The innovation paradox

The innovation paradox

Too many big businesses are stuck in a low-risk, low-innovation cycle – but they have all they need to break free. Joe Perfetti explains

We live in a world of disruption. The average time a company will stay on the S&P 500 stock market index is expected to drop to about 12 years by 2025, according to management consulting firm Innosight. Business models are under threat and the pace of change is accelerating. You’d think that large and successful companies would be quick to adapt and pivot. You would be wrong.

Large public companies have become risk averse. They focus on quarterly results and are severely penalized by financial markets if they miss sales or earnings targets. Predictability is rewarded and uncertainty is penalized. Analysts ask: if you cannot meet a quarterly target, why should I believe you will be able to meet your three- or five-year targets?

This short-term trap stifles innovation. Senior leaders start rewarding certainty and stop funding uncertainty. Self-disruption is looked at as cannibalization that leads to missed targets in the core businesses. ‘ROI’ becomes ‘restriction on investment’ as leaders demand more and more evidence to justify new initiatives and prove they will make money quickly, without risk. Every budget is scrutinized for variance and uncertainty, the financial enemy.

As a result, large incumbent companies have difficulty investing in the edge businesses of tomorrow and often wait to see how markets settle before moving to take advantage of opportunities. In other words, they create a self-fulfilling prophecy: they will be disrupted by the ever-evolving market.

Successful incumbents face another challenge: hubris. They are successful and do not want to change what is working. The philosophy can be summarized by the old adage, “if it ain’t broke – don’t fix it.” As a result, leaders become more hesitant to abandon tried-and-true practices and business models, ceding ground to upstart competitors.

Yet these companies still have tremendous advantages, should they choose to apply them to new market opportunities. They have established brands. They know how to scale businesses. They can take advantage of existing infrastructure and they have the financial resources to invest, fail and learn without jeopardizing their survival.

Start-ups are the opposite. By definition, they live in an uncertain world. They can act and adapt quickly to respond to customer needs, unburdened by the baggage of legacy systems. They can build a minimum viable product and take risks that large companies would be unwilling to contemplate. A start-up is often betting the company on an innovation: failure can lead to financial distress.

Yet these start-ups often lack the resources to succeed. They do not have the brand recognition, the access to ecosystems or the scale to deliver. They often lack the credibility to sign large contracts and become core parts of a customer’s business processes and supply chains. Start-up entrepreneurs may see the future more clearly than others, but the road to success is far more challenging.

This is the heart of the innovation paradox. It is a cold irony that turns risk and reward on its head. Typically, to get more reward, you have to take more risk. Large companies start looking for the opposite – reward without the risk. They are searching for a unicorn.

Finding ways to say yes

To build more sustainable businesses, leaders must break the cycle that traps their organizations in a low-innovation, low-risk status quo. At a Harvard forum in 2019, Brett Biggs, the chief financial officer (CFO) of Walmart, explained that he and his peers are often seen as ‘Dr No’ – “no” is their default answer to every request. Biggs argued that CFOs have to earn the right to say no, by looking for more ways to say yes.

When Walmart first considered getting into the home delivery grocery business, Biggs immediately said yes to the team that wanted to implement the new business model. It was an obvious move – so obvious that detailed analysis, of the sort that would typically be required, would only slow down a decision that was inevitable. Why establish arbitrary barriers to slow down the process?

But this choice did not come without consequences. Walmart needed to make heavy investments in its new model and had to explain the changes to Wall Street, since earnings targets would be missed in the short term and cash flow would drop. The dividend would also suffer temporarily.

The response from Wall Street? Analysts and investors said they understood what Walmart needed to do; they agreed it was a good choice for the future. Despite that, the share price still dropped, from approximately $80 per share to around $60. The company’s investors paid a short-term price. But by December 2019, Walmart’s stock was trading above $120 per share, as the company’s results showed the benefit of the investments made in 2015-2017.

Reed Hastings faced a similar challenge at Netflix. He told the market he was pivoting from DVDs to streaming and would need to invest heavily in the new model. Analysts put a sell on the company and the stock’s value plunged to single digits in 2012 – yet today, Netflix is one of the dominant streaming companies globally, with a share price above $315.

Change the timeline

Valuing a stock is about understanding future cash flow. If I add up all the cash a firm will generate in the future and adjust for risk, I get the share price of the firm. The first change that a large organization needs to make when considering innovation is to adjust the timescale for measurement. Quarterly earnings targets are a trap. Equity analysts look at quarterly numbers for clues about the future, but if they believe you are short-changing the future to boost results, they will still put a sell rating on your company.

Think about it this way. Walmart had net income of about $3.2 billion in the October 2019 quarter. Its market capitalization – the value of its equity, based on adding up all of its risk-adjusted future cash earnings – was about $344 billion at the end of 2019. So, three months of earnings represents about 0.9% of the company’s value. If Walmart took $1 billion of earnings and invested it in innovation, it would be putting aside 0.3% of the company’s value. If it put $100 million into innovation, it would be a rounding error. Value is not just what you earn now, but the impact of what is spent now, over time.

Transparency about investments, and believable communication about their future impact, is critical. Google focused on this when it created Alphabet. It helped investors see that it had a very stable core business as it segregated out its risky, innovative bets in a way that was more transparent.

For incumbents – to paraphrase Franklin D. Roosevelt– the only thing to fear is fear itself. Embrace reinvention, set aside a small portion of earnings for investment in edge businesses, and change your timescale of measurement to go beyond a quarter.

Create and acquire options

At Google, there is a sign on the wall with the maxim “fail well”. Incumbents must learn from that. Early investments must not be held to the same strict ROI standards that would be used for incremental investments in the core business.

We can look to venture capital and private equity to understand how early stage investments should be treated. Start by looking at attractive markets and use design-thinking principles to understand the customer. Think about early investments not in terms of financial success or failure, but as a way of purchasing information. Apply option theory to decisions: remember that to price an option, you do not need to know the return on investment. Option pricing is based on uncertainty. When investing in uncertain projects, evaluate the projects as options.

The advantage that an incumbent has with a business option is that when it looks like a success, larger investments can follow. When an option becomes a failure, not only does it not kill the company, but it becomes an opportunity to learn – to fail well.

Don’t hug the business to death

According to a McKinsey survey published in June 2019, 57% of executives felt that politics slowed down the growth of in-house start-ups, and 90% agreed that they had to get input from stakeholders across corporate groups in making decisions.

The politics of innovation have to be managed closely. Some incumbent leaders may look at an innovation as a threat to results in the existing core business. New ventures need strong executive sponsorship – but they also need the freedom to operate in such a way that innovation is not stifled.

Enabling conditions

To increase the probability of success and leverage the benefits held by incumbents, leaders must consider the following:

  1. The chief executive’s support of innovations and new ventures. Initiatives must be viewed as a priority for the organization.
  2. Strong executive sponsorship. Sponsors can help navigate the politics, marshal resources, and remove barriers to execution.
  3. Manage early stage innovation investments as a portfolio, not an individual project. Cues can be taken from venture capital and private equity. Investing in one project can be uncertain, but a portfolio distributes the risk.
  4. Partner with accelerators. Look for partners, like Boston Consulting Group’s Digital Venture business, which have experience in accelerating corporate start-ups, and/or companies such as Plug and Play, which can link large corporations to entrepreneurial ecosystems.
  5. Reconsider early stage metrics. Focus on the customer need and market opportunity. Allow early stage investments to be viewed as test-and-learn experiments that acquire knowledge and accumulate options, rather than focusing on short-term payback or cash-flow generation: return on investment and break-even will be uncertain and unproveable.
  6. Redefine the notion of failure within the organization. A good decision that has a poor result can be looked at more positively as an experiment. Fail fast and cheap, but – more importantly – fail well by learning and applying new knowledge to future decisions.
  7. Investing in stages. Develop options to flexibly ‘stage gate’ choices to proceed. If results are poor, stop; if results are good, continue with ever-larger investments.
  8. Allow innovations to self-disrupt your business. Manage the incentives of both core and edge businesses so that innovations are not at odds with the goals of the legacy business.
  9. Use the core business’s network and ecosystem. Accelerate innovation by leveraging the company’s resources.
  10. Communicate the business plan with investors transparently. Provide context for the initiative and credibly explain the longer-term value and benefits that are likely to be achieved.

For business, the only constant is change: we must continue to innovate to remain relevant. Doing so is becoming ever more challenging. Large organizations must use their extensive resources and substantial strengths to escape the innovation paradox and build edge businesses that become the core of the future. Risk is not mitigated by doing more of the same – only by leveraging core strengths to create new opportunities.

Joe Perfetti teaches equity analysis at the University of Maryland and is an innovation fellow with Duke CE