LESSON
Number 33
 

The Powerful Leadership System of the World's Biggest Hidden Champion

Manfred J. Hoefle 

There are some major businesses that are little known because they are privately owned and therefore out of the public eye. In the USA, which is dominated by publicly quoted corporations, only a handful of private firms are well-known: these include Cargill, Mars and Gore, plus Dell and Heinz (these two recently delisted from the stock exchange and taken private again). However, very few people have heard of Koch Industries.

An impressive business

The Koch business, headquartered in Wichita, Kansas, was founded in 1940. It operates in oil, chemicals, asphalt, fertilizers, timber, packaging and agriculture. It trades in commodities and also finances its own business deals. Koch Industries is the second-largest private company in the USA (beaten only by Cargill) with sales of 115 billion US dollars in fiscal year 2013. It is bigger than BASF, Siemens, Nestlè, IBM, Proctor & Gamble and Boeing. Koch operates in 50 countries and has around 70,000 employees.

The Koch group, headed by the founder's sons Charles de Ganahl[1] Koch (Chairman and CEO) and David H. Koch (Executive Vice President), has grown at an astonishing pace. It's book value has risen by 2,000 percent or sixteen times faster than the S&P 500 companies index. The Koch brothers own 82 percent of the company. Fortune magazine estimates their individual wealth at 34 billion US dollars, which makes them the sixth richest US citizens.[2]

Charles Koch, who studied chemical engineering at the Massachusetts Institute of Technology (MIT), became head of the then small engineering business at the age of 32, after the death of his father. It was his father who taught him to be modest and hard working[3]. After MIT he continued his education by studying the works of great thinkers in economics: above all the Austrian School of Mises, Hayek and Schumpeter[4]. He also studied economic history, the history of science, psychology, sociology and other fields. His aim was to discover what causes businesses and economies to prosper and discover the root cause of social progress. It is unusual for a young entrepreneur and engineer to spend his free time studying the liberal arts, which are broad, deep and richly textured compared to a regular MBA (now thought essential for aspiring corporate executives).

A business guided by principles

In his book entitled The Science of Success [5], published 2007, Charles G. Koch gives a general introduction to his Leadership System. He describes the objective as "Principled Entrepreneurship": a unique and holistic form of business management, built upon clear principles and years of practical experience. What are the fundamental ideas of this leadership philosophy? What maxims does it follow?

 

Theoretical models as the starting point

Usually progress is achieved by trial and error. Failure is not unusual if you "just think you know what you're doing". Koch concluded that instead you need to get a real idea of what you are doing by using an "Experimental Discovery Method", which enables you to find better solutions. According to Friedrich A. Hayek (1899 -1992) the market economy is just such a discovery method for the creation and exchange of goods.

The Market-Based Management® (MBM®) model developed by Koch is based upon the practical experience, his own and that of others, as well as knowledge of historical developments/events from commerce, economy, culture, politics, government, not-for-profit organizations, science and technology. MBM® is rooted in a theory of human action[6] formulated by Ludwig von Mises (1881-1973) incorporating insights from economics, ethics, management, social philosophy, psychology, biology, anthropology, epistemology and the theory of science.

The key elements of Koch's leadership system are "mental models" as employed by Ludwig von Mises and Michael Polanyi to better understand social, economic and scientific developments. A prerequisite is that these mental models be closely matched to reality – so they are testable and allow meaningful action. Koch uses mental models from economics such as sunk cost (retrospective cost), opportunity cost, the subjective theory of value and comparative advantage. He believes it is important to "embrace change" such as creative destruction, Schumpeter's driver of capitalism/market economy, and to aim for continuous improvement (Kaizen).

The value of such mental models was also recognized by Ralph Waldo Emerson (1803-1882), US philosopher, Unitarian minister and teacher: "The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring principles is sure to have troubles."

The five dimensions of MBM®

For the practical application of MBM a toolbox is provided, a "Decision Making Framework"
(DMF), which can be applied to the following dimensions of business: Vision, Virtue & Talents, Knowledge Processes, Decision Rights and Incentives.

Vision
A sustainable strategy starts by accepting that a business enterprise in a market economy has a superordinate purpose, namely to create value for society. (The underlying mental model here is the self-interest of many combined with the spontaneous order (Hayek and Polanyi) of a market economy.) From this premise Koch derives the primary purpose of enterprises for society, namely to provide greater utility. A prerequisite for achieving this is that a business enterprise must search for new opportunities in order to create value.

To create value an enterprise must develop and apply "Key Capabilities". Koch defines these as: MBM®, Innovation, Operations Excellence, Transaction Excellence, Trading and the Public Sector.

Innovation in all its variants – not just products and processes – is the real key to lasting sustainable success. Here Koch quotes Peter F. Drucker, Innovation and Entrepreneurship, 1993: "Innovation is the specific tool of entrepreneurs, the means by which they exploit change as opportunity for a different business or different service."

Value and Talents
Koch found by observation and practical experience that moral integrity is just as important as talent or expertise; the absence of integrity has caused many company bankruptcies and finance crises.

To make best use of "talents" we must distinguish the various forms of intelligence (according to Howard Gardner[7]) because each has a different learning route. As far as employee development is concerned: first, entrepreneurially outstanding employees should be identified and encouraged, to act as positive examples, secondly, alternative work roles should be found for underperforming staff before, thirdly and finally, the great majority of employees are considered.

After some early painful experiences with business partners, Koch concluded it essential that all partners share the same ideas and attitudes. When entering a business partnership it is best to first agree on rules for dissolving the partnership, should that become necessary.

Integrity, compliance and customer orientation should be aspired to as "Just Conduct" (according to Hayek). The generation, application and sharing of knowledge and experience is a key aspect of behavior. Modesty and respect are also basic attitudes that should be repeatedly exercised.

Knowledge Processes
It is in the best interest of enterprises that the knowledge of employees be collected and utilized by the business as a whole. Several routes must be taken to achieve this: one is to measure and disseminate what employees discover. The evaluation of these discoveries should, wherever possible, be done quantitatively, bearing in mind that a correct assessment is always more important than pedantic exactitude. Appropriate methods for this are marginal analysis, benchmarking and estimated opportunity cost (what should be achieved with available resources rather than what has been achieved so far).

Koch Industries is a decentrally managed organization and exceptionally profit-center oriented. Transfer payments (intra-company transactions) are not accounted for at cost price but at market prices.

Freedom of speech plays a major role based on the "Republic of Science" model of Michael Polanyi .[8] (1891-1976), which combines freedom and discipline. This becomes part of a creative "challenge process" to find the best possible solution, which is only possible in a climate of respect and trust. The methods used are brainstorming and compliance audits. A reference point is Albert Einstein's dictum: "Everything should be made as simple as possible, but not simpler."

Decision rights
Decision rights should be handled analogously to property rights. The authority to make decisions must be earned by proof of ability to make right decisions. Only those who can make serially correct choices are granted greater decision-making power, not those who have a title, seniority or academic diplomas. For example, a trader is only authorized to independently hire people after having done so successfully in collaboration with others. Regular reviews are used to reappraise existing decision rights and frequent feedback is given.

Incentives
Incentives should be used in an attempt to prompt employees to become "entrepreneurs guided by principles". A system of incentives presumes a good understanding of human behavior; after all, no two employees are alike. The mental model used here is from Human Action by von Mises, whereby the prerequisites for every action are: 1) dissatisfaction with the status quo, 2) a vision of an improved status, and 3) a belief that such an improved status can be achieved.

The danger posed by false incentives is greatly underestimated (consider the recent collapse of capital markets). Only people of strong character can resist the temptation of false incentives. There are many examples that prove this point and not only from the business world: most people will give in sooner or later. Fixed budgets are one such false incentive and yet they are still widely used by companies. The biggest false incentive of all is short-termism connected to the quarterly earnings of publicly quoted companies. Koch believes it is a crucial advantage of privately owned businesses that they can avoid such traps.

Incentives must not become entitlements. Only earnings actually realized or targets actually reached should be rewarded. In certain cases, payouts should be delayed. In fact, a different compensation system for managers other than those recommended by Hay Group and other 'compensation specialists' is called for. Another of Koch's insights is that work must be meaningful by also contributing to society: this generates a form of recognition that is important for effective employee motivation and is also a spur to perfection; this is often overlooked although it is a basic trait of human behavior and social interaction.

Timeless insights

There are certain insights into human behavior and the proper functioning of organizations that are valid and relevant for most business activities. To internalize and apply these insights is a central task of good leadership:

The future cannot be forecast. Therefore know your own strengths and

  1. seek the best opportunities to apply them.
  2. The biggest mistake is to be afraid of making a mistake.
  3. Concentrate on opportunities and not on problems.
  4. Drive and shape innovation yourself because customers often do not know what is possible.
  5. Cost cutting alone is simplistic, because it ignores other aspects. Fixed budgets are
  6. counterproductive, because they serve organizational objectives and ignore human potential.
  7. Create and use a tailored leadership system (do not copy, buy or be talked into buying one); to continuously develop the leadership system is a fundamental task of business management.

Lessons for business managers

The Koch leadership system is impressive: it has evolved from a wealth of personal knowledge, was expanded based on wide-ranging observation, and tested by extensive practical experience. Compared to many pre-fabricated, fragmentary or trendy management & leadership systems, MBM is a sturdy tool, self-made by a successful businessman, who first began as a small entrepreneur over 50 years ago.

It is also rooted in the wisdom of exceptional thinkers of the past century: beginning with economists of the Austrian School: Ludwig von Mises, Friedrich A. Hayek and Joseph A. Schumpeter. Further contributors are the Hungarian-British scientist and philosopher Michael Polanyi, Abraham Harold Maslow and Howard Gardner, liberal thinkers Alexis de Tocqueville, Vernon Lomax Smith and Franz Oppenheimer (teacher of the German Chancellor Ludwig Erhard).

The MBM® leadership system is a self-strengthening teaching program that grows in step with the business. It is based on the insight that a process framework is needed to collect experiences and develop ideas about the future, which should be shared so that proven behaviors are passed on to everyone across the Koch business. The purpose of MBM is to promote constructive change throughout Koch Industries. A precondition – and one that Charles G. Koch was keenly aware of – that the system is systematically and consistently applied. That is the role of management – to ensure that MBM is used effectively and flexibly, and not rigidly or superficially.

Lasting values (a culture of virtue) are the solid foundation, while practical rules are the supporting walls of this leadership system. It is a valuable practical guide that deserves recognition well beyond Koch Industries itself.

Manfred J. Hoefle, 8 April 2014

 

Notes
[1] The middle name "de Ganahl" is of maternal lineage from Vorarlberg, Austria. The paternal grandfather came from the Netherlands.
[2] The Koch brothers are conservative-liberal. They are supporters of think-tanks close to the Republicans (above all the Cato Institute and Mercatus Center).
[3] A typical statement by their father was, "Regardless of whether you are an entrepreneur or whether you are an employee of a large company, the absolute prerequisite is that you must know your stuff. There is no substitute for this."
[4] Each of their main works amounts to around 1,000 pages.
[5] Published by John Wiley & Sons, Hoboken, New Jersey. Copyright© 2007 by Koch Industries Inc.
[6] Mises, Ludwig H: Human Action, Chicago, Ill., Regency Co., 1969.
[7] Gardner, Howard: Frames of Mind: The Theory of Multiple Intelligences, Basic Books, New York, 1983.
[8] Polanyi, Michael: Personal Knowledge, The University Press, Chicago, Ill., 1974.
Polanyi uses the analogy of a big jigsaw puzzle with many players where spontaneous order arises through mutual adaption of individual initiatives. He compares the Community of Science to a group of jigsaw puzzle players in close proximity who each contributes to completing the puzzle while keeping a close eye on each other while diligently and tirelessly searching for fitting pieces in cooperation with the others. This approach has proved to be the most effective way of solving complex practical tasks.

[9] In comparison: over the past ten years a leading German conglomerate changed its CEO no less than three times, the organization was restructured also three times, the senior management was widely reshuffled, the Managing Board for a time included several members from outside the corporate group, new management 'subsystems' were introduced with the support of renowned US management consultants (if you cannot do the job you are for, pay others to do it for you), new global strategies drafted, and remuneration rules for the Managing Board modified (again by external consultants) no less than four times.

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