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Orin C. Smith: Managing Growth and Leadership Change at Starbucks

Orin C. Smith is president and chief executive officer, and a member of the Board of Directors of Starbucks Coffee Company. He joined Starbucks as vice president and chief financial officer in 1990, when the company had 45 stores located mostly in the Pacific Northwest. In 1994, he became president and chief operating officer with full profit and loss responsibilities; in 2000, he became chief executive officer. He is slated to retire March 31, 2005. Starbucks now has almost 9,000 stores in 35 countries and has been named by Fortune magazine as one of the “100 Best Companies to Work For” each year since 2002.

Prior to joining Starbucks, Orin spent 14 years with Touche Ross & Co. in the management consulting division, where he was partner-in-charge of the Northwest practice for several years. He was later the executive vice president and chief financial officer of two transportation companies. In between these assignments, he was chief policy and finance officer in the administration of two Washington state governors.

Orin serves on the board of directors of Conservation International, a global nonprofit organization. He is also a member of several nonprofit boards in the Seattle area, including the Advisory Board for the University of Washington Business School, the University of Washington Medicine Board, and The Seattle Foundation.

He holds a B.A. from the University of Washington and an M.B.A. from Harvard Business School. In 2002 he received a Harvard Business School Alumni Achievement Award, becoming one of only 110 graduates to receive the school’s highest award. In 2003, he was named by Business Week as one of the best CEOs in America.

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Ethix: What does Starbucks do to maintain an ethical culture?

Orin Smith: We don’t do a lot formally. We have our code of ethics, but I don’t place a lot of confidence that it in itself will affect behavior. I think it’s very simple: it is the values, beliefs, and behaviors of the top people in the organization. If you exhibit behaviors that are at the margin or over the edge, count on your people finding a rationale for behaving in the same way, and it affects the whole organization. On the other hand, if you have leaders who are committed to ethical behavior in everything they do, your people will model that behavior. The top people in your organization are the ones who really frame the culture of an organization, and we have an extraordinarily strong culture. But I’m not under any illusion that a different kind of business executive at the top of this organization, in very short order, could dramatically change the culture because people will model their behavior. The ones who can’t stand that kind of a change will leave. But those who stay will learn how to adapt to a new set of values and principles.

Unfortunately, often the people with the “better set of values” will be walking out.

Yes.

Picking the New Leader

As you look out over the next few years, even though you’re close to retirement, what is your biggest fear?

We avoided my worst fear: that we would find my successor in an overnight transaction, like so many companies do. My experience in hiring from the outside is that half the time you don’t know who you hired. Actually, all the time you don’t know who you hired. You know pretty well what their history is in terms of producing results and you can assess pretty well what their functional talents are. But who they are as a human being, you can’t tell in the limited time that you are exposed to a candidate. And half of them turn out to be good fits, in my experience; the other half doesn’t. When you apply that to a CEO, you’ve entrusted the whole company to someone you don’t know. And I think that is really, really dangerous, especially for a company that doesn’t need to be fixed. This is a high-performing company.

So what did you do to protect yourself as you go through this transformation?

We started methodically. Over three years ago, I had hoped that I would be able to bring along somebody who was already in the organization. In the end, while I know that there are future successors in this organization, they were still young enough and inexperienced enough that we didn’t think they could make the jump. When a company grows as fast as we do it’s hard to keep up with the increased complexity and responsibilities in your own job, much less jump to a higher level. We’ve had to hire outside far more than I want to, but it will be far less in the future because the mid and upper-mid levels of the company are rich with talent, and we’ll be able to bring them through that system. Our next CEO should come from within.

I’ve had to let more people go in this company because of the lack of fit with the organization’s values and principles than for any other reason.

We started the search for my successor over three years ago, and we found an individual we thought would be a good fit with the culture. While we looked at the other experiences the individual had, and the functional skills, and of course the results, the big issue was: is he going to work out here? We didn’t really know. But we said, “This is going to be at least a two-year process and we’re going to take you through the various parts of the organization. We’ll give you one set of responsibilities and then we’ll add to it over time.” Jim Donald, my successor, was already a CEO of a company, albeit a smaller one. It will be two and a half years that he’s been in this development program with us.

Hiring for Values

Would you have a similar concern when hiring mid-level people from outside?

Oh it’s always a concern. I’ve had to let more people go in this company because of the lack of fit with the organization’s values and principles than for any other reason. We don’t miss it very often on what the skill set is, but we miss it on who the individual is. And by the way, this is not to say these are bad people, it’s just that they don’t share the same ways of operating. They’ve obviously been successful in other environments; they’ll probably be successful after this. But in this particular company—with the things that we hold important—if you behave differently, it’s a foregone conclusion that you will be gone. In the first place, you’ll be ineffective, because if you don’t operate the way others expect you to operate in this environment, you’ll find out you don’t get things done very effectively. And the next thing you know I’m having a conversation that basically says, “The culture has let you go, now I just want to make sure you understand that.”

The reason this is so difficult is that candidates are very good at persuading us that they’re a fit. They read Howard Shultz’s book [see InReview], and they come in here, behaving like it is implied that you should behave in this organization. And they can fool us—it’s a shame—but what they don’t understand is that they fool themselves most of all, because they’re going to fail here. So we miss on that.

Can we do things that help them adjust to the culture? Yes. And with our mid- to top-level executives we will put them through what we call an immersion program. And that means they start out in the stores: they work behind the counter, they sweep the floors, they clean the bathrooms, etc. We want them to understand what our business is and what makes it successful.

And you don’t find that up here in the corporate offices; we don’t have any cash registers here. It’s out there in those stores; it’s those kids that are inspired and passionate to differentiate us from all of our competitors in the marketplace. So they have that experience in stores and then we rotate them into other kinds of positions and give them opportunities to meet with everybody they’re going to work with. We’ll keep them out there as long as 90 days. Jim Donald, before we gave him his first corporate task—and you know, here’s a guy who’s been a CEO—was out in the stores for 90 days. In most companies, on day two you’re making decisions.

What did he do during those 90 days?

He just went through every function in this organization.

But he didn’t go behind the cash register?

He had to get behind the bar and make drinks, he had to staff the register, he had to do all the jobs in the stores. We are very disciplined about that. Every one of the senior executives has resisted this: “90 days—I’m going to do this! No, I want to go do something!” And every one will tell you, after the 90 days is over, that it’s one of the best things they ever did. Because they understood, when they got in the management position, how the organization worked and the implications of decisions that they would be asked to make. Their success within the organization has been enhanced, and they’ll turn around then with every executive that comes to them and put them through the same drill.

I’d also have to say that if somebody comes in with a set of values and beliefs that are contradictory to what we stand for, I’m probably not going to be able to change them. Behavior patterns result from beliefs, some of which they can’t even articulate because they’ve been formed over their lifetime by experiences that they don’t even remember. One of the things that I initially found really shocking was that I had to let a number of very, very talented people go because of the way they managed their people. They were abusive and demeaning, and we don’t allow that to happen. Some people manage with fear. That’s not the environment that’s suitable to this organization. And unfortunately, they managed me quite well, and usually their peers, so we don’t see any of that.

Absolutely. That’s very common.

The only way you find out about it is that somebody finally gets the courage to come and tell you. And we have a very open environment, so anybody in the organization can get in to see me.

Do you have a hotline number, also?

There is, but people are very, very reluctant to take these things on. When something like this happens I meet with the group that’s been affected by it and tell them, “You own a lot of this problem, because I can’t see it. And you didn’t come to me when my door was open, and tell me. You have to have the courage to come in and talk to me about it.” Now, the fact that we have acted on it whenever we discovered it has given them more courage. They know that they’re protected and they can affect an outcome. But in every instance when I’ve had this discussion, it was too late. By the time people had the courage to come to me, too much damage had been done.

So it was not a counseling session about how to change behavior. I will be very explicit and tell them what the problems are, and to a person, they say, “I don’t do that.” Some of these behaviors were so egregious it was hard to understand, but I believe they’re telling me what their truth is. They don’t get up in the morning saying, “I’m going to abuse my people.” They just don’t understand the effects of the way they act and the things they say. It’s very hard that they can’t accept it when you tell them.

Maintaining Distinctiveness

So it’s very clear that one of your important values is your people.

They’re at the top of the list, and we don’t say that lightly. There are lots of other things that are important: customers are important, shareholders are important, but look at what our business is. We provide a great cup of coffee in an environment that’s very attractive and inviting, but people come for the experience. Those are all dimensions of it, but the experience is really made by the people behind that bar.

It is not in the long-term interest of shareholders for us to try to maximize profits in the short run by paying commodity market price.

Our competitors come in and they take pictures of the stores, they read the menu board, and they sample the beverages. Then they go out and knock us off—all around the world. You can go to stores in virtually any country, certainly on every continent except the cold ones, and you can find lots of examples of stores that do the kinds of things we do. What differentiates us, at the end of the day, is that we provide the best experience of any competitor of scale out there. And that’s because we’re able to inspire our people to be passionate and committed to this company, to what they do, for the customer. So when we say we value our people, they are the reason for the success of this company, and there are no two ways about it.

Dealing with Coffee Growers

I’ve noticed also that you have worked at valuing your suppliers, the coffee growers. I saw a quote in a book I was reading yesterday that said you’ve gone to a supplier and asked, “Are we paying you enough money?” Tell me how this relationship with the coffee growers came about, and where you see it going in the future.

Well it’s kind of interesting. We recently received one of the most important awards that we’ve had, and we’ve had many. Some group named us to the list of the top ten most antibusiness practices. I put that in the same bucket with some of the comments that came from Wall Street about Costco a few quarters ago.

Right, we talked to Jim Sinegal about those in Ethix 29.

Oftentimes, people will take a very narrow and a very short-term view about what’s important for shareholders. In the case of the coffee industry, we have created a new segment. It’s a high-quality end of what was and still is a commodity market. First of all, because we are at the high-quality end, historically we’ve always paid quite a bit more for our coffee than the average. Then we entered into this period of oversupply, which we’re still in. What basically happened is that Vietnamese farmers were being subsidized by the Vietnamese government and are producing pretty low-quality coffee. Brazil is the world’s largest supplier of coffee—some high quality, some low quality. We don’t source a lot to Brazil because a lot of it is below elevations that are suitable for the very best coffees.

At one time, a lot of the coffee companies had similar kinds of Arabica coffee but they have shifted over the last forty years to larger and larger proportions of the Robusta, the cheaper coffees. Year in and year out they look at the prices of the coffees and they’ll substitute a lower-price one and get a blend that tastes to them pretty much like the old one. Then they’ll do a survey with customers, and they’ll say, “95 percent of the people can’t tell any difference.” If you do that once, that’s not a big deal; if you do that for thirty years, it is a big deal. You’ve totally changed the profile.

We’ve persuaded consumers to pay high prices for quality—a quality product and quality service. That enables us to pay those farmers the higher prices. Now when the oversupply came with Vietnam and Brazil producing even more coffee, they effectively destroyed much of the industry in Central America and in a number of other countries.

Some of those countries had a little higher quality coffee, but it wasn’t worth it to the big companies to pay that increment for higher quality. Our farmers, whom we had paid market, would not be able to sustain quality and production, or make a living that was suitable even by the meager standards in those countries—to feed, house, and clothe their families.

Our belief was, if you take the long view of the industry, we’re dependent on high-quality coffee. Not just what’s produced today but what will need to be produced when we double, triple, quadruple the size of this company. And it is not in the long-term interest of shareholders for us to try to maximize profits in the short run by paying commodity market price, because we’ll end up not having the suppliers we need to make us successful.

So how do you get the analysts to buy into this, because it seems like they’re all talking short-term profits, lower wages, lower prices, and everything you’ve said is the opposite of that.

I’d say the same thing that Jim Sinegal would say: “I’m going to run my business.” And we do well enough running our business that there isn’t an awful lot that could be said about that. And by the way, I firmly believe that it is in the long-term interests of this company and its shareholders and all of its other constituents that we take this kind of position. But it’s also the right thing to do because these people are so terribly impoverished that it’s hard to say that we ought to squeeze one more penny out of them, so Western countries can enjoy a little cheaper cup of coffee.

The other dimension of this is what I mentioned earlier: the success of this company depends upon having people who are inspired and passionate about their jobs and about the company they work for—proud to say, “I work for Starbucks.” Oftentimes, when we’ve got a major decision we’ll say something like, “What would our people think about the company they work for, if we did this?” Well, apply that to exploiting workers and farmers in developing countries, to a group of young people who are far more aware of these issues than their parents. And ask yourself what that does to how proud they are of where they work.

Ask Nike. I’m on the board of Nike, and I think that they’re a fabulous company and they’re very much like us in the sense that they have a really inspired workforce. But they went through something five or six years ago that was terribly, terribly demoralizing. Now they’ve more than recovered, they’re a leader in this industry, and they’re a model for any company looking at social responsibility. But it did lots of damage.

There’s still some residual out there in the public. It takes a long time to overcome that.

Yes. It takes a very short time to have a negative impact; a long time to erase it.

Coffee Houses as Community

One of the things I’ve observed about Starbucks is that it’s transformed the work world. I see meetings going on in Starbucks all the time. Was this a part of your plan or did this just happen?

Both. When we started opening coffee houses, we did think about it being a community place; it was a place to get a coffee and also a place where you met people you knew. Certainly, if you go to Italy, the neighborhood gathers in their coffee houses. They’re different experiences though, because it’s mostly standing, and people will talk while they’re standing and drinking their beverage. If you look at our first stores, for the most part they were pretty small. They handled a lot of traffic, and still do, but there wasn’t the kind of comfort and ambiance that you see today. So there was a dimension of it that we recognized early, and we started accommodating with larger stores, more comfortable chairs and tables that enabled people to sit around … .

Even adding the Wi-Fi to allow people to actually work there.

Yes, we’ve facilitated that. Wi-Fi is in the very early stages. Wireless companies did surveys of groups asking where they thought would be willing to pay to gain access to the Internet with a wireless device. Starbucks was the place mentioned the most often where they’d like to have it. So immediately they were knocking on our door.

What you see in the U.S. is far more pronounced elsewhere in the world. First of all, people around the world use our stores in much the same way.

When we’ve got a major decision we’ll say something like, “What would our people think about the company they work for, if we did this?”

But there’s even more business conducted because the vast majority of people in those stores stay in; they don’t take their beverage out. In Taiwan or Beijing you’ll find that people use the stores for all kinds of business, far more than they do here. Part of it is not having the office space. Part of it is not doing the entertaining at home. In Japan or in China they don’t often have homes that are of the size or the ambiance for entertaining. So they use us not only for an office but for relationships with friends and families. It’s an incredible phenomenon. In China, as a matter of fact, our people tell us that the Chinese come to our stores more for the experience than the coffee, because they’re not a coffee-drinking nation. But, when they’re there, they drink coffee.

What about seat turnover in your stores? I assume there’s a reverse correlation of how much people spend versus how much time they take.

To my knowledge, we have never studied that. And I do understand the issue clearly. It may mean that we have had to have more stores to accommodate some of this. But when I do think about it, one of things I think about is University Village in Seattle. We have four stores there now.

I know. It cost my daughter an hour one time when she was supposed to meet someone at the Starbucks at University Village. She was in one store and the other person was in the other store.

I’m not surprised! What you’ll find is that the main store there is still one of the highest-producing stores in the entire system. It’s right next to the University of Washington, and attracts students who come there and study. And before wireless devices and PCs, they were packing books and laying them out all over the table. They’ve been doing that for decades and our business has prospered. We do know that a lot of those people have more than one beverage when they stay. And I don’t know of any case where one of our store managers has complained that they needed a policy to evict people. On the other hand, what I have received is a lot of praise from customers that we’re one of the few places that doesn’t try to drive them out after 15 or 20 minutes. So, you know, I’m not going to worry too much about this turnover issue.

What about Independent Coffee Shops?

I’ve heard complaints that Starbucks is driving out many of the small, local companies both here and in the rest of the world. How do you react to that?

The truth is that we don’t drive out small coffee companies. This doesn’t mean, by the way, that we’ve never caused a small company to go out of business. But the likelihood is they were going to go out of business anyway. If you’re a good operator and you’re taking care of your customers, we’re not going to hurt you. As a matter of fact, we’re probably more likely to help you because we draw lots of traffic.

It takes a very short time to have a negative impact; a long time to erase it.

If you take Tully’s point of view, what they wanted to do was go right across the street from us. And they’re not the only company that decided that that was a good strategy. What we’ve really done in the U.S. is that we have created an industry. And underneath that umbrella, thousands of single or sole proprietors have started these businesses, knocking us off, and now earning their livelihood. When I came to Starbucks in 1990 there were maybe 400 coffee shops in America. Today there are 18-19,000. And yes, we’ve got 6,000 of them. But we created the environment where another 12,000 of them came to life. So this is one of the least understood and most distorted accusations you could make.

We also have complaints about ubiquity, the Starbucksization of neighborhoods. This is a very interesting phenomenon. Initially we were afraid of ubiquity and thought it would be a serious constraint to our growth—that we wouldn’t be special if we were in all of these places. But what we’ve learned is that our customer wants our product whenever they have the urge, wherever they are, and they don’t want to be inconvenienced in fulfilling that need. So if it’s more than a couple blocks away, they don’t go for the beverage. We have a ready-made market of people who were suboptimizing, not fulfilling their desire to have a Starbucks coffee. It’s not our customer who gets upset about ubiquity. We survey our users, and ask them, “What would cause you to use us more?” The answer is always, “More stores.”

Outside of the U.S., in some parts of the world, there is some professed concern about the Americanization—the effect that especially the media, movies, books, and so on have on their cultures. So, do we need to be concerned about that? Absolutely. We need to be much more attuned to the neighborhoods we’re in. We have to be far more adaptable so that our footprint on their culture, on their communities, is less than it might have been in the U.S. We need to be far more sensitive, and integrate the store look with the community. And with time we’ll have more products that are unique to that market.

In China the highest-selling frappuccino is green tea, which you can’t sell anyplace here except in the Chinatowns of some of our major cities. It’s just not our taste profile. Over time we’ll have more of that kind of adaptation. But the real substance of the store is not American. In the case of France, the people on the other side of the counter are French and they bring into the place their own culture. We are only the conduit; the conversation is uniquely French, or uniquely Chinese, or uniquely British. So the experience, really, is theirs. Not ours. We’re not changing the content of what is the most important part of that experience: the connections between people.

I remember a number of years ago, that some of the people in France said we won’t let you be successful here. How has that worked out?

Well, it’s far too early to tell. We’ve got a half a dozen stores there. The only thing I’d say to you is that there’s still a 30-minute wait at the first store. Other cultures tend to be far more patient than we are. The press has been very, very good to us. At the beginning, we were fearful of this, but the day before the opening we had this huge coffee-tasting and had in attendance many, many people from the press, and they had an experience they’d never had before. We have a range of incredible coffees, and if you go through the experience with one of our trained coffee people—they did the side-by-side comparisons of all of these different coffees—it opens up a whole new world to you. A world that you only see in wine. When you are in France, in the traditional kinds of cafes, you’re limited, it’s espresso-based beverage at best. And the service level is better than what you typically find, and customers are delighted with it.

The French didn’t expect this.

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