Eric Ries's favorite mistake wasn't a failed product, it was not knowing what “strategy” meant until a panel of Boston consultants told him so. We trace that lesson from The Lean Startup to his new book, Incorruptible, and the structural reasons good companies get corrupted.
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My guest for Episode #353 of the My Favorite Mistake podcast is Eric Ries, author of The Lean Startup — the book that gave a generation of founders a shared vocabulary of minimum viable product, build-measure-learn, and pivot. He's also the founder of the Long-Term Stock Exchange and co-founder of the AI research lab Answer.AI. His new book, Incorruptible: Why Good Companies Go Bad and How Great Companies Stay Great, is available now.
Eric's favorite mistake isn't the failed dorm-room startup he built during the dot-com bubble. It's what that failure exposed: he didn't actually know what the word strategy meant. He had a 40-page business plan and an Excel model so complicated it would crash Excel. He had elite co-founders, real investors, and a working product. What he didn't have was a strategy — and he didn't realize it until a Boston job interview, when a panel of consultants asked what he'd learned and told him his answers were not strategy. That category error became the foundation for The Lean Startup, and the through-line to his new book.
In this conversation, Eric traces the line from that dorm-room failure to Incorruptible. He argues that many of the so-called best practices founders are trained to follow aren't pillars of capitalism — they're modern inventions with a poor track record. The result: mission-driven companies that succeed, then quietly get corrupted by the very structures meant to govern them. He uses Whole Foods as a cautionary tale, Costco as the counter-example, and Novo Nordisk as proof that better structures have existed for a hundred years.
Themes and Questions:
- Why a polished business plan can mask the absence of a real strategy
- The leap-of-faith assumptions that quietly run most early-stage companies
- What “corruption” actually means in the old sense — and why Tolkien understood it better than modern business does
- Why John Mackey couldn't cut prices at Whole Foods, even when the company was profitable every year
- How Sol Price's fiduciary duty to the customer built the engine that powers Costco today
- Why Costco's $1.50 hot dog is a governance signal, not a marketing gimmick
- The industrial foundation structure behind Novo Nordisk, Ikea, and Patagonia — and why companies with it are six times more likely to survive 50 years
- Why cutting costs gets rewarded while the damage from those cuts goes unaccounted for
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Meet Eric Ries
Mark Graban: Hi, welcome to My Favorite Mistake. I'm your host, Mark Graban. Our guest today is Eric Ries. You know him as the author of books including The Lean Startup. That was the book that gave a generation of founders a shared vocabulary: minimum viable product, build-measure-learn, pivot, words like that, concepts like that.
He also founded the Long-Term Stock Exchange and co-founded the AI research lab Answer.AI with Jeremy Howard. His new book is titled Incorruptible: Why Good Companies Go Bad and How Great Companies Stay Great. It was just released. It's available now. Eric, I'm really excited to have you on the show. How are you?
Eric Ries: I'm great. I'm really happy to be here. Good to see you, and always fun to hang out.
Mark Graban: I'm glad we'll get the chance to share that hangout with others. I do want to talk about the new book — really interesting, a lot to dig into there. But I'm not going to let you off the hook, as we always do. Eric, what would you say is your favorite mistake?
A Dorm-Room Startup and a Category Error
Eric Ries: Favorite mistake? There's so many to choose from. I know it's kind of a running joke on the show, but there's so many to choose from. I've made mistakes that are really catastrophic. If you think about the biggest mistakes, they're all opportunity-cost mistakes. Every mega, mega company of the last I don't know how many years, I could have had the chance to work there. I could have had the chance to invest in it, turned them all down. So don't take your investing advice from me.
But my favorite mistake has got to be this one. When I did my very first startup, I wrote about this in The Lean Startup. Did a startup, was still in my dorm room. The mistake wasn't doing the startup — it was actually a great learning experience. And the mistake wasn't that we had the wrong product or anything like that, just typical stuff. In fact, we were building — if you can imagine this in 1999, 2000 — an online website where college students from top schools could create online profiles for the purpose of sharing. If you recall, that did turn out to be a pretty big product just a few years later. We were not really in the wrong space.
What our mistake was that we fundamentally did not know what it meant to create a startup. It was in some ways a philosophical, category-error mistake. We just didn't know. So we were flailing around trying to piece together what to do based on case studies and the stuff you'd see on TV. This is during the dot-com bubble, quite a long time ago.
The Humiliation of Going Back
I'll never forget, after the whole thing collapsed — when the dot-com bubble collapsed, it collapsed. In movies about entrepreneurship, whether we're talking about The Social Network or Ghostbusters or any of the great entrepreneurial movies, the best part is at the end. The plucky protagonist gets to go back to those early skeptics and doubters and say, “See, you told me not to do this, but actually I was right and you were wrong.” It's emotionally so satisfying.
So in real life, you had to go back to those people and be like, “Remember when you told me I shouldn't drop out of school, I should finish my degree instead? Well, you were right. I'm going back to finish my degree now.” It's humiliating. As a 20-year-old especially, it was utterly humiliating.
But in retrospect, we can say it's my favorite mistake because I learned the most from it.
The Boston Interview That Exposed Everything
Here's where it really crystallized for me when I realized the mistake. I didn't really understand it until after. I was going for job interviews. I applied for tech jobs. I didn't even know if I was going to do another startup. I had finally finished my degree. The startup failed so quickly that I wasn't even that far behind my peers. I applied for jobs in Boston, New York, Seattle, Austin, the Bay Area. And how people reacted to my experience was very different in different places.
I'll never forget being in Boston. I interviewed with this very cool company. Everyone's dressed in suits. They all come from a strategy consulting background. These seem like serious people, and I'm thinking, “Yeah, I want to work with serious people.” And they said, “I see here you have a failed startup on your resume. What happened?” I said, “Well, we built this product and nobody wanted to use it, so we…” They said, “Yes.” But the tone was negative. They were super annoyed about it.
They said, “Well, but now that you realize your mistake, what would you do differently?” I said, “What do you mean?” They said, “As a matter of strategy, what did you learn? How would you repeat this? How would you avoid repeating this error?” I said, “We would probably make a product that people do like this time. And maybe we would save money on our office.” I was just giving them the practical tips. They said, “That is not strategy.”
I had this moment of total panic. I realized I don't know what the word strategy means. I had somehow managed to build, launch, and blow up a startup with a not insignificant amount of money, with a not insignificant valuation. We'd actually built a cool product. We'd done a lot of stuff. And I was like, “I don't think we really actually had a strategy.” We weren't even thinking at that level.
I obviously did not get the job in Boston.
Silicon Valley's Opposite Reaction
Meanwhile, I come out to Silicon Valley, and whether I'm interviewing with big companies or small companies, in Silicon Valley nobody asked me that kind of question. It's like talking to art critics about art. That famous Picasso line — when you talk to artists, they talk about how to get cheap turpentine. They're not talking about high-concept, airy-fairy stuff. Everyone in Silicon Valley was like, “Oh, this is great. You have a failed startup on your resume? Well done. Congratulations.”
Mark Graban: Not great that you had failed, but great that you would share that, right?
Eric Ries: Actually both. They said, “It's great.” I said, “Why is it great?” I was expecting to apologize. They said, “Don't apologize. What's great is that you must have learned really valuable lessons on somebody else's dime. Someone else paid for your education. We don't have to pay for it.”
That was really my introduction to the ethos of Silicon Valley, especially as it was in those golden years. They didn't ask me what lessons I had learned. They understood that the lesson is inner. So that's my favorite mistake.
A 40-Page Plan That Wasn't a Strategy
Mark Graban: To be fair, you had investors, mentors. They also didn't know what the word strategy meant?
Eric Ries: Well, it was the dot-com bubble. During manias, all the rules fly out the window. People were investing in stuff they had no business investing in. And it's interesting — when I say we had no strategy, we had a lot of strategy documents. We were very smart. If you look at the people involved in that startup, they've all gone on to do amazing things. It was a very elite club of people. I might be the least successful of anybody, if you really think about it.
We had a 40-page business plan with massive Excel spreadsheets. I remember we had an Excel spreadsheet to model the business. It was so complicated it would crash Excel periodically because it was too complicated to run. It was really well thought out. And it was such a classic mistake. We didn't understand what entrepreneurship was.
So when I say we had no strategy — we did have a strategy. We had a strategy that was a prediction of all the things that were going to happen. I remember we calculated down to the last decimal place the value of each customer we could sign up, and it was huge. Each customer was worth $1,000. So of course we could be profligate in our spending to acquire a customer, because they're worth $1,000.
The problem wasn't that we had no strategy. The problem was that the strategy was based on a whole raft of leap-of-faith assumptions that weren't true. As the old saying goes, it's not the things you don't know that get you, it's what you believe that just ain't so. That was really the essence of the mistake. We had convinced ourselves that we were smarter than reality. We knew how to predict the future. We knew what was going on. Because when you're an elite student, that's how you get trained. That's how you get an A on the assignment, through diligent effort.
Mark Graban: And of course, entrepreneurship requires something a little different. Knowing the answer versus finding it through a hypothesis and iteration. This is the foundation for what you then later crystallized and wrote about in The Lean Startup. Another cautionary tale of what happens when you don't have that.
The product — online profiles for students — was this more of like a student LinkedIn?
Eric Ries: Closer to LinkedIn than Facebook. If you had pitched us Facebook, we would have said, “That's not a real business.” We were cosplaying. We wanted to be a serious business. We'd be like Yahoo. That's not a serious business — they're all about clicks. We're going to build a serious business. We meant we're going to have a product that we sell for money.
We thought the online profiles should be used to help students get jobs, which we did do. It wasn't such a failure that we didn't do it. We built a really cool product. We did get some customers. But the whole economic engine of it was so untethered to reality that it exploded once the free-flowing capital disappeared. We were totally toast.
The Investors Didn't Know Either
Mark Graban: In a mania, it was easier to get funding when you don't know about entrepreneurship, you don't know about strategy. There was a pitch — and I guess the pitch was good, delivered well?
Eric Ries: I guess so. I think back on it, I honestly can't say. It's hard for me to imagine what was going on in our investors' minds. But I think they had seen the pattern. A lot of investing is pattern matching. And it's not the worst idea. A lot of people who are rich are too cowardly with their money. In some ways, it made a certain amount of sense to take a flyer on these young guys who seemed like they knew about this newfangled technology thing. But in retrospect, it was a pretty bad investment, because we didn't know what we didn't know. And we didn't have the runway to figure it out.
Mark Graban: Not knowing what you don't know is different when you can do small, fast, cheap experiments, as a lot of people have learned from you. This goes right back to the core.
Eric Ries: In retrospect, it would not have had to be that different of a plan to lead to something really good. The core product insight — I was in charge of the technology, so my part was good. The technology was good. The core customer insight behind it was good. If we had known what we were doing — honestly, I really think if we had read The Lean Startup, we would have been fine.
Mark Graban: Right, but no one had written it yet. I guess the investors must have shared the leap-of-faith assumptions. Was the problem overestimating the value of the customer once acquired?
Eric Ries: From a tactical perspective, yes. We were spending too much on customer acquisition relative to the actual value of customers, and we didn't really know how to do enterprise sales. We were operating a playbook that assumed we would be able to convert the student profiles into this economically valuable activity in very short order. We didn't know how to do that. We didn't have any virality built into the product like Facebook did, which would have solved all our problems. If anyone had even suggested that to us, it would have been very helpful.
We had tons of business mentors. Nobody was talking to us about how to build a startup. No one had any clue about it. We were being given very generic business advice that had worked for them in their careers, not necessarily what works in a startup.
“Can You Build It” vs. “Should You Build It”
Mark Graban: Back to the two key questions — Steve Blank and you and others write about “Can you build it?” and “Should you build it?” It sounds like the “can you build it” test passed really well, but in hindsight the answer to “should you build it”…
Eric Ries: When you say it that way, you make it sound so clean. But of course the real question is, what is it? Is it economically valuable? At the time, I would have said, “I did my part. I did a good job. It is valuable.” But building something that nobody wants is not praiseworthy if you do it on time and on budget. You're like a general manager in a car, driving it over a cliff, but you're like, “Well, I've got excellent gas mileage. Look how efficient my engine is.” We're going the wrong way. We need to pivot to a different direction. That basic concept — that that was even an option available to us — was missing.
The Dark Underside of Building Companies
Mark Graban: You've got a habit of sharing mistakes not to beat yourself up, but to focus on the learning. I think it's inevitable that when somebody writes a book or has a movement, there are mistakes made in the name of that movement. Looking back at the Lean Startup era, what's a common mistake that founders or companies made in applying those ideas? And did any of that help set up the problem you're writing about now in Incorruptible?
Eric Ries: I'm very proud of the work that we've done with the lean startup movement. These concepts became kind of conventional wisdom in a certain way among a lot of entrepreneurs. Even the people that are opposed to lean startup have to carry the meme forward in order to criticize it. To me, that's the true test of conceptual vocabulary — if you're naming something that people didn't have a word for before, now they can reason about it. Even people who say, “I don't think minimum viable product is a good idea, it should actually be minimum desirable product” — that's good. We've created a framework now where we can have that debate in an intelligent way. In 1999, we really could not.
And it did in a certain way — its very success laid the groundwork for the new book. Because so many people I've helped start companies are today incredibly successful and wealthy by conventional metrics, and they're totally miserable. They built something trustworthy, something really special, and then they lost control of it. There's lots of ways you can lose control of a company, like Frankenstein and his monster. You can have it taken away from you. It can be forcibly taken over by investors. It can lose its ethos, its purpose over time. You can give in to temptation. You can fail the test of succession. Your board can betray you, your employees can betray you, your investors can betray you. And there's a lot of founders who succumb to mental illness, basically. The stress and pressure of it causes all kinds of problems.
There's a dark underside to this business. It doesn't get talked about enough. I really wanted to try to do something about it, because I honestly felt like I was feeding one company after another into a meat grinder. I spent a lot of time trying to understand why are things the way that they are. And I found out through my own experience and through my own research that so many of the so-called best practices that we use today to build, structure, and govern companies — they're not pillars of capitalism, they're relatively modern inventions. But they're old enough to have a pretty good body of evidence available about how well they work, and the evidence is pretty bad.
So it seems like we're teaching people a set of practices that's almost designed to guarantee they're going to have these malign outcomes. Let's stop following these best practices so blindly. More importantly, we have to develop a new set of practices that allow mission-driven, purpose-driven leaders to create the outcomes they want for their organizations.
What “Corruption” Actually Means
Mark Graban: A successful company can hit pitfalls that hit the founder or leadership team. The company gets “corrupted,” which doesn't mean the one meaning of the word around bribery and…
Eric Ries: We have to go back to a more old-fashioned meaning. Tolkien understood what corruption was. When we talk about the corruption of the One Ring, people aren't talking about committing crimes. They're not violating the legal standard. It's an older idea. It's an idea that our grandparents were very comfortable with — that when you start to behave in ways that are value destroying, when you betray the trust people have placed in you, when you extract value rather than create value, those are corrupt acts. They corrupt the moral logic of our whole financial system.
This book is a bit of an old-fashioned book. It's a bit of a throwback. I want to restore some of these older ideas. The idea that there are better and worse ways to make money is one of the oldest ideas in human recorded history, going back to Aristotle and before, as part of almost every religious tradition. And yet we've lost it. In our modern economy, we're supposed to pretend that we think all ways of making money are equally good. But nobody who builds things for a living actually thinks that.
Part of my goal with this book is to say, we can stop pretending. The next time someone says about some evil person, “You've got to hand it to him, at least it worked,” you can be like, “No, I don't have to hand it to him.” The reason why these ideas are dangerous is not because they don't work. Our grandparents warned us. The reason why demagoguery and all these other forms of deception and Ponzi schemes are dangerous is because they work — because in the short term they seem to work. Of course, the long-term damage they do is immense.
This is something that can be prevented. You can actually build an organization that is literally incorruptible. But to do so is going to require us to give up many of our modern so-called best practices that we've been trained to follow.
Systems, Not Heroes and Villains
Mark Graban: Back to broader lean thinking for listeners who are familiar with that approach — one idea would be look at systems, look at systemic causes of mistakes in a factory or in a hospital or in software development, instead of blaming the individual. You can really zoom that out and look at how corporate corruption in this sense is structural and more complicated than good people, bad people framing. Tell us more about those structures.
Eric Ries: It's just a Deming-ism, applied to these structures.
I tell the story in the book of Whole Foods, which went through this self-destruction where it couldn't do what it needed to do. Its stock price fell. Activists came in and basically forced it to be sold. John Mackey's last act of defiance was to sell it to Amazon instead of the person the activists wanted to sell it to. Even in the end, his victory was kind of a form of defeat.
Today, people hear these stories and say, “Well, Whole Foods is still around.” Yes, but the ethos — the thing that made it special — has been lost. Go on the Whole Foods Reddit forum. Go anywhere where customers of Whole Foods are talking about it. You will see the evidence. It fell off the Fortune Best Places to Work list, I think within two years of the acquisition, right away. Something special got lost, even though the activists who did that attack made about $500 million in so-called profit.
I quote an economist who wrote an article right afterwards, the title of which was — forgive my language, but this is literally what he wrote — “The Greedy Bastards Won.” That phrase, the greedy bastards, is what John Mackey called the activists. He just said, “They don't care about the mission of Whole Foods. They're just greedy bastards.” Mackey framed the whole thing as a battle, the good guys at Whole Foods versus the evil villains. The press loves that framing. Even as entrepreneurs and investors, we love to talk about the personal dramas of these companies' success or failure.
So whichever side wins must be the more savvy side by definition. It becomes a test of savviness. But when we're looking at personal dramas, as I say in the book, if the players change but the play remains the same, then something deeper is at work. What could that something deeper be?
Whole Foods and the Five Whys
The case of Whole Foods is especially interesting because when you ask people about it, they say, “Well, the activists created a lot of value. The company's stock was going down, they insisted they do this thing, the stock went up, everybody made money from that transaction. It must be value creation.”
But you look at why couldn't John Mackey, why couldn't Whole Foods do what it needed to do? The simple thing it had to do was cut prices. For many years, Whole Foods was the premium category leader, and their margins were too high. The problem was that any time their margins went down for any reason, Wall Street would punish them by driving their stock suddenly lower. So the whole company had learned this very important lesson: you have to keep the stock price up, you have to keep margins up.
It's a classic confusion in business whether high margins are a liability or a strength. We teach that they're a strength. But then in a different class, in your MBA program, you'll learn Jeff Bezos's famous dictum that your margin is my opportunity.
So their margins were too high. Now here's the really fascinating thing. Do five whys. Why did they refuse to raise prices? Because they were afraid the stock price would go down. But why did they need the stock price to be high? Is that really an operational goal that's important to the company? People say, “Well, of course they want it to be high.” But why? Seriously, why?
Maybe because they're greedy? No — John Mackey had literally donated all his stock options to charity, saying he only wanted to work for the love of the thing itself. His personal greed could not have been the motivation.
“Well, it's important to have a high stock price in case you ever have to raise money.” There's a lot of money-burning startups out there that need it. But Whole Foods — this is the craziest stat to me of the whole story — Whole Foods was profitable every quarter and every year that it was a public company, including 2008 when its stock price dropped 90%. They didn't need it to raise money.
What did they need it for? Maybe they needed it because financial gravity makes you feel like you need it. Because if they ever let the stock price go down, it would allow activists or some acquirer — it makes it cheaper to do the thing that ultimately happened to them. A high stock price is their defense, their moat against this kind of financial manipulation.
Mark Graban: To protect the mission.
Eric Ries: To protect the mission. Here's what's so funny about it. Wall Street created the very problem that it then showed up later to solve and claim this value-creating behavior. It's not value creating. If they had just been organized properly in the beginning, none of this would have been necessary.
Going back to the “Greedy Bastards” article, the author says Mackey wanted to have it both ways. He wanted to have this lofty rhetoric about conscious capitalism and being a mission-driven company, but he also wanted to work in a bog-standard Delaware C-corp shareholder primacy organization. Obviously those two things — that chasm between the mission statement and the legal purpose — created the conflict that ultimately led to the company's demise. The author saw it as a personal drama, a personal failure. But of course, the question this book asks is, why should Whole Foods have been embodied in such a structure? Are there other or better structures available that would make these questions irrelevant? It turns out there are.
The Prehistory of Costco: Sol Price and FedMart
Mark Graban: You think about other companies that took a different path. Let's shift and talk about one of the positive examples, Costco. Its governance has fended off multiple hostile takeover attempts — people who argued Costco should treat customers worse, pay their workers less, maximize margins. What was in place to help Costco keep their mission and keep their reputation the way that Whole Foods did not?
Eric Ries: It's almost a perfect reverse case study. Let me give the prehistory of Costco, because I think it's really interesting.
When people talk about Costco, most people intuitively understand that Costco is some kind of exception that proves the rule. I was talking to someone the other day, and they were giving me this rant about how only family-run companies can resist the pull of short-term metrics and ROI-driven thinking — Toyota, Ford, Mars. They were enumerating companies, and at the end of the rant they said, “Oh, and also for some reason, Costco.” I said, “Excuse me, Costco's not family-run. How come they're immune?” And he said, “I don't know. Just for some reason.”
Even people who tell me, “Man, corruption is inevitable. You can't do anything about it. Once a company gets a certain size, once there's enough money involved, corruption always follows” — that same person later in the conversation will say, “Man, I love shopping at Costco.” Costco's a $400 billion public company. How come they haven't succumbed?
You have to understand the prehistory of Costco dates back to the founding of modern retail. A guy named Sol Price is a legend in retail circles, but I don't think outside of retail his story is that well known. He created a company called FedMart in my hometown of San Diego in the 1950s. FedMart was the first big box warehouse retail store. He pioneered the membership fee, the capped margins, the warehouse look, and what he called the intelligent loss of sales — a relatively small number of SKUs so that he could really focus on quality and all kinds of transport batch optimizations. A lower number of SKUs means less complexity and less inventory at every step of the supply chain. That really is the engine that powers Costco to this day.
What's interesting about Sol is that he was a lawyer before he became an entrepreneur. When he was a lawyer, he was trained that he had what's called a fiduciary duty to his client, meaning he is required by law to put his client's interest before his own. So when he became a retailer, he asked himself, “Who's my client?” To him it was very obvious that his customer is his client. So he felt he had a fiduciary duty to the customer to get the customer the lowest price, the best service, the best quality.
He would do stuff that today is unthinkable. His competitors would often do illegal product dumping to try to drive him out of business — a classic strategy. We see it all the time today. Sell a product below cost, drive the competitor out of business so that once they're gone you can jack prices up. Every time they would try this with him, he would post their Sunday circulars in his own store, put up signs saying, “Don't buy this product from me. It's cheaper down the street.” Can you imagine that? Imagine you went to a website today at some retailer and they're like, “Yeah, actually Amazon has it cheaper. Don't buy it from me.” Unthinkable.
His competitors hated him. But his employees and his customers loved him. He paid above-average wages, not because he had to, but because he wanted the best people. He embodied respect for people as a principle. Customers trusted FedMart, and they would drive miles out of their way to shop there.
The Public Markets Punish Trust
It worked so well that he took the company public. That's when the same thing that happened to Whole Foods started happening to him. Investors started to demand — although he believed in low prices and high wages, investors wanted low wages and high prices. They felt like he was deviating from best practices too much. They wanted more conventional retail. They wanted growth, growth, growth. They embodied this modern idea that companies are not like living organisms that have a health to be maintained. Rather, they're a financial instrument to strip mine customers and employees for the benefits of shareholders.
To this day, Wall Street analysts will write things like — this is about Costco. I quote this in the book; it kind of blew my mind. “Costco is taking money that rightfully belongs to shareholders, and instead is spending it on improving the customer experience.” That's meant to be a criticism. What?
Everything's going great in the business, but it's causing all this tension on Wall Street. So Sol decides he's going to take FedMart private. He gets new investors, takes the company private. Now he'll have the long-term thinking he needs and the backing to do it his way. Wrong. His new investors are captured by the same financial gravity. Almost from the first moment, they're pressuring him for faster growth. They want more conventional retail, higher margins, higher prices, lower wages — the same old thing — culminating in a huge fight one day in 1975. After he had been running FedMart for 20 years, Sol comes to work, and the locks on his doors have been changed. He doesn't work there anymore.
Every founder — I quote in the book that among venture-backed companies, Harvard Law School did a study that showed that only 20% of founders will still be the CEO even three years after an IPO. Everyone's like, “I'm part of the 20% exception.” I'm like, “Okay, good luck with that.” We are just hemorrhaging people out of the system for no good reason.
The story has a happy ending, but not before we see a lot of devastation. What happened to FedMart? Investors got what they wanted. They pursued faster growth and conventional retail. Within seven years, they had driven the company that Sol had built for 20 years into liquidation. Today, FedMart is a Wikipedia footnote, a distant memory.
But Sol, classic entrepreneur that he was, was not done. He took two weeks off to lick his wounds, then leased the office upstairs from FedMart and started again with a new company he called The Price Club.
What the Investors Couldn't See
What's really interesting to me, the FedMart investors understood something that I think Sol never did. They understood that exactly precisely because FedMart was so trusted by its customers, they could get away with betraying them. The customers probably wouldn't notice.
But Sol understood something that his investors never did. When they valued FedMart, what they saw — and this is so classic, Deming would have castigated them so much — they saw customers, contracts, factories, warehouses. They saw value in the physical things that the company controlled on paper. But Sol understood that the value of FedMart lived between the lines of those things, in the relationships, the systems, the engine that made it a trustworthy counterparty.
That's why he would never squeeze suppliers for lowest possible cost. He understood that was only going to get him low quality. Even to this day, Costco performs something like 40% of all the food safety inspections in the United States, almost as many as the US FDA. Not because they have to, but just because that's what's right. And just like you would want in a quality-oriented company, if they certify your facility, you're not allowed to cherry-pick. You can't say, “We'll only certify the stuff we send in.” No — the safety inspection applies to everything produced in that facility, whether it has a Costco destination or not. You don't comply, you can't sell.
Sol Price started Price Club. Price Club was very successful. But today Price Club is forgotten because one of his proteges, a guy who had gone with him from FedMart to Price Club and had worked his way up from stock boy to executive, was named Jim Sinegal. When Jim left Price Club to start his own company, the two companies eventually, a few years later, merged to form the company we now know as Costco.
The Governance Fortress
Costco illustrates the two most important ideas in the book in one story. Sol Price understood ethos — the fiduciary to the customer, the operational commitment to quality, to trustworthiness. That was really what was embodied at FedMart. But what he didn't have was the ability to defend that ethos from attacks from the outside. It was really Jim Sinegal who figured out in Costco how to build what I call a governance fortress, that even to this day protects Costco from outside pressure.
Mark Graban: The thing that would make that really structural is if it survives when Jim Sinegal retires.
Eric Ries: Yeah, and it has. Jim is in his 90s now, I think. In Costco's case, it survived for 40 years. They're on their fourth CEO — because it's embodied in the ethos.
Now I'll give you a funny misconception, since we were talking about mistakes. People say all the time — and this was what I thought too — that Costco is protected by its strong ethos and its large size. People say, “Well, it's just too big to attack, because it's $400 billion.” Are you kidding me? Dream on. You think that would be enough?
If you look at the data, Costco comes under attack every few years from raiders who are trying to dismantle this ethos. I quote a bunch of them in the book. Costco, by the way, has the worst possible governance rating scores from these governance rating agencies. It's considered to have bad governance through and through. So every once in a while, some good-governance reformer will try to attack, and they always attack on this basis — that Costco's governance leads to management entrenchment, which leads to poor performance.
Really? Poor performance? Costco's one of the best-performing stocks in the entire stock market the last 40 years. What do you mean by poor performance? This has become an ideological commitment to the idea of shareholder primacy, divorced from the actual on-the-ground realities that a company like Costco embodies.
The $1.50 Hot Dog and “Figure It Out”
Mark Graban: Were the other CEOs all promoted from within?
Eric Ries: They were all promoted from within. Of course. You see that the coherence of a company that promotes from within, that lives its philosophy, its ethos, all the time is really important.
Probably the most famous story about Costco is the $1.50 hot dog. I think people find this quote so funny. There was a time when the COO of Costco came to Jim Sinegal when he was still the CEO and said, “Boss, we're losing our rear ends here. We've got to raise the price of the hot dog.”
For people who don't know, since 1986, Costco has sold a hot dog and soda combo in a food court outside its stores for $1.50. A Big Mac was about the same price, $1.60 at that time in California. Today, that same Big Mac is $7. The Costco hot dog combo is still $1.50.
When the COO came to Jim Sinegal and said, “We've got to raise the price,” Sinegal said very famously, “If you raise the price of the hot dog, I will effing kill you. Figure it out.”
I love this story for so many reasons, but the biggest one is the questions it causes people to ask. People hear that story for the first time and say, “Is the hot dog a loss leader?” No. They work really hard to bring the cost of the hot dog down. They actually vertically integrated their whole hot dog supply chain. They own their own factories. They vertically integrated everything to drive the cost down. There are all kinds of funny stories about what they did to bring the soda cost down. They actually work really hard. They do all this extra work for no reason, just to keep this promise to customers.
Mark Graban: A company like Toyota would call that value engineering — you have a price target and you figure out how to engineer to it.
Eric Ries: And you make it work. People hear that and say, “But it's so much extra work.” Trustworthiness is hard work. Welcome to business.
But here's the really interesting thing. I've told this story to audiences all over the world. Nobody has ever asked me, why did the COO want to raise prices? Because of course he did. That's how we teach modern business. If you can raise prices — just to give you a sense of the scale of this — Costco sells more hot dogs in a given year than every Major League Baseball stadium combined. They sell 200 million combos. So every dollar they could get away with raising prices would be $200 million of pure profit.
Jim Sinegal referred to this one year as taking heroin. He said, “This is literally the corporate equivalent of heroin. If they were to raise prices across the board at Costco by 3%, they would double their net income and nobody would notice. But you do it once, you've got to do it again. You've got to do it again. And next thing you know, you're not the low-price leader anymore.”
The Understaffing Death Spiral
Mark Graban: You look at these different situations where it seems like somehow investors — people, let me just generalize it — look at simple cause-and-effect relationships. It sounds logical. Cut wages, your profit will be higher. We've all been in stores where they're in the understaffing death spiral. They've not only cut wages but have surly, uninterested employees — which could be due to bad management and a bad environment. You're lucky if you can find one of those underpaid, underappreciated, surly employees. And you say, “Hell, I'm going to stop coming to this store.”
Home Depot was a case study of that for a while. They hired one of the supposed management geniuses who had studied under Jack Welch — Bob Nardelli came in. If Costco had hired a Bob Nardelli, they might be barely surviving today. Home Depot is still here, but Nardelli didn't last very long. Why is that?
Eric Ries: There are so many of these stories. The book is loaded with stories of these executives who are brought in to cause all this value destruction. They often walk away with $100 million-plus in compensation themselves. It happened at Johnson & Johnson. It happened at Boeing.
What's really interesting to me about the Costco story is the COO who proposed raising the prices — Craig Jelinek — succeeded Jim Sinegal as CEO. So it's not that people have a wrong idea and make a mistake. The really good leaders who are trying to embed the ethos deep into the organization love the figure-it-out moments. That's what I call them. They actually love it that their ethos requires all this extra work. People say, “God, this boss seems really difficult.” And the boss says, “Yes, I welcome the chance to teach you what this business is really about.” They're not apologetic about it. They are actually very bold about it, because they understand that this is an engine. You take one piece out, and you'll be in trouble.
Recurring Revenue at All Costs
I give credit to Rory Sutherland, the Ogilvy ad man who is capable of making these concepts very easy to understand for average audiences. He has a great riff about how in our modern business culture, you can be rewarded for cutting costs without ever being held accountable for the devastation that those cuts create. That's true when you cut wages. It's true when you cut quality.
Let me tell you a story that broke my heart. I was talking to a VC, and he was telling me about a founder who came to him for advice. The founder was trying to get funding for a medical device — a life-saving implantable medical device. It was made out of stainless steel, this very complicated, very expensive device. He said the founder was crying, basically — weeping — because every investor he talked to was saying, “There's no recurring revenue here. You implant the thing once and you cure the disease. It's not a very good business.” Literally they kept suggesting to him that we take one of the parts and make it plastic so that it will require periodic replacement, so that we could have recurring revenue.
At this point, I think the shareholder primacy dogma has caused people to lose sight of what is the purpose of making an organization in the first place. Patients are not a resource to be mined. They're our partners. They're our clients. They're the ones we have a fiduciary duty to serve. So we as builders have to reclaim this for ourselves and say, “Enough of this.” We build organizations to be of service. That's what they're for.
The Double Mystery
Mark Graban: There's a difference between the use of the word value meaning stock price, and value as used by lean thinking — meaning something a customer is willing to pay for, that makes that customer's life better. We're creating value as opposed to extracting money from an enterprise. You touch on some heady topics in the book about big-picture structures, why things happen. Why is it that if doing a mission-driven, take-care-of-your-customers, take-care-of-your-employees business can do really well, and there are so many examples of those — why structurally does it somehow lead people to chase the race to the bottom?
Eric Ries: There's two things going on. The book is actually framed as a double mystery. The first mystery is, if this behavior by investors and by our financial system is so irrational, why does it happen? By the ideology of capitalism, it shouldn't happen at all. And yet we see it practically every day. I tell stories in the book going back 200 years. Ask me about Robert Owen, who had the Sol Price experience in 1800. How can this possibly be going on all this time?
When people hear that, they say, “If it's been going on 200 years, I guess it's inevitable.” But here's the problem. If it's inevitable, how can there be exceptions? It's not just Costco. There's a lot of these exceptions.
Marie Krogh and the Industrial Foundation
Let me tell you one exception story by way of illustrating what is going on here. In the 1920s, a woman named Marie Krogh was diagnosed with a terminal illness — diabetes, at a time when there was no known cure for diabetes. But her husband, August Krogh, had just won the Nobel Prize. They lived in Denmark at the time, and he convinced her, despite her fatal diagnosis, that she should accompany him on a lecture tour of North America. Being the dutiful wife that she was, but also a doctor herself, she went with him.
During the lecture tour, she was sitting at dinner next to one of the other scientists, who told her that in Canada, a series of scientists had isolated insulin for the first time — a potential cure for diabetes. She convinced her husband that they should extend their trip, travel to Canada, and go see this technology for themselves. They did. They instantly grasped the significance of this breakthrough, and they asked the Canadians if they could license the technology and bring it back to Denmark, not just to cure Marie, but to cure a lot of people.
Everyone agrees to do it, but they have a caveat. All four of the people involved are worried because they understand this simple truth about life-saving medicines. Imagine you have a life-saving medicine that I need to live. I have no problem with you making a fair profit by selling it to me. I want you to be in business, to have the money to build the facility to sell it to me. I'm very happy for you to make money. But I would live in fear. What if you wake up one day and say, “Wait a minute, Eric needs this life-saving medicine. I could charge him whatever I want.” I'd be powerless to say no.
So years before Martin Shkreli, they understood this was a problem. They spent the trip going back to Denmark trying to figure out, how can we structure this organization to avoid this outcome? They settled on the structure that is now known as the industrial foundation structure, where the laboratory that they built is a for-profit company — they called it the Nordisk Insulin Laboratorium — but it is owned and controlled by a nonprofit foundation. If the term Nordisk sounds familiar, it should, because this is the origin story of the company Novo Nordisk, one of the world's largest companies.
What's interesting about Novo Nordisk is it defies every inevitability story you can imagine, because it has had the idea of science as a public trust as its motivating principle for more than 100 years. All the betrayals that we've been talking about — people have tried it with Novo Nordisk. I tell a story in the book where the for-profit directors of the Novo Nordisk subsidiary tried to liquidate the whole thing and sell it in the early 2000s, when pharma consolidation was the hotness. The trustees of the nonprofit foundation intervened to stop this from happening.
What's crazy about this story is that through their intervention, the nonprofit trustees created more than $500 billion of shareholder value. Because Novo Nordisk is a publicly traded company. It trades, I think, a million shares a day on the New York Stock Exchange. So how can it be? Just like Costco, how can there be this massive exception just staring us in the face? Yet if I tell you, “I'm going to start a new company, and I'm going to use the Novo Nordisk structure,” people would be like, “That's crazy. You can't do that. That violates all our best practices.”
Smarter Than a Nobel Laureate?
Here's what's crazy. The industrial foundation structure is one of several that I talk about in the book that's kind of fallen out of modern understanding and parlance in company-building circles. But there are enough companies that have this structure that it's been studied. You've actually shopped at one of these companies almost certainly if you've ever eaten a Hershey chocolate bar or shopped at an Ikea or gone to Patagonia. You've experienced this structure for yourself. There are enough of these companies that we can say that on average they are six times more likely to live to 50 compared to conventional structures — 60% versus 10% probability.
Here's a really interesting question, the question I want to leave everyone with. The next time someone tells you that such and such thing is a best practice and you have to do it, you're going to be like, “Wow, that person's so smart. That person's so well credentialed.” But I want you to ask yourself this one simple question: are you sure they are smarter than a Nobel laureate? Because August and Marie figured this out 100 years ago, and it seems to work pretty well. So why are we building these extractive, weak-ass companies that are addicted to quick short-term growth, cutting costs, disregarding quality and human lives? Why, when we have a template for how to do it better?
Mark Graban: “The problem with weak-ass companies” was probably part of the brainstorming for the book title.
Eric Ries: I would have been very happy with that, but yes, my poor publisher is a lot happier with Incorruptible.
Closing
Mark Graban: Eric, thank you for the stories today, both about mistakes that you learned from, and mistakes that not only companies make, but some structural issues that are probably harder to fix. The book really points us in some great directions that are practical for entrepreneurs and businesses, and that people can think about when it comes to broader societal issues and structures.
Our guest again, Eric Ries. The new book is Incorruptible: Why Good Companies Go Bad and How Great Companies Stay Great. Eric, thanks so much for being here.
Eric Ries: It's really my pleasure. Thanks, everybody.