Governing Continuous Transformation: Re-framing the Strategy-Governance Conversation (Contributions to Management Science) 3030954722, 9783030954727

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Contributions to Management Science

Bijan Khezri

Governing Continuous Transformation Re-framing the Strategy-Governance Conversation Forewords by: Karl J. Friston and Constance E. Helfat

Contributions to Management Science

The series Contributions to Management Science contains research publications in all fields of business and management science. These publications are primarily monographs and multiple author works containing new research results, and also feature selected conference-based publications are also considered. The focus of the series lies in presenting the development of latest theoretical and empirical research across different viewpoints. This book series is indexed in Scopus.

Bijan Khezri

Governing Continuous Transformation Re-framing the Strategy-Governance Conversation

Forewords by Karl J. Friston and Constance E. Helfat

Bijan Khezri Zug, Switzerland

ISSN 1431-1941 ISSN 2197-716X (electronic) Contributions to Management Science ISBN 978-3-030-95472-7 ISBN 978-3-030-95473-4 (eBook) https://doi.org/10.1007/978-3-030-95473-4 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

“How to govern large organizations in times of high uncertainty and permanent change? To answer this pressing question, Bijan Khezri applied the ‘free energy principle’, a radical new idea from neuroscience with the potential to revolutionize several fields. The basic idea: Our brain is an inference engine which seeks to minimize prediction error. Bijan has been the first to apply this principle to management science – with huge implications: Minimize surprise by opening up your organization and using the collective intelligence across all boundaries. This book is an eyeopener for every reflective leader.” Oliver Gassmann Professor, University of St. Gallen, Director, Institute of Management and Technology, University of St. Gallen “More than two decades ago Nobel Laureate Douglass North suggested we live in a non-ergodic world. And many since have suggested that organizations must operate in an environment of discontinuous change. However, few have articulated how firms can deal effectively with this type of environment until now. Khezri recommends that boards and Upper Echelon executives adopt ‘Free Energy Governance’ in which the board deviates from common governance practice and builds ‘meta-capabilities’ that are used to develop dynamic capabilities in the organization when and where they are needed. Khezri suggests that doing so requires ‘learning from the future as it occurs’. Using a term often applied to best-selling novels, ‘it is a page turner’ in which I learned something new in every chapter! Every board member, all executives and scholars interested in strategic leadership and governance must read this book if they wish to remain relevant in the coming transformational decades.” Michael A. Hitt University Distinguished Professor Emeritus, Mays Business School, Texas A&M University, Former President, Academy of Management, and Former Editor, Academy of Management Journal

“Corporate Governance is not just a matter of legal compliance and firm performance, but disruptive environments impose firm survival as a central concern. 'Free-Energy Governance' is an innovative and unique contribution to the direction and control of strategic renewal and business innovation. Many traditional logics of corporate governance must be challenged with a fresh perspective of top-down/bottom-up/lateral coupling of governance and operational channels, dynamic board capabilities, and distinct models of environmental engagement. Dr. Khezri is a successful CEO with a long-standing board experience in transformative international businesses. We could not ask for a better author to initiate this new conversation in the board research community and convey its merits to the world of board practice.” Martin Hilb Professor Emeritus, University of St. Gallen, Founder and Managing Partner, International Board Foundation, and President, Swiss Institute of Directors

This book is based on the PhD thesis of Mr. Khezri at the University of St. Gallen (Khezri 2021): Free Energy Governance— Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival. Zug, Switzerland: KCRI (Khezri Capital Research International) AG https://www.alexandria.unisg.ch/262427/ 1/Dis5052.pdf

Dedicated to curiosity, revolt, and change

Foreword1

This book offers a remarkable thesis for remarkable times. The times are remarkable as we emerge from a global pandemic—that has evinced the dangers of globalization and connectivity—with growing concerns about climate change and sustainability. Sustainability is the key here: This book is dedicated to firm survival in discontinuous and distributed market environments with the unit of analysis being the sustainability of continuous strategic renewal.

The thesis is remarkable because it gracefully migrates the fundaments of selforganization—in the life sciences—into institutional governance. To appreciate this bold move, consider the question of a firm’s ‘purpose’: Purpose is not so much about knowing which port you are sailing to but ‘why are you sailing in the first place?’

This is, of course, a vexed question, which is probably as difficult to answer as existential questions like “why am I here?”. Free Energy Governance—and the free

1

Professor Karl J. Friston (MBBS, MA, MRCPsych, MAE, FMedSci, FRBS, FRS) is Professor at Queen Square Institute of Neurology (University College London), Scientific Director at the Wellcome Centre for Human Neuroimaging, and Honorary Consultant at The National Hospital for Neurology and Neurosurgery. He was elected a Fellow of the Royal Society in 2006. His nomination for the Royal Society reads: Karl Friston pioneered and developed the single most powerful technique for analysing the results of brain imaging studies and unravelling the patterns of cortical activity and the relationship of different cortical areas to one another. Currently over 90% of papers published in brain imaging use his method (SPM or Statistical Parametric Mapping) and this approach is now finding more diverse applications, for example, in the analysis of EEG and MEG data. His method has revolutionised studies of the human brain and given us profound insights into its operations. None has had as major an influence as Friston on the development of human brain studies in the past twenty-five years. (https://en.wikipedia.org/ wiki/Karl_J._Friston) . xi

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energy principle from which it inherits—eludes this question with a clever inversion. Instead of asking how must a system behave to survive? It asks how do systems that survive behave? The answer is rather deflationary—they survive. In other words, their purpose just is sustainability. This is the starting point of the free energy principle (FEP); however, the FEP addresses its question to statistical physics. In brief, the answer is that systems which ‘survive’ are equipped with a (nonequilibrium) steady state, under which they selforganize. They are—in virtue of their existence—self-sustaining in a particular kind of way: this self-sustainability (a.k.a. self-assembly or autopoiesis) can be read as garnering evidence for their own existence. This self-evidencing can be unpacked in a number of ways, leading to a physics of sentience or ‘Bayesian mechanics’ that shares the same foundation as quantum, statistical, and classical mechanics. Put simply, it means that any sustainable system (will look as if it) actively garners evidence for its own existence, through sensemaking and sentient behavior. At this point, we move from the physics of sentience to active inference, namely, the process theories that try to explain the behavior and choices of sentient creatures like you and me. The ‘remarkable thesis’ is that exactly the same principles apply to any self-sustaining system, from a virus to a vegan, from a fermion to a firm. Free Energy Governance (FEG) unpacks the processes of active inference at three cardinal levels to provide a first principle account of good governance and active exchange with a firm’s commercial and cultural eco-niche. In brief, FEG rests on three pillars: the first (structure) speaks to a central tenet of active inference, the form or structure of a generative model that is used to gather, and generate, evidence for the firm’s existence. Provided the generative model—implicit in a firm’s organizational structure—provides an apt account of its exchange with the outside (eco-niche), it will survive. Universally, the scale-free nature of any eco-niche requires a hierarchically (i.e., deep) generative model and the accompanying notion of upper and lower echelons. The process of evidence gathering or sensemaking can now be understood in terms of message passing and belief updating that is distributed over hierarchical levels—that ultimately leads to action and interaction with the eco-niche. This is considered under the notion of cognition, by analogy with hierarchal message passing in the brain. The final part of the story speaks to the enactive aspect of sensemaking, nicely summarized as: Perceptions are partly predictions that may change reality. (Starbuck and Milliken 1988)

This brings us to capabilities, with a special emphasis on duality management. A key duality here is the right balance between resolving uncertainty about the world in which we operate while, at the same time, exploiting our accumulated knowledge and inferences to bring about states of affairs that confirm we exist. In ethology and the neurosciences, these dual existential imperatives can be thought of in terms of epistemic and pragmatic drives that underwrite information and goal-seeking behavior, respectively. Under Free Energy Governance, they speak to a special kind of openness and institutional curiosity that is grounded in a sustainable set of beliefs about the constructed eco-niche, in which the firm operates.

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On a personal note, I really enjoyed reading this book. It was both exciting and reassuring to see how the same fundamental ideas can be found in fields as disparate as nonequilibrium steady-state physics and theories of governance. I can see a great opportunity to continue joining the dots in so many directions. For example, I would like to see how the author deals with psychopathology at an institutional level and in a similar vein with the use of active inference to explain false inference in psychiatry or, indeed, cancer in self-organizing cells. However, before becoming distracted by the notions of institutional psychosis and neoplasia, there are a host of foundational issues in institutional self-organization to consider—issues that are unpacked in an accessible and artful way in what follows. Karl J. Friston

Reference Starbuck, W.H., and Milliken, F. 1988. Executive perceptual filters: What they notice and how they make sense. In The Executive Effect: Concepts and Methods for Studying Top Managers, ed. D. Hambrick, 35–65. Greenwich, CT: Jay Press.

Foreword2

Every so often a book comes along with bold ambitions to rethink and reshape how business firms operate. This is such a book. It seeks to completely reorient the study and practice of corporate governance by directing attention to the fundamental task of the board of directors—one that is largely overlooked in standard treatments of corporate governance. The book argues that the board’s fundamental task is to minimize surprises in a disruptive world and foster ongoing strategic renewal, so as to ensure the survival and prosperity of the firm. In making the case for this novel perspective on corporate governance and strategic renewal, the book brings together the concept of dynamic capabilities in strategic management with the scientific ‘free energy principle’, which has as a central concern the minimization of prediction errors. The book introduces the concept of ‘dynamic board capabilities’ and analyzes what boards of directors need to do to minimize prediction errors by the firm. Set against a wide swath of literature, the book impressively makes the case for a new logic of strategic renewal in which the board of directors plays a central role. Notably, the board must encourage the firm to learn through taking action, which is essential in order to minimize prediction errors in a complex and uncertain world. The board has a further responsibility to ensure that information flows in a circular fashion between the bottom and the top of the organization. Strategic renewal then requires that the board and the firm as a whole embrace the duality of managing in the present and in the future while learning from taking action and

2 Professor Constance E. Helfat is the J. Brian Quinn Professor in Strategy and Technology as well as the Area Chair for Strategy and Management at Tuck School of Business at Dartmouth. Helfat is a Co-Editor of the Strategic Management Journal.

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promoting the flow of relevant information up and down the organizational hierarchy. This is a demanding undertaking, but one that is critically important for scholars to investigate further and boards of directors to put into practice. Constance E. Helfat

Preface

The FEP [free energy principle] is a mathematical formulation that explains, from first principles, the characteristics of biological systems that are able to resist decay and persist over time. It rests on the idea that all biological systems instantiate a hierarchical generative model of the world that implicitly minimises its internal entropy by minimising free energy. [. . .] Living systems are effectively self-evidencing—they move to maximise the evidence of their existence. So how do they achieve this? [. . .] This is where the FEP comes in. It asserts that all biological systems maintain their integrity by actively reducing the disorder or dispersion (i.e., entropy) of their sensory and physiological states by minimising their variational free energy. [. . .] Markov blankets establish a conditional independence between internal and external states that renders the inside open to the outside, but only in a conditional sense (i.e., the internal states only ‘see’ the external states through the ‘veil’ of the Markov blanket). [. . .] With Markov blankets in mind, it is fairly straightforward to show that the internal states must—by virtue of minimising surprise—encode a probability distribution over the external states; namely, the causes of sensory impressions on the Markov blanket. This brings us back to free energy. Free energy is a functional (i.e., the function of a function) that describes the probability distribution encoded by the internal states of the Markov blanket. [. . .] In other words, free energy is a function of probabilistic beliefs, encoded by internal states about external states (i.e., expectations about the probable causes of sensory input). [. . .] This means that living systems can be characterised as minimising variational free energy, and therefore surprise, where the minimisation of variational free energy entails the optimisation of beliefs about things beyond or behind the Markov blanket. [. . .] It asserts that for a system to resist entropic erosion and maintain itself in a bounded set of states (i.e., to possess a generalised homeostasis), it must instantiate a causal, statistical model of its eco-niche relation. In other words, an organism does not just encode a model of the world, it is a model of the world. (Ramstead et al. 2018)

Learning to actively infer will determine the firm’s competitive advantage and survival in a discontinuous and distributed world. The more fluid the boundaries between firm and eco-niche, the more important the definition of what constitutes a system and how non-dissipative (Markovian) boundaries preserve the firm’s integrity, i.e., belief systems. Our interest is shifting away from pursuing deterministic truth through clever analysis toward designing (entailing) a generative (self-organizing) xvii

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model that empowers the firm to master the shifting conditional independencies between the known and unknown and what lies within and beyond its control. The proposal on offer here is that the mind comes into being when self-evidencing has a temporal thickness [models can be thicker and thinner, deeper or shallower, depending on how far forward they predict] or counterfactual depth [how far back they postdict, that is, whether they can capture how things might have ended up if they had acted differently]. There is no real reason for minds to exist; they appear to do so simply because existence itself is the end-point of a process of reasoning. Consciousness, I’d contend, is nothing grander than inference about my future. (Friston 2017; emphasis by DBK)

The rise and continuous advance of the multi-intelligence firm—embodied, enactive, extended (Clark 2016)3, and en-cultured (Friston 2017)—leveraging human, environmental, as well as machine-based agents—is not only exponentially accelerating discontinuities but is, above all, challenging linear thinking. In fact, entrenched strategy process and governance models have outstripped their shelf life. Strategy management and governance research are in danger of getting trapped in a mechanistically deterministic ‘local’ cause-effect centrism fossilizing Upper Echelon’s perception of the world as increasingly uncertain and unpredictable. Essentially, we are in search of a self-organizing mechanism to account, ex ante, for ambiguity and uncertainty as a basis for competitive advantage and survival. The firm is envisioned as an enactive, sophisticated, and resource-dependent inference machine in form of a generative (learning) model. Essentially, it is a statistical model linking in circular causality, action, perception, firm resources, and the unknown external world. The firm is effectively the model of its selfgenerated eco-niche. The model is indifferent toward reward and value functions. But it is solely dedicated to the pursuit of one simple objective: resist entropic dissipation by way of minimizing surprise through generative prediction error minimization, i.e., minimizing variational free energy. In fact, resisting entropy, with the least energy investment, is the firm’s very first-order hyper-prior (metabelief). All beliefs (probability distributions upon unknown external states) flow from here. The generative model is the firm’s control or belief system (regulator) causally linking as well as dynamically evolving in function of principally four states: (1) active states (action), (2) sensory states (perception), (3) internal states ( firm resources), and (4) external states (hidden unknowns ‘out there’). Free-energy minimization is simply the first-order principle that knows no other purpose but to minimize the upper bound on surprisal of the probabilistic beliefs that the firm’s inner states (firm resources) encode upon the external state (eco-niche). The relation between internal and external is a function of enacted boundaries expressed as conditional dependencies between action and perception or simply a Markov blanket. The firm does not have just one single blanket but many blankets as well as blankets upon blankets.

3 This represents Andy Clark’s ‘EEE Cognition’—embodied, enactive, and extended (Clark, 2021). For a critical review of ‘EEE Cognition’, see Colombo et al., 2019.

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The common understanding underlying entrenched strategy governance models, rather erroneously, has been that action is a consequence of perception, and, therefore, strategy must be environment-driven. In fact, action upon the firm’s eco-niche—akin to pointing the light torch in the dark—determines perception. Inference is enactive (Ramstead et al. 2018). The generative model itself never encodes anything. It just expresses the circular causality among all four states. The generative model, hence, is a model of the firm’s eco-niche. If not, it is no good regulator, and, consequently, the firm will rather sooner than later dissipate in the face of entropic forces. “This implies that the relevant generative model is not ‘contained’ in any single neuron or module, but instead embodied in the entire pattern of connection weights as distributed across the nervous system and potentially, the body itself. This can be understood by analogy to Ashby’s ‘good regulator theorem’ which states that every good regulator (i.e., a control system which maintains integrity in the face of change) must be a model of its environment.” (Allen and Friston 2018)

Therefore, the firm’s true governance challenge is a matter of meta-governing its generative model as an enacted, sophisticated, and resource-dependent belief system exercising the entire organization (‘the body itself ’). In contours, we should now start seeing a model emerging “that underwrites a form of autopoiesis” (Friston 2019), i.e., self-organization. Effectively, it is all about casting inference as optimization (mathematically, by way of gradient decent) starting with two essential constituents: (1) a hyper-prior (which is the firm’s resistance to entropy in order to persist) and (2) epistemic foraging and hypothesis testing (i.e., acting upon the eco-niche to generate belief-evidencing data). At its heart, it is a nondeterministic but probabilistic interpretation of the world, optimizing self-organization in discontinuous environments as a matter of selfevidencing within the firm (at and in-between every layer of the organizational hierarchy) as well as between the firm and its eco-niche. “Because active inference works in belief spaces, that is, on statistical manifolds [. . .], there is no need for sampling or random searches; the optimal paths are instead evaluated by propagating beliefs of probability distributions into the future to find the path of least variational free energy” (Friston et al. 2021; emphasis by DBK). In the context of Free Energy Governance (FEG), it is critical to understand upfront the importance of qualifying active inference as enactive, sophisticated, and resource-dependent, effectively delineating it from more conventional (purely representational) schemes of Bayesian inference. This distinction lays the foundation for FEG’s triplet of structure (top-down/bottom-up coupling of governance and operational channels), cognition (environmental enactment), and capabilities (duality management). Analogously, it goes straight to three crucial questions: (a) How do we sample the world in terms of beliefs? (b) How are beliefs updated and enhanced in terms of precision, i.e., reliability? And (c) what specific internal states (i.e., firm resources in form of cognitive capabilities) are critical to ensuring that the generative model anticipatorily proposes actions in view of belief optimization that underwrite the firm’s nonequilibrium steady state (NEES), i.e., the firm’s integrity and survival.

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Free Energy Governance’s underlying triplet of structure, cognition, and capabilities constitutes the building blocks of a firm’s generative (inference) model: (1) Structure: optimize intra-firm top-down/bottom-up connectivity. Connectivity emerges in flow and language. Bottom-up stimuli emanating from resource markets (such as clients, technologies, suppliers and other) are only as relevant and meaningful to resource reconfiguration and asset allocation as clearly as top-down predictions and prediction models are articulated, communicated, and, above all, programmed to process bottom-up incoming signals. Most organizations are likely to struggle adapting language to an inference-centric world (in form of the circular causality linking corporate purpose, prediction models, predictions, bottom-up stimuli, and prediction error minimization). Consequently, most firms will only sub-optimally leverage humans’ full potential in a world that is increasingly powered by artificial intelligence (AI). More specifically, governance and operational channels are not synchronized to process signals ‘on the fly’. Organizational action is time retarded. The “use of deliberate structure to preserve the spontaneity of self-organization may be one of humanity’s most productive assets” (Brown and Duguid 2017) and should not be wasted. (2) Cognition: embrace environment as enacted through relations and interactions, constructed in our brains. Environment does not objectively (actorindependently) exist but is revealed by the firm’s actions and perceptions that those very actions generate. In fact, the consequences of a firm’s activity construct its eco-niche. Neither in nature nor in business is evolution unidirectionally selective. In a world where the cost of interacting is decreasing at accelerating pace due to technological advancement and disintermediation, discontinuities are consequently more frequent. Indeed, a hallmark of today’s world are the exponential dynamics of the simplicity of an individual firm’s actions and the complexity potentially arising from it at the eco-niche level. No complicated rules of interaction are required (Camazine et al. 2001). Traditional reinforcement learning’s reward functions get disrupted and, most likely, are becoming counterproductive to resisting sustainably dissipative forces. Therefore, the logic of (self-)organizing should not be centered around the maximization of pre-defined rewards but surprise minimization through enactive inference, powered by a simple first-order principle: free-energy minimization. (3) Capabilities: develop duality management as a dynamic board capability to top-down empower the firm optimizing its generative model, i.e., ‘flying the plane while redesigning it’. Exploration vs. exploitation as well as financial (M&A/alliancing-driven growth/innovation) vs. strategic control (organic growth/innovation), for example, are dualities that are not only interdependently linked but that must be continuously balanced (in form of vacillation) to optimally reconfigure the firm’s resources and minimize corporate entropy. Anticipating and developing the right capabilities mix at all hierarchical levels—including the board of directors—are essential to optimizing model (self-)evidence, i.e., firm survival. In a discontinuous world, the logic of

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organizing is moving from hard to soft—from classical to quantum. The inferring firm is constantly optimizing belief propagation as well as the updating of beliefs (sophistication). That process of optimizing recognition densities is only as good as the firm’s generative (‘world’) model. So, we are no longer just interested in the actions’ consequences per se, but how the actions’ consequences impact ulterior beliefs. This recursive formulation of expected free energy “is efficient because only paths that have a sufficiently high predictive posterior probability need to be evaluated” (Friston et al. 2021). Without sophistication (i.e., computational shortcuts), firms will struggle navigating quantum uncertainty, eventually surrendering to the immobilizing but self-inflicted perception that the world is uncertain and unpredictable. Re-aligning exploitation with exploration as well as financial with strategic control are fundamentally matters of optimizing self-evidencing, which is maximizing model evidence by way of minimizing variational free energy, all conditioned by Markov blankets within and without the firm. In physics, the world is divided into realists and anti-realists: Behind the century-long argument over quantum mechanics is a fundamental disagreement about the nature of reality – a disagreement which, unresolved, escalates into an argument about the nature of science. Two questions underlie the schism. First off, does the natural world exist independently of our minds? More precisely, does matter have a stable set of properties in and of itself, without regard to our perceptions and knowledge? Second, can those properties be comprehended and described by us? Can we understand enough about the laws of nature to explain the history of our universe and predict its future? (Smolin 2020)

Management science is equally divided along not too dissimilar fault lines. It is best captured by Karl Weick (1977) when he states that environment “is located in the mind of the actor and is imposed by him on experience in order to make that experience more meaningful. It seldom dawns on organizational theorists to look for environments inside of heads rather than outside of them.” Indeed, the rise of the cognitive lens in strategy management and governance research has enriched our understanding around improving the design of strategy governance processes but has largely remained constrained by the notion that environment is something objective ‘out there’, waiting to be analyzed and adapted to. Google, Uber, Airbnb, and Facebook, to name a few prolific tech-driven business-model disruptors, do not represent success phenomena awaiting to be deterministically discovered. These immensely and sustainably successful companies are the product of a fundamentally ‘anti-realist’ enactment of and interaction with their respective eco-niches, powered by unique and continuously evolving sets of capabilities fostering action-generated top-down/bottom-up prediction error minimization to iteratively optimize their very generative models and implied recognition (posterior probabilities of beliefs about their actions’ consequences). These companies ‘redesign while they fly’ which is, in the words of Silicon Valley veteran Reid Hoffmann, equivalent to “[throwing] yourself off a cliff and assemble your airplane on the way down” (Sullivan 2016). In fact, we are more in control than we resist to believe.

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The revolutions that will matter - the big disruptions that create wealth for inventors and anxiety for workers, or that scramble the geopolitical balance and alter human relations cannot be predicted based on extrapolations of past data, precisely because such revolutions are so thoroughly disruptive. Rather, they will emerge as a result of forces that are too complex to forecast - from the primordial soup of tinkerers and hackers and hubristic dreamers [...] Mature, comfortable societies, dominated by people who analyze every probability and manage every risk, should come to terms with a tomorrow that cannot be foreseen. The future can be discovered by means of iterative, venture-backed experiments. It cannot be predicted. (Mallaby 2022)

Blitz-scaling has been integral to the founding DNA of these superoutperformers. They listen to and sense what wants to emerge (Scharmer 2018): they are the enacting designers of their very eco-niche. For those companies, strategy is rather a matter of ex post sensemaking than ex ante long-term planning. It is a matter of survival. Changing how you listen means that you change how you experience relationships and the world. And if you change that, you change, well EVERYTHING. (Scharmer 2018)

The free energy principle (FEP) as a first-order principle leads to a ‘particular physics’ (Friston, 2019b) inspiring Free-Energy Governance’s essential principles that govern a firm’s continuous strategic renewal in form of a ‘wholesale reinvention’ (Siebel, 2019). “This view dissolves familiar dialectics between mind and matter, self and world, and representationalism (we depict reality as it is) and emergentism (reality comes into being through our abductive encounters with the world)” (Friston et al. 2018; emphasis by DBK). The principles of biocentrism (Lanza et al. 2020) serve as a meta-theory or philosophy of science underpinning the unified account of action, perception, and survival that FEG establishes: “any universe that could have preceded consciousness only existed in a probability state” (Lanza et al. 2020). The principles of Theory U (Scharmer 2018) inspire guidance for action, top-down/bottom-up, eventually moving the firm from absencing to presencing. Free Energy Governance represents physics’ anti-realist stance, as defined by Smolin (2020). Equally, strategy management research should more explicitly fork along (1) a realist (mechanistically deterministic) view of the world that has dominated entrenched strategy governance models and (2) a probabilistic and actioncentric interpretation of the world embracing the firm as a generative model of its eco-niche in form of enactive inference. The consequences for organizing as well as firm performance and survival will be far-reaching once business leaders stop approaching a quantum world, characterized by nonlocal discontinuities, with a classical and deterministic mindset fueling the incapacitating perception of the world as uncertain and unpredictable. “In short, we expect to be surprised in a world that is predictably unpredicatble - and this is the very stuff of free-energy minimization.” (Friston et al. 2018)

The universe speaks in numbers (Farmelo 2019). FEP is a mathematical formulation:

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Equations force a model to be precise, complete and self-consistent, and they allow its full implications to be worked out. It is not difficult to find word models in the conclusions sections of older neuroscience papers that sound reasonable but, when expressed as mathematical models, turn out to be inconsistent and unworkable. Mathematical formulation of a model forces it to be self-consistent and, although self-consistency is not necessarily truth, self-inconsistency is certainly falsehood. (Abbott 2008)

I have immensely benefited from the abductive ideation and mathematical heavy lifting of Professor Karl Friston and his team at The Wellcome Trust Centre for Neuroimaging, University College London, and beyond. It did strike me as plainly obvious that FEP must be applied beyond living organisms to the world of man-made organizations. I have dedicated myself to the word model in translating FEP for the business community, eschewing the mathematics that power FEP’s consistency and real-world applicability in neuroimaging and machine learning. In strategy management, it is the pioneering work of Professor Constance Helfat—specifically the cognitive lens applied to DC (Helfat and Peteraf 2015)— that provided me with the ‘strategic management’ anchor empowering the development of ‘new eyes’ to start building the Free Energy Governance (FEG) model. Equally, Michael Hitt’s work on the implications related to maintaining a sustainable balance between strategic and financial control laid the foundation to fundamentally redefine the board’s mandate and, more specifically, establish duality management as a dynamic board capability. Introducing FEP to strategy management is beyond the increasingly popular trend of applying neuroscience-originated theories, concepts, and techniques to management research (e.g., Ocasio 1997; Boyatzis et al. 2014; Laureiro-Martínez et al. 2015). It is FEP’s mathematically imposed rigor that provides a self-consistent algorithm dynamically relating in circular causality the essential building blocks for developing a self-organizing governance model empowering firms to strive and survive in discontinuous environments: four states (active, sensory, internal, external), one internal-external conditional boundary (Markov blanket), and one orchestrating first-order principle (free energy minimization). Though rather rudimentary and explorative at this stage, Free Energy Governance lays the basis for future research. In fact, many vibrant topics in strategy management—e.g., language and communication, embodied cognition, artificial intelligence, and capability development—can be reformulated as a matter of optimizing free energy minimization, i.e., surprise minimization. We must leave the world of the known to renormalize. Zug, Switzerland

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References Abbott, L.F. 2008. Theoretical neuroscience rising. Neuron 60: 489–495. Allen, M. and Friston, K.J. 2018. From cognitivism to autopoiesis: Towards a computational framework for the embodied mind. Syntheses 195: 2459–2482. https://doi.org/10.1007/s11229-016-1288-5. Boyatzis, R.E., Rochford, K., and Jack, A.I. 2014. Antagonistic neural networks underlying differentiated leadership roles. Frontiers in Human Neuroscience 8, 114: 1–15. Brown, J., and Duguid, P. 2017. The Social Life of Information. Boston, MA: Harvard Business School Press. Camazine, S., Deneubourg, J-L., Franks, N.R., Sneyd, J., Theraulaz, G., Bonabeau, E., 2001. Self-organization in Biological Systems. Princeton, NJ: Princeton University Press. Clark, A. 2016. Surfing Uncertainty: Prediction, Action and the Embodied Mind. New York: Oxford University Press. Colombo, M., Irvine, E., and Stapleton, M. (eds.). 2019. Andy Clark and His Critics. Oxford: Oxford University Press. Farmelo, G. 2019. The Universe Speaks in Numbers: How Modern Math Reveals Nature’s Deepest Secrets. New York: Basic Books Friston, K. 2017. The mathematics of mind-time: Consciousness is not a thing, but a process of inference. Aeon Essays (online): https://aeon.co/essays/consciousnessis-not-a-thing-but-a-process-of-inference. Friston, K.J. 2019. A Free Energy Principle for a Particular Physics. Monograph (under consideration for publication by The MIT Press); 1–148 Friston, K., Fortier, M., and Friedman, D.A. 2018. Of woodlice and men: A Bayesian account of cognition, life and consciousness. An interview with Karl Friston. ALIUS Bulletin 2: 17–43. Friston, K.J., Da Costa, L., Hafner, D., Hesp, C., and Parr, T. 2021. Sophisticated inference. Neural Computation 33(3): 713–763. Helfat, C.E. and Peteraf, M.A. 2015. Managerial cognitive capabilities and the microfoundations of dynamic capabilities. Strategic Management Journal 36: 831–850. Khezri, D.B. 2021. Free Energy Governance - Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival. Dissertation. Zug, Switzerland: KCRI (Khezri Capital Research International) AG. https://www.alexandria. unisg.ch/262427/1/Dis5052.pdf. Lanza, R., Pavšič, M., and Berman, B. 2020. The Grand Biocentric Design: How Life Creates Reality. Dallas, TX: BenBella Books. Laureiro-Martínez, D., Brusoni, S., Canessa, N., and Zollo, M. 2015. Understanding the exploration-exploitation dilemma: An fMRI study of attention control and decision-making performance. Strategic Management Journal 36: 319–338. Mallaby, S. 2022. The Power Law: Venture Capital and the Making of the New Future. New York: Penguin Press.

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Ocasio, W. (1997). Towards an attention-based view of the firm. Strategic Management Journal 18: 187–206. Ramstead, M., Badcock, P.B., and Friston, K.J. 2018. Answering Schrödinger’s question: A free energy formulation. Physics of Life Reviews 24: 1–16. Ramstead, M., Kirchhoff, M. and Friston, K.J. 2020. A tale of two densities: Active inference is enactive inference. Adaptive Behavior 4: 225–239. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers. Siebel, T.M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: RosettaBooks. Smolin, L. 2020. Einstein’s Unfinished Revolution: The Search for What Lies Beyond the Quantum. New York: Penguin Press. Sullivan, T. 2016. Blitzscaling. Harvard Business Review (April) Weick, K.E. 1977. Enactment processes in organizations. In Staw, B.M. and Salancik, G. (eds.). New Directions in Organizational Behaviour, 267–300. Chicago: St. Clair.

Contents

Part I

Re-framing the Strategy-Governance Conversation

1

‘Thinking Born of Curiosity, Revolt, and Change’ . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3 6

2

Sensing, Sensemaking, and Strategic Renewal . . . . . . . . . . . . . . . . 2.1 Strategic Cognition: Sensing and Sensemaking . . . . . . . . . . . . 2.2 Strategic Renewal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . .

7 7 17 21

3

Microfoundations of Strategic Governance . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25 30

4

Free Energy Principle (FEP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

33 40

5

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43 47

Part II

Free Energy Governance (FEG)

6

Structure: Synergizing Governance and Operational Channels . . . 6.1 Upper Echelon View (UEV) . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Prediction Processing Framework (PPF) . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . .

51 51 53 61

7

Cognition: From Superposition to Reality . . . . . . . . . . . . . . . . . . . 7.1 Attention-Based View (ABV) . . . . . . . . . . . . . . . . . . . . . . . . 7.2 Enactivist Approach (EA) . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . .

63 63 67 71

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Contents

8

Capabilities: Duality Management . . . . . . . . . . . . . . . . . . . . . . . . . 8.1 Dynamic Capability View (DCV) . . . . . . . . . . . . . . . . . . . . . . 8.2 Antagonistic Neural Networks Perspective (ANNP) . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

73 73 79 82

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Laying the Foundation for a Self-Organizing (Autopoietic) Governance Logic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85 90

Part III

Conclusion

10

Free Energy Governance vs. Traditional Corporate Governance . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

Implications for Management Practice . . . . . . . . . . . . . . . . . . . . . . 97 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

12

Future Research Agenda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.1 Language and Communication . . . . . . . . . . . . . . . . . . . . . . . . 12.2 Embodied Cognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.3 Artificial Intelligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.4 Board Capabilities’ Developmental Paths . . . . . . . . . . . . . . . . 12.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

Outperformance and Survival as a Matter of Self-Organization . . . 117 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

Part IV

. . . . . . .

93 96

105 106 107 109 111 113 114

Engaged Scholarship Interviews

14

Steve Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 14.1 Steve Case (January 29, 2020) . . . . . . . . . . . . . . . . . . . . . . . . . 131

15

Jan Ståhlberg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 15.1 Jan Ståhlberg (February 14, 2020) . . . . . . . . . . . . . . . . . . . . . . 133

Acknowledgments and Epilogue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

About the Author

Bijan Khezri, for more than 25 years, has been dedicated to innovation, business leadership, and corporate governance as CEO/Chairman, non-executive Director, business owner, and investor across a range of sector-leading IT, media, and sports companies—public as well as private—in the United Kingdom, the United States, Germany, and Switzerland. He is the Founder and Chairman of KCRI (Khezri Capital Research International) AG in Zug (Switzerland), a family office, private equity investor, and governance partner. He studied law at Bonn University and graduated from the Institut de Hautes Etudes Internationales (University of Geneva). He holds a PhD in strategy management from the University of St. Gallen, Switzerland. He has extensively published in the Financial Times, The Wall Street Journal, and other leading publications for close to three decades (Selected Publications). He is the Book Author of Generation Dubai: Exit, Voice, and Loyalty. Since 1995, he has been an approved individual of the United Kingdom’s Financial Conduct Authority.

xxix

Abbreviations

ABV AI Ai ANNP Bn/bn CI CQ DBK DC DCV DMN DNA EA EC EQT FEG FEP fMRI KPI(s) M/m M&A NESS OKR OS PE P&L PC PP PPF R&D TCG

Attention-Based View Artificial Intelligence Active Inference Antagonistic Neural Networks Perspective (ANNP) Billion Collective Intelligence Collaborative Intelligence Daniel Bijan Khezri (Bijan Khezri) Dynamic Capabilities Dynamic Capability View Default Mode Network Deoxyribonucleic Acid Enactivist Approach Embodied Cognition Leading Private Equity Investor Free Energy Governance Free Energy Principle Functional Magnetic Resonance Imaging Key Performance Indicators Million Mergers and Acquisitions Nonequilibrium Steady States Objectives and Key Results Open Strategy Private Equity Profit and Loss Predictive Coding Predictive Processing Prediction Processing Framework Research and Development Traditional Corporate Governance xxxi

xxxii

TMT TPN UEV USD VUCA VUCA

Abbreviations

Top Management Team Task Positive Network Upper Echelon View US Dollar Volatility, Uncertainty, Complexity, and Ambiguity Volatile, Uncertain, Complex, and Ambiguous

Part I

Re-framing the Strategy-Governance Conversation

The evidence suggests that we are in the midst of an evolutionary punctuation: We are witnessing a mass extinction in the corporate world in the early decades of the 21st century. Since 2000, 52% of the Fortune 500 companies have either been acquired, merged, or have declared bankruptcy. It is estimated that 40 percent of the companies in existence today will shutter their operations in the next 10 years [. . .] Merely following the trends of change is not enough. Just like organisms facing the Great Oxidation Event, organizations need to reinvent the way they interact with the changing world. —Siebel (2019)

Reference Siebel, T. M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: RosettaBooks.

Chapter 1

‘Thinking Born of Curiosity, Revolt, and Change’

Abstract Environmental complexity and velocity have been dominant moderators in strategy and governance research. The underlying structure of environmental change has become increasingly distributed and discontinuous. The disintermediating nature of information technologies is challenging entrenched business models as well as logics of organizing. Centralized top-down strategy processes are rather anti-clocked unless dynamically and generatively intertwined in real time with bottom-up stimuli and data emanating from field operations in pursuit of prediction error minimization. Neither established logics of organizing nor prevalent corporate governance models are a match for ‘wholesale digital reinvention’ and continuous strategic renewal. In fact, akin to the AI evolution from a supervised to a deep learning logic, corporate governance is challenged to evolve from a supervised and rule-based (‘best practices’-centric) learning system to one of unsupervised (un)learning, i.e., self-organization. To survive, the firm must be conceived as one cross-hierarchically integrated inference machine. Organizing is generative prediction error minimization. Strategy is redefined as top-down/bottomup predictions processing. “The search for knowledge is not nourished by certainty: it is nourished by a radical absence of certainty [. . .] thinking born of curiosity, revolt, change” (Rovelli 2021).

Scholarship is best understood as conversation. There are many conversations—past and present, cross-fertilizing or merging into one another—relevant to the crossdisciplinary subject matter of this book: what form of hierarchical coupling (structure), firm environmental engagement (cognition), and board capabilities determine the success of continuous strategic renewal and, hence, firm survival. Twenty or thirty years in strategy management research is not a long period of time. But a framework’s consistent persistency across several conversations, not least as a meaningful metaphor (Cornelissen and Kafouros 2008), nurtures field research and eventually fuels or de-constructs dominant logics (Kuhn 2012). Agency, ambidexterity, attention, cognitive dissonance, contingency, double-loop learning, dynamic capabilities, enactment, information processing, microfoundations, organizational sensemaking, resource dependency, and Upper Echelon, for example, are metaphors, lenses, or part theories that have framed conversations inspiring this book. © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_1

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Indeed, metaphors create “powerful insights that also become distortions, as a way of seeing created through a metaphor becomes a way of not seeing” (Morgan 2006). Environmental complexity and velocity have been dominant moderators in strategy and governance research. Indeed, the rate of change has not only been accelerating but the underlying structure of change has become increasingly distributed and discontinuous: ‘sense of urgency’ and ‘heedful interrelating’ (Weick and Roberts 1993) are critical to survival in a world that is now commonly perceived as ‘full of surprises’. “Multiple strategic discontinuities will occur [. . .] the periods of stability will be short [. . .] [producing] significant uncertainty” (Hitt 2000). Discontinuities are fundamentally a function of the costs of interacting with the outer world in form of generating and testing predictions. These costs continue decreasing exponentially because of two mutually reinforcing advances: (1) accelerating dis-intermediation and de-centralization powered by all-pervading connectivity and (2) exponential growth in artificial intelligence (AI) and specifically predictive analytics and machine-powered deep learning, fueled by an equally exponential growth in cheap and distributed computing power capturing and ‘mentalizing’ more and more (big and deep) data. We are seeing a new convergence of technology vectors including elastic cloud computing, big data, artificial intelligence, and the internet of things, the confluence of which enables us to address classes of applications that were inconceivable even 25 years ago. We can now develop prediction engines. This is what digital transformation is all about. This is when the fun starts. (Siebel 2019; emphasis by DBK)

As a result of these advances, the emergence of the multi-intelligence firm manifests itself in continuously decreasing marginal costs of innovation through high levels of automation and eventually self-organization. This trend, reinforced by utility-centric pricing models for computing and predictive power, is setting free more and more resources to be dedicated to growth capital. Consequently, discontinuities are the new norm, while human capital is challenged to continuously repurpose accordingly. However, human capital can only evolve if we understand that beneath this explicate discontinuous world order, there is an implicate order: “movements that at one layer appear to be random at another will be found to have a complex, unfolding order” (Briggs and Peat 1984) such that these “representational dynamics [rest] upon the notion of (conditional) synchronization of chaos – between internal and external states” (Friston 2019). Effectively, we are in the business of minimizing through our actions the “divergence between expected and true (posterior) probability over hidden states” (Friston 2019) conditioned by Markov blankets. “Uncertainty is a personal matter; it is not the uncertainty but your uncertainty” (Lindley 2014). More specifically, the disintermediating nature of information technologies is challenging entrenched business models as well as logics of organizing. To survive, the firm must become one cross-hierarchically integrated inference machine that continuously generates predictions, which are calling to be bottom-up challenged. Organizing is generative prediction error minimization. Strategy is redefined as

1 ‘Thinking Born of Curiosity, Revolt, and Change’

5

prediction processing that is subject to (bottom-up) stimuli-based error-minimization. More importantly, language and communication must evolve to optimize the humanmachine interface so integral to the multi-intelligence firm. Machine learning is fundamentally a prediction challenge. Action precedes perception. It will be demonstrated in the following sections that sensing and sensemaking are not only two sides of the very same coin but that our actions are the source of our perceptions and not the other way around. The need for a strategy process model that is more learning-centric and unsupervised (‘free energy principle’ inspired), enactivist (emphasizing environmental enactment as opposed to adaptation), and complete (dynamically integrating the board of directors with the rest of the organization), is challenging traditional thinking and established paradigms in strategic management, corporate governance, and generally organizational design. “Our problem is to understand the changes that the organization (and the individual) will have to make if it is to obtain the most possible human energy for productive effort” (Argyris 1995). That’s “why the companies that will succeed are those that not only transform a business process, or a department, but also look at wholesale digital reinvention” (Siebel 2019). This is the essence of strategic renewal. Fundamentally, a firm’s capability for success with continuous strategic renewal is a function of its ability to learn as well as unlearn (Bonchek 2016) powered by epistemic foraging in form of interactions and prediction processing. The organization—or, more appropriately, (self-)organizing—is challenged: centralized top-down strategy processes are rather anti-clocked unless dynamically and generatively intertwined in real time with bottom-up stimuli and data emanating from field operations in pursuit of prediction error minimization. Neither entrenched logics of organizing nor prevalent corporate governance models are a match for ‘wholesale digital reinvention’ and continuous strategic renewal. In fact, akin to the AI evolution from a supervised to a deep learning logic, corporate governance is challenged to evolve from a supervised and rule-based (‘best practices’-centric) learning system to one of unsupervised (un)learning, i.e., self-organization. Top-down/bottom-up connectivity is defined as a generative social field. Firms are called upon to “[o]pen up all four ‘channels’ of listening: Listen from what you know, from what surprises you, from the whole, and from what you sense wants to emerge (the emerging whole)” (Scharmer 2018). Surfing uncertainty is not about avoiding uncharted domains but embracing curiosity as an information-enriching activity continuously and generatively feeding and optimizing one’s world model, i.e., the model of the firm and its very eco-niche: The search for knowledge is not nourished by certainty: it is nourished by a radical absence of certainty. Thanks to the acute awareness of our ignorance, we are open to doubt and can continue to learn and to learn better. This has always been the strength of scientific thinking – thinking born of curiosity, revolt, change (Rovelli 2021; emphasis by DBK).

As we embrace thinking born of curiosity, revolt, and change to successfully exploit the very potential for value creation that discontinuous market environments behold, we are challenged to learn from living organisms and find inspiration in the

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pursuit of self-organization. The effectiveness of governance—in terms of firm outperformance and survival—is determined by the firm’s ability to introduce and continuously strengthen self-organizing mechanisms. This is precisely where Free Energy Governance opens a new conversation, inspired by FEP.

References Argyris, C. 1995. Integrating the Individual and the Organization. New York: Translation Publishers. Bonchek, M. 2016. Why the problem with learning is unlearning. Harvard Business Review Digital Articles: 2–4. Briggs, J.P., and F.D. Peat. 1984. Looking Glass Universe: The Emerging Science of Wholeness. New York: Simon & Schuster. Cornelissen, J.P., and M. Kafouros. 2008. The emergent organization: Primary and complex metaphors in theorizing about organizations. Organization Studies 29: 957–978. Friston, K.J. 2019. A Free Energy Principle for a Particular Physics. Monograph (under consideration for publication by The MIT Press), 1–148. Hitt, M.A. 2000. The new frontier: Transformation of management for the new millennium. Organizational Dynamics 28: 6–17. Kuhn, T.S. 2012. The Structure of Scientific Revolutions. Chicago: The University of Chicago Press (4th edition, originally published in 1962). Lindley, D.V. 2014. Understanding Uncertainty. Hoboken, NJ: Wiley. Morgan, G. 2006. Images of Organization. Thousand Oaks, CA: Sage Publications. Rovelli, C. 2021. Helgoland: Making Sense of the Quantum Revolution. New York: Riverhead Books. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers. Siebel, T.M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: RosettaBooks. Weick, K.E., and K.H. Roberts. 1993. Collective mind in organizations: Heedful interrelating on flight decks. Administrative Science Quarterly 38: 357–381.

Chapter 2

Sensing, Sensemaking, and Strategic Renewal

Abstract Sensing and sensemaking form one unitary act and together can be considered a non-operational (cognitive) meta-capability (or dynamic capability). There is no sensing without sensemaking and vice versa. And there is no organizational sensemaking in the absence of a clearly defined deep (existenital) corporate purpose. Generative processes of top-down/bottom-up hypothesis testing (i.e., prediction error minimization) rather than top-down heuristic simplification are guiding the path to navigating a discontinuous world. It is neuroscience’s predictive coding that allows us to take management research’s strategic cognition and, more specifically, the nexus of structure and cognition one step further to provide a more complete and practice-relevant framework for applying sensing and sensemaking in the context of strategic renewal. Effectively, sensing and sensemaking are empowered by the circular causality of top-down knowledge structures (prediction models, predictions, hypotheses, and guesses) and bottom-up stimuli/data stemming from resource markets. By default, uncertainty and complexity are subjective concepts but are consistently deployed in management research as objectively determined. Environmental sensing and sensemaking are non-sensical in the absence of having set the firm’s purpose and context in the first place. Once we define sensing, sensemaking, and strategic renewal in form of action-centric circular causality linking purpose, prediction models, predictions, and prediction error minimization, a new logic of strategic renewal emerges—dynamically connecting structure (hierarchy), cognition, and capabilities.

2.1

Strategic Cognition: Sensing and Sensemaking

Strategic cognition, tracing its very origins to the Carnegie School’s behavioral decision theory ‘as a complement to the rational analytical models’ (Narayanan et al. 2011), has emerged as a distinct and growing field. Strategy initiation and formulation—defined “as a complex activity consisting of scanning, sensemaking, and (strategic) decision making” (Narayanan et al. 2011)—are at the heart of a firm’s collective interpretative power emphasizing as core capabilities the timely and

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_2

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accurate reading of expected environmental change and the corresponding need for resource reconfiguration in pursuit of adaptation. Sensing and sensemaking form one unitary act and together can be considered a non-operational (cognitive) meta-capability (or dynamic capability). There is no sensing without sensemaking and vice versa. Organizational sensemaking as a perspective1 is deeply indebted to Karl Weick and is based on the insight that sensemaking and organizing are ‘mutually constitutive’: “I want to understand how the conditions of interdependency associated with organizing affect how people deal with situations where there are too many or too few meanings” (Weick 2005). Many definitions have been applied to sensemaking: symbolic processes of reality construction, retrospective interpretations built during interaction, bringing meaning into existence so that continued acting is stabilized, as well as being “sensitive to the continuing flow of potentially new stories” (Weick 2005). Indeed, “organizations exist largely in the mind, and their existence takes the form of cognitive maps. Thus, what ties an organization together is what ties thoughts together” (Weick and Bougon 1986). On a more operational level, sensemaking’s very effectiveness is shaped by three critical dimensions: (a) the clarity of a timeless corporate purpose; (b) a dissonancecentric quest for and optimization of filtering anomalies, “[a]s anomalies become shared, sensibleness should become stronger” (Weick 1995); and (c) an enactivist worldview, i.e., environment is not exogenously pre-determined but is enacted through the social and action-centric construction of shared meaning. Fundamentally, firm-level sensing and sensemaking—grounded in dissonance theory (Festinger 1957)—are a social process rather than a singular activity dedicated to detecting anomalies. “Sensing delivers an action-based grip upon the world” (Clark 2016). Action is at the center of sensing and sensemaking. “Instead of seeing perception as the control of action, it becomes fruitful to think of action as the control of perception” (Clark 2016). It is critical that the environmental throughput—listening to what wants to emerge—is neither logic- nor goal-trapped but open to nonuniformity: “As Pondy and Mitroff [1979] argue, rather than suggesting that organizational systems be protected ‘against environmental complexity’, we should realize that “it is precisely the throughput of nonuniformity that preserves the differential structure of an open system” (Scott and Davis 2007). In fact, the throughput of nonuniformity is a measure of firm survivability. Uncertainty and surprise are not to be avoided but to be minimized through action- and hypotheses testing-centric engagement with the world as the underlying world model consequently and generatively gains in informational edge. “In real life, people do not know all of the sources of stimuli, nor do they necessarily know how to distinguish relevant from irrelevant information. They

“[S]ensemaking, as a particular approach to the study of organizational phenomena, has been variously described as a “theory,” a “lens,” or a “framework”; here, we follow Weick (1995) and use his term “sensemaking perspective” (Sandberg and Tsoukas 2015: S6).

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9

must discover the characteristics of sources and tasks experimentally” (Starbuck and Milliken 1988). Sensing and sensemaking are purpose-directed, generative, socially interactive, goal-driven, dissonance-sensitive, and experimental. It is a form of experimentation, i.e., hypotheses testing. “[T]he senses do not give us a picture of the world directly; rather they provide evidence for checking hypotheses about what lies before” (Taylor and Van Every 2000; quoting Gregory, R.L. 1966. Eye and Brain: the psychology of seeing). Purpose/goal directedness (i.e., the world model’s underlying prediction model) is fundamental to sensing and sensemaking. Dissonance is a function of a preset goal generating predictions and submitting those predictions to continuous error minimization. Sensemaking models are constantly adjusted through error- and deviationquerying feedback loops—coupling top-down predictions and bottom-up stimuli in circular causality with the sole objective of minimizing prediction errors and surprise, i.e., free energy. Thus, it makes a great difference how foregrounds, backgrounds, and adaptation levels adjust to current stimuli and experience. Insofar as people can control these adjustments voluntarily, they can design noticing systems that respond to changes or ignore them, that emphasize some constituencies and deemphasize others, or that integrate many stimuli simultaneously or concentrate on a few stimuli at a time. (Starbuck and Milliken 1988)

Fundamentally, sensemaking is about designing noticing systems. Weick himself highlights, though unintentionally, the very weakness of his sensemaking perspective when he states that it is “best treated as a set of heuristics rather than as an algorithm” (Weick 1995). More specifically, sensemaking perspective cannot explain how the ‘convergence of individual cognitive cause maps’ transmorph into the organizational cause map. In fact, Weickian sensemaking is episodic rather than continuous: “For sensemaking to be seen as an ongoing process, the underlying episodic ontology of sensemaking needs to be replaced with another that sees sensemaking as ubiquitous rather than exceptional” (Sandberg and Tsoukas 2015). This requires for world enactment to be embraced as probabilistic by way of topdown/bottom-up generative prediction error minimization. Instead, Weick’s sensemaking perspective is stuck in the classical top-down centric cause-effect logic. Thus, sensemaking must be less heuristics but more algorithm. Cognitive heuristics are a form of ‘cognitive simplification’ (Schwenk 1988) or ‘rules of thumb’ and “tools [that] empower the human mind with what the poet John Keats (1891) called ‘negative capability’ – the ability to survive and thrive in uncertainty” (Hertwig et al. 2019). The so-called simple rules that strategists learn from process experience have formed an important stream within strategy research. While “heuristics are ‘rational,’ especially in unpredictable markets” (Bingham and Eisenhardt 2011), they are nonetheless reflective of “humans’ inability to reason according to the complex [Nash Equilibrium]” (Hertwig et al. 2019). However, under uncertainty, “[r]esearch on ‘fast and frugal’ heuristics [. . .] finds that simple heuristics can outperform analytically complicated and information-intensive

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approaches even when information and time are available” (Bingham and Eisenhardt 2011).2 In fact, in environments characterized by increasing levels of complexity and uncertainty or so-called VUCA (volatility, uncertainty, complexity, and ambiguity), the effectiveness of heuristics (generated from ‘repeated games’ experience) may be limited in one-shot games: The interaction of strategic uncertainty and incomplete information makes for a particularly unpredictable game, especially if there is no relevant historical prior incident to refer to. In repeated games, there are various ways to reduce the degree of strategic uncertainty [. . .] Many important real-world decisions are either one-shot games or strategic situations that are so rare that very little prior information exists to reduce uncertainty. . . How can players resolve, reduce, or otherwise handle the various kinds of uncertainty involved in strategic one-shot interactions, which do not afford the opportunity for learning? (Spiliopoulos and Hertwig 2020)

Generative processes of top-down/bottom-up hypothesis testing (i.e., prediction error minimization) rather than top-down (rule-based) simplification are guiding the path to navigating a discontinuous world. Heuristics—no matter how well-trained— are considered to be a rather sub-optimal process (or strategy) to successfully surf uncertainty (Clark 2016). In fact, heuristics rather tame uncertainty. Heuristics reinforce dominant logics in form of pattern recognition and tend to disregard dissonant bottom-up stimuli as noise: “Each heuristic’s policy represents a wager on the structure of the environment in question; it bets that ignoring some of the (often noisy) available information will enable faster, and potentially even more accurate, decisions” (Hertwig et al. 2019). In fact, heuristics may reinforce the phenomenon of deliberate ignorance (Hertwig and Engel 2020) and tame curiosity’s information-enriching drive as a foundation for prediction error minimization. More importantly, in the socially interactive sphere (where it eventually all plays out), the usefulness of heuristics to strategy formulation must be questioned. “[A]ll or most model competitions involved heuristics that concern individual decision making; thus, leaving open the question of whether their success would generalize to strategic situations in the social world. There are certainly grounds for doubt” (Spiliopoulos and Hertwig 2020): The philosopher Sterelny (2003), for instance, argued that simple heuristics—despite reaching surprisingly high levels of accuracy in nonsocial worlds—will fail in interactions with other intelligent (and especially competitive) agents. For it is precisely in such situations that simple rules of thumb will go wrong. (Spiliopoulos and Hertwig 2020)

Finally, heuristics are fundamentally anchored in a worldview of environmental adaptation rather than enactment, i.e., resolving uncertainty is rather treated as a matter of adaptation to an exogenously determined ‘game’. This book rejects environmental adaptation as a viable survival strategy in a perpetually discontinuous (one-shot interactions) environment.

2

See also Tversky and Kahneman (1974).

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11

Cognitive maps3 are closely related to heuristics (Schwenk 1988) and can be considered a potent form of visualizing sensemaking in form of “graphic representations that locate people in relation to their information environments. Maps provide a frame of reference for what is known and believed. They highlight some information and fail to include other information, either because it is deemed less important, or because it is not known. They exhibit the reasoning behind purposeful actions” (Fiol and Huff 1992). The power of maps should not be underestimated. However, cognitive mapping has not been considered—not as a method, not as a metaphor, not as a visualization of cause-effect relationships—for precisely three reasons: (1) This book is not interested in the content but the process dimension of strategy formulation. Why a certain cognition led ex post to particular actions is not of interest. (2) In the context of the Free Energy Governance framework, any cognitive mapping is incomplete and rather useless unless the circular causality of top-down predictions and bottomup stimuli can be dynamically mapped. Mapping only Upper Echelon’s top-down cognition is incomplete and rather interests-serving (Wood 1992), reinforcing Upper Echelon logics. (3) Cognitive mapping is a form of explanatory rather than ‘design science’. It is more hindsight- than foresight-oriented, centered around ‘what was’ or ‘what is’ instead of ‘what will’. The map’s effectiveness is a consequence of the selectivity with which it brings this past to bear on the present. This selectivity, this focus, this particular attention, this [. . .] interest [. . .] is what frees the map to be a representation of the past [. . .] This is to say that maps work [. . .] by serving interests. Because these interests select what form the vast storehouse of knowledge about the earth the map will represent, these interests are embodied in the map as presences and absences (Wood 1992; emphasis by DBK).

Cognitive mapping cannot capture the action-centric and dynamic process of becoming. Free Energy Governance is anchored in becoming, dedicated to optimizing posterior probabilities of beliefs about the consequences of today’s enactment. Precisely, the question arises what utility cognitive maps serve in highly dynamic and discontinuous environments. There is a risk that obsoleteness is innate to the process of mapping, particularly in dynamic environments. Finally, one must question whether cognitive mapping is inherently flawed as “there may be little or no direct introspective access to higher order cognitive processes” (Nisbett and Wilson 1977): Subjects are sometimes (a) unaware of the existence of a stimulus that importantly influenced a response, (b) unaware of the existence of the response, and (c) unaware that the stimulus has affected the response. It is proposed that when people attempt to report on their cognitive processes, that is, on the processes mediating the effects of a stimulus on a response, they do not do so on the basis of any true introspection. Instead, their reports are

3 “The term ‘cognitive map’ was first used by Tolman (1948) in discussions of learning in laboratory animals and human beings. These cognitive maps consist of concepts about aspects of the decision environment and beliefs about cause-and-effect relationships between them. Such maps serve as interpretive lenses” (Schwenk 1988).

12

2 Sensing, Sensemaking, and Strategic Renewal based on a priori, implicit causal theories, or judgments about the extent to which a particular stimulus is a plausible cause of a given response.

Cognitive mapping is representative of the deterministic view of the world—akin to a physical cause-effect chain—and should be considered rather anti-clocked in the face of discontinuous market environments. To effectively minimize surprise in this ‘uncertain world’, we need unsupervised and generative processes that connect in circular causality purpose-driven top-town predictions with action-generated bottom-up stimuli, continuously refining prediction models relevant to firm performance and survival through epistemic foraging, i.e., environmental engagement in form of en-actment and in pursuit of free energy minimization. It is neuroscience’s predictive coding (Friston 2010; Hohwy 2013; Clark 2016) that allows us to take management research’s sensemaking perspective as well as nexus of structure and cognition (Ocasio 1997; Gavetti 2005) one step further to provide a more complete and relevant framework for applying sensing and sensemaking in the context of strategic renewal. Effectively, sensing and sensemaking are empowered by the circular causality between top-down knowledge structures (prediction models, predictions, hypotheses, and guesses) and bottom-up stimuli/data stemming from resource markets: The challenge of sensing capabilities is that their effectiveness relies on the cognitive lens that is used to observe and interpret the world around us. The fundamental tradeoff is between the uncertainty minimization of deductive and inductive logic that leads to crisp answers about opportunities but can miss the opportunities that are too anomalous or too ambiguous. (Dong et al. 2016)

The purpose-driven, action-centric, dissonance-pursuing, and enactivist lens forms the cognitive basis for firm performance-relevant sensing and sensemaking. “Naturally intelligent systems do not passively await sensory stimulation,” but “before an ‘input’ arrives on the scene, these pro-active cognitive systems are already busy predicting [. . .] all they need to process are sensed deviations from the predicted state” (Clark 2016). Taylor and Van Every (2000) and Starbuck and Milliken (1988) equally highlighted the fallacy of putting perception at the start of the causal sequences and emphasized action’s center stage importance to perception and perceptional filters: “Perceptions are partly predictions that may change reality” (Starbuck and Milliken 1988). Abduction (Hansen 2008) is one form of sensemaking that is of increasing interest to the study of strategic management, often simply defined as ‘any hypothesis or guess is valid’. “While deduction and induction are important, neither produces truly new opportunities” (Dong et al. 2016). Rather than starting from a proven template (deduction) or being trapped in inductive logic “[preventing] individuals from interpreting evidence in alternate ways” (Dong et al. 2016), “abductive reasoning provides managers with the cognitive tools they need to sense opportunities and transform them into hypotheses that can be tested” (Dong et al. 2016): Abductive reasoning usually begins with a surprising observation or experience. This is what shatters our habit and motivates us to create a hypothesis that might resolve the anomaly. Abduction is an inferential procedure in which we create a conjecture that, if it were

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correct, would make the surprising anomaly part of our normal understanding of the world. (Van de Ven 2007; emphasis by DBK)

Innovative abduction, for example, “requires coming up with two new rules: a strategic option that logically connects to the desired outcome and a new way to combine a company’s resources and capabilities, or a new business model, which has not been proven, to implement the option” (Dong et al. 2016). Essentially, continuous strategic renewal is inferential. The ‘micro-macro dichotomy’ of “how sensing and sensemaking - essentially cognitive activities that occur at the individual level - transmorph into an actionable firm-level view, i.e. ‘organizational cognition’” is elegantly addressed by Dong et al. (2016): “While hypothesis setting is an individual activity, hypothesis testing is an organizational activity [. . .] Organizational processes for the testing of new hypotheses do not require creativity; they require the scientific and rigorous generation of new data to confirm or refute the hypothesis.” This is the essence of generative freeenergy minimization. Effectively, sensing and sensemaking is a form of organizational learning: actioncentric hypothesis testing that connects the individual level with that of the firm. Crossan’s 4I model (intuiting, interpreting, integrating, and institutionalizing) as applied to the context of strategic renewal (Crossan and Berdrow 2003) provides a framework for the process of trans-morphing individual sensing and sensemaking (cognition) into firm-level strategic action. Intuiting and interpreting a hypothesis starts at the individual level, and subsequently the interpretation (sensemaking) process becomes socialized, integrated, and institutionalized at the firm level. Upper Echelon’s ability to avoid being trapped in ‘dominant logics’ and to openly and abductively encourage and embrace bottom-up stimuli and engage the organization cross-hierarchically in testing goal-directed hypotheses is the essence of sensing and sensemaking as the foundation for firm performance and survival. Clark (2016) asserts that action, cognition, and perception are continuously co-constructed. Indeed, “business environments are [not] objective environments, awaiting discovery through the application of formal analytical techniques” (Hodgkinson 2015), but are enacted. Our understanding of the “brain as a passive and stimulus-driven, taking energetic inputs from the senses and turning them into a coherent percept by a kind of step-wise build-up” (Clark 2016: 51) has moved to the ‘active view’ where the “largest contributor to ongoing neural response is the ceaseless anticipatory buzz of downwards-flowing neural prediction that drives perception and action in circular causal flow” (Clark 2016: 51). Therefore, “brains are not, fundamentally, in the business of ‘processing inputs’ at all. Rather, they are in the business of predicting [en-acting] their inputs. This pro-active neural strategy keeps us poised for action” (Clark 2016). No board of directors can afford to be a passively ‘stimulus-driven’ and ‘energetic inputs’- intaking organ. Unfortunately, entrenched ‘best practices’ have turned boards into exactly this. ‘Best practices’ effectively nurture ‘skilled incompetence’ when it comes to abductive sensemaking. Equally, the field level (close to resource

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markets) where the power of signal sourcing resides must go beyond the ‘inputintaking’ but must share the stimuli bottom-up for collective sensemaking. However, in the absence of a cross-hierarchically integrated organizing framework—powered by the circular causality of top-down prediction/bottom-up stimuli error minimization—it is hard to see how firms can effectively optimize activation of all possible sources of intelligence and sensors listening to and enacting what wants to emerge. Prediction error minimization forms the core of both ‘noticing’ (Starbuck and Milliken 1988) and ‘interpretation’ systems (Daft and Weick 1984) and lays the foundation for a firm’s capacity for continuous strategic renewal. Top-down/bottomup connectivity, leadership’s cognitive capabilities for intuiting (sensing) and interpreting (sensemaking), and, more importantly, the firm’s social processes for integrating and institutionalizing the purpose-directed collapsing of belief functions (probabilities) constitute a firm’s system of shared meaning and expectations as a basis for continuous strategic renewal. It is the dynamic capability view (DCV), in particular its Helfatian interpretation (Helfat et al. 2007)—to purposefully create, extend, or modify [the firm’s] resource base—that has generated a promising and growing conversation around linking capabilities, cognition, and strategic renewal. However, while powerful as a concept, so far DCV has not provided a unified theoretical framework. The challenge is to operationalize sensing and sensemaking (i.e., prediction error minimization) as specific dynamic (meta-)capabilities at both the individual as well as firm level. “Traditionally, researchers have located dynamic capabilities at the organizational level of analysis; [. . .] starting in the early 2000s, the recognition that such capabilities can also exist at the individual level has become increasingly diffused” (Schilke et al. 2018). Helfat and Peteraf (2015) firmly headlined the conversation as ‘managerial cognitive capabilities and the microfoundations of dynamic capabilities’. Equally, there is a need to enrich the conversation with a complementary research stream concerning the board’s cognitive capabilities of sensing and sensemaking in the context of strategic renewal and, more specifically, linking structure, cognition, and capabilities. Ocasio’s attention-based view (ABV; Ocasio 1997) has provided a framework linking structure (i.e., organizational hierarchy) and cognition embracing strategy process “as assemblages of tightly and loosely coupled networks of operational and governance channels” (Ocasio and Joseph 2005) and “strategy formulation as a fluid and distributed process”. The board of directors’ explicit role as an integral part of this distributed process, however, has been marginalized or simply ignored. Structure and cognition are mutually constitutive. The effectiveness of multiscale top-down/bottom-up integration is dependent on lateral integration at each hierarchical layer. In other words, the inter-hierarchical connectivity is dependent on intra-hierarchical top-down/bottom-up ‘heedful interrelating’ in pursuit of ‘shared meaning’ and performance. In this context, the method of OKRs4 (objectives and

4

OKRs (objectives and key results), in contrast to simply pursuing KPIs (key performance indicators), has become an increasingly popular framework for empowering teams to reach their full potential through aligning around objectives (goals) in form of self-organization.

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key results) has proven to be an invaluable and dynamic tool to foster informal exchanges at the (field) level of resource markets, approximating self-organization: [If] we are to develop a truly comprehensive understanding of the socio-cognitive dynamics of industry leadership, competition, and change, it is essential to consider the role played by generative mechanisms within and across multiple levels of analysis — from the individual to the intra-organizational group, to the organizational, inter-organizational and (even inter-) industry levels. (Hodgkinson 2015)

By default, uncertainty and complexity are subjective concepts but are consistently deployed in management research as objectively determined. Environmental sensing and sensemaking are nonsensical in the absence of having set the firm’s (existential) purpose in the first place. “Purpose – not strategy – is the reason an organization exists. Its definition and articulation must be top management’s first responsibility” (Bartlett and Goshal 1994). Foss and Lindenberg (2013) make an important—microfoundations-centric—contribution by applying a goal-framing perspective to strategic value creation: On the basis of goal-framing theory one can thus argue that the heart of value creation in firms lies in the motivation for joint production for all involved. No matter what the firm wants to achieve, optimal value creation will always crucially depend on eliciting a motivation among employees that is directed at common goals, such that organizational members are motivated to choose their actions in terms of joint goals and exert intelligent effort to reach joint goals. Foss and Lindenberg (2013)

However, Foss and Lindenberg’s (2013) linkage of motivation, goal-framing, and value creation fails to resolve the very dilemma they highlight, i.e., that “overarching goals of employees are subject to a top-down contagion process by overarching goals from top management” (Foss and Lindenberg 2013). In fact, goal-framing theory lacks a structural, cognitive, and capability-centric foundation resolving a firm’s top-down/bottom-up dysconnectivity. Similar to existing and traditional logics of organizing, it falls short of explaining how goals and predictions are (self-evidently) generated in the first place and what generative processes are essential to empower goals and corresponding performance objectives (OKR) to evolve. The drive for self-organizing mechanisms has gradually moved from employee empowerment (Fisher and Fisher 1997) and collective intelligence (CI) in form of crowdsourcing (Bonabeau 2009)—deploying the generative power of information technologies to tap into the collective’s knowledge-base—to collaborative intelligence (CQ) emphasizing the need for a shift in the leadership model from ‘having all the answers to raising the right questions’ as digital tools are increasingly deployed to enable goal-directed intelligence deliberations in distributed multi-intelligence systems. Massive collective intelligence (MCI, IMD 2020) is one of the latest AI-enabled contributions in the field of organizing, leveraging the crowd to generate the very query in the first place. MCI is still in an infancy stage but points toward a potentially promising direction. One important CQ development, which still remains difficult to judge in terms of lasting relevance, is the open strategy (OS) practice (Tavakoli et al. 2017; Hautz

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et al. 2017): “[OS] is categorically different from traditional ‘top-level strategizing and qualitatively different from ‘bottom-up strategizing’. [. . .] [OS] is unique in its overall transparency [. . .], wide inclusiveness [. . .], and the central use of social IT to effectively enable mass participation” (Tavakoli et al. 2017), “promising access to dispersed and creative strategic ideas [. . .] and increased approval of strategy by employees, customers and partners” (Tavakoli et al. 2017). Essentially, the quality of “transparent discourse” (Luedicke et al. 2017), “democratic decision-making,” and “IT-enableness” (Luedicke et al. 2017) fundamentally determines OS’ success. All these CI/CQ approaches are neither distinctly nor uniformly defined. However, they all share a desire to move organizing away from top-down leadershipcontrolled content to something more transparent and unsupervised, direct-democratically engaging field intelligence. Essentially, it is a desire for more self-organization in increasingly discontinuous environments. The question arises, however, whether any of those approaches have gone far enough to be of consistently practical relevance as a foundation for continuous strategic renewal. There are several high-profile case studies—such as IBM, Daimler, HypoVereinsbank, Premium Cola, Rabobank, Red Hat, and Wikimedia5—documenting diverse experiences with OS. Tavakoli et al.’s (2017) literature review summarizes some of OS’ key limitations in terms of transparency and inclusion: “While Daimler gained access to heterogenous ideas from a variety of areas in the organization, some senior managers perceived the initiative as not valuable and did not participate. [. . .] While HypoVereinsbank was able to access a broad pool of knowledge, it was noted that the organisers were concerned that a somewhat secretive culture could hinder open strategy adoption. [. . .] While IBM collected creative and unconventional ideas from the crowd, a high level of resources investment (to build and manage the initiative) was noted. [. . .] Premium Cola’s open approach has led to the emergence of a collective identity, legitimised collective decisions, and maintained motivation among practitioners. However, there were also fears of exposing too much externally.” In summary, OS is rather project-centric than a coherent new strategy governance framework. The very limitations transpiring through the various case studies suggest that OS is likely to battle with Scharmer’s (2018) three ‘enemies’ or ‘inner voices of resistance’: Voice of Judgment, Voice of Cynicism, and Voice of Fear. Dobusch and Müller-Seitz’s (2019) contribution may lead OS’ future development path: “We argue that it is a purposeful combination of open and closed components that constitutes a precondition for establishing a certain, feasible open quality of strategy-making processes. [. . .] we do not understand the necessity of ‘closing for the benefit of openness’ as a contradiction but rather as a productive dynamic that comprises ‘pushes and pulls that become a check-and-balance system’.”

5

Tavakoli et al. (2017) for a general overview, Luedicke et al. (2017) for Premium Cola, Dobusch and Müller-Seitz (2019) for Wikimedia (Wikipedia), and Van der Steen (2017) for Rabobank Nederland and Grafen Bank

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No cross-hierarchical governance framework has yet been advanced to institutionalize sensing and sensemaking as unsupervised learning and unlearning. Once we define sensing, sensemaking, and strategic renewal in form of action-centric circular causality linking purpose, prediction models, predictions, and prediction error minimization, a new logic of strategic renewal emerges—dynamically connecting structure (hierarchy), cognition, and capabilities. In fact, a firm’s sensing and sensemaking capability is directly determined by the top-down/bottom-up circular causality of belief propagation and message-passing. Unless lower hierarchical (field) levels are purpose directedly empowered to sense and make sense of less salient, transient, but nonetheless transformative signals, the firm is likely to sub-optimally direct attention and resources, eventually accentuating a firm’s underperformance and ensuing dissipation. “When a business declines it begins gradually, almost imperceptibly, until so many failures pile up that the unraveling arrives with unnerving speed” (McNish and Silcoff 2015). But more importantly: internal dysfunctionality and strategic disorientation rather than environmental change tend to design the antechamber of decline. Any story of corporate failure or, for that matter, absence of strategic renewal can only be fully grasped once structure (including the board of directors), cognition, and capabilities are linked in circular causality.

2.2

Strategic Renewal

Strategic renewal as a defined concept has laid the foundation for a distinct stream of research in strategic management. Several publications stand out, most notably: Schmitt et al. (2018) for a rather up-to-date overview of past research and theoretical tensions, Schmitt et al. (2016) for linking strategic renewal to environmental scarcity, Eggers and Kaplan (2013) for linking cognition and renewal, Agarwal and Helfat (2009) for emphasizing the role of dynamic capabilities in renewing the firm’s resource base, Crossan and Berdrow (2003) for an in-depth case study defining strategic renewal as tension of organizational learnings, Golden and Zajac (2001) as well as Westphal and Fredrickson (2001) for emphasizing the board of directors’ critical role for strategic renewal, Floyd and Lane (2000) for taking strategic renewal beyond Upper Echelon and emphasizing its crosshierarchical nature, specifically the relevance of middle management, Barr et al. (1992) for relating strategic renewal to sensing (noticing) and sensemaking (interpretation), and Huff et al. (1992) for studying the antecedents of strategic renewal in terms of the dynamic interaction of cumulative stress and inertia.

Numerous definitions have been advanced emphasizing consistently its distinctiveness from the concept of ‘strategic change’: Strategic change functions as an umbrella concept referring to many different types of strategic changes within and across firms [. . .], but strategic renewal refers only to a specific type of strategic change – the transformation of the firm’s current strategic intent and capabilities. (Schmitt et al. 2018)

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The very origins of strategic renewal research were motivated primarily by deterministically understanding its antecedents such as CEO turnover/tenure, TMT demographics, organizational demographics (size/age/lifecycle), past performance, and, above all, the firm-environment linkage suggesting that environmental change leads to organizational stress, which in turn confronts the firm’s inertia and imposes strategic renewal to ‘refit’ the firm with its environment (Huff and Huff 1995). According to this view, the alignment of firm with environment is defined as the predominant driver of strategic renewal (‘co-alignment school’). In distributed and discontinuous market environments, environmental adaptation—based on retrospective sensemaking of environmental change—is no longer (if it ever was) a viable strategic objective or modus operandi. Therefore, environmental ‘co-alignment’ is rejected as a rather futile, illusory, and unsustainable objective. A firm must operate on the basis that its actions change, create, or destroy markets (‘co-creation school’). Environment and environmental change are actor-, i.e., observer-dependent concepts: “quantum level phenomena support – i.e., enable the emergence of – molecular mechanics (e.g., statistical mechanics and thermodynamics), from which biological and cosmological (e.g., classical and possibly Bayesian) mechanics emerge in turn” (Friston 2019). More specifically, starting at the subatomic and moving to the cosmological level (bottom-up) rather than top-down, may allow us to appreciate the co-creation interpretation of the world. Strategic renewal, fundamentally, is not a responsive but rather proactive and continuous commitment to environmental enactment in pursuit of future firm performance and survival. Strategic renewal as ‘organizational becoming’ is the categorical imperative of ‘being in the game’. It is not a matter of choice. What matters are the purpose-directed learning and knowledge-creating processes that circularly connect bottom-up stimuli/message-passing with top-down strategic belief propagation in view of optimizing resource reconfiguration: Although the terms ‘information’ and ‘knowledge’ are often used interchangeably, there is a clear distinction between information and knowledge [. . .] In short, information is a flow of messages, while knowledge is created and organized by the very flow of information, anchored on the commitment and beliefs of its holder. (Nonaka 1994)

It is a generative and action-centric process of Upper Echelon prediction error minimization, continuously developing the firm’s prediction models and engaging the entire organization and beyond: embodied, enactive, extended (Clark 2016): Learning is here defined as the detection and correction of errors, and error as any feature of knowledge or of knowing that makes action ineffective. Error is a mismatch: a condition of learning, and matching a second condition of learning. The detection and correction of error produces learning and the lack of either or both inhibits learning. (Argyris 1976: 365)

Thus, a thinking born of curiosity, revolt, and change (Rovelli 2021) is essential to strategic renewal. At its core, strategic renewal is action-centric prediction error minimization, encompassing a “process, content, and outcome of refreshment or replacement of attributes of an organization” (Agarwal and Helfat 2009), managing “the tension between institutionalized learning and the processes of intuiting, interpreting, and integrating” new learnings (Crossan and Berdrow 2003) as well

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as “the tension between exploration and exploitation” (Crossan and Berdrow 2003). Strategic renewal is “an iterative process of belief, action, and learning” (Floyd and Lane 2000), where “periods of incremental adjustment (single-loop learning) are broken by bursts of revolutionary change (double-loop learning)” (Floyd and Lane 2000). In particular, Floyd and Lane’s (2000) definition of strategic renewal as “an iterative process of belief, action, and learning” captures the essence of Fristonian prediction error minimization but falls short of providing a tangible model. It is only when we start expressing beliefs as probability distributions and action as a state that precedes perception conditioned by a Markovian boundary intermediating the internal and external states, all dedicated in circular causality to continuously optimizing the updating of beliefs (i.e., learning), a mathematically self-consistent model emerges. This book adopts a cross-hierarchical, capabilities-driven and action-centric learning perspective in defining strategic renewal, which is best captured by Schmitt et al. (2018): Strategic renewal (a) involves a transformation of the firm’s core capabilities associated with competitive advantage, (b) concerns the entire organization and has implications across organizational levels and (c) is essential to break path dependence and ensure the firm’s long-term survival.

To approach strategic renewal as an Upper Echelon-centric top-down-only challenge is nonsense. “Given the importance of social interactions to knowledge development and organizational learning, we believe that renewal can be understood best as a system of relational or social exchanges” (Schmitt et al. 2018; emphasis by DBK), which is effectively the essence of reality construction. Indeed, once strategic renewal is embraced as a ‘system of relational or social exchanges’, the need for a cross-hierarchical connect emerges: Although ideas are formed in the minds of individuals, interaction between individuals typically plays a critical role in developing these ideas. That is to say, ‘communities of interaction’ contribute to the amplification and development of new knowledge [. . .] these communities might span departmental or indeed organizational boundaries. (Nonaka 1994; emphasis by DBK)

Floyd and Lane (2000) approached strategic renewal as a manifestation of ‘strategic role conflict’ emphasizing the difference in nature of ‘boundary-spanning interactions’ at the operating level ( focus on factor or product markets), within top management (focus on capital markets and shareholder concerns), and middle managers ( focus on mediating between the two levels and on cues from any one of the three sub-environments). The more dominant a top-down-directed (‘induced’) rather than bottom-up-inspired (‘autonomous’) strategic renewal process, the more likely that critical intelligence form resource markets is ignored and transient and transformation-bearing market signals are lost: The tension between induced and autonomous strategic renewal reflects the fundamental question of who initiates and drives strategic renewal initiatives [. . .] Past strategic renewal research shows that top-down driven renewal initiatives can create institutionalized contexts

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2 Sensing, Sensemaking, and Strategic Renewal that determine acceptable and inacceptable behaviours and processes, effectively creating barriers to bottom-up strategic renewal initiatives [. . .]. Senior managers therefore risk reinforcing their own, centralized renewal orientation [. . .], while stifling lower-level managers and employees’ creative abilities in the process. (Schmitt et al. 2018)

The more top-down-centric and exclusive the ‘community of interactions’ initiating strategic renewal, the less effective organizational learning may be, and the more questionable the transformative nature, performance, and sustainability of strategic renewal. Further, one may propose that the more top-down-centric and exclusive that ‘community’, the more likely that the strategic renewal process is outward-oriented, i.e., turning to M&A, minority investments, and venturepartnering to provide access to new knowledge and markets. In the absence of circular top-down/bottom-up organizational learning, the firm may become trapped in top leadership’s dominant logics, highly dependent on M&A/joint-venture-driven innovation, and increasingly disconnected from the very intelligence the firm’s field close to resource markets beholds. Eventually, financial control (M&A and alliancing) is likely to squeeze out strategic control (in-house innovation), making the firm potentially rather more than less vulnerable to survival risk as innovation can no longer be generated from within the firm: [M&A] diminishes internal innovation [. . .] produces significant transaction costs and absorbs substantial amounts of managerial time and energy, whether assets are being acquired or divested. As firms acquire more units, diversify through acquisition, or both, information-processing demands on corporate managers increase geometrically. They thus tend to emphasize financial controls over strategic controls. Firms using high levels of strategic controls produce more internal innovations, whereas firms using high levels of financial controls tend to produce fewer internal innovations but acquire more innovation externally. (Hitt et al. 1996)

Financial and strategic control, respectively, correlate curvilinearly to firm performance: too little or too much of one or the other is potentially entropy-bound. The firm is challenged to find an optimal balance between external and internal innovation to power continuous strategic renewal as a sustainable foundation for firm performance and survival. Indeed, the question arises, how to best balance financial and strategic control and whether the board of directors potentially assumes a critical and unique strategic role in this process. More specifically, “[successful] changes in the organizational domain are preceded by bottom-up learning and internal selection. Unless preceded by learning, domain shifts increase the organization’s vulnerability to external selection and expose to significant survival risk” (Floyd and Lane 2000). Learning must start organically and bottom-up from the heart of resource markets (clients, suppliers, technologies) and should only then be complemented by M&A. Strategic renewal initiatives must be based on continuous top-down/bottom-up learning loops spanning all hierarchical levels (Mom et al. 2007). Indeed, domain shifts that kick-start with M&A are likely to exponentially increase the risk profile of the firm’s strategic renewal. Transaction costs related to M&A integration may become disproportionally high. Strategic renewal research is in need of a more comprehensive framework: structurally (resolving the hierarchical top-down/bottom-up ‘learning disconnect’),

References

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cognitively (embracing environment as a matter of enactment), and in terms of capabilities (balancing financial and strategic control as well as exploitation and exploration). The board of directors should be integrated as a distinct cognitive variable into the ‘community of interactions’. But, more importantly, the question arises whether the board possesses the right capabilities to be of strategic relevance in discontinuous market environments. When Siebel (2019) defines digital transformation as wholesale reinvention, he effectively establishes the categorical imperative of strategic renewal. There cannot be any ‘wholesale reinvention’, however, without addressing first the firm’s governance framework.

References Agarwal, R., and C.E. Helfat. 2009. Strategic renewal of organizations. Organization Science 20: 281–293. Argyris, C. 1976. Single-loop and double-loop models in research on decision-making. Administrative Science Quarterly 21: 363–375. Barr, P., J. Stimpert, and A. Huff. 1992. Cognitive change, strategic action, and organizational renewal. Strategic Management Journal 13: 15–36. Bartlett, C., and S. Goshal. 1994. Changing the role of top management: Beyond strategy to purpose. Harvard Business Review 72(6): 79–88. Bingham, C., and K. Eisenhardt. 2011. Rational heuristics: The simple rules that strategists learn from process experience. Strategic Management Journal 32: 1437–1464. Bonabeau, E. 2009. Decisions 2.0: The power of collective intelligence. MIT Sloan Management Review 50: 45–52. Clark, A. 2016. Surfing Uncertainty: Prediction, Action and the Embodied Mind. New York: Oxford University Press. Crossan, M.M., and I. Berdrow. 2003. Organizational learning and strategic renewal. Strategic Management Journal 24: 1087–1105. Daft, R.L., and K.E. Weick. 1984. Toward a model of organizations as interpretation systems. Academy of Management Review 9: 284–295. Dobusch, L., and G. Müller-Seitz. 2019. Closing for the benefit of openness? The case of Wikimedia’s open strategy process. Organization Studies 40: 343–370. Dong, A., M. Garbuio, and D. Lovallo. 2016. Generative sensing: A design perspective on the microfoundations of sensing capabilities. California Management Review 58: 97–117. Eggers, J.P., and S. Kaplan. 2013. Cognition and capabilities: A multi-level perspective. Academy of Management Annals 7: 295–340. Festinger, L. 1957. A Theory of Cognitive Dissonance. Evanston: Row, Peterson Company. Fiol, M.C., and A.S. Huff. 1992. Maps for managers: Where are we? Where do we go from here? Journal of Management Studies 29: 267–285. Fisher, K., and M.D. Fisher. 1997. The Distributed Mind: Achieving High Performance Through the Collective Intelligence of Knowledge Work Teams. New York: Amacom. Floyd, S., and P. Lane. 2000. Strategizing throughout the organization: Managing role conflict in strategic renewal. Academy of Management Review 25: 154–177. Foss, N.J., and S. Lindenberg. 2013. Microfoundations for strategy: A goal-framing perspective on the drivers of value creation. Academy of Management Perspectives 27: 85–102. Friston, K.J. 2010. The free energy principle: A unified brain theory? Nature Reviews Neuroscience 11: 127–138.

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———. 2019. A Free Energy Principle for a Particular Physics. Monograph (under consideration for publication by The MIT Press), 1–148. Gavetti, G. 2005. Cognition and hierarchy: Rethinking the microfoundations of capabilities’ development. Organization Science 16: 599–617. Golden, B., and E. Zajac. 2001. When will boards influence strategy? Inclination x power ¼ strategic change. Strategic Management Journal 22: 1087–1111. Hansen, H. 2008. Abduction. In The SAGE Handbook of New Approaches in Management and Organization, ed. D. Barry and H. Hansen, 454–463. London: Sage. Hautz, J., D. Seidl, and R. Whittington. 2017. Open strategy: Transparency and inclusion in strategy processes. Long Range Planning 50: 298–309. Helfat, C.E., and M.A. Peteraf. 2015. Managerial cognitive capabilities and the microfoundations of dynamic capabilities. Strategic Management Journal 36: 831–850. Helfat, C.E., S. Finkelstein, W. Mitchell, M.A. Peteraf, H. Singh, D. Teece, and S.G. Winter. 2007. Dynamic Capabilities: Understanding Strategic Change in Organizations. Malden, MA: Blackwell. Hertwig, R., and C. Engel, eds. 2020. Deliberate Ignorance: Choosing Not to Know. Cambridge, MA/London: The MIT Press. Hertwig, R., T.J. Pleskac, and T. Pachur. 2019. Taming Uncertainty. Cambridge, MA: MIT Press. Hitt, M.A., R.E. Hoskisson, R.A. Johnson, and D.D. Moesel. 1996. The market for corporate control and firm innovation. The Academy of Management Journal 39: 1084–1119. Hodgkinson, G.P. 2015. Reflections on the interplay between cognition, action and outcomes in industries and business markets: What have we learned so far and where might we go next? Industrial Marketing Management 48: 12–25. Hohwy, J. 2013. The Predictive Mind. Oxford: Oxford University Press. Huff, J.O., and A. Huff. 1995. Stress, inertia, opportunity and competitive position: A SIOP model of strategic change in the pharmaceuticals industry. Academy of Management Journal 38: 22–27. Huff, J.O., A.S. Huff, and H. Thomas. 1992. Strategic renewal and the interaction of cumulative stress and inertia. Strategic Management Journal 13: 55–75. IMD (Bouquet, C., and M. Greeven). 2020. How Massive Collective Intelligence can drive insight and engagement in your organization. https://www.imd.org/news/updates/how-MassiveCollective-Intelligence-can-drive-insight-and-engagement. Link copied on 6 August 2021. Luedicke, M.K., K.C. Husemann, S. Furnari, and F. Ladstaetter. 2017. Radically open strategizing: How the Premium Cola Collective takes open strategy to the extreme. Long Range Planning 50: 371–384. McNish, J., and S. Silcoff. 2015. Losing the Signal: The Untold Story Behind the Extraordinary Rise and Spectacular Fall of Blackberry. New York: Flatiron Books. Mom, T.J.M., F.A.J. Van Den Bosch, and H.W. Volberda. 2007. Investigating managers’ exploration and exploitation activities: The influence of top-down, bottom-up, and horizontal knowledge inflows. Journal of Management Studies 6: 910–931. Narayanan, V.K., L.J. Zane, and B. Kemmerer. 2011. The cognitive perspective in strategy: An integrative review. Journal of Management 37: 305–351. Nisbett, R.E., and T.D. Wilson. 1977. Telling more than we can know: Verbal reports on mental processes. Psychological Review 84: 231–259. Nonaka, I. 1994. A dynamic theory of organizational knowledge creation. Organizational Science 5: 14–37. Ocasio, W. 1997. Towards an attention-based view of the firm. Strategic Management Journal 18: 187–206. Ocasio, W., and J. Joseph. 2005. An attention-based theory of strategy formulation: Linking microand macro-perspectives in strategy process. Strategy Process: Advances in Strategic Management 22: 39–61. Rovelli, C. 2021. Helgoland: Making Sense of the Quantum Revolution. New York: Riverhead Books.

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Sandberg, J., and H. Tsoukas. 2015. Making sense of the sensemaking perspective: Its constituents, limitations, and opportunities for further development. Journal of Organizational Behavior 36: 6–32. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers. Schilke, O., S. Hu, and C.E. Helfat. 2018. Quo vadis, dynamic capabilities? A content-analytic review of the current state of knowledge and recommendations for future research. Academy of Management Annals 12: 390–439. Schmitt, A., V.L. Barker, S. Raisch, and D. Whetten. 2016. Strategic renewal in times of environmental scarcity. Long Range Planning 49: 361–376. Schmitt, A., S. Raisch, and H.W. Volberda. 2018. Strategic renewal: Past research, theoretical tensions and future challenges. International Journal of Management Reviews 20: 81–98. Schwenk, C.R. 1988. The cognitive perspective on strategic decision making. Journal of Management Studies 25: 41–55. Scott, W.R., and Gerald F. Davis. 2007. Organizations and Organizing: Rational, Natural, and Open Systems Perspectives. London: Routledge. Siebel, T.M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: Rosetta Books. Spiliopoulos, L., and R. Hertwig. 2020. A map of ecologically rational heuristics for uncertain strategic worlds. Psychological Review 127: 245–280. Starbuck, W.H., and F. Milliken. 1988. Executive perceptual filters: What they notice and how they make sense. In The Executive Effect: Concepts and Methods for Studying Top Managers, ed. D. Hambrick, 35–65. Greenwich, CT: Jay Press. Tavakoli, A., D. Schlagwein, and D. Schoder. 2017. Open strategy: Literature review, re-analysis of cases and conceptualization as a practice. The Journal of Strategic Information Systems 26: 163–184. Taylor, J., and E.J. Van Every. 2000. The Emergent Organization: Communication as Its Site and Surface. Mahwah, NJ: Lawrence Erlbaum Associates. Tversky, A., and D. Kahneman. 1974. Judgment under uncertainty: Heuristics and biases. Science 185: 1124–1131. Van de Ven, A.H. 2007. Engaged Scholarship: A Guide for Organizational and Social Research. Oxford: Oxford University Press. Van der Steen, M. 2017. Managing bottom up strategizing: Collective sensemaking of strategic issues in a Dutch bank. Long Range Planning 50: 766–781. Weick, K.E. 1995. Sensemaking in Organizations. Thousand Oaks, CA: Sage. ———. 2005. The experience of theorizing: Sensemaking as topic and resource. In Great Minds in Management: The Process of Theory Development, ed. K.G. Smith and M. Hitt, 394–413. New York: Oxford University Press. Weick, K.E., and M.G. Bougon. 1986. Organizations as cognitive maps. In The Thinking Organization: Dynamics of Organizational Social Cognition, ed. H.P. Sims and D.A. Gioia, 102–135. San Francisco: Jossey-Bass. Westphal, J.D., and J.W. Fredrickson. 2001. Who directs strategic change? Director experience, the selection of new CEOs, and change in corporate strategy. Strategic Management Journal 22: 1113–1137. Wood, D. 1992. The Power of Maps. New York City: The Guilford Press.

Chapter 3

Microfoundations of Strategic Governance

Abstract There is no universal governance model. The strategic role of the board does vary as a function of culture, laws, governance orientation, ownership structure, and firm-context. The period of 1998–2001, a time of financial markets ‘irrational exuberance’ dominated by a governance orientation centered around stock price considerations, has given birth to today’s compliance-driven governance logic ruling public companies. Simply put, ever since corporate governance has been estranging the board as a uniquely integral part of strategy process. Coincidentally, during this very period, management research started complementing thereto demographic input-output models with behavioral and cognitive dimensions. While opening a new conversation around the cognitive microfoundations of board effectiveness, to this day, the study of the board’s strategic role remains confined to the board room and treats environment as an exogenous variable. The top-down cultivated ‘hierarchical disconnect’ so characteristic of traditional corporate governance (TCG) and strategy processes is more likely to fuel prediction error, reinforcing the perception that the world is unpredictable and uncertain. Indeed, the very limitations of corporate governance research may be an astute reflection of the very real and often self-inflicted limitations of the board’s strategic role. Shareholders are challenged to ensure that the board’s full (strategic) potential is not wasted. More specifically, there is a need for a new (self-organizing) governance logic. The board of directors is a unique and integral part of a firm’s Upper Echelon. It acts from within and without the firm as a boundary spanner and should encapsulate strategy process’s constructive tension between organization and (enacted) environment, exploitation and exploration as well as financial and strategic controls. There is no universal governance model. The strategic role of the board does vary as a function of culture, laws, governance orientation (Kwee et al. 2011), ownership structure (public, private equity, founder-/family-led/-controlled, or a combination thereof), and firm-specific context. Hilb (2012) distinguishes four types of boards: administrative, entrepreneurial, directing/controlling, and supervisory. However, independent of the type of board or model of corporate governance system (the Anglo-American shareholder value maximization-oriented model vs. the

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_3

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Continental stakeholder-centric model embracing a broader set of values and interests), all existing corporate governance approaches suffer from severe shortcomings. While in Switzerland the board’s strategic mandate is law-imposed, in other jurisdictions there are limits to what can or should be expected from the board of directors in terms of strategizing. Theoretical conceptions are no less diverse and controversial: most notably, “[m]anagerial hegemony theory [. . .] argues that boards are a legal fiction dominated by management” (Hendry and Kiel 2004). In most leading capital market jurisdictions, public policy or the so-called ‘best practices’ have advocated at accelerating pace a rather sterile, independence-centric, and stereotypical diversity-oriented approach to corporate governance. “There is a danger, however, that the compliant board is breeding formalism, group-think and risk-aversion at the expense of operational understanding, strategic focus and independent thinking” (Khezri 2014). Effectively, the board has been distanced from initiating and directing strategic renewal. Unless lawmakers evolve corporate governance guidelines ‘in tune’ with the requirements of a distributed and discontinuous world, the board is either relegated to strategic irrelevance or increasingly represents a source of inertia reflective of its struggle with growing complexity. The period of 1998–2001, a time of ‘irrational exuberance’1, was a time when board members at some of the world’s largest companies developed a self-identity akin to that of a venture capitalist. Prolific failures of the time were Tyco, Enron, and WorldCom. Acceleration in stock price appreciation through excessive financial control, particularly in form of M&A rather than organic growth, was corporate governance’s dominant mantra at many companies. Board members were trapped in blind followership of overdominant and overconfident CEOs, creating not only multidimensional conflicts of interest but eventually fertilizing financial selfenrichment at the expense of shareholders and the common good. Pre-IPO candidates were no less immune to the trend (Khezri 2001): Excessive management option packages fueled greed and encouraged corporate leverage. This, in addition to M&A activity [,,,] became the system’s predominant characteristics, and the strength of the share price emerged as the fundamental pillar for the survival of the system [. . .] During the 1990s, directors’ performance was increasingly measured against how well they understood both the mechanics of M&A and capital markets and their ability to keep the ‘winning team’ motivated to take the business to its next growth phase. (Khezri 2002)

The 2002 Sarbanes-Oxley Act in the United States has been the most prominent legislative product resulting from ‘irrational exuberance’, imposing draconian measures on the audit and financial representations of publicly listed companies. ‘Exuberance’ in capital markets also coincided with a productive period in academic 1

Alan Greenspan, then Federal Reserve Board Chairman, gave a speech to the American Enterprise Institute on December 5, 1996, saying that “irrational exuberance has unduly escalated asset values.” While markets only briefly dipped, the period from 1996 to 2001/2 experienced ‘irrational exuberance’ and a neglect for prudent corporate governance. Nobel Prize winning Yale Professor Robert Schiller used the expression for his book publication Irrational Exuberance in 2000, eventually coinciding with the start of a stock market contraction.

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research concerning the board’s strategic role. Management research started complementing thereto demographic input-output models with behavioral and cognitive dimensions. McNulty and Pettigrew (1999) highlighted in their important contribution ‘Strategists on the Board’ that “knowledge about the structure and composition of boards exceeds knowledge about their behavioural dynamics”. Indeed, we generally know very little about the informal and tacit processes that critically shape the formal governance output. The conclusion of their study is that boards rarely initiate but can challenge and contribute to strategy. Their study is relevant to the extent that it went beyond the traditional ‘demographic input-output’ approach and confirmed the importance of the behavioral dimension in assessing a board’s role in strategy process—independent of any regulatory or law-imposed mandate or boundary. Rindova (1999) was among the first to link managerial cognition (Kiesler and Sproull 1982) to corporate governance, distilling the board’s distinct cognitive contribution to strategy process, specifically in terms of ‘environmental scanning and interpretation’. Her contribution can be considered seminal, laying the grounds for a ‘stewardship-inspired’ corporate governance approach (Davis et al. 1997) that is now widely adopted by leading private equity firms (Acharya et al. 2013) where top management team and board strategize together: often in highly complementary ways and based upon cash-financed equity-centric alignment of interests (as opposed to ‘free’ call options). PE is more of a governance than a financing model, explaining its public-market-equivalent outperformance (Harris et al. 2014). According to Rindova (1999), board directors do impact decision-making in form of three varieties: external, requisite, and representative. “Directors’ contribution as a source of requisite variety is to increase the pool of available interpretative frameworks on which the decision group can draw.” However, Rindova does not open the black box of how this variety of interpretative frameworks on an individual level transmorphs into an interpretation shared at the organizational level, not least at the lateral level of the board of directors. Further, Rindova also treats environmental stimuli as objective reality—to be sensed and make sense of—with ‘clever analysis preceding strategic action’. She emphasizes absorptive capacity (Cohen and Levinthal 1990), i.e., the board’s ‘problem-solving’ and ‘thinking through’ expertise ‘developed in primary occupations’. Rindova appreciates the dynamic nature of strategy process when she postulates that board participation in strategic decision-making rises with increasing environmental complexity and uncertainty. However, Rindova’s approach is rather static as it falls short of connecting the board table to the rest of the organization and interchangeably treats perception as interpretation. A Free Energy Governance lens instantly exposes the obvious shortcomings. Forbes and Milliken (1999), equally a seminal contribution, made an important step toward opening the black box of the board’s strategy dynamics by focusing on (thereto understudied) process variables linking demography and group processes/ behavior. Indeed, “the very existence of the board as an institution is rooted in the wise belief that the effective oversight of an organization exceeds the capabilities of

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any individual and that collective knowledge and deliberation are better suited to this task”. Forbes and Milliken’s contribution is relevant in three regards: (1) It is impossible to meaningfully infer board performance from demographic variables in the absence of a process model linking demography and output. (2) The board’s role as a group is essentially a cognitive role, and therefore, a cognitive rather than behavioral perspective is critical to better understand the essence of board performance. (3) Effort norms (i.e., intensity and cognitive resourcefulness of the task performance behavior), cognitive conflicts (i.e., leveraging differences in perspective), and the use of knowledge and skills are important process variables underlying board performance. The dimension of effort norms cannot be stressed enough: the sheer presence of the collective’s pool of competencies and experiences is rather meaningless unless actively and purposefully exercised. While parsimonious as a model, Forbes and Milliken fail to explain how cognitive conflicts can be leveraged beyond board effectiveness but in service of firm performance and survival. The model is structurally isolated from the rest of the organization and therefore of limited value. More importantly, it treats input of data and stimuli as a black box. Nonetheless, Forbes and Milliken have laid the foundation for a conversation framing the cognitive and social dimensions of board effectiveness (Westphal and Zajac 2013). To assess the potential for the board’s strategic role, we must move beyond the ‘board table’ and into the organization. Golden and Zajac (2001), in ‘When will boards influence strategy? Inclination x power ¼ strategic change’, developed a power-centric model suggesting that “strategic change is significantly affected by board demography and board processes” and, more importantly, that “a board’s inclination for strategic change interacts with a board’s power to affect change”. As with so many contributions in corporate governance, they appear to be too commonsense to be worth undertaking the research. Nonetheless, Golden and Zajac’s (2001) contribution is an important step toward further developing Forbes and Milliken’s effort norms. ‘What are the particular conditions under which boards are more likely to think, act, and decide independently and achieve strategic change?’ is Golden and Zajac’s essential research question. Demographic variables such as board size and tenure, average age of board members, and board diversity (here defined as occupational heterogeneity) affect strategic change curve-linearly. Too much or too little has potentially a negative impact. Further, the demographic variables are then related to board processes to determine attentional focus in terms of orientation on rather internal (exploitation) than external issues (exploration). The relevance of ABV (Ocasio 1997) is put into perspective. But, eventually, it all comes down to the board’s power, here defined as the board’s relative power over the CEO (Golden and Zajac 2001): “preferences or inclinations may be an important initial condition, but power amplifies the observed effect of those preferences.” However, Golden and Zajac (2001) cannot explain how the board (laterally) generates an inclination for strategic renewal in the first place. Demographic and procedural variables aside, the study fails to take into consideration how the board formally and informally interacts with the organization beyond the CEO.

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Therefore, board power remains a black box. The board’s relative power over the CEO is a function of knowledge, informational flows, and learning capability. To set free the true cognitive and collective power of the board may be less a function of demographic and procedural variables but the Chairman’s power and inclination to foster a collective dialogue at the board level (lateral interaction to exercise strategic control) and connect with the rest of the organization—beyond the CEO. Essentially, there are three important conclusions to take forward from Golden and Zajac (2001): (a) demographic and procedural variables impact strategic change rather curve-linearly; (b) power relationships are critical to understanding the ‘impel vs. impede’ debate in strategic renewal; and (c) attentional focus and engagement in terms of an Ocasioian linkage of cognition and structure (Ocasio 1997) are a promising venue upon which to pursue future research. How board configurations—defined as a function of board diversity and concentration in leadership (such as CEO also serving as Chairperson)—impact Upper Echelon’s speed and breadth of strategic action is the central research focus of Bongjin et al. (2009). This valuable contribution proposes a model linking board configurations with TMT’s strategic action capability, moderated by environmental dynamism and complexity: “board involvement in strategy can either enhance or inhibit the speed and breadth of TMT strategic action capabilities, thereby directly impacting firm performance”. Their contribution moves Golden and Zajac’s (2001) power-centered approach to a more action-centric approach in the context of firm performance rather than just limited to board impact. But like with so many studies in corporate governance research, one may question whether commonsense hypotheses are simply packaged into reasonable research without necessarily providing business leaders with any new meaningful practice-relevant insights. The world of governing strategic renewal is too complex to make use of deterministic models. At best, those models provide a framework and language that potentially improve the quality of Upper Echelon’s strategy design deliberations. The need to move from supervised to unsupervised learning models cannot be overstressed in this context. Bongjin et al. (2009) rightly criticize the increasing involvement of regulators imposing far-reaching rules governing board structure—particularly relating to board diversity—that “may actually harm firm performance”. Following the 2008 financial crisis—not too dissimilar from the aftermath of the dot-com crisis in 2000/ 2001—policymakers went into regulatory overdrive. Indeed, corporate governance ‘best practices guidelines’ may rather fuel ‘governance inertia’ than freeing the board as an impactful variable supporting continuous strategic renewal. In this context, Hoppmann et al.’s (2019) research is insightful: [B]y highlighting boards as a source of inertia, our study also challenges existing findings in the literature on strategic management, which suggests that the main reasons for organizational inertia are biased managerial cognition, a lack of incentive to change, or difficulties in redeploying firm resources [. . .]. Given that boards have the power to initiate strategic changes and replace managers, such inertia at lower organizational levels might not be problematic per se if the board notices and deals with it. Therefore, our findings suggest that an additional – and potentially more fundamental – source of organizational inertia lies in a

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lack of self-evaluation and self-reconfiguration that prevents boards from renewing their ability to judge strategic issues.

Hoppmann et al. (2019) make an invaluable contribution in moving away from deterministic models that suggest which specific board configurations and leadership concentrations enhance board effectiveness, firm performance, and a firm’s overall strategic capability. Instead, they focus on the board’s meta-capabilities such as selfevaluation and self-reconfiguration to power continuous strategic renewal: “[T]he board’s power vis-à-vis management is strongly related to the board chair, who initiates self-evaluation and self-reconfiguration, thereby ensuring that the board can still critically evaluate strategic proposals and reconfigure strategies.” Unfortunately, though, Hoppmann et al. (2019) do not go far enough since successful strategic renewal remains bottlenecked by the board chair. We need governance processes that neutralize the overdependencies on Chairman and CEO. Hence, cross-hierarchical connectivity—in terms of Upper Echelon listening channels of bottom-up stimuli emerging for top-down prediction-processing—is fundamental. While corporate governance research must be less deterministic and more meta-capabilities inspired (i.e., DC)—as advocated by Hoppmann et al. (2019)—there is a need to establish first-order governing principles such as free energy minimization. In the absence thereof, corporate governance research remains confined to Upper Echelon and trapped in “universally prescribed board configurations” (Bongjin et al. 2009) breeding inertia. The “nature, extent, and consequences of board involvement in strategy remain elusive” (Bongjin et al. 2009). Indeed, the very limitations of corporate governance research may be an astute reflection of the very real and often self-inflicted limitations of the board’s strategic role. Shareholders are challenged to ensure that the board of directors’ full (strategic) potential is not wasted. More specifically, we need governance models that focus on reconfiguring the firm as a generative and inferential model of its eco-niche, governed by first-order principles. The top-down cultivated hierarchical disconnect so characteristic of traditional corporate governance and strategy processes is more likely to fuel prediction error, reinforcing the perception that the world is unpredictable and uncertain. Indeed, “we are leaving the age of organized organizations and moving into an era where the ability to understand, facilitate, and encourage processes of self-organization will become a key competence” (Morgan 1993). Friston’s free energy principle is laying the foundation for the multi-intelligence firm’s self-organization: thinking born in curiosity, revolt, and change.

References Acharya, V., O. Gottschalg, M. Hahn, and C. Kehoe. 2013. Corporate governance and value creation: Evidence from private equity. Review of Financial Studies 26: 368–402. Bongjin, K., M. Burns, and J. Prescott. 2009. The strategic role of the board: The impact of board structure on top management team strategic action capability. Corporate Governance: An International Review 17: 728–743.

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Cohen, W.M., and D.A. Levinthal. 1990. Absorptive capacity: A new perspective on learning and innovation. Administrative Science Quarterly 35: 128–152. Davis, J.H., F.D. Schoorman, and L. Donaldson. 1997. Toward a stewardship theory of management. Academy of Management Review 22: 20–47. Forbes, D.P., and F.J. Milliken. 1999. Cognition and corporate governance: Understanding boards of directors as strategic decision-making groups. Academy of Management Review 24: 489–505. Golden, B., and E. Zajac. 2001. When will boards influence strategy? Inclination x power¼strategic change. Strategic Management Journal 22: 1087–1111. Harris, R.S., T. Jenkinson, and S.N. Kaplan. 2014. Private equity performance: What do we know? Journal of Finance 69: 1851–1882. Hendry, K., and G.C. Kiel. 2004. The role of the board in firm strategy: Integrating agency and organizational control perspectives. Corporate Governance: An International Review 12: 500–520. Hilb, Martin. 2012. New Corporate Governance. Successful Governance Tools. 4th ed. Heidelberg: Springer. Hoppmann, J., F. Naegele, and B. Girod. 2019. Boards as a source of inertia: Examining the internal challenges and dynamics of boards of directors in times of environmental discontinuities. Academy of Management Journal 62: 437–468. Khezri, B. 2001. Lost in the valley. Financial Times, June 5. https://static1.squarespace.com/static/ 606c27fa9e99b634a2d6ec0d/t/608187f33e2223461d42fa10/1619101688247/KCRI_Publica tions_FT_Lost-in-the-Valley_05.06.2001.pdf. ———. 2002. A CEO’s take on corporate reform. Wall Street Journal, July 22. https://static1. squarespace.com/static/606c27fa9e99b634a2d6ec0d/t/608179b6d782a33c52ce3bdc/16190 98040651/KCRI_Publications_WSJ_A-CEO%E2%80%99s-Take-on-Corporate-Reform_22.0 7.2002.pdf. ———. 2014. Improving corporate governance – Before the next market crisis. The Washington Times, October 10. https://static1.squarespace.com/static/606c27fa9e99b634a2d6ec0d/t/6081 7779558c2212855e3e57/1619097468034/KCRI_Publications_WT_Improving-corporate-gov ernance-before-the-next-market-crisis_10.08.2014.pdf. Kiesler, S., and L. Sproull. 1982. Managerial response to changing environments: Perspectives on problem sensing and social cognition. Administrative Science Quarterly 27: 548–570. Kwee, Z., F.A.J. Van den Bosch, and H. Volberda. 2011. The influence of top management team’s corporate governance orientation on strategic renewal trajectories: A longitudinal analysis of Royal Dutch Shell plc, 1907–2004. Journal of Management Studies 48: 984–1014. McNulty, T., and A. Pettigrew. 1999. Strategists on the board. Organization Studies 2: 47–74. Morgan, G. 1993. Imaginization: The Art of Creative Management. Thousand Oaks: Sage. Ocasio, W. 1997. Towards an attention-based view of the firm. Strategic Management Journal 18: 187–206. Rindova, V.P. 1999. What corporate boards have to do with strategy: A cognitive perspective. Journal of Management Studies 36: 953–975. Westphal, J.D., and E. Zajac. 2013. A behavioral theory of corporate governance: Explicating the mechanisms of socially situated and socially constituted agency. The Academy of Management Annals 7: 607–661.

Chapter 4

Free Energy Principle (FEP)

Abstract The ‘free energy principle’ (FEP) is a first-order principle of ‘least action’, empowering self-organization. FEP commands the generative process of active inference (Ai) dedicated to minimizing the (information-theoretical) mathematical difference between top-down predictions and action-generated bottom-up stimuli— in pursuit of minimizing error, surprise, and entropy. The power of Fristonian Ai is fundamentally fourfold: (1) it is a pure belief-based setting in dynamic and nonstationary environments; (2) the Ai agent carries out epistemic exploration to account for uncertainty by making inferences in Bayes-optimal fashion; (3) the reward signal so characteristic of reinforcement learning is removed; and, finally, (4) Ai sets free the collaborative human-machine AI potential so integral to the multi-intelligence firm as the mathematical expression of beliefs in form of probabilities provides the very common denominator to align humans with machines. There are only two distinctions that matter: ‘what is known and unknown’ and ‘what is in our control and what is not’. There are four states: active (action), internal (firm resources), sensory (perception), and external (unknown and hidden behind the Markov blanket). According to Free Energy Governance (FEG), free energy principle-powered Ai is the future site of organizational becoming.

In summary, (i) agents resist a natural tendency to disorder by minimizing a free energy bound on surprise; (ii) this entails acting on the environment to avoid surprises, which (iii) rests on making Bayesian inferences about the world. In this view, the Bayesian brain ceases to be a hypothesis, it is mandated by the free energy principle; free energy is not used to finesse perception, perceptual inference is necessary to minimize free energy. This provides a principled explanation for action and perception that serve jointly to suppress surprise or prediction error. (Friston 2009; emphasis by DBK)

The ‘free energy principle’ (FEP) is a first-order principle—it is not a theory but conforms to the principle of ‘least action’: “One could argue that nearly all physical sciences can be reduced to a metrology in service of confirming a variant of the principle of least action [. . .] This is important because it means that physics does not offer any ground truth—it is just a search for measurements that endorse an appropriately formulated prediction based upon a variational principle” (Friston 2019). © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_4

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FEP, hence, has no purpose of its own. It powers the generative process of active (enactive) inference (Ai) that is dedicated to minimizing the (informationtheoretical) mathematical difference between top-down predictions and actiongenerated bottom-up stimuli—in pursuit of minimizing error, surprise, and entropy (for the latest comprehensive introduction to Ai see Parr et al. 2022). Variational free energy and thermodynamic free energy are inversely related: if (variational) free energy is high, “then thermodynamic entropy (e.g., energy not available for doing productive work) will be high and thermodynamic free energy (e.g., energy available for doing productive work) will be low” (Fox 2021). The power of Fristonian Ai is fundamentally fourfold: (1) It is a pure belief-based setting in dynamic and non-stationary environments. (2) The Ai agent carries out epistemic exploration to account for uncertainty by making inferences in Bayesoptimal fashion. (3) The reward signal so characteristic of reinforcement learning is removed and replaced with one sole purpose: suprise-minimization. Effectively, the agent is empowered to minimize surprise by way of a generative model of the partially observable world: only perceiving “itself and the world via outcomes” (Noor et al. 2021). (4) Ai should provide the basis to set free the collaborative human-machine AI potential so integral to the multi-intelligence firm. The mathematical expression of beliefs in form of probabilities may provide the very common denominator to ‘align the actions of humans and machines’ (Fox 2021). This Ai-based common denominator is a new language, and according to FEG, it is the future site of organizational becoming: In active inference, the agent makes choices based on its beliefs about these states of the world and not based on the value of the states (Friston et al., 2016). This distinction is key: in standard model-based reinforcement learning frameworks, the agent is interested in optimizing the value function of the states (Sutton & Barto, 1998) that is, making decisions that maximize expected value. In active inference, we are interested in optimizing a free energy functional of beliefs about states, that is, making decisions that minimize expected free energy. (Noor et al. 2021)

As the focus shifts from maximizing ‘expected value’ to optimizing ‘a free energy functional of beliefs about states’, an important question, however, arises: how do we properly ascribe confidence to beliefs? That’s where precision comes into play: “[T]he Bayesian brain has to optimize not just its expectations – it also has to optimize precision. This means that one has to predict how much precision is afforded to various sources of sensory evidence relative to prior beliefs” (Friston 2019). Precision determines reliability of sensory input. Optimization is central to Ai. Certain sensory input may be encoded as salience providing affordance without additional computational investment. In this context and for the purposes of understanding Free Energy Governance (FEG), it is important to retain that FEG is about optimization that engages all the precision-sponsoring sources of (enacted) sensory evidence at any given point in time, optimally leveraging knowledge retained through prior experience but without missing the silent but nonetheless dissonance-bearing signals empowering us to evolve our very generative model. Salience must be continuously fertlized by double-loop learning.

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When dynamics change, salience should be prevented from potentially increasing free energy. In the context of corporate governance, one may think of ‘pattern recognition’ as one form of salience. The more senior and experienced board members are, the more likely that they feel comfortable with mental shortcuts such as pattern recognition built through prior experience. It is a form of prior-biased heuristics or, too often simply, deliberate ignorance (Hertwig and Engel 2020). However, in a discontinuously ‘non-repeat game environment’, pattern recognition without maintaining sensitivity for small but nonetheless transformative variations puts survival at risk. Therefore, we need a process and a measure of error that optimizes survival: hence, action-centric free energy minimization powering enactive Ai. In the Preface, we alluded to sophistication, which is about optimally deploying the available computational power—in terms of precision as well as timing: “only the sophisticated agent can see past the short-term pain for the long-term gain” (Friston et al. 2021). A sophisticated agent has beliefs about beliefs, focusing on the ‘sequences of belief states as opposed to states per se’. This substantially enhances the confidence in the selection of actions and consequently narrows down the number of potential paths to consider for prediction error minimization. [I]n the navigation example, there were five actions and 64 hidden states, leading to a large number of potential paths (1.0486
1010 for a planning horizon of four and 1.0737
1015 for a planning horizon of six). However, only a tiny fraction of these paths is actually evaluated—usually several hundred, which takes a few hundred milliseconds on a personal computer. Given reasonably precise beliefs about current states and state transitions, only a small number of paths are eligible for evaluation. (Friston et al. 2021)

Free Energy Governance (FEG) effectively transposes the Ai framework to the firm and adopts FEP as a first-order principle underlying a new logic of organizing built around three core dimensions: structure (hierarchy), cognition (environmental enactment), and capabilities (sensing and sensemaking). The framework is centered around cross-hierarchical generative processes of sensing and sensemaking to institutionalize continuous strategic renewal as a matter of enactive inference in pursuit of firm outperformance and survival. In analogy to active inference, FEG is “a unified account of action, perception and learning” (Friston 2010) embracing strategic renewal as a circularly causal top-down/bottom-up learning system dedicated to purpose-driven and action-generated predictions, prediction error minimization, and the continuous updating of prediction models through double-loop learning. “Single-loop learning occurs when errors are detected and corrected without altering the governing values of the master program. Double-loop learning occurs when, in order to correct an error, it is necessary to alter the governing values of the master programs” (Argyris 2005; emphasis by DBK). Most governance models are at best single-loop (rule-based) learning systems but struggle to activate double-loop learning. Consequently, both generative and recognition models only evolve sluggishly, if ever: Unlearning seems to be a distinctly social phenomenon, and it may be predominantly organizational. [. . .] The need for unlearning arises from ways organizations typically differ from individual people: (a) Organizations rely on action generators, which add inertia and

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4 Free Energy Principle (FEP) impede reflection, (b) Organizations emphasize explicit justification, which rigidifies and perfects their rationality, (c) To facilitate documentation and communication, organizations use perceptual categories that destroy subtlety and foster simplification. (Starbuck 1983)

Indeed, once we understand the brain as a high-energy-powered (Bayesian/ inferential) probability processing engine, it is an ambitious or sheer realistically utopic target for any organization to approximate Bayesian efficiency. In fact, we are tasking the firm to mastermind survival by developing institutionalized shortcuts through smart modeling and a rich repertoire of prior experiences facilitating the action-centric and top-down/bottom-up generative processing of beliefs (i.e., probabilities) within ‘a bounded set of states with a high probability’: The FEP [Free Energy Principle] stems from the idea that living systems can be distinguished from other self-organising systems because they actively avoid deleterious phasetransitions by bounding the entropy of their sensory and physical states – under the FEP, to be alive simply means to revisit a bounded set of states with a high probability. (Badcock et al. 2019)

Social fields are not as real-time as electrically charged and chemically powered neural responsiveness. But the underlying logic and principles, nonetheless, determine firm performance and survival. All living self-organizing systems, as is true for organizations, strive to reduce entropy in pursuit of minimizing surprise. But organizations, other than living systems, are too often trapped in what Argyris (1995) termed ‘skilled incompetence’, meaning that organizations are programmed to deal with error and “threat in ways that are counterproductive to their own intentions”, not least because organizations struggle with unlearning and deliberately suppress subtlety. Experiments in computer gaming have demonstrated the superiority of the ‘free energy agent’ crystalizing the limitations of purely ‘reward-pursuing’ strategy approaches that are overly dependent on ‘repeat-game experience’ (established priors) compared to those that are designed to simply minimize surprise in form of generative top-down/bottom-up prediction error minimization. In late 2017, a group led by Rosalyn Moran, a neuroscientist and engineer at King’s College London, pitted two AI players against one another in a version of the 3D shooter game Doom. The goal was to compare an agent driven by active inference to one driven by reward maximization. The reward-based agent’s goal was to kill a monster inside the game, but the free energy-driven agent only had to minimize surprise. The Fristonian agent started off slowly. But eventually it started to behave as if it had a model of the game, seeming to realize, for instance, that when the agent moved left, the monster tended to move to the right. After a while, it became clear that even in the toy environment of the game, the rewardmaximizing agent was ‘demonstrably less robust’; the free energy agent had learned its environment better. It outperformed the reinforcement-learning agent because it was exploring. (Raviv 2018)

FEP embraces the brain as a hierarchically deterministic structure fueled by top-down/bottom-up generative processes: “a Bayesian hierarchy of ‘hypotheses’ or ‘best guesses’ about the hidden causes of our sensory states” (Badcock et al. 2019). This captures the structural dimension of Ai and equally that of FEG.

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[T]he lowest or most peripheral levels of the cortical hierarchy comprise relatively segregated, highly specialised neural mechanisms responsible for sensorimotor processing (‘domain-specific’ systems), while its higher, deeper or more central layers consist of developmentally plastic, highly integrated (‘domain-general’) mechanisms. The latter are widely distributed subsystems that respond flexibly to input received from multiple lower levels, feed information downstream for further processing, and underlie the executive cognitive functions unique to humans. (Badcock et al. 2019; emphasis by DBK)

To embrace both strategic renewal and corporate governance as an Ai-based surprise minimization process requires continuous and generative interaction between top-down predictions (strategic decision making, domain-general) and bottom-up (business unit/resource market level, domain-specific) action-generated stimuli, in circular causality. Free Energy Governance is fundamentally redefining the logic of coupling governance and operational channels. Ai is enactivist. An enactivist environmental engagement (cognition) constitutes FEG’s second dimension: According to this emerging class of models, naturally intelligent systems do not passively await sensory stimulation. Instead, they are constantly active, trying to predict (and actively elicit, [. . .]) the streams of sensory stimulation before they arrive. Before an input arrives on the scene, these pro-active cognitive systems are already busy predicting its most probable shape and implications. Systems like that are already (pretty much constantly) poised to act, and all they need to process are sensed deviations from the predicted state. [. . .] Action is not so much a ‘response to an input’ as a neat and efficient way of selecting the next input, driving a rolling cycle. (Clark 2016)

Environment is en-acted in form of purpose-directed (prediction model centric) and curiosity-driven sensory revealing of significance and valency by way of sophisticatedly propagating beliefs about beliefs’ consequences. This leads to the Markov blanket: a learning algorithm, a veil intermediating the internal and external worlds, within and without firms. The Markov blanket is the site where action and perception circularly and generatively interact to update beliefs. The relevance and insightfulness of applying the ‘blanket’ to an organizational setting, precisely in the context of strategic renewal, is to embrace the firm-environment interrelatedness in form of a veil propagating and updating beliefs (i.e., probability distributions): One needs to differentiate between the system and its environment—those states that constitute or are intrinsic to the system and those that are not. To do this, we have to introduce a third set of states that separates internal from external states. This is known as a Markov blanket. Markov blankets establish a conditional independence between internal and external states that renders the inside open to the outside, but only in a conditional sense (i.e., the internal states only ‘see’ the external states through the ‘veil’ of the Markov blanket). [. . .] With Markov blankets in mind, it is fairly straightforward to show that the internal states must—by virtue of minimising surprise—encode a probability distribution over the external states; namely, the causes of sensory impressions on the Markov blanket. (Ramstead et al. 2018)1

1 Bruineberg and Hesp (2018: 38) outline limitations to Ramstead et al.’s (2018) broad interpretation of the Markov blanket.

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The boundaries between organization and environment are increasingly fluid, non-deterministic but probabilistic. It comes back to the question ‘what constitutes a system?’ as a basis for establishing Markovian boundaries, separating the internal and external states. “Many investigators define boundaries of an organization by focusing on its actors – for example, attempting to determine who is and who is not regarded as a member [. . .] A widely used behavioral indicator of relatedness is frequency of interaction. Although no social unit is completely separated from its environment on the basis of this criterion [...] A third possibility is to focus on the nature of the activities performed [. . .] organizational boundaries are coterminous with activity control” (Scott and Davis 2007). “The organization ends where its discretion ends, and another’s begins” (Pfeffer and Salancik 1978). In terms of FEG’s application of the free energy principle, there are only two fundamental distinctions that matter: ‘what is known and unknown’ and ‘what is in our control and what is not’. Once the mathematical rigor of Ai is applied, the cohesiveness of the FEP-powered generative model emerges. We have four states: active (action), internal (firm resources), sensory (perception), and external (unknown and hidden behind the Markov blanket). As outlined in the Preface, these are the four critical variables that define the generative as well as recognition model. Both models are distinct but dynamically linked. Effectively, ‘internally encoding a probability distribution over the external states’ is the essence of the Markov blanket. A Partially Observable Markov Decision Process (POMDP) “is a mathematical framework for modeling decision making in situations where the outcomes are partly under the control of an agent and partly random [. . .] the agent must maintain a probability distribution over the set of possible states” (Fox 2021). Each living system has a distinct probability distribution over a bounded (most probable) set of external states. And our explorative interactions with the outer world are fundamental to continuously optimizing this probability distribution through epistemic foraging. Essentially, existence and reality can only be defined in relation to and interaction with something else: If the fine grain of the world is made of material particles that have mass and motion, it seems difficult to reconstruct our perceiving and thinking complexity from this amorphous grain. But if the fine grain of the world is better described in terms of relations, if nothing has intrinsic properties except in relation to other things, perhaps in this physics we can better find elements able to combine in a comprehensible way, to be the basis of those complex phenomena that we call our perceptions and our consciousness. (Rovelli 2021)

Environment in form of ‘external states’ is first and foremost a matter of ‘internally encoding a probability distribution over external states’. Fundamentally, FEG is about continuously challenging and fine-tuning this probability distribution in pursuit of ‘proximal avoidance of surprise’. It is obvious to see that the quality of our Markov blanket in terms of probability distributions and underlying interactions with the outer world in pursuit of optimization critically determines whether the world is perceived as uncertain and unpredictable or whether perception is embraced as a function of our very actions generatively minimizing prediction error. We are in control!

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FEG’s third building block is dedicated to capabilities. Once we have (1) established cross-hierarchical top-down/bottom-up connectivity (structure) and (2) internalized environment as conditioned by the Markov blanket (cognition), the firm is now challenged to optimize resource reconfiguration to resist the forces of disorder to optimize the survival prospects. The concept of dynamic board capabilities is introduced—more specifically, duality management in terms of ‘real-time’ balancing exploitation vs. exploration and financial vs. strategic control. FEP as a first-order principle is essential to operationalizing dynamic capabilities, which is about empowering a firm to operate in new, complex, and discontinuous environments where established operational capabilities and reward functions may be of little value. Julie Pitt, Director of Data Science Platform at Netflix, puts the free energy minimization model into operational perspective and effectively summarizes the very essence of a dynamic capability: [T]he beauty of the free energy model is that it allows an artificial agent to act in any environment, even one that’s new and unknown. Under the old reinforcement-learning model, you’d have to keep stipulating new rules and sub-rewards to get your agent to cope with a complex world. But a free energy agent always generates its own intrinsic reward: the minimization of surprise. [That] reward includes an imperative to go out and explore. (Raviv 2018; emphasis by DBK)

Free energy minimization is introduced “for the ultimate integration of the life sciences and social sciences under one unifying principle” (Bruineberg and Hesp 2018). Nonetheless, Veissière’s critical note below demands putting into perspective FEP’s underlying imperative of ‘be curious, explore, and act’ as “social organization can only survive in the longterm if there is sufficient space between existential limits to allow for exploration” (Fox 2021): Social scientists, at least since Weber, have often lamented the human cost of bureaucratization and rationalization, but these dynamics have rarely been theorized as natural consequences of free energy minimization. Rather than propose a weird metaphysics of autonomous, self-organizing ‘societies’, however, social and cognitive scientists should mind the cognitive gap, and remember that the ‘culprit’, if there is one, is none other than the simplicity-craving, free energy-minimizing human mind. For the rest, we can also celebrate the many human traditions in spirituality, the humanities, and the Arts that have emphasized the importance of doubt, uncertainty, novelty, and unknowability. In the end, it may very well be these propensities to resist free energy minimization that make us humans. (Veissière 2018)

In fact, Weberian bureaucratization is a top-down formalistic system that increases rather than minimizes free energy. Today, organizations are challenged to optimize top-down belief propagation and bottom-up signal flow throughout the organization, across and within all hierarchical layers. Informal flows of communication are at least as important as what the formal structures impose. Prediction error minimization is only as good as effective the circular causality of action, perception, belief propagation, and, most crucially, optimization of belief-updating are. FEP is not simplicity-craving but empowers a system to exploit uncertainty and complexity in pursuit of performance and survival by way of curiosity-driven epistemic foraging and exploration. Correspondingly, Free Energy Governance

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(FEG) is a next-generation learning system designed for a discontinuous world, de-chaining the firm from dominant top-down logics and empowering continuous strategic renewal through purpose-directed generative, inferential, and crosshierarchical prediction error minimization. Contrary to Veissière (2018), FEP empowers doubt, novelty-seeking curiosity, and embraces perceived uncertainty as a source rich in information to power prediction error minimization. More specifically, the very information that powers free energy minimization has a ‘social life’ (Brown and Duguid 2017)—active inference implies an active engagement with the world. Are there any imperatives that live beyond FEP? Over the past decade or so, I have seen nearly every heuristic or hypothesis fall under the remit of the free-energy principle, from self-organisation to neural hermeneutics, from reinforcement learning to Bayesian decision theory, from perception to attention, from exploration to exploitation, from pragmatics to epistemics, from novelty to salience, from morphogenesis to evolution, from motor control theory to expected utility theory [. . .] and so on. [. . .] Is this something to be celebrated or resisted? (Friston 2019)

It is overdue for the free energy principle to be applied to strategy management and inspire novel processes as well as a new language empowering multiintelligence firms to thrive in discontinuous and distributed market environments. FEP lays the foundation to re-define entrenched notions of structure, cognition, and capabilities in the context of governing strategic renewal. In short, we expect to be surprised in a world that is predictably unpredictable - and this is the very stuff of free-energy minimization. (Friston et al. 2018)

References Argyris, C. 1995. Integrating the Individual and the Organization. New York: Translation Publishers. ———. 2005. Double-loop learning in organizations: A theory of action perspective. In Great Minds in Management: The Process of Theory Development, ed. K.G. Smith and M. Hitt, 261–279. Oxford, New York: Oxford University Press. Badcock, P.B., K.J. Friston, and M. Ramstead. 2019. The hierarchically mechanistic mind: A free energy formulation of the human psyche. Physics of Life Reviews 31: 104–121. Brown, J., and P. Duguid. 2017. The Social Life of Information. Boston: Harvard Business School Press. Bruineberg, J., and C. Hesp. 2018. Beyond blanket terms: Challenges for the explanatory value of variational (neuro-)ethology. Comment on “Answering Schrödinger’s question: A free energy formulation” by Ramstead, M. et al. Physics of Life Reviews 24: 37–39. Clark, A. 2016. Surfing Uncertainty: Prediction, Action and the Embodied Mind. New York: Oxford University Press. Fox, S. 2021. Active inference: Applicability to different types of social organization explained through reference to industrial engineering and quality management. Entropy 23 (198): 1–25. https://doi.org/10.3390/e23020198. Friston, K.J. 2009. The free energy principle: A rough guide to the brain? Trends in Cognitive Science 13: 293–301.

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———. 2010. The free energy principle: A unified brain theory? Nature Reviews Neuroscience 11: 127–138. ———. 2019. Beyond the desert landscape. In Andy Clark and His Critics, ed. M. Colombo, E. Irvine, and M. Stapleton, 174–190. Oxford: Oxford University Press. Friston, K., M. Fortier, and D.A. Friedman. 2018. Of woodlice and men: A Bayesian account of cognition, life and consciousness. An interview with Karl Friston. ALIUS Bulletin 2: 17–43. Friston, K.J., L. Da Costa, D. Hafner, C. Hesp, and T. Parr. 2021. Sophisticated inference. Neural Computation 33 (3): 713–763. Hertwig, R., and C. Engel, eds. 2020. Deliberate Ignorance: Choosing Not to Know. Cambridge, MA: The MIT Press. Noor, Sajid, P.J. Ball, T. Parr, and K.J. Friston. 2021. Active inference: Demystified and compared. Neural Computation 33: 674–712. https://doi.org/10.1162/neco_a_01357. Parr, T., G. Pezzulo, and K.J. Friston. 2022. Active Inference: The Free Energy Principle in Mind, Brain, and Behavior. Cambridge, MA: The MIT Press. Pfeffer, J., and G.R. Salancik. 1978. The External Control of Organizations: A Resource Dependence Perspective. New York: Harper & Row. Ramstead, M., P.B. Badcock, and K.J. Friston. 2018. Answering Schrödinger’s question: A free energy formulation. Physics of Life Reviews 24: 1–16. Raviv, S. 2018. The genius neuroscientist who might hold the key to true AI. Wired Magazine. Downloaded on 5 January 2020. https://www.wired.com/story/karl-friston-free energyprinciple-artificial-intelligence/. Rovelli, C. 2021. Helgoland: Making Sense of the Quantum Revolution. New York: Riverhead Book. Scott, W.R., and Gerald F. Davis. 2007. Organizations and Organizing: Rational, Natural, and Open Systems Perspectives. London: Routledge. Starbuck, W.H. 1983. Organizations as action generators. American Sociological Review 48: 91–102. Veissière, S. 2018. Cultural Markov blankets? Mind the other minds gap!: Comment on “Answering Schrödinger’s question: A free energy formulation” by Ramstead , M. et al. Physics of Life Reviews 24: 47–49.

Chapter 5

Conclusion

Abstract Strategic renewal research is now confronted with important challenges concerning process design, cognition, and dynamic capabilities. Sensing and sensemaking of relevant signals as a basis for initiating strategic renewal are preceded by an action-centric and explorative engagement with the world. We are moving from co-aligning organization with environment in form of adaptation to co-creation as firms build agility through distinctive environmental enactment. All existing frameworks and studies in corporate governance as well as strategic cognition remain characterized by one or a combination of the following fundamental limitations: (1) environment and environmental change are generally treated as objective reality; (2) strategic renewal is treated as a top-down ‘content’ rather than a top-down/bottom-up ‘process challenge’; (3) strategic renewal is studied at the managerial level but only marginally at the board level; (4) formal processes only are the focal unit of analysis; and (5) demographic and universally measurable variables dominate with no due consideration for strategy-relevant meta-capabilities at the board level. FEG introduces a novel cross-hierarchical generative (inference centric) framework empowering the firm as a generative model of its eco-niche. Shareholders and board directors must reinterpret the board’s ‘strategic relevance’ in a discontinuous world. If not, the board is prone to turn into (or remain) a source of inertia compromising firm performance and survival.

Strategic renewal research is now confronted with important challenges concerning process design, cognition, and dynamic capabilities. Sensing and sensemaking of relevant signals as a basis for initiating strategic renewal are preceded by an actioncentric engagement with the world. More specifically, we are moving from co-aligning organization with environment in form of adaptation (Huff et al. 1992) to co-creation as firms build agility through distinctive environmental enactment (Weick 1995; Agarwal and Helfat 2009; Schmitt et al. 2016). Consequently, strategic renewal is not so much an isolated event or project of choice but a continuous and cross-hierarchically generative social process that is integral to a firm’s way of becoming or organizing, i.e., survival.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_5

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In a discontinuous world, we are moving from a ‘hard’ to a ‘soft’ operating logic where fluidity and agility (vacillating/balancing duality) and informal structures (Gulati and Puranam 2009) increasingly determine firm performance and survival: “[H]ighly centralized and formalized structures are doomed to be ineffective and irrational in that they waste the organization’s most precious resource: the intelligence and initiative of its participants” (Scott and Davis 2007). There is a need for an integrated cross-hierarchical framework that is less reliant on structural compartmentalization. Further, there is a need to redefine what precisely is the top, i.e., Upper Echelon. Top-down/bottom-up connectivity is of relevance within each and every horizontal layer. Indeed, if in a discontinuous and distributed world firm performance and survival are increasingly determined by cognitive dimensions, we are challenged to explain: (1) What determines that “the organization comes to be constituted as an actor with a point of view and identity that transcend that of any of its members, singly” (Taylor and Van Every 2000)? Unless enacted at the organizational level, there are only individual waves of probabilities in superposition waiting to be collapsed. (2) What specific structure, cognition, and capabilities determine for bottom-up stimuli (sensory input) to dynamically connect to top-down strategic decision processes (predictions and prediction models) so that seemingly marginal and transient data points are empowered to provide relevant and potentially transformation-bearing insights? (3) What if the default-mode sensemaking of bottom-up signals is a critical cognitive capability underpinning strategic renewal, should the board of directors— rather than TMT—be uniquely positioned in developing and exercising such a capability since the board is assumed to be less trapped in a given firm’s dominant logics (Prahalad and Bettis 1986), core rigidities (Leonard-Barton 1992), and task-positive frames of exploitation? Conversations in strategic cognition, corporate governance, and theoretical neurobiology are waiting to be cross-fertilized. The Carnegie School’s “triplet of routines, cognition, and hierarchy” (Gavetti 2005) is developed and advanced in this book as the triplet of structure, cognition, and capabilities, linked in circular causality. In summary, the problem analysis is threefold: • Structure: While pace of change in terms of increasing velocity has been a constant feature of a globalized world, in fact of any organized economic activity over time, probabilities of environmental states are increasingly of a distributed and discontinuous nature. Continuous strategic renewal is the new organizing imperative. Initiating strategic renewal within centralized organizational structures for a distributed world, however, challenges entrenched models of organizing. “In the current environment, where human capital is crucial and contracts are highly incomplete, the primary goal of a corporate governance system should be to protect the integrity of the firm, and new precepts need to be worked out”

5 Conclusion

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(Zingalis 2000). Strategy process requires a circular and cross-hierarchical framework: neither can the strategic role of the board of directors be ignored nor should the field-level’s proximity to resource markets be disregarded as a critical pillar of strategy process. “There is room for a fresh perspective on how organizational structures, processes and systems should be designed to enable both induced [top-down] and autonomous [bottom-up] renewal initiatives”. (Schmitt et al. 2018). Top-down/bottom-up surprise/prediction-error-minimization will determine a firm’s structural design, enabling generative processes that optimize firm performance and survival. Indeed, the traditional top-down coupling of governance and operational channels (Ocasio and Joseph 2005) requires a fresh perspective. • Cognition: Conceiving organizing (becoming) as a system of generatively evolving beliefs in form of expectations, interpretations, and perceptions is essential to embracing environment as ‘shared expectation’ to be enacted rather than an objective reality to analytically adapt to. If not, executive leadership as well as the board of directors will be rather incapacitated as uncertainty and unpredictability will not only dominate perception and predictions but also trap sensemaking. Consequently, the very ability to continuously renew the business strategically will be compromised. The firm’s self-identity as an action-centric and curiosity-driven enactor of its eco-niche by way of action-challenging beliefs about the unknown (probability distributions assigned upon the outer world) forms the very basis for mastering discontinuities. • Capabilities: Against this background, we must turn toward capabilities and question whether traditional capabilities centered around operational and domain expertise only (Dane 2010; Almondoz and Tilcsik 2016) are sufficiently adequate to support firm performance and survival in a discontinuous world. Cognitive capabilities such as sensing, sensemaking, and duality management become increasingly critical to cross-fertilize exploitation and exploration as well as strategic and financial control (i.e., a firm’s capacity for internal vs. external innovation/growth). As cognitive capabilities rise in their complementary relevance to operational capabilities and domain expertise, the question arises whether the board represents a unique cognitive variable in strategy process. Referring to Hitt et al. (1996) and their proposed tension field of strategic vs. financial control, we must ask whether the board of directors is uniquely positioned to govern the balance between top-down financial control (i.e., reliance on M&A and other forms of strategic alliancing) and strategic control (i.e., in-house-generated innovation powered by R&D) to optimize resource reconfiguration as a matter of free energy minimization. The organizational design considerations emerging in this context are putting into new perspective how structure, cognition, and capabilities are dynamically related. Indeed, in a discontinuous world, structural compartmentalization may reach its limits when it comes to cross-fertilizing exploitation and exploration. Cognitive ‘vacillation’ (Boumgarden et al. 2012) gains in traction. Firms have to become

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less dependent upon structural reorganizations as it could compromise the impactfulness and sustainability of continuous strategic renewal. All existing frameworks and studies in corporate governance as well as strategic cognition remain characterized by one or a combination of the following fundamental limitations: (1) Environment and environmental change are generally treated as objective/ exogenously determined reality to be sensed, made available for sensemaking (interpretation), and adapt to (resource reconfiguration). Accordingly, traditional top-down information processing and adaptive capabilities as well as domain expertise take center stage, however, too often at the expense of cognitive capabilities fostering enactive inference as a basis for firm performance and survival. (2) Strategic renewal is treated as a top-down content rather than a top-down/ bottom-up process challenge: content follows process as much as strategy follows structure and people. Generative processes linking in circular causality top-down predictions with bottom-up stimuli—anchored in a deep corporate purpose (Gulati 2022)—are essential to continuously generate relevant strategy content and guide action agendas. (3) Strategic renewal is studied at the managerial level but only marginally at the board level. “[T]he role of the board remains unaddressed” (Oehmichen et al. 2017; referring to ambidexterity). And whenever strategic renewal is studied at the board level, it is rather trapped within the ‘board room’ and disconnected from the rest of the organization. Board effectiveness rather than firm performance and survival remains the predominant ‘corporate governance’ concern. It is essential to move from corporate to organizational governance to empower continuous strategic renewal. ‘Corporate’ has a tendency of implying ‘topdown’ and ‘formal’, emphasizing financial control at the expense of top-down/ bottom-up prediction processing’s circular causality dedicated to firm survival. (4) Formal processes are the focal unit of analysis as reflected in predominant ‘best practices’ that consider informal engagement as suspicious of potentially breeding conflicts of interests. Unavoidably, formality tends to reinforce friction and increase free energy as only formalized data and stimuli can reach the prediction generators, i.e., Upper Echelon. Hence, there is a need to de-formalize and mentalize organizing. (5) Demographic and universally measurable variables dominate with no due consideration for strategy-relevant meta-capabilities at the board level. Consequently, the board is reduced to a rather passively reactive and stimulus-intaking organ far removed from the notion of purveyor and surveyor of the firm’s generative model. Lastly, the board’s potential role in exercising the development of strategy-relevant cognitive (dynamic) capabilities at the managerial leadership level has been altogether disregarded. While the board has significant powers such as changing the CEO, its contribution throughout the strategic renewal process remains generally nonetheless moderated by the power of the CEO, the Chairman, as well as the Chairman-CEO

References

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relationship. Environmental dynamics and ownership structure—whether founder-, family-, PE-controlled or publicly listed—certainly have a moderating impact on the board’s strategic role. Public shareholders, however, are less reliably a driver of strategic renewal unless survival is visibly at risk, which is often too late. Shareholders and board directors must finally awake and re-interpret the board’s strategic relevance in a discontinuous and distributed world. If not, the board is prone to turn into (or remain) a source of inertia. This book is dedicated to firm survival in discontinuous and distributed market environments with the unit of analysis being the sustainability of continuous strategic renewal determined by the triplet of a firm’s (1) structure (cognitive coupling of governance and operational channels as a matter of top-down/bottom-up prediction error minimization), (2) cognition (environmental enactment), and (3) dynamic board capabilities (duality management of exploitation/exploration and financial/ strategic control). This new ‘extended’ conversation is headlined ‘Free Energy Governance’.

References Agarwal, R., and C.E. Helfat. 2009. Strategic renewal of organizations. Organization Science 20: 281–293. Almondoz, J., and A. Tilcsik. 2016. When experts become liabilities: Domain experts. Academy of Management Journal 59: 1124–1149. Boumgarden, P., J. Nickerson, and T.R. Zenger. 2012. Sailing into the wind: Exploring the relationships among ambidexterity, vacillation, and organizational performance. Strategic Management Journal 33: 587–611. Dane, E. 2010. Reconsidering the tradeoff between expertise and flexibility: A cognitive entrenchment perspective. Academy of Management Review 35: 579–603. Gavetti, G. 2005. Cognition and hierarchy: Rethinking the microfoundations of capabilities’ development. Organization Science 16: 599–617. Gulati, R. 2022. Deep Purpose: The Heart and Soul of High-Performance Companies. New York: HarperCollins Publishers. Gulati, R., and P. Puranam. 2009. Renewal through reorganization: The value of inconsistencies between formal and informal organization. Organization Science 20: 422–440. Hitt, M.A., R.E. Hoskisson, R.A. Johnson, and D.D. Moesel. 1996. The market for corporate control and firm innovation. The Academy of Management Journal 39: 1084–1119. Huff, J.O., A.S. Huff, and H. Thomas. 1992. Strategic renewal and the interaction of cumulative stress and inertia. Strategic Management Journal 13: 55–75. Leonard-Barton, D. 1992. Core capabilities and core rigidities: A paradox in managing new product development. Strategic Management Journal 13: 111–126. Ocasio, W., and J. Joseph. 2005. An attention-based theory of strategy formulation: Linking microand macro-perspectives in strategy process. Strategy Process: Advances in Strategic Management 22: 39–61. Oehmichen, J., M.L.M. Heyden, D. Georgakakis, and H.W. Volberda. 2017. Boards of directors and organizational ambidexterity in knowledge-intensive firms. International Journal of Human Resource Management 28: 283–306. Prahalad, C.K., and R.A. Bettis. 1986. The dominant logic: A new linkage between diversity and performance. Strategic Management Journal 7: 485–501.

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Schmitt, A., V.L. Barker, S. Raisch, and D. Whetten. 2016. Strategic renewal in times of environmental scarcity. Long Range Planning 49: 361–376. Schmitt, A., S. Raisch, and H.W. Volberda. 2018. Strategic renewal: Past research, theoretical tensions and future challenges. International Journal of Management Reviews 20: 81–98. Scott, W.R., and Gerald F. Davis. 2007. Organizations and Organizing: Rational, Natural, and Open Systems Perspectives. London: Routledge. Taylor, J., and E.J. Van Every. 2000. The Emergent Organization: Communication as Its Site and Surface. Mahwah, NJ: Lawrence Erlbaum Associates. Weick, K.E. 1995. Sensemaking in Organizations. Thousand Oaks, CA: Sage. Zingalis, L. 2000. In search of new foundations. Journal of Finance 55: 1623–1653.

Part II

Free Energy Governance (FEG)

[T]heory is a statement of concepts and their interrelationships that shows how and/or why a phenomenon occurs [. . .]. We believe, however, that a more productive question to ask, and for us to address, is “What is a theoretical contribution?” That is, what signifies a significant theoretical (as opposed to an empirical or a methodological) advancement in our understanding of a phenomenon?... Our synthesis reveals two dimensions—originality and utility—that currently dominate considerations of theoretical contribution. Thus, theory directed at practical importance would focus on prescriptions for structuring and organizing around a phenomenon and less on how science can further delineate or understand the phenomenon. . . Yet the reality is that, excepting some passionate calls for change . . . practical utility’s role in theoretical contribution seems to receive mainly lip service. —Corley and Gioia (2011)

Free Energy Governance (FEG) introduces a novel cross-hierarchical generative framework that uniquely applies the triplet of structure, cognition, and capabilities as the building blocks of the firm’s generative model, specifically in the context of continuous strategic renewal in distributed and discontinuous market environments. Essentially, six core theoretical perspectives together lay the foundation for this new conversation: Structure: (1) Upper Echelon View (UEV) and (2) Prediction Processing Framework (PPF); Cognition: (3) Attention-Based View (ABV); (4) Enactivist Approach (EA); Capabilities: (5) Dynamic Capability View (DCV); and (6) Antagonistic Neural Networks Perspective (ANNP). Structure, cognition, and capabilities form one integrated system under FEG. Failure in any one domain is likely to challenge firm survival. The framework’s core propositions, outlined at the end of this chapter, summarize FEG’s ambition for a practice-relevant theoretical contribution as both a generative logic of organizational governance as well as an early-warning system predicting corporate decay.

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Reference Corley, K., and Gioia, D. 2011. Building theory about theory building: What constitutes a theoretical contribution? Academy of Management Review 36: 12–32.

Chapter 6

Structure: Synergizing Governance and Operational Channels

Abstract Upper Echelon View (UEV) and Prediction Processing Framework (PPF) address FEG’s structural dimension. Indeed, Upper Echelon is the site of strategic decision-making. However, UEV suffers from several limitations. There is no explicit consideration for the board of directors and the linkage of Upper Echelon into the rest of the organization, i.e., the coupling of governance and operational channels, is unidirectionally top-down and therefore, at best, incomplete. How the field data can systematically talk to Upper Echelon and influence their values, perception, and attention remains a black box. The prediction processing framework (PPF) embraces structure more holistically, addressing the hierarchical disconnect and, more importantly, the circular causality between top-down predictions and bottom-up stimuli. Dissonance-bearing messages occur at the firm’s stimuli level (bottom) close to resource markets long before top leadership has ‘any sense’ of a looming challenge. PPF is determined by three ‘categorical imperatives’: (1) Upper Echelon’s prediction models and predictions must be ‘explainable’; (2) each of the hierarchical layers must have formal and informal interfaces coupling each layer to the next layer; and (3) the firm’s generative model is the firm’s eco-niche. PPF provides an entirely new perspective and language embracing strategic renewal as a matter of bottom-up/top-down prediction error minimization, not least setting free the full potential of the human-machine interface.

6.1

Upper Echelon View (UEV)

Strategies are abstractions in the mind of managers [. . .] Indeed, the imposition of meaning on issues characterized by ambiguity has become a hallmark of the modern top manager. (Calori et al. 1994)

UEV (Hambrick and Mason 1984) defines the organization as a reflection of its Upper Echelon, i.e., its top management team. UEV’s central premise is that “executives’ experiences, values, and personalities affect their (1) field of vision (the directions they look and listen), (2) selective perception (what they actually see and hear), and (3) interpretation (how they attach meaning to what they see and hear)” (Hambrick 2007). Overall, the power of UEV is its aggregating nature: rather © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_6

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than considering individual leadership qualities, top leadership is treated as one unit of analysis to explain strategic choices and firm performance. Essentially, UEV embraces sensing and sensemaking, not only as essential leadership qualities but as the foundation for strategic choices and firm performance. There are numerous studies that have applied or attempted to further develop UEV by focusing on team diversity and CEO characteristics.1 We also know relatively little about how the interaction of cognitive capabilities of individuals in the top management team affects team decision making, particularly with regard to strategic change. Research has often used demographic diversity of top management teams as a proxy for cognitive diversity, and has produced mixed results regarding the impact of such diversity on organizational performance (Finkelstein et al., 2009: 132). Future research could investigate whether diversity of managerial cognitive capabilities within a team helps or hinders strategic change. (Helfat and Peteraf 2015)

However, UEV suffers from several limitations, in particular: (1) There is no explicit consideration for the board of directors as part of Upper Echelon; the many dimensions by which a non-executive Chairman relates to the CEO, for example, are likely to determine strategic choices. (2) The linkage of Upper Echelon into the rest of the organization, i.e., the coupling of governance and operational channels, is unidirectionally top-down and therefore limited. How the field data can systematically talk to Upper Echelon and influence their values, perception, and attention remains a black box. While UEV has neglected the board of directors, FEG emphasizes the importance of the board as part of a firm’s Upper Echelon: TMT and the board of directors, here jointly labeled as Upper Echelon, are together the locus of strategic decision-making. More importantly, the board of directors can potentially assume a unique cognitive role in strategy process in the form of dynamic board capabilities that is highly complementary to that of senior executive leadership’s strategic capacity. Further, UEV has neither addressed “the psychological and social processes by which executive profiles are converted into strategic choices” (Hambrick 2007) nor can UEV explain how strategic renewal is initiated. As a result, UEV is rather topdown-centric and provides no systematic interface for bottom-up stimuli, neither from within nor outside the organization. More specifically, the Upper Echelon framework cannot accommodate the circular causality of top-down predictions and bottom-up stimuli in pursuit of surprise minimization. Therefore, at best, it is incomplete. Indeed, while UEV’s central premise is about establishing a causal link between senior executives’ characteristics and strategic action, Hambrick recognizes in his ‘Update’ (Hambrick 2007) that this can be a futile task, confusing causality with consequences. UEV must be further developed against the propositions that (1) the board’s strategic capacity (such as initiating strategic renewal) critically determines 1 Georgakakis et al. (2014): “Despite the relevance of this topic, however, upper echelon studies provide inconclusive results on the effects of diverse TMT composition on firm outcomes [...] To overcome this inconsistency, upper echelons research should adopt approaches that simultaneously consider both the drivers and consequences of TMT composition.”

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firm performance and (2) strategic choices are a function of top-down/bottom-up prediction processing and generative sensing and sensemaking (i.e., error minimization). Cognition and structure are inseparably linked. Unless these limitations are addressed, UEV is far too restrictive and one-sided (top-down) to explain through the lens of leadership qualities the anatomy of success and failure of strategic renewal. This book invites to a new stream of UEV-centric research that operationalizes UEV’s impact on firm performance not so much in terms of ‘antecedents and consequences of team diversity’ but as a function of (1) structure, cognitively coupling governance and operational channels in form of top-down/bottom-up circular prediction error minimization; (2) cognition, embracing environment as a matter of action-centric enactment; and (3) capabilities, developing duality management as a dynamic board capability to rewire the plane while flying it. At the firm level, Upper Echelon is a relevant unit of analysis: top-level predictions and underlying prediction models lay the foundation for purpose-directed generative predictive processing. However, UEV has fallen short of linking Upper Echelon cognition to the rest of the organization. Nonetheless, UEV provides an essential foundation for Free Energy Governance (top-down). Above all, UEV must be credited with providing a useful metaphor: Upper Echelon. But otherwise, it is rather anti-clocked in its exclusive ‘top-down’ emphasis and misses the essential ‘bottom-up’ signal feedback loop optimizing Upper Echelon’s world models. The prediction processing framework (PPF) allows us to embrace structure more holistically.

6.2

Prediction Processing Framework (PPF)2

[Prediction error minimization theory] profoundly reverses how we conceive our relation to the world through the senses. A standard conception is that the senses convey a rich signal that somehow represents worldly states of affairs, which the brain is passively soaking up in a bottom-up manner. If there is any top-down interpretation of the incoming data, then this is mere feedback from the cognitive system on the key bottom-up signal. On the prediction error minimization view, this picture is reversed. The rich representation of the worldly states of affairs is signaled in the top-down predictions of sensory input, maintained by the perceptual hierarchy in the brain. These predictions, as it were, query the world and dampen down predicted sensory input. The result is that only prediction error is propagated up through the system in a bottom-up fashion, and aids in revision of the model parameters. . . The functional role of the bottom-up signal from the senses is then to be feedback on the internal models of the world. (Hohwy 2013; emphasis by DBK)

See Ramstead et al. (2020; emphasis by DBK): “Bayesian formulations, centred on the brain – variously known as predictive processing, predictive coding or the prediction error minimisation framework.” 2

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Indeed, a more structural (representational) rather than enactive emphasis of predictive processing (Bayesian inference) belongs to Hohwy (2013). The essence of predictive processing (PP) has a long-standing tradition in various disciplines. According to Swanson (2016), “[t]hemes from Kant active in PP include: (1) the emphasis on ‘top-down’ generation of percepts; (2) the role of ‘hyperpriors’; (3) the general function of ‘generative models’; (4) the process of ‘analysis-by-synthesis’; and (5) the crucial role of imagination in perception.” Clark (2013) notes that “[s]uch models follow Helmholtz (1860) in depicting perception as a process of probabilistic, knowledge-driven inference. From Helmholtz comes the key idea that sensory systems are in the tricky business of inferring sensory causes from their bodily effects.” Overall, interest in PP is increasingly entering the mainstream (Raviv 2018).3 Drawing on Freud’s distinction of psychical energy as either freely mobile or bound, Holmes (2020) has framed psychosis as a matter of impaired PP, i.e., compromised Ai, where free energy remains unbounded: “As Freud suggests, what makes trauma traumatic is the piercing of the defensive shield that protects the self, dividing the entropy of the external world from the living order within. […] Psychological trauma hurts because painful “negative valence” […] arises in situations of chronic unminimized prediction error. Freud’s definition of trauma points to an absence of top-down models with which to bind upcoming free energy” (Holmes 2020). In fact, “[p]rediction error minimization uses models that generate data in a top-down fashion rather than classify the bottom-up data” (Hohwy 2013). PP does not require ‘labeled training data’ (Hohwy 2013). For the purposes of FEG, Hohwy’s structural (representational) interpretation of predictive processing emphasizes the critical importance of top-down/bottom-up connectivity in form of circular causality. Neither governance nor strategic renewal research have addressed the hierarchical disconnect of the top-down/bottom-up circular causality, certain exceptional contributions aside (Floyd and Lane 2000; Crossan and Berdrow 2003; Dong et al. 2016; Schmitt et al. 2018). PPF opens the processual black box of how shared meaning and expectations are constructed and optimized in pursuit of optimizing the performance and sustainability of strategic renewal. More importantly, we must first recall how hierarchical disconnect and managerial distortions have pervaded organizational existence: Hierarchies detach top managers from the realities that their subordinates confront, so top managers' ideologies can diverge from the perceptions of low-level personnel [...] Top managers' macroscopic points of view let them see more ideological elements than their ideologies can incorporate, and their secondhand contact with most events and their spokesperson roles encourage them to simplify and rationalize their ideologies (Axelrod, 1976). Public statements encourage distortion while committing the speakers to their pronouncements. (Starbuck 1983)

3

See also Cepelewicz (2018).

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In fact, hierarchy-fostered reflexes and behaviors are likely to lead to ‘skilled incompetence’. Therefore, strategic renewal is fundamentally about continuous learning and un-learning. In management science, PPF’s epistemological origins can be traced to Argyris’ theory of action perspective (Argyris 1976), specifically the concept of ‘double-loop learning’ defined as a form of “learning that challenges the existing routines and status quo” (Argyris 2005). Action-centric learning is at the heart of the cross-hierarchical prediction processing framework (PPF). Starbuck and Milliken (1988) have captured the essence of the top-down/bottom-up challenge that PPF is dedicated to resolve: The influence of executives’ definitions of what matters may gain strength through the uncoupling of executives’ decisions about what to observe from their subordinates’ acts of perception. This uncoupling and the asymmetry of hierarchical communications impair feedback, and so executives’ perceptions adapt sluggishly to the actual observations made by their subordinates. Organizations encourage the creation of formalized scanning programs; they assign specialists to monitor foreground events, and they discourage subordinates from reporting observations that fall outside their assigned responsibilities. Even when subordinates do notice events that have been formally classified as background, they tend not to report these upward, and superiors tend to ignore their subordinates’ messages. (Starbuck and Milliken 1988)

Organizational attention is top-down-directed but must be challenged by bottomup data and action-generated stimuli, encouraging (un-)learning in form of top-down/bottom-up circular error minimization. Bottom-up initiatives and stimuli are routinely filtered and time-delayed by organizational hierarchies, if they ever reach the top: “Although some lower-level managers and engineers were acutely aware of the electronic revolution in the world at large, this awareness did not penetrate upward, and the advent of electronic calculators took Facit’s top managers by surprise” (Starbuck 1983). More importantly, corporate failures too often prove the fact that even if relevant stimuli reach the top, they are unlikely to timely change predictions and underlying prediction models. “Crises also bring unlearning when people discover that their beliefs do not explain events, that their behavior programs are producing bad results, that their superiors’ expertise is hollow. Although this unlearning clears the way for new learning during reorientations, it so corrodes morale and trust that many organizations cannot reorient” (Starbuck 1983). This is particularly true for (narcissistic) CEO-centrism. There is a need for a fundamentally new organizing framework. A system’s preparedness to unlearn (Bonchek 2016) powers “the receptivity to corrective feedback of the decision-making unit” (Argyris 1976) and, hence, is critical to PPF’s top-down/bottom-up learning (prediction error minimization) challenge. Indeed, the entrenched top-down obsession to deterministically rationalize and formalize strategy process leads firms to ‘destroy subtlety and foster simplification’ at the expense of cultivating purpose-directed but unsupervised bottom-up sensing capabilities. Our challenge is to minimize the potent fallibility of Upper Echelon by re-distributing organizational sensing and sensemaking across the broadest possible set of (intelligent) nodes, including machines, within and without the firm. The challenge is to match the world’s distributed nature with organizational models that are equally distributed in their sensing (i.e., stimuli-intaking) as well as

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sensemaking (i.e., prediction processing and model updating) capacity. This is what the multi-intelligence firm is about. But to optimize the human-machine interface and interaction, we need a new framework, new concepts, and a new language. PPF has the potential to leverage the firm’s broadest and deepest accessible bottom-up (resource market) intelligence for organizational sensing and sensemaking as a basis for optimizing prediction models and the very predictions those models generate. More specifically, PPF lays the foundation for optimizing continuous strategic renewal. Upper Echelon remains the centralized purveyor of predictions as well as trustee of prediction models. Hence, the prediction processing-powered Free Energy Governance framework is distributed at the bottom but centralized at the top. However, for prediction error minimization to work, each hierarchical layer must be dedicated to one simple first-order principle: minimize free energy to minimize error and surprise. Consequently, prediction models will generatively evolve by way of selflearning. This is the essence of unsupervised self-organization. PPF is a form of Bayesian inference. “This generative model is decomposed into a likelihood (the probability of sensory data, given their causes) and a prior (the a priori probability of those causes)” (Friston 2010). Equally, strategy process is about assigning probabilities to a bounded set of selected external states in form of predictions leveraging prior experience. “[U]nder the [FEP], to be alive simply means to revisit a bounded set of states with a high probability” (Badcock et al. 2019). It is a continuous interplay “between raw data seeking an explanation (bottom-up) and hypotheses seeking confirmation (top-down)” (Clark 2016; quoting Shipp 2005). The challenge is not only one of building intra-firm connections between Upper Echelon’s top-down predictions and field management’s bottomup stimuli (data) but optimizing the top-down/bottom-up process within each and every layer of the hierarchy in form of feedback connections. Optimization is central to PPF. “This optimization makes every level in the hierarchy accountable to the others” (Friston 2010). While the generative sensemaking processes and capabilities are a critical performance element at every level of the hierarchy, the efficacy of such capabilities is determined by top-down belief propagation and bottom-up message-passing within and across organizational layers or business units. Embracing the brain as a probabilistic (Bayesian) prediction machine that generates actions to produce stimuli to eventually qualify or refute predictions and, if necessary, adapt accordingly the underlying priors and prediction models may analogously enrich our understanding of the circular causality defining the relationship of a firm’s structure, cognition, and capabilities in the context of strategic renewal. This is the essence of sensemaking: the quest for optimizing the match between worldview and ‘world stimuli’ through action-generated dissonance-detecting error or surprise minimization, i.e., minimizing the mathematical difference between prediction and its posterior accuracy by way of epistemic (explorative) foraging. As early as 1980, Louis (1980) pointedly captured the Bayesian essence of organizational sensemaking as enactive prediction processing: Sense making can be viewed as a recurring cycle comprised of a sequence of events occurring over time. The cycle begins as individuals form unconscious and conscious anticipations and assumptions, which serve as predictions about future events. Subsequently,

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individuals experience events that may be discrepant from predictions. Discrepant events, or surprises, trigger a need for explanation, or post-diction, and, correspondingly, for a process through which interpretations of discrepancies are developed. Interpretation, or meaning, is attributed to surprises. Based on the attributed meanings, any necessary behavioral responses to the immediate situation are selected. Also based on attributed meanings, understandings of actors, actions, and settings are updated and predictions about future experiences in the setting are revised. The updated anticipations and revised assumptions are analogous to alterations in cognitive scripts.

Organizational sensemaking is not about optimally approximating an objectively defined external reality, but developing and enacting models of reality by way of topdown/bottom-up predictive coding. Effectively, the “future arrives in the present – and becomes the past. Time moves at different rates in the brain’s hierarchy” (Holmes 2020), as is true for the firm. While time has strictly no speed, humans project speed onto time as relations and interactions increase in intensity and complexity. A firm’s very existence is determined by its curiosity-fueled interaction with its external environment: fast at the ‘reflex low level’ (i.e., resource-markets) and more slowly at higher cognitive levels (i.e., strategic decision-making). “The world that we know, that relates to us, that interests us, what we call ‘reality’, is the vast web of interacting entities, of which we are part, that manifest themselves by interacting with each other” (Rovelli 2021). Therefore, strategy process starts with mapping probability distributions upon external (unknown and hidden) states through inter-action; i.e., epistemic foraging. This veil—separating the inside from the outside, i.e., the Markov blanket—is guiding our novelty-seeking actions to generate stimuli that inferentially optimize estimates of a bounded set of probabilities. “Our brain is poised to seek novelty and surprise rather than to avoid uncertainty” (Clark 2016). Surprise is not only a measure of error and entropy but should be embraced as a valuable source of survival-relevant information: “Biological agents must therefore minimize the long-term average of surprise to ensure that their sensory entropy remains low” (Friston 2010). We need error feedback loops to adjust predictions and, more importantly, to eventually update prediction models (‘double-loop learning’). Surprise is information-rich but only of value when new information is instantly deployed to generatively perfect predictions and underlying prediction models (in terms of posterior precision, i.e., reliability). PPF lays the theoretical foundation for ‘failing fast to succeed’, a critical facet of advancing innovation: In short, the long-term (distal) imperative — of maintaining states within physiological bounds — translates into a short-term (proximal) avoidance of surprise [. . .] This is where free energy comes in: free energy is an upper bound on surprise, which means that if agents minimize free energy, they implicitly minimize surprise. (Friston 2010)

Error messages, often in the form of rather soft signals, occur at the firm’s stimuli level (bottom) close to resource markets (e.g., clients, products, suppliers, and technologies) long before top leadership has ‘any sense’ of a challenge to existing predictions and underlying models (Shepherd et al. 2017). Strategic renewal is regrettably too often, in hindsight, a story of ‘dominant logics’-trapped Upper Echelon admitting having missed and ignored relevant (and plainly accessible)

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signals early on. Consequently, “in every case of survival, the reorientations included wholesale replacements of the top managers, and we infer that survival requires this” (Starbuck 1983). Wurtzel, former Chairman/CEO and the founder’s son of a leading US electronics retailer that filed for bankruptcy, tracks in his brilliant and timeless first-hand account—Good to Great to Gone: The 60 Year Rise and Fall of Circuit City—Upper Echelon’s ‘skilled incompetence’ or ‘trained incapacity’ leading to corporate demise. Wurtzel (2012) advances the concept of Habits of Mind to explain why organizations succeed or are challenged with survival. More specifically, Habits of Mind may equally explain why Upper Echelon is generally resisting strategy process as a matter of top-down/bottom-up prediction error minimization. Instead, strategic deafness prevails: My premise is that there can be no “rules” or “formulas” for business strategy. Strategies are situational[. . .] Behind every strategy, however, lie Habits of Mind of those who developed the strategy[. . .]Habits of Mind are not situation-specific, but ways of thinking about one’s organization in relation to the world in which it exists. It is theses Habits of Mind that drive strategic decision-making and lead either to success or to failure. (Wurtzel 2012, emphasis by DBK)

Five out of Wurtzel’s twelve Habits of Mind can be considered PPF foundational, fostering success of strategic renewal: “Be Humble, Run Scared: Continuously doubt your understanding of things. Business success contains the seeds of its own destruction”; “Curiosity Sustains the Cat: The world is constantly changing. Be open and curious and strive to learn from others”; “Evidence Trumps Ideology: In business, as in politics, decisions are too often based on unproven assumptions about what works and what doesn’t. We all need operating assumptions about human nature, the economy, and the like, but when things do not work out as planned, we need to determine whether our assumptions were based on evidence or ideology”; “Confront the Brutal Facts: The worst person you can fool is yourself. Ignoring or denying reality does not help it go away”; “Chase the Impossible Dream: Do not be limited by [. . .] the “Tyranny of the OR”. (Wurtzel 2012)

Indeed, it is a fact of ‘being human’ that our actions and decisions cannot be entirely ring-fenced from our very habits of mind. However, critical self-awareness for habits of mind is essential. Certain habits—as much as they are at one point a source of success—will breed inertia in the absence of critical self-evaluation (Hoppmann et al. 2019): “the processes which produce crises are substantially identical to the processes which produce successes” (Starbuck and Milliken 1988). PPF’s top-down/bottom-up generative prediction error processing is possibly best suited to neutralize Upper Echelon’s subtle but nonetheless often prevailing resistance for habits to be generatively challenged by bottom-up stimuli. Today’s organizations are generally an artifact of top-down centralization geared toward minimizing uncertainty by way of environmental adaptation. Firms develop a risk-averse tendency and preference for being rather ‘fast followers’ than ‘first-line enactors/innovators’. This mode of organizing, however, is visibly struggling in a discontinuous and distributed world. In vain, we keep looking for guiding certainty: Hence, we look for supervision either by employing external learning analogies, such as the computer programmer, or we look in vain for some kind of bootstrapping self-supervision

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[. . .] We find the required additional constraints, the knowledgeable supervisor, in the world itself [. . .] Perhaps the mistake, in earlier conceptions of the problem of perception, was to look for a supervisor (a programmer or the system itself), which somehow knows the truth [. . .] The prediction error minimization approach cuts out the middleman and lets the supervisor be the truth itself [. . .] perceptual content is given in our predictions and this is precisely what allows the world to deliver a supervisory signal. (Hohwy 2013; emphasis by DBK)

It is the circular causality of belief propagation/message-passing where PPF’s effectiveness in the organizational context most likely breaks down. Neither the bottom-up message-passing nor the top-down belief propagation are unobstructed. We fail to appreciate how organizational friction (high levels of free energy) compromise firm performance due to: (1) top-down (enforced) predictions and prediction models that are not receptive to bottom-up challenge, (2) weak top-down/bottom-up/lateral generative sensing and sensemaking capabilities in form of error signaling and processing; and (3) poor communication and absence of a language that is suitable to leverage PPF for strategic renewal. In the organizational context, PPF is determined by three categorical imperatives: (1) Upper Echelon’s prediction models and corresponding predictions must be “explainable”4 and explicitly articulated and communicated top-down to be bottom-up challenged. The language and communications layers are critical to resource reconfiguration (Helfat and Peteraf 2015), firm performance, and, eventually, firm survival: “Heidegger’s revolutionary proposal was that “it is in words and language that things first come into being and are”” (Taylor and Van Every 2000). Indeed, “[t]o a phenomenologist language is not a window through which to observe social reality but a canvas on which it gets painted [. . .] For him or her, the language of communication is not just a medium or means or instrument (although it is that too) but theme, because it is in language that reality comes into being” (Taylor and Van Every 2000). It is an enactive interpretation of language. (2) Each of the hierarchical layers must have formal and informal interfaces that couple each layer to the next layer. For a given hierarchical structure of a firm to have any legitimacy, generative top-down/bottom-up sensing and sensemaking at every hierarchical level should equally make sense before an error message travels to the next level. There should not and cannot be any bypassing of hierarchical layers. In short, for the learning-driven prediction processing organization to be effective, each hierarchical layer must not only be engaged and empowered to challenge predictions but, more importantly, that layer must be cognitively and operationally coupled to the next layer. If any layer can be bypassed or excluded, then that layer has no organizational legitimacy. (3) The firm’s generative model is the firm’s eco-niche. When we perceive the world as uncertain and unpredictable, it is a mere reflection of the inadequacy of our generative (reality) model. This is mostly due to a lack of purpose, predictions

Yan Yufik must be credited with the term “explainable” in this context (personal conversation, October 2020).

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not being consciously explainable and, consequently, relevant stimuli emanating from resource markets cannot be captured and processed in form of prediction error minimization. But above all, Upper Echelon’s error-feedback receptivity is either non-existent or clouded by Habits of Mind, eventually incapacitating the ability to listen to what wants to emerge. The human brain ceaselessly engages in prediction error minimization, continuously building new and stronger neural connections and more reliable world models. In fact, the brain’s plasticity is driven by one first-order principle in form of a ‘categorical imperative’: free energy (error) minimization. However, organizations will never work as efficiently as the (Bayesian) brain. But it is a target model worth approximating: purpose-directed, action-centric, top-down/bottom-up belief propagation/message-passing-enabling, dissonance-seeking, and fundamentally prediction error minimizing to minimize surprise, simply put: free energy minimizing. The consequences for organizational design, environmental engagement, leadership capabilities, as well as strategy process are far-reaching. PPF provides an entirely new perspective and language embracing strategic renewal as a matter of bottom-up/top-down prediction error minimization. More importantly, PPF and FEG define strategy as hypothesis testing (Dong et al. 2016) connecting in circular causality structure, cognition, and capabilities. The board of directors should not only serve as a purveyor as well as surveyor of the firm’s prediction models but must pro-actively ensure that the models and the predictions that Upper Echelon generates are explainable across the entire organization (communication and language), are continuously bottom-up challenged, and timely evolve when predictions’ accuracy is weakening or is consistently failing, i.e., free energy is rising. The board of directors’ essential focus should be to build and guide the development of an organizational structure, a mode of environmental engagement, and cognitive capabilities (at the board level, TMT, and throughout the organization) that are fundamentally dedicated to prediction error minimization, i.e., free energy minimization. For example, one could argue that corporate governance is generally caught in a certain PPF dilemma: (1) the quest for novelty and to embrace surprise as information-enriching emphasizes the exploration-oriented board dedicated to firm performance and survival, while (2) the avoidance of surprise and uncertainty is characteristic of the entrenched ‘hands-off, nose-in’ exploitation monitoring board that is overly concerned with risk avoidance and obsessed with stereotypical diversity in board composition as a basis for board effectiveness and ‘best practices’ compliance. The latter logic is not only programmed for financial rather than strategic control but above all is novelty poor, anchored in impoverished levels of curiosity. Here, the objective is not to model when the one or the other governance logic is likely to dominate. In fact, all boards are certain to be caught in this field of dichotomist tension at some point in the firm’s lifecycle. But according to Free Energy Governance, at all times, the board must assume a critical role as guarantor of continuous top-down/bottom-up generative prediction error minimization across and within all hierarchical levels, independent of whether the emphasis at a given point is rather financial- than strategic-control centric.

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[PP] traces the path from perceptual inference to active inference to active inference about uncertainty (i.e., precision) to our current position that is starting to deal with epistemic inference (i.e., salience) and the nature of novelty, curiosity [. . .] it is clear that we are nowhere near the end of the journey. (Friston 2019)

Indeed, inference is enactive. A structural interpretation of PPF, on its own, is rather incomplete. But PP lays the structural foundation to redefine board governance in service of continuous strategic renewal. As Siebel (2019) rightly asserts in the context of digital transformation, ‘it is not just a good idea, it’s about survival’.

References Argyris, C. 1976. Single-loop and double-loop models in research on decision-making. Administrative Science Quarterly 21: 363–375. ———. 2005. Double-loop learning in organizations: A theory of action perspective. In Great Minds in Management: The Process of Theory Development, ed. K.G. Smith and M. Hitt, 261–279. Oxford, New York: Oxford University Press. Badcock, P.B., K.J. Friston, and M. Ramstead. 2019. The hierarchically mechanistic mind: A free energy formulation of the human psyche. Physics of Life Reviews 31: 104–121. Bonchek, M. 2016, November. Why the Problem with Learning Is Unlearning, 2–4. Harvard Business Review Digital Articles. Calori, R., G. Johnson, and P. Sarnin. 1994. CEOs’ cognitive maps and the scope of the organization. Strategic Management Journal 15: 437–457. Cepelewicz, J. 2018. To make sense of the present, brains may predict the future. Quanta Magazine. Downloaded on 30 September 2018. https://www.quantamagazine.org/to-make-sense-of-thepresent-brains-may-predict-the-future-20180710/. Clark, A. 2013. Whatever next? Predictive brains, situated agents, and the future of cognitive science. Behavioral and Brain Sciences 36: 181–204. ———. 2016. Surfing Uncertainty: Prediction, Action and the Embodied Mind. New York: Oxford University Press. Crossan, M.M., and I. Berdrow. 2003. Organizational learning and strategic renewal. Strategic Management Journal 24: 1087–1105. Dong, A., M. Garbuio, and D. Lovallo. 2016. Generative sensing: A design perspective on the microfoundations of sensing capabilities. California Management Review 58: 97–117. Floyd, S., and P. Lane. 2000. Strategizing throughout the organization: Managing role conflict in strategic renewal. Academy of Management Review 25: 154–177. Friston, K.J. 2010. The free energy principle: A unified brain theory? Nature Reviews Neuroscience 11: 127–138. ———. 2019. Beyond the desert landscape. In Andy Clark and His Critics, ed. M. Colombo, E. Irvine, and M. Stapleton, 174–190. Oxford: Oxford University Press. Georgakakis, D., W. Ruigrok, and S. Peck. 2014. Antecedents and consequences of top management team diversity. Expanding the upper echelons research stream. Dimitrios Georgakakis, Dissertationen/Universität St. Gallen: No. 4270 (viewed 7 November 2019). https://search. ebscohost.com/login.aspx?. Hambrick, D.C. 2007. Upper Echelons theory: An update. Academy of Management Review 32: 334–343. Hambrick, D.C., and P.A. Mason. 1984. Upper Echelons: The organization as a reflection of its top managers. Academy of Management Review 9: 193–206. Helfat, C.E., and M.A. Peteraf. 2015. Managerial cognitive capabilities and the microfoundations of dynamic capabilities. Strategic Management Journal 36: 831–850.

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Hohwy, J. 2013. The Predictive Mind. Oxford: Oxford University Press. Holmes, J. 2020. The Brain has a Mind of its Own: Attachment, Neurobiology, and the New Science of Psychotherapy. London: Confer Books. Hoppmann, J., F. Naegele, and B. Girod. 2019. Boards as a source of inertia: Examining the internal challenges and dynamics of boards of directors in times of environmental discontinuities. Academy of Management Journal 62: 437–468. Louis, M.R. 1980. Surprise and sensemaking: What newcomers experience in entering unfamiliar organizational settings. Administrative Science Quarterly 25: 226–251. Ramstead, M., M. Kirchhoff, and K.J. Friston. 2020. A tale of two densities: Active inference is enactive inference. Adaptive Behavior 4: 225–239. Raviv, S. 2018. The genius neuroscientist who might hold the key to true AI. Wired Magazine. Downloaded on 5 January 2020. https://www.wired.com/story/karl-friston-free energyprinciple-artificial-intelligence/. Rovelli, C. 2021. Helgoland: Making Sense of the Quantum Revolution. New York: Riverhead Books. Schmitt, A., S. Raisch, and H.W. Volberda. 2018. Strategic renewal: Past research, theoretical tensions and future challenges. International Journal of Management Reviews 20: 81–98. Shepherd, D.A., J.S. McMullen, and W. Ocasio. 2017. Is that an opportunity? An attention model of top managers’ opportunity beliefs for strategic action. Strategic Management Journal 38: 626–644. Siebel, T.M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: RosettaBooks. Starbuck, W.H. 1983. Organizations as action generators. American Sociological Review 48: 91–102. Starbuck, W.H., and F. Milliken. 1988. Executive perceptual filters: What they notice and how they make sense. In The Executive Effect: Concepts and Methods for Studying Top Managers, ed. D. Hambrick, 35–65. Greenwich, CT: Jay Press. Swanson, L.R. 2016. The predictive processing paradigm has roots in Kant. Frontiers in Systems Neuroscience 10: 1–13. https://doi.org/10.3389/fnsys.2016.00079. Taylor, J., and E.J. Van Every. 2000. The Emergent Organization: Communication as Its Site and Surface. Mahwah, NJ: Lawrence Erlbaum Associates. Wurtzel, A. 2012. Good to Great to Gone: The 60 Year Rise and Fall of Circuit City. New York City: Diversion Books.

Chapter 7

Cognition: From Superposition to Reality

Abstract Attention-Based View (ABV) and Enactivist Approach (EA) address FEG’s ‘cognition’ dimension. To this day, strategy management research is not entirely de-chained from its very path dependency of putting perception ahead of action, i.e., putting environment ahead of strategy. While ABV’s structure-cognition nexus is FEG’s critical building block, ABV erroneously treats action as a consequence of perception. Once we embrace attention as action-generated, we start understanding that clever analysis in form of belief-updating follows actiongenerated stimuli, not the other way around. ABV is trapped in the ‘old-school’ limitations imposed by ‘bounded rationality’. In a discontinuous and distributed (quantum) world, agents’ ‘bounded rationality’ is ‘meaningless’ as enactive inference empowers ‘the world to deliver a supervisory signal’. Effectively, agents off-load ‘the burden of cognition’ to the environment. Bounded rationality is replaced by extended cognition. The boundedness of human cognition is effectively neutralized. There are at least as many reality models as there are economic actors. Every organization chooses—akin to holding (acting upon) a light torch in the darkness—which environmental significance to attend to. Whatever the torch highlights is equivalent to breaking a quantum wave of probabilities—moving from superposition to reality, intermediated by the Markov blanket. Environmental enactment is essentially a purpose-directed, inter-active, inferential, and social learning (sensemaking) process.

7.1

Attention-Based View (ABV)

Attention is a concept with a long and rich yet diverse history in organization science. (Ocasio 2011)1

1 See Ocasio (2011) for an epistemological overview of attention in organization science. Attention “is not a unitary concept but a variety of interrelated mechanisms and processes that at the level of the human brain operate in diverse ways [and research] is similarly focused on diverse aspects of attention: attentional perspective, attentional engagement, and attentional selection” (Ocasio 2011).

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_7

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Ocasio (1997) proposes ABV as an attention-centric meta-theory for socially situated organizational action and adaptation, linking structure and Upper Echelon cognition: (1) what decision-makers do depends on their focus (focus of attention), (2) what they focus on depends on the context (situated attention), and (3) context depends on the firm’s rules, resources, and social relationships (structural distribution of attention). ABV advances an interpretation of “strategy as the product of relatively tacit psychological mechanisms that activate, buffer, or guide managers in their strategic thoughts” (Bouquet and Birkinshaw 2011). To this day, ABV is one of strategy research’s most important and relevant frameworks, while Ocasio himself remains one of the most prolific researchers in the field of strategic cognition. Ocasio not only advanced the linkage of structure and cognition but strategy as an organizationally distributed phenomenon: As such, the ABV may be viewed as part of two recent trends in strategic management. The first is found in attempts to build a behavioral theory of strategy (Gavetti, 2012; Powell, Lovallo, & Fox, 2011) by exploring the cognitive foundations of strategy making, competitive advantage, and firm performance. The second is the increasing emphasis on providing microfoundations for macro constructs, such as dynamic capabilities (Felin & Foss, 2005; Gavetti 2005; Teece, 2007). At the same time, the ABV harkens back to foundational work in management, especially Simon’s work on bounded rationality (Simon, 1947; Simon & March 1958). Indeed, the ABV extends Simon’s key point that limited attention is a central aspect of the boundedness of human rationality. (Stea et al. 2015)

While ABV’s structure-cognition nexus is a critical building block of Free Energy Governance, fundamentally, ABV suffers from severe shortcomings that weaken its relevance to practice. By highlighting some of ABV’s most fundamental weaknesses, we should further cement the case for FEG as a meta-theory connecting in circular causality structure, cognition, and capabilities. Once we understand how the Bayesian brain is building a model of its world, we start seeing how anachronistic and full of friction our deep-rooted conceptions of organizational attention are. ABV defines attention as “noticing, encoding, interpreting, and focusing of time and effort by organizational decision-makers on both (1) issues [. . .] and (2) answers” (Ocasio 1997), in particular concerning environmental change and corresponding strategic action. Top leadership’s attention to the right issues and solutions is considered the source of the firm’s competitive advantage. Essentially, it is content- rather than process-centric, and the firm’s performance bottleneck remains Upper Echelon’s attention, i.e., bounded rationality. Attention is reductionist and implies trade-offs. Indeed, a firm’s performance is determined by leveraging its structurally distributed attention as valuable ‘computing power’ such that the complexity and equivocality of market signals are neither ignored nor ‘explained away’ (Shepherd et al. 2017) but optimally leveraged for advancing the firm’s self-evidencing, i.e., survival. Therefore, firm outperformance and survival are highly dependent on neutralizing the imposing dominance of Upper Echelon’s cognitive boundedness, i.e., its centrality in top-down dictating organizational attention.

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The critical question then is how, in the first place, context is selected to determine attention or how bottom-up market signals connect with top-down Upper Echelon expectations and predictions to determine attention? In a world that is distributed and discontinuous, how can such processes be defined and implemented so that bottom-up stimuli can enhance the precision of top-down attention in form of feeding as well as challenging predictions and underlying prediction models so that a firm’s attention is a real-time product of continuous top-down/bottom-up hypothesis testing? Strategy is an inherently social property (Bouquet and Birkinshaw 2011; Dong et al. 2016). The coupling of governance and operational channels (Ocasio and Joseph 2005)—top-down (prediction-driven) and bottom-up (stimuli-/datadriven)—is essential to fully leveraging a firm’s structurally distributed attention as competitive advantage. While ABV views organizations as ‘systems of structurally distributed attention’ (Ocasio 1997) where structure channels attention, ABV treats the process of ‘channeling’ as a black box. Indeed, the nature of stimuli that catches the attention of an organizational member does vary in function of task specificity and hierarchical positioning: “the interplay between cognitive and experiential, semiautomatic forms of behavior suggests the need for more explicit attention to the role of the organizational hierarchy than most theory on capabilities implies” (Gavetti 2005). In this regard, ABV does not explicitly consider the board of directors’ potentially unique cognitive role in terms of determining a firm’s attention. Neither UEV nor ABV, both fundamentally top-down-oriented frameworks, have given due consideration to the dynamic interplay between top management team (TMT) and the board of directors. More specifically there is no transparent structural link between the Upper Echelon level and field intelligence, for example. The very process that governs the two layers’ interactions in determining a firm’s attention and actions remains opaque. Ocasio also recognized the need for attentional coherence but lacks the specifics on how to achieve it: Most theory and research on attention in organizations invokes top-down processes, whether driven by goals (Cyert and March 1963, Greve 2008), identity (Hoffman and Ocasio 2001), cognitive models (Kaplan 2008), or logics of action (Thornton and Ocasio 1999). Bottom-up processes, or data- or stimulus-driven processes, have received less research attention, although they are the focus of ecological perspectives (Hansen and Haas 2001, Hsu 2006) [. . .] The interaction of top-down and bottom-up attentional processes is also implicit in the Weick and Sutcliffe (2006) concept of the ‘quality’ of organizational attention and in the Rerup (2009) analysis of attentional triangulation, combining attentional stability (top-down), attentional vividness (bottom-up), and attentional coherence (combining both). (Ocasio 2011)

This limitation is of particular relevance against the background that senior managers “live inside their frames and, to a very great extent, don’t know what lies outside” (Hamel and Prahalad 1994). While this may be equally true for individual board directors, generally, directors are less likely to be trapped to the same degree in the very same exploitation-centric frames as TMT is in a given organization. ABV cannot explain attentional coherence.

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Further, the link between cognition and action is essential (Weick 1995): “What people refer to as their environment is generated by human actions and accompanying intellectual efforts to make sense out of these actions. The character of this produced environment depends on the particular theories and frameworks, patterns of attention, and affective dispositions supplied by the actor-observers” (Smirchich and Stubbart 1984). However, ABV erroneously treats action as a consequence of attention and perception. According to PPF, actions determine in circular causality the stimuli that dictate attention and sensemaking. Once we embrace attention as action-generated, we start understanding that clever analysis (Rindova 1999) in form of belief-updating follows action-generated stimuli, not the other way around. As highlighted earlier, language and communication are not mere tools but are the very site of organizational becoming. Language must evolve to match and set free the full potential of the multi-intelligence firm. This is an area that ABV is only lately catching up with: Research on attention has tended to overlook the social interactions underlying communication in shaping the situated attention and attentional engagement that occurs within and between communication channels. [. . .] attention in the ABV [Attention Based View] should be studied not only as an individual level cognitive phenomenon, but also as a social one, where the attention and co-orientation of organizational actors is shaped by communication. (Burgelman et al. 2018)

Indeed, ABV is limited to ‘tacit psychological mechanisms’ (Bouquet and Birkinshaw 2011), which is conceptually attractive but practically of little value. Those ‘tacit psychological mechanisms’ have a name: free-energy minimizing top-down/bottom-up prediction error minimization. While ABV is laying a critical foundation in linking cognition and structure, the question arises whether ABV’s attention will need to be redefined as something more granular and practical. Attention not only is too diffuse as a cognitive concept but also is hard to meaningfully operationalize in the context of continuous strategic renewal. In that regard, PPF in form of enactive inference is potentially a critical complement to and possibly substitute for ABV. PPF provides the concepts and logics that give new meaning to the linkage of structure and cognition. According to PPF, prediction models and predictions self-optimize as a matter of pursuing surprise minimization by way of free energy minimization. It is strictly, a priori, not an attention challenge but a (purpose-directed) prediction challenge. The evolution of self-driving vehicles provides an exemplary illustration of this point: once the challenge was conceived as a prediction rather than attention challenge, the road to perfection is simply a matter of continuous and purpose-directed prediction error minimization: [T]he ability to see a problem and reframe it as a prediction problem [is an]‘AI Insight’. . . Autonomous vehicles could not function outside a highly predictable, controlled environment – until engineers reframed navigation as a prediction problem. (Agrawal et al. 2018)

Finally, ABV is treating environment as an objectively observer-independent construct. According to ABV, the firm’s competitive advantage is determined by paying attention to the right issues and answers waiting to be discovered ‘out there’,

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while attention’s critical moderators are managerial focus, situational context, and degree of structural distribution. ABV is trapped in the ‘old-school’ limitations imposed by ‘bounded rationality’. In a discontinuous and distributed (quantum) world, agents’ bounded rationality is ‘meaningless’ as “perceptional content is given in our predictions and this is precisely what allows the world to deliver a supervisory signal” (Hohwy 2013). Effectively, the firm is off-loading “the burden of cognition to its environment” (Lindsay 2021). ‘Bounded rationality’ is replaced by extended cognition. The boundedness of human cognition is effectively neutralized. Once we exit the classical logic of cause-effect locality and embrace the world in superposition as probabilistic, it becomes evident that the firm selects through action its very stimuli according to its existential purpose. Therefore, bounded rationality— in terms of the agent’s limitation to pay attention to and compute all relevant objective stimuli beholding the ‘truth of the world’ as a basis for resource recombination—is non-sensical. Reality is not what it seems (Rovelli 2017): What we perceive as reality is a process that involves our consciousness. An external reality, if it existed, would by definition have to exist in the framework of space and time. But space and time are not independent realities but rather tools of the human and animal mind. (Lanza et al. 2020)

In a discontinuous and distributed world, the antecedents of competitive advantage are changing. They are less rooted in top management’s attentional focus but the firm’s very system of cross-hierarchical interactions that activates the self-organizing multi-intelligence firm in form of purpose-directed, curiosity-driven, and environmentally enacting top-down/bottom-up prediction error minimization, i.e., enactive inference. ABV, nonetheless, must be credited with laying management science’s foundation for linking structure and cognition and introducing neuroscience-based concepts to strategy management. We now turn to environmental enactment as a foundation for cognition.

7.2

Enactivist Approach (EA)

Emergence of a self entails emergence of a world. The emergence of a self is also by necessity the co-emergence of a domain of interactions proper to that self, an environment or Umwelt [. . .] Emergence of a self and world ¼ sensemaking. The organism’s environment is the sense it makes of the world. The environment is a place of significance and valence, as a result of the global action of the organism. (Thompson 2007)

Active inference is enactive inference (Ramstead et al. 2020). Indeed, the essential question is how the firm brings forth ‘significance and valence’ that does not preexist but is the result of action-centric and socially constructed engagement with the outer world—equivalent to internally assigning probabilities to external (hidden, unknown) states in form of a Markov blanket. This revealing of ‘significance and valence’ then lays the foundation for generating ‘shared meaning’ and ‘shared expectations’ in form of unique interpretation models (belief systems) underlying firm performance and survival.

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As the organization is sensing and making sense of the environment, in fact, the organization engages in enacting an environment (eco-niche) proper to that of the firm: I use the word enactment to preserve the fact that, in organizational life, people often produce part of the environment they face (Pondy & Mitroff, 1979, p.17). I like the word because it suggests that there are close parallels between what legislators do and what managers do. Both groups construct reality through authoritative acts. (Weick 1995)

Enactive inference is not a form of top-down authoritative acts but a matter of top-down/bottom-up eco-niche construction (Constant et al. 2018). Enactment and sensemaking are purpose-directed, goal-oriented, and action-centric social processes of reality construction, i.e., revealing environmental significance and valence for a given purpose and goals. Daft and Weick (1984) differentiate between environmentdriven and interpretation-driven approaches to strategy-making: In environment-driven frames, top managers experience environments as concrete, hard, measurable, and determinant. They therefore first seek to identify environmental demands and then develop strategies in response to them. Top managers thus assume the environment to determine strategy. Such environment ! strategy beliefs represent deterministic logics (Fahey and Narayanan, 1989). On the other hand, top managers of firms confronting more unstable or unanalyzable environments are thought ‘to construct, coerce, or enact a reasonable interpretation that makes previous action sensible’ (Daft and Weick, 1984: 287). Thus, they attempt to construct their environments through their strategies rather than developing strategies in response to environments (Lyles and Schwenk, 1992), resulting in strategy ! environment beliefs, or proactive logics (Fahey and Narayanan, 1989). (Nadkarni and Barr 2008; emphasis by DBK)

Despite Weick’s strong influence on strategic management research, to this day, the environment-driven approach remains dominant. Consequently, in a world characterized by discontinuities, Upper Echelon’s environmental perception is increasingly trapped in uncertainty and unpredictability. To be environment-driven in a discontinuous world is entropy-bound. “To argue that environments are enacted [. . .] does not mean that environments are fabricated at will. Phenomenologically speaking at least, it rather means that environments are brought to actors’ awareness—are disclosed in particular ways [. . .] the environment is disclosed—namely it is made available to experience” (Sandberg and Tsoukas 2015). More specifically, PPF’s ‘disclosing’ is a matter of purpose-centric prediction error minimization in pursuit of surprise minimization to resist entropy to persist. Active states (action), sensory states (perception), internal states (firm resources), and external states (hidden and unknown states beyond the Markovian veil) are dynamically linked such that internal and external states are conditioned by the Markov blanket which in turn is a function of action and perception (i.e., firm resources). And everything is orchestrated in circular causality by one simple firstorder principle: free energy minimization—in pursuit of minimizing surprise to minimize dissipation. To this day, strategy management research is not entirely de-chained from its very path dependency of putting perception ahead of action, i.e., putting environment ahead of strategy. According to strategic choice theory (Child 1972), firms choose

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their environmental domains,2 and according to the theory of environmental determinism (Aldrich 1979), the organizational population evolves as a function of environment-controlled selection and retention processes.3 “Most researchers seem to place themselves somewhere between these polar views. Despite the heated discussion, however, neither the strategic choicers, nor the environmental determinists, nor those in between, question the pivotal notion of environments as independent, external, and tangible entities” (Smirchich and Stubbart 1984; emphasis by DBK). Organizations socially construct (enact) their eco-niche in form of ‘shared meaning’ and ‘shared expectations’ through action. “[B]asic biology makes it clear that what appears ‘out there’ is actually a construction – a whirl of neural-electrical activity – occurring in the brain” (Lanza et al. 2020). Environment is never fixed but a dynamic co-construct of organizational action and perception. Environment is “made available to experience” (Thompson 2007). Every organization chooses— akin to holding a light torch in the darkness—which environmental significance to act upon and attend to. Whatever the torch highlights is equivalent to breaking a quantum wave of probabilities—moving from superposition to reality, intermediated by the Markov blanket. In this regard, strategy research is challenged to be less mechanistically deterministic (environment ! strategy) but more quantum (strategy ! environment): The quantum world is more tenuous than the one imagined by old physics; it is made up of happenings, discontinuous events, without permanence. It is a world with fine texture, intricate and fragile as Venetian lace. Every interaction is an event, and it is these light and ephemeral events that weave reality, not the heavy objects charged with absolute properties that our philosophy posited in support of these events. (Rovelli 2021)

Indeed, the more ‘explainable’ and more broadly ‘shared’ a firm’s Markov blanket—defined as conditional independencies between internal and external states—the stronger and more effective the error minimization process, and the more likely that surprise is leveraged for the purpose of advancing (un-)learning, knowledge creation, and model optimization. “The problem is that there are too many meanings, not too few. The problem faced by the sensemaker is one of equivocality, not one of uncertainty. The problem is confusion, not ignorance” (Weick 1995). The critical consideration is how an organization trans-morphs the sensing and sensemaking activity at the individual level into a firm’s (institutionalized) environmental enactment as a basis for continuous strategic renewal. Enactment is essentially an (interactive and generative) social learning (sensemaking) process (Crossan and Berdrow 2003)—hence, enactive inference. Dong et al. (2016) elegantly address this micro-macro dichotomy: “While hypothesis setting is an individual activity, “Child argues that organizations can select their environmental domains, that environmental forces are not so confining that they cannot be outflanked or sometimes even safely ignored” (Smirchich and Stubbart 1984). 3 “Aldrich believes that ‘environments’ are relentlessly efficient in weeding out any organization that does not closely align itself with environmental demands. He doubts that many organizations self-consciously change themselves very much or very often, or that the conscious initiatives by organizations are likely to succeed” (Smirchich and Stubbart 1984). 2

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hypothesis testing is an organizational activity” (Dong et al. 2016). According to Smirchich and Stubbart (1984), “organization members actively form (enact) their environments through their social interaction. A pattern of enactment establishes the foundation of organizational reality, and in turn has effects in shaping future enactments. The task of strategic management in this view is organization making — to create and maintain systems of shared meaning that facilitate organized action.” It is impossible to address enactment at the firm level without due consideration to hierarchy (structure), i.e., the cognitive coupling of governance and operational channels, in form of top-down/bottom-up prediction error minimization. In addition, due consideration must be given to capabilities such as sensing (making actiongenerated stimuli available for sensemaking) and sensemaking (continuously top-down reassigning probabilities to predictions and re-evaluate prediction models on the basis of bottom-up stimuli feedback loops; i.e., belief-updating). Organizations are challenged to better distinguish how their actions differ from those of others as they construct eco-niches. The sensing system of certain types of fish is of interest in this regard: [W]henever a fish emits a pulse it also sends a copy of the command around to the sensing system, enabling that system to counteract the effect of the pulse it has produced. The fish is tracking and registering the distinction between “self” and “other”, between the effects on its senses of its own actions and the effects of events going on around it. (Godfrey-Smith 2016)

The ‘fish’ illustrates that we have to look no further than the animal world to understand the very human limitations of sensing as well as distinguishing between ‘self’ and ‘other’. It is fascinating to assess the environmental enactment capabilities of animals: [S]harks have organs called Lorenzini blisters, which sense electrical fields’. Dolphins and toothed whales, for example, benefit from echolocation abilities, ‘whose sound pulses can penetrate soft tissue to provide them with an X-ray-like mental image of the object of interest’. In order to ‘tell’ other dolphins what they have discovered, ‘they actually create a visual picture of what they just saw in the minds of other dolphins. (Lanza et al. 2020).

In a discontinuous and distributed world, linear cause-effect thinking is struggling to make sense of ‘exponential reality’. Concepts such as uncertainty and unpredictability are effectively an expression or, more appropriately, an admission of the very limitations of the firm’s prediction processing model and, more specifically, the firm’s free energy minimization (in-)capability. The pursuit of distilling objectively defined deterministic relationships, so characteristic of strategy and governance research, is failing to guide practice to thrive in a discontinuous world: Energy is but a representation of the mind, a rule of its understanding. In the mind, were we able to lay it open, we would see the internal logic of the universe. [. . .] The answer lies not in any isolated, external definition of ‘nature’, but in ourselves. (Lanza et al. 2020)

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To act upon the world to listen and sense what wants to emerge is fundamental to strategic renewal and firm survival: “Listen from what you know, from what surprises you, from the whole, and from what you sense wants to emerge (the emerging whole)” (Scharmer 2018). Environmental enactment is a function of purpose-directed exploitation and exploration of a firm’s eco-niche. In a discontinuous world, powered by pervasive connectivity, the eco-niche’s web of relations and corresponding interactions is becoming too complex to compute with linear thinking and classical tools. Hence, the more critical and survival-relevant become our governance (enactive inference) models. More specifically, optimization is essential across the constituent elements determining the circular causality underlying enactive inference: (1) actions generating reliable sensory input (precision), (2) the ability to express beliefs about beliefs’ consequences (sophistication) to enact only a bounded set of external states, (3) leveraging salience without missing the very error-signaling value that non-salient stimuli may nonetheless behold, and (4) the foresight to anticipatorily develop and strengthen the internal states (i.e., firm resources) in form of capabilities critical to resource recombination (sensing/sensemaking/duality management). In fact, if the firm is an enactive inference machine expressed as a generative model, then the board of directors is the purveyor as well as surveyor of the firm’s generative model. Reconfiguring assets in a discontinuous quantum world imposes a new governance mandate. Consequently, firms and, more specifically, the board of directors must develop new dynamic (meta-)capabilities. Duality is an essential quantum concept that underpins the mastery of managing the distributed and discontinuous nature of today’s market realities.

References Aldrich, H.E. 1979. Organizations and Environments. Englewood Cliffs: Prentice-Hal. Agrawal, A., J. Gans, and A. Goldfarb. 2018. Prediction Machines: The Simple Economics of Artificial Intelligence. Boston: Harvard Business Review Press. Bouquet, C., and J. Birkinshaw. 2011. How global strategies emerge: An attention perspective. Global Strategy Journal 1: 243–262. Burgelman, R.A., S.W. Floyd, T. Laamanen, S. Mantere, E. Vaara, and R. Whittington. 2018. Strategy processes and practices: Dialogues and intersections. Strategic Management Journal 3: 531–558. Child, J. 1972. Organizational structure, environment and performance: The role of strategic choice. Sociology 6: 1–22. Constant, A., M. Ramstead, S. Veissière, J.O. Campbell, and K.J. Friston. 2018. A variational approach to niche construction. Journal of the Royal Society Interface 15: 141. https://doi.org/ 10.1098/rsif.2017.0685. Crossan, M.M., and I. Berdrow. 2003. Organizational learning and strategic renewal. Strategic Management Journal 24: 1087–1105. Daft, R.L., and K.E. Weick. 1984. Toward a model of organizations as interpretation systems. Academy of Management Review 9: 284–295. Dong, A., M. Garbuio, and D. Lovallo. 2016. Generative sensing: A design perspective on the microfoundations of sensing capabilities. California Management Review 58: 97–117.

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Gavetti, G. 2005. Cognition and hierarchy: Rethinking the microfoundations of capabilities’ development. Organization Science 16: 599–617. Godfrey-Smith, P. 2016. Other Minds: The Octopus, the Sea, and the Deep Origins of Consciousness. New York: Farrar, Straus and Giroux. Hamel, G., and C.K. Prahalad. 1994. Competing for the Future. Boston, MA: Harvard Business School Press. Hohwy, J. 2013. The Predictive Mind. Oxford: Oxford University Press. Lanza, R., M. Pavšič, and B. Berman. 2020. The Grand Biocentric Design: How Life Creates Reality. Dallas: BenBella Books. Lindsay, G. 2021. Models of the Mind: How Physics, Engineering and Mathematics Have Shaped Our Understanding of the Brain. London: Bloomsbury Sigma. Nadkarni, S., and P.S. Barr. 2008. Environmental context, managerial cognition, and strategic action: An integrated view. Strategic Management Journal 29: 1395–1427. Ocasio, W. 1997. Towards an attention-based view of the firm. Strategic Management Journal 18: 187–206. ———. 2011. Attention to attention. Organization Science 22: 1286–1296. Ocasio, W., and J. Joseph. 2005. An attention-based theory of strategy formulation: Linking microand macro-perspectives in strategy process. Strategy Process: Advances in Strategic Management 22: 39–61. Ramstead, M., M. Kirchhoff, and K.J. Friston. 2020. A tale of two densities: Active inference is enactive inference. Adaptive Behavior 4: 225–239. Rindova, V.P. 1999. What corporate boards have to do with strategy: A cognitive perspective. Journal of Management Studies 36: 953–975. Rovelli, C. 2017. Reality Is Not What It Seems: The Journey to Quantum Gravity. New York: Riverhead Books. ———. 2021. Helgoland: Making Sense of the Quantum Revolution. New York: Riverhead Books. Sandberg, J., and H. Tsoukas. 2015. Making sense of the sensemaking perspective: Its constituents, limitations, and opportunities for further development. Journal of Organizational Behavior 36: 6–32. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers. Shepherd, D.A., J.S. McMullen, and W. Ocasio. 2017. Is that an opportunity? An attention model of top managers’ opportunity beliefs for strategic action. Strategic Management Journal 38: 626–644. Smirchich, L., and C. Stubbart. 1984. Strategic management in an enacted world. Academy of Management Review 10: 724–736. Stea, D., S. Linder, and N. Foss. 2015. Understanding organizational advantage: How the theory of the mind adds to the attention-based view of the firm. Cognition and Strategy: Advances in Strategic Management 32: 277–298. Thompson, E. 2007. Mind in Life: Biology, Phenomenology, and the Sciences of Life. Cambridge, MA: Belknap Press. Weick, K.E. 1995. Sensemaking in Organizations. Thousand Oaks, CA: Sage.

Chapter 8

Capabilities: Duality Management

Abstract Dynamic Capability View (DCV) and Antagonistic Neural Networks Perspective (ANNP) address FEG’s ‘capabilities’ dimension. The board’s cognitive capabilities in terms of meta-managing interdependently opposing logics as unity are increasingly relevant to continuous strategic renewal. Duality management—such as vacillation between exploitation vs. exploration and balancing financial and strategic control—is established as a dynamic board capability. Effectively, FEG extends DCV to the board level. More importantly, by adopting a free energy principlepowered perspective—i.e., redefining the firm as an enactive inference machine— DCV’s triplet of ‘sensing, seizing, and reconfiguring assets’ is operationalized such that the firm is engaged as a ‘whole’. ANNP is established and applied as the neuroscientific basis for duality management: managing the existing while contradicting the present to develop the future. This TPN/DMN antagonism— between exploitative task execution (TPN) and explorative (abductive) thinking (DMN)—is a neurological representation of the contradictory demands that challenges companies’ sustainable outperformance and survival. The board’s traditional monitoring and advisory roles must be explicitly complemented with a duality (TPN/DMN) management mandate. More specifically, the board’s dynamic capability of duality management lays the foundation for the board’s newly established governance purpose in discontinuous and distributed markets: ‘duality stewardship’.

8.1

Dynamic Capability View (DCV)

The dynamic capability view (DCV) has become a vibrant topic in the domain of strategic management, originating “in spirit from Schumpeter’s (1934) innovationbased competition where competitive advantage is based on the creative destruction of existing resources and novel recombination into new operational capabilities” (Pavlou and El Sawy 2011). A variety of interpretations or emphasis within DCV have emerged. Strategic change, innovation, and learning are at its core (Vogel and Guettel 2013). Sensing strategic opportunities in dynamic market environments, seizing the opportunity, and

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reconfiguring a firm’s resource base accordingly are DCV’s central three pillars (Teece 2007): For example, Amazon’s launch of the Kindle in 2006 involved sensing the impending threat to its core bookselling business, seizing the opportunity through rapid development of a firstgeneration e-book reader, and then gradually reconfiguring its internal activities to ensure that the Kindle became an integrated part of its overall market offering. (Birkenshaw et al. 2016)

According to Eisenhardt and Martin (2000), dynamic capabilities are rather non-idiosyncratic ‘routines’ or ‘well-known processes such as alliancing, product development, and strategic decision making’: “while the specifics of any given dynamic capability may be idiosyncratic to a firm (e.g., exact composition of a cross-functional product development team) and path dependent in its emergence, 'best practice' exists for particular dynamic capabilities across firms,” and, hence, competitive advantage “lies in using dynamic capabilities sooner, more astutely, or more fortuitously than the competition to create resource configurations that have that advantage” (Eisenhardt and Martin 2000). Helfat et al. (2007), in contrast, juxtaposes dynamic capabilities to operational capabilities and routines: “A dynamic capability is the capacity of an organization to purposefully create, extend, or modify its resource base.” Dynamic capabilities are fundamental to the meta-conversation that nourishes continuous strategic renewal. Concerning strategic capabilities such as M&A and alliancing, of course, there are ‘best practices’ that are non-idiosyncratic. But this is not what dynamic capabilities are about. “In a similar manner to that in which organizational learning research distinguishes between single-loop and double-loop learning (Argyris and Schön, 1978), capability research also distinguishes between operational capabilities and dynamic capabilities” (Laamanen and Wallin 2009). There has been lately a shift in DCV from behavioral to cognitive interpretations (Helfat and Peteraf 2015), explicating the cognitive microfoundations underpinning Teece’s (2007) three core pillars of dynamic capabilities: (1) sensing (perception), (2) seizing (sensemaking), and (3) asset reconfiguration (language, communication, and social cognition): With respect to dynamic managerial capabilities for seizing and reconfiguring in particular, we have emphasized ways in which top management can shape aspects of the organizational context, such as by encouraging cooperation, lowering resistance to change, designing a business model for a new venture, and investing in new skills and assets. This suggests that managerial cognitive capabilities may function as mediators of the relationship between changes in organizational context and strategic change, which in turn can affect firm performance. (Helfat and Peteraf 2015)

To advance DC for the purposes of this book, we must first address one of DC’s critical moderators: the nature of market dynamics. DC’s traditional distinction between moderate and high velocity dynamics may have lost its practical relevance. Indeed, independently of industrial vertical, the increasingly distributed and discontinuous nature of market-transforming forces cannot be overestimated. However, ‘market velocity’ is too generic of a concept. A more suitable DC concept is Schmitt et al.’s (2016) environmental scarcity (inspired by Cameron and Zammuto 1983),

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meaningfully relating sensing and sensemaking as meta-capabilities, respectively, to eco-niche dynamics and strategic renewal: Combining the type and the rate of decline allows us to distinguish four environmental scarcity situations (Zammuto and Cameron, 1985): environmental dissolution (gradual decline in shape); environmental erosion (gradual decline in size); environmental collapse (sudden decline in shape); and environmental contraction (sudden decline in size). (Schmitt et al. 2016)

In certain environmental scenarios, sensing rather than sensemaking is the more relevant challenge, and vice versa. More importantly, the same perception (sensing) does not necessarily lead to the same interpretation and action plan (seizing the opportunity and reconfiguring resources accordingly). While slow and gradual market changes test in particular our sensing capability, more sudden changes challenge a firm’s sensemaking capability. There really is no objectively uncertain market environment: uncertainty is an actor-dependent mental experience facing one’s very limitations of the dynamic interplay between sensing and sensemaking. Therefore, independent of the degree of market velocity, dynamic capabilities are critical. It is worth recalling the essence of Free Energy Governance’s underlying enactive inference: the challenge is not “choosing the right response in light of a given stimulus but [. . .] choosing the right stimulus in light of a given goal” (Anderson 2014). In particular, at times of environmental scarcity (Schmitt et al. 2016) such as the sudden collapse and contraction of capital markets banking in 2007/2008, for example, sensing (perception) is likely to be rather univocal across the banking industry, but sensemaking (seizing the opportunity) is certain to differ among industry participants. For example, JP Morgan, one of the world’s leading financial services providers, purpose-directedly acquired defunct Wall Street investment bank Bear Stearns in the midst of the financial market crisis (March 2008), while most other leading banks were struggling to make sense of their very existence’s future. It is a firm’s timeless purpose—continuously reinterpreted and translated in form of medium-term goals as well as ad hoc action readiness—that determines the firm’s sensemaking and whether scarcity, in whatever shape and rate of change, is actionized as opportunity to ‘lead and disrupt’ (O’Reilly and Tushman 2016): [S]ituations of sudden environmental decline (i.e., environmental contraction and environmental collapse) send strong and clear signals that do not create challenges for managerial perception (Zammuto and Cameron, 1985). In these situations, managerial interpretation is more important, since it determines how senior executives assess the challenges arising from environmental decline, evaluate alternative strategic opportunities, and translate their interpretations into strategic choices. (Schmitt et al. 2016)

The stronger and sudden the impact of environmental scarcity, the higher the urgency to act, and, hence, the stronger the tendency for strategic renewal to be rather ‘financial control’-centric (i.e., M&A and other forms of alliancing), precisely for two reasons: (1) the existing resource base is too trapped in the past to unlearn and advance renewal from within and without or (2) the opportunity for market consolidation is too irresistible (as JP Morgan had demonstrated during the 2007/2008 financial crisis) and time-to-action is critical. At that stage, emphasizing financial control by

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tapping into the corporate control market must be the right strategic choice, either as an acquiror or as an acquiree. In fact, at any point in time, a firm is challenged to balance strategic (organic R&D-driven innovation and growth) with financial control (external growth and innovation by way of forms of strategic partnering). There is no tyranny of OR (Wurtzel 2012). It is a duality, a continuous ‘balancing act’ that is mutually reinforcing and, with perspective in time and space, forms a unity. FEG establishes duality management as a dynamic capability, specifically as a dynamic board capability. Tension among competing, opposing, and potentially contradictory organizational-level objectives and logics is real: “Over two decades have passed since Handy (1994) noted that the phrase, ‘It’s a paradox,’ had become a management cliché for describing opposing forces in complex organizational environments. For Handy, the phrase was overused and underspecified; but it typified a fact of life, that is, contradiction and paradox are the ‘new normal’ in this volatile, rapidly changing landscape of organizations” (Putnam et al. 2016). Indeed, strategy management has traditionally embraced (1) environmental co-creation vs. co-alignment, (2) exploitation vs. exploration, and (3) financial vs. strategic control as dualism or paradox rather than as duality. Against the background of a world that is increasingly distributed, discontinuous, and inescapably interdependent, persistency in contradiction of interdependent elements—which is the defining core of a paradox1—is potentially nonsense and therefore severely limits the theoretical as well as practical relevance of a strategic paradox lens (Smith and Lewis 2011): Paradox scholars diverge from the dialectics tradition when the new synthesis renders the underlying tension obsolete—in dialectics the synthesis meets a newly emerging antithesis, while the tension in paradox persists. [. . .] [D]uality scholars stress the interplay between contradictory elements as mutually constituted and ontologically inseparable, such that it would be impossible to describe one without the other) [. . .] Duality scholars focus on changing, processual, dynamic relationships that remain in a constant state of becoming. (Schad et al. 2016)

Putnam et al. (2016) rightly shift “the locus of paradox and contradiction to discourses, social interaction processes, practices, and ongoing organizational activities rather than actors’ cognitions or large-scale systems” and adopt “a bottom-up view of organizing, one that focuses on how tensions, contradictions, and dialectics develop as part of actions and interactions”. This is in line with Helfat and Peteraf (2015) emphasizing language, communication, and social cognition as critical cognitive microfoundations underpinning dynamic capabilities such as reconfiguring the firm’s asset base. The firm is a generative social field and emerges in language. Persistency of contradiction with regard to interdependent elements is nonsense. “We define paradox as contradictory yet interrelated elements that exist simultaneously and persist over time” (Smith and Lewis 2011: 383). “We define paradox as persistent contradiction between interdependent elements [...]. Even as paradox involves a dynamic and constantly shifting relationship between alternative poles, the core elements remain impervious to resolution” (Schad et al. 2016). 1

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It is important to appreciate that many dichotomies that have defined the science and practice of strategy management such as firm vs. environment, executive leadership vs. non-executive board, individual vs. firm, exploitation vs. exploration, financial control vs. strategic control, formal vs. informal channels, and flexibility vs. stability, for example, are less and less dichotomist in a distributed and discontinuous world but co-exist in superposition as duality or synchronicity: The study of the rise and fall of institutions highlights three key issues concerning the nature of social systems and their development patterns: whether order or contest and disorganization is the more common tendency in institutions; whether the roots of institutional transformation are endogenous or exogenous (DiMaggio, 1988; Zucker, 1988); and whether process matters in explaining institutional persistence and change. The specific context of an emerging and turbulent field underscores the question of whether and how institutions can endure at all when they are continuously faced with change and innovation. (Farjoun 2002)

Therefore, the board’s cognitive capabilities in terms of meta-managing interdependently opposing logics as unity are increasingly relevant to continuous strategic renewal. How the board of directors and executive leadership relate to each other and mutually reinforce their respective impact on firm performance and survival must be redefined: the traditional governance dichotomy of ‘control vs. collaboration’ (Sundaramurthy and Lewis 2003) is not a paradox but a duality. In a discontinuous world that demands continuous strategic renewal, the board cannot exercise its (‘best practices’-imposed) ‘supervisory’ mandate without being an integral part of the generative top-down/bottom-up process of predictive coding empowering strategic renewal. This book adopts a duality-centric action perspective where firm-level tension between opposing logics is the source of endogenously powered change as well as stability (Farjoun 2002, 2010). Duality management—such as vacillation of exploitation vs. exploration (Boumgarden et al. 2012) and balancing financial and strategic control (Hitt et al. 1996)—is established as a dynamic board capability. The goal-directed, action-centric, and generative circular causality of top-down, bottomup, and lateral sensemaking processes (prediction error minimization) forms the basis for leveraging opposing logics in form of duality. In a discontinuous world, ambidexterity needs to be equally redefined as duality. The ‘ambidexterity school’ has emphasized structural compartmentalization to empower a company’s simultaneous ability to exploit cash flow in existing product markets (operational capabilities) while exploring innovation around future sources of growth. Indeed, ambidexterity is not “a complement to the dynamic capabilities perspective” (Birkenshaw et al. 2016) but is a dynamic capability in its own right (O’Reilly and Tushman 2008). It has been tempting to address ambidexterity through a paradox lens. Indeed, contradiction and competition among organization-level objectives are real. But in a world that is both distributed and discontinuous, there is no placeholder for the persistency of contradiction, the very defining attribute of a paradox. Duality management advocates real-time vacillation with different levels of emphasis

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depending on the firm’s very specific needs at a point in time of the firm’s lifecycle. This raises the question of whether the board of directors is uniquely positioned to assume responsibility for supervising a sustainable balance or vacillation between exploitation and exploration (Oehmichen et al. 2017) as well as financial and strategic control. Financial control dangerously develops its very own top-down dynamics as bottom-up stimuli are either intentionally or consequentially de-emphasized or simply anaesthetized. The connectivity between top-down predictions and bottom-up stimuli may falter as top management is less concerned with organic bottom-up R&D but is dedicated to top-down justifying M&A rationales and economics, for example. Consequently, Upper Echelon is in danger of surrendering strategic control and getting trapped in the sprouting ‘comfort zone’ of financial control with potentially survival-threatening long-term consequences: A potentially reliable indicator for the ‘financial control trap’ is when bankers are increasingly present in Upper Echelon discussions, advocating acquisitions and divestitures as a basis to extend and modify the firm’s resource base. In contrast, the more team-members that are closely connected to resource markets at the firm’s ‘bottom’ are interacting with the board of directors – formally as well as informally – the less likely that ‘financial control’ will solely shape strategic considerations.

Ensuring a sustainable balance between strategic and financial control and avoiding the trap of ‘financial control’ are a mandate that the CEO-led executive leadership cannot be solely entrusted with. It is at this critical juncture that the board must exercise a meta-role supported by meta-capabilities to impose the firm as a generative model in form of top-down/bottom-up prediction error minimization governed by one simple first-order principle: free energy minimization. A firm’s sensing capability is only as good as dissonant market signals can challenge in real time the firm’s sensemaking models. And unless ‘language, communication, and social cognition’ (Helfat and Peteraf 2015) are geared toward change and innovation, resource reconfigurations may be impossible to realize, irrespective of the firm’s sensing and sensemaking capacity. Therefore, to effectively operationalize DC’s triplet of sensing, seizing, and reconfiguring, we need a model that dynamically links DC’s triplet with environment. This is Free Energy Governance’s underlying enactive inference: (1) active states (action/sensing), (2) sensory states (perception/sensemaking and seizing the opportunity), (3) internal states (firm resources/resource reconfiguration), and (4) external states (unknown/hidden) are all linked in circular causality, conditioned by the internal/external Markov blanket and governed by free energy minimization. Contrary to Birkenshaw et al.’s (2016: 36) view that “it is not possible to identify a universal set of dynamic capabilities”, Free Energy Governance establishes duality management as a universal dynamic board capability. The non-executive metamanagement of tension between interdependent (but mutually constitutive) logics (duality management) should be the very essence of the board’s strategic mandate in discontinuous and distributed markets. However, so far, DC’s cognitive focus remains firmly limited to the managerial level (Helfat and Peteraf 2015). Free Energy Governance extends DCV to the board level. More importantly, by adopting a free energy principle-powered perspective, the firm is redefined as an

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enactive inference machine. Successfully reconfiguring assets, as Helfat and Peteraf (2015) rightly identified, is a matter of communication and language. As assets are not only distributed beyond the firm’s traditional boundaries but are increasingly machine learning-powered, Upper Echelon is challenged to fundamentally reconfigure its organizational vocabulary in the first place in order to optimize the effectiveness of the human-machine interface. Free Energy Governance in form of enactive inference provides that language. A neuroscience-inspired perspective will further support duality management as a dynamic board capability. This leads us to the Antagonistic Neural Networks Perspective (ANNP).

8.2

Antagonistic Neural Networks Perspective (ANNP)

Advances in neuroscience research—modeling the brain as “intrinsically organized into dynamic, anti-correlated functional networks” (Fox et al. 2005)—offer a fertile perspective that can potentially enrich our understanding of the board’s unique (cognitive) role in strategic renewal. ANNP is established and applied as the neuroscientific basis for duality management: managing the existing while contradicting the present to develop the future. It is a form of organizational learning that strategic management literature has labeled ambidexterity (O’Reilly and Tushman 2008), co-managing exploitation and exploration. In neuroscientific terms, the antagonistic relationship is between two large-scale cortical networks—the task-positive network (TPN) and the default mode network (DMN)—which, simply put, are neuroanatomical representations of top management’s day-to-day task-specific focus on exploitation (TPN) on the one side and the rather non-routine divergent and creative thinking that initiates exploration and strategic renewal (DMN): The TPN is important for problem solving, focusing of attention, making decisions, and control of action. The DMN plays a central role in emotional self-awareness, social cognition, and ethical decision making. It is also strongly linked to creativity and openness to new ideas. (Boyatzis et al. 2014)

Both networks are antagonistic. They cannot be activated simultaneously, confirming that it is impossible ‘to redesign (exploration) the plane while flying it (exploitation)’. But this is exactly what today’s strategic renewal and, eventually, survival challenge is about. Neither structurally compartmentalizing nor intertemporal separation or simply leaving it to executive leadership can be the definite answers to addressing the TPN/DMN challenge. The very distributed and discontinuous nature of today’s market environments imposes strategic renewal as a continuous mandate. Therefore, an “over-emphasis on task-oriented leadership can prove deleterious to an organization: in particular when openness to new ideas, people, emotions, and ethical concerns are important to success” (Boyatzis et al. 2014). In fact, DMN may lay the neuroscientific foundation

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for innovative abduction: “Thus, our findings may indicate that individual creativity, as measured by the divergent thinking test, is related to the inefficient reallocation of attention, congruent with the idea that diffuse attention is associated with individual creativity” (Takeuchi et al. 2011). This dimension has been altogether ignored by the Attention-Based-View (ABV). The TPN/DMN antagonism—between task execution and explorative thinking— is a neurological representation of the contradictory demands that challenge corporate leadership as well as companies’ sustainable outperformance and survival. More specifically, it is this TPN/DMN antagonism that, according to the ambidexterity school in management science (O’Reilly and Tushman 2008), is best resolved through organizational compartmentalization, in particular, when innovation is of a discontinuous rather than incremental nature. However, O’Reilly and Tushman (2016) subsequently concluded that ‘to disrupt and lead’, “a strong separation between the past and the future can undermine the success of the new unit”. Indeed, “[e]xploration and exploitation function as complements in generating organizational performance” (Boumgarden et al. 2012), and a firm’s capability to cultivate real-time vacillation between exploitation and exploration depending on the very demands at a given point in time represents a source of competitive advantage. Laureiro-Martínez et al. (2015) provide further insight into the respective neural correlates: “Exploitation relies on brain regions associated mainly with anticipation of rewards; exploration depends on regions associated mainly with attentional control”. Their research is dedicated to demonstrating that “superior decisionmaking performance relies on the ability to sequence” and “recognize when to switch”. But here exploitation and exploration activities remain ‘separated’, and Upper Echelon ‘switch-decisioning’ remains both a bottleneck and a black box. Laureiro-Martínez and Brusoni (2018) subsequently introduced the concept of ‘cognitive flexibility’. However, any conceptualization of flexibility or agility must be operationalized beyond top-down only ‘controlled’ decision-making processes. FEG is firmly rooted in the belief that in a discontinuous and distributed world the marginal benefit of structural reorganizations as well as structural compartmentalization of exploitation and exploration are rather suboptimal or possibly counterproductive. Competitiveness and survival are increasingly determined by the extent to which a system is rather less rule- or top-down ‘supervised learning’-based. Exploration happens increasingly in real time within exploitation. In effect, “the emergence of the ‘new’ is essentially hypothesis testing within the existing” (Khezri 2021). In distributed and discontinuous market environments, the real leadership challenge is to ‘de-antagonize’ the TPN/DMN dichotomy in form of duality management. Resolving the TPN/DMN challenge is rather difficult to conceive without a unitary framework such as FEG: integrating in circular causality top-down/bottom-up connectivity (structure), action-centric enactment of environment (cognition), and duality management as a meta-TPN/DMN Upper Echelon capability (capabilities). Once the TPN/DMN antagonism is conceived as a ‘free energy minimization’ challenge rather than one of top-down directed ‘division-of-labor switching’, it becomes obvious that today’s entrenched models of organizing are highly entropy-bound.

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In discontinuous market environments, the source of competitive advantage is determined by self-organizing first-order principles linking in circular causality top-down/bottom-up sensing, sensemaking, and asset reconfiguration: Free Energy Governance. A distinctive feature of FEG is to explicitly embrace the firm’s formal as well as informal organizations as equally relevant to message-passing and belief propagation. “There is a close link between formal and informal organization—formal organization affects informal organization via its effects on who interacts with whom” (Gulati and Puranam 2009). Hence, redefining the formal role of the board is critical to the informal processes resulting from it. A new (organizational rather than just corporate) governance framework is required to resolve the TPN/DMN antagonism. FEG’s cross-hierarchical connectivity logically concludes that managing the TPN/DMN antagonism is not a top-down challenge calling for structural compartmentalization but one of duality management: “By vacillating between (or among) discrete formal organizational modes such as centralization and decentralization, the organization may increase dynamically the levels of exploration and exploitation beyond those achievable through an approach based strictly on a static design choice” (Boumgarden et al. 2012). In summary, we must conceive organizing as an informally deep learning and self-designing compass. Centralizing intelligence—at any hierarchical layer of the organization—can be counterproductive, increasing free energy, promoting entropy, and eventually capitulating to TPN/DMN’s antagonistic forces. In essence, the governance response to the TPN/DMN challenge is threefold: 1. Sensitizing the entire organization in regard to Upper Echelon’s tendency to top-down extrapolating its dominant (supervising) knowledge structures, logics, and past experience as guide and predictor for future success; a fallacy that taskspecific exploitation tends to reinforce (McKenzie et al. 2009). 2. Embracing strategic renewal as a matter of continuous deep learning in form of cultivating cross-hierarchical processes empowering purpose-directed and actiongenerated bottom-up market stimuli as a basis for ‘double-loop learning’ (question the very models that generate top-down predictions). 3. Developing abductive attentional engagement at every level of the organization forms the basis for effective top-down/bottom-up prediction error minimization. After “noticing an environmental change”, it is essential “to question [one’s] understanding of how the subsystems of the environment (e.g., technology and markets) and the organization (e.g., knowledge and goals) are linked” (Shepherd et al. 2017) without losing sight of the fact that environment is not objectively defined but a product of action-generated and socially constructed (shared) meaning and expectations. The more experience a person has the more they are able to provide quick and plausible explanations for combinations of circumstances (Isenberg, 1986). Unfortunately, in complex situations with many interconnected variables, it is often the small details at the periphery, the weak signals that radically affect how a scenario plays out (Ansoff, 1975). These are the

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Indeed, it is a salience trap. While salience is critical to enactive inference, it can nonetheless potentially increase free energy. To empower abductive sensemaking so that weak signals can serve as an information-rich enhancement to predictions processing—listening to what wants to emerge—organizational design is challenged to neutralize the tendency of experienced managers and board members to overconfidently superimpose the potential fallacy of their historic and self-confidence powered pattern recognition. Since the human brain’s TPN and DMN spheres are antagonistically related, the only way to embrace antagonism as duality is by linking in circular causality top-down predictions and bottom-up stimuli. Indeed, this ‘real-time switching/vacillation process’ cannot be relegated to a single person (e.g., CEO or Executive Chairman) or Upper Echelon as a team but must be the result of an un-supervised and FEP-determined learning process that relates top-down predictions and bottom-up data input in circular causality to dictate resource reconfiguration accordingly. Consequently, the board’s potentially unique DMN dimension cannot be ignored but must be integrated into this process. At the very top, the board of directors—given its cognitive diversity in composition and cognitive distance to the firm’s dominant TPN exploitation logics—emerges as a monitoring surveyor of a system that is centered around managing the dynamic interplay of dual forces (exploitation/exploration and financial/strategic control). The board’s traditional monitoring and advisory roles must be explicitly complemented with a ‘duality (TPN/DMN) monitoring/management’ mandate. Traditional corporate governance models have emphasized the board’s TPN dimension rather than DMN-centric dimensions. It is the TPN/DMN (vacillation) challenge that further reinforces the call for a new governance approach that is less concerned with the contents of strategy but dedicated to unsupervised learning processes fostering purpose-directed top-down/bottom-up surprise minimization in pursuit of firm survival. The board’s dynamic capability in form of duality management lays the foundation for the board’s newly established governance purpose: duality stewardship. Once the board embraces the firm as a free energy principlepowered generative model and assumes its DMN-centric responsibility to enforce self-organization by way of enactive inference, the firm’s prospects for survival are most likely optimized.

References Anderson, M.L. 2014. After Phrenology: Neural Reuse and the Interactive Brain. Cambridge, MA: MIT Press. Birkenshaw, J., A. Zimmermann, and S. Raisch. 2016. How do firms adapt to discontinuous change? California Management Review 58: 36–58. Boumgarden, P., J. Nickerson, and T.R. Zenger. 2012. Sailing into the wind: Exploring the relationships among ambidexterity, vacillation, and organizational performance. Strategic Management Journal 33: 587–611.

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Boyatzis, R.E., K. Rochford, and A.I. Jack. 2014. Antagonistic neural networks underlying differentiated leadership roles. Frontiers in Human Neuroscience 8 (114): 1–15. Cameron, K., and R. Zammuto. 1983. Matching managerial strategies to conditions of decline. Human Resource Management 22: 359–375. Eisenhardt, K.M., and J. Martin. 2000. Dynamic capabilities: What are they? Strategic Management Journal 21: 1105–1121. Farjoun, M. 2002. The dialectics of institutional development in emergent and turbulent fields: The history of pricing conventions in the on-line database industry. Academy of Management Journal 5: 848–874. ———. 2010. Beyond dualism: Stability and change as a duality. Academy of Management Review 35: 202–225. Fox, M.D., A.Z. Snyder, J.L. Vincent, M. Corbetta, D.C. Van Essen, and M.E. Raichle. 2005. The human brain is intrinsically organized into dynamic, anticorrelated functional networks. Proceedings of the National Academy of Sciences 102: 9673–9678. Gulati, R., and P. Puranam. 2009. Renewal through reorganization: The value of inconsistencies between formal and informal organization. Organization Science 20: 422–440. Helfat, C.E., and M.A. Peteraf. 2015. Managerial cognitive capabilities and the microfoundations of dynamic capabilities. Strategic Management Journal 36: 831–850. Helfat, C.E., S. Finkelstein, W. Mitchell, M.A. Peteraf, H. Singh, D. Teece, and S.G. Winter. 2007. Dynamic Capabilities: Understanding Strategic Change in Organizations. Malden, MA: Blackwell. Hitt, M.A., R.E. Hoskisson, R.A. Johnson, and D.D. Moesel. 1996. The market for corporate control and firm innovation. The Academy of Management Journal 39: 1084–1119. Khezri, D.B. 2021. Free Energy Governance - Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival. dissertation. Zug: KCRI (Khezri Capital Research International) AG. https://www.alexandria.unisg.ch/262427/1/Dis5052.pdf. Laamanen, T., and J. Wallin. 2009. Cognitive dynamics of capability development paths. Journal of Management Studies 46: 950–981. Laureiro-Martínez, D., and S. Brusoni. 2018. Cognitive flexibility and adaptive decision-making: Evidence from a laboratory study of expert decision makers. Strategic Management Journal 39: 1031–1058. Laureiro-Martínez, D., S. Brusoni, N. Canessa, and M. Zollo. 2015. Understanding the explorationexploitation dilemma: An fMRI study of attention control and decision-making performance. Strategic Management Journal 36: 319–338. McKenzie, J., N. Woolf, C. van Winkelen, and C. Morgan. 2009. Cognition in strategic decision making: A model of non-conventional thinking capacities for complex situations. Management Decision 47: 209–232. O’Reilly, C.A., and M.L. Tushman. 2008. Ambidexterity as a dynamic capability: Resolving the innovator’s dilemma. In Research in Organizational Behavior, ed. B.M. Staw and A.P. Brief, 185–206. Bingley: Emerald Group. ———. 2016. Lead and Disrupt: How to Solve the Innovator’s Dilemma. Stanford, CA: Stanford University Press. Oehmichen, J., M.L.M. Heyden, D. Georgakakis, and H.W. Volberda. 2017. Boards of directors and organizational ambidexterity in knowledge-intensive firms. International Journal of Human Resource Management 28: 283–306. Pavlou, P.A., and O.A. El Sawy. 2011. Understanding the elusive black box of dynamic capabilities. Decision Sciences 42: 239–273. Putnam, L.L., G.T. Fairhurst, and S.G. Banghart. 2016. Contradictions, dialectics, and paradoxes in organizations: A constitutive approach. Academy of Management Annals 1: 65–171. Schad, J., M.W. Lewis, S. Raisch, and W.K. Smith. 2016. Paradox research in management science: Looking back to move forward. The Academy of Management Annals 1: 5–64. Schmitt, A., V.L. Barker, S. Raisch, and D. Whetten. 2016. Strategic renewal in times of environmental scarcity. Long Range Planning 49: 361–376.

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Shepherd, D.A., J.S. McMullen, and W. Ocasio. 2017. Is that an opportunity? An attention model of top managers’ opportunity beliefs for strategic action. Strategic Management Journal 38: 626–644. Smith, W.K., and M.W. Lewis. 2011. Toward a theory of paradox: A dynamic equilibrium model of organizing. The Academy Management Review 36: 381–403. Sundaramurthy, C., and M.W. Lewis. 2003. Control and collaboration: Paradoxes of governance. Academy of Management Review 3: 397–415. Takeuchi, H., Y. Taki, H. Hashizume, Y. Sassa, T. Nagase, R. Nouchi, and R. Kawashima. 2011. Failing to deactivate: The association between brain activity during a working memory task and creativity. Neuroimage 55: 681–687. Teece, D. 2007. Explicating dynamic capabilities: The nature and microfoundations of sustainable enterprise performance. Strategic Management Journal 28: 1319–1350. Vogel, R., and W.H. Guettel. 2013. The dynamic capability view in strategic management: A bibliometric review. International Journal of Management Reviews 15: 426–446. Wurtzel, A. 2012. Good to Great to Gone: The 60 Year Rise and Fall of Circuit City. New York City: Diversion Books.

Chapter 9

Laying the Foundation for a Self-Organizing (Autopoietic) Governance Logic

Abstract Beneath all chaos is an underlying structure. Our challenge is to exploit disorder’s underlying order. To survive, living organisms are encoded to resist disorder, i.e., entropy, by way of self-organization. Firms are nothing more than molecules and are subject to obeying the very same laws of thermodynamics: entropy will eventually rise. Three specific propositions, previously developed as part of this book’s underlying dissertational research, are outlined: (1) STRUCTURE: The stronger a firm’s cross-hierarchical top-down/bottom-up cognitive (throughput) coupling between and within governance and operational channels, the less dominant a firm’s top-down approach cultivating a form of CEO-centrism in strategy ownership. (2) COGNITION: The stronger a firm’s cognitive disposition toward environmental enactment and innovative abduction as opposed to adaptation, the stronger the firm’s strategic control, and the smaller the risk of falling for the financial control trap. (3) CAPABILITIES: The stronger the board’s DMN-centric ‘duality stewardship’ empowering Upper Echelon to sustainably balance exploitation vs. exploration as well as financial vs. strategic control, the stronger the sustainability of successful and continuous strategic renewal and, hence, the firm’s prospects for survival. Strategy is less macroscopic but more subatomic, less linear and determnistic, but more quantum and discontinuous. There is a dominant tendency of glorifying the ‘realist’ beauty of top-down linear cause-effect relationships to the very detriment of (quantum) self-organization.

Free Energy Governance (FEG) is the opening chapter of a new generative logic of self-organization establishing a number of categorical imperatives guiding outperformance and survival in random (entropic) market environments: The fact is, order anywhere in the cosmos is so singular, it always requires an explanatory mechanism or process, while randomization requires no elucidation – it is simply the way of the world. When particles are allowed to act randomly, whether as the contents of a glass of club soda on the rocks or the countless atoms making up the air in the room, they slam into each other, exchanging energy until complete randomization of their positions and velocities is observed. (Lanza et al. 2020)

Whether in business or (geo) politics, humanity is trapped in the belief that order is the norm. To no avail, we keep looking for top-down supervision to impose order © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_9

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to support the system’s resistance to disorder in its pursuit of non-equilibrium steady states (NESS). Prediction error minimization ‘cuts out the supervision middleman’ and empowers ‘the perceptual content given in our predictions’ to ‘allow the world to deliver a supervisory signal’ (Hohwy 2013). Beneath all chaos is an underlying structure. Our challenge is to exploit disorder’s underlying order. To survive, living organisms are encoded to resist disorder, i.e., entropy, by way of self-organization. Firms are nothing more than molecules and are subject to obeying the very same laws of thermodynamics. There is no escaping from thermodynamics’ second law—entropy will eventually rise: If physical theories were people, thermodynamics would be the village witch. Over the course of three centuries, she smiled quietly as other theories rose and withered, surviving major revolutions in physics, like the advent of general relativity and quantum mechanics. The other theories find her somewhat odd, somehow different in nature from the rest, yet everyone comes to her for advice, and no-one dares to contradict her. Einstein, for instance, called her ‘the only physical theory of universal content, which I am convinced, that within the framework of applicability of its basic concepts will never be overthrown.’ Her power and resilience lay mostly on her frank intentions: thermodynamics has never claimed to be a means to understand the mysteries of the natural world, but rather a path towards efficient exploitation of said world. (Goold et al. 2016; emphasis by DBK)

To successfully exploit the dynamics of a given disorder requires less top-down Upper Echelon intervention but more focus on empowering unsupervised selforganization. The circular coupling of governance (predictions) and operational (stimuli) channels in form of prediction error minimization (structure), environmental engagement in form of enactment rather than adaptation (cognition), and sensing and sensemaking (capabilities) in form of duality management are the very building blocks of Free Energy Governance as a generative model of the firm and its eco-niche. FEG endows the firm to exploit the value creation potential that discontinuous environments behold. FEG empowers transitions “from states of ignorance to states of insight” (Friston et al. 2017). FEG is a world-disclosing perspective powered by one categorical imperative: the resolution of equivocality (or VUCA) through purpose-directed, curiosity-driven, and action-centric prediction error minimization. Eventually, the essence of firm outperformance and survival is best captured in one simple and self-evidencing maxim: free energy minimization by way of prediction error minimization. In analogy to Goold’s (2016) statement, FEG is not “a means to understand the mysteries” but provides “a path towards efficient exploitation of said world”. In the following, specific propositions are presented which were previously developed and applied as part of this book’s underlying dissertational research. It is left to the individual reader to test the propositions’ relevance within one’s very proprietary context. Proposition 1: Structure Cognitive coupling of governance and operational channels—formally and informally—ensures that dissonant signals can travel frictionless from the field level to Upper Echelon and generatively challenge top-down predictions and underlying prediction models. The higher the organizational friction in terms of obstructing bottom-up error messages traveling to and reaching top-down prediction generators,

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the higher free energy (the potential for surprise), and the more likely that top-down dominant logics fossilize prediction models and, hence, reinforce a firm’s entropy. The inter- as well as intra-hierarchical circular connectivity facilitating top-down belief propagation (predictions) and bottom-up message passing (stimuli) lays the foundation for generative and unsupervised self-organization. The board of directors’ effective impact upon strategic renewal—actually, the impact of any organizational member—is critically determined by the cognitive coupling of governance and operational channels: a firm where executive leadership is emphasizing a top-down approach cultivating a form of CEO-centrism in strategy ownership, for example, the governance and operational channels are unlikely to be coupled for the purposes of free energy minimization. Bottom-up message passing is likely prone to be suffocated by overdominant top-down belief propagation. Consequently, it is just a matter of time for firm survival to be at risk: The stronger a firm’s cross-hierarchical top-down/bottom-up cognitive (throughput) coupling between and within governance and operational channels, the stronger the firm’s orientation toward free energy (surprise) minimization based self-organization, the less dominant a firm’s top-down approach cultivating a form of CEO-centrism in strategy-ownership, the stronger the sustainability of successful and continuous strategic renewal and, hence, the firm’s prospects for survival.

Proposition 2: Cognition Cognition in form of world enactment is the purposedirected, action-centric, and social construction of ‘shared meaning’ and ‘shared expectations’, anchored in the understanding that a firm’s environment is a matter of environmental engagement in form of interaction revealing ‘significance’ and assigning probabilities to a bounded set of external (unknown) states. It is that distinctive selection/retention process—anchored in top-down/bottom-up prediction error minimization—which creates a unique generative interpretation model, i.e., the firm’s eco-niche, as a basis for firm outperformance and survival. Environmental enactment is not about inventing reality. In fact, there are at least as many environments as there are economic actors. In a world where technology cost-effectively empowers exponential growth in energy exchanges rendering the web of relations and interactions correspondingly more complex, discontinuities are naturally the new normality. Classical linear cause-effect thinking is no match for quantum exponentiality. Indeed, the wonderful organizational artefacts that the brain’s prefrontal cortex has empowered Upper Echelon to mechanistically design to perfection and impose upon its members, are struggling in quantum environments. The firm’s generative model is the firm’s eco-niche. If uncertainty and unpredictability dominate our worldly perception, well, then this reflects the very limitations and corrosiveness of our models and the underlying processes generating those models. There is no objective uncertainty. There is only your uncertainty. Environment is enacted: each act opens to a new fork of multiple paths leading to potentially very different outcomes. Reality is a subjective algorithm implying an infinite number of worlds—in superposition. Our actions not only create the junctures leading to different paths, but we are in control to decide which path to take at each juncture.

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Those who are overwhelmed by ambiguity and uncertainty have disengaged from the action-centric crafting of their very own destiny. In fact, we are challenged not to allow for the human brain’s computational limits to solely determine perception and sensemaking. Instead, outsourcing some of the ‘heavy information lifting’ to the environment in form of extended cognition is the essence of optimizing predictionerror-minimization. The more exponential and, hence, discontinuous a market environment, the more we need self-organizing mechanisms that leverage the world as a supervisory signal challenging in circular causality the very perceptual content of our predictions. A firm’s cognitive disposition toward environmental enactment rather than adaptation—i.e., embracing the world through the Markovian veil as a purpose-directed, curious, and action-centric ‘holder of a light torch in the dark’ seeking to reveal significance in equivocality—is fundamentally a matter of free energy minimization. Revealing (enacting) environmental significance is action-generated and socially constructed at the firm level. The ‘torch’ is fundamentally guided by a Markov blanket—our internal assignment of probabilities upon a bounded (most likely) set of hidden (unknown) external states. Our interactions generate evidence allowing us to generatively ‘upgrade’ (enhance precision of) that probability assignment. Determining the significance and overall relevance of environmental signals is a function of the firm’s explainability and consistency of purpose, predictions, and underlying prediction models. However, the ultimate organizational power is when non-salient but potentially transformative/dissonant signals can be amplified, i.e., given significance, as they travel bottom-up through the organization to be made available for Upper Echelon sensemaking, error-minimization, and double-looplearning. Fundamentally, it is about continuously opening the firm’s channels of listening, in particular listening to what wants to emerge (Scharmer 2018). A company that embraces the identity and action agenda of a ‘fast and smart follower’ (a ‘realist’) is unlikely to engage in innovative abduction as a basis for creating new market opportunities by way of product as well as business model innovation (Gassmann et al. 2020). The relentless pursuit of adaptation will likely result in incapacitation of strategic control, foster financial control, and, consequently, will lead to surprise at the potential expense of firm survival: The stronger a firm’s cognitive disposition towards environmental enactment and innovative abduction as opposed to adaptation, the stronger the firm’s orientation towards free energy (surprise) minimization based self-organization, the stronger the firm’s strategic control and the smaller the risk of falling for the ‘financial control trap’, the stronger the sustainability of successful and continuous strategic renewal and, hence, the firm’s prospects for survival.

Proposition 3: Capabilities TPN/DMN duality management is the cognitive microfoundation of dynamic board capabilities. Exploitation vs. exploration and financial vs. strategic control are two essential dualities that shape the initiation and sustainability of strategic renewal pathways. Rather than conceiving the board of directors just as a monitoring, advisory, or boundary-spanning meta-appendix to the organization, the board must embrace DMN-centric duality management as a critical responsibility complementing TPN-centric top executive leadership. In the absence of embracing

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governance as a TPN/DMN duality management challenge, the board of directors is likely to be reduced to a rear mirror-trapped, reactive monitoring body, overly concerned with board effectiveness and financial control instead of continuous strategic renewal as a basis for firm outperformance and survival. Consequently, the board of directors is at risk to be relegated to strategic irrelevance or, possibly worse, a source of entropy-bound inertia. While duality management capabilities are not strictly limited to the board and while they are equally critical capabilities at the top and middle management levels, the board of directors, due to its cognitive distance to TPN-centric exploitation logics, is best positioned to assume this duality stewardship role. An overemphasis on external innovation and growth (e.g., by way of M&A and joint ventures) is likely to weaken the focus on internal R&D and eventually compromises the firm’s strategic control and consequently survival. Therefore, DMN-centric duality management is critical for success of continuous ‘wholesale renewal’. Essentially, the board’s sensing and sensemaking capabilities must ensure that executive leadership’s dominant and exploitation-centric logics, as expressed in predictions and underlying prediction models, remain challenged by bottom-up resource market stimuli to optimally balance exploitation/exploration and financial/strategic control. The board is the purveyor and surveyor of the firm’s generative model, empowering self-organization by way of free-energy minimization: The stronger the board’s DMN-centric ‘duality stewardship’ empowering Upper Echelon to sustainably balance exploitation vs. exploration as well as financial vs. strategic control, the stronger the firm’s orientation towards free energy (surprise) minimization based self-organization, the stronger the sustainability of successful and continuous strategic renewal and, hence, the firm’s prospects for survival.

In summary, the board must assume the role of sponsor (or enforcer) of three categorical imperatives defining the success and sustainability of strategic renewal and firm survival: (1) Foster cognitive coupling between and within all hierarchical layers: Process follows structure, and strategy follows process (structure). (2) Embrace environment as action-generated and socially constructed ‘shared meaning’ and ‘shared expectations’: Environment must be enacted as a matter of purpose-directed revealing of significance and valence rather than taken as an exogenously given object awaiting top-down-directed adaptation. Nothing exists in the absence of a relation and interaction with its external world and we are in control of selecting relations and actions (cognition). (3) De-chain the firm from thinking in terms of antagonisms, but embrace real-time duality management as a critical determinant of performance and survival: Exploration vs. exploitation as well as financial vs. strategic control, respectively, do not co-exist but form a mutually reinforcing real-time duality. We are challenged to embrace the world’s interdependently opposing forces less as paradox but as dualities in synchronicity (capabilities). In sum, [move] beyond the old doctrine of strategy, structure, and systems to a softer, more organic model built on the development of purpose, process, and people [. . .] Before senior

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Strategy is less macroscopic but more subatomic, less linear and deterministic but more quantum and discontinuous. Our hierarchical model (structure), our conception of reality construction (cognition), and the firm’s capability to empower interdependencies not as opposing forces but dualities (capabilities) will determine the success of strategic renewal and, ultimately, the survivability of the very firm the board of directors has been entrusted to govern. To date, neither strategy process nor corporate governance research has developed a cross-hierarchical framework to match the very demands for continuous strategic renewal in an increasingly distributed and discontinuous world. There are many possible reasons for this shortfall. But above all, it is this dominant tendency— as much in the world of practice as in academic research—of glorifying the ‘realist’ beauty of top-down linear cause-effect relationships that crowds out quantum selforganization.

References Bartlett, C., and S. Goshal. 1994. Changing the role of top management: Beyond strategy to purpose. Harvard Business Review 72 (6): 79–88. Friston, K.J., M. Lin, C.D. Frith, G. Pezzulo, J.A. Hobson, and S. Ondobaka. 2017. Active inference, curiosity and insight. Neural Computation 29: 2633–2683. Gassmann, O., K. Frankenberger, and M. Choudury. 2020. The Business Model Navigator: The Strategies Behind the Most Successful Companies. Harlow (UK): Pearson. Goold, J., M. Huber, A. Riera, L.d. Rio, and P. Skrzypczyk. 2016. The role of quantum information in thermodynamics—A topical review. Journal of Physics A: Mathematical and Theoretical 49: 1–50. Hohwy, J. 2013. The Predictive Mind. Oxford: Oxford University Press. Lanza, R., M. Pavšič, and B. Berman. 2020. The Grand Biocentric Design: How Life Creates Reality. Dallas, TX: BenBella Books. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers.

Part III

Conclusion

Designers who erect an organizational palace had better anticipate problems caused by shifting subsoils. [. . .] pursuing stability and avoiding uncertainty interfere with an organization’s [. . .] survival. Residents of changing environments need a tent. [. . .] an organizational tent neither asks for harmony between the activities of different organizational components, nor asks that today’s behavior resemble yesterday’s or tomorrow’s. Those who live in an organizational tent [. . .] invent sensors for alerting themselves to significant events, and ceaselessly question their present assumptions and habits (Landau, 1973). They remain ready to replace old methods, and they discard even adequate old methods in order to try new ones, looking upon each development as an experiment that suggests new experiments. [. . .] They regard their organization as a means, not an end (White, 1969). They avoid anchoring their satisfactions in the roles and procedures. [They] draw satisfactions from the skills and relationships that contribute to processes— the processes generating the organization to come. The desired balance can be caricatured with six aphorisms: (1) cooperation requires minimal consensus; (2) satisfaction rests upon minimal contentment; (3) wealth arises from minimal affluence; (4) goals merit minimal faith; (5) improvement depends on minimal consistency; and (6) wisdom demands minimal rationality. —Hedberg et al. (1976)

Reference Hedberg, B. L. T., Nystrom, P. C., and Starbuck, W. H. 1976. Camping on seesaws: Prescriptions for a self-designing organization. Administrative Science Quarterly, 21: 41–65.

Chapter 10

Free Energy Governance vs. Traditional Corporate Governance

Abstract Through the lens of the theoretical concepts developed in this book, FEG and traditional corporate governance (TCG) are assessed in comparative perspective. TCG models are predominantly characterized by a compliance mentality centered around board effectiveness as a matter of managing (agency) conflicts of interests through optimizing stereotypical board diversity and enforcing director independence. FEG introduces a radically new logic exercising the ‘corporate wholesale reinvention’ that strategic renewal is now imposing. Indeed, any such juxtaposition of two governance logics can hardly escape the accusation of oversimplification. However, once we embrace the world as discontinuous and distributed, we start understanding that today’s entrenched corporate governance approaches are a ‘low-scale, low-leverage legacy business’, breeding inertia. Public policy prescribed ‘best practices’ guiding corporate governance is an anachronism of modern business, reinforcing Upper Echelon’s risk-averseness (i.e., compromising epistemic foraging) and, consequently, entrapment in the incapacitating perception of the world as VUCA (volatile, uncertain, complex, and ambiguous). FEG embraces any dimension of VUCA as informationrich input for top-down/bottom-up prediction error minimization in pursuit of minimizing surprise. An overreliance on CEO-framed information flows and analysis, which is so characteristic of TCG, is as good as flipping a coin: the very processes that explain success equally breed failure.

Through the lens of the theoretical concepts developed in this book, we must eventually reckon the governance revolution that is calling upon us to set free the full potential of the social action field that continues to be called, rather archaically, a firm, implying something solid, unyielding, and unlikely to change. Traditional corporate governance (TCG) models (for an overview, see Hilb 2012) are essentially characterized by a compliance mentality centered upon managing (agency) conflicts of interests by way of optimizing stereotypical board diversity and enforcing director independence. Indeed, among TCG models, there is a range of types of boards, varying in degrees from shareholder value to stakeholder centrism, from predominantly unitary to dual structures (e.g., Germany), and from collaborative (stewardship) to control (agency) orientation:

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We apply agency and stewardship theories to detail contrasting, yet potentially complementary, approaches to governance. Rooted in economics and finance, agency theory informs a control approach aimed at curbing self-serving behaviors of managers (agents) that may negatively impact owners’ (principals) wealth (Eisenhardt, 1989). Stewardship theory details a collaborative approach, tapping insights from sociology and psychology. Proponents of this approach strive to enhance board-management ties and decision making by empowering managers (stewards) of the firm. (Sundaramurthy and Lewis 2003)

Free Energy Governance (FEG) introduces a radically new logic. FEG represents a logical match to the ‘corporate wholesale reinvention’ that strategic renewal is now imposing: “more caterpillar-to-butterfly process, moving gracefully from one way of working to an entirely new one, replacing corporate body parts and ways of functioning completely in some cases to capture far more value than was possible using low-scale, low-leverage legacy business” (Siebel 2019; quoting Hinchcliffe, D. on distinguishing digitization from digital transformation). Table 10.1 summarizes FEG vs. TCG and highlights the very new dimensions along which a governance model should be assessed. Indeed, any such juxtaposition of two governance philosophies or logics can hardly escape the accusation of oversimplification. But then, we only crystalize the ‘spectrum of truth’ through extremes. Once we embrace the world as discontinuous and distributed—mandating continuous strategic renewal—and once we define strategy process as top-down/bottom-up prediction error minimization in pursuit of surprise minimization, we start understanding that today’s entrenched corporate governance approaches are a ‘low-scale, low-leverage legacy business’. This is in particular true when we consider the very absence of deep purpose (Gulati 2022) that a majority of business enterprises is struggling with. Without deep purpose, predictions-processing is nonsensical. TCG has entirely ignored the existential importance of deep purpose as integral to the governance mandate. Deep purpose is not top-down imposed but discovered from within—top-down/bottom-up—and must be continuously reinterpreted over time. The board must be the sponsor and guarantor of this process. In physics, the world is divided into those (realists) who firmly believe that “there is a real world out there, whose properties in no way depend on our knowledge or perception of it” (Smolin 2020) and those who “believe that the properties we ascribe to atoms and elementary particles are not inherent in those objects, but are created only by our interactions with them, and exist only at the time when we measure them”. Equally, entrenched governance models are trapped in the ‘realist’ logic that environment is ‘out there’ to be analyzed and adapted to rather than being en-acted through ‘real-world’ relations and inter-actions. Classical physics considers the latter position as fundamentally ‘antirealist’. Indeed, Free Energy Governance is fundamentally ‘antirealist’. Being ‘antirealist’ is the essence of competitive advantage in a discontinuous and distributed world and lays the foundation for self-organization. The internal logic of the Free Energy Governance framework should be freestanding as both a new logic of organizing as well as an early-warning system predicting entropic decay putting firm survival eventually at risk. Indeed, “the grander the theoretical claims, the more free-standing the theory has to be. In other words, even if a reader were only to read the conceptual part of the paper, he or she would be convinced of the internal logic of the conceptual argument” (Siggelkow 2007). The free energy principle is a first-order principle underlying self-organization. Free Energy Governance is empowering continuous strategic renewal as a matter of

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Table 10.1 FEG vs. TCG models Logic Structure (hierarchy)

Process Capabilities Dominant neural network Learning Performance metric Performance variables

Corporate Purpose Control Environmental engagement Digital transformation Strategic renewal Machine learning logic

Governance Mandate [achieved by way of]

Free Energy Governance (FEG) Top-down/bottom-up (top-down ‘belief propagation’ and bottom-up ‘message-passing’ in circular causality) Generative (continuous) Meta/dynamic (cognitive) DMN-centric Double-loop Minimizing prediction error to minimize surprise Structure (top-down/bottom-up connectivity), cognition (environmental enactment), and capabilities (duality management) Existential and axiomatically integral to the free-energy minimizing governance mandate Strategic/financial (duality) Co-creation (enactment) Wholesale reinvention (holistic) Autonomous (proactive, top-down and bottom-up stimuli/message-passinginspired) Free energy minimization (optimizing first-order principle of ‘least action’ to resist dissipation to persist) Continuous strategic renewal/firm outperformance/firm survival [optimizing (1) governance/operational coupling, (2) environmental enactment, and (3) dynamic duality management of exploration and exploitation as well as financial and strategic control—all powered by free energy minimizing enactive inference]

Traditional Corporate Governance (TCG) Top-down (unidirectional Upper Echelon ‘belief propagation’) Static (agenda-driven) Operational (domain-centric) TPN-centric Single-loop Regulatory compliance and board effectiveness (‘best practices’) Board composition (domain expertise, diversity, network)

Diffuse and opportunistic with no relevance to governance Financial Co-alignment (adaptation) Selective transformation (domainspecific) Induced (reactive, top-down CEO belief propagation-driven) Supervised/rule-based (maximizing pre-determined reward functions)

Regulatory compliance/board effectiveness/firm performance [monitoring, advising, challenging, boundary-spanning (networking)— all guided by CEO-centric and principally Upper Echelon-dominated frames]

unsupervised self-organization. Therefore, survival is essentially about bottom-up and purpose-directed selecting and empowering of stimuli/signals to challenge topdown predictions and underlying prediction models, in circular causality. Error and surprise are information-rich and should feed predictions processing in real-time: “pursuing stability and avoiding uncertainty interfere with an organization’s [. . .]

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survival” (Hedberg et al. 1976). To minimize surprise, one must actively seek it in the first place by way of epistemic foraging. Public policy prescribed best practices guiding corporate governance is an anachronism of modern business, reinforcing Upper Echelon’s entrapment in the incapacitating perception of the world as VUCA (volatile, uncertain, complex, and ambiguous). Free Energy Governance embraces any dimension of VUCA as information-rich input for top-down/bottom-up prediction error minimization in pursuit of minimizing surprise. An overreliance on CEO-framed information flows and analysis, which is so characteristic of TCG, is as good as flipping a coin: the very processes that breed success equally breed failure.

References Gulati, R. 2022. Deep Purpose: The Heart and Soul of High-Performance Companies. New York: HarperCollins Publishers. Hedberg, B.L.T., P.C. Nystrom, and W.H. Starbuck. 1976. Camping on seesaws: Prescriptions for a self-designing organization. Administrative Science Quarterly 21: 41–65. Hilb, M. 2012. New Corporate Governance. Successful Governance Tools. 4th ed. Heidelberg: Springer. Siebel, T.M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: RosettaBooks. Siggelkow, N. 2007. Persuasion with case studies. Academy of Management Journal 50: 20–24. Smolin, L. 2020. Einstein’s Unfinished Revolution: The Search for What Lies Beyond the Quantum. New York: Penguin Press. Sundaramurthy, C., and M.W. Lewis. 2003. Control and collaboration: Paradoxes of governance. Academy of Management Review 3: 397–415.

Chapter 11

Implications for Management Practice

Abstract ‘How can one possibly redefine the board’s strategic meta-role when traditional governance modes are so ubiquitously entrenched and cognitive capabilities so poorly developed or non-manifest?’ To be practice-relevant, theory must be intuitive and inspire Upper Echelon questioning its very Habits of Mind. To conceive strategic renewal as a continuous and generative process of top-down predictions/ bottom-up stimuli surprise minimization urges Upper Echelon to consequently optimize the multi-intelligent sources of stimuli, redesign processes as well as incentive structures, and develop a new language to empower enactive inference. Indeed, to date, corporate governance research and practice are more concerned with defining behavioral responsibilities rather than addressing its very capability needs. There is no ‘one size fits all’ best-practices-catalogue, but FEG’s nexus of structure, cognition, and capabilities provides the building blocks for a fundamentally new governance logic. In a discontinuous world, the essential governance challenge is to ensure the selforganizing optimization of top-down/bottom-up prediction error minimization: learning to infer. Once we embrace FEG as a novel organizational framework and early detector of a firm’s impending entropic decay, we must reckon that unless replaced with a FEG-inspired logic, TCG is likely to continue relegating the board of directors to strategic irrelevance, reinforce financial control at the expense of strategic control, prioritize top-down content over top-down/bottom-up process, cultivate inertia, and inhibit the full growth and survival potential of firms as self-organizing systems.

The relevance of theory to the practice of stategy management and governance is essentially determined by three dimensions. Theory must: • Be intuitive as well as ‘problem- or opportunity-driven’ (Corley and Gioia 2011). • Establish new metaphors or give new meaning to existing language that empowers purposeful sensing, sensemaking, and strategic renewal.

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• Inspire Upper Echelon questioning its very Habits of Mind, i.e., provide a new and enriching perspective around ‘doing things differently’. Theory building is also a product of its time: “identify domains that will soon be in need of theorizing” (Corley and Gioia 2011). Accelerating disintermediation, decentralization, and de-/re-localization demand a new (and intuitive) logic of organizing. To conceive strategic renewal as a continuous and generative process of top-down predictions/bottom-up stimuli error/surprise minimization is a novel framework urging Upper Echelon to consequently redesign processes, incentive structures, language, and communication. Free Energy Governance provides rich and new meaning to existing concepts and establishes new relationships: (1) Top-down/bottom-up prediction processing is applied to strategic management and defined in form of a generative process—integrating in circular causality top-down belief propagation and bottom-up message passing—in pursuit of one objective: minimize surprise to resist entropy to persist, powered by one first-order principle of least action, i.e., free energy minimization. A purposedirected firm is the foundation for Free Energy Governance’s top-down/bottomup circular causality to come and stay alive. Steve Jobs, for example, seeded a timeless purpose for Apple, so tangible in everything we have come to expect from Apple products and services. Product innovation and delivery, however, are a function of uncompromising ‘fail fast’ generative prediction error minimization that engages not only a visionary founder and the entire firm (top-down/bottom-up) but also its ecosystems: enactive inference conditioned by Markovian blankets upon blankets. Purpose is the axiom of strategic prediction models (worldviews, long-term target models). Purpose should be timeless but must be continuously re-interpreted in the very context of the firm’s time and space. “The world we want tomorrow starts with the business we build today.” (Mars purpose statement quoted in Gulati 2022) Predictions could be wild guesses, and this is most likely how some of the most transformative inventions and innovations have kicked off—in someone’s mind and most likely that very abductive mind is located close to resource markets (e.g., clients, suppliers, technology) rather than within Upper Echelon. Indeed, action-generated bottom-up stimuli emanating from resource markets are the very oxygen fueling the continuous re-interpretation of purpose, prediction models, and predictions to empower firm performance and survival. Human nature is innately social and participatory. However, the organization’s field levels tend to be rather introverted and risk averse and are too often overly concerned with job security or reluctant to assuming more responsibility. Therefore, the bottom close to resource markets—where transformation-bearing signals pass through—is likely to resist airing ideas and sharing market signals that contradict dominant top-down predictions and prediction models. In fact, the more sharing-reluctant the firm’s field (close to resource markets), the more likely that the firm is too (narcissistically) top-down directed and eventually will have no other choice but to turn to an over-emphasis of financial control with potentially survival-threatening consequences. Effectively, there is not sufficient bottom-up oxygen to power top-down strategic control.

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Our understanding of the firm’s cognition must be more extended rather than corporate-centric. This requires openness to a vast array of sources of stimuli to be revealed and assessed for purpose-directed significance to be then related to top-down/bottom-up prediction processing. Top-down/bottom-up prediction error minimization is empowering the firm to fully leverage the multiintelligence dimension of the human-machine interface. Upper Echelon communication is centered around four dimensions, dynamically linked in FEG’s circular causality: (a) purpose, (b) prediction models, (c) predictions, and (d) stimuli. The simplicity and plasticity of the language are critical to ensure that reach and inclusion of team members are optimized. More importantly, firm members must be incentivized to stimuli challenge predictions. Underlying prediction models, according to the first-order free energy minimization principle, will self-evidently evolve by way of (unsupervised) selforganization (STRUCTURE). (2) Enactment, coined by Karl Weick (1977) and astutely applied by Smirchich and Stubbart (1984) to strategy process, has conceptually inspired FEG. By now, the reader should see that it is too obvious what a nonsense the idea of an objective reality is, as much as uncertainty is not an objective but an actor-dependent experience. However, enactment in terms of Weick’s ‘legislating’ a firm’s operating and competitive landscape has been too vague and top-down-centric to really provide the world of practice with more than a conceptually appealing black box. The concept of the Markov blanket—separating the inner from the outer world through the veil of internally generated probability assignments upon a bounded set of external (unknown) states and governed by the interplay of action and feedback loops in pursuit of free energy minimization—is providing strategy process and corporate governance with an entirely new conception of self as well as eco-niche construction. Enactment is redefined as enactive inference. Essentially, Free Energy Governance is liberating Upper Echelon from the overwhelming cognitive distortion that their biggest challenge is taming (Hertwig et al. 2019) uncertainty when, instead, they should be really surfing (Clark 2016) it. Unless environment is redefined as a purpose-directed and action-centric generative prediction challenge in form of prediction error minimization, firms will continue being incapacitated by the fateful pursuit of adaptive fitness. More importantly, redefining strategy as top-down/bottom-up predictive coding lays the foundation to optimally leverage and co-evolve the human-machine potential (COGNITION). (3) Dynamic board capabilities in form of duality management are an entirely new genre of Upper Echelon capabilities that FEG establishes. To date, corporate governance practice is more concerned with defining behavioral responsibilities rather than addressing its specific capability needs. Board capabilities are not of an operational (executive) nature but must be meta-operational. Sensing and sensemaking, though not novel concepts in strategy management research, will need to be more effectively operationalized beyond their conceptional appeal. Enactive prediction processing becomes manifest in duality management in form of balancing financial and strategic control as well as exploitation and exploration. Duality management is all about probabilistic resource-reconfigurations in

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superposition waiting to be enacted. ‘Duality stewardship’ is FEG’s essential governance mandate. The concepts of financial and strategic control have been defined in multiple ways, in both corporate governance and management research. Hitt et al.’s definition (Hitt et al. 1996) of relating the concepts to external and internal innovation, respectively, and empirically distilling the survival-threatening implications resulting from overdependence on financial control, for example, provide Upper Echelon with a critical early-warning dimension for corporate entropy. More importantly, it establishes a strategic imperative: do not ever allow for financial control to crowd out strategic control. The R&D percentage share of total revenues is potentially a good indicator of a looming financial control trap. Within each industry, there is a rough percentage benchmark for R&D investment for organic reinvention. Once a firm operates year-on-year below industry R&D investment standards, financial control is likely to be the only control left (CAPABILITIES). How to make it all work in practice is a daunting task. There is no best-practices catalogue. First of all, best practices should be considered a potential source of inertia. We need first-order principles to empower structural organization (formal and informal throughput), environmental engagement, and capability development to foster self-organizing processes. Free Energy Governance does exactly this. FEG is a new logic, and that means that its implementation is also a matter of a new mindset and culture. Above all, it axiomatically starts with the firm-wide adoption of a deep purpose (Gulati 2022). Fostering a culture of wild guesses (predictions) in form of innovative abduction to be challenged across all hierarchical levels is an essential free energy foundation for performance and survival. Indeed, we must ask: How can one possibly redefine the board’s strategic ‘meta-role’ when traditional governance modes are so ubiquitously entrenched and cognitive capabilities so poorly developed or non-manifest?

The dissertational research underlying this book publication revealed that practitioners have strategic goals and variably emphasize financial or strategic control dimensions. But they may lack clarity around the firm’s purpose. ‘Why should this business exist and prevail in the first place?’ is an important question too rarely asked. Survival, first and foremost, is a matter of staying relevant. Questioning the very right to existence of a business is a good starting point to distill and reinterpret its purpose. In this context, Jan Ståhlberg, one of the early architects building EQT into a USD80bn-plus leading global PE investor, explains PE’s public market equivalent peer outperformance: Indeed, private equity should outperform public companies for a number of reasons: First, PE has more strategic freedom. We constantly question the status quo. Public boards are dedicated to what they have. They rarely question the existing business. Second, we neutralize any potential conflicts of interest and build alignment of interests so that the collective power of all involved can be optimally leveraged for a long-term goal. Third, optimal capital allocation is a key value-driver. Public companies have more difficulty in convincing markets to over-capitalize for future growth opportunities. Fourth, at least at EQT, a paranoia-powered sense of urgency has always been part of our DNA. (Ståhlberg 2021)

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“Private equity is best understood not as a financing method but as a governance structure” (Klein et al. 2013). In fact, PE-sponsored governance approaches have moved into a diametrically opposite direction relative to public market (best practices) governance models. This should largely explain PE’s consistent outperformance of public market equivalent peers for the past 20 years. “According to Harris et al. (2014), top quartile buyout fund outperformance relative to the S&P 500 has consistently averaged at least 20-27% over a fund’s life and more than 3% annually. This conclusion is relatively insensitive to assumptions about benchmark indices and systematic risk” (Khezri 2015). Against this background, it is rather logical to expect PE being one of the fastest growing financial asset classes for years, if not decades, to come. It is a matter of PE’s superior governance model. FEG guides the direction to further perfect the PE governance logic. If the public at large is to participate in the innovation economy,1 we must fundamentally revise public market governance regulations. Governance may not be the root cause for the ‘eclipse of the public corporation’ as Michael Jensen (1989) labeled the phenomenon. But unless we advance governance models that match the challenges of a distributed and discontinuous world, overall trust in the governance of the public company and its performance potential will fade. Jan Ståhlberg’s practice-relevant statements (Ståhlberg 2021) concerning transparency, communication, and reaching out to the bottom should inspire management practice: •

•

1

We operated on the basis that ‘everyone should know’. Everyone is informed in realtime about everything. Indeed, this may lead to an overload of information, but overall this is still preferable than top-down filtering that may risk excluding potentially insightful stimuli and feedback. How did we manage this: we allowed everyone in the firm to listen into the investment calls, for example. It was a brilliant move. While other PE firms cultivated ‘closed doors’, we embraced such openness as a major learning platform, training young professionals to understand our sense of urgency, paranoia, long-term focus and, not least, our principles. More importantly, we often benefited from insights we would have not accessed otherwise. Our organizational structure has never been cascaded. And, I believe, looking at some of the core propositions of Free Energy Governance, this is Free Energy Governance: connecting top and bottom in circular causality of sensemaking with the least friction and optimal response time. Overall, I think as long as people are open-minded, the composition of the board is not the problem. Communication is everything. Value creation, in my experience, has been usually determined by a combination of the following governance imperatives: First, you must start with a clear purpose and long-term goal. Prepare to invest for the longterm, and into structure. Second, you need to continuously question yourself. Paranoia is key. Third, team-decisions are critical. Create a culture that empowers and encourages people to contribute, to take decisions, and not to be risk-averse. Team-decisions are an optimal way to get the best out of everyone. Fourth, the organization must be open and transparent; no room for politics. When I was running the global Mid-Market operations out of New York, I was known for ‘walking around’, watering plants and putting my coffee cup in the dishwasher. You cannot expect bottom-up stimuli reaching the top when the top is not reaching out to the bottom. And sometimes a simple walk through the office can make all the difference. Listen humble and with respect. In summary, it really comes down to three things: communication, transparency, and respect.

Steve Case elevated this to the level of a public policy concern. See Steve Case (2020).

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As always, the specific needs and challenges of a firm’s given lifecycle determine the relative emphasis of top-down (belief-propagation) and bottom-up (messagepassing): “The various experiences I’ve had, ranging from starting America Online, to chairing a merged AOL/Time Warner, to backing entrepreneurs via Revolution, or by helping to oversee public institutions like the Smithsonian, lead me to conclude that governance cannot be viewed in a vacuum—what is appropriate really depends on the context in which you’re operating. A ‘one size fits all’ approach will likely be flawed” (Case 2021). Indeed, “one size fits all” is a flawed approach, and “where you are in the firm’s lifecycle” is essential. However, to emphasize either a top-down or bottom-up leadership approach as a function of lifecycle and context does pre-suppose, in the first place, that a firm has built the foundation to ‘vacillate’ and autonomously determine the level of emphasis of top-down dominance or top-down/bottom-up circular causality. Maintaining that agility is a strategic imperative in pursuit of firm survival. Otherwise, the firm’s strategic options are narrowing toward the top-downonly comfort zone, most likely ending up capitulating to the dictate of financial control, condemning the firm to M&A and joint ventures only to secure growth and innovation at the price of eventually losing strategic control. We are challenged to exit dominant logics to truly embrace the world as distributed and discontinuous. In practice, continuous strategic renewal is organizing’s categorical imperative. Traditional corporate governance models are likely to continue compromising the full performance potential of executive leadership as they tend to relegate the board of directors to strategic irrelevance, reinforce financial control at the expense of strategic control, prioritize fast (pattern-recognition-fueled) content over slow process, and eventually inhibit the full growth potential of firms as self-organizing systems. The very causes supporting Siebel’s statement that we “are in the midst of an evolutionary punctuation: [. . .] witnessing a mass extinction in the corporate world” (Siebel 2019) are, amongst other, reflective of the unsuitability of our governance models to translate free energy principle-based machine learning logics into organizing. In today’s discontinuous market environments, CEOs are under accelerating pressure to resist entropy. Firm survival takes center stage. Boards are in danger of being rather survival-inhibiting; notwithstanding individual members’ best intentions and outstanding capabilities (though, too often non-manifest or domain-centric and past experience-trapped). This is not necessarily so because board members are incompetent, ignorant, or victims of debilitating group dynamics and cognitive ‘blind spots’ but because the essential governance challenge in a discontinuous and distributed world is now a matter of setting free the self-organizing optimization of top-down/bottom-up prediction error minimization: learning to infer. The firm is the generative model. The continuous nature of strategic renewal makes prediction modeling as well as prediction error minimization an integral and DMN-centric dimension of traditional monitoring, advisory, and boundary-spanning board responsibilities. Effectively, in the absence of board-level meta-capabilities, as developed in this book, the board can no longer fulfill even its most basic and traditional responsibilities.

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Free Energy Governance should be embraced as (a) practically intuitive, (b) a practice-oriented framework providing a new language empowering the humanmachine interface’s full potential as well as giving new meaning to existing organizational language as well as establishing new metaphors facilitating intra-firm communication and engagement, and (c) providing Upper Echelon with a fundamentally new survival-centric governance framework defining strategy process as prediction error minimization, thus, empowering ‘doing things differently’. The demands upon organizational design, a firm’s environmental engagement model, as well as board capabilities are significant. Hard structures, fossilizing prediction models beyond bottom-up challenge, should be recognized as a survival-threatening relic of the past. From a practice perspective, Free Energy Governance is both a novel organizational framework and an early detector of a firm’s looming entropic decay: Might it be possible to detect decline early and reverse course, or even better, might we be able to practice preventive medicine? I began to think of decline as analogous to a disease, perhaps like cancer, that can grow on the inside while you still look strong and healthy on the outside [. . .] Yet our research indicates that organizational decline is largely self-inflicted, and recovery largely within our control. (Collins 2009)

References Case, S. 2020. A weeklong series: 10 Tech trends from the decade that was . . . and what will be. Revolution, January 6, 2020. https://blog.revolution.com/a-weeklong-series-10-tech-trendsfrom-the-decade-that-was-and-what-will-be-258b6c9afa68. Case, S. 2021. Steve Case discusses free-energy governance’s core propositions in an open-style interview with Bijan Khezri (January 29, 2020). In Free Energy Governance – Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival, ed D.B. Khezri. Zug: KCRI (Khezri Capital Research International) AG. https://www.alexandria. unisg.ch/262427/1/Dis5052.pdf. Clark, A. 2016. Surfing Uncertainty: Prediction, Action and the Embodied Mind. New York: Oxford University Press. Collins, J. 2009. How the Mighty Fall: And Why Some Companies Never Give in. New York: HarperCollins. Corley, K., and D. Gioia. 2011. Building theory about theory building: What constitutes a theoretical contribution? Academy of Management Review 36: 12–32. Gulati, R. 2022. Deep Purpose: The Heart and Soul of High-Performance Companies. New York: HarperCollins Publishers. Harris, R.S., T. Jenkinson, and S.N. Kaplan. 2014. Private equity performance: What do we know? Journal of Finance 69: 1851–1882. Hertwig, R., T.J. Pleskac, and T. Pachur. 2019. Taming Uncertainty. Cambridge, MA: MIT Press. Hitt, M.A., R.E. Hoskisson, R.A. Johnson, and D.D. Moesel. 1996. The market for corporate control and firm innovation. The Academy of Management Journal 39: 1084–1119. Jensen, M.C. 1989. The eclipse of the public company. Harvard Business Review 67(5): 61–74. Khezri, D.B. 2015. Private Equity PME-Outperformance – A Matter of Governance: New Corporate Governance - Dynamic Capabilities at the Board Level. PhD Seminar Paper (Prof. Dr. Andreas Grüner), St. Gallen (SG): University of St. Gallen. Klein, P.G., J.L. Chapman, and M.P. Mondelli. 2013. Private equity and entrepreneurial governance: Time for a balanced view. Academy of Management Perspectives 27: 39–51.

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Siebel, T.M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: RosettaBooks. Smirchich, L., and C. Stubbart. 1984. Strategic management in an enacted world. Academy of Management Review 10: 724–736. Ståhlberg, J. 2021. Jan Ståhlberg discusses free-energy governance’s core propositions in an openstyle interview with Bijan Khezri (February 14, 2020). In Free Energy Governance - Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival, ed D.B. Khezri. Zug: KCRI (Khezri Capital Research International) AG. https://www.alexandria.unisg. ch/262427/1/Dis5052.pdf. Weick, K.E. 1977. Enactment processes in organizations. In New Directions in Organizational Behaviour, ed. B.M. Staw and G. Salancik, 267–300. Chicago: St. Clair.

Chapter 12

Future Research Agenda

Abstract FEG is the product of a multidisciplinary research project connecting the dots among strategy, governance, and neuroscience research opening a new conversation headlined ‘introducing the free energy principle to strategy management’. FEG redefines the nexus of structure and cognition (ABV), advances the dynamic capability view (DCV) from the managerial to the board level, and establishes strategy as an enactive (Bayesian) inference challenge. In terms of future research, four areas should advance the optimization of FEG: (1) language and communication, in particular explainability of corporate purpose, prediction models, and predictions; (2) embodied cognition, in terms of a deeper understanding around the neurobiology underlying leadership’s world engagement as well as false inference; (3) artificial intelligence, in particular the strategy application of Ai-powered machine algorithms; and (4) board capabilities’ developmental paths, in particular the board’s ability to collectively develop meta-capabilities. FEG as a framework provides the fundamental building blocks that empower a firm to implement free energy minimization as a self-organizing principle: structure (top-down/bottom-up connectivity), cognition (environmental enactment), and capabilities (duality management). Within the FEG framework, many vibrant strategy research topics lend themselves to be repurposed as a matter of optimizing free-energy minimization. More specifically, survival rather than just performance is the critical dependent variable.

Free Energy Governance is introduced as the opening of a new conversation headlined ‘introducing the free energy principle to strategy management’. Specifically in terms of implications relating to theory, the FEG framework: (1) redefines and reinforces the nexus of structure and cognition (ABV), (2) advances the dynamic capability view (DCV) from the managerial to the board level and establishes duality management as a dynamic board capability, and (3) applies neuroscience’s firstorder free energy minimization principle to organizational governance, effectively establishing strategy as an enactive, sophisticated, and resource-dependent Bayesian inference challenge. FEG is not a substitute for traditional agency or stewardship theories or any combination thereof. Epistemologically, FEG is rooted in strategic cognition

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research and aspires to be a fundamentally new logic of organizing linking structure, cognition, and capabilities. If, indeed, a firm’s long-term strategic capacity for sustainable outperformance and survival is axiomatically determined by the depth of the firm’s (existential) purpose and the firm-level capability of (1) revealing environmental significance (listening to what wants to emerge)—resulting from the firm’s very interactions with the many worlds that eventually shape a distinctive interpretation—and (2) reconfiguring resources correspondingly, then we need a framework that goes beyond anything proposed so far. We need a new logic. Free Energy Governance is the product of a multidisciplinary research project connecting the dots among strategy, governance, and neuroscience research. Shortcomings in existing strategy and governance research that have inspired this book’s underlying dissertation have been addressed in previous sections. In terms of future research, the following four areas are worth considering for advancing the optimization of Free Energy Governance: (1) language and communication, (2) embodied cognition, (3) artificial intelligence, and (4) board capabilities’ developmental paths.

12.1

Language and Communication

The effectiveness of FEG is critically determined by transparency in communication, specifically around the explainability of corporate purpose, prediction models, and predictions “to obtain the most possible human energy for productive effort” (Argyris 1995). Helfat and Peteraf (2015) linked language and communication as a cognitive microfoundation underlying the effective reconfiguration of a firm’s resource base. Theories of communication should fertilize FEG-related (practiceoriented) research: [T]here is no organization nor any ideology other than that which emerges in communication. If organization is emergent in communication, as we believe, then it is not a being, but a becoming. What we ought to be studying is not organization or ideology, because neither has any ontological status independent of communication, but the processes of communication by which we continue to construct both to become the world we live in. (Taylor and Van Every 2000)

Upper Echelon is well advised to re-develop awareness for both (1) its agency status in form of “responsibility to act that confers legitimacy on the action” (Taylor 2009) and (2) how organizing emerges in language and action. The avalanche of scripts and presentations that circulate within companies to impose top-down-dominant logics is more likely to be free energy-maximizing than -minimizing. Corporate communication is inherently geared toward anesthetizing the individual’s capability for abductive thinking, preventing its members to listen and hear what truly wants to emerge. Strategy process scholars are increasingly turning to the importance of the communication dimension to refine existing theories. More specifically, Helfat and Peteraf (2015) concerning DCV and Burgelman et al.’s (2018) concerning ABV, for example, are exemplary. When Maturana writes (as quoted in Taylor 2009) that

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“[l]anguage occurs only in the flow of coordination of recursive consensual actions between organisms caught up in continuing interaction,” we might as well replace language with reality. Indeed, “[q]uantum physics more than the immensity of the universe and the discovery of its great history, more even than the extraordinary vision of Einstein, has been [. . .] the heart of this radical questioning of our mental maps of reality” (Rovelli 2021). In this context, it is worth recalling biocentrism’s ninth principle (Lanza et al. 2020): There are several basic relationships – called “forces” – that the mind uses to construct reality. They have their roots in the logic of how various components of the information system interact with each other to create the 3-D experience we call consciousness or reality. Each force describes how bits of energy interact at different levels, starting with the strong and weak forces (which govern how particles hold together or fall apart in the nucleus of atoms) and moving up to electromagnetism and then gravity (which dominates interactions on astronomical scales such as the behavior of solar systems and galaxies).

Language is not a tool but a force. Indeed, “[c]omplex organization [. . .] emerges in a superordinate metaconversation where all the conversations of the organization’s members, including its own, have become its object of focus” (Taylor 2009). From this perspective, it is so much more intuitive to appreciate that domain expertise and operational capabilities, respectively, are not enough to actively lead this ‘superordinate meta-conversation’ at the board level where it should be anchored. The board is challenged to develop new meta-capabilities accordingly. Organizational sensemaking has traditionally relied on evocative language, scripts, and framing (e.g., threats vs. opportunities). But as we embrace organizing as a ‘dense web of interactions’ (Rovelli 2021) dedicated to enactive inference conditioned by the Markov blanket, we must appreciate that “this focus on verbal processes to the exclusion of embodied processes does not sufficiently encompass the scope of sensegiving” (O’Malley et al. 2009). In fact, the form and reach of our interactions with the outside world as a basis for enacting, i.e., perceiving reality, are fundamentally a function of our respective bodily energies and constituencies crystalizing in language and actions.

12.2

Embodied Cognition

Firms are challenged to develop an appreciation for the neurobiology underlying Upper Echelon’s world engagement as a basis for reality construction and must redefine the nexus of body-mind-action-language. In The Hour Between Dog and Wolf, trader-turned-neuroscientist John Coates (2012) details the neurobiology explaining boom and bust in financial markets. Coates’ systemic application of the neurobiology underlying embodied cognition is equally relevant to Upper Echelon confronting environmental scarcity: If dopamine fuels a desire for information and unexpected reward, perhaps it also fills us with a burning curiosity. [. . .] Importantly, dopamine, like noradrenaline, does a lot more

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than motivate the brain: it also prepares the body for action. [. . .] Dopamine drives us to push beyond established routines and to try new search patterns and hunting techniques. [. . .] If a crisis lasts longer than fight-or-flight, then the shell of the adrenal glands [. . .] secrets ever increasing amounts of cortisol. [. . .] Novelty, uncertainty and uncontrollability – the three conditions are similar in that when subjected to them we have no downtime, but are in a constant state of preparedness. [. . .] But now, under heavy load of stress [. . .] a person can no longer concentrate and instead scans the environment, the reason being that when confronted with true novelty we no longer know what is relevant and what to focus on. [. . .] Cortisol’s lethal effects on the brain are compounded by another chemical produced during stress, one produced in the amygdala called CRH [. . .] CRH in the brain instills anxiety and what is called ‘anticipatory angst’, a general fear of the world leading to timid behavior. [E]volution has equipped us with a stress response that can be fatally dysfunctional in modern society. [C]an we turn off the cortisol? [. . .] Our conscious and rational selves have very little control over subcortical parts of the brain such as the amygdala, the hypothalamus and the brain stem. [M]ental toughness involves a particular attitude to novel events: a toughened individual welcomes novelty as a challenge, sees in it an opportunity for gain; an untoughened individual dreads it as a threat [. . .] What is intriguing about the research into toughness is the finding that to each of these attitudes – viewing novelty as a challenge or as a threat – there corresponds a distinctive physiological state.

Embodied cognition (EC) and the emotional significance of stimuli are gaining momentum in cognitive science. Indeed, the brain is not the only cognitive resource. Brain, body, and environment together form one integrated cognitive (embodied/ enactive/extended) system. While the prediction processing framework (PPF) is rooted in a number of EC’s core assumptions, this book does not specifically address the relevance of EC to strategy process research. For a critical review of EC, see Goldinger et al. (2016): In recent years, there has been rapidly growing interest in embodied cognition, a multifaceted theoretical proposition that (1) cognitive processes are influenced by the body, (2) cognition exists in the service of action, (3) cognition is situated in the environment, and (4) cognition may occur without internal representations. Many proponents view embodied cognition as the next great paradigm shift for cognitive science. [. . .] We also argue that the principles of EC are often (1) co-opted from other sources, such as evolution; (2) vague, such that model building is not feasible; (3) trivially true, offering little new insight; and, occasionally, (4) nonsensical. (Goldinger et al. 2016)

Advances in neuroscience generally and neurobiology in particular start laying the foundation for developing models of sensing and sensemaking conditioned by neurohormones (in particular dopamine and cortisol). Eagleman (2017) provides a neurohormone-centric representation of prediction error minimization: When there is a mismatch between your expectation [top-down model] and your reality [bottom-up stimuli], this midbrain dopamine system broadcasts a signal that reevaluates the price point. This signal tells the rest of the system whether things turned out better than expected (an increased burst of dopamine) or worse (a decrease in dopamine). That prediction error signal allows the rest of the brain to adjust its expectations to try to be closer to reality next time. The dopamine acts as an error corrector. (Eagleman 2017; emphasis by DBK)

Indeed, neurobiology (and neurohormones) at the board level cannot be disregarded as an important variable determining whether stimuli are embraced as threat or opportunity or are ignored altogether. Hodgkinson and Healy (2011) have

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Artificial Intelligence

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put the significance of emotional stimuli into corporate context: “The predominance of the information processing view of the firm has ensured that current conceptions of sensing capabilities are decidedly affect free [. . .] However, to the extent that affect controls attention (Compton, 2003), the moods and emotions of managers likely determine to a significant degree what the firm attends to and how it responds” (Hodgkinson and Healy 2011). Recasting the phenomena of false inference and institutional psychosis as a matter of impaired prediction error minimization may highlight how critically firm performance is also a function of Upper Echelon’s embodied cognition as determined, amongst other, by psychological aspects as well as neurobiology. The Bayesian brain makes weighted predictions, based on attachment dispositions established in childhood [which can be thought of as self in action]. […] Minimising prediction errors depends on a dynamic interaction (“conversation”) between top-down models and bottom-up signals in which the inherent error in both directions is taken into account. […] In line with attempts to move psychiatric diagnosis from purely descriptive phenomenology to neuroscience-based constellations, FEP enthusiasts are beginning to formulate aspects of psychiatric illness in prediction error terms. […] The psychosis sufferers’ fMRIs showed [that] [b]ottom-up (midbrain) communication/conversation with top-down cortical models was impaired, especially in the dopaminergic pathways which are implicated in psychosis. (Holmes 2020)

As much as today’s fMRIs are up to measuring a leader’s ability to switch between DMN and TPN, there is a need for future research assessing the real-time ratio of anabolic (e.g., dopamine) over catabolic (e.g., cortisol) levels (also known as growth factor) in the context of decision-making at times of environmental scarcity. The higher the growth factor the more likely that scarcity is embraced as opportunity rather than threat. This book has, maybe rather restrictively, treated prediction error minimization as affect-free as well as ‘rational’, i.e., pre-supposing that the agent is information-seeking. Indeed, the phenomenon of deliberate ignorance or strategic ignorance (Hertwig and Engel 2020), possibly rational too, has not been considered but could be a matter of embodied cognition. More specifically, the question arises whether neurobiology can explain information-seeking vs. deliberately ignorant behaviors, for example: Utility-maximizing individuals may even be willing to pay to be shielded from information (Nyborg 2011). (Hertwig and Engel 2020)

The future study of strategic cognition will inevitably have to embrace cognition as embodied, enacted, and extended.

12.3

Artificial Intelligence

Artificial intelligence (AI) will continue to be of increasing relevance to the study of corporate governance and strategic decision-making, as is true for any aspect of organizing. In fact, Friston’s free energy principle is powering machine learning

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algorithms. Free energy minimization is a machine logic in its own right, empowering living as well as artifactual organisms to optimally resist entropy. Artificial intelligence is essentially a challenge of prediction processing: Prediction is the process of filling in missing information. Prediction takes information you have, often called ‘data’, and uses it to generate information you don’t have. Much discussion about AI emphasizes the variety of prediction techniques. [. . .]: classification, clustering, regression, decision trees, Bayesian estimation, neural networks, topological data analysis, deep learning, reinforcement learning, deep reinforcement learning, capsule networks, and so on. (Agrawal et al. 2018)

But above all, it is a matter of active inference (Ai), in pursuit of surprise minimization: The first time I asked Friston about the connection between the free energy principle and artificial intelligence, he predicted that within five to 10 years, most machine learning would incorporate free energy minimization. The second time, his response was droll. ‘Think about why it’s called active inference’, he said. [. . .]. ‘Well, it’s AI’, Friston said. So is active inference the new AI? ‘Yes, it’s the acronym.’ (Raviv 2018)

It will be only a matter of time for machine learning-based tools to assist leadership’s sensemaking of data through (en)active inference (Ai), beyond traditional human sensemaking capabilities. However, as the cost of prediction is lowered, the value of human judgment increases, and, consequently, human qualities are revalued in relation to machine power: “Humans have three types of data that machines don’t. First, human senses are powerful [. . .] Second, humans are the ultimate arbiters of our own preferences [. . .] Third, privacy concerns restrict the data available to machines” (Agrawal et al. 2018). Indeed, the “development of nonlinear thinking will become more critical as artificial intelligence becomes more advanced” (Hitt 2000). Fast-forward 3–5 years from the date of this book and it will be rather difficult to conceive defining companies as inference machines without giving due consideration to the strategy application of AI-based (and most likely Ai-powered) algorithms. Machines will assume an increasingly important role in strategic decision-making, and, consequently, the role, value, and developmental path of human cognition will and must consequently co-evolve. In this regard, Mo Gawdat (2021), former Chief Business Officer of Google [X], provides a thought-provoking ‘singularity’ perspective on AI: [By 2029], machine intelligence will break out of specific tasks and onto general intelligence. By then, there will be machines that are smarter than humans [. . .] [By 2049], AI is predicted to be a billion times smarter (in everything) than the smartest human. To put this into perspective, your intelligence, in comparison to that of the machine, will be comparable to the intelligence of a fly in comparison to Einstein. We call that moment singularity. Singularity is the moment beyond which we can no longer see, we can no longer forecast. It is the moment beyond which we cannot predict how AI will behave because our current perception and trajectories will no longer apply. Now the question becomes: how do you convince this super-being that there is actually no point squashing a fly?

Effectively, the challenge is moving from coding to ethics to survival. First-order principles—such as Ai’s free energy minimization—will lay the foundation for

12.4

Board Capabilities’ Developmental Paths

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governance models to increasingly self-organize. Hilb (2020) made a valuable contribution to ‘the role of artificial intelligence in shaping the future of corporate governance’. In particular, Hilb’s reference to ‘autopoietic intelligence making corporate governance self-evolve’ deserves to be further explored. The direction is clear: organizations will eventually have to embrace unsupervised learning mechanisms to master discontinuous (AI-powered) environments. It is very likely that firms will turn to Ai-driven generative models. The Free Energy Governance framework should inspire future research for AI-powered strategic renewal. More specifically, FEG introduces the language that optimizes the human-machine communication interface.

12.4

Board Capabilities’ Developmental Paths

In strategy research and beyond, the literature on capabilities’ developmental paths is rich. Relevant contributions for this book are (1) Helfat (2000) addressing the “broad question of exactly how it is that firm capabilities emerge, develop, and change over long time spans”; (2) Gavetti (2005) linking hierarchy, cognition, and capabilities development; (3) Hodgkinson and Healy (2011) “[demonstrating] how the fundamental capabilities of sensing, seizing, and transforming each require firms to harness the cognitive and emotional capacities of individuals and groups to blend effortful forms of analysis with the skilled utilization of less deliberative, intuitive processes”; and (4) Laamanen and Wallin (2009) putting cognition at the heart of capability development but, more importantly, addressing the board dynamics that are critical to firm-level capabilities’ developmental paths: Recognizing that transforming a firm’s capability constellation is a decision that requires high levels of board involvement, [. . .] What emerged from this supplementary analysis was a striking realization that the firms’ choices bore a remarkable resemblance to the profiles of their board members. (Laamanen and Wallin 2009)

Indeed, the board is ultimately responsible for anticipating the firm’s future ‘capability constellation’ (including that of the board itself) to sustainably succeed with continuous strategic renewal. However, to avoid the cognitive traps related to individual board profiles that Laamanen and Wallin (2009) identified, we must study the cognitive microfoundations of capability development at the board level. To date, this area represents a void in both strategy and governance research: In my personal capacity as CEO and board director, I have always believed that firm survival is a matter of anticipating capability gaps well in advance, constantly questioning whether the firm’s ability to develop operational capabilities from within or without is well ahead of its future growth aspirations.

To govern and succeed in discontinuous market environments, being a board member is not just about monitoring financial performance, managing conflicts of interest, and sharing wisdom, expertise, and networks. But above all, it must be embraced as a new commitment to capabilities development as well as learning and

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unlearning, i.e., purpose-directed firm-level prediction error minimization. A firm’s state of becoming—fueled by continuous strategic renewal—is also a function of the board collectively embracing developmental paths of meta-capabilities such as the ability to real-time and purposefully balance dualities: exploitation and exploration as well as financial and strategic control. So, where do we turn to in our quest to develop duality management capabilities at the board level? In fact, it requires a new ‘anti-realist’ mindset. Lanza et al.’s (2020) eleventh principle captures the essence: “Observers ultimately define the structure of physical reality – of states of matter and spacetime – even if there is a ‘real world out there’ beyond us, whether one of fields, quantum foam, or some other entity.” Observers are actors. Acting is observing and observing is acting. Once we embrace the world as actor independently nonexistent, we set free the developmental path that lays the foundation for seeing dualities where others continue seeing impossibilities: How can you throw yourself off a cliff and assemble the plane on the way down? The answer pre-supposes an anti-realist mindset beyond any pre-conceived cause-effect determinism. “Thus the ‘real world’ would prove to be the ultimate illusion” (Halpern 2020). The business world is now starting to embrace the metaverse, a concept that has already inspired the gaming industry for decades. Facebook’s rebranding to Meta is beyond an aspiration. The future belongs to virtual abundance, dissipating preconceived boundaries of mind and matter. It is this ability ‘to throw yourself off the cliff’ that is the essence of entrepreneurship. Every great company can trace its very origins to that ‘cliff’. But in the absence of board members being capable of observing the observer and leading a meta-conversation that is geared toward reconfiguring assets on the fly by way of vacillating exploitation/exploration and financial/strategic control, the firm may never succeed in assembling/re-designing the plane during flight mode. DMN-centric duality management as a dynamic board capability should be learned and adopted as a Habit of Mind: At the age of 29, I found myself as a board director of the then world’s leading Public-KeyInfrastructure (PKI) supplier, Baltimore Technologies plc, encrypting financial institutions’ most valuable transactions as well as governments’ most sensitive communications. In early 2000, the company’s valuation had ‘blitz-scaled’ into the FTSE-100 - indexing the London Stock Exchange’s largest companies in terms of market capitalization– growing from GBP50m to GBP8.5bn in less than two years. At the time, this was astronomical. There was no capability constellation at the firm level that could have prepared anyone for such exponential rise, no matter how much experience and wisdom individual members had accumulated in prior careers – which, obviously, I had not. But the sheer fact that Baltimore’s public market valuation was in no relation to its business substance led me to question early on whether and how that gap could be eventually reconciled without a mighty fall. A few months after Baltimore’s adoption into the FTSE100 index, I shared my concerns with the board in my resignation letter. Eighteen months later, I returned as CEO to restructure a globally expanded business that lost its ability to independently survive. The company was caught in the ‘financial control trap’. Eventually, there was no other choice but to restructure to exit. A very experienced board of directors had utterly failed. (Khezri 2002)

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Conclusion

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When, in retrospect, I reflect upon the Baltimore experience, I ask myself: ‘what capabilities are required at the level of the individual board member when the necessary firm capabilities are not yet developed?’ To answer the question, I cannot resist but turn to the principles that Scharmer (2018) developed as part of Theory U, in particular: Principle 9: Practice Deep Listening and Dialogue: Connect with Your Mind and Heart Wide Open: “When connecting to other people and contexts, open up all four ‘channels’ of listening: Listen from what you know, from what surprises you, from the whole, and from what you sense wants to emerge (the emerging whole).” Principle 10—Collective Sense Making: Use Social Presencing Theater and Embodied Knowing: “Whatever process you use to make sense of the learning journey, what matters most is that you pay disciplined attention to all the voices and manifestations of the field [. . .] Paying disciplined attention means that you are intentionally holding back all inclinations to mix your own interpretations or solutions. You suspend all that because you want the data of the ‘field’ to speak to you. But the data of the field cannot speak to you if your mind is too busy expressing opinions and proposing solutions.” Principle 22—Create Enabling Infrastructures That Allow the System to Sense and See Itself: “[. . .] ‘making the system sense and see itself’ can change the coordination dynamics among the players in a field, moving them toward eco-system awareness.”

As traditional governance models are increasingly uprooted in a discontinuous world, there is not only a need for a new governance logic but correspondingly new board capabilities’ developmental paths. Specifically, duality management as a dynamic board capability demands dedicated research.

12.5

Conclusion

The firm is conceived as an enactive, sophisticated, and resource-dependent inference machine, linking in form of a generative model in circular causality four states: (1) action, (2) perception, (3) firm resources, and (4) unknown/hidden events. It is an action-generated belief system, expressed in probabilities about the beliefs a firm holds about its beliefs’ consequences. There is only one path: the path of ‘least action’. It is the path that satisfies a simple first-order principle: free energy minimization. Of course, that path presupposes that the firm has a purpose of why it should survive in the first place—equivalent to living organisms’ purpose to reproduce. It is this purpose that energizes its members and partners and determines the firm’s context-specific goals. But the actions are always uncompromisingly determined by free-energy minimization, fostering self-organization in pursuit of surprise minimization, i.e., survival. Survival implies non-dissipative boundaries. A drop of ink in water dissipates. The firm’s boundaries, however, must be nonetheless soft and not hard. In fact, the firm’s boundaries must be increasingly flexible allowing for an optimal actiongenerated throughput of resource markets-originated stimuli. The softer the boundaries facilitating dissonant throughput, the higher the importance of simultaneously protecting the system’s integrity, i.e., its nonequilibrium steady state (NESS).

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However, top-down-only directed and centralized power structures and strategy processes will be increasingly overwhelmed to master the challenge. Free Energy Governance (FEG) as a framework provides the fundamental building blocks that empower a firm to implement free energy minimization as a selforganizing principle: (1) structure (top-down/bottom-up connectivity), (2) cognition (environmental enactment), and (3) capabilities (duality management at the board level). Language and communication, embodied cognition, artificial intelligence, and board capabilities’ developmental paths are just examples of the many critical dimensions that will optimize free energy minimization in the context of strategic renewal. Many vibrant topics in strategy management can be re-formulated as a free-energy minimizing challenge, optimizing surprise-minimization by way of prediction-error-minimization.

References Agrawal, A., J. Gans, and A. Goldfarb. 2018. Prediction Machines: The Simple Economics of Artificial Intelligence. Boston: Harvard Business Review Press. Argyris, C. 1995. Integrating the Individual and the Organization. New York: Translation Publishers. Burgelman, R.A., S.W. Floyd, T. Laamanen, S. Mantere, E. Vaara, and R. Whittington. 2018. Strategy processes and practices: Dialogues and intersections. Strategic Management Journal 3: 531–558. Coates, J. 2012. The Hour Between Dog and Wolf: How Risk Taking Transforms Us, Body and Mind. New York: Penguin Press. Eagleman, D. 2017. The Brain: The Story of You. New York: Vintage Books. Gavetti, G. 2005. Cognition and hierarchy: Rethinking the microfoundations of capabilities’ development. Organization Science 16: 599–617. Gawdat, M. 2021. Scary Smart: The Future of Artificial Intelligence and How You Can Save Our World. London: Bluebird. Goldinger, S.D., W.A. Hansen, M.H. Papesh, A.S. Barnhart, and M.C. Hout. 2016. The poverty of embodied cognition. Psychonomic Bulletin & Review 23: 959–978. Halpern, P. 2020. Synchronicity: The Epic Quest to Understand the Quantum Nature of Cause and Effect. New York City: Basic Books. Helfat, C.E. 2000. Guest editor’s introduction to the special issue: The evolution of firm capabilities. Strategic Management Journal 21: 955–961. Helfat, C.E., and M.A. Peteraf. 2015. Managerial cognitive capabilities and the microfoundations of dynamic capabilities. Strategic Management Journal 36: 831–850. Hertwig, R., and C. Engel. 2020. Deliberate Ignorance: Choosing Not to Know. Cambridge, MA: The MIT Press. Hilb, Michael. 2020. Toward artificial governance ? The role of artificial intelligence in shaping the future of corporate governance. Journal of Management and Governance 24: 851–870. https:// doi.org/10.1007/s10997-020-09519-9. Hitt, M.A. 2000. The new frontier: Transformation of management for the new millennium. Organizational Dynamics 28: 6–17. Hodgkinson, G.P., and M.P. Healy. 2011. Psychological foundations of dynamic capabilities: Reflexion and reflection in strategic management. Strategic Management Journal 3: 1500–1516.

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Khezri, B. 2002. A CEO’s take on corporate reform. Wall Street Journal, July 22. https://static1. squarespace.com/static/606c27fa9e99b634a2d6ec0d/t/608179b6d782a33c52ce3bdc/16190 98040651/KCRI_Publications_WSJ_A-CEO%E2%80%99s-Take-on-Corporate-Reform_22.0 7.2002.pdf. Laamanen, T., and J. Wallin. 2009. Cognitive dynamics of capability development paths. Journal of Management Studies 46: 950–981. Lanza, R., M. Pavšič, and B. Berman. 2020. The Grand Biocentric Design: How Life Creates Reality. Dallas, TX: BenBella Books. Lightman, A. 2021. Probable Impossibilities. New York: Pantheon Books. O’Malley, A.L., S.A. Ritchie, R.G. Lord, J.B. Gregory, and C.M. Young. 2009. Incorporating embodied cognition into sensemaking theory: A theoretical examination of embodied processes in a leadership context. In Current Topics in Management, ed. A. Rahim et al., vol. 14, 151–181. Center for Advanced Studies in Management. Raviv, S. 2018. The genius neuroscientist who might hold the key to true AI. Wired Magazine. Downloaded on January 5, 2020. https://www.wired.com/story/karl-friston-free energyprinciple-artificial-intelligence/. Rovelli, C. 2021. Helgoland: Making Sense of the Quantum Revolution. New York: Riverhead Books. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers. Taylor, J. 2009. Organizing from the bottom-up? – Reflections on the constitution of organization in communication. In Building Theories of Organization: The Constitutive Role of Communication, ed. L. Putnam and A.M. Nicotera, 153–186. New York: Routledge. Taylor, J., and E.J. Van Every. 2000. The Emergent Organization: Communication as Its Site and Surface. Mahwah, NJ: Lawrence Erlbaum Associates.

Chapter 13

Outperformance and Survival as a Matter of Self-Organization

Abstract The classical cause-effect determinism upon which the paradigm of strategy management as well as corporate governance research has been built is uprooted. Popperian academics’ relentless pursuit of empirically establishing, qualifying, and then falsifying mechanistic cause-effect relationships is struggling to inspire the business community, which itself is wriggling too often with the (selfinflicted) limitations of its very world models. Together—academia and practice—are challenged to reconnect organizing to that self-evidencing dimension of the universe’s information system. FEG is as valid for business organizations as it is for political constructs or, for that matter, navigating geopolitical dislocations and debt cycle disruptions. Any organism that suffers from (1) top-down/bottom-up hierarchical dysconnectivity and a top-down dominance of supervised content prescriptions, (2) an urge to adapt to the outer world amid an incapacity for enactive inference, and (3) the non-existence of both a timeless (deep) purpose as well as metacapabilities, is naturally entropy-bound. In the absence of a generative (Bayesian) model, we become incapacitated. Indeed, ‘camping on seesaws’ is the categorical imperative of survival-pursuing self-organization: organization as a means, not an end. It is right here where the fundamental difference between Traditional (TCG) and Free Energy governance models lies. FEG sees through formal organization as organizing manifests itself as a self-organizing generative model ‘operating as a whole’—within and without the firm—embracing self-organization as a selfevidencing (universal) information system.

[T]he universe is an information system that is in fact nothing more or less than the spatiotemporal logic of the observer, meaning the self. This alone explains why the laws and forces of nature – which could have almost any value – are all exquisitely balanced in favor of our existence. It is why, for instance, the value of the strong nuclear force is within the narrow range that allows the atomic nuclei in our bodies to hold together without disastrously binding protons together as well. It explains why the gravitational force is exactly as it must be for the sun to ignite, and for fusion to proceed, generating the forces needed to make the carbon atoms that are the very backbone of life itself. (Lanza et al., 2020; emphasis by DBK)

In discontinuous and distributed market environments, sudden scarcities (Schmitt et al. 2016) are more frequent, and the resulting mandate for strategic renewal is of a © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_13

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continuous and wholesale nature (Siebel 2019). Entrenched models of organizing and governance, however, only sub-optimally exercise firms’ sensing and sensemaking capabilities. The classical cause-effect determinism upon which the paradigm of strategy management as well as corporate governance research has been built is uprooted. Indeed, “the processes which produce crises are substantially identical to the processes which produce successes” (Starbuck and Milliken 1988). Popperian academics’ relentless pursuit of empirically establishing, qualifying, and then falsifying deterministic cause-effect relationships is struggling to inspire the business community, which itself is too often wriggling with the (self-inflicted) limitations of their very world models. The only thing that can be falsified is a null ‘hypothesis’. In other words, the only way you can falsify something is to reject the null hypothesis in favor of an alternative hypothesis. The notion of falsifiability is thus a very weak notion. It is weak on several fronts. First, and my favorite, is that the hypothesis that ‘a hypothesis is falsifiable’ is itself not falsifiable. This usually keeps people quite when they ask me whether the free energy principle is falsifiable. On a more serious note, falsifiable hypotheses are a hangover from classical inference. (Friston et al. 2018; emphasis by DBK).

Together, academia and practice are challenged to reconnect organizing to that self-evidencing dimension inherent of the universe’s information system to “purposefully create, extend, or modify [the firm’s] resource base” (Helfat et al. 2007)— to thrive and survive. Purposeful behaviour is one of life’s defining features, but it is only possible if living systems operate as a whole. [. . .] It is only by managing information that the cell can impose order on the extreme complexity of its operations and therefore fulfil its ultimate purpose of staying alive and reproducing. (Nurse 2020)

Free Energy Governance (FEG) proposes a framework that integrates the critical building blocks (structure, cognition, and capabilities) empowering a purposedirected, self-organizing, and surprise-minimizing firm as a generative model governed by one simple first-order principle: free-energy minimization. Effective self-organization is a function of first-order principles dedicated to optimizing resistance to dissipation. Free energy, as an information-theoretic rather than thermodynamic measure, is uniquely positioned to measure and guide a firm’s survivability as a self-organizing information as well as belief system: [Friston] recalls a thought he had as a teenager: ‘There must be a way of understanding everything by starting from nothing [. . .] If I’m only allowed to start off with one point in the entire universe, can I derive everything else I need from that?’ In Friston’s world, the free energy principle is now the nearly nothing that can explain almost everything. (Lindsay, 2021; emphasis by DBK)

Exploitation and exploration encapsulate the everything of a firm’s selfevidencing actions. The relevance of corporate (exploitation) budgets and the success of exploration, respectively, are a function of the (self)-organizing process that generates the underlying assumptions concerning states that we either do not know or are not in control of. In fact, planning and exploration are a matter of enactive, sophisticated, and resource-dependent inference. Indeed, “learn to plan and plan to learn” (Friston et al. 2021) is learning to infer. We need mechanisms of organizing

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and governance that account ex ante for error, uncertainty, and ambiguity. In summary, the inferential discovery of informational dissonance as an errorminimizing source for optimizing the accuracy of posterior beliefs rather than ‘explaining dissonance away’ (Shepherd et al. 2017) is essential to firm survival in discontinuous environments. I have been immensely privileged to complete a PhD in strategy management at the age of 51, while simultaneously transforming an international and diversified media company, Marquard Media Group (MMG). The company has been embarking on a wholesale reinvention from an advertisement-centric to a transaction-led business model, from lifestyle and IT publishing to e-commerce, IT educational services, and gamification software development (see Khezri and Schuster 2021). As MMG’s Group-CEO and part-owner, it has been fascinating to build the bridge between theory and practice in real-time. So, how does FreeEnergy Governance work when it comes to (self-evidencing) exploitation and exploration? FEG emerges in language and communication. To express an exploration challenge, for example, as a matter of enactive inference is instantly giving structure to the project’s execution path. More specifically, exploration is the dynamic interplay of purpose, action, perception, firm resources, and the unknown revealed through hypothesis testing, i.e., prediction-error minimization. Even to the least mathematically inclined manager, it is intuitive to start thinking about exploration as an algorithmic equation dynamically linking knowns and unknowns as well as what is within and beyond the firm’s control. More importantly, exploration is action-centric in form of epistemic foraging and hypothesistesting generating bottom-up stimuli and data-input to continuously update prior beliefs to optimize posterior precision. Even if we stick to a ‘word model’ instead of mathematical formulations, enactive inference’s essential building blocks—six altogether—dynamically map exploration’s conditional (in)dependencies: (1) four states: active (action), sensory (perception), internal (firm resources), and external (hidden unknowns); (2) one internal-external Markovian boundary: the site where our actions upon hidden states generate outcomes that feed in circular causality our perception and allow the precision-enhancing updating of prior beliefs (predictions); and finally, (3) one first-order principle: free-energy-minimization as a measure of minimizing equivocality, error, and uncertainty, i.e., the divergence between predictions (prior beliefs) and outcomes (posterior beliefs). Eventually, everything becomes measurable. Once managers start approaching exploration in form of enactive inference linking in circular causality all four states conditioned by the Markov blanket and governed by freeenergy minimization, we can straightaway see that success in exploration is critically determined by the level of sophistication of: (1) prediction models (a self-evidencing eco-niche model that connects corporate purpose with the very predictions the firm stipulates), (2) the bounded set of external states that the firm decides to act upon to bottom-up sample the world and test hypotheses with the least required computational (resource) investment, and (3) belief-updating resulting from the consequences (posterior beliefs) that the firm’s actions generate. It is now self-evident to appreciate that action is central to perception. More importantly, the firm’s generative model and actions ‘control’ ambiguity and uncertainty. The firm’s generative model is the firm’s eco-niche. The firm is more in control than it traditionally resists to believe. The perception of ‘uncertainty’ is actor/ observer-, i.e., firm-specific. As I am finalizing this book, Marquard Media Group is in the process of completing the Group’s 2022 budgets. While certain financial ratios guide the CEO’s top-down evaluation of the bottom-up generated budgets, however, the budget’s essential part are less the numbers but the level of sophistication and precision of the underlying assumptions supporting the numbers. More specifically, when managers start articulating assumptions (world models and related hypotheses) in form of dynamically linking corporate purpose, predictions (beliefs) and planned actions to minimize error and surprise, the bottom-up seeds for Free-Energy Governance are planted. In my role as CEO, board member and, not least,

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part-owner, I am uniquely positioned to introduce FEG’s language as a basis to bottom-up cultivate enactive inference in pursuit of neg-entropy (i.e., non-equilibrium steady states— the state of survival). But the journey for changing the language as well as the firm’s logic of organizing must start with the board of directors, top-down, purveying FEG’s core building blocks around structure, cognition, and capabilities as a matter of self-evidencing selforganization in pursuit of firm survival.

If you ask board members at the start of a board meeting, for example, to summarize in no more than 3 min on a piece of paper the firm’s timeless purpose (not vision or mission) but answer the question ‘why this business should exist in the first place?’, you will be surprised to learn that there may be as many purposes as board members or just a blank space. Everything in business flows from the clarity and self-evidence of the firm’s timeless purpose. The organism’s timeless purpose, beyond resisting dissipation to survive and reproduce, lays the foundation for self-organization and, hence, Free Energy Governance. Upper Echelon will need to cease the ill-fated pursuit of top-down dominating strategy content. The firm’s intelligence is at the bottom of the organization, close to resource markets (clients, suppliers, partners, and technologies) where the exponential dynamics of transformation-bearing signals are staged. Indeed, we must ask: does ‘strategy’ as a top-down ‘plan of action’ still has meaning in a fast-paced, distributed, and discontinuous world? Rationality seems better understood as a postdecision rather than a predecision occurrence. Rationality makes sense of what has been, not of what will be. It is a process of justification in which past deeds are made to appear sensible to the actor himself [herself] and to those other persons to whom he [she] feels accountable. (Weick 1969)

Indeed, business leaders retrospectively make sense of what has happened and then label it ‘strategy’. Listening to the practitioners who expressed their views as part of this book’s underlying dissertational research, it is evident that purpose, principles, and clearly defined long-term target (prediction) models are essential. Long-term strategic plans, however, are not only being marginalized but could be a source of inertia. As much as human judgment is revalued in a machine learning and data-driven environment, purpose rather than strategy is what really matters (Bartlett and Goshal 1994; Gulati 2022). But purpose must be continuously enacted in the very context of time and space. The most successful companies do not change their purpose, even when they change their corporate brand (e.g., Google to Alphabet, Facebook to Meta). They merely re-interpret purpose according to its spatiotemporal context. Gulati (2022) has introduced the concept of Deep Purpose, which reinforces the existential nature of corporate purpose to firm outperformance and survival: In defining purpose, deep purpose leaders look to the past, immersing themselves in the intentions of founders and early employees, scouring for themes that capture the firm’s ineffable soul or essence. This attention to history lends purpose an extra weightiness, resulting in deeper emotional connections and more commitment to the reason for being. Paradoxically, it also serves as a bridge to the future, helping leaders to chart a path ahead that is meaningful, coherent, and grounded.

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Purpose lays the foundation for the very data we seek to enact to feed the firm’s generative model, empowering self-organization. To borrow from Seneca’s famous quote, purpose is not so much about knowing which port you are sailing to. But ‘why are you sailing in the first place?’ is the question that every company must answer to continuously enact its very eco-niche to thrive and survive. Jan Ståhlberg’s (2021) reflections upon the foundation and success of EQT, one of the world’s leading PE investors, put into perspective how firm performance and the eco-niche’s common good are interdependently and causally linked as duality: Yes, EQT has been an incredible success story. The original team was in a range of 26–34 years old when the firm started in the mid-1990s, supported by the Wallenberg family. The success of the Wallenberg family, which at the time was in its fifth generation and controlled a third of Sweden’s stock market, comes really down to a long-term approach powered by a circular reasoning: what is good for society is good for the country, and this will be good for our companies and eventually our family. Society was always a central focus of all business decisions. In my view, EQT’s success cannot be separated from that background story. [. . .] You must invest into structures, into a future that serves well beyond your typical 5-year PE investment horizon. Our competitive advantage in the PE industry was to develop an operations-focused industrial approach. Obviously, many large companies laughed at us because for them PE and long-term is a contradiction in itself.

In summary, firm outperformance and survival are essentially a matter of combining (1) a timeless (deep, Gulati 2022) purpose, (2) generative top-down/bottomup prediction error minimization in form of free energy minimizing enactive inference, and (3) principled values and aspirations determining eco-niche prosperity and sustainability. If all three elements are articulated in simple (“explainable”) language and communicated to all members, within and beyond the firm’s boundaries, then the firm’s long-term prospects will be substantially enhanced in form of a selforganizing generative model. The board of directors rather than executive leadership only must ensure that those elements come to life—and, more importantly, stay alive. Firm survival is essentially determined by ‘learning from the future as it emerges’. This is the essence of enactive Ai as a basis for self-organization: We have the gift to engage with two very different qualities and streams of time. One of them is a quality of the present moment that is basically an extension of the past. The present moment is shaped by what has been. The second is a quality of the present moment that functions as a gateway to a field of future possibilities. The present moment is shaped by what is wanting to emerge. That quality of time, if connected to, operates from presencing the highest future potential. The word presencing blends ‘sensing’ with ‘presence’. It means to sense and actualize one’s highest future potential. Whenever we deal with disruption, it is the second stream of time that matters most. Because without that connection we tend to end up as victims rather than co-shapers of disruption. (Scharmer, 2018)

In a discontinuous and distributed world, “perhaps all social institutions [. . .] face disruptive forces so fast, big, and unpredictable that every entity will fall within years or decades, without exception. Can we still stave off decline in the face of severe turbulence?” (Collins 2009; emphasis by DBK). ‘What are the origins of competitive advantage?’ is strategy research’s most fundamental question:

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Ex post, it is clear that some firms actively identify, interpret, and act upon early signals from their internal and external environment, and so position themselves to effectively exploit these opportunities well in advance of others’ demonstration of the pay-off from the strategies which emerge later on as ‘best practice’. These firms are creating new sources of competitive advantage. Understanding how they organize ex ante to do this is, in our view, a central question for strategy research. (Cockburn et al. 2000)

Free Energy Governance is not about optimizing a firm’s ‘shelf life’ for the sake of it, but essentially answers Cockburn’s central question for strategy research: FEG is about continuously and optimally generating ex ante new sources of competitive advantage by way of purpose-driven free energy minimizing enactive inference, engaging the whole organization, and beyond, i.e., the firm’s eco-systems. As machines will assume an increasingly prominent role in strategic decision-making, Upper Echelon is challenged to effectively enact the human-machine interface to fully leverage the firm’s multi-intelligence dimension. Language and communication are the site of emergence for that interface. Ai provides the language and logic to fully leverage AI as a foundation for competitive advantage in a discontinuous and distributed environment. FEG is as valid for business organizations as it is for political constructs or, for that matter, navigating geopolitical dislocations and debt cycle disruptions. Any organism that suffers from a (1) top-down/bottom-up dysconnectivity, (2) top-down dominance of ideological and supervised content prescriptions, (3) dominant logic to adapt to ‘the outer world’ amid a self-inflicted incapacity for enactive inference, and not least (4) non-existence of a timeless purpose as well as meta-capabilities, such as listening to what wants to emerge in the web of random interactions and observing the observer, is naturally entropy-bound and incapacitated to navigate macrodisruptions. Therefore, national democracies such as Switzerland, for example, are likely to get sustainably stronger and more prosperous over time: (1) strong top-down/ bottom-up connectivity in form of direct democracy fostering dialogue and cultivating an ‘explainable’ public discourse across the political hierarchy from the federal level to the cantonal to the local community level; (2) a timeless purpose in form of protecting its autonomy, self-sufficiency, and sustainability as a small, land-bound, and overall unique country anchored in the Calvinist humbleness to never take its national wealth for granted but to proactively, collectively, and equitably advance the country’s collective prosperity; and (3) a first-order (self-organizing) principle in form of respect for and belief in the individual’s autonomy and capability for selfdiscipline and sound judgement as a foundation to foster the country’s freedom, prosperity, and autonomy. All three dimensions are cross-fertilizing in circular causality. Each element is foundational. The Habit of Mind (Wurtzel 2012) that best captures Switzerland’s DNA: “Be Humble, Run Scared.”1 1

I am grateful to my dear Swiss friends—Frank Bodin, Jürg Marquard, Luka and Thomas Müller, Marcel Peter, Christoph Tonini, and Marc Walder—for the enriching conversations allowing me to understand from within Switzerland as a uniquely ‘self-organizing construct’. Each one of you—in very distinct ways—represents the uniqueness of Swissness. At the time of finalizing this book

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Switzerland is as close as a national democracy can sustainably self-organize and, consequently, outperform. A supranational construct such as the European Union (EU), for example, is structurally top-down/bottom-up disconnected. Hence, the foundation for a generative self-organizing model is non-existent. In addition, the EU is struggling to unite its peoples around a timeless and energizing purpose: peace and economic integration are no longer sufficiently invigorating (though, Russia’s invasion of Ukraine may change this). The EU is left with nothing more but advancing its very self as a self-serving purpose, justifying ever more expansion and supranational integration. But to what end? Simply put, the self has become the EU’s first-order principle: rather than serving as a means, it has become an end. Entropic forces are inevitably on the rise, advancing dissipation from within its member states (Khezri 2005). The EU is the antithesis to entropy-defying selforganization. It “is trapped in a self-feeding vicious circle” (Khezri 2009). Michael Hitt’s endorsement of this book invited me to revisit the works of Nobel laureate Douglass North, which had not only inspired my studies of economics but do befit the very context of applying FEG to the study of the rise and decline of nations: Humans attempt to use their perceptions about the world to structure their environment in order to reduce uncertainty in human interaction. But whose perceptions matter and how they get translated into transforming the human environment are consequences of the institutional structure, which is a combination of formal rules, informal constraints, and their enforcement characteristics. This structure of human interaction determines who are the entrepreneurs whose choices matter and how such choices get implemented by the decision rules of that structure. Institutional constraints cumulate through time, and the culture of a society is the cumulative structure of rules and norms (and beliefs) that we inherit from the past that shape our present and influence our future. […] Does the uncertainty that humans face come from the inherent instability of the human landscape or from the perceptions and belief systems that we have about the human environment? (North 2005; emphasis by DBK)

“Sometime before the year 2025, America will pass through a great gate in history, commensurate with the American Revolution, Civil War, and the twin emergencies of the Great Depression and World War II” (Strauss and Howe 1997). The study of more than 500 years of modern history has quite consistently

manuscript, an upcoming direct democracy-initiated vote on COVID-related regulations is dividing Swiss society in unprecedented ways. I have all the confidence that the generative and open discourse integral to self-organizing generative models (i.e., direct democracy)—no matter how divisive the debate—will continue strengthening the organism’s resilience. This was equally true for the 1992 vote when Swiss people rejected closer European integration. In contrast, other democracies’ top-down blitz enforcements of COVID-related restrictions (often grossly intruding on fundamental freedoms, thus, bordering upon constitutional unlawfulness) are equally dividing society. But in the void of self-organizing generative mechanisms, societal psychopathology is cultivated and will further disenfranchise and fragment the very foundation of democracy and society, potentially leading to entropic dissipation. In a world that is less classical but more quantum, eighteenth- and nineteenth-century constructs of governance—such as the nation-state as well as democracy—are no less in need to be fundamentally challenged and reinterpreted. In the absence of self-organizing mechanisms, entropy is rising, and revolt is, eventually, looming.

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distilled 100-year cycles (the saeculum) each consisting of four turnings: growth (spring), maturation (summer), entropy (fall), and destruction (winter). “The farther backward you look, the farther forward you are likely to see” (Winston Churchill, as quoted in Strauss and Howe 1997). This temporal thickness (Friston 2017), unconstrained from today’s dominant and erroneous interpretation of time as a phenomenon of linear progress, powers sophisticated (generative) self-organizing (first-order principle governed) prediction models. “Finally, unlearn the linear view that positive change always comes willingly, incrementally, and by human design [. . .] our faith in linear progress has often amounted to a Faustian bargain with our children. Faust always ups the ante, and every bet is double or nothing. Through much of the Third Turning, we have managed to postpone the reckoning. But history warns that we can’t defer it beyond the next bend in time” (Strauss and Howe 1997). We cannot change the universe’s seasonality, but we can prepare for it. This is precisely where free-energy minimization as a first-order principle and, more specifically, Free-Energy Governance will make the difference: define a timeless (deep/ existential) purpose as the axiomatic foundation for a generative top-down/bottomup prediction-error-minimization model, go out and explore so that epistemic and pragmatic actions can deliver the stimuli (data points) to update and enhance—in circular causality—the precision of posterior beliefs. Thus, the crisis-winter will be more likely enacted as opportunity rather than threat. “Be Humble and Run Scared” (Wurtzel 2012) as free-energy minimizing self-organization blends with the universe’s information system. “Each circle of time has a great moment of discontinuity” (Strauss and Howe 1997): reality (learning) models, underlying principles, and corresponding actions determine how successfully the very present moment is leveraged “as a gateway to a field of future possibilities” (Scharmer 2018) and whether one emerges as co-shaper rather than victim of discontinuity. Ray Dalio’s (2021) study of world history, from China’s Tang dynasty in 600 CE to the present time, brilliantly crystalizes the rise and fall of nations as a function of credit and reserve-currency cycles. Accordingly, we are now in the saeculum’s Fourth Turning that Strauss and Howe (1997) foretold 25 years ago. Indeed, there are many timeless cause-effect relationships that the study of history beholds in form of salient determinants (hyper-priors) suggesting what to predict next. While throughout history such cause-effect relationships may have ex-post consistently elucidated disruption and, indeed, should serve as an alert gauge for impending discontinuity, circumstances are always rather unique. More specifically, classical cause-effect relationships at the macro (cosmic) level get disrupted at the quantum (subatomic) level. Technological advancement and inventiveness, the accelerating nature of disintermediation at every level of economic activity as well as geopolitical balance-of-power shifts and (de-)globalization, for example, make the timing and shape of credit and business cycles less and less predictable. Nature’s very rhythm— the universe’s information system—is inescapable, as much as modern technologies are “[flattening] the very physical evidence of natural cycles” (Strauss and Howe 1997). But to survive, above all, the collective—“the body itself” (Allen and Friston 2018)—must be united around a timeless purpose, “operate as a whole” (Nurse 2020), and exercise self-discipline in its pursuit—at both the individual as well as

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collective level. Fragmentation within the collective, lack of purpose, and absence of self-discipline are likely to foster skilled incompetence: actions become counterproductive, decadence spreads, and entropic dissipation accelerates. Navigating and preparing for the seasonal disruption of credit cycles are no less a matter of governing continuous transformation. Fundamentally, it is a generative free-energy minimization, i.e., Free-Energy Governance, challenge. ‘Reality’ is a matter of emergence in interactions and relations. We are living in a multi-world—every action confronts us with new forks of infinite possibilities for actions leading to distinct paths. The more timeless our purpose and the more bottom-up challenged our top-down predictions and underlying models are, the less vulnerable we are in the face of discontinuities. Adaptation is an ill-suited catch-up tool in discontinuous and distributed market environments. To navigate discontinuity, we must learn to purpose-directedly, generatively, and en-actively infer our very world. In the absence of a generative (Bayesian) model, we become incapacitated. Indeed, when throwing yourself off the cliff to assemble the plane in free-fall, ‘camping on seesaws’ (Hedberg et al. 1976) is the categorical imperative of survival-pursuing self-organization: organization as a means, not an end. It is right here where the fundamental difference between Traditional (TCG) and Free Energy Governance lies. FEG sees through formal organization as organizing manifests itself as a self-organizing generative model operating within and without the firm, dedicated to a timeless purpose. To appreciate self-organization as a self-evidencing information system, at any logical level—subatomic, cellular, human, firm, or cosmic—Alan Lightman’s (2021) ‘probable impossibilities’ provide a fascinating perspective on human existence between two infinities: the ultratiny (Planck’s quantum length of 10 33 centimeters, i.e., “a hundred million billion times smaller than a quark [. . .] the same ratio as the nucleus is smaller than the state of Rhode Island” where “time and space no longer exist in a way that has meaning to us”), i.e., the nothing, and the ultra-large, the universe, i.e., the everything. How many times should the size of a human body be halved to reach the size of an atom (a size unknown until the twentieth century)? The answer is about 33. Going in the opposite direction, one can ask how many times the size of the human body should be doubled to reach the size of a typical star, like our Sun [. . .] The answer is 30. Thus, counting in doublings, the size of the human being is nearly halfway between an atom and a star [. . .] And it is a deeply human experience – concerning what the human mind understands and what that mind does not yet understand. The [Markovian] boundary between the known and the unknown is not a static boundary. (Lightman 2021)

As Lanza et al. (2020) wrote, “the laws and forces of nature – which could have almost any value – are all exquisitely balanced in favor of our existence”. This is true for living organisms but not for man-made artifacts, such as nation-states, societies and organizations. Indeed, the innate reflex is to explain dissonance away and to avoid uncertainty, reinforcing the known, top-down suppressing self-organization, and subsequently increasing free energy. This is precisely how credit cycles, for example, consistently become inflationary and eventually blow-up with potentially and systemically devastating consequences. More specifically, the system gets

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caught in the financial control trap (steroidal monetary policy) crowding out strategic control (credit creation for productive purposes and inventiveness) as: (1) topdown/bottom up prediction-error minimization is non-existent; (2) enactment of a new model remains incapacitated as adaptation to the known dominates and, finally, (3) governance capabilities de-antagonizing polarizing forces as duality are nondeveloped and the absence of a Markov blanket is turning the interdependency between internal and external orders entropic. Eventually, the system breaks down. Free-Energy Governance is (self)-empowering thinking born of curiosity, revolt, and change (Rovelli 2021). FEG embraces the world beyond the firm’s Bayesian priors to listen and hear what urges to be enacted in the haziness of the distributed and discontinuous web of exponential inter-actions that has no pre-existence or spatio-temporal logic. More specifically, the firm’s competitiveness—in terms of continuous strategic renewal and, hence, survival in discontinuous market environments—is determined by the temporal thickness and counterfactual depth (Friston 2017) of the firm’s top-down/bottom-up active inference capability. We must leave the world of the known to renormalize to self-organize to outperform to survive. Let’s call it Friston’s Law: All the quantities in a self-organising system that can change will change to minimise free energy. So, there you have it. Armed with this knowledge, everything that we call mental life becomes mathematically tractable. (Solms 2021)

References Allen, M., and K.J. Friston. 2018. From cognitivism to autopoiesis: Towards a computational framework for the embodied mind. Syntheses 195: 2459–2482. https://doi.org/10.1007/s11229016-1288-5. Bartlett, C., and S. Goshal. 1994 Changing the role of top management: Beyond strategy to purpose. Harvard Business Review 72(6): 79–88. Cockburn, I.M., R.M. Henderson, and S. Stern. 2000. Untangling the origins of competitive advantage. Strategic Management Journal 21: 1123–1145. Collins, J. 2009. How the Mighty Fall: And Why Some Companies Never Give in. New York: HarperCollins. Dalio, R. 2021. Principles for Dealing with the Changing World Order. New York: Avid Reader Press. Friston, K. 2017. The Mathematics of Mind-Time: Consciousness Is Not a Thing, but a Process of Inference. Aeon Essays (online): https://aeon.co/essays/consciousness-is-not-a-thing-but-aprocess-of-inference. Friston, K., M. Fortier, and D.A. Friedman. 2018. Of woodlice and men: A Bayesian account of cognition, life and consciousness. An interview with Karl Friston. ALIUS Bulletin 2: 17–43. Friston, K.J., L. Da Costa, D. Hafner, C. Hesp, and T. Parr. 2021. Sophisticated inference. Neural Computation 33 (3): 713–763. Gulati, R. 2022. Deep Purpose: The Heart and Soul of High-Performance Companies. New York: HarperCollins Publishers. Hedberg, B.L.T., P.C. Nystrom, and W.H. Starbuck. 1976. Camping on seesaws: Prescriptions for a self-designing organization. Administrative Science Quarterly 21: 41–65.

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Helfat, C.E., S. Finkelstein, W. Mitchell, M.A. Peteraf, H. Singh, D. Teece, and S.G. Winter. 2007. Dynamic Capabilities: Understanding Strategic Change in Organizations. Malden, MA: Blackwell. Khezri, B. 2005. The end of an age in Europe. Wall Street Journal, June 1. https://static1. squarespace.com/static/606c27fa9e99b634a2d6ec0d/t/607fcf64cd4b8b3d25684e3f/161 8988903862/KCRI_Publications_WSJ_The-End-of-an-Age-in-Europe_01.06.2005.pdf. Khezri, B. 2009. Generation Dubai: Exit, Voice and Loyalty. Guernsey (CI): BK Capital Group. Khezri, B., and P. Schuster. 2021. Marquard Media: 4Players’ learning DNA to survive disruptions. In Connected Business: Create Value in a Networked Economy, ed. O. Gassmann and F. Ferrandina. Cham: Springer Nature. Lanza, R., Pavšič, M., and Berman, B. 2020. The Grand Biocentric Design: How Life Creates Reality. Dallas, TX: BenBella Books. Lightman, A. 2021. Probable Impossibilities. New York: Pantheon Books. Lindsay, G. 2021. Models of the Mind: How Physics, Engineering and Mathematics Have Shaped Our Understanding of the Brain. London: Bloomsbury Sigma. North, D.C. 2005. Understanding the Process of Economic Change. Princeton: Princeton University Press. Nurse, P. 2020. What Is Life? Oxford: David Fickling Book. Rovelli, C. 2021. Helgoland: Making Sense of the Quantum Revolution. New York: Riverhead Books. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers. Schmitt, A., V.L. Barker, S. Raisch, and D. Whetten. 2016. Strategic renewal in times of environmental scarcity. Long Range Planning 49: 361–376. Siebel, T.M. 2019. Digital Transformation: Survive and Thrive in an Era of Mass Extinction. New York: RosettaBooks. Solms, M. 2021. The Hidden Spring: A Journey to the Source of Consciousness. New Yok: W.W. Norton & Company. Ståhlberg, J. 2021. Jan Ståhlberg discusses free-energy governance’s core propositions in an openstyle interview with Bijan Khezri (February 14, 2020). In Free Energy Governance - Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival, ed D.B. Khezri. Zug, Switzerland: KCRI (Khezri Capital Research International) AG. https://www. alexandria.unisg.ch/262427/1/Dis5052.pdf. Starbuck, W.H., and F. Milliken. 1988. Executive perceptual filters: What they notice and how they make sense. In The Executive Effect: Concepts and Methods for Studying Top Managers, ed. D. Hambrick, 35–65. Greenwich, CT: Jay Press. Strauss, W. and Howe, N. 1997. The Fourth Turning - An American Prophecy: What the Cycles of History Tell Us About America's Next Rendezvous with Destiny. New York: Three Rivers Press. Weick, K.E. 1969. The Social Psychology of Organizing. Reading, MA: Addison-Wesley. Wurtzel, A. 2012. Good to Great to Gone: The 60 Year Rise and Fall of Circuit City. New York City: Diversion Books. Shepherd, D.A., J.S. McMullen, and W. Ocasio. 2017. Is that an opportunity? An attention model of top managers’ opportunity beliefs for strategic action. Strategic Management Journal 38: 626–644.

Part IV

Engaged Scholarship Interviews

Engaged scholarship is defined as a participative form of research for obtaining the different perspectives of key stakeholders (researchers, users, clients, sponsors, and practitioners) in studying complex problems. By involving others and leveraging their different kinds of knowledge, engaged scholarship can produce knowledge that is more penetrating and insightful than when scholars or practitioners work on the problems alone. Van de Ven (2007)

As part of the original dissertational research (Khezri 2021), DBK personally addressed Free Energy Governance’s core propositions in form of open-style interviews with two prominent business leaders: Steve Case (Case 2021) and Jan Ståhlberg (Ståhlberg 2021).

References Case, S. 2021. Steve Case discusses free-energy governance’s core propositions in an open-style interview with Bijan Khezri (January 29, 2020). In Free Energy Governance - Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival, ed. Khezri, D. B. Zug, Switzerland: KCRI (Khezri Capital Research International) AG. https://www.alexandria.unisg.ch/262427/1/ Dis5052.pdf. Ståhlberg, J. 2021. Jan Ståhlberg discusses free-energy governance’s core propositions in an open-style interview with Bijan Khezri (February 14, 2020). In Free Energy Governance - Sensing, Sensemaking, and Strategic Renewal: Surprise Minimization and Firm Survival, ed. Khezri, D. B. Zug, Switzerland: KCRI (Khezri Capital Research International) AG. https://www.alexandria.unisg.ch/2 62427/1/Dis5052.pdf. Van de Ven, A. H. 2007. Engaged Scholarship: A Guide for Organizational and Social Research. Oxford: Oxford University Press.

Chapter 14

Steve Case

Abstract Case’s governance experience encompasses private and publicly listed companies as well as public institutions. Five key interview statements are worth highlighting: (1) “there is a need to take a fresh look at governance models”; (2) “governance cannot be viewed in a vacuum – what is appropriate really depends on the context”; hence, “a ‘one size fits all’ approach will likely be flawed”; (3) “where the organization is in the lifecycle will likely lead to a sense of how ‘top down’ vs ‘bottoms up’ the governance should be”; (4) “sometimes the best way to expand and grow is to not just rely on internal innovation, but to acquire [. . .] be careful to not let M&A become the only source of innovation and growth, as that too can stifle innovation in other parts of the company”; (5) “Signals for transformative changes can often start at the bottom, because younger people may be more attuned to this. But in other instances, the leadership needs to come from the top, as people at lower levels may be too task-specific and miss the relevant signals.”

14.1

Steve Case (January 29, 2020)

Steve Case is one of America’s best-known and most accomplished entrepreneurs and a pioneer in making the Internet part of everyday life. Steve’s entrepreneurial career began in 1985 when he co-founded America Online (AOL). Under Steve’s leadership, AOL became the world’s largest and most valuable Internet company. In 2014, Steve was named a Presidential Ambassador for Global Entrepreneurship. Steve is on the Board of Regents of the Smithsonian Institution in Washington, D.C. He is CEO and Chairman of Revolution, a venture and growth capital dedicated investment firm.

“I tend to agree with many of the propositions of the Free Energy Governance framework. Most importantly, I believe there is a need to take a fresh look at governance models, in light of the many challenges/opportunities of our times. The various experiences I’ve had, ranging from starting America Online, to chairing a merged AOL/Time Warner, to backing entrepreneurs via Revolution, or by helping to oversee public institutions like the Smithsonian, lead me to conclude that governance cannot be viewed in a vacuum – what is appropriate really depends on the context in which you’re operating. A ‘one size fits all’ approach will likely be flawed. Rather, you need to finetune the governance for the specific circumstance, © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_14

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based on where the organization is in its life cycle, how the team is working and what changes might be needed to position the organization for the future, how the company or organization fits in a broader context (competition, technology, government, and other), what challenges you face and/or opportunities you’re seeking to seize, etc. That assessment will likely lead to a sense of how ‘top down’ vs ‘bottoms up’ the governance should be, for the next chapter. As an entrepreneur and a backer of entrepreneurs, I tend to prefer a more distributed ‘bottoms up’ approach. But I’ve seen situations where stronger ‘top down’ leadership is required. An example is the leadership Bob Iger has brought to Disney in recent years, pulling the entire company together to launch Disney+. He (and the board) concluded that Disney needed to control its streaming future and insisted that every division work together to ensure a successful launch of Disney+. By contrast, the merger of AOL and Time Warner was disappointing in part because it lacked a clear unified vision and failed to bring every division of the company together to build on its early lead in media, communications and Internet. In other situations, driving in innovation down in the organization, to unleash a wave of experimentation and a culture of innovation can be transformative. Often the innovators just need resources and a champion, and to get the friction/bureaucracy removed, so they can launch new initiatives. In those instances, too much top-down leadership could be stifling, and slow innovation. And sometimes the best way to expand and grow is to not just rely on internal innovation, but to acquire compelling and compatible businesses. This leads to an M&A-centric effort, which likely does enable the company to expand more rapidly, but then there are integration issues to deal with. And you need to be careful to not let M&A become the only source of innovation and growth, as that too can stifle innovation in other parts of the company. Yes, the world is more distributed and discontinuous, and that process will be accelerated by a whole range of new technologies. Overall, I tend to agree that invention and innovation are getting cheaper. However, while that may be true, in certain cases commercial scalability is still very expensive and in some cases is so complicated as a result of regulations that innovation is there but market scalability is impossible. This is increasingly true for healthcare, for example. Commercial scaling is very hard, even in a low-cost innovation environment. It is tricky to find the right balance between top-down/bottom-up. Signals for transformative changes can often start at the bottom, because younger people may be more attuned to this. But in other instances, the leadership needs to come from the top, as people at lower levels may be too task-specific and miss the relevant signals. The key takeaway for me is leadership and governance matters. Thomas Edison famously said, ‘vision without execution is hallucination’ and I agree with that. You need vision to have a sense of where you want/need to go, but you can’t get there without strong execution, which ultimately comes down to people – and how they are led, managed and governed.”

Chapter 15

Jan Ståhlberg

Abstract Jan Ståhlberg is one of Europe’s private equity veterans who has consistently embraced governance as a critical driver of performance and value creation. Five key interview statements are worth highlighting: (1) “private equity should outperform public companies [. . .] PE practitioners constantly question the status quo.” (2) “Public boards are more dedicated to what they have. They rarely question the existing business.” (3) “Everyone is informed in real-time about everything. Indeed, this may lead to an overload of information, but overall, this is still more preferable than top-down filtering that may risk excluding potentially insightful stimuli and feedback [. . .] this is Free Energy Governance: connecting top and bottom in circular causality of sensemaking with the least friction and optimal response time.” (4) “Create a culture that empowers and encourages people to contribute, to take decisions, and not to be risk averse.” (5) “You cannot expect bottom-up stimuli reaching the top when the top is not reaching out to the bottom. And sometimes a simple walk through the office can make all the difference. Listen humble and with respect. In summary, it really comes down to three things: communication, transparency, and respect.”

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Jan Ståhlberg (February 14, 2020)

Jan Ståhlberg is Founder of Trill Impact, a buyout firm dedicated to impact investing. Jan is a former partner of EQT, a company he joined in 1995 as part of the initial team. During his tenure, until mid-2018, he held positions such as Vice Chairman, Deputy Managing Partner, and Head of Mid-Market globally across Europe, the United States, and Asia.

“From my perspective PE, and in particular EQT, for example, have always embraced governance as a critical driver of both performance and long-term value creation. Indeed, private equity should outperform public companies for a number of reasons: First, PE has more strategic freedom. PE practitioners constantly question the status quo. Public boards are more dedicated to what they have. They rarely question the existing business. Second, PE neutralize any potential conflicts of interest and build alignment of interests so that the collective power of all involved can be optimally leveraged for a long-term goal. Third, optimal capital allocation is a © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 B. Khezri, Governing Continuous Transformation, Contributions to Management Science, https://doi.org/10.1007/978-3-030-95473-4_15

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key value-driver. Public companies have more difficulty in convincing markets to over-capitalize for future growth opportunities or public boards are often reluctant to reduce capitalization to benefit from more efficient capital costs fearing a potential embarrassment asking for a capital injection even in a very unlikely negative scenario although that lower capitalization may be in the best interest of the shareholders. Fourth, at least at EQT, a paranoia-powered sense of urgency has always been part of the DNA. In my personal experience, buying businesses directly from the founding entrepreneurs can be challenging for PE. Founders are typically obsessed with their business, in every detail. It is almost impossible to replace the Founder. Governance is typically very effective. But once you take out the Founder and introduce more professional structures, the organization can get paralyzed since the organization is not used to a traditional chain of command. Yes, EQT has been an incredible success story. The original team was in a range of 26–34 years old when the firm started in the mid-1990s, supported by the Wallenberg family. The success of the Wallenberg family, which at the time was in its fifth generation and controlled a third of Sweden’s stock market, comes really down to a long-term approach powered by a circular reasoning: what is good for society is good for the country, and this will be good for our companies and eventually our family. Society was always a central focus of all business decisions. In my view EQT’s success cannot be separated from that background story. I believe EQT benefited hugely from the Wallenberg network. In my opinion, for PE to create substantial value, you must be long-term focused. You must invest into structures, into a future that serves well beyond your typical 5-year PE investment horizon. Our competitive advantage in the PE industry was to develop an operations-focused industrial approach. Obviously, many large companies laughed at us because for them PE and long-term is a contradiction in itself. I believe those founding roots have ‘governed’ EQT to this day. It is reflected in the organizational design and the firm’s long-term orientation. EQT operated on the basis that ‘everyone should know’. Everyone is informed in real-time about everything. Indeed, this may lead to an overload of information, but overall, this is still more preferable than top-down filtering that may risk excluding potentially insightful stimuli and feedback. How did we manage this: we allowed everyone in the firm to listen into the investment calls, for example. It was a brilliant move. While other PE firms cultivated ‘closed doors’, we embraced such openness as a major learning platform, training young professionals to understand our sense of urgency, paranoia, long-term focus and, not least, our principles. More importantly, we often benefited from insights we would have not accessed otherwise. Our organizational structure has never been cascaded. And, I believe, looking at some of the core propositions of Free energy Governance, this is Free energy Governance: connecting top and bottom in circular causality of sensemaking with the least friction and optimal response time. Overall, I think as long as people are open-minded, the composition of the board is not the problem. Communication is everything. Value creation, in my experience,

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has been usually determined by a combination of the following governance imperatives: First, you must start with a clear purpose and long-term goal. Prepare to invest for the long-term, and into structure. Second, you need to continuously question yourself. Paranoia is key. Third, team-decisions are critical. Create a culture that empowers and encourages people to contribute, to take decisions, and not to be risk averse. Team-decisions are an optimal way to get the best out of everyone. Fourth, the organization must be open and transparent; no room for politics. When I was running the global Mid-Market operations out of New York, I was known for ‘walking around’, cleaning tables and putting my coffee cup in the dishwasher. You cannot expect bottom-up stimuli reaching the top when the top is not reaching out to the bottom. And sometimes a simple walk through the office can make all the difference. Listen humble and with respect. In summary, it really comes down to three things: communication, transparency, and respect. Indeed, the world is discontinuous and increasingly distributed. Young people are an unpredictable force for change. I believe you call it enactment as part of the Free Energy Governance framework. You can enact your world and then things do not look that unpredictable. With Trill Impact, I am now dedicated to a megatrend, which I believe is about to accelerate and will fundamentally disrupt leading corporations: in terms of sustainability, a business has either a positive or negative footprint; a positive footprint will win hearts and minds and will eventually lower costs of capital.”

Acknowledgments and Epilogue

Enrolling in a PhD program is kind of ‘throwing yourself off a cliff and assemble your airplane on the way down’; the more so at the age of 45 while being intensely immersed in business and, not least, a dedicated family father of two teenagers. Converting a PhD thesis (Khezri 2021) into book format, i.e., something more readable, is another endeavor of its own. In retrospect, it just feels like ‘probable impossibilities’. But there is a neat structure underlying impossibilities: first-order principles. In a nutshell, this is the essence of the topic of this book: free-energy minimization. Pick any goal: there is a path of ‘least action’. The journey starts with epistemic and pragmatic foraging. Acknowledgments generally consist of a list of individuals and instituions that have meaningfully influenced and determined a presented output. But for any person or institution to enter one’s life and contribute to one’s endeavors, we must en-act our environment first: to have a purpose, one must reach out beyond the self, equipped with a sense of urgency, listening carefully with all senses, considerate of choices, and progressing by way of active (generative) inference. This is the essence of presencing (Scharmer 2018): ‘a gateway to a field of future possibilities, the highest future potential’. It is a journey that sometimes is simply and most potently summarized as a social field of interactions with a select number of individuals exercising a special place and role in one’s life. Above all, I must thank my parents, in particular my mother. She instilled a ‘thinking born of curiosity’, continuously encouraging me at a very young age to reach out beyond the self and explore. She gifted the seeds of curiosity and cultivated confidence in action to continuously develop new eyes. The very acknowledgments expressed as part of my doctoral thesis equally apply to this book, in particular with regard to my supervisors, Professors Nils Jent and Martin Hilb, at the University of St. Gallen. They both literally ‘opened the gates’ to a new developmental path and social field, finally encouraging me to convert the thesis into book format to make its contents more widely accessible. I am deeply grateful for their trust, support, and continuous encouragement. Throughout my

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academic development, Professor Oliver Gassmann, Director of the Institute of Management and Technology at the University of St. Gallen, stands out. Oliver has been a critical and supportive advisor, guiding me to take the right decisions at crucial junctures. I am deeply grateful for his support and friendship. It was Oliver who introduced me to Springer Nature. Dr. Prashanth Mahagaonkar, Executive Editor, has embraced the book proposal from the first day. Ramya Prakash diligently managed the publishing process. I am grateful for their advice and support. I had the privilege of working with and learning from great entrepreneurs and financiers. Each one of them has shaped the many paths that have continuously enriched my life. Unfortunately, despite all entrepreneurial genius (which is often negatively correlated to managerial talent), one too many could not resist being succumbed to capital markets’ quarterly pressures, eventually leading to the pitiful trap that excessive financial control beholds. The firm’s survival is usually at risk long before one admits to realize. My business partnership with Jürg Marquard coincided with the PhD studies, allowing me to build a fascinating real-time bridge between practice and theory on the back of what Jürg had built over 50 years of successful entrepreneurship. I am deeply grateful to Jürg for our partnership and unique friendship and, above all, to the exceptional senior leadership team at Marquard Media Group: Benjamin Sterbenz, Christian Müller, Phillip Schuster, Rainer Rosenbusch, and Zsuzsanna Óhidi. You have embraced Free Energy Governance as a natural way of organizing and becoming! It is an honor to have Professor Karl Friston, the world’s leading neuroscientist, and Professor Constance Helfat, one of the most renown strategy scholars, each contribute a Foreword. No book author could ask for a more unique and for this subject matter certainly more befitting combination. If this book has any lasting relevance, then it is because their respective forewords symbolize the opening of a new multi-disciplinary conversation. Both Karl and Connie are scholars of the very highest accomplishments. The contents of this book have drawn their attention, I believe, for reasons that usually do tend to subsequently set free the best in scholarship: the multidisciplinary potential of the topic or simply an outsider’s input to provide new momentum to topics that somehow are calling for a fresh perspective. This book attempts to show that if we take the trouble to look to the side, at the domains of other disciplines, we shall gain a different conception of the entire landscape. (Olson 1982)

As I am writing these last words, a naturally mutating epidemic continues taking its toll—in human lives as well as devalued purchasing power, following inflationary fiscal and monetary policies. A coronavirus—which is dead to start with but awakens to life within the inflammatory bounds of the human body—is crystalizing the very limitations of policy-making institutions, the ill-preparedness of healthcare systems, the blind faith in government-sponsored scientific assertions, and most regrettably, the inflammatory decadence of the human state of health (physically and mentally).

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Before worrying about our planet’s sustainability, we should be concerned about the very well-being and survival of the human specie; not because of the consequences of human-inflicted environmental deterioration but humans’ self-decaying life-style choices. Nature is mindless and one-sided as Alan Lightman (2021) rightly states. Nature is self-organizing and regenerating. The universe is expanding at an accelerating rate. Eventually, the sun will no longer ignite and planet Earth will be quarantined within the multiverse, with no life left whatsoever. The discourse that is missing today is how humans can regain autonomy of their very well-being individually and collectively. Bodily self-awareness and self-discipline will naturally align the human specie with nature. Indeed, it is a matter of survival. The organizational artifacts humans create suffer from the very same destructive forces that humans’ distortions inflict upon nature’s autopoietic balance: we are disconnected from the universe’s self-organizing information system. ‘History is nothing but a procession of false Absolutes, a series of temples raised to pretexts, a degradation of the mind before the Improbable’ (Cioran 1975). We need revolt to change. I dare to predict that we are past the mid-point of the Fourth Turning (Strauss and Howe 1997). Financial crises (2007/08; 2022/23), pandemics (COVID-19-), and great power wars (Russia’s invasion of Ukraine) are only symptoms of the final stages of a cycle coming to an end. “The question now is whether the events we are witnessing are preparing another open and level ground for a reawakened animal faith and the creation of undreamed-of new things, or whether on the contrary our sullen doings have reached repetition in futility’ (Barzun 1989), making a total collapse inevitable. I am confident that a FEG-inspired approach—engaging and leveraging the intelligence of every member—can master continuous transformation and reinvention, without the devastation of systemic collapse. But time is running out. For now, “[t]he majority have ceased to believe what they believed before, but they still affect to believe, and this empty phantom of public opinion is strong enough to chill innovators and to keep them silent and at a respectful distance” (De Tocqueville 2000; originally published in 1863). At the very end, my gratitude goes to my life. It is best described as a unique combination of family love, a toughened physiology thanks to a passion for open-sea swimming all-year round, a drive to learn and listen with all senses, energizing dialogues in trivial daily encounters, and not least the joys of investing, leading and owning businesses. My generation’s average life expectancy is approaching 100. Everything to date has been mere learning and, increasingly, unlearning. It feels like the real journey is yet to start. With an expectation of 50 more years to go, I envision the great learnings and encounters that curiosity will enact. There is nothing more enriching than to humbly engage with the world as an eternal student. Maybe this is the very essence of freedom. With all my heart, this book is dedicated to Mila and our children Alexi and Stella: thinking born of curiosity, revolt, and change.

Bijan Khezri Unterägeri, April 2022

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References Barzun, J. 1989. The Culture We Deserve. Middletown, CT: Wesleyan University Press. Cioran, E.M. 1975. A Short History of Decay. New York: Simon & Schuster. (originally published in 1949 by Editions Gallimard; 1975 English translation by Richard Howard). De Tocqueville, A. 2000. Democracy in America. Chicago, IL: The University of Chicago Press. Khezri, D.B. 2021. Free Energy Governance - Sensing, Sensemaking and Strategic Renewal: Surprise Minimization and Firm Survival. Dissertation. Zug, Switzerland: KCRI (Khezri Capital Research International) AG. https://www.alexandria.unisg.ch/262427/1/Dis5052.pdf. Lightman, A. 2021. Probable Impossibilities. New York: Pantheon Books. Scharmer, C.O. 2018. The Essentials of Theory U: Core Principles and Applications. Oakland, CA: Berrett-Koehler Publishers. Olson, M. 1982. The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities. New Haven/London: Yale University Press. Strauss, W., and N. Howe. 1997b. The Fourth Turning - An American Prophecy: What the Cycles of History Tell Us About America’s Next Rendezvous with Destiny. New York: Three Rivers Press.