Harvard Business Review

Executive Summaries

Cover Feature

How Pixar Fosters Collective Creativity

Ed Catmull Reprint: R0809D

Many people believe that good ideas are rarer and more valuable than good people. Ed Catmull, president of Pixar and Disney Animation Studios, couldn't disagree more. That notion, he says, is rooted in a misguided view of creativity that exaggerates the importance of the initial idea in developing an original product. And it reflects a profound misunderstanding of how to manage the large risks inherent in producing breakthroughs.

In filmmaking and many other kinds of complex product development, creativity involves a large number of people from different disciplines working effectively together to solve a great many inherently unforeseeable problems. The trick to fostering collective creativity, Catmull says, is threefold: Place the creative authority for product development firmly in the hands of the project leaders (as opposed to corporate executives); build a culture and processes that encourage people to share their work-in-progress and support one another as peers; and dismantle the natural barriers that divide disciplines.

Mindful of the rise and fall of so many tech companies, Catmull has also sought ways to continually challenge Pixar's assumptions and search for the flaws that could destroy its culture. Clear values, constant communication, routine postmortems, and the regular injection of outsiders who will challenge the status quo are necessary but not enough to stay on the rails. Strong leadership is essential to make sure people don't pay lip service to those standards. For example, Catmull comes to the orientation sessions for all new hires, where he talks about the mistakes Pixar has made so people don't assume that just because the company is successful, everything it does is right. Forethought

New Thinking for a New Financial Order

Diana Farrell Reprint: F0809A

World financial assets are growing faster than the world economy. Confronting that and other modern realities of global finance requires more than regulatory reform: It calls for deeper thinking about new private and public international players and markets.

Lessons from the Oxford and Cambridge Boat Race

Mark de Rond Reprint: F0809B

After 180 years of competitive rowing, the Cambridge University Boat Club has a tried-and-true method for assembling teams: It tests different athletes in different combinations to identify not just the best rowers, but the best groupings of them. Try taking a page from that playbook as you put together your next high-performance business team.

Start Thinking About Carbon Assets--Now

Alex Rau and Robert Toker Reprint: F0809C

If you're afraid to involve your company in the carbon-credit market, the prospect of delaying your participation should scare you more. The authors' guide to the basics about carbon assets will assuage your fears by arming you with facts.

The Best Advice I Ever Got

Linda Mason Reprint: F0809D

The chairman and founder of Bright Horizons Family Solutions heeded the wisdom of visionary real estate developer James Rouse: Make your passions central to your life. By doing that, she has created a highly successful company with employees who are driven by its mission to give children the best possible start in life.

Prevent Disasters in Design Outsourcing

Jason Amaral and Geoffrey Parker Reprint: F0809E

When outsourcing the design of a platform-based product, avoid three common perils: misaligned objectives, unanticipated rivalry between design partners, and poor version control. If you don't elude these dangers, your planned cost savings--and even your entire platform--could be in jeopardy.

A Conversation with Thorkil Sonne Reprint: F0809F

This Danish entrepreneur shares widely applicable lessons from his experience managing employees with autism. More than two-thirds of workers at his software-testing firm, Specialisterne, have the condition and are thriving in their jobs.

Put Your Data to Work in the Marketplace

Thomas C. Redman Reprint: F0809G

Most companies underutilize their data assets, but sometimes they figure out how to leverage them to satisfy marketplace demands. The author outlines nine ways to create new value from your data.

Reviews

Featuring Buying In: The Secret Dialogue Between What We Buy and Who We Are, by Rob Walker HBR Case Study

Don't Try This Offshore

Stephen Brown Reprint: R0809A

Since the mid-1990s, management-metaphor boutique Serendipity Associates (SA) has been offering clients sizzling similes and snappy sound bites. But the head of SA, Barton Brady, gets word that someone is now poaching in his territory. It's the low-rent operation Tropes R Us, which has started offshoring production to Ireland and will soon flood the market with high-quality, low-cost metaphors. Does this move confirm Brady's fear that the U.S. is losing its competitive edge in right-brain work? Four experts comment on this fictional case study.

Daniel H. Pink, an author and consultant, says SA should move to higher ground--to find new ways to differentiate itself on the basis of right-brain capabilities that will be difficult to offshore. Doing this, he writes, requires an education system that nurtures creativity.

John Chuang, CEO of talent consulting firm Aquent, writes that Brady could rally U.S. citizens to protest the country's current immigration policy, which makes it difficult for companies to import top talent. Brady should also broaden the definition of SA's business.

Richard Phelps, a human resource executive at PricewaterhouseCoopers, argues that contrary to the prevailing view of many in the West, workers in emerging economies are equal to the demands of creative work. SA should assemble the best right brains on the planet and either hire them or contract with them to represent the SA brand.

Charlie Wrench, the CEO of brand and design consulting firm Landor Associates, advises Brady not to worry about his country--which Wrench believes will continue to attract a disproportionate share of the world's creative talent--but about his multinational clients, who need service providers to display a powerful combination of right-brain and left-brain skills. Features

Making Sense of Ambiguous Evidence

A Conversation with Documentary Filmmaker Errol Morris Reprint: R0809B

The information that top managers receive is rarely unfiltered. Unpopular opinions are censored. Partisan views are veiled as objective arguments. Honest mistakes are made. The manager is then left to sort it all out and come to a wise conclusion.

Few people know how to get an accurate read on a situation like documentarian Errol Morris. He is the award-winning director of such films as The Thin Blue Line and this year's Standard Operating Procedure, an exploration of the elusive truth behind the infamous photographs taken at Abu Ghraib prison. The Guardian has ranked him among the world's top 10 directors, crediting him with "a forensic mind" and "a painter's eye."

In this article, Morris talks with HBR's Lisa Burrell about how he sorts through ambiguous evidence and contradictory views to arrive at the real story. "I don't believe in the postmodern notion that there are different kinds of truth," he says. "There is one objective reality, period." Getting to it requires keeping your mind open to all kinds of evidence--not just the parts that fit with your first impressions or developing opinions--and, often, far more investigation than one would think.

If finding the truth is a matter of perseverance, convincing people of it is something of an art, one with which Morris has had much experience not only as a documentarian but also as a highly sought-after director of TV ads for companies like Apple, Citibank, Adidas, and Toyota. He holds up John Kerry's 2004 bid for the U.S. presidency as a cautionary tale: Kerry struck voters as inauthentic when he emphasized only his military service and failed to account for his subsequent war protest. Morris would have liked to interview him speaking in his own words--natural, unscripted material--so that his humanity, which seemed to get lost in the campaign, could emerge.

Social Intelligence and the Biology of Leadership

Daniel Goleman and Richard Boyatzis Reprint: R0809E

A decade ago in these pages, Goleman published his highly influential article on emotional intelligence and leadership. Now he, a cochair of the Consortium for Research on Emotional Intelligence in Organizations, and Boyatzis, a professor at Case Western, extend Goleman's original concept using emerging research about what happens in the brain when people interact. Social intelligence, they say, is a set of interpersonal competencies, built on specific neural circuits, that inspire people to be effective.

The authors describe how the brain's mirror neurons enable a person to reproduce the emotions she detects in others and, thereby, have an instant sense of shared experience. Organizational studies document this phenomenon in contexts ranging from face-to-face performance reviews to the daily personal interactions that help a leader retain prized talent. Other social neurons include spindle cells, which allow leaders to quickly choose the best way to respond to someone, and oscillators, which synchronize people's physical movements. Great leaders, the authors believe, are those whose behaviors powerfully leverage this complex system of brain interconnectedness.

In a handy chart, the authors share their approach to assessing seven competencies that distinguish socially intelligent from socially unintelligent leaders. Their specific advice to leaders who need to strengthen their social circuitry: Work hard at altering your behavior. They share an example of an executive who became socially smarter by embracing a change program that comprised a 360-degree evaluation, intensive coaching by an organizational psychologist, and long-term collaboration with a mentor. The results: stronger relationships with higher-ups and subordinates, better performance of her unit, and a big promotion.

Seven Ways to Fail Big

Paul B. Carroll and Chunka Mui Reprint: R0809F

What causes companies to fail spectacularly? A recent study of 750 of the biggest U.S. business disasters of the past 25 years reveals that seven popular but risky strategies are often to blame.

Drawing on that extensive research, Carroll, a journalist, and Mui, a fellow at Diamond Management & Technology Consultants, describe seven sirens that lure companies onto the rocks. One is the synergy mirage--hoped-for but nonexistent merger synergies. Group disability insurer Unum unwittingly pursued these when it acquired individual disability insurer Provident, assuming the units could cross-sell each other's products. It turns out they had entirely different sales models and customers. Pseudo-adjacencies also lead companies astray, as school bus operator Laidlaw learned when it spent billions on a move into ambulance services. The firm expected its logistics expertise to carry over but discovered ambulances were not a transportation business but a highly regulated health care business demanding skills it sorely lacked. Faulty financial engineering, stubbornly staying the course, bets on the wrong technology, and rushing to consolidate are all dangerous, too, as Conseco, Kodak, Motorola, and Ames can attest. And a rollup of almost any kind is a high-wire act in which a slight market downturn is all it takes to finish you off.

If the executives at these companies had taken a closer look at history, they might have avoided billions in losses. But even experienced teams can fall into these traps. The best way to safeguard your company against them is to institute a formal strategy review by a devil's advocate panel not involved in strategy development. Its members must have license to ask tough questions, say the authors, who offer guidelines to help panels focus on facts, test assumptions, and bring to light flaws in the strategy that could lead to costly blunders.

The New Arsenal of Risk Management

Kevin Buehler, Andrew Freeman, and Ron Hulme Reprint: R0809G

The global banking system is facing a severe liquidity crisis: In the first half of 2008, major financial institutions wrote off nearly $400 billion, causing banks around the world to initiate emergency measures. Similar crises have occurred within recent memory: Think of S&Ls, the dot-com bust, and Enron. Risk is, quite simply, a fact of corporate life--but because risk-management research has increasingly emphasized mathematical modeling, managers may find it incomprehensible and thus shy away from powerful tools and markets for creating value.

Buehler, Freeman, and Hulme, all with McKinsey, describe the evolution of risk management since the 1970s, show how new markets have changed the landscape in both financial services and the energy sector, and explain what it takes to compete in the current environment. To demonstrate how significant a factor risk can be when incorporated into strategy and organization, they take the case of Goldman Sachs--which, despite its reliance on highly volatile trading revenues, has so far avoided the big write-offs that have afflicted its leading competitors. The authors believe that this is because Goldman takes the antithesis of the typical corporate approach--its culture embraces rather than avoids risk. And, they say, Goldman very efficiently employs all four of the following factors: quantitative professionals, strong oversight, partnership investment, and a clear statement of business principles, with emphasis on preserving the company's reputation.

Staying on the sidelines of risk management may have shielded some companies from crisis, but it has also prevented them from growing as quickly as they might have. In their companion article, "Owning the Right Risks," the authors outline a process that will enable executives in any company to incorporate risk into their strategic decision making.

Owning the Right Risks

Kevin Buehler, Andrew Freeman, and Ron Hulme Reprint: R0809H

In the 1970s a revolution occurred in the field of corporate strategy. A boom in mergers and acquisitions launched new professions in M&A banking, M&A law, and strategy consulting, and companies started to focus on owning businesses in which they had a competitive advantage. At the same time, another revolution occurred in how financial services companies understood, bought, and sold risk--described in the authors' companion article in this issue, "The New Arsenal of Risk Management." Now these two revolutions are coming together to trigger a third in the corporate approach to risk management.

Engineering and dynamically managing a company's risk portfolio has become the organizing principle for strategic choice. When companies focus on the risks for which they are naturally advantaged, they can typically support higher debt levels and save on operating costs. McKinsey's Buehler, Freeman, and Hulme describe five steps to help corporate managers adjust to the third revolution: 1) Identify and understand your major risks; 2) decide which risks are natural; 3) determine your capacity and appetite for risk; 4) embed risk in all decisions and processes, including investment, commercial, financial, and operational; and 5) align governance and organization around risk.

TXU is one company that has already successfully adapted. Following the 2002 deregulation of wholesale and retail electricity markets in the U.S. state of Texas, TXU embarked on an ambitious risk-return restructuring program that relied on sophisticated risk-management tools to quantify its risk capacity. The program led to share price increases that created more than $32 billion in value before the company was taken private in the largest leveraged buyout in history.

How to Protect Your Job in a Recession

Janet Banks and Diane Coutu Reprint: R0809J

As the economy softens, corporate downsizing appears almost inevitable. Don't panic yet, though. While layoff decisions might seem beyond your control, there's plenty you can do to make sure you retain your job.

In this article, Banks, a former HR executive at Chase Manhattan and FleetBoston Financial, and Coutu, an HBR senior editor and former affiliate scholar at the Boston Psychoanalytic Society and Institute, describe how to improve your chances of survival. It's mostly a matter of coolheaded planning, they observe. When cuts loom, the first thing to do is act like a survivor. Be confident and cheerful. Research shows that congeniality trumps competence when push comes to shove. Look to the future by focusing on customers, for without them, no one will have work. Survivors also tend to be versatile; tight budgets demand managers who can wear several hats, so start demonstrating what other capabilities you can offer. If you're, say, a manager who once worked as a teacher, take on a training role.

Remember to be a good corporate citizen: Participation matters now more than ever. It isn't the time to behave as if work is beneath you or to argue for a new title. When one executive's department was folded under the management of a less-experienced colleague, she swallowed her pride and wholeheartedly supported the new hierarchy. Her superiors noticed her commitment and eventually rewarded her with a prestigious appointment.

It's also important to offer leaders hope and realistic solutions. Energize your colleagues around change, like the VP of learning at a firm undergoing major staff reductions did. He organized a humorous in-house radio show that revived spirits and helped management communicate with employees--and ended up with a promotion.

Where Oil-Rich Nations Are Placing Their Bets

Rawi Abdelal, Ayesha Khan, and Tarun Khanna Reprint: R0809K

The combination of the gigantic American trade deficit and the price of oil at more than $125 per barrel (at press time) has created an attendant pool of financial liquidity among oil exporters in the Gulf. And this era of petrodollar surpluses is markedly different from the last one.

In the 1970s, the member states of the Gulf Cooperation Council (GCC)--Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates--outsourced the management of their petrodollars to American and UK bankers. This time around, they have adopted active investment and development strategies: They are investing heavily in large Western organizations as well as in emerging markets in Africa and India. They are spending lavishly at home to establish institutional infrastructures, to create free-trade zones for manufacturing and services, and to build recreational facilities that will attract businesses, skilled knowledge workers, and tourists.

These moves are destined to have long-run effects not just on their local economies but also on regional and international trading, argue Harvard Business School's Abdelal, Khan, and Khanna. In fact, the authors say, the actions of the GCC states are pulling the Gulf closer than it has ever been to the center of the international financial system. In this article, the authors consider how oil exporters' new investment strategies and interests over the next decades will affect the economic landscape in the West, reshape nearby markets in the Middle East, and dramatically reconfigure the GCC home environment itself.

How Pixar Fosters Collective Creativity

Behind Pixar's string of hit movies, says the studio's president, is a peer-driven process for solving problems.

by Ed Catmull

cD- Listen to Ed Catmull discuss managing creativity.

A few years ago, I had lunch with the head of a major motion picture studio, who declared that his central problem was not finding good people--it was finding good ideas. Since then, when giving talks, I've asked audiences whether they agree with him. Almost always there's a 50/50 split, which has astounded me because I couldn't disagree more with the studio executive. His belief is rooted in a misguided view of creativity that exaggerates the importance of the initial idea in creating an original product. And it reflects a profound misunderstanding of how to manage the large risks inherent in producing breakthroughs.

When it comes to producing breakthroughs, both technological and artistic, Pixar's track record is unique. In the early 1990s, we were known as the leading technological pioneer in the field of computer animation. Our years of R&D culminated in the release of Toy Story in 1995, the world's first computer-animated feature film. In the following 13 years, we have released eight other films (A Bug's Life; Toy Story 2; Monsters, Inc.; Finding Nemo; The Incredibles; Cars; Ratatouille; and WALL·E), which also have been blockbusters. Unlike most other studios, we have never bought scripts or movie ideas from the outside. All of our stories, worlds, and characters were created internally by our community of artists. And in making these films, we have continued to push the technological boundaries of computer animation, securing dozens of patents in the process.

While I'm not foolish enough to predict that we will never have a flop, I don't think our success is largely luck. Rather, I believe our adherence to a set of principles and practices for managing creative talent and risk is responsible. Pixar is a community in the true sense of the word. We think that lasting relationships matter, and we share some basic beliefs: Talent is rare. Management's job is not to prevent risk but to build the capability to recover when failures occur. It must be safe to tell the truth. We must constantly challenge all of our assumptions and search for the flaws that could destroy our culture. In the last two years, we've had a chance to test whether our principles and practices are transferable. After Pixar's 2006 merger with the Walt Disney Company, its CEO, Bob Iger, asked me, chief creative officer John Lasseter, and other Pixar senior managers to help him revive Disney Animation Studios. The success of our efforts prompted me to share my thinking on how to build a sustainable creative organization.

What Is Creativity?

People tend to think of creativity as a mysterious solo act, and they typically reduce products to a single idea: This is a movie about toys, or dinosaurs, or love, they'll say. However, in filmmaking and many other kinds of complex product development, creativity involves a large number of people from different disciplines working effectively together to solve a great many problems. The initial idea for the movie--what people in the movie business call "the high concept"--is merely one step in a long, arduous process that takes four to five years.

A movie contains literally tens of thousands of ideas. They're in the form of every sentence; in the performance of each line; in the design of characters, sets, and backgrounds; in the locations of the camera; in the colors, the lighting, the pacing. The director and the other creative leaders of a production do not come up with all the ideas on their own; rather, every single member of the 200- to 250-person production group makes suggestions. Creativity must be present at every level of every artistic and technical part of the organization. The leaders sort through a mass of ideas to find the ones that fit into a coherent whole--that support the story--which is a very difficult task. It's like an archaeological dig where you don't know what you're looking for or whether you will even find anything. The process is downright scary.

Sidebar Icon Taking Risks (Located at the end of this article)

Then again, if we aren't always at least a little scared, we're not doing our job. We're in a business whose customers want to see something new every time they go to the theater. This means we have to put ourselves at great risk. Our most recent film, WALL·E, is a robot love story set in a post-apocalyptic world full of trash. And our previous movie, Ratatouille, is about a French rat who aspires to be a chef. Talk about unexpected ideas! At the outset of making these movies, we simply didn't know if they would work. However, since we're supposed to offer something that isn't obvious, we bought into somebody's initial vision and took a chance.

To act in this fashion, we as executives have to resist our natural tendency to avoid or minimize risks, which, of course, is much easier said than done. In the movie business and plenty of others, this instinct leads executives to choose to copy successes rather than try to create something brand-new. That's why you see so many movies that are so much alike. It also explains why a lot of films aren't very good. If you want to be original, you have to accept the uncertainty, even when it's uncomfortable, and have the capability to recover when your organization takes a big risk and fails. What's the key to being able to recover? Talented people! Contrary to what the studio head asserted at lunch that day, such people are not so easy to find.

What's equally tough, of course, is getting talented people to work effectively with one another. That takes trust and respect, which we as managers can't mandate; they must be earned over time. What we can do is construct an environment that nurtures trusting and respectful relationships and unleashes everyone's creativity. If we get that right, the result is a vibrant community where talented people are loyal to one another and their collective work, everyone feels that they are part of something extraordinary, and their passion and accomplishments make the community a magnet for talented people coming out of schools or working at other places. I know what I'm describing is the antithesis of the free-agency practices that prevail in the movie industry, but that's the point: I believe that community matters.

The Roots of Our Culture

My conviction that smart people are more important than good ideas probably isn't surprising. I've had the good fortune to work alongside amazing people in places that pioneered computer graphics.

At the University of Utah, my fellow graduate students included Jim Clark, who cofounded Silicon Graphics and Netscape; John Warnock, who cofounded Adobe; and Alan Kay, who developed object-oriented programming. We had ample funding (thanks to the U.S. Defense Department's Advanced Research Projects Agency), the professors gave us free rein, and there was an exhilarating and creative exchange of ideas.

At the New York Institute of Technology, where I headed a new computer-animation laboratory, one of my first hires was Alvy Ray Smith, who made breakthroughs in computer painting. That made me realize that it's OK to hire people who are smarter than you are.

Then George Lucas, of Star Wars fame, hired me to head a major initiative at Lucasfilm to bring computer graphics and other digital technology into films and, later, games. It was thrilling to do research within a film company that was pushing the boundaries. George didn't try to lock up the technology for himself and allowed us to continue to publish and maintain strong academic contacts. This made it possible to attract some of the best people in the industry, including John Lasseter, then an animator from Disney, who was excited by the new possibilities of computer animation.

Last but not least, there's Pixar, which began its life as an independent company in 1986, when Steve Jobs bought the computer division from Lucasfilm, allowing us to pursue our dream of producing computer-animated movies. Steve gave backbone to our desire for excellence and helped us form a remarkable management team. I'd like to think that Pixar captures what's best about all the places I've worked. A number of us have stuck together for decades, pursuing the dream of making computer-animated films, and we still have the pleasure of working together today.

It was only when Pixar experienced a crisis during the production of Toy Story 2 that my views on how to structure and operate a creative organization began to crystallize. In 1996, while we were working on A Bug's Life, our second movie, we started to make a sequel to Toy Story. We had enough technical leaders to start a second production, but all of our proven creative leaders--the people who had made Toy Story, including John, who was its director; writer Andrew Stanton; editor Lee Unkrich; and the late Joe Ranft, the movie's head of story--were working on A Bug's Life. So we had to form a new creative team of people who had never headed a movie production. We felt this was OK. After all, John, Andrew, Lee, and Joe had never led a full-length animated film production before Toy Story.

Disney, which at that time was distributing and cofinancing our films, initially encouraged us to make Toy Story 2 as a "direct to video"--a movie that would be sold only as home videos and not shown first in theaters. This was Disney's model for keeping alive the characters of successful films, and the expectation was that both the cost and quality would be lower. We realized early on, however, that having two different standards of quality in the same studio was bad for our souls, and Disney readily agreed that the sequel should be a theatrical release. The creative leadership, though, remained the same, which turned out to be a problem.

In the early stage of making a movie, we draw storyboards (a comic-book version of the story) and then edit them together with dialogue and temporary music. These are called story reels. The first versions are very rough, but they give a sense of what the problems are, which in the beginning of all productions are many. We then iterate, and each version typically gets better and better. In the case of Toy Story 2, we had a good initial idea for a story, but the reels were not where they ought to have been by the time we started animation, and they were not improving. Making matters worse, the directors and producers were not pulling together to rise to the challenge.

Finally A Bug's Life was finished, freeing up John, Andrew, Lee, and Joe to take over the creative leadership of Toy Story 2. Given where the production was at that point, 18 months would have been an aggressive schedule, but by then we had only eight left to deliver the film. Knowing that the company's future depended on them, crew members worked at an incredible rate. In the end, with the new leadership, they pulled it off.

How did John and his team save the movie? The problem was not the original core concept, which they retained. The main character, a cowboy doll named Woody, is kidnapped by a toy collector who intends to ship him to a toy museum in Japan. At a critical point in the story, Woody has to decide whether to go to Japan or try to escape and go back to Andy, the boy who owned him. Well, since the movie is coming from Pixar and Disney, you know he's going to end up back with Andy. And if you can easily predict what's going to happen, you don't have any drama. So the challenge was to get the audience to believe that Woody might make a different choice. The first team couldn't figure out how to do it.

John, Andrew, Lee, and Joe solved that problem by adding several elements to show the fears toys might have that people could relate to. One is a scene they created called "Jessie's story." Jessie is a cowgirl doll who is going to be shipped to Japan with Woody. She wants to go, and she explains why to Woody. The audience hears her story in the emotional song "When She Loved Me": She had been the darling of a little girl, but the girl grew up and discarded her. The reality is kids do grow up, life does change, and sometimes you have to move on. Since the audience members know the truth of this, they can see that Woody has a real choice, and this is what grabs them. It took our "A" team to add the elements that made the story work.

Toy Story 2 was great and became a critical and commercial success--and it was the defining moment for Pixar. It taught us an important lesson about the primacy of people over ideas: If you give a good idea to a mediocre team, they will screw it up; if you give a mediocre idea to a great team, they will either fix it or throw it away and come up with something that works.

Toy Story 2 also taught us another important lesson: There has to be one quality bar for every film we produce. Everyone working at the studio at the time made tremendous personal sacrifices to fix Toy Story 2. We shut down all the other productions. We asked our crew to work inhumane hours, and lots of people suffered repetitive stress injuries. But by rejecting mediocrity at great pain and personal sacrifice, we made a loud statement as a community that it was unacceptable to produce some good films and some mediocre films. As a result of Toy Story 2, it became deeply ingrained in our culture that everything we touch needs to be excellent. This goes beyond movies to the DVD production and extras, and to the toys and other consumer products associated with our characters.

Of course, most executives would at least pay lip service to the notion that they need to get good people and should set their standards high. But how many understand the importance of creating an environment that supports great people and encourages them to support one another so the whole is far greater than the sum of the parts? That's what we are striving to do. Let me share what we've learned so far about what works.

Power to the Creatives

Creative power in a film has to reside with the film's creative leadership. As obvious as this might seem, it's not true of many companies in the movie industry and, I suspect, a lot of others. We believe the creative vision propelling each movie comes from one or two people and not from either corporate executives or a development department. Our philosophy is: You get great creative people, you bet big on them, you give them enormous leeway and support, and you provide them with an environment in which they can get honest feedback from everyone.

After Toy Story 2 we changed the mission of our development department. Instead of coming up with new ideas for movies (its role at most studios), the department's job is to assemble small incubation teams to help directors refine their own ideas to a point where they can convince John and our other senior filmmakers that those ideas have the potential to be great films. Each team typically consists of a director, a writer, some artists, and some storyboard people. The development department's goal is to find individuals who will work effectively together. During this incubation stage, you can't judge teams by the material they're producing because it's so rough--there are many problems and open questions. But you can assess whether the teams' social dynamics are healthy and whether the teams are solving problems and making progress. Both the senior management and the development department are responsible for seeing to it that the teams function well.

To emphasize that the creative vision is what matters most, we say we are "filmmaker led." There are really two leaders: the director and the producer. They form a strong partnership. They not only strive to make a great movie but also operate within time, budget, and people constraints. (Good artists understand the value of limits.) During production, we leave the operating decisions to the film's leaders, and we don't second-guess or micromanage them.

Indeed, even when a production runs into a problem, we do everything possible to provide support without undermining their authority. One way we do this is by making it possible for a director to solicit help from our "creative brain trust" of filmmakers. (This group is a pillar of our distinctive peer-based process for making movies--an important topic I'll return to in a moment.) If this advice doesn't suffice, we'll sometimes add reinforcements to the production--such as a writer or codirector--to provide specific skills or improve the creative dynamics of the film's creative leadership.

What does it take for a director to be a successful leader in this environment? Of course, our directors have to be masters at knowing how to tell a story that will translate into the medium of film. This means that they must have a unifying vision--one that will give coherence to the thousands of ideas that go into a movie--and they must be able to turn that vision into clear directives that the staff can implement. They must set people up for success by giving them all the information they need to do the job right without telling them how to do it. Each person on a film should be given creative ownership of even the smallest task.

Good directors not only possess strong analytical skills themselves but also can harness the analytical power and life experiences of their staff members. They are superb listeners and strive to understand the thinking behind every suggestion. They appreciate all contributions, regardless of where or from whom they originate, and use the best ones.

A Peer Culture

Of great importance--and something that sets us apart from other studios--is the way people at all levels support one another. Everyone is fully invested in helping everyone else turn out the best work. They really do feel that it's all for one and one for all. Nothing exemplifies this more than our creative brain trust and our daily review process.

The brain trust.

This group consists of John and our eight directors (Andrew Stanton, Brad Bird, Pete Docter, Bob Peterson, Brenda Chapman, Lee Unkrich, Gary Rydstrom, and Brad Lewis). When a director and producer feel in need of assistance, they convene the group (and anyone else they think would be valuable) and show the current version of the work in progress. This is followed by a lively two-hour give-and-take discussion, which is all about making the movie better. There's no ego. Nobody pulls any punches to be polite. This works because all the participants have come to trust and respect one another. They know it's far better to learn about problems from colleagues when there's still time to fix them than from the audience after it's too late. The problem-solving powers of this group are immense and inspirational to watch.

Sidebar Icon Getting Real Help (Located at the end of this article)

After a session, it's up to the director of the movie and his or her team to decide what to do with the advice; there are no mandatory notes, and the brain trust has no authority. This dynamic is crucial. It liberates the trust members, so they can give their unvarnished expert opinions, and it liberates the director to seek help and fully consider the advice. It took us a while to learn this. When we tried to export the brain trust model to our technical area, we found at first that it didn't work. Eventually, I realized why: We had given these other review groups some authority. As soon as we said, "This is purely peers giving feedback to each other," the dynamic changed, and the effectiveness of the review sessions dramatically improved.

The origin of the creative brain trust was Toy Story. During a crisis that occurred while making that film, a special relationship developed among John, Andrew, Lee, and Joe, who had remarkable and complementary skills. Since they trusted one another, they could have very intense and heated discussions; they always knew that the passion was about the story and wasn't personal. Over time, as other people from inside and outside joined our directors' ranks, the brain trust expanded to what it is today: a community of master filmmakers who come together when needed to help each other.

The dailies.

This practice of working together as peers is core to our culture, and it's not limited to our directors and producers. One example is our daily reviews, or "dailies," a process for giving and getting constant feedback in a positive way that's based on practices John observed at Disney and Industrial Light & Magic (ILM), Lucasfilm's special-effects company.

At Disney, only a small senior group would look at daily animation work. Dennis Muren, ILM's legendary visual-effects supervisor, broadened the participation to include his whole special-effects crew. (John, who joined my computer group at Lucasfilm after leaving Disney, participated in these sessions while we were creating computer-animated effects for Young Sherlock Holmes.)

As we built up an animation crew for Toy Story in the early 1990s, John used what he had learned from Disney and ILM to develop our daily review process. People show work in an incomplete state to the whole animation crew, and although the director makes decisions, everyone is encouraged to comment.

Sidebar Icon Overcoming Inhibitions (Located at the end of this article)

There are several benefits. First, once people get over the embarrassment of showing work still in progress, they become more creative. Second, the director or creative leads guiding the review process can communicate important points to the entire crew at the same time. Third, people learn from and inspire each other; a highly creative piece of animation will spark others to raise their game. Finally, there are no surprises at the end: When you're done, you're done. People's overwhelming desire to make sure their work is "good" before they show it to others increases the possibility that their finished version won't be what the director wants. The dailies process avoids such wasted efforts.

Technology + Art = Magic

Getting people in different disciplines to treat one another as peers is just as important as getting people within disciplines to do so. But it's much harder. Barriers include the natural class structures that arise in organizations: There always seems to be one function that considers itself and is perceived by others to be the one the organization values the most. Then there's the different languages spoken by different disciplines and even the physical distance between offices. In a creative business like ours, these barriers are impediments to producing great work, and therefore we must do everything we can to tear them down.

Sidebar Icon Pixar's Operating Principles (Located at the end of this article)

Walt Disney understood this. He believed that when continual change, or reinvention, is the norm in an organization and technology and art are together, magical things happen. A lot of people look back at Disney's early days and say, "Look at the artists!" They don't pay attention to his technological innovations. But he did the first sound in animation, the first color, the first compositing of animation with live action, and the first applications of xerography in animation production. He was always excited by science and technology.

At Pixar, we believe in this swirling interplay between art and technology and constantly try to use better technology at every stage of production. John coined a saying that captures this dynamic: "Technology inspires art, and art challenges the technology." To us, those aren't just words; they are a way of life that had to be established and still has to be constantly reinforced. Although we are a director- and producer-led meritocracy, which recognizes that talent is not spread equally among all people, we adhere to the following principles:

Everyone must have the freedom to communicate with anyone.

This means recognizing that the decision-making hierarchy and communication structure in organizations are two different things. Members of any department should be able to approach anyone in another department to solve problems without having to go through "proper" channels. It also means that managers need to learn that they don't always have to be the first to know about something going on in their realm, and it's OK to walk into a meeting and be surprised. The impulse to tightly control the process is understandable given the complex nature of moviemaking, but problems are almost by definition unforeseen. The most efficient way to deal with numerous problems is to trust people to work out the difficulties directly with each other without having to check for permission.

It must be safe for everyone to offer ideas.

We're constantly showing works in progress internally. We try to stagger who goes to which viewing to ensure that there are always fresh eyes, and everyone in the company, regardless of discipline or position, gets to go at some point. We make a concerted effort to make it safe to criticize by inviting everyone attending these showings to e-mail notes to the creative leaders that detail what they liked and didn't like and explain why.

We must stay close to innovations happening in the academic community.

We strongly encourage our technical artists to publish their research and participate in industry conferences. Publishing may give away ideas, but it keeps us connected with the academic community. This connection is worth far more than any ideas we may have revealed: It helps us attract exceptional talent and reinforces the belief throughout the company that people are more important than ideas.

We try to break down the walls between disciplines in other ways, as well. One is a collection of in-house courses we offer, which we call Pixar University. It is responsible for training and cross-training people as they develop in their careers. But it also offers an array of optional classes--many of which I've taken--that give people from different disciplines the opportunity to mix and appreciate what everyone does. Some (screenplay writing, drawing, and sculpting) are directly related to our business; some (Pilates and yoga) are not. In a sculpting class will be rank novices as well as world-class sculptors who want to refine their skills. Pixar University helps reinforce the mind-set that we're all learning and it's fun to learn together.

Our building, which is Steve Jobs's brainchild, is another way we try to get people from different departments to interact. Most buildings are designed for some functional purpose, but ours is structured to maximize inadvertent encounters. At its center is a large atrium, which contains the cafeteria, meeting rooms, bathrooms, and mailboxes. As a result, everyone has strong reasons to go there repeatedly during the course of the workday. It's hard to describe just how valuable the resulting chance encounters are.

Staying on the Rails

Observing the rise and fall of computer companies during my career has affected me deeply. Many companies put together a phenomenal group of people who produced great products. They had the best engineers, exposure to the needs of customers, access to changing technology, and experienced management. Yet many made decisions at the height of their powers that were stunningly wrongheaded, and they faded into irrelevance. How could really smart people completely miss something so crucial to their survival? I remember asking myself more than once: "If we are ever successful, will we be equally blind?"

Many of the people I knew in those companies that failed were not very introspective. When Pixar became an independent company, I vowed we would be different. I realized that it's extremely difficult for an organization to analyze itself. It is uncomfortable and hard to be objective. Systematically fighting complacency and uncovering problems when your company is successful have got to be two of the toughest management challenges there are. Clear values, constant communication, routine postmortems, and the regular injection of outsiders who will challenge the status quo aren't enough. Strong leadership is also essential--to make sure people don't pay lip service to the values, tune out the communications, game the processes, and automatically discount newcomers' observations and suggestions. Here's a sampling of what we do:

Postmortems.

The first we performed--at the end of A Bug's Life--was successful. But the success of those that followed varied enormously. This caused me to reflect on how to get more out of them. One thing I observed was that although people learn from the postmortems, they don't like to do them. Leaders naturally want to use the occasion to give kudos to their team members. People in general would rather talk about what went right than what went wrong. And after spending years on a film, everybody just wants to move on. Left to their own devices, people will game the system to avoid confronting the unpleasant.

There are some simple techniques for overcoming these problems. One is to try to vary the way you do the postmortems. By definition, they're supposed to be about lessons learned, so if you repeat the same format, you tend to find the same lessons, which isn't productive. Another is to ask each group to list the top five things they would do again and the top five things they wouldn't do. The balance between the positive and the negative helps make it a safer environment. In any event, employ lots of data in the review. Because we're a creative organization, people tend to assume that much of what we do can't be measured or analyzed. That's wrong. Most of our processes involve activities and deliverables that can be quantified. We keep track of the rates at which things happen, how often something has to be reworked, whether a piece of work was completely finished or not when it was sent to another department, and so on. Data can show things in a neutral way, which can stimulate discussion and challenge assumptions arising from personal impressions.

Fresh blood.

Successful organizations face two challenges when bringing in new people with fresh perspectives. One is well-known--the not-invented-here syndrome. The other--the awe-of-the-institution syndrome (an issue with young new hires)--is often overlooked.

The former has not been a problem for us, thank goodness, because we have an open culture: Continually embracing change the way we do makes newcomers less threatening. Several prominent outsiders who have had a big impact on us (in terms of the exciting ideas they introduced and the strong people they attracted) were readily accepted. They include Brad Bird, who directed The Incredibles and Ratatouille; Jim Morris, who headed Industrial Light & Magic for years before joining Pixar as the producer of WALL·E and executive vice president of production; and Richard Hollander, a former executive of the special-effects studio Rhythm & Hues, who is leading an effort to improve our production processes.

The bigger issue for us has been getting young new hires to have the confidence to speak up. To try to remedy this, I make it a practice to speak at the orientation sessions for new hires, where I talk about the mistakes we've made and the lessons we've learned. My intent is to persuade them that we haven't gotten it all figured out and that we want everyone to question why we're doing something that doesn't seem to make sense to them. We do not want people to assume that because we are successful, everything we do is right.

• o o

For 20 years, I pursued a dream of making the first computer-animated film. To be honest, after that goal was realized--when we finished Toy Story--I was a bit lost. But then I realized the most exciting thing I had ever done was to help create the unique environment that allowed that film to be made. My new goal became, with John, to build a studio that had the depth, robustness, and will to keep searching for the hard truths that preserve the confluence of forces necessary to create magic. In the two years since Pixar's merger with Disney, we've had the good fortune to expand that goal to include the revival of Disney Animation Studios. It has been extremely gratifying to see the principles and approaches we developed at Pixar transform this studio. But the ultimate test of whether John and I have achieved our goals is if Pixar and Disney are still producing animated films that touch world culture in a positive way long after we two, and our friends who founded and built Pixar with us, are gone. Taking Risks

Pixar's customers expect to see something new every time. That's downright scary. But if Pixar's executives aren't always a little scared, they're not doing their jobs.

Getting Real Help

Pixar's brain trust of directors offers advice on works in progress. But the production's leaders decide what to use and what to ignore.

Overcoming Inhibitions

Showing unfinished work each day liberates people to take risks and try new things because it doesn't have to be perfect the first time.

Pixar's Operating Principles

1. Everyone must have the freedom to communicate with anyone.

2. It must be safe for everyone to offer ideas.

3. We must stay close to innovations happening in the academic community.

Social Intelligence and the Biology of Leadership

New studies of the brain show that leaders can improve group performance by understanding the biology of empathy.

by Daniel Goleman and Richard Boyatzis

cD- Watch an interview with Daniel Goleman.

cD- Join the discussion with Annie McKee about social and emotional intelligence.

In 1998, one of us, Daniel Goleman, published in these pages his first article on emotional intelligence and leadership. The response to "What Makes a Leader?" was enthusiastic. People throughout and beyond the business community started talking about the vital role that empathy and self-knowledge play in effective leadership. The concept of emotional intelligence continues to occupy a prominent space in the leadership literature and in everyday coaching practices. But in the past five years, research in the emerging field of social neuroscience--the study of what happens in the brain while people interact--is beginning to reveal subtle new truths about what makes a good leader.

The salient discovery is that certain things leaders do--specifically, exhibit empathy and become attuned to others' moods--literally affect both their own brain chemistry and that of their followers. Indeed, researchers have found that the leader-follower dynamic is not a case of two (or more) independent brains reacting consciously or unconsciously to each other. Rather, the individual minds become, in a sense, fused into a single system. We believe that great leaders are those whose behavior powerfully leverages the system of brain interconnectedness. We place them on the opposite end of the neural continuum from people with serious social disorders, such as autism or Asperger's syndrome, that are characterized by underdevelopment in the areas of the brain associated with social interactions. If we are correct, it follows that a potent way of becoming a better leader is to find authentic contexts in which to learn the kinds of social behavior that reinforce the brain's social circuitry. Leading effectively is, in other words, less about mastering situations--or even mastering social skill sets--than about developing a genuine interest in and talent for fostering positive feelings in the people whose cooperation and support you need.

The notion that effective leadership is about having powerful social circuits in the brain has prompted us to extend our concept of emotional intelligence, which we had grounded in theories of individual psychology. A more relationship-based construct for assessing leadership is social intelligence, which we define as a set of interpersonal competencies built on specific neural circuits (and related endocrine systems) that inspire others to be effective.

The idea that leaders need social skills is not new, of course. In 1920, Columbia University psychologist Edward Thorndike pointed out that "the best mechanic in a factory may fail as a foreman for lack of social intelligence." More recently, our colleague Claudio Fernández-Aráoz found in an analysis of new C-level executives that those who had been hired for their self-discipline, drive, and intellect were sometimes later fired for lacking basic social skills. In other words, the people Fernández-Aráoz studied had smarts in spades, but their inability to get along socially on the job was professionally self-defeating.

Sidebar Icon Do Women Have Stronger Social Circuits? (Located at the end of this article)

What's new about our definition of social intelligence is its biological underpinning, which we will explore in the following pages. Drawing on the work of neuroscientists, our own research and consulting endeavors, and the findings of researchers affiliated with the Consortium for Research on Emotional Intelligence in Organizations, we will show you how to translate newly acquired knowledge about mirror neurons, spindle cells, and oscillators into practical, socially intelligent behaviors that can reinforce the neural links between you and your followers.

Followers Mirror Their Leaders--Literally

Perhaps the most stunning recent discovery in behavioral neuroscience is the identification of mirror neurons in widely dispersed areas of the brain. Italian neuroscientists found them by accident while monitoring a particular cell in a monkey's brain that fired only when the monkey raised its arm. One day a lab assistant lifted an ice cream cone to his own mouth and triggered a reaction in the monkey's cell. It was the first evidence that the brain is peppered with neurons that mimic, or mirror, what another being does. This previously unknown class of brain cells operates as neural Wi-Fi, allowing us to navigate our social world. When we consciously or unconsciously detect someone else's emotions through their actions, our mirror neurons reproduce those emotions. Collectively, these neurons create an instant sense of shared experience.

Mirror neurons have particular importance in organizations, because leaders' emotions and actions prompt followers to mirror those feelings and deeds. The effects of activating neural circuitry in followers' brains can be very powerful. In a recent study, our colleague Marie Dasborough observed two groups: One received negative performance feedback accompanied by positive emotional signals--namely, nods and smiles; the other was given positive feedback that was delivered critically, with frowns and narrowed eyes. In subsequent interviews conducted to compare the emotional states of the two groups, the people who had received positive feedback accompanied by negative emotional signals reported feeling worse about their performance than did the participants who had received good-natured negative feedback. In effect, the delivery was more important than the message itself. And everybody knows that when people feel better, they perform better. So, if leaders hope to get the best out of their people, they should continue to be demanding but in ways that foster a positive mood in their teams. The old carrot-and-stick approach alone doesn't make neural sense; traditional incentive systems are simply not enough to get the best performance from followers.

Here's an example of what does work. It turns out that there's a subset of mirror neurons whose only job is to detect other people's smiles and laughter, prompting smiles and laughter in return. A boss who is self-controlled and humorless will rarely engage those neurons in his team members, but a boss who laughs and sets an easygoing tone puts those neurons to work, triggering spontaneous laughter and knitting his team together in the process. A bonded group is one that performs well, as our colleague Fabio Sala has shown in his research. He found that top-performing leaders elicited laughter from their subordinates three times as often, on average, as did midperforming leaders. Being in a good mood, other research finds, helps people take in information effectively and respond nimbly and creatively. In other words, laughter is serious business.

It certainly made a difference at one university-based hospital in Boston. Two doctors we'll call Dr. Burke and Dr. Humboldt were in contention for the post of CEO of the corporation that ran this hospital and others. Both of them headed up departments, were superb physicians, and had published many widely cited research articles in prestigious medical journals. But the two had very different personalities. Burke was intense, task focused, and impersonal. He was a relentless perfectionist with a combative tone that kept his staff continually on edge. Humboldt was no less demanding, but he was very approachable, even playful, in relating to staff, colleagues, and patients. Observers noted that people smiled and teased one another--and even spoke their minds--more in Humboldt's department than in Burke's. Prized talent often ended up leaving Burke's department; in contrast, outstanding folks gravitated to Humboldt's warmer working climate. Recognizing Humboldt's socially intelligent leadership style, the hospital corporation's board picked him as the new CEO.

The "Finely Attuned" Leader

Great executives often talk about leading from the gut. Indeed, having good instincts is widely recognized as an advantage for a leader in any context, whether in reading the mood of one's organization or in conducting a delicate negotiation with the competition. Leadership scholars characterize this talent as an ability to recognize patterns, usually born of extensive experience. Their advice: Trust your gut, but get lots of input as you make decisions. That's sound practice, of course, but managers don't always have the time to consult dozens of people.

Findings in neuroscience suggest that this approach is probably too cautious. Intuition, too, is in the brain, produced in part by a class of neurons called spindle cells because of their shape. They have a body size about four times that of other brain cells, with an extra-long branch to make attaching to other cells easier and transmitting thoughts and feelings to them quicker. This ultrarapid connection of emotions, beliefs, and judgments creates what behavioral scientists call our social guidance system. Spindle cells trigger neural networks that come into play whenever we have to choose the best response among many--even for a task as routine as prioritizing a to-do list. These cells also help us gauge whether someone is trustworthy and right (or wrong) for a job. Within one-twentieth of a second, our spindle cells fire with information about how we feel about that person; such "thin-slice" judgments can be very accurate, as follow-up metrics reveal. Therefore, leaders should not fear to act on those judgments, provided that they are also attuned to others' moods.

Such attunement is literally physical. Followers of an effective leader experience rapport with her--or what we and our colleague Annie McKee call "resonance." Much of this feeling arises unconsciously, thanks to mirror neurons and spindle-cell circuitry. But another class of neurons is also involved: Oscillators coordinate people physically by regulating how and when their bodies move together. You can see oscillators in action when you watch people about to kiss; their movements look like a dance, one body responding to the other seamlessly. The same dynamic occurs when two cellists play together. Not only do they hit their notes in unison, but thanks to oscillators, the two musicians' right brain hemispheres are more closely coordinated than are the left and right sides of their individual brains.

Firing Up Your Social Neurons

The firing of social neurons is evident all around us. We once analyzed a video of Herb Kelleher, a cofounder and former CEO of Southwest Airlines, strolling down the corridors of Love Field in Dallas, the airline's hub. We could practically see him activate the mirror neurons, oscillators, and other social circuitry in each person he encountered. He offered beaming smiles, shook hands with customers as he told them how much he appreciated their business, hugged employees as he thanked them for their good work. And he got back exactly what he gave. Typical was the flight attendant whose face lit up when she unexpectedly encountered her boss. "Oh, my honey!" she blurted, brimming with warmth, and gave him a big hug. She later explained, "Everyone just feels like family with him."

Unfortunately, it's not easy to turn yourself into a Herb Kelleher or a Dr. Humboldt if you're not one already. We know of no clear-cut methods to strengthen mirror neurons, spindle cells, and oscillators; they activate by the thousands per second during any encounter, and their precise firing patterns remain elusive. What's more, self-conscious attempts to display social intelligence can often backfire. When you make an intentional effort to coordinate movements with another person, it is not only oscillators that fire. In such situations the brain uses other, less adept circuitry to initiate and guide movements; as a result, the interaction feels forced.

The only way to develop your social circuitry effectively is to undertake the hard work of changing your behavior (see "Primal Leadership: The Hidden Driver of Great Performance," our December 2001 HBR article with Annie McKee). Companies interested in leadership development need to begin by assessing the willingness of individuals to enter a change program. Eager candidates should first develop a personal vision for change and then undergo a thorough diagnostic assessment, akin to a medical workup, to identify areas of social weakness and strength. Armed with the feedback, the aspiring leader can be trained in specific areas where developing better social skills will have the greatest payoff. The training can range from rehearsing better ways of interacting and trying them out at every opportunity, to being shadowed by a coach and then debriefed about what he observes, to learning directly from a role model. The options are many, but the road to success is always tough.

How to Become Socially Smarter

To see what social intelligence training involves, consider the case of a top executive we'll call Janice. She had been hired as a marketing manager by a Fortune 500 company because of her business expertise, outstanding track record as a strategic thinker and planner, reputation as a straight talker, and ability to anticipate business issues that were crucial for meeting goals. Within her first six months on the job, however, Janice was floundering; other executives saw her as aggressive and opinionated, lacking in political astuteness, and careless about what she said and to whom, especially higher-ups.

To save this promising leader, Janice's boss called in Kathleen Cavallo, an organizational psychologist and senior consultant with the Hay Group, who immediately put Janice through a 360-degree evaluation. Her direct reports, peers, and managers gave Janice low ratings on empathy, service orientation, adaptability, and managing conflicts. Cavallo learned more by having confidential conversations with the people who worked most closely with Janice. Their complaints focused on her failure to establish rapport with people or even notice their reactions. The bottom line: Janice was adept neither at reading the social norms of a group nor at recognizing people's emotional cues when she violated those norms. Even more dangerous, Janice did not realize she was being too blunt in managing upward. When she had a strong difference of opinion with a manager, she did not sense when to back off. Her "let's get it all on the table and mix it up" approach was threatening her job; top management was getting fed up.

When Cavallo presented this performance feedback as a wake-up call to Janice, she was of course shaken to discover that her job might be in danger. What upset her more, though, was the realization that she was not having her desired impact on other people. Cavallo initiated coaching sessions in which Janice would describe notable successes and failures from her day. The more time Janice spent reviewing these incidents, the better she became at recognizing the difference between expressing an idea with conviction and acting like a pit bull. She began to anticipate how people might react to her in a meeting or during a negative performance review; she rehearsed more-astute ways to present her opinions; and she developed a personal vision for change. Such mental preparation activates the social circuitry of the brain, strengthening the neural connections you need to act effectively; that's why Olympic athletes put hundreds of hours into mental review of their moves.

At one point, Cavallo asked Janice to name a leader in her organization who had excellent social intelligence skills. Janice identified a veteran senior manager who was masterly both in the art of the critique and at expressing disagreement in meetings without damaging relationships. She asked him to help coach her, and she switched to a job where she could work with him--a post she held for two years. Janice was lucky to find a mentor who believed that part of a leader's job is to develop human capital. Many bosses would rather manage around a problem employee than help her get better. Janice's new boss took her on because he recognized her other strengths as invaluable, and his gut told him that Janice could improve with guidance.

Before meetings, Janice's mentor coached her on how to express her viewpoint about contentious issues and how to talk to higher-ups, and he modeled for her the art of performance feedback. By observing him day in and day out, Janice learned to affirm people even as she challenged their positions or critiqued their performance. Spending time with a living, breathing model of effective behavior provides the perfect stimulation for our mirror neurons, which allow us to directly experience, internalize, and ultimately emulate what we observe.

Janice's transformation was genuine and comprehensive. In a sense, she went in one person and came out another. If you think about it, that's an important lesson from neuroscience: Because our behavior creates and develops neural networks, we are not necessarily prisoners of our genes and our early childhood experiences. Leaders can change if, like Janice, they are ready to put in the effort. As she progressed in her training, the social behaviors she was learning became more like second nature to her. In scientific terms, Janice was strengthening her social circuits through practice. And as others responded to her, their brains connected with hers more profoundly and effectively, thereby reinforcing Janice's circuits in a virtuous circle. The upshot: Janice went from being on the verge of dismissal to getting promoted to a position two levels up.

A few years later, some members of Janice's staff left the company because they were not happy--so she asked Cavallo to come back. Cavallo discovered that although Janice had mastered the ability to communicate and connect with management and peers, she still sometimes missed cues from her direct reports when they tried to signal their frustration. With more help from Cavallo, Janice was able to turn the situation around by refocusing her attention on her staff's emotional needs and fine-tuning her communication style. Opinion surveys conducted with Janice's staff before and after Cavallo's second round of coaching documented dramatic increases in their emotional commitment and intention to stay in the organization. Janice and the staff also delivered a 6% increase in annual sales, and after another successful year she was made president of a multibillion-dollar unit. Companies can clearly benefit a lot from putting people through the kind of program Janice completed.

Hard Metrics of Social Intelligence

Our research over the past decade has confirmed that there is a large performance gap between socially intelligent and socially unintelligent leaders. At a major national bank, for example, we found that levels of an executive's social intelligence competencies predicted yearly performance appraisals more powerfully than did the emotional intelligence competencies of self-awareness and self-management. (For a brief explanation of our assessment tool, which focuses on seven dimensions, see the exhibit "Are You a Socially Intelligent Leader?")

Sidebar Icon Are You a Socially Intelligent Leader? (Located at the end of this article)

Social intelligence turns out to be especially important in crisis situations. Consider the experience of workers at a large Canadian provincial health care system that had gone through drastic cutbacks and a reorganization. Internal surveys revealed that the frontline workers had become frustrated that they were no longer able to give their patients a high level of care. Notably, workers whose leaders scored low in social intelligence reported unmet patient-care needs at three times the rate--and emotional exhaustion at four times the rate--of their colleagues who had supportive leaders. At the same time, nurses with socially intelligent bosses reported good emotional health and an enhanced ability to care for their patients, even during the stress of layoffs (see the sidebar "The Chemistry of Stress"). These results should be compulsory reading for the boards of companies in crisis. Such boards typically favor expertise over social intelligence when selecting someone to guide the institution through tough times. A crisis manager needs both.

Sidebar Icon The Chemistry of Stress (Located at the end of this article)

• o o

As we explore the discoveries of neuroscience, we are struck by how closely the best psychological theories of development map to the newly charted hardwiring of the brain. Back in the 1950s, for example, British pediatrician and psychoanalyst D.W. Winnicott was advocating for play as a way to accelerate children's learning. Similarly, British physician and psychoanalyst John Bowlby emphasized the importance of providing a secure base from which people can strive toward goals, take risks without unwarranted fear, and freely explore new possibilities. Hard-bitten executives may consider it absurdly indulgent and financially untenable to concern themselves with such theories in a world where bottom-line performance is the yardstick of success. But as new ways of scientifically measuring human development start to bear out these theories and link them directly with performance, the so-called soft side of business begins to look not so soft after all. Do Women Have Stronger Social Circuits?

People often ask whether gender differences factor into the social intelligence skills needed for outstanding leadership. The answer is yes and no. It's true that women tend, on average, to be better than men at immediately sensing other people's emotions, whereas men tend to have more social confidence, at least in work settings. However, gender differences in social intelligence that are dramatic in the general population are all but absent among the most successful leaders.

When the University of Toledo's Margaret Hopkins studied several hundred executives from a major bank, she found gender differences in social intelligence in the overall group but not between the most effective men and the most effective women. Ruth Malloy of the Hay Group uncovered a similar pattern in her study of CEOs of international companies. Gender, clearly, is not neural destiny. Are You a Socially Intelligent Leader?

To measure an executive's social intelligence and help him or her develop a plan for improving it, we have a specialist administer our behavioral assessment tool, the Emotional and Social Competency Inventory. It is a 360-degree evaluation instrument by which bosses, peers, direct reports, clients, and sometimes even family members assess a leader according to seven social intelligence qualities.

We came up with these seven by integrating our existing emotional intelligence framework with data assembled by our colleagues at the Hay Group, who used hard metrics to capture the behavior of top-performing leaders at hundreds of corporations over two decades. Listed here are each of the qualities, followed by some of the questions we use to assess them.

Empathy

• Do you understand what motivates other people, even those from different backgrounds?
• Are you sensitive to others' needs?

Attunement

• Do you listen attentively and think about how others feel?
• Are you attuned to others' moods?

Organizational Awareness

• Do you appreciate the culture and values of the group or organization?
• Do you understand social networks and know their unspoken norms?

Influence

• Do you persuade others by engaging them in discussion and appealing to their self-interests?
• Do you get support from key people?

Developing Others

• Do you coach and mentor others with compassion and personally invest time and energy in mentoring?
• Do you provide feedback that people find helpful for their professional development?

Inspiration

• Do you articulate a compelling vision, build group pride, and foster a positive emotional tone?
• Do you lead by bringing out the best in people?

Teamwork

• Do you solicit input from everyone on the team?
• Do you support all team members and encourage cooperation? The Chemistry of Stress

When people are under stress, surges in the stress hormones adrenaline and cortisol strongly affect their reasoning and cognition. At low levels, cortisol facilitates thinking and other mental functions, so well-timed pressure to perform and targeted critiques of subordinates certainly have their place. When a leader's demands become too great for a subordinate to handle, however, soaring cortisol levels and an added hard kick of adrenaline can paralyze the mind's critical abilities. Attention fixates on the threat from the boss rather than the work at hand; memory, planning, and creativity go out the window. People fall back on old habits, no matter how unsuitable those are for addressing new challenges.

Poorly delivered criticism and displays of anger by leaders are common triggers of hormonal surges. In fact, when laboratory scientists want to study the highest levels of stress hormones, they simulate a job interview in which an applicant receives intense face-to-face criticism--an analogue of a boss's tearing apart a subordinate's performance. Researchers likewise find that when someone who is very important to a person expresses contempt or disgust toward him, his stress circuitry triggers an explosion by stress hormones and a spike in heart rate of 30 to 40 beats per minute. Then, because of the interpersonal dynamic of mirror neurons and oscillators, the tension spreads to other people. Before you know it, the destructive emotions have infected an entire group and inhibited its performance.

Leaders are themselves not immune to the contagion of stress. All the more reason they should take the time to understand the biology of their emotions.

Seven Ways to Fail Big

Lessons from the most inexcusable business failures of the past 25 years.

by Paul B. Carroll and Chunka Mui

cD- Download an audio slideshow about how to avoid failure.

Businesses rack up losses for lots of reasons--reasons not always under their control. The U.S. airlines can't be faulted for their grounding following the 9/11 attacks, to be sure. But in our recent study of 750 of the most significant U.S. business failures of the past quarter century, we found that nearly half could have been avoided. In most instances, the avoidable fiascoes resulted from flawed strategies--not inept execution, which is where most business literature plants the blame. These flameouts--involving significant investment write-offs, the shuttering of unprofitable lines of business, or bankruptcies--accounted for many hundreds of billions of dollars in losses. Moreover, had the executives in charge taken a look at history, they could have saved themselves and their investors a great deal of trouble. Again and again in our study, seven strategies accounted for failure, and evidence of their inadvisability was there for the asking.

Sidebar Icon About the Research (Located at the end of this article)

Take adjacency moves. Frequently what appears to be an adjacent market turns out to be a different business altogether. Laidlaw, the largest school-bus operator in North America, bought heavily into the ambulance business in the 1990s, figuring its logistics expertise would carry over to that kind of enterprise. It turned out that operating ambulances isn't really a transportation business--it's part of the intricate and highly regulated medical business. Laidlaw struggled with negotiating contracts and collecting payments for its services, before selling off its ambulance units at a considerable loss.

The underlying business moves we discuss here aren't always bad ideas; they've generated a tremendous amount of wealth for some companies. But they are alluring in ways that can tempt executives to disregard danger signals. In this article we'll describe the seven risky strategies and offer advice on how to resist their charms.

The Synergy Mirage

Often a company seeks growth by joining forces with another firm that has complementary strengths. The whole isn't always greater than the sum of its parts, however. Look at the 1999 merger of disability insurers Unum and Provident, which operated in the group and individual markets, respectively. Executives thought that each company's salespeople would be able to sell the other's products, but the two businesses served entirely different customers through different models. Unum's sales reps called on corporations to sell group policies; Provident's crafted sales pitches for individuals. They had different skills and no particular desire to collaborate on cross-selling. Joining the two companies proved costly and complicated. The merger just ended up producing higher prices for everyone and an aggressive posture toward denying claims, which provoked a series of lawsuits that imperiled UnumProvident's reputation and finances. Unum eventually undid the merger, dropping the Provident name and exiting the individual market in 2007. Its stock price plummeted and is still less than half what it was in 1999, and the company continues to cope with class action suits from claimants.

Even when synergies do exist, excitement over them can lead a company astray. Quaker Oats overpaid horribly for Snapple, which it acquired to freshen up a dowdy brand and gain access to Snapple's direct-store-delivery system and network of independent distributors. At the time, analysts warned that the $1.7 billion price might be as much as $1 billion too high. Quaker never dug deep enough to understand Snapple's distributors, who fought efforts to push Gatorade and other Quaker products. Just three years after the acquisition, Quaker sold Snapple for $300 million. Synergies can prove problematic in more subtle ways, too, as when executives focus so much management time and energy on capturing them that they lose out on other, more fruitful opportunities. And clashes of culture, skills, or systems can make it impossible to achieve even synergies that seem easy and obvious.

Faulty Financial Engineering

Aggressive financial practices don't necessarily lead to fraud, but they can be dicey. The stakes are high--brands and reputations and even entire businesses can crumble as a consequence, and corporate officers may be exposed to massive fines and even prison.

If subprime mortgage lenders and the banks that supported them had paid attention to the story of Green Tree Financial, they might have realized how dangerous lending to unqualified buyers was. A darling of both Main Street and Wall Street in the 1990s, Green Tree made its fortunes by offering 30-year mortgages on trailer homes--which depreciate rapidly and can have a life span as short as 10 years. Three years after a $50,000 purchase, a home owner might be stuck with an asset worth $25,000 while owing more than $49,000 in principal. At that point, defaulting starts to look pretty attractive. All the while, Green Tree followed aggressive "gain on sale" accounting methods to record profits, basing its calculations on unrealistic assumptions about defaults and prepayments. With profits based on loan origination, there was also little incentive to qualify buyers.

Attracted by Green Tree's rapid growth, Conseco, an Indiana-based life and health insurer, bought the firm for $6.5 billion in 1998 in the hope of creating a broader financial services company, only to find itself stuck with a house of cards. Conseco ultimately took almost $3 billion in write-offs and special charges related to Green Tree, essentially erasing all profits earned by the unit between 1994 and 2001. CEO Steve Hilbert resigned in April 2000, and Conseco filed for Chapter 11 bankruptcy protection in 2002--reportedly the third-largest bankruptcy in U.S. history at the time.

Sidebar Icon Avoiding Disasters: The Devil's Advocate (Located at the end of this article)

The rise and fall of Green Tree and its ensnarling of Conseco illuminate two problems with financial engineering strategies: First, they can produce flawed products, such as easy-credit mortgages, that attract customers in the short term but expose both buyer and seller to excessive risk over time. Second, they encourage further hopelessly optimistic borrowing to finance more investment. Green Tree's model was elegant in that the firm could borrow short-term funds at low rates and lend at much higher rates--but at the same time preposterous, because the machine seized up as soon as the flaws in the underlying mortgage product became apparent.

Sidebar Icon Questions Every Company Should Ask (Located at the end of this article)

Overly clever financial reporting is also risky, especially when it involves cutting corners to increase profits and deliver better bonuses. Such techniques tend to veer toward fraud, even when outside auditors have blessed them. Like other aggressive practices, they're powerfully addictive: Investors reward increased profits, which leads the company to scramble for even greater creativity.

Stubbornly Staying the Course

Redoubling your investment in your current strategy in response to market signals is a strategy in itself, and it can lead to disaster. Executives too often kid themselves into thinking that a problem isn't so severe or delay any reaction until it is too late. Eastman Kodak stuck to its core in the face of a blatant danger: digital photography. Company executives had made a detailed analysis of the threats posed by digital technology as far back as 1981 (when Sony introduced the first commercial electronic camera, the Mavica) but couldn't shake their attachment to prints and traditional processing. The margins were hard to pass up as well--60% on film, chemicals, and processing, versus 15% on digital products. Digital technology also eliminated the huge recurring revenue stream that came from film and reprints (though some companies--HP and Epson--now profit from recurring revenues from ink cartridges for printers).

This is a common reason companies don't change course: The economics of the new model don't measure up to the economics of the old. Companies also falter because they don't consider all the options. Kodak's executives couldn't fathom a world in which images were evanescent and never printed. The company fought only a rear-guard action against digital cameras and didn't make a big move into the space until the early 2000s. It now has a share of the online photo-posting market, but its hesitation was costly: Over the past decade, Kodak has lost 75% of its stock market value. As of 2007, the company had fewer than a third of the number of employees it had 10 years earlier.

Pager company Mobile Media had even less of an excuse to stand by its strategy, because pagers were essentially a fad that lasted only several years. They were a status symbol in the mid-1990s, when cell phones were still bulky and calls expensive. But even as cellular technology followed Moore's law, Mobile Media acquired other pager companies and focused on designing new-generation technologies that nobody wanted. Following a purge of senior executives, Mobile Media filed for bankruptcy in January 1997. But the brunt of the decline in paging was borne by Arch Communications, which bought Mobile Media in 1999.

It isn't just fast-moving technology companies that fatally ignore new threats. Pillowtex was an old-line company that manufactured pillows, comforters, and towels. It grew steadily for decades--largely through acquisition--and by 1995 reached annual sales of almost half a billion dollars. In 1994, however, the United States began to phase out quotas on imports. Other companies immediately began outsourcing production to developing countries so they could compete with low-price imports, but Pillowtex redoubled its acquisition efforts, hoping that efficiencies from scale would give it an edge. The company's SEC filings from the late 1990s barely mention outsourcing as an option, instead highlighting the $240 million that Pillowtex spent on new, efficient machinery for its U.S. plants in 1998 alone. Two bankruptcies later, the company shut down in 2003 and was liquidated. Although part of the company's rationale for keeping manufacturing in the United States was to protect American workers, 6,450 lost their jobs. The layoff was the largest in the history of the U.S. textile industry.

Pseudo-Adjacencies

Adjacent-market strategies attempt to build on core organizational strengths to expand into a related business--by, say, selling new products to existing customers, or existing products to new customers or through new channels. Such strategies are often sensible; they fueled much of General Electric's growth under Jack Welch. But in our research we found many cases where ill-conceived adjacencies brought down even storied firms. Oglebay Norton, a regional steel provider, is just one example. After 143 years the Cleveland-based company was looking to diversify because steel was in decline. Limestone seemed like a logical choice because Oglebay's shipping business was already hauling it for its steel mills. Limestone is used in steel production to separate impurities, which are removed before molten iron is turned into steel. It has many other industrial uses, especially in production.

Oglebay began buying up limestone quarries, but it lacked a fundamental understanding of the limestone business. For one thing, iron ore was shipped on the Great Lakes, mostly on 1,000-footers, but limestone often needed to be transported on rivers to get closer to customers. That required much smaller vessels, which Oglebay didn't have in its fleet. The company filed for bankruptcy on February 23, 2004, with $440 million of debt, most of which was incurred as part of the push into limestone. It would emerge from bankruptcy but never recover its footing. After selling off its fleet piecemeal to retire its debt, it was acquired by Carmeuse North America.

Four patterns emerged among the failed adjacency moves in our research. The first was that a change in the company's core business, rather than some great opportunity in the adjacent market, drove the move--witness Oglebay Norton's desperation to reduce its reliance on steel. A second was that the company lacked expertise in the adjacent markets, leading it to misjudge acquisitions and mismanage competitive challenges. Avon made this mistake with a move into health care in the early 1980s, including the acquisition of medical-equipment-rental businesses and substance-abuse centers--a strategy justified by its "culture of caring." But these acquisitions did nothing to build on Avon's core asset, its door-to-door sales force, and overlooked the regulatory realities, in which it had no expertise. Avon took a bath. After significant losses, it took a total charge of $545 million for dismantling its health care business in 1988.

The third recipe for disaster was overestimating the strength or importance of the capabilities in a core business. Successful companies are particularly prone to this; their ability to achieve in their own market makes them overly optimistic about their prospects in others. Laidlaw, the school-bus operator, fell victim to this type of thinking when it figured it could leverage its considerable expertise in logistics in the ambulance services business and went on a buying spree. The company suffered big losses in the ambulance business, taking a $1.8 billion write-down on it in 2000.

Finally, adjacency strategies tended to flop when a company overestimated its hold on customers. Just because people buy one service from you doesn't mean they'll buy others. Several utilities seeking to expand in the mid-1980s fell prey to this kind of thinking. When regulators began threatening to cut rates, utilities looked for opportunities in other industries. Some made a classic mistake: They jumped into high-growth markets without having any idea about whether they were qualified to operate in them. They thought they could simply leverage their customer bases and sell them products like life insurance, but they found few buyers.

Bets on the Wrong Technology

The huge rewards for breakthrough products and services understandably inspire many companies to search relentlessly for the next Google or eBay or iPod. Still, in our research we discovered that many technology-dependent strategies were ill-conceived from the get-go. No amount of luck or sophisticated execution could have saved them. To keep pursuing the strategies that produced these failures--some quite spectacular--companies had to go to great lengths to deceive themselves.

Motorola's Iridium satellite-telephone unit--a $5 billion venture that filed for Chapter 11 less than a year after the phone system went live--is widely cited as a failure of execution or marketing. In fact, the failure stemmed from a misguided captivation with technology. The project began in the 1980s to solve a legitimate problem: Cell phones were expensive and lacked global connectivity, and existing satellite alternatives were cumbersome and unreliable. But as Motorola pursued its development plans, it ignored its own engineers' warnings that the ultimate product would share the limitations of early 1980s cellular technology even as cell phones got better and cheaper with every passing year. Motorola was so enamored with its technology that its market research amounted to little more than marketing. For instance, when it asked if customers would like a global portable phone for a "reasonable price," it didn't define "reasonable" as an initial outlay of about $3,000, plus monthly charges and pricey minutes; and its description of a phone that would "fit in your pocket" assumed that your pocket would hold a brick.

Federal Express made a similar mistake in the mid-1980s with Zapmail, a service whereby couriers would pick up paper documents and deliver them to a nearby processing center, where they would be faxed to another processing center, close to the destination, and delivered by courier to the recipient, all within two hours. The price was $35 for up to five pages, with a discount and faster delivery if the customer brought the documents into a FedEx office. At the time, few companies owned fax machines, because they were expensive and transmission quality was often poor. As prices fell and the technology improved rapidly, fax machines proliferated; soon it seemed silly to use FedEx as an intermediary. In 1986, FedEx shut Zapmail down, taking a $340 million pretax write-off after losing $317 million during its two years of service.

Rushing to Consolidate

As industries mature, the number of companies in them diminishes. Holdouts have an incentive to combine and reduce capacity and overhead and gain purchasing and pricing power. Our research shows that it is sometimes better to sit back and let others fumble through consolidation. Though there's more glory in being the buyer, it may be wiser to sell and pocket the cash before industry conditions deteriorate.

Take the demise of Ames Department Stores. The company pioneered the concept of discount retailing in rural areas four years before Sam Walton got into the game. But it got reckless in its attempts to build a national presence. In its zeal to compete with Wal-Mart, Ames made a series of acquisitions, without adequately considering what it would take to win that battle. The moves didn't build on its core strength--merchandising--and exacerbated its greatest weaknesses: back-office systems like accounting. For instance, after Ames acquired discount chain G.C. Murphy in 1985, it suffered an enormous amount of shrinkage (industry speak for theft) because it had no system for checking inventory. Disgruntled Murphy's employees were reportedly stealing goods off delivery trucks and then logging complete shipments into stores. In 1987, Ames lost $20 million worth of merchandise and couldn't tell why. Even as the company struggled to integrate G.C. Murphy, Ames's managers went for another, bigger, takeover--Zayre, for which it paid $800 million, a glaring overpayment. The company filed for bankruptcy in 1990 but recovered, only to make the same mistake again. After struggling with the disastrous acquisition of Hills Department Stores, Ames again filed for bankruptcy in 2000 and was liquidated in 2002.

Consolidation plays are subject to several kinds of errors. For one thing, you may be buying problems along with assets. Ames repeatedly overlooked the fact that many of the stores it bought were damaged goods. For another, increased complexity may lead to diseconomies of scale. Systems that work well for a business of a certain size may break as a company grows. USAir bought Pacific Southwest Air for $385 million in 1987 to expand into the West and then bought archrival Piedmont for $1.6 billion. The company almost tripled in size in a bit more than a year, and its information systems couldn't handle the load. Service suffered, computers repeatedly broke down on payday, and crews were taxed to the limit by their new schedules. Before the merger, USAir and Piedmont had operating profits six to seven percentage points higher than the industry average; after the merger operating profits were 2.6 points below the industry average.

Furthermore, companies may not be able to hold on to customers of a company they buy, especially if they change the value proposition. And last, other options may be preferable to being the industry's consolidator. Ames didn't have to go toe-to-toe with Wal-Mart. It was doing nicely as a regional retailer with a far more limited product line. As far as we can tell, Ames never considered holding on to its position and potentially selling out to Wal-Mart down the line.

Roll-Ups of Almost Any Kind

The notion behind roll-ups is to take dozens, hundreds, or even thousands of small businesses and combine them into a large one with increased purchasing power, greater brand recognition, lower capital costs, and more effective advertising. But research shows that more than two-thirds of roll-ups have failed to create any value for investors.

We were interested to find that many roll-ups were afflicted by fraud--among them, MCI WorldCom, Philip Services, Westar Energy, and Tyco--but we won't focus on those in this article because for the most part the lesson is simply, "Don't do it." Instead, let's look at the fortunes of Loewen Group. Based in Canada, it grew quickly by buying up funeral homes in the U.S. and Canada in the 1970s and 1980s. By 1989, Loewen owned 131 funeral homes; it acquired 135 more the next year. Earnings mounted, and analysts were enthusiastic about the company's prospects given the coming "golden era of death"--the demise of baby boomers.

Yet there wasn't much to be gained from achieving scale. Loewen could realize some efficiencies in areas like embalming, hearses, and receptionists, but only within fairly small geographic proximities. The heavy regulation of the funeral industry also limited economies of scale: Knowing how to comply with the rules in Biloxi doesn't help much in Butte. A national brand has little value, because bereaved customers make choices based on referrals or previous experience, and being perceived as a local neighborhood business is actually an advantage. In fact, Loewen often hid its ownership. And it damaged whatever reputation it did have with its methods of shaming the bereaved into buying more expensive products and services (such as naming its low-end casket the "Welfare Casket").

Nor did increased size improve the company's cost of capital. Funeral homes are steady, low-risk businesses, so they already borrow at low rates. The cost of acquiring and integrating the homes far outweighed the slight scale gains. What's more, the increase in the death rate that Loewen had banked on when buying up companies never happened. Fast-forward several years and the company filed for bankruptcy, after rejecting an attractive bid. (Relaunched under the name Alderwoods, Loewen was sold to the same suitor for about a quarter of the previous offer.)

Often roll-ups cannot sustain their fast rate of acquisition. In the beginning, all that matters is growth--buying a company or two or four a month, with all the cultural and operational issues that accompany a takeover. Investors know that profitability is hard to decipher at this point, so they focus on revenue, and executives know that they don't have to worry about consistent profitability until the roll-up reaches a relatively steady state. Operating costs frequently balloon as a result. Worse, knowing that the company is in buying mode, sellers demand steeper prices. Loewen overpaid for many of its properties. In another case, as Gillett Holdings and others tried to roll up the market for local television stations in the 1980s, the stations began demanding prices equal to 15 times their cash flow. Gillett, which bought 12 stations in 12 months and then acquired a company that owned six more, filed for bankruptcy protection in 1991.

Finally, roll-up strategies often fail to account for tough times, which are inevitable. A roll-up is a financial high-wire act. If companies are purchased with stock, the share price must stay up to keep the acquisitions going. If they're purchased with cash, debt piles up. All it took to finish off Loewen was a small decline in the death rate. For Gillett, it was an unexpected TV ad slump. When you go into a roll-up, you need to know exactly how big a hit you can withstand. If you're financing with debt, what will happen if you have a 10%--or 20% or 50%--decline in cash flow for two years? If you're buying with stock, what if the stock price drops by 50%?

• o o

The vast majority of business research focuses on successful companies, in an effort to generalize from their traits, tactics, or strategies. Executives scrutinize healthy businesses for best practices they might be able to imitate. Our research looks at the data that others tend to ignore: companies that tried to do the same thing as the winners and failed. We know that companies are capable of learning from failure, given the right incentives. Airlines have a better-than-average record on preventing disaster because their own personnel go down with customers. Perhaps that's an overly dramatic example, but we do believe that enormous value lies in learning from companies that have lost millions, if not billions, in pursuit of fundamentally flawed strategies. About the Research

Our research focused on the most significant business failures among U.S. public companies from 1981 through 2005, because reporting requirements ensured uniformity and access to data, while the universe of companies was large enough for us to generalize results. We defined "failure" as a significant investment write-off, a shutdown of an unprofitable line of business, or a bankruptcy.

Working with leading information vendors, including Reuters, Thomson Financial, and Bankruptcy.com, we built a database of more than 2,500 failures. We also did a literature search to find failures that didn't show up in databases--for instance, companies that sold themselves before having to account for a major problem. Aided by researchers from Diamond Management & Technology Consultants, we narrowed the field to the 750 most meaningful cases: bankruptcies of companies with at least $500 million in assets in the last quarter before bankruptcy and write-offs and discontinued operations greater than $100 million (excluding write-offs for in-process research and development). Our analysis revealed that strategy had been the key factor behind failure in 355. To identify the red flags that might have alerted management to impending failure, we also turned to personal interviews, court documents, local newspaper coverage, and business-school cases. Avoiding Disasters: The Devil's Advocate

Devising a new strategy is heady stuff, and decision makers can quickly lose their objectivity. Even companies that have strong internal safeguards against failure can overlook the questions that might uncover unfounded assumptions, unattainable forecasts, untreated deal fever, or otherwise flawed thinking. Steve Hilbert, the Conseco CEO who acquired Green Tree Financial, had a rigorous acquisition process and a crack team, both honed by dozens of deals over almost two decades. Yet he paid an exorbitant premium for a company that was clearly imperiled, in spite of outright skepticism from investors and analysts. Any internal doubts were either muffled or unheeded, which just underscores how hard it is to tell a CEO that his rousing vision (in Hilbert's case, creating a financial services Wal-Mart) is flawed.

That's why we recommend that companies institute a formal review by a devil's advocate who is truly separate from the strategy-development process and has explicit license to ask tough questions. The deal process of Pitney Bowes, the mail management company that has acquired more than 80 companies since 2000, includes two reviews by people who were not personally involved in the early planning. (See the sidebar, "Questions Every Company Should Ask," for the type of queries that can produce useful insights.) Of course, CEOs often encourage questions merely for the sake of appearances and may strike back at naysayers, so the internal devil's advocate model has its limits.

Setting up a final line of defense--a rigorous "last chance" hearing by an objective, independent panel--will counter that problem. It's best to convene the panel toward the end of the strategy-formulation process, to keep it separate from that process, but before it's too late to turn back. Some companies successfully use a devil's advocate review earlier to build consensus or even use it after an acquisition to identify potential problems. Our research uncovered some guiding principles that ensure constructive discourse, no matter when the review takes place.

Make the process transparent to the board--with limits. CEOs may resist this approach on the grounds that it invites directors to meddle with their authority. Transparency is usually more palatable to CEOs, however, if everyone involved understands the distinction between governance and management. As long as boards don't attempt to take over the management of the business, they have every right to understand and react to CEOs' decisions. Some CEOs have even used the independent review as a tool for getting the board's buy-in to an otherwise controversial strategy.

Establish a limited charter and clear ground rules. The company should define explicit parameters for the scope and conduct of the panel and the ultimate use of its findings, to keep the discussion from ranging too far and uncomfortable findings from being buried. Ground rules will also discourage panel members from coming in with their own agendas.

Panelists should set aside their own preconceptions of the "right" answer and should stay in the real world, rather than compare strategies with some model of perfection, because almost no strategy could bear up to such scrutiny. The goal is to figure out whether the strategy is the best alternative, warts and all.

The conduct of the review itself should be restrained. The devil's advocate is not an inquisition, and the managers who designed the strategy will feel defensive as it is. The review should explore facts, not feelings, intuition, or emotion, and should focus on aspects of the strategy that are pivotal to its success, not on minor defects.

Organize for success. The credibility and effectiveness of the review hinge on the credibility and position of the review's leader, who should be outside the management hierarchy directly associated with the proposed strategy and have no stake in the outcome of the review. A corporate executive or manager from a different unit might lead a business-unit-level devil's advocate review. An independent board member or some other seasoned outsider familiar with the organization, such as a retired executive with no ax to grind, might lead a corporate-level review.

Panel members should provide a fresh point of view, not replicate existing expertise--the panel is not a smarter set of experts. Good panelists must be able to ask broad and open questions that tease out the systems-level assumptions, issues, and consequences of any strategy. Two personality types often make poor panelists: people who come to quick conclusions and then advocate their own position (the greater the expertise, the greater tendency to fit this profile); and overly empathetic people, who may identify quickly with the managers responsible for the plan and readily accept their assumptions.

Focus on the strategy, not the process. The goal isn't to check that all the right steps were taken. At the end of the day, the strategy will stand on its own, or not.

Reviewers should ask for a detailed written description of the strategy--not spreadsheets and slides. The latter make it easy to gloss over the details and leave much to reader interpretation. Bruce Nolop, Pitney Bowes's former CFO, observed in this magazine, "I've been amazed at how many elements of a deal that seemed clear in PowerPoint can fall apart when they're subjected to prose. In bullet-point format, the rationale for a deal might be summed up in a phrase, such as `cross-selling.' But a memorandum demands clarity about exactly who is cross-selling to whom--and how and why." (See "Rules to Acquire By," September 2007.)

Next examine and test the strategy's underlying assumptions. One such technique is the Strategic Assumptions Surfacing and Testing process, designed by Ian Mitroff, Richard Mason, and Jim Emshoff (and taught to us by Vince Barabba). In it participants organize into groups with divergent experiences and perspectives and go through a process of debate and role-playing that identifies areas where the strategy may be vulnerable.

Deliver questions, not answers. The purpose of the review is not to suggest alternative approaches. The review team might well leave the patient chopped up on the table, if that is warranted. While this might sound harsh, it's important to head off any attempt to replicate the strategy process to provide "better" answers. That's just not possible in the short window of the review. The product of the review should be a report that summarizes and synthesizes the team's discussions and findings.

Come to closure. More than once we've seen leaders exercise the equivalent of a "pocket veto" of a review team's findings. The final call belongs to management, but at the very least, some type of formal response to the work of the team should be built into the process. Questions Every Company Should Ask

Had they tested their strategies by asking a few tough questions, most of the companies in our study could have stopped themselves from making ill-fated moves. These are the issues that devil's advocates, internal and external, should explore.

Is this a realistic strategy for long-term success? One of the companies we studied, Green Tree Financial, prospered in the 1990s by selling 30-year mortgages to unqualified buyers on trailer homes, which depreciate rapidly and may have a life span as short as 10 years. Did anyone ask, Is that a sustainable model? Green Tree sold itself at a bloated price to Conseco, which later filed for Chapter 11.

A strategy must be able to stand up to the sunshine: How would it look on the front page of the Wall Street Journal? Such a question might have prevented some cases of fraud or even close calls. Tyco, for instance, probably wouldn't have used such aggressive accounting methods for acquisitions if it had realized they'd be scrutinized by the media. The strategy must also be able to weather storms. Loewen Group attracted numerous investors during its funeral-home acquisition spree but crashed when the death rate tapered off a bit.

What can we learn from history? A thoughtful review of the past might have prevented a number of the failures we explored. When insurer Unum merged with Provident in 1999 in an attempt at synergy--the companies were in the group and individual disability markets, respectively--the move flopped. In their fervor to complete the deal, Unum's executives overlooked the fact that, not long before the merger, Unum had exited the very line of business that Provident was bringing to the table. A devil's advocate might have asked, Why did we get out of the business? Might we draw some lessons about the ability to cross-sell between individual and group disability customers?

A superficial look back can be counterproductive, however. One client we worked with suffered a high-profile failure thanks to an ill-conceived joint venture. For almost a decade afterward, most of its managers immediately rejected any potential partnership. They were looking at history but without nuance and context.

Do vital information and dissenting views about strategies reach decision makers? Our research showed that usually someone in the organization recognized that a strategy was doomed; the information just didn't reach the right person. Plenty of people at Unum had firsthand knowledge of how tough it would be to make a go of it in the personal disability market, yet their concerns either didn't reach or didn't influence strategy makers. And in the late 1980s and early 1990s, many IBM employees knew that OS/2 didn't stand a chance against Windows, yet their convictions didn't get to the top brass. In the end, IBM lost some $2 billion on its OS/2 effort.

Regular communication channels may quash any message challenging the strategy, so companies need to create a system that gets unfiltered opinions straight to the top. Microsoft routinely conducts surveys asking team members for their anonymous predictions about when a product will be delivered. Group leaders know that such surveys can happen at any time, which tends to keep them honest. The surveys don't help Microsoft avoid product delays, but they do give management an accurate picture.

Have we assessed the true advantages--and liabilities--that come with scale? Companies often overestimate the power of scale--it doesn't necessarily deliver presumed advantages, like greater purchasing power--and routinely underestimate the complexities. When they double in size, companies aren't just doing the same thing, twice as often. USAir's acquisitions tripled the company's size in just one year--1987--and completely brought down its information systems.

Have we considered all our options? This question is especially important for companies that stay the course. Kodak, for instance, could have sold itself in the 1980s or 1990s at a far higher valuation than it now has, or it could have moved faster into the digital world, capturing a greater share of sales of cameras and printers and, perhaps, the revenue from picture websites and cell phone cameras. Its principal competitors in film and paper, Agfa and Fuji, made such moves.

Would we bet on it? Gordon Bell, a prominent investor who funds start-ups, is very blunt with executives of firms in his portfolio. For instance, when someone makes predictions for company performance, Bell will zero in on one number and ask the CEO, "Wanna bet? A side bet, you and me, for $1,000." If the CEO gulps, Bell knows he or she has doubts. At least once, when an underperforming CEO didn't take the bet, Bell had him fired. You can take this notion up a notch to engage in prediction markets, set up like a stock market, where people can buy and sell shares reflecting their honest assessment of how a particular plan will play out.

The Risk Revolution | The Tools: The New Arsenal of Risk Management

by Kevin Buehler, Andrew Freeman, and Ron Hulme

Discussions of risk usually come to the forefront in times of crisis but then recede as normalcy returns. As we write, the global banking system is facing a major credit and liquidity crisis. Losses from subprime mortgages, structured investment vehicles, and "covenant lite" loans are creating a credit crunch that may in turn trigger a global slowdown. In the past year major financial institutions have written off nearly $400 billion, and central banks around the world have initiated emergency measures to restore liquidity. Several other crises have occurred within memory: the U.S. savings-and-loan collapse in the 1980s and 1990s, Black Monday in 1987, the Russian debt default and the related dive of Long-Term Capital Management in 1998, the dot-com bust of 2000, and the Enron-led merchant-power collapse of 2001.

The resounding message is that risk is always with us. Executives need to wake up to that fact. Unfortunately, a growing emphasis on mathematical modeling has rendered much of the risk-management debate and research incomprehensible to those outside the finance function and the financial services industry. As a result, many corporate managers have shied away from the powerful risk-management tools and markets created over the past three decades--and thus have forgone considerable opportunities to create value.

Our aim here is to help managers understand both the advantages and the limitations of the markets and tools that are implicated in the credit and liquidity crisis. We will describe the evolution of risk management in recent decades, show how new markets have changed the landscape in both financial services and the energy sector, and explain what it takes to compete in the current environment. These analyses will help readers make sense of the crisis and will illustrate just how powerful a lens risk can be when applied to corporate strategy and organization. In the companion article published in this issue, we describe a process whereby executives in all companies can incorporate risk into their strategic decision making.

The Idea That Changed the World

For the first 70 years of the twentieth century, corporate risk management was largely about buying insurance. Risk management in the financial sector was also rudimentary: Bank regulators lacked tools for measuring risk in the system, so constructive intervention was difficult. Banks themselves had no way to control the interest-rate risk in their loan portfolios or to quantify and manage credit risk--in part because few alternatives to insurance existed. To be sure, some futures and options contracts were written and sold, but reliable tools for pricing them were rare, and the markets for these securities were thin and characterized by wide bid-ask spreads.

The low level of interest in risk management was also to some extent a product of prevailing thought in finance, originating with Franco Modigliani and Merton Miller's "indifference theory," which argued that a company's value was not (in most cases)