Market-Based Manager

Charles Koch is CEO of Koch Industries, the largest privately held company in America, and a longtime funder of libertarian causes. His new book, The Science of Success (Wiley), explains his concept of "market-based management" (MBM), which he says has helped his company succeed. This method tries to apply "the principles that allow free societies to prosper" within the firm, using ideas about incentives, knowledge, and the way markets function derived from thinkers such as F.A. Hayek, Ludwig von Mises, and Michael Polanyi.

Q: Your company is privately held. Can a public company effectively implement MBM?

A: The pressure on public companies to satisfy quarterly earning requirements often takes focus away from maximizing long-term value. When most public companies become diverse [as Koch Industries is], their stock price gets hammered. Also, we reinvest 90 percent of our earnings, and because we are private we can absorb more volatility.

The future is unknown and unknowable. You'll have blips, downtimes, uptimes.

But if what you are doing makes sense and you're proving your capacity to create value over time, a public company could just tell people, "If you don't want that, don't buy our stock, because we are going to be practicing principled entrepreneurship and create real value and it won't be a straight line; it's a process of experimental discovery and creative destruction."

It wasn't always like this extreme emphasis on short-term quarterly earnings. Some dynamics changed in the market, and in the regulatory system, and with litigation, so it could change again.

Q: You write that MBM tries both to ensure every employee is adding value and to encourage internal entrepreneurship. How do these principles work together?

A: An entrepreneur can't just sit there and say, "Gosh, I want a certain revenue." You have to go out and find ways to create value. Hayek pointed out that the market economy is an experimental process for finding and delivering what people value, and inherent in experimentation is failure. A good trader might be profitable 55 percent of the time, and if the trader is following our principles and using good scientific methods and following risk management procedures, then just add up how much net value the trader created. That leaves room for some failure. If he just sat there saying, "I'm going to avoid failure," the trader would have no trades.

But if someone just plunges in without understanding how a particular market works, that's not acceptable—even if once in a while they hit a home run.

Q: You write that height in a hierarchy doesn't make you right. Can you give an example of a lower-level Koch employee teaching you something?

A: That happens every day. We try to have decisions made by comparative advantage, and in the majority of things someone else has much greater competence and capability to make a decision than me. For example, in China someone purchasing copies goes to a copying store trying to apply their existing standard, which involves filling out and filing certain forms. The guy producing copies says, "I have 100 copies for you; just pay me." The buyer says, "But we can't 'til you've filled out a form!" I thought the standard was working very well in most cases, but in smaller transactions it was being misapplied. That's a constant battle to get people to use their judgment to apply standards in a way that isn't just following them for their own sake but that creates value.

Q: How does MBM inform your philanthropic and ideological work?

A: Even in nonprofit work, you must define what you are trying to achieve. In business that might be certain earnings. In a nonprofit you need to create proxies, measures for what changes in society you want to see, and it needs to be more than just activities. At reason, for example, it could be you want to get circulation up—but what if it goes up but changes no one's opinions over time?