business.

The path-dependent route to today’s complex data tables was paved with lots and lots of columns and lots and lots of rows. These data tables are leftovers from the early days of computing SQL language was designed to manipulate these rows and columns. A.I. comes along and can analyze all the possible combinations of data cells. Business executives ask their data departments to generate a lot of these combinations to search for patterns. It often takes a long time, a lot of revisions, and generates no clear answers.

Another aspect of history is the use of dashboards. We tend to design dashboards rather than formulate good business questions. The metrics on dashboards are sometimes useful for operations but they’re often not at all useful for understanding the causal connections between data points. Consequently, different people can interpret them in different ways and there is no consensus as to what they mean and what to do about it.

The purpose of data analytics is to generate good decisions that lead to action.

The entrepreneurial method drives towards D and A: decisions and actions. Analytics should help to formulate the hypotheses on which to base decisions. The problem with complex dashboards and algorithmic pattern recognition is that they often don’t give clear direction on recommended action, especially when the interpretation varies depending on who is doing the interpreting.

Ahmed’s experience is that sharing a numerical dashboard with 10 executives is very likely to result in 10 different interpretations, and the resultant confusion and disagreement freezes action rather than accelerating it.

We need data to tell us stories that we can all rally around.

The most powerful tool for developing consensus around action is narrative — often called storytelling. While 10 dashboard interpretations might lead to 10 different action plans, a single well-told story can align everyone who hears it, understands it, and internalizes it. We heard about the power of narrative in episode #181 (Mises.org/E4B_181) in which Brian Rivera explained the role of storytelling and sensemaking in The Flow System of management, and in episode #152 (Mises.org/E4B_152) where Derek and Laura Cabrera explained the power of aligned mental models for driving business. Stories achieve alignment.

Ahmed Elsamadisi built his service, narrator.ai, to output data analytics in the form of a story. The complexity riddle is removed and replaced with a narrative that all executives, not just data scientists, can understand. Narrator.ai re-integrates data science with the all-important human element of understanding stories.

The way to get data to tell stories is with a conversation.

Ahmed says that the way we ask questions (data queries) is flawed. It’s quite a normal practice to set the A.I. to search the data tables to look for patterns to see if anything interesting emerges. This is what Ahmed calls “lazy hypothesis generation”, which is never going to yield useful actionable insights (yet many big analytics companies are taking in huge customer revenues for just this service). Clients may claim to be making data-driven decisions but that’s mis-characterizing this business behavior, typical though it may be.

Ahmed advises us to think more in terms of a conversation with data. To facilitate this, he has developed a universal data model with just three variables: an entity (such as a customer), an action, and time. Every business question is about a customer taking some action in some time period. The universal data model enables the conversation: what action did the customer take in what period of time, e.g., when did they open the email and what action did they take after opening it. This is not a database query, it’s a more thoughtful question about the customer experience and how to understand it.

Ahmed told us that training customers in this conversational mode of interaction with the universal data model results in a cultural shift in thinking. The conversation can go back and forth in several iterations until the understanding is fully honed. Clients hear the data talking to them through the stories that narrator.ai generates. The have deeper insights and a story to share to form a consensus around the action that the story suggests. Narrator.ai clients have used stories for everything from describing new product specs to updating board decks.

Great conversations with data are based on empathy and thinking about the customer experience.

At Economics For Business, we elevate customer empathy a the most important business skill, in the context of an understanding of customer value as subjective, a good feeling from an enjoyable or satisfying experience.

Ahmed advises us to think in this same way when formulating conversations with data to generate insights. If we think about the customer’s experience, desired and actual, and the actions they take before and after that experience, and the time context of the experience, we’ll do well in formulating good questions. The action component of the universal data model is central to the Austrian deductive method: knowing what people do can help us deduce motivation and expectation. Knowing what they did next can shed light on the ends they had in mind. Actions like opening e-mails or repeat buying are also revealing of intent and expectations. The more we converse with the data, the more insight we can gain.

Storytelling with data is another implementation of subjective quantification — with the benefit of enhanced intuition over time.

In episode #176 (Mises.org/E4B_176), Peter Lewin introduced us to the Austrian concept of subjective quantification — turning customers subjective valuations into numbers such as capital value on a balance sheet. We tested the subjective quantification term with Ahmed, and he endorsed it — with a major addition. It’s important to include the dimension of time. If, over time, we have better and better conversations with data and formulate better questions and hypotheses, we’ll get better and better at generating insights. Our intuition will improve. We’ll get a better “feel” for the data. Even our empathy can become more accurate.

Additional Resources

Narrator.ai and its excellent blog, Narrator.ai/blog

“Top Ten Signs You Have A Data Modeling Problem”: Mises.org/E4B_183_Blog

Ahmed Elsamadisi on LinkedIn: Mises.org/E4B_183_LinkedIn

182. Gordon Miller: What’s Your Absorptive Capacity for User-Generated Innovation?

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It’s often the case that lead users — the most sophisticated, committed, and energetic users — are an excellent source of innovation ideas. Those customers who are most engaged are thinking the most intensely and the most creatively about what they want from the usage experience. We came across a particularly instructive example: video game modders. Who are modders, what do they do, and what can we learn from them? Professor Gordon Miller has studied this important entrepreneurial phenomenon, and he joins Economics for Business to share his knowledge.

Key Takeaways and Actionable Insights.

Modding is user-generated value innovation.

Modding, from modifying, is the act of a changing a game, usually through computer programming, with software tools that are not part of the game. This can mean fixing bugs, modifying content to improve it, or adding content. But modding is not an activity taken on by those at game companies—developers release patches and downloadable content, not mods. Modding is instead done by players and fans of the game… Modding is more than adjusting the preferences or game settings, it is making changes that cannot be made through the game as it is.

Game producers and designers enable and encourage this user innovation.

Game producers have come to recognize that the creative ideas and initiatives of the modding community can contribute new value to their businesses and franchises. Games like Minecraft enable users to explore, within a predesigned GUI, a practically endless 3-dimensional world to build innovative structures and other things like functional computers and console emulators. Minecraft also makes available code and tools for modders to create mods that are essentially new games, or major innovations within the original game. The famous DOTA (“Defense Of The Agents”) game is entirely the product of the modding community, encouraged and enabled by the developer, Valve Software.

Modding is a practical application of the theory of absorptive capacity.

Absorptive capacity refers to the capability of a firm to recognize, collect, assimilate, process, transform and use external knowledge for competitive advantage in innovation, flexibility, and overall business performance. The external sources of knowledge are knowledge networks, either formal or informal or a combination of both. Formal networks might include suppliers and partners, university research departments and labs, and even industry share groups. It’s sometimes called open innovation — actively looking at and tapping into what other firms are doing.

Informal networks are those like the modder community — lead users, user groups, tinkerers, and so on. This is sometimes referred to as distributed innovation or user innovation — it’s not the producer originating the innovation, but an external informal source.

The challenge is to be able to generate awareness of these sources of knowledge, evaluate them, bring them inside to the company for evaluation and processing, and turn them into useful innovations or internal changes.

In highly dynamic industries, it is productive to tap into these knowledge networks.

Professor Miller refers to the external networks of knowledge, both formal and informal, as the wisdom of the crowd. If you are operating in an environment characterized by high dynamism and rapid change, the wisdom the of crowd is an important and often decisive resource.

  1. The wisdom of the crowd can contribute to innovation and business performance, especially in the form of idea diversity.
  2. Innovation performance improves through better firm capitalization of knowledge resources.
  3. The wisdom of the crowd offsets firm rigidity — making it more receptive to new ideas,
  4. Entrepreneurial judgment can increase innovation performance by increasing absorptive capacity.
  5. Innovation performance feeds back into absorptive capacity, creating an iterative self-improvement loop.

Professor Miller proposes three areas of business development by capitalizing on external user groups.

First, firms struggling to innovate due to internal rigidities may well benefit from developing communities — similar in concept to modding communities – connected to their own industries. By absorbing and incorporating the learning that occurs in such groups, they can take advantage of readily available innovative ideas for change.

Second, these communities may also provide a wellspring of talent for enhancing the firm’s absorptive capacity in useful ways. This is a pool of unique and entrepreneurial individuals with the potential to enhance the firm’s human capital and make the firm more explorative.

Third, even if the firm does not fully tap in to all the knowledge coming from the community, there is still the potential for new solutions to emerge that are stimulated by external ideas. There are always hobbyists and fans, and technology easily facilitates their interactions. Crowdsourced knowledge provides a uniquely useful tool for enhancing organizational innovation.

The wisdom of the crowd is a path to profit.

Modding as an art form allows players to express what they most want games to be. This becomes a useful indicator for determining the most profitable paths to pursue. Firms seeking to enhance their innovative capabilities and remain profitable must pay attention to external sources of learning, however informal.

Additional Resources

Download our free E4B PDF: “Assessing Your Firm’s Absorptive Capacity”: Mises.org/E4B_182_PDF

The Invisible Hand In Virtual Worlds: The Economic Order of Video Games by Matthew McCaffrey: Mises.org/E4B_182_Book