This article originally appeared on HBR.org.
At any given moment, about 5%–7% of companies either are in free fall or are about to be. Free fall is a crisis of obsolescence and decline that can happen at any point in a company’s life cycle, but most often it affects maturing incumbents whose business model has come under competitive attack from insurgents or is no longer viable in a changing market. And here’s a sobering fact: Only about 10%–15% of those companies will ever pull out of it. Of those who do, about half have to fundamentally redefine at least a part of their core business in order to save themselves.
At first, the causes of free fall appear to be external: a global financial crisis, a banking system collapse, government deregulation, or, more common, a new business model or technology harnessed by a nimble insurgent competitor. But these forms of external turbulence tend to be the trigger of free fall, not the cause.
Think of Kodak, which in the 1990s was the apparently unassailable leader in its market, with 80% market share in its core film business. By now everyone knows the story: Kodak went into a free fall that led to bankruptcy in 2012 because it failed to respond to the disruption of digital technology—even though one of its own engineers invented a technology for capturing a digital image in 1975. Clearly, something else, beyond the disruptive technology itself, is behind the demise of companies like Kodak.
We set out to understand why once successful companies enter these deadly tailspins, and found that the root causes are usually internal. Leaders did not prepare for the external problem, did not adapt fast enough, or did not have a second-generation engine for the business ready to go when the first-generation engine became obsolete. Systemic dysfunction on the inside prevented the company from being able to adapt to profound strategic challenges on the outside.
We also found that free-fall situations are responsible for some of the largest swings in value—not only down but also up. If handled properly, free fall represents an enormous opportunity. Just think of Apple, which pulled itself out of catastrophic free fall in the late 1990s and has since risen to spectacular new heights.
Other companies can do the same. After studying and working with hundreds of companies in free fall, we’ve identified concrete steps that leadership teams can take to engineer successful turnarounds and transformations.
Build a Re-Founding Team
When a company is in free fall, it makes sense to replace the management team, for all sorts of reasons. First, you need to inject new energy into a tired organization under stress. Second, you need to ensure that the team you’re building is made up of people with open minds who want to invent the future, not just defend the past. It’s unreasonable to expect the architects of the strategies and practices that led to your downfall to see the error of their ways, or the right path forward. Instead, you need to find leaders and employees with a rebellious spirit. Third, you need to locate key employees at the front line and promote them—as a source of knowledge and energy, and as a signal that the future will be about merit and open-mindedness. Finally, you need to make change happen relatively quickly. If you replace your team gradually (which can be tempting because it seems less disruptive), you’ll lose valuable time, and the employees you bring in will begin to absorb the organizational biases of the past.
When Kent Thiry took over as CEO of Total Renal Care in 1999, the company was losing more than $60 million per year. Thiry immediately replaced most of the management team. To reinforce the idea that everyone in the company had a stake in its rescue and rebirth, he began referring to the company as a village, and abolished the use of formal titles internally. He convened town hall meetings with local staff and organized regular national voice-of-the-village calls attended by as many as 4,000 people from offices and clinics around the country. He even let employees rename the company, which they christened DaVita (“giver of life” in Italian). By 2010 the company had become the best-performing stock in the S&P 500, worth $30 per share and earning investors a return of 29 times. Since then its stock has more than doubled.
Focus on the “Core of the Core”
Reversing free fall takes enormous energy and resources. Leaders who succeed at the job usually do so by combing through the company in search of noncore assets to shed, businesses to sell, activities to stop, functions to eliminate, and product lines to simplify, as Steve Jobs did when he took back the reins at Apple in 1997, and as Jørgen Vig Knudstorp, the CEO of Lego, did in 2004.
Founded in the 1930s, Lego developed a repeatable model that allowed it to grow for decades. By 1993 the company had $1.3 billion in revenue. Starting that year, however, it began diverting cash from its profitable toy brick business into an array of adjacencies: theme parks, television programs, watches, retail stores, plastic toys without the brick system, video games, and even a Steven Spielberg–cobranded “movie studio in a box.” All of these moves drew resources from the core—and virtually all of them failed. From 1993 to 2003, according to the company’s current CEO, Knudstorp, the Lego Group lost value at an average rate of 300,000 euros per day. The company was in free fall.
When Knudstorp took over as CEO in 2004, he quickly settled on a course of action: return the company to its core. To that end, he installed a new management team, and with its help he began to focus the company’s energy on the one core product that had made it great: its toy brick system. He and his team first attacked the portfolio of assets. They sold part of the theme park business, shut down adjacencies, and stopped planned expansions. Then they went deeper. They found that the number of unique elements in Lego sets had grown from about 6,000 in 1997 to more than 14,000 in 2004. Colors had proliferated from six to 50. They also found that 90% of these elements were used only one time. So in addition to cutting businesses, research projects, and toy lines, the team eliminated more than 50% of the components.
From there, the team began to create rules to determine when the company could add products and elements. The cost of a single element is remarkably high, because each requires a separate mold and creates scheduling and inventory complexity on the shop floor. Today 70% of the parts in any Lego product are from a subset of universal pieces.
The team then turned to the product line. It gave online customers the ability to design their own Lego set and to order bricks to make structures designed by others. It sought input from thousands of the most intense Lego fans. It began moving into adjacencies that were tightly linked to the core—Lego for girls, a new set of mini figure elements, licensing the brand for a Lego movie.
The results were amazing. Since Knudstorp took over, Lego’s revenues have increased by 400%, and its operating profit margin has increased from -21% to 34%. That’s the power of shrinking to grow.
First, strip away complexity, and second, return to the core of the core. This approach—shrinking to grow—has been adopted by a number of companies that pulled themselves out of free fall, among them IBM, Apple, and Charles Schwab.
Invest Hugely in a New Capability
Companies in free fall have a lot to fix but seldom have all of the tools they need. They usually find that they are missing at least one capability crucial for adapting their business model to new conditions. Nearly all of the 50 cases of successful reversal of free fall that we have studied required at least one major new capability. It’s extremely hard to focus on new capabilities when you’re in free fall, but if you don’t, everything else you try to do may be for naught.
In the photography industry, Leica provides a sharp example of how adding new capabilities can help a company reverse free fall. A century ago Leica brought to market the first lightweight camera, whose most distinctive feature was the quality of its lens, allowing small film images to be blown up without losing much resolution. Leica’s image quality made it the preferred camera of the great photographers of the last century. Yet when digital photography arrived, the company was slow to embrace it, only incorporating it into its cameras in 2006. The company’s problems were compounded by the decline of traditional photo stores and the rise of the internet and discount camera retailers.
Because Leica made cameras at the top end of the price range and didn’t adapt to these changes, it lost money throughout the 1990s. From 2005 to 2007 its revenues declined from 144 million euros to 90 million euros, and it lost between 10 million and 20 million euros per year. The company was in free fall.
Enter Andreas Kaufmann, an Austrian investor who acquired a controlling stake in Leica in 2006. He believed that Leica possessed unique assets that it could build upon to renew itself—its brand, its unparalleled image quality, its heritage with great photographers, and its lens’ quality. Kaufmann proceeded to engineer a turnaround of the company by focusing on the top end of the market. In 2011 the private equity firm Blackstone invested 160 million euros in the company. This capital allowed the company to obtain new capabilities that in turn became central to revamping its product line (autofocus, digital version of the M line of cameras) and its channels of distribution (branded stores). Today Leica’s revenues have tripled from its low point, and the company is again solidly profitable.
Nothing about free fall is easy. Breaking out of it is probably the greatest leadership challenge, and one that many leaders will face in their careers. But some of the largest positive swings in value can occur as companies recover from free fall and get themselves back on the path to sustainable growth. The opportunity is there—if you understand and manage the internal causes that led to the crisis in the first place.
Chris Zook is a partner in Bain & Company’s Boston office and has been a co-head of the firm’s global strategy practice for twenty years. He is a co-author of a number of bestselling books including Profit from the Core and The Founder’s Mentality: How to Overcome the Predictable Crises of Growth (Harvard Business Review Press, June 2016).