ACCELERATING CORPORATE INNOVATION: LESSONS FROM THE VENTURE CAPITAL MODEL
What can corporate innovators learn from the innovation practices of agile start-ups?
Jerome S. Engel is an adjunct professor at the Haas School of Business at the University of California, Berkeley, where he is the faculty director of the Lester Center for Entrepreneurship and Innovation. He lectures in the MBA program in entrepreneurship, innovation, venture capital, and private equity, and leads several executive education programs including as faculty director of the Venture Capital Executive Program and faculty codirector of the Corporate Entrepreneurship and Innovation Program. He has an extensive corporate consulting background, was a partner at Ernst & Young, serves on several corporate boards, and has over 20 years of experience as a venture capitalist, currently serving as a general partner in Monitor Venture Partners, an early-stage venture capital firm associated with the Monitor Group. http://entrepreneurship.berkeley.edu; engel@haas.berkeley.edu.
OVERVIEW: The last half century has seen the emergence of a new model of business innovation featuring the convergence of entrepreneurs, rapid technological change, and venture capital. This combination has proven an effective force at realizing disruptive innovation that has often left incumbents shattered in their wake. What can the mature enterprise learn from this venture capital model of innovation management? What is the role of the CTO in identifying and adopting these approaches? This article investigates the ten leading strategies employed by venture capitalists and entrepreneurs to test new ideas and commercialize innovations quickly. The most disruptive innovations are seen to be those that go beyond technical discovery to embrace business model innovations that disrupt supply chains, disintermediate incumbents, and create new markets. This article presents the tools the modern CTO needs to participate in this dynamic process.
KEY CONCEPTS : Entrepreneurship, Venture capital, Strategy, Corporate venturing
As we enter this century’s second decade, the rate of business innovation is accelerating, challenging all incumbents’ ability to maintain their competitive edge. The model of the industrial enterprise that excels through internal innovation has been shattered by the reality of new ventures that achieve true scale and competitive advantage through rapid cycles of innovation, experimentation, and distribution. These patterns are most evident in Internet-related disruptions, such as Google, Facebook, and Groupon. The current cycle of disruptive innovation is shaking every industry to its core, be it energy, manufacturing, transportation, health care, hospitality, media, consumer products, fashion, or natural resources. Managing innovation for an enterprise is no longer a simple matter of new-product development, something for those fellows in R&D to do, nor is it simply adapting to the new information technology realities. Instead, innovation has become a strategic ongoing process that embraces all resources available to the enterprise. New-product development is now only one component of a broader program that must embrace learning from and partnering with ventures outside the enterprise.
Since the 1970s, a major source of business innovation has been new ventures, often funded by venture capital. Indeed, many of today’s major corporations were themselves venture capital-funded start-ups (Freeman and Engel 2007). These examples of innovation and business creation have much to teach today’s incumbents about agile, strategic innovation. Their processes and mechanisms for managing uncertainty, mitigating risk, and empowering commitment represent a powerful model for innovation that the corporate Chief Technology Officer (CTO) can put to work for the large enterprise. In this article, we will explore how the venture capital model of innovation can be applied to the internal management of innovation. What can corporate innovators learn from the practices of venture-funded organizations?
New technologies have the potential to create disruptive innovation. For the mature corporation, this can be comforting, as it can play to their advantage. Although certain technical innovations can disrupt incumbents, they more often represent incremental evolutions. Even if they are protected by patents or other intellectual property mechanisms, technical innovations may not create significant disruption because they often give advance warning of their arrival.
More disruptive is when these technical innovations are coupled with business model innovations. New ways of extracting value from tactical technical advantage has led to major disruptions of incumbent enterprises. Examples abound: Google’s Adwords, Netflix’s streaming subscriptions, and YouTube’s user-generated video entertainment disintermediated traditional players—ad agencies and television broadcasters; Dell’s mass customization approach to PC retailing made buying off the shelf seem second best; and the Spanish retailer Zara, with its ultrafast product development cycles and weekly inventory turnovers, changed the very idea of a fashion season, from something that happens four times a year to a weekly event. Software vendors have become solutions providers, using software-as-a-service (SaaS) business models to convert old-line direct-sales businesses into service enterprises. New intermediaries such as EnerNOC, exploiting technical innovations such as smart meters, have arisen to help electrical utilities convert their customers from mere consumers of power to partners in energy management.
Some of the most disruptive innovations do not rely on significant technical breakthroughs at all, but rather on the creation of applications for emerging platforms (such as software solutions distributed via the SaaS business model over the Internet or entertainment applications, games, and utilities for the iPhone or the iPad distributed via the iTunes App Store) or the recombination of existing capabilities (for instance, Netflix’s metamorphosis from CD rental outlet to streaming media content provider). In either case, these innovations involve rapid cycles of technical and business innovation. How can an incumbent with thousands, perhaps tens of thousands, of customers, employees, vendors, and other stakeholders move this quickly, risk all that is already in hand, for the sake of a potential opportunity? Where will the ideas come from? Businesses can build technical teams, but disruptive innovations require constant experimentation and short-cycle feedback and revision by cross-disciplinary teams able to innovate and evolve rapidly. Even if a company has the resources for this sort of effort, how can the teams be freed to move quickly enough and be motivated to sustain a focused effort long enough to build a sustainable advantage in this arena?
For the last decade, mature corporations have struggled to resolve this dilemma. The very language of innovation management has changed. The emergence of the Chief Technology Officer (CTO), and even more recently the Chief Innovation Officer (CIO), give recognition to the scope of the challenge. “Open innovation” (Chesbrough 2003) has become the mantra, bringing a new understanding that innovations that arise outside the corporation must be identified, understood, evaluated, and where appropriate, embraced. While these steps are laudable, they are not sufficient. Embracing innovations that arise from the new generation of “gazelles,” the young, often venture capital-funded companies that have proven so effective at creating major innovations and scaling quickly, requires more subtlety than simply acquiring them. Rather, large companies must work to understand the processes of these agile start-ups and identify what makes them so effective. This deep understanding is essential, both so that corporations can be effective partners with gazelles and so that they can adopt the best practices of these innovators.
From a corporate executive’s perspective, the gazelle is a simple entity, often with a single line of business and market focus. Its simplicity derives from its business model, not from its technology, which may well be a platform with potential applications in many markets or products. But start-ups, even well-funded ones, typically lack the resources to address more than one market at a time, and within that market, limit themselves to one anchor product or service offering. Venture capitalists 1 rely on a model that uses capital efficiency and quick commercialization to prove efficacy and viability. Achieving a solid business model is often sufficient to motivate potential acquirers to pay a significant premium, not only for the proven market but also for opportunities to extend to ancillary and adjacent markets.
What constitutes a good opportunity to a major corporation is on a different dimension altogether. For the large enterprise, what constitutes a good opportunity is often appropriately defined with a strategic bias, where the emphasis is not on the absolute value of the new activity in isolation, but rather on what value the activity adds to the enterprise. In this calculation, near-term financial returns are of little relevance. What is important is the strategic fit of the initiative with existing or future business lines. The principal measure is not how much the initiative will earn in its own right, but how much it will enhance the operations, sales, profitability, and value of the overall enterprise.
How do the gazelles achieve their rapid evolution and market penetration? They lack so many of the advantages of the corporate incumbents—brand recognition, existing customers, management resources, positive cash flows, financial resources. Successful entrepreneurs are masters at creating something from nothing. In circumstances of massive uncertainty and limited resources, they manage to innovate, adjust, and sustain focus. The result is a substantially different innovation process from that in place at most major corporations.
The venture capital model of innovation management relies on ten primary strategies to manage uncertainty, mitigate risk, and empower commitment. Each of these offers useful perspectives for the corporate innovator. The challenge in evaluating this venture-capital model of innovation is that many of the strategies and mechanisms are designed to create advantages out of seeming disadvantages: the simplicity of the business and its relative scarcity of resources. Further, the engine that drives the implementation of action is an alignment of incentives achieved through the sharing of ownership in the new business initiative, in structures that share risk and reward and encourage sustained effort over a period of years. It is difficult to create such mechanisms in the large mature enterprise. Recognizing these constraints however, and the challenges of implementation, it is essential that the corporate innovator look carefully to learn and investigate what can be adopted, modified, and embraced.
Venture capital is known for investing in high-tech ventures that bring new technologies to market. But when you ask venture capitalists what they invest in, they invariably report that they invest in the team and the market. Some venture capitalists will place a priority on one or the other, but rarely will you hear a venture capitalist say that he invests principally in the technology. 2 Instead, venture capitalists look for “A teams,” often defined as top 1 percent performers with proven track records, and where possible, teams that have worked with each other before. The logic for this practice is that top teams will recognize missteps more quickly and take action, making the needed adjustments to respond to a faulty venture plan or a lagging market response. This awareness and ability to respond is invaluable because, with all the uncertainties in a new venture, it is more likely than not that the business plan at inception is wrong.
The challenge for CTOs and innovation managers in adopting this “A team” strategy for internal ventures is the difficulty of attracting the entrepreneurial talent within the enterprise structure. The inability to establish compensation structures that couple risk and reward as a start-up does through shared ownership is well understood. Venture capitalists often consider one of their most valuable resources their contacts with a vast pool of proven executive entrepreneurial talent, often based on a venture capitalist’s years of experience investing in a specific industry. The entrepreneurial network is also one of the benefits of the clustering of venture activities in regions like Silicon Valley. The CTO, with his or her intrinsically internal focus, would need special resources and capabilities to take such an “A team” based approach.
In fact, CTOs are often not the source of opportunities or initial teams. Opportunities may arise from individual achievers within the business and teams collect around them organically. CTOs can serve as guides and mentors for these teams to help develop the most promising opportunities. Being a touchpoint and safe harbor for internal teams looking to find a home for their innovative ideas can be a major role for the CTO. Initially, corporate resources can be provided sparingly, but information should be provided liberally. The CTO can be a major resource as such information comes from outside the existing team’s boundaries. It is often the lack of necessary data on markets, new technologies, and business models that drives poor decision making at every level in this process. CTOs can look to expand and reinforce their information networks and extended team resources to better influence the processes that lead to team formation and business initiative exploitation.
Venture capitalists work to select investments that address large and, more importantly, growing markets. The size of the market may be less obvious than it seems at first blush because a truly innovative start-up may be introducing a new capability for which there previously was no market simply because there was no viable solution. For example, there was certainly a need for portable hearing aids before the invention of the transistor, but since there was no capability to create such a thing, there was no market by traditional measures. A timelier example would be the market for auction services before eBay. There certainly were auction houses, but who could have guessed that the market would support an online auction house that allowed individuals to sell small, personal items? As consumers adapted this person-to-person marketplace as a way to sell everyday items, eBay proved to have little in common with its bricks-and-mortar brethren, other than the use of the auction mechanism to set prices. In actuality, it was an entirely new market that displaced traditional personal marketplaces, such as classified advertising in local newspapers. The market that eBay essentially created is now huge; eBay alone does over $9 billion in annual sales.3
CTOs and innovation managers of major enterprises actually hold an advantage in certain instances that is important to exploit. CTOs, with their knowledge of the strategy of their own enterprise, and perhaps superior corporate intelligence as to the intentions of other relevant incumbents, can give priority to initiatives that support or serve markets that the corporate strategy may create. Straightforward examples are the development of applications to support new platforms like the iPad and iPhone. The CTO is in a position to gauge the level of commitment to new initiatives that create new markets. For example, efforts to develop an electric vehicle received substantial attention in the late 1990s, but these efforts were ambivalent and lacked the commitment of current endeavors. The ability to differentiate between these transient and sustained efforts is a crucial advantage. A market-based approach often makes most sense in support of an enterprise-wide strategic initiative in which the commitment to that initiative creates the market. A growing and robust market gives new initiatives the opportunity to ride the wave and survive, and hopefully flourish, even through the inevitable mistakes.
Venture capitalists look for investments that address real pains and provide solutions, not just ameliorations or enhancements. How do you know what is a true need that customers believe requires an immediate solution? Many venture capitalists communicate directly with prospective customers for a new product to assess the level of need, as part of due diligence on a prospective investment. Experienced venture capitalists have a test for determining the customer’s level of need. When interviewing a prospective customer for a new start-up’s product or service, a venture capitalist may ask how much the customer has set aside in the budget to fund a solution to the problem. A true need, venture capitalists believe, will have a budget allocation, even if the solution is not known at the time of the budget preparation. No budget, not much pain. This ability to distinguish between a product or service that customers must have as opposed to one they just want is key to understanding the nature of a market opportunity.
The enterprise has a major advantage in incremental innovation if it exploits its access to its customer base. Customer needs are a primary driver in the incremental, if not the disruptive, innovation process. CTOs and innovation managers must emphasize the importance of getting close to customers and understanding their experiences. CTOs should develop practices to keep an eye on users’ adaptations of products to solve their own problems; this can be a source of much innovation. This is likely to require a systematic managerial approach that provides direct access to intelligence gathered by business units and sales managers.
Traditional R&D-based product development can be technology driven or customer driven. Venture capitalists push the companies they invest in beyond this duality. With the emergence of quick iteration capabilities, venture capitalists are encouraging their portfolio companies to view product development and customer development as interrelated processes. The service or product is built in a series of rapid iterations based on ongoing customer interaction, with the customer having hands-on involvement with the real product to the greatest extent possible. Hence, we have seen the emergence of the perpetual beta. Innovation based on customer interaction is constant.
This is one of the key differentiators between innovation in a venture capital-backed start-up and that in a major enterprise. In the start-up, customer contact is a key ingredient in product development and often involves senior executives. In the corporate R&D center, access to the customer is too often restricted, and product specifications are intermediated and filtered by the enterprise. The CTO seeking to develop a more agile innovation system must gain direct and ongoing access to the customer channel. In order to go beyond being either a pure research organization or a pseudo-contract development arm for the line organization, the CTO must be able to drive R&D work based on market insights garnered directly from existing and potential customers.
In the diverse enterprise with many lines of business, customer development and corporate strategy is integrated at the CEO. Business units by design maintain focus on core results and are often poor responders to hints of market shift. The CTO must take an active role in both gathering and assessing new information about customer needs and the ability of the organization to address those needs. The roles and responsibilities of CTOs are highly diverse and sometimes marginalized in this domain.
Venture capitalists invest in stages. The successful start-up will have multiple rounds of financing, each increasing in size and valuation. The venture capitalist is willing to pay a much higher price at later stages of investment, as both risks and the potential market become more defined. While this approach is theoretically more expensive, it has a number of benefits:
- It allows the venture capitalist to limit losses by declining further investment if progress is not sufficient or externalities arise that make the investment no longer attractive.
- The limitation of resources encourages accountability and fosters a focus on doing what needs to be done, not just what is in the plan.
- Stepped financing incentivizes the entrepreneurial team to create the maximum real value as quickly as possible and to utilize as little capital as possible. The success of the team’s efforts is demonstrated by the valuation subsequent investors are willing to offer.
- It creates an open ownership structure in which the progress of the company is periodically validated by new investors.
This approach is dramatically different from the typical corporate approaches, which may fund projects on an annual budget cycle; take an “all in” approach, funding projects for rapid build-out and infrastructure development at the outset; or use gating processes to measure progress against benchmarks that may not include external validation of the continuing relevance of the project.
Staged resource deployment is strongly linked to customer development and failing fast. CTOs who are comfortable with these concepts can move the organization away from a high-cost, high-risk “all in” product development process to a process focused on experimentation. Experiments develop relevant information, skills, and agility at a low cost. Results can then be integrated into the next set of experiments.
Venture capital business-development strategies are designed to identify key risks and wring them out early, before substantial funds are committed. Since failure is recognized as a real possibility, the biggest risks and unknowns are addressed first. It is perceived as good management to fail fast (and relatively cheaply), if the failure is due to risks that are judged likely to have been fatal in any case.
This approach is decidedly different from corporate approaches in which risks are often avoided or deferred so that a series of incremental successes can be piled up to enhance internal support and secure incremental resources. Decisions are driven by managers with career objectives rather than by entrepreneurs and investors who take an owner’s perspective. Accordingly, for the traditional CTO or innovation manager, a “fail fast” methodology may be particularly challenging to implement.
The opportunity for the CTO again involves agile development and customer engagement. This requires expanding the perspective from the “technology-failure” risk framework of a traditional R&D organization to a combined technology and “customer-failure” risk framework. Venture capitalists select opportunities based on a threefold risk model: market, technology, and management. In the corporation, management risk is assumed to be minimized, leaving the CTO to assess technological capabilities and the marketing organization to address customer acceptance. The venture capital model would suggest that these three attributes should be more closely integrated in a quick-iteration, experimental framework. Market testing needs to be early and frequent and negative outcomes should result in quick termination or readjustment.
Venture capitalists and entrepreneurs place a premium on speed. Time is the enemy, sapping resources and energy from the start-up while giving competitors time to develop and externalities more opportunities to overwhelm. Venture capital investment terms make early exits highly rewarding for all parties, encouraging entrepreneurs to grow the company—and exit venture funding—quickly so that venture funds can be returned to investors or reallocated to other portfolio companies. These factors lead to a drive for quick market entry and validation that mature corporations find difficult to match.
For the CTO or innovation manager of a major enterprise, the speed and flexibility of start-ups is attractive but unattainable. Where start-ups will introduce products early to gain market position and “buzz,” the mature enterprise has established goodwill to protect, meaning there are significant potential downsides to an incomplete or faulty offering. Patience is often the rule here, operating with the confidence that an incumbent’s natural scale and resource advantages can overcome the first–mover advantage.
CTOs and R&D organizations should adopt agile development teams to complement advantages in scale. Agile development is a technique based on the concept of minimal viable products created and tested by teams that have a broad skill set and open access to the market.
A number of the key venture capital strategies identified here can be grouped under the umbrella term “the lean start-up,” a set of practices that are highly effective in reducing the required investment and sustaining alignment for the long haul. Although it seems directly contradictory to the idea of the lean start-up, “pour it on” is an equally important corollary strategy. Once the experimentation and discovery process has yielded a validated product or service offering and a business model, venture capitalists will invest generously at relatively substantial valuations to achieve and sustain market leadership. This is where the first-mover advantage comes into play. It is accepted wisdom that a new market will likely consolidate around two or three market leaders, and the front-runner will take a disproportionally dominant market share. Thus, an early leadership position can translate into substantial valuation differentiation. It is this reality that makes later-stage marketing funding relatively large. When they have a winner, venture capitalists are quick to take advantage and pour the money on to claim market share. Extreme examples of this are the recent venture capital investments in Groupon and Facebook at extraordinary valuations. This is a clear demonstration of the belief that the market leader captures a disproportionate share of value.
For the major enterprise, this two-step approach may seem foreign. While there may certainly be test markets and trials, once the decision for market entry is made, the enterprise will usually assure that the resources are deployed to support success. The CTO must be aware of the opportunity for customer engagement during the trial phase and maximize the benefits that can be derived during these preliminary experiments to encourage flexibility and responsiveness to customer input. But once a winning formula of product, delivery, pricing, and business model are proven, the CTO should be supportive and understanding of the need for rapid deployment and adoption.
In public companies, executives can leave and exercise their stock options independent of the actions of others who hired them. In the venture-funded start-up, stock restrictions keep founders from selling shares to outsiders, and managers earning stock options are likewise encumbered. In fact, upon separation from the start-up, these managers often face a difficult decision: to keep their ownership, they must exercise their options, requiring them to invest in a company that they no longer influence and that has no ready market for its stock. There is literally no exit for anyone until there is an exit for all. This subtle and often overlooked attribute of venture capital financing keeps everyone’s eye on the prize—achieving a liquid exit and a substantial return on investment.
It is very difficult for the CTO to emulate this kind of incentive. Subjecting employees to this risk without being able to provide comparable rewards is a nonstarter. And even if it were possible to provide commensurate incentives, providing a huge potential upside creates perverse politics. This is a case in which the CTO may have to accept the limitations of the corporate environment.
Entrepreneurs and venture capitalists are always selling, but the company is never for sale. This strategy is a result of the very fluid valuation of a young company. There is no reliable value barometer that can measure the value of a start-up. In this environment, behaving as if the company is for sale destroys value. Therefore, the marketing of the enterprise is masked in a very public, continual positioning of the company at trade shows, investor conferences, and press releases. The goal is to have the company “discovered” and pursued.
While the corporate CTO cannot replicate these last two strategies, they still represent a source of substantial opportunity for the astute R&D manager. The imperative for all parties in a start-up venture to achieve liquidity makes these companies a fruitful garden for harvesting innovation. In other words, corporate R&D may not be able to replicate the venture-funded environment, but corporations can still benefit from entrepreneurial innovations by buying into these start-ups themselves.
There are challenges. Differing criteria for assessing opportunities and implementing strategies constitute considerable hurdles. The start-up culture, criteria, and methodologies of these gazelles are likely to be incompatible with the mature enterprise. Managing this interface and transition is a specialized capability that some such as Intel, Cisco, and Google have demonstrated competency. When done well it can be a strategic competency—and yet one more means of accelerating innovation.
The need for corporate innovation has never been greater. In the last decade, many of our most successful incumbent corporations have failed to evolve and have been outmaneuvered by new insurgents. The most disruptive innovations often are business model innovations. Netflix destroys Blockbuster and moves to take on the TV networks. Hertz fails to see the business-line extension into hourly rentals and is preempted by Zipcar. Seybold refuses to cannibalize its enterprise software solution and finds itself being displaced by SalesForce.com. At the same time, the venture capital-funded ecosystem of young innovative start-ups offer important lessons for established corporations looking to revitalize their innovation processes.
What can one learn from the venture capital model of rapid innovation? Which of those lessons can be applied internally? Three broad points pull it all together:
- The most disruptive innovations are not technical or product innovations alone. Rather, they are a combination of technical and business model innovations. Technical innovations can provide the enterprise the capability to reconfigure the value chain, disrupting incumbents. But such innovations do not emerge from the technical domain alone. CTOs must manage a process of continual market engagement and customer contact to help the enterprise recognize, anticipate, and, where appropriate, create such disruptions.
- Many of the inputs of innovation management in the venture capital model rely on a market orientation and rapid-cycle innovations managed by superior teams. This approach is not easy for mature corporations to adopt. Their management processes of annual budget cycles, segregation of duties, vertical organizations, and professional management all interfere with the ability to anticipate and respond. The CTO needs to be an advocate for flexibility, exploration, experimentation, and staged allocation of resources, for not only their organization, but for all involved.
- The venture capital model provides a garden of opportunity for partnerships, collaborations, and acquisitions. A CTO who is conversant with the venture model can be a powerful force in attracting the right opportunities to the enterprise. The CTO must have access to all the tools of strategic corporate development, including investment and acquisition. These aspects of corporate engagement with the venture capital model will be discussed in more detail in a future article.
The CTO is in a unique position to contribute to the enterprise’s evolution as an innovation machine. As the executive closest to the technical capabilities of the enterprise, the CTO needs to embrace a broad market perspective and have easy access to current and prospective customers. When evaluating the potential of new technological innovations, the CTO should embrace the opportunity for business model innovations that the new technology may allow or facilitate. These considerations will require insights from market-facing elements of the enterprise and may give rise to strategic implications that require CEO-level adjudication. All of this must be done in the context of agile development and rapid innovation cycles. When internal barriers such as of corporate culture or vested interests interfere, alternatives including engaging with external organizations through partnership, joint venturing, investment, or acquisition should be considered. These are the lessons of the venture capital model.
For the purposes of this article, a “venture capitalist” is defined as someone who invests money on behalf of third parties, most frequently institutional investors.
The exception to this rule is biotech where, at the early stages of the venture, science trumps all.
For 2010, eBay, Inc., posted $9.2 billion in revenue, net income on a GAAP basis of $1.8 billion. Excluding Skype, net revenue was up 13 percent for the year and earnings per diluted share were up 18 percent.
References
Chesbrough , H. W. 2003 . Open Innovation: The New Imperative for Creating and Profi ting from Technology . Boston, MA : Harvard Business School Press .
Freeman , J. , and Engel , J. 2007 . Models of innovation: Startups and mature corporations . California Management Review 50 ( 1 ): 94 – 119