For years, Microsoft’s Outlook has been losing ground to Google’s Gmail and to the e-mail apps integrated into iPhones and other mobile devices. But now the company is trying to inject new life into Outlook, attempting to transform it from a simple e-mail product into a platform that connects users to a multitude of third-party services such as Uber, Yelp, and Evernote. Whether or not the leap from product to platform works is an immensely important question—not just for Microsoft but also for a growing number of businesses built around products or services.

The appeal of such a move is understandable. Products produce a single revenue stream, while platforms—which we define as intermediaries that connect two or more distinct groups of users and enable their direct interaction—can generate many. Indeed, a large number of the world’s most valuable companies by market capitalization in 2015 were platform companies, including five of the top 10 (Apple, Microsoft, Google, Amazon, and Facebook). Although some of those companies started with platforms, many started with products: Amazon launched as a retailer in 1994 and six years later introduced Amazon Marketplace; Google began with a search engine in the mid-1990s and then introduced search advertising in 2000; and Apple created the iPod in 2001 but didn’t move toward a platform until it developed the iTunes Store in 2003 and the App Store in 2008.

Not every company, however, makes the leap successfully. To understand why some enterprises pull it off and others don’t, we studied more than 20 firms that have tried to become platform providers. On the basis of that work, we have identified four steps that can make the difference between effective transformations and failure.

1. Start with a Defensible Product and a Critical Mass of Users

Too many companies believe that a platform move will somehow revive a struggling product. That’s a mistake. A great platform starts with a great product—one that claims a critical mass of customers and provides enough value to keep them from defecting to competitors (in other words, is defensible). The product must also attract enough frequent users to make the potential platform appealing to third parties. After all, no platform can thrive unless it creates value for those third parties.

Consider the case of Qihoo 360 Technology, one of the largest internet firms in China. It started out in 2006 by selling 360 Safe Guard, a security software product. Then Qihoo began giving the product away free—an unusual move at the time—both to build its user base and to capitalize on a unique feature: the antivirus software’s ability to learn and improve. Qihoo’s servers, unlike those of its competitors, not only kept a “blacklist” of malware that 360 Safe Guard had detected, but also compiled a “whitelist” of the safe programs most frequently found on users’ computers. The more users who installed 360 Safe Guard, the more information Qihoo could gather for both lists, and the faster the software could identify viruses and suspicious files when it conducted a scan. The positive feedback loop improved the product with every new user, which in turn attracted more new users.

The broad user base for Qihoo’s core security product proved an immensely valuable asset in creating a new platform. Third-party software firms were eager to make Qihoo a channel for reaching customers, and Qihoo generated profits from connecting them. Qihoo itself also tapped into its user base to introduce and market its own new products. For example, the company used its security software to cross-promote its web browser, and it used its browser to promote its search engine, both of which quickly gained significant market share. Qihoo then created an advertising platform on top of its browser and search engine. Because the company so effectively transformed its early product successes into platforms, competitors had difficulty catching up.

Note that Qihoo’s product defensibility was rooted in a core competency: its ability to leverage strong learning effects. Companies can, of course, take advantage of other core competencies in building defensible products. Apple, for instance, capitalizes on its design capability; Amazon leverages its strength in logistics.

But note, too, that popularity doesn’t necessarily make a product defensible. For example, in 2014 Qihoo introduced the 360 Android Smart Key, a device that plugged into the earphone jack of Android phones, allowing users to control the phone’s flashlight, camera, and other functions by pressing a single button. Qihoo distributed one million Smart Keys free of charge to college students in hopes of building a critical mass of users and converting the device into a platform. Users loved it, but it was not defensible: Competitors such as Xiaomi built similar products, and Google later incorporated similar features into its Android operating system. Qihoo never managed to turn the Smart Key into a platform.

2. Apply a Hybrid Business Model Focused on Creating and Sharing New Value

It has long been assumed that leaders must commit to either a product-based or a platform-based business model, because each demands a particular approach to resource allocation and operations. But we found that firms making successful transitions from product to platform often employ a hybrid model.

In a product business model, firms create value by developing differentiated products for specific customer needs, and they capture value by charging money for those items. In a platform business model, firms create value primarily by connecting users and third parties, and they capture value by charging fees for access to the platform. Platform models bring a shift in emphasis—from meeting specific customer needs to encouraging mass-market adoption in order to maximize the number of interactions, or from product-related sources of competitive advantage (such as product differentiation) to network-related sources of competitive advantage (the network effects of connecting many users and third parties).

A hybrid of the two business models is valuable in part because during the product-to-platform transition, although customers start to derive benefits from the use of third-party products, a firm’s own products often remain the primary attraction. We observed, for example, that users of 360 Safe Guard benefit from the access to many safe third-party software products, but the main draw for them is still 360 Safe Guard. Likewise, Amazon users derive significant value from third-party sellers, but what they prize most is being able to obtain products directly from Amazon. Thus successful product-to-platform transitions require firms to engage in activities to increase the value of the product while also trying to attract third parties. Indeed, Qihoo continued to improve the quality of 360 Safe Guard, even as it gave away free copies and sacrificed millions of dollars in revenue in order to grow the user base.

Hybrids in general can be useful adaptation tools, and hybrid models can be especially useful for transitioning to a platform-based business because they enable firms to identify new opportunities to create and capture value without abandoning their core customers. The stumbling block for most firms attempting the leap from product to platform is a “product mindset” that views the value pie as comparatively fixed and thus leads to a focus on claiming as much of that pie as possible. But if companies instead follow a hybrid model, applying a “platform mindset” on top of a product mindset, they are likely to discover ways to create new value for existing users or nonusers that might not otherwise have been visible.

A case in point.

Consider the computer-game developer Valve, founded in 1996. Valve’s first product, a video game called Half-Life, proved very successful—so much so that external hackers started developing their own modifications to change the game play. These unauthorized “mods” often made the game unstable and created barriers between users who wanted to connect and play against one another. Rather than fight the trend, Valve recognized that there was an unmet demand for an alternative to Half-Life—and thus the potential to create new value. Consequently, the company hired the hackers who had created the most popular mod and encouraged them to turn it into a second game, dubbed Counter-Strike. Still, a growing number of mods continued to create serious problems for Valve users. To fix those, the company distributed patches through an online software channel it created in 2003 called Steam.

Initially Valve included Steam in all the games it sold, but as the number of users swelled, company leaders realized that Steam could be transformed into an online platform to solve a major challenge for all PC game developers: distribution. At the time, most game developers had to ship physical boxes of software to retailers, which was costly and slow. Steam, by contrast, allowed developers to distribute their software titles instantly and at no marginal cost—a value proposition attractive to both gamers and game producers, particularly those producers who did not have access to big-box retailers.

Valve discovered new sources of value by capitalizing on independent developers’ interest in using Steam to distribute their own games. The availability of more and more games drew more and more customers to the platform, including many who had not previously purchased Valve products but who were now downloading Steam and buying various games. Although Valve continues to sell its own software to users, today it makes much more money by taking a small percentage of every sale by other developers.

Turning threats into opportunities.

Shifting from a product mindset to a platform mindset can be downright counterintuitive—indeed, several of the firms we studied discovered new platform opportunities almost by accident and in spite of their own missteps. For example, Lego Mindstorms (the entry-level robotics toy) emerged as a platform only after a Stanford graduate student hacked the robotic-controller code. Lego’s leaders initially had a product-mindset reaction: They sent a cease-and-desist letter to protect the “fixed” value pie. But after some reflection, they saw the hacking as a sign of untapped value on the demand side. If Lego turned the Mindstorms software into a platform, then it could be used as an education or experimentation tool, not just a toy, and the company would sell many more units and bring many more users into the ecosystem. So Lego switched course—and mindset—to embrace a hybrid business model.

Similarly, the first iPhone was a closed-system product with a handful of apps produced by Apple. As it became more popular, hackers began to “jailbreak” the phone so that they could install their own apps. Steve Jobs was initially determined to protect his integrated product ecosystem, and he vigorously opposed opening it to third-party apps. So, like Lego, Apple first reacted to the hacking by going on the defensive: It made the phone’s operating software more secure and threatened to void the warranty if a jailbreak had been applied. Eventually, though, Jobs saw the wisdom in creating a more open platform, and a year after launching the iPhone, Apple opened the App Store. Today the company captures immense value from its hybrid business model, selling its own products and taking a 30% cut of platform sales. The latter amounts to considerable revenue, given that 75 billion apps were downloaded in 2014.

3. Drive Rapid Conversion to the New Platform

A viable product and business model won’t guarantee success. It’s also important to convert users of your products into users of your platform. Three elements are key.

Provide adequate value.

The proposed platform needs to create sufficient new value for customers to start using it. Valve’s Steam and Qihoo’s 360 Safe Guard both accomplished this. SF Express, one of China’s leading parcel delivery services, has not. Facing intense pressure from lower-cost rivals, SF Express in 2014 launched an e-commerce platform connecting its large customer base to third-party merchants. It also opened hundreds of brick-and-mortar stores where shoppers could use tablets to order products from the affiliated merchants. SF Express would then deliver the products to the stores, where consumers could try them and return them immediately if they wished. But people did not flock to the stores; they didn’t see much value in the “try and buy” concept because Chinese retailers already let customers return most merchandise purchased online within seven days.

Stay consistent with your brand.

Companies can accelerate conversion to the new platform by carefully adding new products and services that are consistent with their brands. Qihoo opened an app store to third-party software developers and used its technology to ensure that the apps sold there were free from viruses and malware. This occurred in 2007, when viruses were rampant in the Chinese software market. Many users became more willing to use Qihoo’s security product because it allowed them to download third-party apps virus-free. A positive feedback loop arose: More users attracted more third-party developers to the platform, which in turn attracted more users. Likewise, when Qihoo offered its own browser and search engine to its users, safety was positioned as the core feature of these products. These connected products took advantage of the company’s core capability in security and helped enhance Qihoo’s brand image.

Involve users in improvements.

Firms can actively open pathways for people inside and outside the firm to enhance both the product and the platform. Minecraft launched in 2009 as a stand-alone building-block game, but it’s now a wildly popular platform (which Microsoft acquired in 2014 for $2.5 billion). In addition to releasing a series of updates to increase the product’s appeal (by allowing players to compete against one another, for example, and offering a “survival mode” to make the game more dangerous), the maker of Minecraft also created channels for third parties to contribute their own improvements. For example, it allows third-party developers to create and sell modifications to the game, and in 2012 it even hired some of the most prominent Minecraft modifiers to work with and support other third-party developers in the Minecraft community. In a similar fashion, when Valve noticed that many customers wanted to trade items related to a video game (such as objects discovered as part of a game quest), it added a marketplace within the Steam platform where users could trade and interact, which provided yet another source of revenue.

4. Identify and Act on Opportunities to Deter Competitive Imitation

The product-to-platform transition, like any business model innovation, will invite imitation when it succeeds. One effective way to fend off copycat competitors is to identify and control the openings for value creation.

The case of MakerBot offers a cautionary tale. The company created the first widely adopted desktop 3-D printers and then built on its popular products by introducing a platform called Thingiverse, which allowed users to share or sell designs to be printed. The platform accelerated the adoption of MakerBot’s printers and helped the firm establish itself as the dominant brand in consumer 3-D printing. But MakerBot had used open-source designs to build its original models, and new competitors were able to leverage the same designs to enter the market. Similarly, many of the object designs created for MakerBot use the industry’s standard file format and are compatible with competitors’ 3-D printers. While the company continues to explore opportunities for capturing value from the platform, such as allowing designers to charge fees to those who download their designs, it faces intense competition because it failed to develop proprietary design specs.

Thus when there are opportunities for competitors to quickly imitate a product-to-platform transition, firms should consider which aspects of their platform ecosystems to own and control themselves and which should be offered by third parties. Firms might want to create proprietary standards or direct their equity investment and acquisition activities so as to erect barriers to competitive imitation. They might also consider exclusivity contracts with partners that are in a position to choke competitors’ growth. For example, a platform owner’s exclusive agreement with, say, PayPal, the runaway leader in peer-to-peer payments, could thwart would-be competitors using less popular payment mechanisms.

Finally, because the digital world evolves quickly, platform owners should always be on the lookout for new growth points, and they should be thoughtful about controlling them. Qihoo, for example, gave third-party software developers opportunities to distribute all kinds of applications to users of its security products, but it developed its own web browser and used its default home page to capture value from advertisers. Developing its own search engine and promoting that through its web browser also allowed the company to capture value through search advertising.

The Outlook for Outlook

Let’s get back to Microsoft’s attempt to transform Outlook into a platform. Outlook e-mail clearly has a critical mass of users and some defensibility, thanks to its being bundled with Office Suite and Microsoft Exchange. And Microsoft has had both a product mindset and a platform mindset for years.

Where the transformation may stall is in the third and fourth steps: converting users and cutting off competition. Although Microsoft has added new services to Outlook—PayPal, Uber, Yelp, Evernote, and others—it is not clear that the integrations create enough value to drive rapid user adoption of these services, because they’re all also available as stand-alone apps—and popular ones at that.

Even if Microsoft can drive rapid conversion, it also has to erect barriers to imitation. If the new Outlook platform catches on, what’s to keep Apple and Google from following suit with their e-mail clients? Third parties will want to partner with Apple and Google to attract more users, particularly on mobile devices—an area where Outlook is weak. And although Microsoft has already purchased a few third-party apps (such as Wunderlist, a popular mobile to-do list and task management program) to prevent them from partnering with its competitors, those acquisitions are probably not enough to keep other companies from imitating its strategy successfully. Indeed, Microsoft’s business model innovation could end up benefiting its competitors. Moving from product to platform is treacherous, and how Microsoft—and many others contemplating similar moves—handle the challenges we’ve described will determine their success.

In many ways, online marketplaces are the perfect business model. Since they just facilitate transactions between suppliers and customers rather than take possession of or full responsibility for products or services, they have very low cost structures and very high gross margins—70% for eBay, 60% for Etsy. And network effects make them highly defensible. Alibaba, Craigslist, eBay, and Rakuten are more than 15 years old, but they still dominate their sectors.

Little wonder that entrepreneurs and investors are rushing to build the next eBay or Airbnb or Uber for every imaginable product and service category. In the past 10 years, the number of marketplaces worth more than $1 billion has gone from two—Craigslist and eBay—to more than a dozen in the United States, including Airbnb, Etsy, Groupon, GrubHub Seamless, Lending Club, Lyft, Prosper, Thumbtack, Uber, and Upwork. And that number is expected to double by 2020, according to Greylock Partners, a Silicon Valley venture capital firm where one of us (Simon) is a partner.

Yet online marketplaces remain extremely difficult to build. Most entrepreneurs see it as a chicken-and-egg problem: To attain a critical mass of buyers, you need a critical mass of suppliers—but to attract suppliers, you need a lot of buyers. This challenge does indeed trip up many marketplaces. But even after a marketplace has attracted a critical mass of both buyers and sellers, it’s far from smooth sailing. Our combined experience in evaluating, advising, and investing in hundreds of marketplace businesses (including several mentioned in this article) suggests that other pitfalls can derail marketplaces: growing too fast too early; fostering insufficient trust and safety; resorting to sticks rather than carrots to deter user disintermediation; and regulatory risk. In this article, we discuss how to avoid those hazards.

Growth

Once marketplaces reach a critical inflection point, network effects kick in and growth follows an exponential, rather than linear, trajectory. These network effects also create barriers to entry: Once many buyers and sellers are using a marketplace, it becomes harder for a rival to lure them away. As a result, entrepreneurs often mistakenly assume that they need to reach the exponential growth phase as quickly as possible. But a headlong rush to fast growth is often unnecessary and can even backfire, for several reasons. 

The importance of first-mover advantage for marketplaces is overstated.

Entrepreneurs should really focus on being the first to create a liquid market in their segment. The winning marketplace is the first one to figure out how to enable mutually beneficial transactions between suppliers and buyers—not the first one out of the gate. Indeed, many prominent marketplaces were not first movers: Airbnb was founded more than a decade after VRBO; Alibaba was a second mover in China after eBay; and Uber’s UberX copied Lyft’s peer-to-peer taxi business model.

Why does being the first mover provide less of an advantage than is commonly assumed? The reason is that chasing early growth before a marketplace has proved its value to both buyers and sellers leaves the business vulnerable to competition from later entrants. If either side’s users do not derive significant value on a consistent basis, they will readily jump ship. But when buyers have access to a sufficient selection of products or services at attractive prices and sellers earn attractive profits, neither side has an incentive to go elsewhere, and strong network effects kick in rapidly: More buyers bring more sellers and vice versa.

Groupon and LivingSocial—platforms where retailers sell discounted offerings to consumers—provide a cautionary tale. Both companies expanded aggressively, attracting millions of users and thousands of merchants. Their success, however, was short-lived: Once merchants realized that Groupon and LivingSocial discounts did not bring repeat customers, they began to do business on many competing deal sites. As a result, Groupon’s value fell from $18 billion at the time of its 2011 IPO to less than $2 billion today; LivingSocial filed for an IPO at $10 billion in 2011, withdrew, and was acquired by Amazon. By the end of 2014, it was worth less than $250 million.

Growing too early puts stress on the business model.
A start-up’s initial business model inevitably has flaws that must be fixed. But because growth for marketplaces can be so explosive, it puts much more pressure on the business model than does the more linear growth experienced by regular product or service firms, amplifying the impact of the flaws and making them harder to fix. Indeed, trying to change the model while growing very fast increases the risk of a catastrophic breakdown. Thus, premature growth can actually reduce the probability of reaching the inflection point that triggers exponential growth.

For these reasons, marketplace entrepreneurs should resist the temptation to accelerate growth before figuring out an optimal supply-demand fit—that is, when buyers are as happy to purchase the products or services as providers are to supply them. This may mean waiting much longer than conventional companies do to scale a new offering. For example, Airbnb took two years to figure out exactly how to allow individuals to rent their homes to complete strangers under conditions and at prices that satisfied both parties. (Recall that the initial service was an air mattress and a cooked breakfast. In most cases, this was either not what travelers wanted or not something hosts were willing to offer.)

The wrong type of growth can hurt performance.
Many marketplaces find it tempting to grow through “power sellers”—those who have moved from selling as a hobby or source of supplemental income to running a full-time business on the marketplace. That’s because attracting a few power sellers is more cost-effective than attracting many nonprofessional sellers, and the former tend to be more efficient at carrying out transactions than the latter.

However, growth through power sellers can be undesirable. After building most of its early growth on power sellers, eBay discovered that their dominance forced it to make compromises that favored those sellers but hurt the buyer experience. For example, power sellers demanded the ability to do “bulk listings” (to automate the listing of many products), which was more efficient from the sellers’ point of view. This created problems for eBay: By skewing seller incentives toward commodity goods, bulk listings reduced the diversity of products offered for sale, crowding out unique products and causing the quality of the average listing to go down. Furthermore, bulk listings enabled power sellers to negotiate lower per-listing fees from eBay. Over the years, power sellers came to dominate eBay’s supply side and made it difficult for nonprofessional sellers to compete.

Other types of marketplaces face a similar issue. In the case of Airbnb, multi-property hosts might show pictures of certain apartments on the site but switch travelers to different ones upon arrival to suit the hosts’ planning needs. Or hosts that bought property specifically to list on the site might not provide the authentic experience that travelers seek. As a result, Airbnb may have to place some limits on multi-property hosts, even though that would conceivably negatively impact growth in the short run.

The bottom line: Platforms should resist the temptation to use the industrialization of the supply side to boost growth.

Trust and Safety
By definition, an online marketplace does not directly control the quality of the products or services that are bought and sold on its platform, so it must put mechanisms in place to ensure that participants have little or no fear about conducting business on the site. The goal is to eliminate (or at least minimize) improper behavior, such as abusing rented property, misrepresenting products, and outright fraud.

Ratings-and-reviews systems have been the most widely used mechanism for engendering trust between marketplace participants ever since eBay’s first successful large-scale implementation of such a system, in 1998. Nearly all prominent marketplaces use R&R systems, which typically allow the two sides of the market to rate and review each other by awarding stars (1 to 5), providing text feedback, or both.

However, research shows that these systems rarely build sufficient trust or provide adequate safety on their own. Many online R&R systems suffer from significant biases: People who voluntarily rate a product or service tend to be either very happy or very unhappy with it. This severely undermines the value of the information provided and skews results.

For instance, a recent study estimated that more than 50% of eBay sellers have received positive feedback for 100% of the transactions rated by their buyers, and 90% of sellers have received positive feedback for more than 98% of the transactions rated by their buyers. There are several reasons for this. Many buyers want to be nice, so they leave exceedingly generous reviews. Some fear that sellers will harass them by e-mail if they leave negative feedback. Many unhappy buyers simply leave and do not return to the site. And a few take extreme (and comical) measures: A good example of an R&R system gone awry is the phenomenon of sarcastic reviews on Amazon’s marketplace. Fake reviewers take over the comments for a product or service, awarding 4 or 5 stars and then writing ironically scathing, often hilarious comments.

Even reliable ratings and reviews systems are not enough to overcome potential users’ fears that something bad might happen, especially when the stakes are high. It’s hard to imagine buying or renting cars or houses from complete strangers solely on the basis of positive user reviews. And when things go wrong, users often hold the marketplace at least partly responsible, even though technically it is merely an enabler of transactions. A buyer who has a bad experience may blame the corresponding seller and leave a bad review, but he or she may also blame the marketplace and never return, which hurts all other sellers.

To properly engender trust and overcome fears, marketplaces must go beyond R&R systems and accept some de facto responsibility for transactions. This can take several forms:

Provide insurance to one or both parties in a transaction.
Turo (formerly RelayRides), a marketplace where individuals can rent their cars to other people, offers specially designed insurance policies that provide coverage to both parties. Airbnb now insures hosts against property damage of up to $1 million. Lyft and Uber provide insurance coverage to their drivers for damage done to others.

Vet and certify participants.
Upwork (formerly Elance-oDesk) has developed hundreds of proprietary certification tests that it administers to freelance contractors on its platform to assure buyers that the workers they hire are qualified.

Offer dispute resolution and payment security services.
Airbnb holds the money paid by the traveler in escrow for 24 hours after the traveler has checked in; Alibaba holds the money paid by the buyer in escrow until the buyer confirms receipt of the goods from the seller. And both Airbnb and Alibaba have comprehensive dispute resolution procedures that offer recourse to both sides of the market.  

Disintermediation
Many marketplaces fear that once they facilitate a successful transaction, the buyer and the seller will agree to conduct their subsequent interactions outside the marketplace. This risk is greatest for marketplaces that handle high-value transactions (eBay Motors, Beepi) or recurring transactions (Airbnb, CoachUp, Handy, HourlyNerd, Upwork). But in our experience, entrepreneurs tend to overestimate the threat of disintermediation and choose the wrong approach to prevent it.

The instinct is often to impose penalties, such as temporarily suspending accounts, if attempts to take transactions off a platform are detected. The fact of the matter is that all marketplaces that facilitate high-value or recurring transactions suffer some disintermediation: Some hosts and guests take their transactions off Airbnb, as do some contractors and employers that first connected on Upwork. But we have yet to see a promising marketplace that has been severely hindered—let alone put out of business—by this behavior, and we’ve found that carrots are more effective deterrents than sticks. For example, algorithms for detecting transactions initiated online but completed offline are difficult and costly to implement and can create user resentment.

Participants usually prefer to conduct business in a “well-lit showroom” that reduces search or transaction costs and allows deals to be conducted securely and comfortably. As long as a marketplace provides value, there should be sufficient incentive for one or both sides to conduct all their transactions through the platform. If users find it onerous to do so, then either the marketplace does not create enough value or its fees are too high.

One company that has successful incentives to combat disintermediation is eBay Motors. It provides an automatic purchase-protection service against certain types of fraud (for example, nondelivery of the vehicle), facilitates car inspections through partner shops at discounted rates, and uses its bargaining power to help sellers obtain lower shipping costs. Another example is Upwork. In addition to providing worker certifications, it allows employers to audit and monitor the work being done by contractors in real time. It also allows them to process online payments in many currencies at discounted exchange fees. As these examples show, some of the mechanisms that make transactions safer to conduct also help reduce the risk of disintermediation, killing two birds with one stone.

Regulation
Online marketplaces that provide radically new alternatives to conventional business models test the limits of existing regulatory frameworks almost by definition. They enable new types of transactions, such as peer-to-peer lending or property rentals. As a result, marketplaces face serious regulatory challenges much more frequently than traditional product or service companies do. Should homeowners renting out their properties be subject to hotel taxes? Under what conditions should individuals be allowed to sell rides in their cars? When should marketplaces for services be allowed to treat their service providers as independent contractors and when should they be compelled to treat them as employees?

With respect to regulatory risks, most entrepreneurs have one of two reflexes: ignore them or try to fix everything up front. Neither is a good idea. Unwinding a regulatory problem late tends to be much more difficult than preventing it early. Furthermore, ignoring regulations can generate bad press, which may alienate users. At the other extreme, attempting to clear all regulatory hurdles from the beginning is unrealistic. Regulatory time frames are too long for most young companies to work within, and it is very hard to gain clearance for a business concept that has not yet been proved in the market.

The right approach, not surprisingly, is somewhere in the middle: Strive to engage regulators without breaking stride or slowing down to the decision-making speed of governments. No marketplace we know of has dealt with all its regulatory challenges perfectly, but four interconnected guiding principles—developed by David Hantman, Airbnb’s former head of global public policy—can help.

1. Define yourself before your opposition or the media does.
Marketplace entrepreneurs should develop a clear vision of their business model and find the most positive—yet accurate—way to describe it to the outside world. Then they should engage regulators and the media to ensure that they are understood on their own terms.

2. Pick the time and place to engage with regulators.
Entrepreneurs operating in industries subject to heavy and national regulation should consult an industry attorney before launch in order to fully understand all relevant laws. As soon as their buyer-seller proposition is clear, they should initiate a dialogue with regulators in order to obtain either explicit legal clearance (ideal) or an implicit safe haven (second best) for continuing to develop the service.

The examples of Lending Club and Prosper, the two leading peer-to-peer lending marketplaces in the United States, illustrate the importance of smoothing regulatory frictions before they grind you to a halt. Prosper was launched first, in 2005, followed by Lending Club a year later. Lending Club, however, was first to tackle the difficult regulatory issues. Less than two years after its launch, it established a partnership with an FDIC-insured bank so that the loans it facilitated were subject to  the same borrower protection, fair lending, and disclosure regulations as regular bank loans. In early 2008, it became the first peer-to-peer lending marketplace to voluntarily go through a quiet period during which it did not accept any new lenders and focused on completing its registration with the U.S. Securities and Exchange Commission (SEC) as an issuer of public investment products.

In contrast, Prosper ignored regulatory issues until scrutiny by the SEC forced it, too, to enter a quiet period. The results of these differing approaches were significant: Prosper’s quiet period lasted nine months, whereas Lending Club’s lasted just six. And Lending Club was allowed to continue to serve the borrower side of its marketplace during its quiet period; Prosper had to shut down both the investor and the borrower sides. Lending Club eventually overtook Prosper to become the largest peer-to-peer lending marketplace: In 2012, it made $718 million in loans, compared with $153 million for Prosper.

At the other end of the spectrum, marketplaces operating in spaces that are regulated lightly and only at the city or state level can afford to wait until they reach supply-demand fit in their first city before engaging with regulators. While regulatory issues at the national level are usually a matter of life and death for companies, local regulators are typically less powerful and can be more easily circumvented if necessary.

3. Don’t just say no; offer constructive ideas.
When confronted with regulatory gray areas—an all-too-common occurrence—marketplace entrepreneurs have an opportunity to turn a potentially adversarial relationship with regulators into a partnership. For example, Getaround, the peer-to-peer car rental platform, preempted a collision by working directly with the California state government to enact a law that allows private individuals to rent out their cars to strangers under separate insurance coverage designed for this purpose. Getaround’s approach is remarkable because peer-to-peer car rentals were not explicitly illegal beforehand—meaning that the company incurred a significant risk by drawing regulatory attention to its service.

Even when existing regulations are merely inconvenient for new marketplaces, entrepreneurs should resist the temptation to ignore or thumb their noses at the relevant authorities and strive instead to find an area where their interests align. For example, a major concern for governmental bodies that regulate taxis is ensuring the safety of passengers and drivers. Ridesharing companies should want the same thing. The marketplaces could use their data on driver and passenger identity and on trip times and paths to work constructively with state regulators to create a safer environment than traditional taxi companies provide.

4. Speak softly and carry a big stick.
Entrepreneurs should avoid engaging in acrimonious disputes with regulators; at the same time, they should have effective weapons at their disposal to defend their position. They can use two means of leverage when fighting potentially adverse regulation. The first is the power of satisfied buyers and sellers, who are voters and taxpayers likely to resent government interference with a service they value. To harness the support of users, companies should develop a credible infrastructure for running lobbying campaigns in their own behalf: social media, dedicated websites, and so on. For example, Airbnb helped its San Francisco hosts organize rallies around city hall and testify in public hearings, which eventually swayed the city’s regulators to legalize short-term rentals in people’s homes in 2014 (the “Airbnb law”).

The second lever is tax revenue. Marketplaces that generate sizable revenues for local governments have some leverage in regulatory negotiations. For instance, as part of its ongoing efforts to persuade city governments to legalize its service, Airbnb has offered to collect hotel taxes from its hosts and remit them to local authorities in several cities worldwide. This offer, still pending approval, is clearly a powerful negotiating instrument: According to conservative estimates, the taxable revenue generated by Airbnb hosts was more than $5 billion in 2015. This is an interesting case, since few marketplaces have proactively offered to take responsibility for ensuring that their users pay taxes.

Sometimes, if regulatory uncertainty is unlikely to be resolved in the immediate future (a time frame measured in months for start-ups) and the repercussions of noncompliance are severe, then the right response is to comply with the worst-case scenario, even if that means incurring higher costs. One of the most serious regulatory issues now faced by service marketplaces concerns the legal status of their workers. Several prominent service marketplaces (Handy, Lyft, Postmates, Uber, and Washio) are currently contending with class-action lawsuits that accuse them of improperly classifying their workers as independent contractors rather than employees. The cost implications are substantial:

Changing a worker’s status from independent contractor to employee increases costs by 25% to 40%. While the outcomes of the lawsuits and the corresponding regulation are still uncertain, some marketplace start-ups, including Alfred, Enjoy Technology, Luxe, and Managed by Q, have preempted the issue by voluntarily turning their workers into employees. Early stage start-ups that simply cannot afford to operate under uncertain regulatory status may need to do the same. In most cases, however, an intermediate status somewhere between employee and independent contractor would be the ideal approach.

Online marketplaces are profoundly changing the nature of work and of companies. Since the early days when marketplaces made it possible to sell and buy simple products like PEZ dispensers and handicrafts, the assortment and price range of goods available online has exponentially increased. Over the past five years, platforms for a remarkable variety of task-oriented services have arisen. New technologies such as 3-D printing and virtual reality will continue to open up opportunities for individuals and small firms to directly sell increasingly complex products and services previously provided only by large firms.

The growing number of products and services available through online marketplaces will cause traditional corporate structures to gradually shrink and coexist with overlapping networks of independent workers who come together for limited periods of time to perform specific tasks. The result will be a much more fluid and flexible work environment that empowers both workers and customers. But the challenges of managing growth, building trust and providing safety, minimizing disintermediation, and shaping regulation won’t go away. The solution is not to follow the pack. It is to deeply understand the needs of customers, regulators, and society as a whole and, in a disciplined fashion, become an active player in shaping the future.

Back in 2007 the five major mobile-phone manufacturers—Nokia, Samsung, Motorola, Sony Ericsson, and LG—collectively controlled 90% of the industry’s global profits. That year, Apple’s iPhone burst onto the scene and began gobbling up market share.

By 2015 the iPhone singlehandedly generated 92% of global profits, while all but one of the former incumbents made no profit at all.

How can we explain the iPhone’s rapid domination of its industry? And how can we explain its competitors’ free fall? Nokia and the others had classic strategic advantages that should have protected them: strong product differentiation, trusted brands, leading operating systems, excellent logistics, protective regulation, huge R&D budgets, and massive scale. For the most part, those firms looked stable, profitable, and well entrenched. 

Certainly the iPhone had an innovative design and novel capabilities. But in 2007, Apple was a weak, nonthreatening player surrounded by 800-pound gorillas. It had less than 4% of market share in desktop operating systems and none at all in mobile phones.

As we’ll explain, Apple (along with Google’s competing Android system) overran the incumbents by exploiting the power of platforms and leveraging the new rules of strategy they give rise to. Platform businesses bring together producers and consumers in high-value exchanges. Their chief assets are information and interactions, which together are also the source of the value they create and their competitive advantage.

Understanding this, Apple conceived the iPhone and its operating system as more than a product or a conduit for services. It imagined them as a way to connect participants in two-sided markets—app developers on one side and app users on the other—generating value for both groups. As the number of participants on each side grew, that value increased—a phenomenon called “network effects,” which is central to platform strategy. By January 2015 the company’s App Store offered 1.4 million apps and had cumulatively generated $25 billion for developers.

Apple’s success in building a platform business within a conventional product firm holds critical lessons for companies across industries. Firms that fail to create platforms and don’t learn the new rules of strategy will be unable to compete for long.  

Pipeline to Platform

Platforms have existed for years. Malls link consumers and merchants; newspapers connect subscribers and advertisers. What’s changed in this century is that information technology has profoundly reduced the need to own physical infrastructure and assets. IT makes building and scaling up platforms vastly simpler and cheaper, allows nearly frictionless participation that strengthens network effects, and enhances the ability to capture, analyze, and exchange huge amounts of data that increase the platform’s value to all. You don’t need to look far to see examples of platform businesses, from Uber to Alibaba to Airbnb, whose spectacular growth abruptly upended their industries.

Though they come in many varieties, platforms all have an ecosystem with the same basic structure, comprising four types of players. The owners of platforms control their intellectual property and governance. Providers serve as the platforms’ interface with users. Producers create their offerings, and consumers use those offerings.

To understand how the rise of platforms is transforming competition, we need to examine how platforms differ from the conventional “pipeline” businesses that have dominated industry for decades. Pipeline businesses create value by controlling a linear series of activities—the classic value-chain model. Inputs at one end of the chain (say, materials from suppliers) undergo a series of steps that transform them into an output that’s worth more: the finished product. Apple’s handset business is essentially a pipeline. But combine it with the App Store, the marketplace that connects app developers and iPhone owners, and you’ve got a platform.

As Apple demonstrates, firms needn’t be only a pipeline or a platform; they can be both. While plenty of pure pipeline businesses are still highly competitive, when platforms enter the same marketplace, the platforms virtually always win. That’s why pipeline giants such as Walmart, Nike, John Deere, and GE are all scrambling to incorporate platforms into their models.

The move from pipeline to platform involves three key shifts:

1. From resource control to resource orchestration.
The resource-based view of competition holds that firms gain advantage by controlling scarce and valuable—ideally, inimitable—assets. In a pipeline world, those include tangible assets such as mines and real estate and intangible assets like intellectual property. With platforms, the assets that are hard to copy are the community and the resources its members own and contribute, be they rooms or cars or ideas and information. In other words, the network of producers and consumers is the chief asset.

2. From internal optimization to external interaction.
Pipeline firms organize their internal labor and resources to create value by optimizing an entire chain of product activities, from materials sourcing to sales and service. Platforms create value by facilitating interactions between external producers and consumers. Because of this external orientation, they often shed even variable costs of production. The emphasis shifts from dictating processes to persuading participants, and ecosystem governance becomes an essential skill.

3. From a focus on customer value to a focus on ecosystem value.
Pipelines seek to maximize the lifetime value of individual customers of products and services, who, in effect, sit at the end of a linear process. By contrast, platforms seek to maximize the total value of an expanding ecosystem in a circular, iterative, feedback-driven process. Sometimes that requires subsidizing one type of consumer in order to attract another type.

These three shifts make clear that competition is more complicated and dynamic in a platform world. The competitive forces described by Michael Porter (the threat of new entrants and substitute products or services, the bargaining power of customers and suppliers, and the intensity of competitive rivalry) still apply. But on platforms these forces behave differently, and new factors come into play. To manage them, executives must pay close attention to the interactions on the platform, participants’ access, and new performance metrics.

We’ll examine each of these in turn. But first let’s look more closely at network effects—the driving force behind every successful platform.

The Power of Network Effects
The engine of the industrial economy was, and remains, supply-side economies of scale. Massive fixed costs and low marginal costs mean that firms achieving higher sales volume than their competitors have a lower average cost of doing business. That allows them to reduce prices, which increases volume further, which permits more price cuts—a virtuous feedback loop that produces monopolies. Supply economics gave us Carnegie Steel, Edison Electric (which became GE), Rockefeller’s Standard Oil, and many other industrial era giants.

In supply-side economies, firms achieve market power by controlling resources, ruthlessly increasing efficiency, and fending off challenges from any of the five forces. The goal of strategy in this world is to build a moat around the business that protects it from competition and channels competition toward other firms.

The driving force behind the internet economy, conversely, is demand-side economies of scale, also known as network effects. These are enhanced by technologies that create efficiencies in social networking, demand aggregation, app development, and other phenomena that help networks expand. In the internet economy, firms that achieve higher “volume” than competitors (that is, attract more platform participants) offer a higher average value per transaction. That’s because the larger the network, the better the matches between supply and demand and the richer the data that can be used to find matches. Greater scale generates more value, which attracts more participants, which creates more value—another virtuous feedback loop that produces monopolies. Network effects gave us Alibaba, which accounts for over 75% of Chinese e-commerce transactions; Google, which accounts for 82% of mobile operating systems and 94% of mobile search; and Facebook, the world’s dominant social platform.

The five forces model doesn’t factor in network effects and the value they create. It regards external forces as “depletive,” or extracting value from a firm, and so argues for building barriers against them. In demand-side economies, however, external forces can be “accretive”—adding value to the platform business. Thus the power of suppliers and customers, which is threatening in a supply-side world, may be viewed as an asset on platforms. Understanding when external forces may either add or extract value in an ecosystem is central to platform strategy.

How Platforms Change Strategy
In pipeline businesses, the five forces are relatively defined and stable. If you’re a cement manufacturer or an airline, your customers and competitive set are fairly well understood, and the boundaries separating your suppliers, customers, and competitors are reasonably clear. In platform businesses, those boundaries can shift rapidly, as w e’ll discuss.

Forces within the ecosystem.
Platform participants—consumers, producers, and providers—typically create value for a business. But they may defect if they believe their needs can be met better elsewhere. More worrisome, they may turn on the platform and compete directly with it. Zynga began as a games producer on Facebook but then sought to migrate players onto its own platform. Amazon and Samsung, providers of devices for the Android platform, tried to create their own versions of the operating system and take consumers with them.

The new roles that players assume can be either accretive or depletive. For example, consumers and producers can swap roles in ways that generate value for the platform. Users can ride with Uber today and drive for it tomorrow; travelers can stay with Airbnb one night and serve as hosts for other customers the next. In contrast, providers on a platform may become depletive, especially if they decide to compete with the owner. Netflix, a provider on the platforms of telecommunication firms, has control of consumers’ interactions with the content it offers, so it can extract value from the platform owners while continuing to rely on their infrastructure.

As a consequence, platform firms must constantly encourage accretive activity within their ecosystems while monitoring participants’ activity that may prove depletive. This is a delicate governance challenge that we’ll discuss further.

Forces exerted by ecosystems.
Managers of pipeline businesses can fail to anticipate platform competition from seemingly unrelated industries. Yet successful platform businesses tend to move aggressively into new terrain and into what were once considered separate industries with little warning. Google has moved from web search into mapping, mobile operating systems, home automation, driverless cars, and voice recognition. As a result of such shape-shifting, a platform can abruptly transform an incumbent’s set of competitors. Swatch knows how to compete with Timex on watches but now must also compete with Apple. Siemens knows how to compete with Honeywell in thermostats but now is being challenged by Google’s Nest.

Competitive threats tend to follow one of three patterns. First, they may come from an established platform with superior network effects that uses its relationships with customers to enter your industry. Products have features; platforms have communities, and those communities can be leveraged. Given Google’s relationship with consumers, the value its network provides them, and its interest in the internet of things, Siemens might have predicted the tech giant’s entry into the home-automation market (though not necessarily into thermostats). Second, a competitor may target an overlapping customer base with a distinctive new offering that leverages network effects. Airbnb’s and Uber’s challenges to the hotel and taxi industries fall into this category. The final pattern, in which platforms that collect the same type of data that your firm does suddenly go after your market, is still emerging. When a data set is valuable, but different parties control different chunks of it, competition between unlikely camps may ensue. This is happening in health care, where traditional providers, producers of wearables like Fitbit, and retail pharmacies like Walgreens are all launching platforms based on the health data they own. They can be expected to compete for control of a broader data set—and the consumer relationships that come with it.

Managers of pipeline businesses focus on growing sales. For them, goods and services delivered (and the revenues and profits from them) are the units of analysis. For platforms, the focus shifts to interactions—exchanges of value between producers and consumers on the platform. The unit of exchange (say, a view of a video or a thumbs-up on a post) can be so small that little or no money changes hands. Nevertheless, the number of interactions and the associated network effects are the ultimate source of competitive advantage.

With platforms, a critical strategic aim is strong up-front design that will attract the desired participants, enable the right interactions (so-called core interactions), and encourage ever-more-powerful network effects. In our experience, managers often fumble here by focusing too much on the wrong type of interaction. And the perhaps counterintuitive bottom line, given how much we stress the importance of network effects, is that it’s usually wise to ensure the value of interactions for participants before focusing on volume.

Most successful platforms launch with a single type of interaction that generates high value even if, at first, low volume. They then move into adjacent markets or adjacent types of interactions, increasing both value and volume. Facebook, for example, launched with a narrow focus (connecting Harvard students to other Harvard students) and then opened the platform to college students broadly and ultimately to everyone. LinkedIn launched as a professional networking site and later entered new markets with recruitment, publishing, and other offerings.

Access and governance.
In a pipeline world, strategy revolves around erecting barriers. With platforms, while guarding against threats remains critical, the focus of strategy shifts to eliminating barriers to production and consumption in order to maximize value creation. To that end, platform executives must make smart choices about access (whom to let onto the platform) and governance (or “control”—what consumers, producers, providers, and even competitors are allowed to do there).

Platforms consist of rules and architecture. Their owners need to decide how open both should be. An open architecture allows players to access platform resources, such as app developer tools, and create new sources of value. Open governance allows players other than the owner to shape the rules of trade and reward sharing on the platform. Regardless of who sets the rules, a fair reward system is key. If managers open the architecture but do not share the rewards, potential platform participants (such as app developers) have the ability to engage but no incentives. If managers open the rules and rewards but keep the architecture relatively closed, potential participants have incentives to engage but not the ability.

These choices aren’t fixed. Platforms often launch with a fairly closed architecture and governance and then open up as they introduce new types of interactions and sources of value. But every platform must induce producers and consumers to interact and share their ideas and resources. Effective governance will inspire outsiders to bring valuable intellectual property to the platform, as Zynga did in bringing FarmVille to Facebook. That won’t happen if prospective partners fear exploitation.

Some platforms encourage producers to create high-value offerings on them by establishing a policy of “permissionless innovation.” They let producers invent things for the platform without approval but guarantee the producers will share in the value created. Rovio, for example, didn’t need permission to create the Angry Birds game on the Apple operating system and could be confident that Apple wouldn’t steal its IP. The result was a hit that generated enormous value for all participants on the platform. However, Google’s Android platform has allowed even more innovation to flourish by being more open at the provider layer. That decision is one reason Google’s market capitalization surpassed Apple’s in early 2016 (just as Microsoft’s did in the 1980s).

However, unfettered access can destroy value by creating “noise”—misbehavior or excess or low-quality content that inhibits interaction. One company that ran into this problem was Chatroulette, which paired random people from around the world for webchats. It grew exponentially until noise caused its abrupt collapse. Initially utterly open—it had no access rules at all—it soon encountered the “naked hairy man” problem, which is exactly what it sounds like. Clothed users abandoned the platform in droves. Chatroulette responded by reducing its openness with a variety of user filters.

Most successful platforms similarly manage openness to maximize positive network effects. Airbnb and Uber rate and insure hosts and drivers, Twitter and Facebook provide users with tools to prevent stalking, and Apple’s App Store and the Google Play store both filter out low-quality applications.

Metrics.
Leaders of pipeline enterprises have long focused on a narrow set of metrics that capture the health of their businesses. For example, pipelines grow by optimizing processes and opening bottlenecks; one standard metric, inventory turnover, tracks the flow of goods and services through them. Push enough goods through and get margins high enough, and you’ll see a reasonable rate of return.
As pipelines launch platforms, however, the numbers to watch change. Monitoring and boosting the performance of core interactions becomes critical. Here are new metrics managers need to track:

Interaction failure.
If a traveler opens the Lyft app and sees “no cars available,” the platform has failed to match an intent to consume with supply. Failures like these directly diminish network effects. Passengers who see this message too often will stop using Lyft, leading to higher driver downtimes, which can cause drivers to quit Lyft, resulting in even lower ride availability. Feedback loops can strengthen or weaken a platform.

Engagement.
Healthy platforms track the participation of ecosystem members that enhances network effects—activities such as content sharing and repeat visits. Facebook, for example, watches the ratio of daily to monthly users to gauge the effectiveness of its efforts to increase engagement.

Match quality.
Poor matches between the needs of users and producers weaken network effects. Google constantly monitors users’ clicking and reading to refine how its search results fill their requests.

Negative network effects.
Badly managed platforms often suffer from other kinds of problems that create negative feedback loops and reduce value. For example, congestion caused by unconstrained network growth can discourage participation. So can misbehavior, as Chatroulette found. Managers must watch for negative network effects and use governance tools to stem them by, for example, withholding privileges or banishing troublemakers.

Finally, platforms must understand the financial value of their communities and their network effects. Consider that in 2016, private equity markets placed the value of Uber, a demand economy firm founded in 2009, above that of GM, a supply economy firm founded in 1908. Clearly Uber’s investors were looking beyond the traditional financials and metrics when calculating the firm’s worth and potential. This is a clear indication that the rules have changed.

Because platforms require new approaches to strategy, they also demand new leadership styles. The skills it takes to tightly control internal resources just don’t apply to the job of nurturing external ecosystems.

While pure platforms naturally launch with an external orientation, traditional pipeline firms must develop new core competencies—and a new mindset—to design, govern, and nimbly expand platforms on top of their existing businesses. The inability to make this leap explains why some traditional business leaders with impressive track records falter in platforms. Media mogul Rupert Murdoch bought the social network Myspace and managed it the way he might have run a newspaper—from the top down, bureaucratically, and with a focus more on controlling the internal operation than on fostering the ecosystem and creating value for participants. In time the Myspace community dissipated and the platform withered.

The failure to transition to a new approach explains the precarious situation that traditional businesses—from hotels to health care providers to taxis—find themselves in. For pipeline firms, the writing is on the wall: Learn the new rules of strategy for a platform world, or begin planning your exit.

THE RULE OF 72 is a handy way to peg the years it will take for an investment to double. Take 72 and divide it by the compound interest rate. Earn 8% and you’ll double your money every nine years. Close enough, anyway.

In 1944, 72 years ago, the U.S. gross domestic product was $225 billion (in current dollars). Today it’s approximately $18 trillion. That represents an annual compound growth rate of 2.9%. If the U.S. economy had grown just one percentage point more per year, the rule of 72 says the size would be double what it is today. (Actually, a bit more, when you run the numbers: $37.1 trillion.)

Question: How many more billionaires would the U.S. have in an economy twice as big? How much more investment capital? How much more opportunity for entrepreneurs? With a $37 trillion economy, spread over 320 million people, there’d be no government debt or looming SocialSecurity crisis, state and city pensions would be fully funded, and the country’s infrastructure would be spectacular.

All this would’ve been possible had the political class paid just a wee bit more attention to economic growth over those 72 years. A pox on them for not doing so.

AGE OF THE COMMON BILLIONAIRE

But I digress. Let’s move to the world economy. Today its size is approximately $80 trillion. Last year was a so-so year for growth, but still the GWP (gross world product) grew at 3.4%. That rate of growth predicts a $258 trillion global economy by 2050. Think about that: an economy more than three times as large as today’s. Let’s assume a lower rate of growth, say 3%. That’s still $145 trillion in additional annual production, which will create many thousands of new billionaires. The FORBES Billionaires issue in 2050 will be as thick as a big city’s phone book.

Where should tomorrow’s billionaires seek their fortunes? Because trends are your friends, keep an eye on two megatrends.

– Global population. It’s getting bigger, richer, more urban and older. Global population today is 7.3 billion. The UN predicts 9.7 billion by 2050. But pay special attention to the subtrends within the megatrends. Take the growth of the global middle class. Today that population is around 2 billion. By 2050 this number could, more or less, double. When people move from poverty to the middle class, they want and, therefore, buy things. What do they want? Sanitation.Air-conditioning.Modern housing.Higher-protein diets.The ability to travel. Trillions of dollars will be made serving these needs.

Urban population will grow from 4 billion to 6.3 billion by 2050. Trillions of dollars will be made in the housing and transportation industries.

The world’s older population (people over 65) will grow from today’s 600 million to 1.5 billion or so by 2050. Trillions of dollars will be made in a range of new drugs, medical procedures and health services aimed at meeting the needs of seniors.

– Technology acceleration. In tech circles there’s a robust debate about whether Moore’s Law, which estimates the rate of microchip evolution, is slowing. In a narrow sense it is. The distance between circuits on a chip is already down to the width of several atoms. Cram the circuits much closer and electrons will start jumping the circuits and behave unpredictably. But will technology’s exponential progress then stop?

The futurist Ray Kurzweil thinks not. He points out that the Moore’s Law rate of progress (where digital technology’s capabilities double every 18 to 24 months) predates the silicon era, which began in 1958 with Fairchild Semiconductor’s integrated circuit. Kurzweil claims the exponential era began in the 1890s. He says it will continue after silicon semiconductors have run their course (by the early 2020s), thanks to quantum computing and other already proven concepts.

Kurzweil could be wrong, but that’s not a wager I’d make. It’s never been smart to bet against the rate of technological change. That’s like betting against human ingenuity. Tomorrow’s billionaires will be those who use ingenuity and rapidly evolving technology to transform traditional industries–agriculture, energy, manufacturing, transportation, construction, finance, health care–to serve Earth’s growing population.

Think bigger, richer, more urban and older. Then get there first with the right technology. You might make a future FORBES Billionaires issue.

Imagine an economy without friction—a new world in which labor, information, and money move easily, cheaply, and almost instantly. Psst—it’s here. Is your company ready?

Cars bursting into flames are never a good thing. So when a Tesla Model S ran over a metal object in Kent, Wash., in October 2013 and burst into flames, owners, potential customers, investors, and company executives got worried. When the same thing happened a few weeks later in Smyrna, Tenn., federal regulators opened an investigation. We all know what happens next: a massive recall, costly repairs at dealerships nationwide, and a painful financial hit to the carmaker. Yet none of that occurred. The problem was that the Model S could lower its chassis at highway speed to be more aerodynamic, and if debris hit the car’s battery pack in just the wrong way, it could catch fire. So Tesla beamed a software update to the affected cars, raising ground clearance at highway speed by one inch. The problem went away. Just four months after opening their investigation, the regulators closed it.

Using software and the mobile-phone network, Tesla avoided any need for a recall. It doesn’t have any dealerships; customers can configure and order a car online, and they can test-drive cars at company-owned showrooms. Tesla’s advanced electric technology is simpler than gas or diesel technology, so cars can be built with fewer employees and less capital. Combine those factors and here’s what happens: General Motors creates about $1.85 of market value per dollar of physical assets, while Tesla creates about $11. GM creates $240,000 of market value per employee, while Tesla creates $2.9 million. You don’t get differences like that just by being more efficient. Tesla, though in the same business as GM, is a fundamentally different idea.

GM is changing, but for now it’s still a 20th-century corporation. Tesla is a 21st-century corporation, built for sweeping new realities that change the rules of success. The big theme is the arrival of the long-heralded friction-free economy, a new world in which labor, information, and money move easily, cheaply, and almost instantly. Companies are forming starkly new, more fluid relationships with customers, workers, and owners; are rethinking the role of capital (as traditionally defined), finding they can thrive while owning less and less of it; are creating value in new ways as they reinvent R&D and marketing; and are measuring their performance by new metrics because traditional gauges no longer capture what counts.

Not all 21st-century corporations are glamorous Silicon Valley startups. They can be of any age and in any industry (even cars). Nike is a 21st-century corporation, aggressively reinventing manufacturing with 3D printing and cannily using social media for marketing. General Electric is becoming one, if partly as a result of shareholder frustration and outside pressure. Every company needs to be one.

The new realities begin at capitalism’s foundation, capital. In a friction-free economy, a company doesn’t need nearly as much as it used to. Consider the world’s most valuable company, Apple. Unlike Google  and Microsoft, the second and third most valuable firms, Apple gets most of its revenue from selling physical products. Yet the company says “substantially all” of its products are made by others. Because it can coordinate vastly complex global supply chains, it can pay those firms, mostly Foxconn, to make its products and get them where they need to be on time. Apple has even rented other companies’ servers to host its iCloud service so that it can add or remove capacity easily, paying only for what it needs.

The U.S. government classifies Apple as a manufacturer, and with some 500 brick-and-mortar stores worldwide, its total capital—$172 billion of it, according to the EVA Dimensions consulting firm—is immense. But in traditional models it would need much more. Its achievement is using that capital to stunning effect, creating a market value of $639 billion. By comparison, Exxon Mobil uses far more capital, $304 billion, to create a market value, $330 billion, that’s barely half as much as Apple’s.

Those are companies that make and sell physical stuff. A friction-free economy also enables companies with virtually no physical capital to compete powerfully with capital-heavy incumbents. It’s often observed with wonder that Alibaba  is the world’s most valuable retailer but holds no inventory, that Airbnb is the world’s largest provider of accommodations but owns no real estate, and that Uber is the world’s largest car service but owns no cars. Each has found ingenious ways to take friction out of its industry, connecting buyers and sellers directly and conveniently, enabling new, nearly capital-free business models.

But hold on—actually, those and all 21st-century corporations own tons of capital. Accounting rules just don’t always call it that. There is intellectual capital in the form of software, patents, copyrights, brands, and other knowledge; customer capital in the form of relationships with buyers; and especially human capital. The 21st-century corporation, even if it makes or sells physical products, is above all a human-capital enterprise, which raises a profound question: Who really owns it?

It was obvious long ago that law firms consist almost entirely of human capital, so it’s illegal for them to sell stock to the public; outside stockholders couldn’t own anything of value. Are consulting firms and ad agencies any different? Even companies that own valuable patents or brands may still get most of their value from human capital. What if the hundred smartest people left Starbucks or Johnson & Johnson or Walt Disney, or what if a crazed CEO tried to destroy each company’s titanium-strength culture? In the 21st-century corporation, whether it’s acknowledged or not, employees own most of the assets because they aremost of the assets.

That reality is affecting corporate structure. The number of U.S. corporations increased only modestly and their revenues rose 150% from 1990 to 2008, says the IRS (using the most recent available data), while the number of proprietorships and partnerships, which are owned by their managers, increased far more, and their revenues rose 394%. The 21st-century corporation isn’t always a corporation.

Most businesses will have to create value in new ways or lose out to competitors that do so, often with Internet-enabled business models. The trend is as old as the Internet’s early days, when a slew of web insurance upstarts forced term-life premiums to plunge 50% or more—and when user-friendly hotel- and airline-booking sites put some 18,000 travel agents out of business almost overnight. Now entrepreneurs are extending the trend into physical products in sophisticated ways. Warby Parker sells high-quality eyeglasses for a small fraction of what traditional retailers charge by using a low-friction online model; private investors recently valued the firm at $1.2 billion. Even an industry that seems highly resistant to online disruption, consumer packaged goods, is threatened. Harry’s and Dollar Shave Club, which make and sell men’s grooming products online, are forcing Gillette (owned by Procter & Gamble) to promote its wares on value, not just quality, for the first time.

The trend is especially frightening for even established category leaders because even if they switch to new, low-friction business models, they could still end up smaller and less profitable than they were. That’s because “some tech and tech-enabled firms destroy more value for incumbents than they create for themselves, and many gains are competed away in the form of consumer surplus,” says the McKinsey Global Institute. For example, Microsoft’s Skype service brought in some $2 billion in 2013, yet McKinsey calculates that in that year Skype transferred $37 billion away from old-guard telecom firms to consumers by giving them free or low-cost calls.

Other new business models have similar stories. San Francisco’s taxi regulator reported that the number of fares per licensed cab fell 65% from March 2012 to July 2014 as Uber, Lyft, and others entered the market. Uber is currently valued at $51 billion by its investors. Meanwhile, the cumulative market value of every New York City taxi medallion is less than $13 billion, as Fortune reported in September.

When Airbnb entered Austin, hotel revenue dropped 8% to 10%, say Boston University researchers, and “affected hotels have responded by reducing prices, an impact that benefits all consumers, not just participants in the sharing economy.” Yet the new companies causing the disruptions collect only a fraction of what the incumbent firms lose.

The 21st-century corporation will increasingly be an idea-based business, operating not just in infotech but also in media, finance, pharmaceuticals, and other industries that consume lots of brainpower. McKinsey finds that while “asset-light, idea-intensive sectors” generated 17% of Western companies’ profits in 1999, they generate 31% today. The losers in that shift are capital- and labor-intensive sectors like construction, transportation, utilities, and mining. That doesn’t mean companies in those industries are doomed. As Tesla shows, they may be able to prosper if they’re reimagined.

Or they can succeed if they redefine success. An intensifying source of pressure on companies of all kinds is the rise of competitors willing to sacrifice profits for growth. Frequently they are family-owned or state-owned companies that have achieved massive scale in emerging markets. For example, Alcoa’s recent decision to split into two companies, a high-tech materials business and a commodity aluminum producer, was prompted in part by the cost advantage achieved by giant Chinese aluminum smelters; forced to compete with them, Alcoa’s commodity business was dragging down the whole company. As emerging-market companies increase their share of global business—they’re now about 30% of the Fortune Global 500—the profit pressure will increase.

Further pressure will come from another category of 21st-century corporations that sacrifice profits for growth, those that see vast territories to be grabbed in new-model businesses. Exhibit A is Amazon, which famously reports little or no profit quarter after quarter. Investors agree with CEO Jeff Bezos that the money is better invested in expansion; future profits will be that much greater as a result. The stock recently hit an all-time high.

Some of the deepest rethinking to be done by 21st-century employers will follow from this question: What happens when the labor market becomes friction-free? It’s clearly headed that way, as the rise of the gig economy shows. Companies still employ full-time workers who aren’t really needed full time, but keeping them on staff is easier than constantly hiring and firing. At least it used to be. Now employers are hiring millions of workers worldwide to do information-based work through online marketplaces such as Upwork; each worker is rated by previous employers, and you don’t pay unless you’re satisfied with the work. While much of the work is routine, like language translation, a marketplace called HourlyNerd rents out former consultants and top business-school graduates to help with strategic planning, financial analysis, and other high-level tasks; customers are mostly small and medium-size businesses but have also included giants like General Electric and Microsoft.

Project the trend a few steps further, and the whole model of employment could change fundamentally. Employee-owned businesses are likely to increase, but they’re just one option among many, which may eventually include a far more radical structure. Former Cisco CEO John Chambers said in June that “soon you’ll see huge companies with just two employees—the CEO and the CIO.” It’s crazy, except that Chambers has a record of making crazy predictions (like opening your hotel-room door with your smartphone) that eventually come true.

Even employers that continue with plenty of employees will probably change the relationship. “It’s possible to measure the outcome in almost any job now, so you can reward people accordingly,” an executive of a performance-evaluation software maker told Fortune recently. As a result, top performers are being paid more, and the rest are getting less. Aon Hewitt reports that virtually all large employers now offer bonuses to regular salaried employees, often for achieving specific periodic goals like collecting more receivables or other performance metrics that are now easy to track. When individual performance was cumbersome to measure, pay was less differentiated and underperformers could keep their jobs. No more.

What’s true for workers is true for the 21st-century corporation itself. As friction disappears and ambitious new competitors arise in emerging markets, underperforming companies can’t hide. Winners will win bigger, and the rest will fight harder for what’s left. Idea-intensive sectors “are developing a winner-take-all dynamic, with a wide gap between the most profitable firms and everyone else,” says new research from the McKinsey Global Institute. More generally, competition is simply getting tougher. Global corporate profits recently totaled about 10% of world GDP, says MGI, a number we may someday recall with envy; the profit share could shrink to 8% by 2025, MGI predicts, barely more than it was in 1980. Result: “As profit growth slows, there will be more companies fighting for a smaller slice of the pie.”

It’s a world in which corporations, though fighting ever harder, keep less of the global economy’s output—seemingly the recipe for a declining role in world affairs. Yet for many 21st-century corporations it will be just the opposite. Some are achieving the scale of nations, a new phenomenon. Conducting billions of searches a day, Google possesses better real-time knowledge of what’s going on in the world than any government does; research shows it can predict disease outbreaks, stock market movements, and much else, and could influence elections if it wanted to. With 1.5 billion users, Facebook has a bigger population than China does and can accurately describe its users’ personalities and predict their success in work and romance. On any given day, Apple probably has more cash on hand than the U.S. Treasury. Bharti Airtel, an Indian telecom company, has about as many customers as the U.S. has residents. With 2.2 million workers, Walmart employs more people than any other organization on earth except the U.S. and Chinese defense departments.

And now one more mind-bending concept for the 21st century: Corporations, even as some achieve colossal stature, will on average live shorter lives than they used to. The trend is striking: The average life span of companies in the S&P 500 has declined from 61 years in 1958 to about 20 years now, says Yale’s Richard Foster, who predicts further steady declines. Well before the 21st century’s end, the concept of companies as continuing institutions could even cease to be the norm.

After all, why do companies exist? The English economist Ronald Coase won a Nobel Prize in economics for answering that question. In the theoretical world, the global economy spins like a top based on price signals between individual operators, with no apparent need for big companies. But in the real world, as Coase pointed out, “there are negotiations to be undertaken, contracts have to be drawn up, inspections have to be made, arrangements have to be made to settle disputes, and so on.” That is, there are transaction costs—friction—and consolidating transactions inside companies is the most efficient way of handling them. Now, as technology shrinks those costs, many companies are unbundling themselves, outsourcing functions to others, crowdsourcing R&D, and exchanging employees for contractors. A continual Hollywood model, in which people and resources come together to achieve a goal and then disperse to other projects, may become common across the economy. It’s happening already.

The good news is that accelerating change, creative destruction, and new business models are all opportunities for the venturesome. A unifying theme as the economy transforms is that in almost every business, barriers to entry are coming down. Opportunity is more widely available than ever. Every person and every organization can possess the 21st century’s most valuable assets: openness to new ideas, ingenuity, and imagination. 

Before I became a business school professor, I worked as a management consultant. One engagement in particular had a profound influence on my career. The project involved working with the Asia-based sales force of a global consumer products company. This company practiced “route sales,” which meant reps spent their days visiting mom-and-pop convenience stores, servicing accounts. One thing about the organization surprised me: Its sales managers spent inordinate time listening to the reps complain about their compensation.

The complaints were based on what the reps saw as a myriad of problems. Their quotas were set too high, so they couldn’t possibly reach them. Or their territory was subpar, limiting their ability to sign new accounts. Sometimes the complaints focused on fairness: A rep who was hitting his quotas and making decent money would want a manager to do something about a “lazy” colleague who was earning outsize pay simply because he had a good territory. Imagine any conceivable complaint a salesperson might have about pay, and I guarantee that sales managers at my client’s company had heard it.

The reps weren’t the only ones obsessed with the compensation system. The company liked to play around with the system’s components to try to find better ways to motivate reps and boost revenue, or to increase the return on the money it spent paying salespeople—a large part of its marketing budget. This company’s sales comp system was fairly basic: Reps earned a salary and a commission of around 1% of sales. The company worried that the system was too focused on outcomes and might over- or under-reward reps for factors outside their control. So it began basing compensation on their effort and behavior, not just on top-line sales. For instance, under the new system, a portion of compensation was based on customer satisfaction surveys, the number of prospective accounts visited (even if they didn’t buy), and the retention of existing accounts.

Largely because of this consulting assignment, I became so curious about the best ways to compensate salespeople that I began reading academic articles on the subject. Eventually I pursued a PhD in marketing at Yale, where I studied the theory and practice of how companies can and should manage and pay salespeople—research I now continue at Harvard Business School.

Although there are fewer academics studying sales force compensation and management than researching trendy marketing subjects, such as the use of social media or digital advertising, in the past decade it’s become a fast-moving field. While some of the basic theories established in the 1970s and 1980s still apply, academics have begun testing those theories using two methods new to this area of research: empirical analysis of companies’ sales and pay data, and field experiments in which researchers apply various pay structures to different groups of salespeople and then compare the groups’ effort and output.

This new wave of research is already providing evidence that some standard compensation practices probably hurt sales. For instance, the research suggests that caps on commissions, which most large companies use, decrease high-performing reps’ motivation and effort. Likewise, the practice of “ratcheting” quotas (raising a salesperson’s annual quota if he or she exceeded it the previous year) may hurt long-term results. Research based on field experiments (as opposed to the lab experiments academics have been doing for many years) is also yielding new insight into how the timing and labeling of bonuses can affect salespeople’s motivation.

In this article I will take readers through the evolution of this research and suggest the best ways to apply it. With luck, this knowledge not only will help companies think about better ways to compensate salespeople, but also might mean that their managers spend fewer hours listening to them gripe about unfair pay.

The Dangers of Complex Compensation Systems

Researchers studying sales force compensation have long been guided by the principal-agent theory. This theory, drawn from the field of economics, describes the problem that results from conflicting interests between a principal (a company, for instance) and an agent hired by that principal (an employee). For example, a company wants an employee’s maximum output, but a salaried employee may be tempted to slack off and may be able to get away with it if the company can’t observe how hard the employee is working. Most incentive or variable pay schemes—including stock options for the C-suite—are attempts to align the interests of principals and agents. Commission-based plans for salespeople are just one example.

Salespeople were paid by commission for centuries before economists began writing about the principal-agent problem. Companies chose this system for at least three reasons. First, it’s easy to measure the short-term output of a salesperson, unlike that of most workers. Second, field reps have traditionally worked with little (if any) supervision; commission-based pay gives managers some control, making up for their inability to know if a rep is actually visiting clients or playing golf. Third, studies of personality type show that salespeople typically have a larger appetite for risk than other workers, so a pay plan that offers upside potential appeals to them.

During the 1980s several important pieces of research influenced firms’ use of commission-based systems. One, by my Harvard colleague Rajiv Lal and several coauthors, explored how the level of uncertainty in an industry’s sales cycle should influence pay systems. They found that the more uncertain a firm’s sales cycle, the more a salesperson’s pay should be based on a fixed salary; the less uncertain the cycle, the more pay should depend on commission. Consider Boeing, whose salespeople can spend years talking with an airline before it actually places an order for new 787s. A firm like that would struggle to retain reps if pay depended mostly on commissions. In contrast, industries in which sales happen quickly and frequently (a door-to-door salesperson may have a chance to book revenue every hour) and in which sales correlate more directly with effort and so are less characterized by uncertainty, pay mostly (if not entirely) on commission. This research still drives how companies think about the mix between salaries and commissions.

Another important study, from the late 1980s, came from the economists Bengt Holmstrom and Paul Milgrom. In their very theoretical paper, which relies on a lot of assumptions, they found that a formula of straight-line commissions (in which salespeople earn commissions at the same rate no matter how much they sell) is generally the optimal way to pay reps. They argue that if you make a sales comp formula too complicated—with lots of bonuses or changes in commission structure triggered by hitting goals within a certain period—reps will find ways to game it. The most common method of doing that is to play with the timing of sales. If a salesperson needs to make a yearly quota, for instance, she might ask a friendly client to allow her to book a sale that would ordinarily be made in January during the final days of December instead (this is known as “pulling”); a rep who’s already hit quota, in contrast, might be tempted to “push” December sales into January to get a head start on the next year’s goal.

While a very simple comp plan such as the one advocated by Holmstrom and Milgrom can be appealing (for one thing, it’s easier and less costly to administer), many companies opt for something more complex. They do so in recognition that each salesperson is unique, with individual motivations and needs, so a system with multiple components may be more attractive to a broad group of reps. In fact, to get the optimal work out of a particular salesperson, you should in theory design a compensation system tailored to that individual. For instance, some people are more motivated by cash, others by recognition, and still others by a noncash reward like a ski trip or a gift card. Some respond better to quarterly bonuses, while others are more productive if they focus on an annual quota. However, such an individualized plan would be extremely difficult and costly to administer, and companies fear the “watercooler effect”: Reps might share information about their compensation with one another, which could raise concerns about fairness and lead to resentment. So for now, individualized plans remain uncommon.

Concerns about fairness create other pressures when designing comp plans. For instance, companies realize that success in any field, including sales, involves a certain amount of luck. If a rep for a soft-drink company has a territory in which a Walmart is opening, her sales (and commission) will increase, but she’s not responsible for the revenue jump—so in essence the company is paying her for being lucky. But when a salesperson’s compensation decreases owing to bad luck, he or she may get upset and leave the firm. That attrition can be a problem. So even though there are downsides to making a compensation system more complex, many companies have done so in the hope of appealing to different types of salespeople and limiting the impact of luck by utilizing caps or compensating people for inputs or effort (such as number of calls made) instead of simply for closing sales.

Using Real Company Data to Build Understanding

The big difference between earlier research on sales compensation and the research that’s come out in the past decade is that the latter is not based just on theories. Although companies tend to be very secretive about their pay plans, researchers have begun persuading them to share data. And companies have been opening up to academics, partly because of the attention being given to big data; managers hope that allowing researchers to apply high-powered math and estimation techniques to their numbers will help them develop better tools to motivate their workforce. Indeed, these new empirical studies have revealed some surprises, but they have also confirmed some of what we already believed about the best ways to pay.

Tom Steenburgh, a professor at the University of Virginia’s Darden School of Business, published one of the first of these papaers, in 2008. He persuaded a B2B firm selling office equipment to give him several years of sales and compensation information. This unique data set allowed Steenburgh to look at sales and pay data for individual salespeople and use it to make assumptions about how pay influences behavior. The company had a complex compensation plan: Reps earned a salary, commissions, quarterly bonuses based on hitting quotas, an additional yearly bonus, and an “overachievement” commission that kicked in once they passed certain sales goals. He focused on the issue of timing games: Was there evidence that salespeople were pushing or pulling sales from one quarter to another to help them hit their quotas and earn incentive pay? That’s a really important question, because pushing and pulling don’t increase a firm’s revenue, and so paying salespeople extra for doing that is a waste.

Even though the salespeople in the study could receive (or miss out on) substantial bonuses for hitting (or missing) quotas, Steenburgh found no evidence of timing games. He concluded that the firm’s customers required sales to close according to their own needs (at the end of a quarter or a year, say) and that the firm’s managers were able to keep close enough tabs on the reps to prevent them from influencing the timing of sales in a way that would boost their incentive payments. That finding was significant, because quotas and bonuses are a large part of most sales compensation plans.

In 2011 Sanjog Misra, of UCLA, and Harikesh Nair, of Stanford, published a study that analyzed the sales comp plan of a Fortune 500 optical products company. In contrast with the firm Steenburgh studied, this company had a relatively simple plan: It paid a salary plus a standard commission on sales after achieving quota, and it capped how much a rep could earn in order to prevent windfalls from really big sales. Such caps are relatively common in large companies.

As they analyzed the data, Misra and Nair concluded that the cap was hurting overall sales and that the company would be better off removing it. They also determined that many reps’ motivation was hurt by the firm’s practice of ratcheting. Setting and adjusting quotas is a very sensitive piece of the sales compensation formula, and there’s disagreement over ratcheting: Some feel that if you don’t adjust quotas, you’re making it too easy for reps to earn big commissions and bonuses, while others argue that if you raise a person’s quota after a very strong year, you’re effectively penalizing your top performers.

Misra and Nair estimated that if this firm removed the cap on sales reps’ earnings and eliminated quotas, sales would increase by 8%. The company implemented those recommendations, and the next year companywide revenue rose by 9%.

A third empirical study of sales rep pay, on which I am the lead author, was published in Marketing Science in 2014. Like Steenburgh, we utilized data from a B2B office equipment supplier with a complex compensation plan. We examined how the components of the plan affected various kinds of reps: high performers, low performers, and middle-of-the-road performers.

We found that although the salary and straight commission affected the three groups in similar ways, the other components created different incentives that appealed to certain subsets of the sales force. For instance, overachievement commissions were important for keeping the highest performers motivated and engaged after they’d hit their quotas. Quarterly bonuses were most important for the lower performers: Whereas the high performers could be effectively incentivized by a yearly quota and bonus, more-frequent goals helped keep lower performers on track. Some people compare the way people compensate a sales force to the way teachers motivate students: Top students will do fine in a course in which the entire grade is determined by a final exam, but lower-performing students need frequent quizzes and tests during the semester to motivate them to keep up. Our study showed that the same general rule applies to sales compensation.

Our research also suggested that the firm would benefit if it shifted from quarterly bonuses tocumulative quarterly bonuses. For example, say a salesperson is supposed to sell 300 units in the first quarter and 300 units in the second quarter. Under a regular quarterly plan, a salesperson who misses that number in the first quarter but sells 300 units in the second quarter will still get the second-quarter bonus. Under a cumulative system, the rep needs to have cumulative (year-to-date) sales of 600 units to get the second-quarter bonus, regardless of his first-quarter performance. Cumulative quotas do a better job of keeping reps motivated during periods in which they’re showing poor results, because reps know that even if they’re going to miss their number, any sales they can squeeze out will help them reach their cumulative number for the next period. In fact, even before we made our recommendations to the company in our study, managers there decided to move to cumulative quotas.

Out of the Lab, Into the Field

In addition to sharing sales and compensation data with academics, companies in the past several years have been allowing controlled, short-term field experiments in which researchers adjust reps’ pay and measure the effects. Prior to the use of field experiments, most academic experiments regarding sales force compensation took place in labs and involved volunteers (usually undergraduates) rather than real salespeople. Shifting from this artificial setting into actual companies helps make the results of these studies more practical and convincing.

As an example of one such experiment, consider recent work my colleague Das Narayandas and I did with a South Asian company that has a retail sales force for its consumer durable products. The company uses a simple system of linear commissions—reps earn a fixed percentage of sales, with no quotas, bonuses, or overachievement commissions. Managers were interested in seeing how instituting bonuses would affect the reps’ performance, so over six months we tested various ways to frame and time bonuses—always comparing results against a control group.

For one of our experimental groups, we created a bonus that was payable at the end of the week if a rep sold six units. For another group, we framed the bonus differently, using the well-known concept of loss aversion, which posits that the pain people feel from a loss exceeds the happiness they feel from a gain. Instead of telling reps they would receive a bonus if they sold six units, we told them they would receive a bonus unless they failed to sell at least six units. To test the concept even further, the company’s managers suggested another experiment in which we paid the bonuses at the beginning of the week and then had the reps return the money if they missed the goal.

The results showed that all three types of bonuses exerted similar effects and that in every case the group receiving the bonus generally outsold the control group. Loss aversion didn’t have much effect. We believe that’s partly because we were using cash, which is liquid and interchangeable; in the future we might experiment with noncash rewards, such as physical objects.

We also tried to measure the impact on sales reps’ effort of cash payments that were framed as gifts (as opposed to bonuses). Whereas bonuses are viewed as transactional, research shows that framing something as a gift creates a particular form of goodwill between the giver and recipient. In our study we used cash but told employees it was a gift because there were no strings attached—they didn’t have to meet a quota to receive it. We found that the timing of a gift directly influences how reps respond: If you give the gift at the beginning of a period, they view it as a reward for past performance and tend to slack off. If you tell them they will receive a gift at the end of a period, they work harder. We concluded that if companies want to encourage that kind of reciprocity, they need to pay careful attention to timing.

Other researchers are using field experiments to better understand how salespeople react to changes in payment schemes, but most of this work is so new that it hasn’t been published yet. One paper presented at a conference in 2014 showed that if salespeople receive cash incentives for passing tests about the product they are selling, they will sell more. (This is an example of sales compensation based on effort as opposed to results.) Another recent field experiment found that sales reps valued noncash incentives (such as points that could be used for vacations or for items such as televisions) more than the actual monetary cost of the good the points could purchase. As more researchers and companies embrace the use of field experiments, sales managers will learn even more about the best ways to motivate their teams.

It Pays to Experiment

After spending a decade in academia studying sales force compensation, I sometimes wonder what would happen if I were transported back into my job as a management consultant. What would I tell sales force managers to do differently?

Some of my advice would be straightforward: I would urge managers to remove the caps on commissions or, if they have to retain some ceiling for political reasons, to set it as high as possible. The research is clear on this point: Companies sell more when they eliminate thresholds at which salespeople’s marginal incentives are reduced. There might be problems if some reps’ earnings dramatically exceed their bosses’ or even rival a C-suite executive’s compensation, but the evidence shows that firms benefit when these arbitrary caps are removed.

I would tell sales managers to be extremely careful in setting and adjusting quotas. For instance, the research clearly shows that ratcheting quotas is detrimental. It’s tempting to look at a sales rep who blows through her yearly number and conclude that the quota must be too low—and quotas do need to be adjusted from time to time. But in general it’s important to prevent reps from feeling that unfairness or luck plays a part in compensation, and resetting quotas can contribute to that perception. And if something outside the salesperson’s control—such as an economic downturn—made it more difficult to hit a goal, I would consider reducing the quota in the middle of the year. It’s important to keep quotas at the right level to properly motivate people.

On the basis of my own research, I would advocate for a pay system with multiple components—one that’s not overly complicated but has enough elements (such as quarterly performance bonuses and overachievement bonuses) to keep high performers, low performers, and average performers motivated and engaged throughout the year.

Finally, I would urge my client companies to consider experimenting with their pay systems. Over the past decade managers have become attuned to the value of experimentation (A/B testing, in particular); today many consumer goods companies experiment constantly to try to optimize pricing. There are important lessons to be learned from doing controlled experiments on sales reps’ pay, because the behaviors encouraged by changes in incentives can exert a large influence on a firm’s revenue, and because sales force compensation is a large cost that should be managed as efficiently as possible. Involving academic researchers in these experiments can be beneficial: Having a trained researcher take the lead generally will result in a more controlled environment, a more scientific process, and more-robust findings. These studies also help the world at large, because research that improves how companies motivate salespeople will result in better and more-profitable businesses for employees and shareholders.

Life expectancy of an American born today averages 78.2 years. But this year, over 70,000 Americans have reached their 100th birthday. What are they doing that the average American isn’t (or won’t?)

To answer the question, we teamed up with National Geographic to find the world’s longest-lived people and study them.  We knew most of the answers lied within their lifestyle and environment (The Danish Twin Study established than only about 20% of how long the average person lives is determined by genes.). Then we worked with a team of demographers to find pockets of people around the world with the highest life expectancy, or with the highest proportions of people who reach age 100.

We found five places that met our criteria:

•  Barbagia region of Sardinia – Mountainous highlands of inner Sardinia with the world’s highest concentration of male centenarians.
• Ikaria, Greece – Aegean Island with one of the world’s lowest rates of middle age mortality and the lowest rates of dementia.
•  Nicoya Peninsula, Costa Rica – World’s lowest rates of middle age mortality, second highest concentration of male centenarians.
• Seventh Day Adventists – Highest concentration is around Loma Linda, California. They live 10 years longer than their North American counterparts.
• Okinawa, Japan – Females over 70 are the longest-lived population in the world.

We then assembled a team of medical researchers, anthropologists, demographers, and epidemiologists to search for evidence-based common denominators among all places. We found nine:

1. Move Naturally 
The world’s longest-lived people don’t pump iron, run marathons or join gyms. Instead, they live in environments that constantly nudge them into moving without thinking about it. They grow gardens and don’t have mechanical conveniences for house and yard work.

2. Purpose. The Okinawans call it “Ikigai” and the Nicoyans call it “plan de vida;” for both it translates to “why I wake up in the morning.” Knowing your sense of purpose is worth up to seven years of extra life expectancy

3. Down Shift
 Even people in the Blue Zones experience stress. Stress leads to chronic inflammation, associated with every major age-related disease. What the world’s longest-lived people have that we don’t are routines to shed that stress. Okinawans take a few moments each day to remember their ancestors, Adventists pray, Ikarians take a nap and Sardinians do happy hour.

4. 80% Rule
  “Hara hachi bu”  – the Okinawan, 2500-year old Confucian mantra said before meals reminds them to stop eating when their stomachs are 80 percent full. The 20% gap between not being hungry and feeling full could be the difference between losing weight or gaining it. People in the Blue Zones eat their smallest meal in the late afternoon or early evening and then they don’t eat any more the rest of the day.

5. Plant Slant
  Beans, including fava, black, soy and lentils, are the cornerstone of most centenarian diets. Meat—mostly pork—is eaten on average only five times per month.  Serving sizes are 3-4 oz., about the size of deck or cards.

6. Wine @ 5
 People in all Blue Zones (except Adventists) drink alcohol moderately and regularly.  Moderate drinkers outlive non-drinkers. The trick is to drink 1-2 glasses per day (preferably Sardinian Cannonau wine), with friends and/or with food. And no, you can’t save up all weekend and have 14 drinks on Saturday.

7. Belong
 All but five of the 263 centenarians we interviewed belonged to some faith-based community.  Denomination doesn’t seem to matter. Research shows that attending faith-based services four times per month will add 4-14 years of life expectancy.

8. Loved Ones First 
Successful centenarians in the Blue Zones put their families first. This means keeping aging parents and grandparents nearby or in the home (It lowers disease and mortality rates of children in the home too.). They commit to a life partner (which can add up to 3 years of life expectancy) and invest in their children with time and love (They’ll be more likely to care for you when the time comes).

9. Right Tribe 
The world’s longest lived people chose–or were born into–social circles that supported healthy behaviors, Okinawans created ”moais”–groups of five friends that committed to each other for life. Research from the Framingham Studies shows that smoking, obesity, happiness, and even loneliness are contagious. So the social networks of long-lived people have favorably shaped their health behaviors.

To make it to age 100, you have to have won the genetic lottery. But most of us have the capacity to make it well into our early 90’s and largely without chronic disease. As the Adventists demonstrate, the average person’s life expectancy could increase by 10-12 years by adopting a Blue Zones lifestyle.

Charlene de Carvalho was a stay-at-home mom with five kids and no business education when, at age 47, she inherited control of Heineken. She decided to take on the challenge. Here, for the first time, she opens up about her remarkable journey.

You might say that one life ended and another began the day that Charlene de Carvalho buried her father.

 It was a gray day in Noordwijk, the Netherlands, in January 2002 when the London housewife and mother of five bid goodbye to Freddy Heineken. Charlene loathed fanfare as much as her father, a visionary businessman who had transformed a modest Dutch brewery into the world’s third-largest brewer. So this was a simple ceremony in an ordinary cemetery, with no funeral preceding it, attended only by Freddy’s secretary and his immediate family: Freddy’s wife, Lucille; his son-in-law, Michel; and 47-year-old Charlene.

Until her father’s passing, Charlene had no money to her name except a single share of Heineken stock—then worth 25.60 euros, or $32—that her father had given her. Now, as his only child and the sole heir to the Heineken fortune, she was inheriting about 100 million shares, equal to one-quarter of the company’s total stock outstanding. This 25% stake came with voting control, meaning that her single vote outweighed the votes of other investors on any board matter. Charlene had not thought much about her new responsibilities until that dreary morning at the cemetery. As she left her father’s grave, her husband put her on the spot. “Charlene, you have to make a decision within 10 days if you want to inherit the role that your father played.”

What Michel de Carvalho was suggesting was that Charlene, who had had no formal business education, guide the family company that Freddy, even after stepping down as CEO in 1989, had helped build to $9.3 billion in annual revenues. It took Charlene less than a week to respond in the affirmative to her husband’s proposition. With that, she uprooted her tidy life in London, began traveling the globe to study Heineken’s far-flung operations, and learned how to become an effective owner and the guardian of a dynasty.

Freddy Heineken

Freddy Heineken, Charlene’s father, could be flamboyant in business but kept a conservative household and a tight rein on his only child.
Perhaps you’ve never heard of Charlene de Carvalho-Heineken, and that has suited her just fine. At age 60, she is one of the world’s wealthiest women, worth some $11 billion. Before she sat down with Fortune in Amsterdam for this story, she had never spoken with the media. Particularly after her father was kidnapped 31 years ago, she worked hard to live below the radar—for many years content to be unknown even to employees of the company that bears her name.

She came to Fortune reluctantly, coaxed by her outgoing, energetic 70-year-old husband, an investment banker who holds the vice chairman position at Citigroup’s investment bank and chairs Citi Private Bank in the EMEA (Europe, Middle East, Africa) region. Before Freddy’s death, Michel de Carvalho had no need to rely on his spouse for anything except raising their five children and being a good banker’s wife. Today he calls Charlene “my boss.” Michel’s proposition the day of Freddy’s burial was, she says, “my wake-up call.”

And in fact, the transfer of control from Freddy to his daughter was a wake-up call for Heineken too. Charlene and Michel, who is a Heineken director, called on the board to replace the then-CEO with a more aggressive leader. That man, Jean-François van Boxmeer, is still Heineken’s chief. Reversing Freddy’s risk aversion, which hampered Heineken’s growth in the old man’s later years, van Boxmeer has spent more than $28 billion on 49 acquisitions, extending Heineken’s operations from 39 countries in 2002 to 71 today. Heineken still ranks as the world’s No. 3 brewer, behind Anheuser-Busch InBev and SABMiller, but sales have nearly tripled. With $24.9 billion in 2013 revenue, the company has an enviable portfolio of premium brands such as Amstel, Dos Equis, Sol, and the eponymous green-bottled lager that is the most widely distributed beer on earth.

These growing brands have propelled Heineken shares upward and helped the company, with a stock market capitalization around $43 billion, remain independent in a rapidly consolidating beer market. “The best defense is always a high share price,” says Michel. But the premium-brand portfolio, as well as Heineken’s strength in emerging markets like Nigeria (its second-largest profit producer, after Mexico) and Vietnam, has attracted unwanted suitors as well. In September, London-based SABMiller made an unsolicited bid for the company. Heineken issued a statement saying that it “consulted with its majority shareholder and concluded that SABMiller’s proposal is non-actionable.” That powerful shareholder is Charlene, whose story of discovering her power is a unique one. It’s also universal in some ways, offering lessons about building and protecting businesses for the long term.

To understand Heineken and the woman who controls it, it helps to know a bit about the people who came before her. In 1864, Charlene’s great-grandfather, Gerard Adriaan Heineken, bought a small brewery, De Hooiberg, in Amsterdam and began brewing beer with a special yeast. Gerard had one son, Henry, who chaired Heineken for 23 years and lost family control of the company in 1942 when he sold shares to pay for taxes and brewery expansion. His son, Alfred, known as Freddy, started working at the brewer, carrying sacks of barley, at 18. In 1954, Freddy borrowed money and bought enough Heineken stock to regain family control. He created Heineken Holding NV, which owns 50.005% of Heineken NV, the operating company.

CEO van Boxmeer notes that Heineken never suffered from siblings jockeying for control: This has been a family of mostly only children. “It’s not a very crowded legacy,” he says.

Growing up in the Dutch coastal town of Noordwijk, Charlene Heineken was a fairly typical only child: “painfully shy,” as she says, and protected, though not as spoiled as you might expect. “Mommy drove me to school every day. There were no chauffeurs,” she explains, adding, “I didn’t like the fact that my name was on every café.” Her father was a flamboyant salesman—he created Heineken’s green bottle and first TV advertising—but he preferred a simple life at home. Most evenings, Charlene and her parents would eat dinner on tray tables in the living room, in front of the TV. “Spaghetti and meatballs was all he wanted,” says Charlene about her father.

The Heinekens had vacation homes, including a ski lodge in St. Moritz, Switzerland, and they knew the Onassis and Agnelli families and Monaco’s Prince Rainier and Princess Grace, but they didn’t socialize a lot. That was fine with Charlene. “Society,” she says, “is a horrible word.”

Had Freddy’s only child been named Charles instead of Charlene, he probably would have been pushed into the family business. But the idea of taking a key role at Heineken was not mentioned to Charlene. “I don’t think he thought much beyond my having a happy, comfortable life,” she says. When she was 17, he wouldn’t let her leave home for college. “Daddy said, ‘You’re too young. You’re not going to live at a university on your own,’” she recalls. “I wasn’t allowed to go to Paris. That was ‘too racy.’ Some hippie friends of mine went to India with backpacks. That was not in the cards.”

Short of choices, she enrolled in a secretarial course in The Hague, and then went to the University of Leiden, where she studied law (“I hated it,” she says). At age 20 she left the Netherlands. She studied French in Geneva and photography in New York City. She worked for an ad agency in London. She interned at Heineken in Paris, where she followed the local boss around to get a taste for the family business. “I flitted from one thing to another, not making up my mind,” she says. She visited her father regularly in the Netherlands and St. Moritz, where he struggled to breathe at the high altitude, no doubt due to his four-pack-a-day cigarette habit. “In his dreams, I would have married a nice Dutch boy and lived next door,” she says.

Charlene met Michel de Carvalho on the ski slopes of St. Moritz. For an overprotected heiress who didn’t know what she wanted out of life, he was quite a catch. Born to a Brazilian diplomat father and British mother in England, he had been a teenage actor—he had a speaking role, as a shepherd boy named Farraj, with Peter O’Toole in the Oscar-winning epicLawrence of Arabia (his stage name was Michel Ray). He went to Harvard University, and then he rebelled against his parents by putting off Harvard Business School to join the British ski team at the 1968 Olympic Games in Grenoble, France. He didn’t win a medal. But he loved competing, and he went back to the Olympics as a member of Britain’s luge team in 1972 and 1976.

Lawrence Of Arabia

Peter O’Toole (left) with Michel de Carvalho during location filming on ‘Lawrence of Arabia’, 1962.
Wooing Charlene Heineken from the grip of her father turned out to be the ultimate sport for de Carvalho. “It was an unbreakable bond,” says Michel. He recalls Freddy sitting with him at a three-hour dinner in Amsterdam and grilling him on his past romances, his bank account, even his eyesight. “The nicest thing Charlene’s father ever said about me was, ‘He’s not interested in Charlene for her money.’” Michel and Charlene married in London in the fall of 1983. Two days after they returned from their honeymoon in St. Croix and Virgin Gorda, something happened that would alter Charlene’s life dramatically.

Michel de Carvalho, Charlene de Carvalho, Heineken headquarters

Michel de Carvalho with Charlene at Heineken headquarters

One moment Freddy Heineken was walking out of his office at Heineken headquarters in central Amsterdam, and the next, he, along with his chauffeur, was lying in the back of a minivan, with kidnappers in charge. For the next 21 days Charlene and her mother holed up with a squad of police and hostage negotiators at the seaside Heineken home in Noordwijk, 50 kilometers southwest of Amsterdam. “They asked for $20 million in unmarked bills. Of course we marked the bills, but you couldn’t see it,” says Charlene. “We paid the $20 million and didn’t get Daddy back.” Finally, chasing a lead, the police stormed a warehouse north of Amsterdam one night. Behind a fake wall they found Freddy and his chauffeur chained to a concrete wall. They were hungry and exhausted but basically fine. Freddy later joked that he was tortured: “They made me drink Carlsberg.”

After that ordeal Charlene was glad to leave Amsterdam and settle in London with her new husband, who was working for Credit Suisse. While Michel flew to visit clients around the globe, Charlene stayed home, having babies in efficient succession. After Alexander, their first child, arrived in 1984, Charlene had three more, including twin girls, within four years. At 37, she had five kids under the age of 7. She was happy and stressed. “I used to sit and sort the Legos by color, almost obsessively,” she says. “I needed to have one part of my life organized.”

While women in the Netherlands generally attach their maiden name to their married name, Charlene, as a London resident, had dropped “Heineken” from her surname. “I’ve always thought double-barreled names were nonsense,” she says, so she liked being known as Mrs. de Carvalho. “My friends knew, but they were not impressed” by her lineage, she says. “I lived off his salary and his bonus in his house,” she says, referring to Michel. “I lived the life of a wife of a man who worked for a bank.”

Charlene had little desire to engage in the family business, but that hardly mattered when, in 1988, her father invited her to join the board of Heineken’s holding company. That’s because Freddy was an authoritarian boss who selected board members who would agree with him. “He had to be boss,” says Charlene. “Delegating was not his thing.” This became more of a problem as Freddy aged and became cautious and more tightfisted, in contrast to his adventurous youth. “I don’t think it was the kidnapping,” Charlene says. “I think he was just feeling slightly less king of the mountain.”

Meanwhile, the beer industry was brimming with big deals—SAB was expanding aggressively beyond its native South Africa, Belgium-based Interbrew (now part of AB InBev) bought Labatt for $2 billion—after Freddy Heineken wasn’t willing to pay up for the Canadian brand. “Labatt was a turning point in the industry,” says Charlene. “In retrospect, maybe we should have bought it.”

When Freddy died on Jan. 3, 2002, Heineken profit growth had slowed, and the stock was declining. Michel was worried, and his proposition to Charlene that day in the cemetery was not just about her stepping up; he knew he would have to as well.

He had by this time moved to Citigroup, so he wrote to Sandy Weill, then Citi’s CEO, and said he would have to resign because he now needed to spend one or two days each week in the Netherlands to help his wife oversee Heineken. “Sandy wrote back and said, ‘What’s the difference if you’re in Amsterdam or London, as long as you’re available on your BlackBerry or phone?’” Free to roam, he and Charlene began visiting Heineken breweries and offices around the world, asking about problems and assessing talent.

“Many people assumed we would sell the business or screw it up,” says Michel. As the couple met with managers and investors around the world—initially, he more than she, since they had young children at home—they spent many hours at night comparing notes. “I’m finding it fascinating,” she recalls thinking.

Vowing not to meddle with day-to-day operations, they reserved the right to shake things up in four areas: the company’s image, its balance sheet, acquisitions, and the selection of board members and key executives. And they made clear that they were not fooling around. “You have seen the sweet and docile side of Charlene. May I remind you that she is half her father,” Michel wrote to Heineken’s chairman. “That is probably a side that you should leave dormant.”

And so, when they saw Heineken missing opportunities in the global market, Charlene and Michel urged the board to replace CEO Thony Ruys. Then they helped evaluate internal candidates and settled on van Boxmeer, a scrappy operator who had joined Heineken in 1984, worked in several emerging markets, and led Heineken’s business in the Congo.

The 53-year-old van Boxmeer has stretched the balance sheet in ways that Freddy never would have. He led the acquisition of Edinburgh-based Scottish & Newcastle for $15.5 billion, in partnership with Carlsberg—a deal that fortified Heineken in the European beer market and gave it a major footprint in the fast-growing cider category. In 2010, Heineken bought Femsa Cerveza, Mexico’s second-largest brewer. That $7.6 billion purchase added 20,000 employees to Heineken, which now has 81,000 employees worldwide.

“We’ve been blessed to have a majority shareholder who empowers us,” says van Boxmeer. Truth be told, if the de Carvalhos had their way, Heineken would move even faster. “I’m always frustrated,” says Michel. “One of the things that drives me is the thought that one guy is constantly looking down and wondering whether we’re going to fuck it up.”

When I ask Charlene de Carvalho-Heineken what her greatest worry is, she takes a few seconds to think and then replies, “Sometimes success breeds complacency.” She and Michel were surprised by SABMiller’s takeover approach in September because SAB’s top brass had informally proposed combining many times, and “we had left a fairly clear message that we have no interest,” says Michel.

They weren’t frightened by SAB’s latest overture since “the lady who throws the switch,” as Michel calls his wife, owns over 50% of Heineken’s voting stock. But they view the bid as fair warning to be on top of their game. “There’s a silver lining in the cloud,” says Michel, explaining that the takeover bid enables Heineken’s CEO to “tell 81,000 employees, ‘You all have to work harder to keep the stock up.’ This gives Jean-François a free hand to be a tougher CEO.”

Michel says he worries about succession. Van Boxmeer will complete the last year of his third four-year contract in 2017, and he and Charlene would be pleased if he renews. “Jean-François is one of the world’s great CEOs,” says Michel. But they’re concerned that there is no clear successor. Will the next CEO come from inside the company? “Ideally, yes,” Charlene says. Michel adds: “I would be very disappointed if three or four executives wouldn’t consider themselves to be candidates, but in Holland and in London, unlike the U.S., putting yourself even slightly above the parapet is a recipe for disaster.”

Learning how to preserve the dynasty has become the de Carvalhos’ most important mission. Charlene and Michel recently hired a British consultant on inherited wealth, Martin Jenkins, to talk with the family about, as Michel said in a letter to the five children in June, “your ambitions, desires, questions, maybe even fears of inheriting a legacy.” Jenkins meets with the family as a group and with the individual children, now 23 to 29, whom their parents call the “G-5.”

And in September, on the same day that Charlene rejected SABMiller’s bid, she and Michel were in Chicago at a conference hosted by Byron Trott, a former Goldman Sachs executive who has his own firm, BDT & Co., to advise and invest for billionaire owners of closely held companies. At the conference, the de Carvalhos chatted with people who share the same burdens of wealth that they do—people named Walton and Smucker and Koch. “We all have exactly the same problem,” says Michel. “But every family relationship is a little different,” adds Charlene.

What is the best advice they’ve received about passing control of the business to the next generation? “Think hard and pick one,” says Michel. “That’s the message we’ve been hearing.” Though they may opt to hand control to more than two of their children (see box).

The de Carvalhos have not yet decided which of their five children will control Heineken after they’re gone or incapable, but one heir surely in this mix is eldest son Alexander. He’s an associate at Lion Capital, a London-based private equity and buyout firm, and he joined the Heineken holding company board last year.

The 29-year-old Alexander has been interested in the family business since he was 8 years old. “I was checking share prices and looking at board materials and made countless notes,” he says. He was 17 when his grandfather Freddy, whom he adored, passed on. Every day he wears Freddy’s watch—“a very scratched, very old simple Rolex”—and he goes out of his way to hail a Heineken-branded taxi to ride to work. “Heineken is the first thing I think about when I get up in the morning and the last thing I think about when I go to bed,” he says.

His parents are pleased that Alexander wants the job of guarding and guiding the family business. But they’re not counting out younger son Charles, 23, who is working for an Internet retailer in Vietnam, or oldest daughter Louisa, 28, who has worked in film production and is now with a spirits company in London. Twins Isabel and Sophie are studying art and music, respectively, and may play roles in Heineken’s work on philanthropy and social responsibility.

Charlene guides her children this way: “If you have a passion and the ability to pursue it, follow that,” she says. “You’ll probably be better off following your passion than doing what you’re supposed to do.” Her advice is bittersweet, coming from the woman who discovered her passion for business later than she would have preferred. “It was probably a mistake not to do some business education,” she says. “I think it may have given me the respect that I have to fight for.”

Indeed, respect cannot be bought, even for $11 billion. It is hard earned.

This story is from the December 22, 2014 issue of Fortune. 

In the early days of the digital revolution, many leaders of established companies did their best to ignore the upheaval, convinced that the threat from new technologies wouldn’t ever amount to much. As that premise faltered, many flipped in their thinking, concluding that digital would inexorably destroy their positions. To survive, it seemed, they’d have to stop throwing money at the old businesses, salvage what they could, and launch independent digital ventures. The existing units probably wouldn’t survive, but disruptive digital businesses could replace the zombies in a company’s portfolio.

Both views proved misguided. The failure of the first hardly needs elaboration: No company can safely ignore the changes wrought by digital technologies. The failure of the second may be less obvious but is now well documented. Companies that milked existing businesses while betting on independent digital start-ups that had no competitive advantages usually wound up discarding decades’ worth of physical assets and gambling away millions in real value. Sears Holdings may be the poster child for this kind of miscalculation: Underinvesting in its stores while pouring resources into online ventures, it has suffered a 75% decline in stock price over the past seven years. Similar examples crop up in many industries.

The central problem with either extreme is that it fails to account for how customers have changed: They now weave their digital and physical worlds so tightly together that they can’t fathom why companies haven’t done the same. Let me relate a personal anecdote that illustrates the problem.

Last December my daughter Stacy wanted to buy the Just Dance 4 video game for her little girl. She found it on a major retailer’s website for $29.97. To be on the safe side—Christmas was approaching—she decided to go to the retailer’s local store and pick it up. There, however, it was selling for $47.97, a 60% markup. She was surprised, but she remembered the company’s price-matching guarantee, so she asked for the online price. No dice, said the cashier—the guarantee applied only to competitors’ prices.

“Wait,” Stacy said. “I can buy this game online and have it shipped to the store free, right?” The cashier agreed, but cautioned that it might take several days. My daughter replied, “But it’s on your shelf now. Can’t I just pay for it online and take one from the shelf?” Of course not, was the response; the store and the online operation were separate businesses, and that would mess things up. Standing at the register, Stacy ordered the item on her phone, and a few days later she came back to collect it—another exasperating process.

People experience disconnects like this one all the time. Here we are, a quarter century into the digital revolution, yet many companies still agonize over whether to invest significant resources in digital capabilities. Those that have done so tend to run their digital operations as independent business units—the way companies prefer to manage them, as opposed to the way customers expect to use them.

As the revolution progresses, some companies will go the way of Tower Records, their businesses thoroughly disrupted and destroyed by digital alternatives. But most will find that they must fuse the digital and physical worlds, just as consumers are doing. Look at your own business: Is the physical part of it really going to disappear? Wouldn’t innovations that fuse the digital and the physical open up vast new opportunities? And even if some of these “digical” fusions ultimately prove to be 10- to 20-year transitions toward further disruption, aren’t they still the best way to extend your core business, generate cash to fund continued evolution, and build the capabilities that will be essential for future success?

My colleagues and I have studied more than 300 companies around the globe and have worked directly with hundreds more that are trying to cope with the dazzling but daunting changes reshaping the marketplace. We’ve found that most industries are still in the early stages of digital-physical transformation. We’ve also found that the greatest barrier to adopting fusion strategies is not skepticism about their promise but inexperience with their execution. Executives are intrigued by the possibilities and recognize their potential but are uncertain how to make them work.

Not surprisingly, best practices in this area are still emerging. But drawing on our study of leaders from 20 global industries, we have identified five rules that account for much of the difference between success and failure. Some of them are common sense but not commonly practiced. Others may sound heretical, at least to the proponents of digital disruption. But the leaders we studied uncovered big growth opportunities while rivals stood by wringing their hands. So it’s worth examining what they did and how. 

Rule #1: Build your strategy around digital-physical fusion. It can be your new competitive edge.

Some of the world’s leading strategy experts have pronounced sustainable competitive advantage dead. They explain that technology now changes so rapidly, and advantages are copied so quickly, that companies must learn to leap continually from one wave of opportunity to the next—even though each new wave will probably be shorter, more crowded, and less connected to the one before. The problem with this approach is that a company may end up throwing away core advantages while pouring resources into risky ventures that have no competitive edge or right to win. To beat the odds, you have to either be very lucky or find some advantage that your core business can provide to the new venture and vice versa. These advantages may include proprietary customer insights, distinctive capabilities, and ways to capitalize on a competitor’s vulnerabilities.

Digical fusions can leverage a company’s existing strengths to provide just such an edge. Consider the case of Commonwealth Bank of Australia (CBA), which started life in 1911 and today operates with 52,000 employees in a dozen countries. When Ralph Norris was named CEO, in 2005, CBA had the worst customer satisfaction ranking in the industry and was losing market share in several important sectors. Like other major banks, it had been trying to reduce costs—and it was perhaps fearful that the internet would make branch banking obsolete. So it had reduced its branches from 1,756 in 1993 to 1,006 in 2005. The closures not only made it easier for online banks to gain share but also encouraged the entry and expansion of new branch-based competitors, including AHL Investments (Aussie Home Loans) and other nonbanking lenders. These aggressive rivals scooped up many of CBA’s old branch managers, loan officers, and customers.

Norris began his tenure by touring the branches and studying customer complaints. He found that customers were criticizing virtually every touchpoint—they spoke of lousy products, long lines, inept employees, and high error rates. Norris, whose background is in IT, also scrutinized the digital infrastructure. He found decades-old systems that made it nearly impossible for even the best employees to do the right thing by customers.

Norris’s vision was to build Australia’s finest financial services organization by excelling in customer service. He set a goal to rise from worst to first in customer satisfaction, linked the compensation of all senior executives to that metric, and focused on five areas for improvement: home loans, deposits, term deposits, passbooks, and customer relationship systems. He also set out to develop the digital capabilities that would make his goal possible, hiring and promoting top-tier IT talent that was committed to his vision. He persuaded CBA’s board to undertake a “core banking modernization” program budgeted at A$580 million over four years (and later expanded to A$1.1 billion over six years). He simultaneously launched a program to revamp the branch network to improve convenience and service levels.

These efforts produced an impressive succession of digical innovations. The project Finest Online modernized CBA’s internet banking service and combined it with in-person channels to eliminate all-too-frequent problems such as an inability to link personal accounts to commercial accounts. CBA’s mobile real estate app recognizes photos of properties, shows floor plans, helps customers figure out whether they can afford a given house, and starts the mortgage application process. The bank’s Kaching app was one of the first to allow multiple types of payment from a smartphone, including through Facebook. (The company responds in real time to inquiries on a Facebook wall.) CBA offers online loan approval in 24 hours, as opposed to the 14 to 21 days previously required, and in 2013 it launched SmartSign, a service that allows customers to execute loan documents electronically using a secure online portal. It also rolled out videoconferencing to its branches, enabling customers—particularly those in rural areas—to connect more easily with the bank’s specialists.

CBA’s system is now so firmly embedded that it continues to gain steam even as competitors invest in their own systems and service improvements. Its fusion-based strategy helped propel the bank to the highest customer-satisfaction ranking for retail banks in 2013. CBA’s shares rose more than 80% from mid-2006 to mid-2014, compared with a 9% gain in the S&P/ASX 200 index over the same period. Most important, the technology platforms, customer-focused culture, and rapid-fire innovation processes that CBA developed in those eight years seem to be taking even longer for competitors to copy.

Rule #2: Add links and strengthen linkages in the customer experience.

Thomas Edison is thought to have invented the lightbulb, but his carbon-filament bulb actually just improved on existing models. Edison’s real contribution was to create a system of electric-power generation and distribution that made lightbulbs work. He figured out every element of the system, set up a kind of idea factory to develop innovations for each one, and commercialized one after another. The results transformed daily life.

Digical innovations are similar. They don’t just change a company’s existing products or services, as at CBA. They allow companies to identify adjacencies that strengthen the base business and create new revenue streams. Like Edison, a digical-savvy company thinks systematically about each piece of the customer experience. It develops innovative components and weaves them into a holistic system that extends competitive advantages and accelerates growth.

Nike illustrates this approach. For many years it was as firmly rooted in the physical world as any company could be, producing shoes, apparel, and sports equipment to be sold through retail stores. It put up a website in 1996 but declined to sell any merchandise online for three years. In 1999 things began to change, starting with the NIKEiD program. Buyers could visit nike.com and customize certain Nike shoes, choosing their base and accent colors and adding a “personal I.D.” to the product. Nike then began introducing digical innovations at other points in the customer experience chain. In 2006 it unveiled the Nike+ app, which connects a shoe that has a built-in sensor and receiver to an iPod Nano. Runners could see data about their time, distance, calories burned, and pace on the Nano’s screen or hear it through their headphones. After a workout they could sync the Nano with a computer and chart their progress. They could even get personalized coaching.

Today more than 30 million customers use Nike+, tracking and sharing runs, workouts, and fitness goals—and providing the company with invaluable data about who its customers are and what they value most. Nike+ FuelBand SE electronic bracelets take postsale involvement further, measuring all a user’s movements throughout the day and recording indicators such as steps taken and calories burned. As with Nike+, users can capture this data, track and record their level of activity, and share the information through social media.

The results of all this innovation have been dramatic. Nike enjoys the highest social media engagement with customers in its industry. It has recorded an increased market share in key areas (including Western Europe and soccer—both once dominated by Adidas), a 42% increase in e-commerce sales from FY 2013 to FY 2014, and an overall growth rate that significantly outpaces that of key rivals. And it may be just warming up. “Digital sport is incredibly important to us,” Nike’s CEO, Mark Parker, told CNBC in April 2014. “You’re going to see digital be more and more integrated into other products that we have.” Through its partnerships with Apple and others, he said, the company hopes to expand the reach of the Nike Fuel system and other applications to 100 million users worldwide.

Rule #3: Transform the way you approach innovation.

When traditional companies add digital features to innovation programs, their approach typically resembles a waterfall. Marketers and product designers create ideas, build prototypes, and then throw the ideas downstream to IT, with instructions to develop specific digital features. “We’re launching a new product and marketing campaign. We want the mobile app to help us push out marketing messages and coupons and to make it easier for customers to send us e-mails when they have service questions. The CEO says she needs it in four weeks.”

But another way to fuse the digital with the physical is to start by creating a team of complementary experts. Teams of this sort are not new, but digical innovation requires dramatically deeper and broader integration. Leaders engage digital experts at every stage, from idea generation to development, testing, and launching, and assemble teams for every possible type of innovation project. Their approach generates more wide-ranging, innovative, and integrated solutions, because team members’ combined expertise can fuse the best of the digital and physical worlds in every aspect of the project.

Disney has followed this course since the design of Disneyland began, in 1952. But even Disney’s prodigious digical skills were stretched when the company launched a revolutionary project in 2009. The goals were to create a “more immersive, more seamless, and more personal experience” for Disney guests and to gather real-time data on guest behaviors that would help the company analyze traffic patterns and spending habits, manage labor efficiencies, and optimize the company’s future investment spending. The project would span the entire theme park experience and take in just about every customer touchpoint. Disney decided that the $1 billion-plus vision was so much bigger than anything its celebrated Imagineering team of designers and product developers had ever undertaken that it required a new kind of organization. It set up an entrepreneurial unit dubbed Next Generation Experience, which ultimately employed more than 1,000 people from across the company’s functions.

Next Generation’s leaders engaged experts from IT, Imagineering, theme park operations, marketing, and other functional areas. Their first release, the MyMagic+ system, combines digital technology with the three-dimensional theme park: My Disney Experience, a new website and mobile app, facilitates vacation planning and collects information about personal preferences; FastPass+ lets guests reserve attraction and character-greeting times and seats for shows; and MagicBands (RFID wristbands) act as tickets, room keys, FastPass+ verifications, and credit cards, allowing guests to charge meals or souvenirs with a flick of the wrist. The bands also interact with sensors in the park and transmit behavioral information that enables Disney to enhance the guest experience still further. Future applications may include the personalization of rides and attractions—for example, Winnie the Pooh might greet a child by name and wish him a happy birthday. Thanks to the initiative, Disney is on target to realize some $500 million in annual incremental revenue with a 20% operating margin. If those numbers hold up, it will earn a healthy return on its billion-dollar investment.

Rule #4: Organizational separation is just an interim step.

The choice between digital disruption and digical transformation has dramatic implications for a company’s operating model and organizational design. But those implications may not be apparent at first, because in either case successful innovators typically start by separating their digital revolutionaries from the core business. Separation enables these companies to attract talented innovators and programmers, locating them in San Francisco, Cambridge, Tel Aviv, Hyderabad, or anywhere else they want to be. A specialized capability—one unimpeded by corporate bureaucracy and uncontaminated by old-style thinking—can be built quickly. An upstart culture can challenge the status quo and seek to develop radical innovations. Compensation plans and incentives can be tailored to the needs of the new rather than to the requirements of the old.

But at some point these companies must make a decision. If they are facing digital disruption, they’ll leave the businesses separate for a long time—maybe forever. The core, after all, is a rival to be milked and ultimately destroyed. The businesses compete for market share, management attention, and financial resources in a battle to the death. Only one will be left standing. That may be the model Sears chose. Under CEO Edward S. Lampert, Sears has invested heavily in its wholly separate e-commerce business; one Credit Suisse analyst has said, “[Its] website is better than [that of] just about any other retailer I cover.” Online sales have grown steadily, and by late 2013 they were about $1.2 billion a year, according to analysts. But the company’s underinvestment in brick-and-mortar has been significant. In 2012, for instance, Sears spent an average of $1.46 per square foot on its stores, compared with the average of $9.45 per square foot spent by four of its chief competitors, according to the New York Times. Online sales account for only about 2.5% of total sales, which have declined steadily since 2007; e-commerce revenue can’t possibly grow fast enough to replace lost revenue from the stores.

Digital-physical transformations have different objectives and thus different operating models. The initial aim is to acquire digital skills as strong as those of any pure play disrupter. But the ultimate goal is to create the best of both worlds, developing capabilities that pure plays will be unable or unwilling to copy. So separation is a transitional step; over time the company will want to build at least some integration, which has advantages of its own: It satisfies customers’ wish for a seamless digital-physical experience, enables greater efficiency and economies of scale, and permits better coordination, avoiding duplicated effort. It also facilitates timely communication and execution of decisions, thus reducing conflict. An integrated business can leverage existing company assets in ways that a separate unit cannot.

This kind of fusion is working well for Macy’s. As early as 2005 the company was devoting considerable resources to website and infrastructure capacity, and in 2010 it mapped out an “omnichannel” strategy—a long-term plan that included a host of initiatives designed to create seamless customer experiences both online and in stores. Finding that customers who used both channels to shop were five times as profitable as those who shopped online only, Macy’s invested heavily in its iconic Herald Square store in New York City and hundreds of others as well and began integrating them with its online business. It has turned virtually all of them into omnichannel fulfillment centers: Customers can order online and pick up their items at a local store. The Herald Square store is undergoing a $400 million renovation and will feature interactive directories, the widespread use of RFID tagging to track individual items, and a mobile app to guide customers as they shop. Sales associates equipped with mobile devices will be able to summon shoes from the back room without ever leaving the customer.

Organizational changes reflect Macy’s growing integration. In January 2013, for example, Robert B. Harrison, previously the executive vice president for omnichannel strategy, became the first chief omnichannel officer, reporting to CEO Terry Lundgren. He also joined the company’s executive committee. As he continued to manage the development of strategies to closely integrate stores, online, and mobile activities, Harrison assumed responsibility for systems and technology, logistics, and related operating functions.

Macy’s digical fusion has been great for its financial performance. Total sales have grown by $4.4 billion (19%) over the past four years, and the company recently reported a fifth consecutive year of double-digit earnings growth. Its stock rose steadily from 2010 to 2013, increasing by 43% in 2013 alone (compared with a gain in the S&P 500 of about 30%).

Rule #5: Build a digical-savvy leadership team that includes the CEO.

If digital technologies are expected to supplant the core business, the CEO’s primary task is to change the mix of businesses, not the fundamental capabilities of people within them. This kind of corporate evolution is much like biological evolution: Individual organisms don’t change, but the population evolves as superior species destroy less adaptable ones. The CEO encourages the physical business to keep up the good fight and siphons money to the new ventures on which the company’s hopes are pinned.

CEOs who lead digical transformations face a more complex task. They must change not only the mix of businesses but also the capabilities of people in and around those businesses—including themselves, their board members, their executive teams, and the operating organization. Appointing a chief information or technology or digital officer (titles vary, but it’s a common solution) may be helpful but isn’t sufficient. And it will be harmful if it creates the illusion that the new executive will handle digital capabilities and no one else need get involved.

Typically, digitally challenged CEOs are unaware of the extent of their ignorance and have a hard time hiring tech-savvy people. They also have a tendency to starve digital investments, encourage bad ideas, and kill good ones (or at least demand multiple rounds of improvements). But a growing number of CEOs are strengthening their grasp of the issues. They join the boards of digitally advanced companies. They spend more time with technology experts—venture capitalists, high-tech start-up teams, professionals in their own organizations. They read about digital topics, take online courses, acquire mentors, and play with the technologies their customers use. They also invite technology leaders onto their boards and launch “no executive left behind” programs to ensure that every leader in the organization accelerates his or her digital training. CEOs needn’t learn to write code, but they should understand why technology is important and how it can transform businesses and functions in the company portfolio.

The remarkable makeover of Burberry, the august UK-based clothing company, demonstrates some of the possibilities. When Angela Ahrendts took over Burberry’s top job, in 2006, the brand had begun to turn itself around but was struggling to catch on among younger shoppers. Ahrendts brought a new vision. She believed that Burberry should explicitly target previously neglected customers—millennials—and speak to them in their mother tongue: digital. She hired a fresh marketing team, most of its members under 25, and launched innovations such as the hugely popular Tweetwalk, which showed backstage pictures of Burberry’s collections before the runway show. She also created a new partnership at the top, including herself; the chief creative officer, Christopher Bailey; and the chief technology officer, John Douglas. She established a “strategic innovation council” and staffed it with what she viewed as the youngest and most forward-thinking directors in the company. The council developed digitally immersive physical experiences—live streaming of runway shows, video content on giant screens, digital mirrors that turned into screens displaying catwalk scenes—that made store customers feel like they were stepping into a digical “Burberry World.” Store merchandise carried RFID tags, so a customer picking up an item could instantly see product information and marketing materials on a screen. This digical strategy contributed to a significant increase in share price: From the time Ahrendts arrived to early 2014, shortly before she left, Burberry’s stock more than tripled, while the FTSE 100 index rose roughly 19%.

The Digical Future

Digical innovations are propelling leading companies in a growing range of businesses. The Ford Fiesta outsells competitors partly because of the company’s pioneering Ford Sync technology; more than half of Fiesta buyers say Ford Sync was a major reason for their purchase decision. Delta Air Lines was bankrupt in 2005 and rated last on Fortune’s list of most admired airlines in 2007, yet it is highly profitable and number one on the magazine’s list today. Among the many reasons for this improvement may be Delta’s sizable investments in digitally augmenting the physical aspects of flight. Its Fly Delta app, for example, not only provides information about flight itineraries, airplanes, and airports, but also lets passengers record their parking spots, check in, change seats, retrieve boarding passes, pay for excess baggage, track checked luggage, and view the ground under the plane (with Glass Bottom Jet). The immensely popular app had been downloaded an estimated 11 million times as of April 2014.

Perhaps the surest sign that digital technologies are transforming physical businesses rather than annihilating them is the growing number of digital companies that are themselves moving toward digital-physical fusions. Two early pioneers of online trading—E*Trade and TD Ameritrade—have invested in physical branches. Google, which started life as purely a digital search engine, is now producing smartphones and tablets and smart glasses; it has also been building driverless cars, acquiring robotics companies, laying physical fiber, creating delivery services, and moving into connected devices within the home. Digital retailers such as Warby Parker and Bonobos are launching physical stores. Andy Dunn, the CEO of Bonobos, says, “We were wrong at the beginning. In 2007 we started the company, and we said, ‘The whole world is going online only. All we’re going to do is be online.’ But what we’ve learned recently is that the offline experience of touching and feeling clothes isn’t going away.”

A digical lens will change how people perceive and manage nearly every activity in life and business. Try using it. Pick apart your customers’ experience chain to understand how digital technologies apply. Combining the physical and the digital promises to transform nearly every element of nearly every industry, including yours.

In a new book out this week chock full of Google-flavored business wisdom, How Google Works, Google executive chairman and former CEO Eric Schmidt and former Senior Vice President of Products Jonathan Rosenberg share nine insightful rules for emailing (or gmailing!) like a professional. 

Communication in the Internet Century usually means using email, and email, despite being remarkably useful and powerful, often inspires momentous dread in otherwise optimistic, happy humans. Here are our personal rules for mitigating that sense of foreboding:
1. Respond quickly. There are people who can be relied upon to respond promptly to emails, and those who can’t. Strive to be one of the former. Most of the best—and busiest—people we know act quickly on their emails, not just to us or to a select few senders, but to everyone. Being responsive sets up a positive communications feedback loop whereby your team and colleagues will be more likely to include you in important discussions and decisions, and being responsive to everyone reinforces the flat, meritocratic culture you are trying to establish. These responses can be quite short—“got it” is a favorite of ours. And when you are confident in your ability to respond quickly, you can tell people exactly what a non-​response means. In our case it’s usually “got it and proceed.” Which is better than what a non-​response means from most people: “I’m overwhelmed and don’t know when or if I’ll get to your note, so if you needed my feedback you’ll just have to wait in limbo a while longer. Plus I don’t like you.”

2. When writing an email, every word matters, and useless prose doesn’t. Be crisp in your delivery. If you are describing a problem, define it clearly. Doing this well requires more time, not less. You have to write a draft then go through it and eliminate any words that aren’t necessary. Think about the late novelist Elmore Leonard’s response to a question about his success as a writer: “I leave out the parts that people skip.” Most emails are full of stuff that people can skip.

3. Clean out your inbox constantly. How much time do you spend looking at your inbox, just trying to decide which email to answer next? How much time do you spend opening and reading emails that you have already read? Any time you spend thinking about which items in your inbox you should attack next is a waste of time. Same with any time you spend rereading a message that you have already read (and failed to act upon).

When you open a new message, you have a few options: Read enough of it to realize that you don’t need to read it, read it and act right away, read it and act later, or read it later (worth reading but not urgent and too long to read at the moment). Choose among these options right away, with a strong bias toward the first two. Remember the old OHIO acronym: Only Hold It Once. If you read the note and know what needs doing, do it right away. Otherwise you are dooming yourself to rereading it, which is 100 percent wasted time.

If you do this well, then your inbox becomes a to‑do list of only the complex issues, things that require deeper thought (label these emails “take action,” or in Gmail mark them as starred), with a few “to read” items that you can take care of later.

To make sure that the bloat doesn’t simply transfer from your inbox to your “take action” folder, you must clean out the action items every day. This is a good evening activity. Zero items is the goal, but anything less than five is reasonable. Otherwise you will waste time later trying to figure out which of the long list of things to look at.

4. Handle email in LIFO order (Last In First Out). Sometimes the older stuff gets taken care of by someone else.

5. Remember, you’re a router. When you get a note with useful information, consider who else would find it useful. At the end of the day, make a mental pass through the mail you received and ask yourself, “What should I have forwarded but didn’t?”

6. When you use the bcc (blind copy) feature, ask yourself why. The answer is almost always that you are trying to hide something, which is counterproductive and potentially knavish in a transparent culture. When that is your answer, copy the person openly or don’t copy them at all. The only time we recommend using the bcc feature is when you are removing someone from an email thread. When you “reply all” to a lengthy series of emails, move the people who are no longer relevant to the thread to the bcc field, and state in the text of the note that you are doing this. They will be relieved to have one less irrelevant note cluttering up their inbox.

7. Don’t yell. If you need to yell, do it in person. It is FAR TOO EASY to do it electronically.

8. Make it easy to follow up on requests. When you send a note to someone with an action item that you want to track, copy yourself, then label the note “follow up.” That makes it easy to find and follow up on the things that haven’t been done; just resend the original note with a new intro asking “Is this done?”

9. Help your future self search for stuff. If you get something you think you may want to recall later, forward it to yourself along with a few keywords that describe its content. Think to yourself, How will I search for this later? Then, when you search for it later, you’ll probably use those same search terms. This isn’t just handy for emails, but important documents too. Jonathan scans his family’s passports, licenses, and health insurance cards and emails them to himself along with descriptive keywords. Should any of those things go missing during a trip, the copies are easy to retrieve from any browsers.

Artwork detail: Liliana Porter, Man with String, 2009, string and pencil lines on paper

Work/life balance is at best an elusive ideal and at worst a complete myth, today’s senior executives will tell you. But by making deliberate choices about which opportunities they’ll pursue and which they’ll decline, rather than simply reacting to emergencies, leaders can and do engage meaningfully with work, family, and community. They’ve discovered through hard experience that prospering in the senior ranks is a matter of carefully combining work and home so as not to lose themselves, their loved ones, or their foothold on success. Those who do this most effectively involve their families in work decisions and activities. They also vigilantly manage their own human capital, endeavoring to give both work and home their due—over a period of years, not weeks or days.

That’s how the 21st-century business leaders in our research said they reconcile their professional and personal lives. In this article we draw on five years’ worth of interviews with almost 4,000 executives worldwide, conducted by students at Harvard Business School, and a survey of 82 executives in an HBS leadership course.

Deliberate choices don’t guarantee complete control. Life sometimes takes over, whether it’s a parent’s dementia or a teenager’s car accident. But many of the executives we’ve studied—men and women alike—have sustained their momentum during such challenges while staying connected to their families. Their stories and advice reflect five main themes: defining success for yourself, managing technology, building support networks at work and at home, traveling or relocating selectively, and collaborating with your partner.

Defining Success for Yourself

When you are leading a major project, you determine early on what a win should look like. The same principle applies to leading a deliberate life: You have to define what success means to you—understanding, of course, that your definition will evolve over time.

Executives’ definitions of professional and personal success run a gamut from the tactical to the conceptual (see the exhibit “How Leaders Define Work/Life ‘Wins’”). For one leader, it means being home at least four nights a week. For another, it means understanding what’s going on in the lives of family members. For a third, it’s about having emotional energy at both work and home.

Some intriguing gender differences emerged in our survey data: In defining professional success, women place more value than men do on individual achievement, having passion for their work, receiving respect, and making a difference, but less value on organizational achievement and ongoing learning and development. A lower percentage of women than of men list financial achievement as an aspect of personal or professional success. Rewarding relationships are by far the most common element of personal success for both sexes, but men list merely having a family as an indicator of success, whereas women describe what a good family life looks like to them. Women are also more likely to mention the importance of friends and community as well as family.

The survey responses consisted of short phrases and lists, but in the interviews executives often defined personal success by telling a story or describing an ideal self or moment in time. Such narratives and self-concepts serve as motivational goalposts, helping people prioritize activities and make sense of conflicts and inconsistencies.

When work and family responsibilities collide, for example, men may lay claim to the cultural narrative of the good provider. Several male executives who admitted to spending inadequate time with their families consider absence an acceptable price for providing their children with opportunities they themselves never had. One of these men, poor during his childhood, said that his financial success both protects his children and validates his parents’ struggles. Another even put a positive spin on the breakup of his family: “Looking back, I would have still made a similar decision to focus on work, as I was able to provide for my family and become a leader in my area, and these things were important to me. Now I focus on my kids’ education...and spend a lot more time with them over weekends.”

Even the men who pride themselves on having achieved some degree of balance between work and other realms of their lives measure themselves against a traditional male ideal. “The 10 minutes I give my kids at night is one million times greater than spending that 10 minutes at work,” one interviewee said. It’s difficult to imagine a woman congratulating herself for spending 10 minutes a day with her children, but a man may consider the same behavior exemplary.

Indeed, women rarely view themselves as working for their families the way men do. Men still think of their family responsibilities in terms of breadwinning, whereas women often see theirs as role modeling for their children. Women emphasize (far more than men do) how important it is for their kids—particularly their daughters—to see them as competent professionals. One said, “I think that work is such a big part of who I am. I want my kids to understand what I do. I am a whole being.”

Many women said that the most difficult aspect of managing work and family is contending with cultural expectations about mothering. One admitted that she stopped working at home after her daughter referred to the Bloomberg network as “Mommy’s channel.” Another commented, “When you are paid well, you can get all the [practical] help you need. What is the most difficult thing, though—what I see my women friends leave their careers for—is the real emotional guilt of not spending enough time with their children. The guilt of missing out.”

Both men and women expressed versions of this guilt and associated personal success with not having regrets. They often cope by assigning special significance to a particular metric, such as never missing a Little League game or checking in once a day no matter what. “I just prioritize dinner with my family as if it was a 6 PM meeting with my most important client,” said one interviewee. Another offered this suggestion: “Design your house right—have a table in the kitchen where your kids can do homework while your husband cooks and you drink a glass of red wine.” Though expressed as advice, this is clearly her very personal, concrete image of what success at home looks like.

Managing Technology

Nearly all the interviewees talked about how critical it is to corral their e-mails, text messages, voice mails, and other communications. Deciding when, where, and how to be accessible for work is an ongoing challenge, particularly for executives with families. Many of them cautioned against using communications technology to be in two places at once, insisting on the value of undivided attention. “When I’m at home, I really am at home,” said one. “I force myself to not check my e-mail, take calls, et cetera. I want to give my kids 100% of my attention. But this also works the other way around, because when I’m at work I really want to focus on work. I believe that mixing these spheres too much leads to confusion and mistakes.”

That last point is a common concern: Always being plugged in can erode performance. One leader observed that “certain cognitive processes happen when you step away from the frenetic responding to e-mails.” (The history of science, after all, is marked by insights that occurred not in the laboratory but while the scientist was engaged in a mundane task—or even asleep.) Another executive pointed out that 24-hour availability can actually hamper initiative in an organization: “If you have weak people who must ask your advice all the time, you feel important. But there is a difference between being truly important and just not letting anyone around you do anything without you.”

Strikingly, some people at the top are starting to use communications technology less often while they’re working. Several invoked the saying “You can’t raise a kid by phone”—and pointed out that it’s not the best way to manage a team, either. Often, if it’s logistically possible, you’re better off communicating in person. How do you know when that’s the case? One interviewee made an important distinction between broadcasting information and exchanging and analyzing ideas: “Speaking [on the phone] is easy, but careful, thoughtful listening becomes very challenging. For the most important conversations, I see a real trend moving back to face-to-face. When you’re evaluating multibillion-dollar deals...you have to build a bridge to the people.”

When it comes to technology in the home, more than a third of the surveyed executives view it as an invader, and about a quarter see it as a liberator. (The rest are neutral or have mixed feelings.) Some of them resent the smartphone’s infringement on family time: “When your phone buzzes,” one ruefully noted, it’s difficult to “keep your eyes on that soccer field.” Others appreciate the flexibility that technology affords them: “I will probably leave here around 4 PM to wrangle my kids,” said one participant, “but I will be back and locked into my network and e-mails by 8 PM.” Another participant reported, “Sometimes my kids give me a hard time about being on my BlackBerry at the dinner table, but I tell them that my BlackBerry is what enables me to be home with them.”

Both camps—those who hate being plugged in and those who love it—acknowledged that executives must learn to manage communications technology wisely. Overall, they view it as a good servant but a bad master. Their advice in this area is quite consistent: Make yourself available but not too available to your team; be honest with yourself about how much you can multitask; build relationships and trust through face time; and keep your in-box under control.

Building Support Networks

Across the board, senior executives insisted that managing family and professional life requires a strong network of behind-the-scenes supporters. Absent a primary caregiver who stays at home, they see paid help or assistance from extended family as a necessity. The women in our sample are adamant about this. One said, “We hire people to do the more tactical things—groceries, cooking, helping the children dress—so that we can be there for the most important things.” Even interviewees without children said they needed support at home when they became responsible for aging parents or suffered their own health problems.

Emotional support is equally essential. Like anyone else, executives occasionally need to vent when they’re dealing with something crazy or irritating at work, and friends and family are a safer audience than colleagues. Sometimes leaders also turn to their personal networks for a fresh perspective on a problem or a decision, because members of their teams don’t always have the distance to be objective.

Support at work matters too. Trusted colleagues serve as valuable sounding boards. And many leaders reported that health crises—their own or family members’—might have derailed their careers if not for compassionate bosses and coworkers. The unexpected can waylay even the most carefully planned career.

“When you’re young, you think you can control everything,” one interviewee said, “but you can’t.” Executives told stories about heart attacks, cancer, and parents in need of care. One talked about a psychotic reaction to medication. In those situations, mentors and team members helped leaders weather difficult times and eventually return to business as usual.

What about mixing personal and professional networks, since executives must draw on both anyway? That’s up for discussion. The men we surveyed tend to prefer separate networks, and the women are pretty evenly split. Interviewees who favor integration said it’s a relief to be “the same person” in all contexts and natural to form friendships at work, where they spend most of their time. Those who separate their work lives from their private lives have many reasons for doing so. Some seek novelty and a counterbalance to work. “If all of your socializing centers around your work life, you tend to experience an ever-decreasing circle of influence and ideas,” one pointed out. Others want to protect their personal relationships from the churn of the workplace.

Many women keep their networks separate for fear of harming their image. Some never mention their families at work because they don’t want to appear unprofessional. A few female executives won’t discuss their careers—or even mention that they have jobs—in conversations outside work. But again, not all women reported such conflict between their professional and personal “selves,” and several suggested that the tide is turning. One pointed out, “The more women have come into the workplace, the more I talk about my children.”

Traveling or Relocating Selectively

Discussions about work/life balance usually focus on managing time. But it’s also critical to manage your location—and, more broadly, your role in the global economy. When leaders decide whether to travel or relocate (internationally or domestically), their home lives play a huge part. That’s why many of them believe in acquiring global experience and racking up travel miles while they’re young and unencumbered. Of those surveyed, 32% said they had turned down an international assignment because they did not want to relocate their families, and 28% said they had done so to protect their marriages.

Several executives told stories about getting sidetracked or derailed in their careers because a partner or spouse needed to relocate. Of course, travel becomes even trickier with children. Many women reported cutting back on business trips after having children, and several executives of both sexes said they had refused to relocate when their children were adolescents. “When children are very young, they are more mobile,” one explained. “But once they are 12 or 13, they want to be in one place.”

Female executives are less likely than men to be offered or accept international assignments, in part because of family responsibilities but also because of the restrictive gender roles in certain cultures or perceptions that they are unwilling to relocate. Our survey results—from a well-traveled sample—jibe with student interviewers’ qualitative findings. Almost none of the men surveyed (less than 1%, compared with 13% of the women) had turned down an international assignment because of cultural concerns. But for female executives, not all travel is created equal: Gender norms, employment laws, health-care access, and views on work/life balance vary from country to country. One American woman said it requires extra effort in Europe to make sure she doesn’t “come off as being intimidating,” a concern she attributes in part to being tall. Another woman said that in the Middle East she has had to bring male colleagues to meetings to prove her credibility.

Though women in particular have such difficulties, international assignments are not easy for anyone, and they may simply not be worth it for many executives. Members of both sexes have built gratifying careers while grounding themselves in a particular country or even city. However, if travel is undesirable, ambitious young executives should decide so early on. That way they can avoid getting trapped in an industry that doesn’t mesh with their geographic preferences and give themselves time to find ways other than travel to signal open-mindedness, sophistication, skill diversity, and willingness to go above and beyond. (Several executives noted that international experience is often viewed as a sign of those personal attributes.) “International experience can be helpful,” one executive observed, “but it’s just as important to have had exposure across the business lines. Both allow you to understand that not everybody thinks as you do.” Some executives even question the future of globe-hopping, noting that carbon costs, fuel costs, and security concerns may tighten future travel budgets.

Collaborating with Your Partner

Managing yourself, technology, networks, travel—it’s a tall order. Leaders with strong family lives spoke again and again of needing a shared vision of success for everyone at home—not just for themselves. Most of the executives in our sample have partners or spouses, and common goals hold those couples together. Their relationships offer both partners opportunities—for uninterrupted (or less interrupted) work, for adventurous travel, for intensive parenting, for political or community impact—that they might not otherwise have had.

Leaders also emphasized the importance of complementary relationships. Many said how much they value their partners’ emotional intelligence, task focus, big-picture thinking, detail orientation—in short, whatever cognitive or behavioral skills balance out their own tendencies. And many of those we surveyed consider emotional support the biggest contribution their partners have made to their careers. Both men and women often mentioned that their partners believe in them or have urged them to take business risks or pursue job opportunities that were not immediately rewarding but led to longer-term satisfaction. They also look to their partners to be sounding boards and honest critics. One executive said that her partner asks “probing questions to challenge my thinking so I can be better prepared for an opposing viewpoint.”

A partner’s support may come in many forms, but what it almost always boils down to is making sure the executive manages his or her own human capital effectively. The pressures and demands on executives are intense, multidirectional, and unceasing. Partners can help them keep their eyes on what matters, budget their time and energy, live healthfully, and make deliberate choices—sometimes tough ones—about work, travel, household management, and community involvement.

Men, however, appear to be getting more spousal support overall. Male interviewees—many of whom have stay-at-home wives—often spoke of their spouses’ willingness to take care of children, tolerate long work hours, and even relocate, sometimes as a way of life. But by and large, they no longer seem to expect the classic 1950s “corporate wife,” who hosted dinners for the boss and cocktail parties for clients. (Exceptions exist in some countries and industries. One male executive who works in oil fields said, “When you are living and working in those camp environments, it is indispensable to have your wife talk with other spouses.”) Men frequently noted that their partners won’t allow them to neglect their families, health, or social lives. For example: “My wife is militant about family dinner, and I am home every night for dinner even if I have to work afterward.”

Women, by contrast, slightly more often mentioned their partners’ willingness to free them from traditional roles at home. One explained, in a typical comment, “He understands the demands of my role and does not put pressure on me when work takes more time than I would like.” In other words, male executives tend to praise their partners for making positive contributions to their careers, whereas women praise theirs for not interfering.

When we look at the survey data, we see other striking differences between the sexes. Fully 88% of the men are married, compared with 70% of the women. And 60% of the men have spouses who don’t work full-time outside the home, compared with only 10% of the women. The men have an average of 2.22 children; the women, 1.67.

What Tomorrow’s Leaders Think

The fact that the interviewees all agreed to take time from their hectic schedules to share their insights with students might introduce a selection effect. Busy leaders who choose to help students presumably value interpersonal relationships. Because they’re inclined to reflect on work and life, they’re probably also making deliberate choices in both realms—and they certainly have enough money to pay for support at home. All that may explain why many interviewees reported being basically happy despite their struggles and why few mentioned serious damage to their marriages or families due to career pressures. This sample is an elite group of people better positioned than most to achieve work/life balance. That they nevertheless consider it an impossible task suggests a sobering reality for the rest of us.

Our student interviewers say, almost universally, that the leaders they spoke with dispensed valuable advice about how to maintain both a career and a family. One interviewer reported, “All acknowledged making sacrifices and concessions at times but emphasized the important role that supportive spouses and families played.” Still, many students are alarmed at how much leaders sacrifice at home and how little headway the business world has made in adapting to families’ needs.

Male executives admitted that they don’t prioritize their families enough. And women are more likely than men to have forgone kids or marriage to avoid the pressures of combining work and family. One said, “Because I’m not a mother, I haven’t experienced the major driver of inequality: having children.” She added, “People assume that if you don’t have kids, then you either can’t have kids or else you’re a hard-driving bitch. So I haven’t had any negative career repercussions, but I’ve probably been judged personally.”

Executives of both sexes consider the tension between work and family to be primarily a women’s problem, and the students find that discouraging. “Given that leadership positions in corporations around the world are still dominated by men,” one explained, “I fear that it will take many organizations much longer than it should to make accommodations for women to...effectively manage their careers and personal lives.”

Students also resist leaders’ commonly held belief that you can’t compete in the global marketplace while leading a “balanced” life. When one executive argued that it’s impossible to have “a great family life, hobbies, and an amazing career” all at the same time, the student interviewing him initially thought, “That’s his perspective.” But after more conversations with leaders? “Every single executive confirmed this view in one way or another, and I came to believe that it is the reality of today’s business world.” It remains to be seen whether, and how, that reality can be changed for tomorrow.

We can’t predict what the workplace or the family will look like later in this century, or how the two institutions will coexist. But we can assert three simple truths:

Life happens. Even the most dedicated executive may suddenly have his or her priorities upended by a personal crisis—a heart attack, for instance, or a death in the family. As one pointed out, people tend to ignore work/life balance until “something is wrong.” But that kind of disregard is a choice, and not a wise one. Since when do smart executives assume that everything will work out just fine? If that approach makes no sense in the boardroom or on the factory floor, it makes no sense in one’s personal life.

There are multiple routes to success. Some people plan their careers in detail; others grab whatever opportunity presents itself. Some stick with one company, building political capital and a deep knowledge of the organization’s culture and resources; others change employers frequently, relying on external contacts and a fresh perspective to achieve success. Similarly, at home different solutions work for different individuals and families. Some executives have a stay-at-home partner; others make trade-offs to enable both partners to work. The questions of child care, international postings, and smartphones at the dinner table don’t have “right” answers. But the questions need to be asked.

No one can do it alone. Of the many paths to success, none can be walked alone. A support network is crucial both at and outside work—and members of that network must get their needs met too. In pursuit of rich professional and personal lives, men and women will surely continue to face tough decisions about where to concentrate their efforts. Our research suggests that earnestly trying to focus is what will see them through.

1. CLARIFY THE OPPORTUNITY: Review brand strength, web traffic, conversion rates, online pricing issues, competitor success, search engine opportunities & technology implications.

2. EXPLORE THE BUSINESS MODEL: Assess which capabilities you will manage in-house vs. outsource.

3. NAIL DOWN SOFTWARE INVESTMENT: Determine whether a licensed or hosted solution works best.

4. SIMPLIFY INTEGRATION STRATEGY: Identify how you can reduce the number of software tools and systems.

5. BUTTON DOWN SOFTWARE: Compare and contrast at least two software options.

6. EXPLORE PARTNERS: Choose an implementation partner who can go beyond software programming and address other issues e-commerce uncovers (branding, content and marketing).

7. SHAPE THE VISION: Prioritize requirements, frame outsourcing strategy and develop a 3-year plan for branding, web development, content creation and traffic building.

8. DESIGN AND BUILD: Be Agile – continually reassess top priorities and build the most important pieces first.

9. CELEBRATE… BRIEFLY! Develop an ongoing process for measuring, managing and enhancing all aspects of the process.

Source: www.hansondodge.com

80% of consumers research purchases online

52% of consumers prefer to purchase directly from the brand

48% of e-commerce businesses plan to launch new technology within 18 months

Off-line sales are driven by online advertising

1/3 of all online shopping starts at Amazon

35% of marketing will be spent on digital by 2016

55% of online shopping was done on mobile devices in 2013

Amazon will lower your selling price and marginalize your channel partners

Big Data and personalized shopping will change the user experience in 2014

Want to improve your SEO? Create more relevant content!

Source: www.hansondodge.com 

A look back at a pair of real estate purchases and the lessons they offer for equity investors.
By Warren Buffett

The author visiting (for just the second time) the 400-acre farm near Tekamah, Neb., that he bought in 1986 for $280,000

FORTUNE -- "Investment is most intelligent when it is most businesslike." --Benjamin Graham, The Intelligent Investor

It is fitting to have a Ben Graham quote open this essay because I owe so much of what I know about investing to him. I will talk more about Ben a bit later, and I will even sooner talk about common stocks. But let me first tell you about two small nonstock investments that I made long ago. Though neither changed my net worth by much, they are instructive.

This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble's aftermath as in our recent Great Recession.

In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.

I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop, and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.

In 1993, I made another small investment. Larry Silverstein, Salomon's landlord when I was the company's CEO, told me about a New York retail property adjacent to New York University that the Resolution Trust Corp. was selling. Again, a bubble had popped -- this one involving commercial real estate -- and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.

Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant -- who occupied around 20% of the project's space -- was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property's location was also superb: NYU wasn't going anywhere.

I joined a small group -- including Larry and my friend Fred Rose -- in purchasing the building. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I've yet to view the property.

Income from both the farm and the NYU real estate will probably increase in decades to come. Though the gains won't be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.

I tell these tales to illustrate certain fundamentals of investing:

You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits, respond with a quick "no."
Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake.
If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field -- not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: "You don't know how easy this game is until you get into that broadcasting booth.")
My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following -- 1987 and 1994 -- was of no importance to me in determining the success of those investments. I can't remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings, whereas I have yet to see a quotation for either my farm or the New York real estate.

It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings -- and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his -- and those prices varied widely over short periods of time depending on his mental state -- how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.

Owners of stocks, however, too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits -- and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of "Don't just sit there -- do something." For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.

A "flash crash" or some other extreme market fluctuation can't hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.

During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?

When Charlie Munger and I buy stocks -- which we think of as small portions of businesses -- our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings -- which is usually the case -- we simply move on to other prospects. In the 54 years we have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.

It's vital, however, that we recognize the perimeter of our "circle of competence" and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.

Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.

I have good news for these nonprofessionals: The typical investor doesn't need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th century, the Dow Jones industrial index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial. The goal of the nonprofessional should not be to pick winners -- neither he nor his "helpers" can do that -- but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

That's the "what" of investing for the nonprofessional. The "when" is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs's observation: "A bull market is like sex. It feels best just before it ends.") The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs. Following those rules, the "know-nothing" investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

If "investors" frenetically bought and sold farmland to one another, neither the yields nor the prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.

Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I've laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife's benefit. (I have to use cash for individual bequests, because all of my Berkshire Hathaway shares will be fully distributed to certain philanthropic organizations over the 10 years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's. I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions, or individuals -- who employ high-fee managers.

And now back to Ben Graham. I learned most of the thoughts in this investment discussion from Ben's book The Intelligent Investor, which I bought in 1949. My financial life changed with that purchase.

Before reading Ben's book, I had wandered around the investing landscape, devouring everything written on the subject. Much of what I read fascinated me: I tried my hand at charting and at using market indicia to predict stock movements. I sat in brokerage offices watching the tape roll by, and I listened to commentators. All of this was fun, but I couldn't shake the feeling that I wasn't getting anywhere.

In contrast, Ben's ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. These points guide my investing decisions today.

A couple of interesting sidelights about the book: Later editions included a postscript describing an unnamed investment that was a bonanza for Ben. Ben made the purchase in 1948 when he was writing the first edition and -- brace yourself -- the mystery company was Geico. If Ben had not recognized the special qualities of Geico when it was still in its infancy, my future and Berkshire's would have been far different.

The 1949 edition of the book also recommended a railroad stock that was then selling for $17 and earning about $10 per share. (One of the reasons I admired Ben was that he had the guts to use current examples, leaving himself open to sneers if he stumbled.) In part, that low valuation resulted from an accounting rule of the time that required the railroad to exclude from its reported earnings the substantial retained earnings of affiliates.

The recommended stock was Northern Pacific, and its most important affiliate was Chicago, Burlington & Quincy. These railroads are now important parts of BNSF (Burlington Northern Santa Fe), which is today fully owned by Berkshire. When I read the book, Northern Pacific had a market value of about $40 million. Now its successor (having added a great many properties, to be sure) earns that amount every four days.

I can't remember what I paid for that first copy of The Intelligent Investor. Whatever the cost, it would underscore the truth of Ben's adage: Price is what you pay; value is what you get. Of all the investments I ever made, buying Ben's book was the best (except for my purchase of two marriage licenses).

* Warren Buffett is the CEO of Berkshire Hathaway. This essay is an edited excerpt from his annual letter to shareholders.

This story is from the March 17, 2014 issue of Fortune.

Nearly everyone who sits on Google’s board of directors has at least one computer science or engineering degree or doctorate. There are two university presidents and eminent scholars – Stanford University’s John Hennessy and former Princeton University President Shirley Tilghman – and several members of the National Academy of Engineering and other illustrious organizations. For Google, it pays to have technical expertise at the top.

But Google is an unusual corporate giant in promoting those with scientific prowess to the top of the management ladder. Beyond Silicon Valley, few senior corporate executives boast technical expertise in the products that their companies produce. American boardrooms are filled with MBAs, especially from Harvard, while firms in the rest of the developed world (with the possible exception of Germany) seem to prefer professional managers over technical or scientific talent.

Nowadays, it seems as anomalous to have knowledge workers serve as professional leaders as it once did to have scientists in the boardroom. It was previously thought that leadership is less necessary in knowledge-intensive organizations, where experts were assumed to be superior because they were motivated by intellectual pleasure rather than such extrinsic motivations as profit growth and cost targets.

This difference in attitude is evident in many areas of society, not least in hospitals in the United States and the United Kingdom, where knowledge-intensive medical practitioners operate separately from managers. Hospitals used to be run by doctors; today, only 5% of US hospitals’ CEOs are medical doctors, and even fewer doctors run UK hospitals. “Medicine should be left to the doctors,” according to a common refrain, “and organizational leadership should be left to professional managers.”

But this is a mistake. Research shows that higher-performing US hospitals are likely to be led by doctors with outstanding research reputations, not by management professionals. The evidence also suggests that hospitals perform better, and have lower death rates, when more of their managers up to board level are clinically trained.

We see similar findings in other fields. My research shows that the world’s best universities, for example, are likely to be led by exceptional scholars whose performance continues to improve over time. Departmental-level analysis supports this. A university economics department, for example, tends to perform better the more widely its head’s own research is cited.

With experts in charge, it may not always look like there is an effective reporting structure in place. But, as the academic saying goes: just because you cannot herd cats, does not mean there is not a feline hierarchy. As with cats, academics operate a “relative hierarchy” in which the person in charge changes, depending on the setting.

Even in the world of sports, where success is not an obvious preparation for management, we see interesting linkages between experience and organizational performance.

The very best NBA basketball players often make top coaches, while former Formula 1 champion drivers are associated with great team performance. Of the 92 soccer clubs in the English football league, club managers played an average of 16 years in senior clubs. Alex Ferguson, arguably Britain’s best manager, scored an average of one goal every two games in his professional career.

But where the pattern does occur, especially in the business world, we should take note. The senior partner of any professional services firm is likely to have been a top performer during a long career with the firm. This might be because experts and professionals in knowledge-intensive organizations prefer a boss who has excelled in their field. The leader’s credibility is vital: if she sets high standards, it seems only right that she should have matched or exceeded them herself. In short, she must lead by example.

This sort of leadership arrangement creates a virtuous circle. A leader with prior experience knows how her subordinates feel, how to motivate them, and how to create the right working environment. She probably makes better hiring decisions, too – after all, the best scientist or physician is more likely than a professional manager to know which researchers or doctors have the greatest potential.

The problem, however, is not simply that today’s leaders lack technical knowledge; it is that experts are often reluctant to lead. But that can change. By communicating the importance of management and leadership early in a specialist’s career, and by offering tailored, digestible, and jargon-free training, we could bridge the gap. Many medical schools are already considering including management education as part of the curriculum.

The trick is to get experts, who are trained to go ever deeper into their specialization, to step back and view the big picture. With the right preparation, there is no reason why a leader cannot specialize and manage. The results could be remarkable. Think of how governments run by scientists with management skills might respond to climate change. Top minds should be put to top use.