Dave Stahlman 15.939 Strategic Options and Information Technology Assignment 1

Thermo Electron

Overview

Thermo Electron Corporation, of Waltham, Mass, has discovered a formula for: encouraging entrepreneurship and innovation, expanding into many varied technological fields, and assuring markets that such growth is focused, all while ensuring very handsome returns for its shareholders. The secret is its systems of “spin-outs.” When a new venture within Thermo Electron begins to show promise, especially if it is somewhat removed from its parent’s core business, Thermo will take the venture public, creating a new publicly held company. The key managers receive stock options and a great deal of autonomy, but Thermo Electron maintains majority ownership and a fair degree of oversight. Innovators are thus empowered to pursue and profit from their ideas while Thermo’s shareholders share in the profits.

Background

Founder John Hatsopoulos envisioned a company which would be based on the entire discipline of mechanical engineering, rather than just a particular niche technology. Initially, he offered stock options as incentives to innovators across a wide span of engineering initiatives. This worked very well from the company’s founding in 1956 through the 1970’s, as Thermo grew at an average rate of 20% per year. By the 1980’s however, he realized that the business was becoming too diverse, which both caused investment analysts to question Thermo’s focus as well as minimizing the effect of each new innovator’s efforts on the overall stock price. The solution, first put into practice in 1983, was to “spin-out” (not “spin off”) each new substantial innovation to form a new company. To date, Thermo Electron has created 12 new companies in this manner, in fields ranging from heart valves to hazardous waste disposal.

Spin-out Process

As a new innovation is proposed, it is not immediately spun out. Instead, it is nurtured within Thermo (or one of Thermo’s “children”) until it is ready to stand on its own. At this point, an Initial Public Offering (IPO) is held for a portion of the new company’s stock. Thermo always maintains at least 51% control, usually ranging from 51-86%. The startup’s senior managers are given lucrative stock options to encourage growth, and the remainder of the shares are sold to the public. The managers’ options are a mix of stock from the new venture and Thermo, to ensure incentives remain aligned. As a very interested majority shareholder, Thermo supports the company with management and administrative support, but the startup must pay for these services according to contract.

Hatsopoulos is adamant in his use of the term “spin out” rather than “spin off.” He maintains that many companies spin off projects when the parent is not interested in a particular venture, particularly if the venture is not in the parent’s core business. Thermo, by contrast, keeps control of these companies through majority ownership, and sees such innovation as central to Thermo’s business and profitability. The spinout is a way to motivate people and reward innovation, which may indeed be Thermo’s core competency.

Advantages

There are many advantages to this approach. First, of course, is its encouragement of innovation. Entrepreneurs recognize that they will be able to not only share in the fruits of their innovation, but to direct its implementation. The CEO and senior managers of the start-up are both the prime movers and the primary beneficiaries of the new company’s success. A second, related advantage is that this system works very well to keep entrepreneurs within Thermo. Rather than merely encouraging innovation, it provides incentives to people who might otherwise have left the company to remain under Thermo’s umbrella. Hatsopoulos claims that since 1983, only two entrepreneurs have left his company.

A third key advantage to this system is access to capital, both for the new company and Thermo Electron. At the IPO, the spin-out is able to command a much higher price for its shares than would another start-up, due to the market’s respect for Thermo’s performance in the past in identifying and nurturing new ventures. The feeling is that Thermo has picked another winner, and the parent will not let this company fail. This obviously provides money for the start-up, but also, because of the use of a public offering, Thermo does not need to draw on its cash reserves to fund the new company. After the IPO, the new venture further benefits from its relationship with Thermo by having ready access (at market rates!) to its parent’s considerable cash reserves. Fourth, financial analysts find it easier to assess the value of each individual stock, rather than trying to analyze a company such as Johnson and Johnson, which spins off companies but does not issue new stock. The industry for each new Thermo company is well defined.

Finally, the new company benefits from willing managerial and logistical advice and support from the parent. Although the spin-out is billed for this support, Thermo has a vested interest in ensuring they venture gets all the support it needs.

Disadvantages

There are several disadvantages to this strategy, which may be why few companies, if any, have successfully copied it. The most significant is the level of bookkeeping and close involvement with the SEC. Each company is publicly traded, which results in a plethora of SEC mandated reports. . Results The results of this strategy have been impressive. The average return of the 12 new companies has been 30 % per year. Thermo’s consolidated revenues have grown from $286 million in 1985 to $1.6 billion in 1995. Hatsopoulos’ goal for the next five years is 30% annual growth.

Conclusion...Why is this interesting?

As knowledge becomes the key driver for competitive advantage in companies, they must find ways to encourage and harness the development of new knowledge. Thermo Electron’s key threats do not come only from large, established companies, they also come from entrepreneurs who can quickly set up a virtual company via today’s efficient communications, logistics, and financial markets. Through their spin-out approach, Thermo is able to provide entrepreneurs the flexibility and rewards they demand, while the parent company shares in the success of the innovation.

This is also interesting against the backdrop of the re-engineering craze that other companies have followed during this same period. As others struggle to downsize in order to focus on core competencies, Thermo Electron is actually expanding while each new venture focuses on its own niche competency. The ongoing challenge is to see whether Thermo Electron itself can maintain its efficiency in presiding over this process, or whether the children will outgrow the parent, with Thermo Electron eventually going the way to the conglomerates of yesterday.