Eric Ries: The Hidden Force Destroying Good Companies | Incorruptible

They fail because of the unusual failures.

The organization has a character and an intelligence that is not possessed by any of the individual members.

Sam Walton called his company Walmart because he was paying tribute to Saul Price's company FedMart. They sell over 200 million hot dogs a year.

Thanks for doing this.

Yeah, this book comes from my personal pain. All my books have, really. I have seen some things. You know, I have journeyed into the heart of darkness of our modern economy and I have seen the darkness that lurks there. I have helped so many people create these incredible companies that are trustworthy. You know, they're loved and trusted by their employees, by their customers, by their investors. Like, they do this magic thing. They have this spark that's really vital. And then our modern gravitational force of our financial system cracks them right open and sucks out the marrow and leaves the burnt-out husk for the rest of us. And that might sound like a problem that is related to like rich people or, you know, investors or boardrooms or whatever, but this is affecting every single one of us. Just, I'll tell you this one story and then we'll get into it. I was out to dinner with a group of friends. We were traveling, so we were not at home, and someone said, 'Oh, I haven't been to this restaurant in a couple years, but it's pretty good. Let's go have dinner there.' So we had a big group dinner there. We get there and the person takes one bite of the food and like is on their phone. It's like, 'One sec. Oh, sorry guys. This restaurant's been taken over by private equity. I could taste it.' And we went to a different restaurant the second night that a different person had recommended. We get there, we take one bite, and that person's on their phone being like, 'Is it the same damn private equity firm?' No, it's a different firm, but the taste is the same. How is it that you can taste the cap table in the food? That's what's happening. When a favorite product goes public, when the company goes public that makes your favorite product, or when it gets taken over, or when it just loses its way. We're seeing this all over our economy, left, right, and center. Founders are losing control of their companies at alarming rates. Harvard Law School has a study that shows that among venture-backed companies, only 20% of founders will still be CEO after three years post-IPO. And everyone's like, 'Well, I'm in the exception. I'm in the 20%.' But buddy, statistically speaking, you are in the 80%. So this is like going on all over our economy. In fact, I would go so far as to say that we have created an economy that creates many, many, many, many ways for people to make money without creating any value at all.

And many of these ways of making money that we're all supposed to celebrate, our grandparents and great-grandparents would have seen not just as morally dubious, they would have been crimes. So what are we doing? Who is this for? I just feel like I have been up against this, like helping so many people create these great companies and watching with total despair what happens to them next. So yes, I think the next generation of founders, leaders, board members deserve better.

There's so many. I mean, unfortunately, I have a chart in the book that has 200 years of this case study. And there's so many companies like Polaroid, Sears, Circuit City that are like consumer brands that you know and remember if you're of a certain age.

And if you talk to people about like whatever happened to Sears, they'll be like, 'Oh yeah, Sears, I guess they got disrupted.'

Didn't make it to e-commerce or whatever. But if you study the story, you'll be like, 'Wait a minute. Yes, they got disrupted, but that's only because they were strip-mined before.' The guy who strip-mined Sears, I think, made $4 billion while like having the company, driving the company into bankruptcy. But the story that I think illustrates the phenomenon crisply and clearly, is the easiest to understand and kind of gives you the whole method in one story, is the legend of Saul Price. So Saul Price, I feel like younger entrepreneurs don't know his story now. He's kind of fallen out of the public lexicon, but he needs to make a comeback because his story is incredible. He is the father of modern retail, okay? Unequivocally the father of modern retail. To see how influential he was, he's not even his company. You got to realize that if you ever wondered why did Sam Walton call his company Walmart, it's because he was paying tribute to Saul Price's company FedMart. Okay, that's how influential Saul Price was. He created FedMart in the '50s, but before he became a retailer, he was a lawyer. He spent a whole career as a lawyer where he learned this important rule of when you're a lawyer, you have what's called a fiduciary duty to your client. That means you put your client's interests before your own. I always ask company leaders now, thinking about who do you owe a fiduciary duty to, I ask, who would you rather die than betray? Now in our modern economy, we teach that it's only shareholders that are worthy of fiduciary duties. But that's not how Saul saw it. He had a very clear hierarchy: customers first, employees second, shareholders last. This is not uncommon among the greatest thinkers and leaders in companies. For example, the great Peter Drucker. He said actually it's employees first, customers second, shareholders last, or it's employees who create the value that customers benefit from. But anyway, we teach now the opposite. We teach shareholder primacy, meaning shareholders first. So that was Saul's idea. He created FedMart as a big box retail store, members only, discounted prices. He practiced capped margins, meaning he wouldn't mark up any item more than 14%. He paid above market wages. He really, like, that was his ethos: low prices, high wages, be a trustworthy counterparty to everyone you touch. There's so many legends of Saul. So many. But one of my favorites is that when his competitors would try to drive him out of business using the loss leader strategy, meaning they would make key items that people like to buy at FedMart cheaper at their store and then they would widely advertise, 'They don't have the lowest price, come to me.' Saul would post signs inside his own store being like, 'Don't buy this from me. It's cheaper down the street.'

You imagine how much that drove everyone crazy. To him, that was obvious. I'm a fiduciary to the customer. I want to get the lowest price for customers. I don't care where they get it from. Why should I privilege them getting it from me? And so customers loved FedMart. They would drive miles out of their way to shop at FedMart because like that feeling that someone's taking care of you, that they're going to treat you fairly. You don't have to go double check. Think how many vendors and merchants you work with where like if they give you a special offer, you have to read the fine print. If they want to sell you something, you got to be like, 'What's the catch?' Even if you think you're going to like it, you got to double check. Is this really the lowest price? It's, you know, Cory Doctorow calls it enshittification. All these products are just getting worse and worse and worse all around us. Saul didn't believe in any of that. So, FedMart was a huge success, a rocket ship company for its time. He took it public.

Made a ton of money for everybody. But as a public company, he was under relentless pressure to do the opposite of what he thought was right. Public market investors, what do they care about? Quarterly returns. What do they care about? They wanted high prices and low wages. And Saul would always say no. But he didn't like the constant friction that he felt with the public market. So he actually arranged to take the company private.

But that did not help. The new board, steeped in the best practices of the governance class that we've all been taught, what did the new board think? The new board was all about fiduciary duty to shareholders. What did they want? They wanted higher prices and lower wages. But here's the funny part of the story. Saul was uncompromising, so he just, unlike a lot of founders, he was just like, 'No, you don't. There's only one way to do it, it's the right way. If you don't like it, don't invest in my company.' So you can imagine this made him very popular with the new investors who had helped him take the company private. This led up to a big conflict. One day in 1975, to be clear, Saul Price had been running this company, which he invented from nothing, for 20-plus years. Comes into work in 1975, can't get into his office because the locks on his door have been changed. He doesn't work there anymore. I have seen this story play out over and over and over again. So many contemporary companies.

So what happened? This story is like the ultimate A/B test.

In corner A, wearing the blue trunks, we have FedMart and its investors. They got what they wanted. The company was converted to conventional best practices of retail: faster growth, higher profits, squeeze, squeeze, squeeze. It took them seven years to bankrupt what Saul had built. In 1982, every FedMart store was liquidated. The whole thing was a total disaster. If you know Aesop's fable of the man who killed the golden goose,

That's the golden goose story. That's why that story has been around for thousands of years.

But let's look at corner B. Wearing the red trunks, we have Saul Price, like a classic entrepreneur. He took two weeks off and then he was back at work.

He leased the office upstairs from FedMart HQ, started a new company he called Price Club.

To understand this story, you have to understand two things, two acts of mutual incomprehension. First, there was something that the investors understood that I don't think Saul ever did while he was alive. They understood that precisely because FedMart was so trustworthy to its customers, it could betray them and get away with it. It got away with it for seven years.

So that's why they thought they could make more money through betrayal than they could make through trustworthiness. In the short term, betrayal is very profitable, but in the long run, it's utterly destructive. But there's something that Saul understood that I don't think the investors ever did. When they look at FedMart, investors saw the buildings, the warehouses, the inventory, the customers, the employees, the contracts. They saw all the surface trappings of a company, and they said that's what FedMart is. But Saul understood something they didn't understand. He understood the engine that created all those things. It was a series of interlocking parts that made the company hum.

And because he understood the engine, he understood that he could do it again. And in fact, Price Club was very successful also in the FedMart model. But today, although when I was growing up, Price Club was a big deal company in my home community, today it's mostly forgotten because of what happened next. See, Saul wasn't the only person to leave FedMart to go work at Price Club. A bunch of people quit with him in protest. One of those people was named Jim Sinegal. Jim had worked his way up from stock boy to executive. Saul was a big believer in promoting from within. And so he also understood the engine that made this all work. And so a few years after he left to go to Price Club, he decided to strike out on his own and start a new company. And that company, a few years after that, merged with Price Club to form a company they called Price Costco, which today most people just call

Costco. Costco is a $400 billion public company that nonetheless to this day reflects the ethos of Saul Price. The same capped margins, the 90% membership renewal rate, all the things you'd expect from FedMart. But why I like the story so much is that it illustrates the two things we desperately need if we're going to build an incorruptible company. We need an ethos like Saul Price had, a philosophy that aligns everyone the company touches around being of genuine service. But we also need something else. Why is it that investors were able to decapitate FedMart but Costco is still growing strong 40 years later? It's not for lack of trying. As I document in the book, investors and activists and all kinds of people, academics, people have come for Costco from every possible angle. But it doesn't give. It has the strength to resist. Why? Because Jim Sinegal was there. He was there the day FedMart's investors betrayed Saul Price. And he said, 'That's not happening to me.' So he built Costco with what I call a governance fortress. The tools that are needed, the legal tools that are needed for Costco to maintain its structural integrity in the face of hostile outside pressure. That's why Costco is practically the exception to every business rule. People talk about late-stage capitalism, they always have to be like, 'Well, except Costco.'

Now you know why.

Ethos plus integrity. That's our magic formula.

It's time. Okay. Our grandparents would have had no trouble calling so many things in our modern economy corrupt that we are all supposed to pretend we think are good. In the book, I document what I call the builder's intuition, that every great leader that I know shares this as like automatic, that they're like, 'Of course, there are better and worse ways to make money. Not every way of making money is equally good.' And the good way is this: what Tim O'Reilly calls create more value than you capture. Make something new. Actually build something, make something in the world, and then capture a little bit of that value for yourself. That is a really simple formula that so many companies deviate from. And because we live in such a finance-driven economy, we're supposed to pretend that we think that all the ways of making money are good. And you hear people say stuff like, 'Well, such and such evil person, you got to hand it to him. At least it works.' No kidding, it works. That's why it's dangerous. That's why our grandparents warned us about that kind of behavior, and that's why it used to be illegal. Let me give one example that I think will blow most people's mind about things that used to be legal, because I think people kind of know a bunch of them, like stock buybacks used to be illegal like in the 1980s. Okay, this is like a very new thing. So many forms of gambling and speculation were illegal in living memory.

But in the 19th century, if you were like, 'Hey, I have an idea,' and by the way, this is like a long-standing thing for the vast majority of the time there have been joint stock corporations. If you went around and said, 'You know what? I think the purpose of this company should be changed from making a railroad to just enriching shareholders,' that would have been a crime.

The courts would have voided your charter as beyond the scope of what was authorized. Our great-grandparents thought it was completely obvious that every corporation should exist to pursue some beneficial purpose. So yeah, I think by learning to call these behaviors corrupt, we can start to be much more alert to them. And we can also start to puncture this sense of inevitability that the current trajectory of our economy has. It's breeding this incredible cynicism that this is how it's going to always be, but this is not how it's always been. And if you can recognize in your mind that our grandparents lived in an almost unrecognizably different economy than we do, then that creates the possibility that you can imagine for our grandchildren an unimaginably different reality than the one we inherit. So let's get to work.

Yeah, this is a huge problem. And I think for some people listening, they're going to find this to be a little bit strange. Other people, this is old news. So I kind of feel like I don't know how much detail to give you. You guide me. If you study what organizations are like in a deep way, not like the surface stuff like strategy, culture, vision, whatever, but like what is this thing, you realize that it is a category of what in the scientific literature we call emergent intelligence. Meaning the organization has a character and an intelligence that is not possessed by any of the individual members of the population.

You can see this, by the way, in lots of animal species. I link to this incredible study that was done at the Weizmann Institute, where they wanted to prove that ants have emergent intelligence, which has obviously been known for many decades, but they wanted to create like a cool demonstration of it. And they created this thing they called the piano movers puzzle. So, if you can imagine two walls with gaps in them and a big I-beam kind of object that is like very awkward to get through the gaps, you know, they call it the piano movers puzzle. Like imagine you're taking a sofa down through the stairwell and everyone's like, 'Pivot, pivot, pivot.'

Yeah.

So they constructed it, and obviously if you give this challenge to one individual human being, they can eventually find their way through to the end. If you give the challenge to one individual ant, the ant can never solve the problem. But here's the interesting thing. They ask, 'What happens as we add more people or more ants to the puzzle?' Well, as more and more and more ants are added to the puzzle, they start to be able to solve the puzzle.

And all of a sudden, if you watch the video, you can see the ant swarm like trying something, thinking about it for a second, trying something else. It is so obviously an intelligence doing this manipulation. If you watch it, ants get monotonically better at the puzzle the more ants you add. Humans, oh no. The more humans you add to the puzzle, unless you give them very specific ability to communicate and structure their communication, they get worse and worse and worse. So human organizations are alive.

This again, this is not a metaphysical thing. It's a scientific truth. It's all these studies. One of my favorites is there was a study that they measured the ethical character of organizations and they found that measuring the ethical character of an organization predicts future compliance problems better than measuring the ethical character of any of the individual people that work there, including the leadership, because the organization is the entity that has the ethical character, not any individual person. So once you understand this, you can see immediately why founders lose control all the time. It's like Frankenstein and his monster. You create this thing, you birth it, and then it has its own fate and destiny. We utterly neglect, the way we teach entrepreneurship today, the way we teach leadership today, we utterly neglect the nurturing and caring of this being, to teach it right from wrong, to teach it the values you want it to embody and to bind it to those constraints going forward.