Business Strategy, Internet Industry, Product Management

Thoughts on Innovation At Established Companies

I spent two plus year working in an innovation group at my prior job and in earlier roles I’ve lead many new product efforts. These experiences have taught me about why many corporate innovation efforts fail. I’m not going to name the places where I’ve worked in this piece. While every organization has its specific challenges, this piece focuses on what I see as common challenges to that any organization pursing innovation.

There’s been much written on why companies miss disruptive shifts in their markets. Clayton Christensen’s The Innovators Dilemma is the seminal work in the genre. As much as I think The Innovators Dilemma is mandatory reading and its recommendations are strong, there are a series of more practical issues which that work and others in the genre do not address.

Venture Capital Exists For a Reason

Many new innovative products are financed through venture capital funding new companies. Venture capital is well structured for financing new innovations and established corporations are not.

One of the primary reasons is the power law nature of returns for new innovations.  Power law distributions have much fatter tails than the “normal” distribution. The main implication of the power law is home runs generate more return than the rest of the fund. Venture funds take a portfolio approach. If they invest in 50 companies, then the odds the home run are greater. To increase the size of their portfolio, venture investors almost always co-invest with other funds, broadening their portfolio.

Except for the largest corporations, it’s not possible to establish a broad enough innovation portfolio to have a decent chance of a home run as it takes too much money. Looking at venture funded companies, in general, it takes at least $50M in funding to get them to cash flow positive. For the home runs, levels of investment are often much much higher to fuel the growth necessary to capture the opportunity.

An established company running an innovation effort typically either does not have the level of funds available or is unwilling to spend it. As a venture funded startup goes through its Series A, B, C, etc financing rounds, its financial statements are showing a sea of red ink. Venture investors expect this. For a public company, this level of spending means lower earnings per share which for most companies is not tolerable.

The other alternative is boot-strapping, using a small amount funds up front and using profits to grow the business. We love a great bootstrap story but there really are not that many of them that generate large scale returns. Boot-strapped businesses, because they are capital constrained, tend to grow slower. With in an established company, the slower growth of a boot-strapping will often result in executives thinking it’s too small a business to be worthwhile.

Long Time Scales

The other area where established companies struggle with innovation efforts is the time frame of returns. Venture investors assume, on that average, returns are years away which is why their investment funds have 10 year lifetimes. Venture investors will set aside money for follow-on investment rounds knowing that it takes years and follow-on investment to build a strong business.

Most established companies lack this level of patience and typically expect to see large returns much quicker which typically is not possible. Even an exponential growth rate doesn’t yield big numbers early on. The returns of the new business always seem puny and irrelevant when compared to the firm’s existing businesses.

Risk Aversion

Startups by their very nature move fast and are willing to take risks. If a startup can not show progress and achieve milestones, it will be unable to raise the next round of funding. The greatest risk is not being able to raise the next round.

By contrast, established corporations, particularly publicly traded ones, are risk minimization machines. There are many high paid professionals whose job it is to reduce risk regardless if it reduces speed. Considering there’s more to lose, this is a rational mindset. But for innovation efforts, it can become a serious obstacle.

This obstacle rears its head when there’s risk of lawsuits or regulatory concerns. A start-up will see a 25% risk of a lawsuit or regulatory action as preferable to the 100% certainty of ceasing to exist if it doesn’t make progress. Extreme examples are Uber or Airbnb. It’s inconceivable to me that any established company could have built those businesses because of the risks involved. YouTube is another example. The risk of being sued for copyright infringement is too large for an established company to take on a nascent product.

Option To Give Up

One of greatest impediments to innovation efforts at established companies is that it’s too easy to give up. Being a risk minimization machine, an established organization will at some level see giving up as a good thing when obstacles and risks arise. Those employees working on the innovation efforts will be moved to some other project. The senior executives are spared the discomfort of having to explain a reduction in profitability or a new lawsuit on an earnings call. For the startup, giving up means shutting down or at least a pivot, both of which are painful.

The Technology Myth

At the core of innovation efforts is the belief that new technology is what will drive future business success. The problem with this belief is not that it values technology, but rather that it discounts all the other pieces that go into building a successful business. The ignoring all the activities a business must get right is a primary factor in dramatically underestimating just how much funding it takes to turn one of these ideas into a real business. The technology is the cheap part. Turning an early stage product into a real business which includes productizing it, marketing it, selling it which all gets expensive.

What Works Better

Given all these challenges, established firms are most likely to be successful with innovations that are connected or adjacent to their existing businesses. The first reason is there’s leverage from the existing business which both plays to the firm’s existing strengths and lowers some of the costs. In adjacent business, many of the assets of the company are valuable such as the brand, the sales and support operations and the channels to market.

The second reason is that executive leadership will be able to recognize the value being created. The most innovation famous story, one which has reached the level of myth in the technology world, is Xerox Parc which in the late 1970’s invented the future of computing but failed to see the value and commercialize it. Malcolm Gladwell has a great essay on Xerox Parc titled the Creation Myth.  Gladwell tells us there’s one innovation from Parc where Xerox recognized the value:

Meanwhile, the thing that they invented that was similar to their own business—a really big machine that spit paper —they made a lot of money on it.” And so they did. Gary Starkweather’s laser printer made billions for Xerox. It paid for every other single project at Xerox PARC, many times over.

This outcome is partially because Xerox could readily understand the value of laser printing because it was similar to their core copier business and partially because printers was a smaller leap to turn into a real business since many of the activities needed to be the copier business are also useful for the printer business.

The underlying goal of most innovations efforts to create a continuous pipeline of profitable new businesses. Note that a pipeline of profitable business is not what the professional venture investors try to achieve.  Rather they focus on the power law and look for the home runs. Pure innovation is not repeatable or predictable.  For better or worse, established firms want a repeatable process for new sources of profits.

The repeatable process for new sources of profits is a system for successfully moving into adjacencies. Cisco does this via acquiring smaller companies and then leveraging its salesforce, customer relationships and brand to increase the value of the acquired product. Acquisition is not an easy model as most acquisitions fail but Cisco has built strengths in acquiring and integrating so it can achieve a high success rate.

Amazon is another great example. Amazon started in books and has systematically expanded to new categories to the point where it covers a huge portion of the retail landscape. These category expansions leverage all the strengths that Amazon has built including its world class supply chain, fulfillment capabilities and strong brand. One of Amazon’s biggest flops was outside its core competencies, the Fire Phone. Amazon has also been successful at consumer electronics, most notably Alexa.

If you read this far, what I want to leave you with is that innovating is an unpredictable endeavor where failure is much more common than success. Established firms are on the whole not suited to this pursuit in areas disconnected to their core business. Even if an innovation effort discovers a great new technology, the constraints that established firms have mean they are unlikely to successfully commercialize it. Instead, established firms should build a system to move into adjacencies where they are most likely to be successful and can leverage their existing strengths and capabilities.

Business Strategy, Product Management

My Product Camp 2015 Presentation

I spoke on “Overcoming the Barriers to Building Great Products” at this year’s Silicon Valley Product Camp.  In this presentation, I look at how great products generate superior financial returns even though they have equivalent or lesser functionality to their competition.  I then present a hypothesis that building a great product requires making decisions that run counter to the quantifiable ROI requirements that almost every business endorses.

Business Strategy, Internet Industry

Strategy Lessons from Cloud Price Cuts

Google cut prices dramatically last week on it’s Infrastructure as a Service (IaaS) offering, Google Cloud Platform.   Amazon followed suit on Amazon Web Services the next day and cut prices to match Google’s price cut.  What business strategy lessons can we learn from these prices cuts and what can we predict about the future prices?

Commodity Products Compete On Price

Even though it takes both access to a large amount of capital and a high level of technical capabilities to run a large scale cloud provider, the cloud computing services especially compute and storage are a commodity as one providers offering is equivalent to another’s in the purchasers mind.  There’s little difference in a virtual machine from Amazon, Google or Microsoft Azure.

As cloud resources are undifferentiated products, it’s not surprising that Google is choosing to compete on price.  As a smaller player (in terms of cloud market share) hoping to take share from Amazon, Google needs to compete on price.  Other attributes such as reliability surely matter but there’s not enough difference for Google to effectively compete on those.

As is frequently the case when when one player cuts prices, the other players respond with their own price reductions.  Amazon responded by cutting prices to match Google for on-demand instances.  Interestingly, there’s a significant difference in pricing structure for heavy usage.  Google gives automatic discounts at 70% and 100% usage in a billing cycle.  Amazon is cheaper when using reserved instances but they require up front payment and thus the buyer loses the option to terminate or reduce usage with out penalty.  The reserved instance approach helps Amazon when comes to capacity planning but is less buyer friendly.

The other piece to note is that Amazon cut prices only on services where Google competes with them.   Amazon left prices alone on services that do not have a Google equivalent such as Dynamo DB or the RedShift data warehousing service.  Services where the competitors do not have competitive offering are differentiated and not a commodity.

What to Expect For Future Prices

For both compute and storage, we can expect costs to fall due to Moore’s law for processing and that hard drives get denser over time.  Even if data center costs stay flat, providers being able to get more yield for a given amount of rack space and power means costs will continue to fall.  The other question is will competition force lower margins over time?  If so, prices could fall faster than costs as competition drives margins and thus prices provider lower.

As providers show no signs of being able to differentiate offerings in cloud storage and compute, I expect prices to continue to fall.  With prices likely to fall, Amazon three year reserved instances become on a gamble since as realized price for Google’s offering may fall over enough over the next 3 years where it’s a better deal to use Google’s pay as you go price especially considering the flexibility to change or reduce consumption as needs change.