Out With the Old, In With The New

Peter Drucker, the father of modern management and perhaps the most influential thinker on that subject once said, “If you want something new, you have to stop doing something old.” When written in the mid 1950s, Drucker was describing the rationale for his legendary “management by objectives” concept, which as we all know, is about aligning employee performance with corporate objectives in order to assure that corporate strategy is executed effectively and consistently.

But, that same notion could also be the tweet that Josh Lerner – Harvard Business School professor, expert on entrepreneurism, innovation, venture capital and private equity, and author of the recently released book The Architecture of Innovation” – might use to describe how corporates must approach innovation today.

Lerner draws his insights from decades of work at the intersection of entrepreneurship, venture investing, and private equity. He may spend a lot of his days at the blackboard as an HBS professor, but he is an active and well-respected advisor to the biggest names in the business in these areas. One of Lerner’s most potent observations — and key input to this book — relates to his research into the performance of companies that had been acquired by private equity firms and then ultimately spun off business units. He and his colleagues observed that before the transaction and spin offs, there were few differences in performance between the firms and their category competitors. After the acquisition and spin off, things changed. The acquired firms became more innovative, not because they did more “innovative” things, but because the things they decided to innovate around were more focused, investments in innovation more targeted, and incentives around outcomes more clearly defined.  Overall performance in the core business improved as well. This drove a number of additional insights around the structure of — or architecture of innovation — in large organizations.

“An abundance of evidence suggests that greater attention to the ways in which organizations and incentives shape the innovation process can produce significantly better results,” Lerner says, conceding with “innovation is complex and multi-faceted.” But he is pretty emphatic that the traditional ways that corporations attack “innovation” today is deeply flawed — and worse.

Centralized R&D models, which relegate the responsibility for innovation to a particular group within a company, is a pretty standard way for many large companies to organize its innovation initiatives. The rationale for such a method is to “ring fence” innovation so that it doesn’t disrupt or distract the core business and so that outcomes related to innovation can be measured and monitored. Except that the actual results don’t exactly map to those expectations.

As recently as the end of the 1990s, for those companies that organized innovation that way, R&D- driven innovation contributed less than 25 percent of the value of what investments in traditional assets would have produced for that company (e.g. supply chain efficiencies, cost reductions, etc.). A cascade of misaligned incentives produce the wrong outcomes, Lerner concludes, including not knowing when to deep six innovations that just won’t ever produce useful results and, ironically, shuttering projects just because new leadership feels compelled to change things.

So, if R&D efforts in large corporates don’t drive innovation, then the venture capital model must. Venture investing is, of course, when independent investors contribute funds and the professionals who manage those funds make bets on companies that have the prospect of delivering a return on those investments over a set time horizon, usually 8 to 10 years. But Lerner doesn’t exactly think that’s the poster child for commercializing innovation either. Investments made by the entire venture capital sector over the course of any given year amount to much less than the R&D budgets of a single giant pharmaceutical firm like Merck or a not-so-innovative GM. And, in 2011, venture-backed firms represented less than 10 percent of all publically traded firms in the U.S.

The venture model, Lerner believes, is flawed for a number of reasons too, including its dependence on public markets to produce liquidity – the hallowed “exit.” That causes VCs to invest only in firms that can scale and drive an exit in their investment time horizon or by pegging company valuations to the public market’s view of the value of that sector. The result is that some promising sectors or companies are completely overlooked given their longer or more difficult time horizons. Some companies can also become completely overvalued because the market overstates the value of a technology or a concept that may not be all that valuable to the sector at all, making it harder to ultimately produce a return on that investment.

Architecting Innovation in Payments

Lerner’s insights as applied to innovation in the payments sector is relevant, important and critical, especially as the pace around innovation in this sector is increasing. Payments is about the most complex platform industry there is and igniting innovation in payments is anything but a given, even if a company is doing it within the construct of a successfully operating platform. The complexity, as we all know, rests with the discipline of having a strategy that can create the delicate balance across all stakeholders, deliver traction in a relevant timeframe and drive profits. Many investments in innovation by corporates and venture funds underestimate the complexity of getting that to happen and overestimate the adoption of “new” by merchants and consumers, often because the incentives associated with driving this adoption haven’t been well developed.

The combination of new technology, investment bubbles and a lack of appreciation for this complexity has caused otherwise rational people to make irrational or ill-timed bets in payments. Consider the following:

  • Ill-timed investments in payments technology didn’t just start a few years ago. The Internet bubble of the 2000s, fueled by the ability to shop online for the first time, is rife with payments innovation road kill, including one that the venture community itself voted one of its worst all time investments – Flooz. This online currency worked then like Facebook Credits and Amazon Coins works today – except that the stuff people wanted to buy was physical goods from places like Macy’s and the Gap. Even $50 million dollars and endorsements from celebs such as Whoopi Goldberg couldn’t get enough legitimate consumers to try it. Flooz shut down in 2001, not too long after it launched in 2001, when the only people who responded well to its proposition were crooks who used it to hack into people’s accounts.
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  • Then there’s Pay By Touch. This company attracted $360 million dollars in 2003-2004 when it devised the payment method to end all payment methods – pay by finger. It was rolled out to 700 retail locations to great fanfare only to fall into bankruptcy less than five years later. Investors had themselves convinced that the payment system of the future was one that rode ACH (so cheaper for merchants), leveraged something that everyone carried into the grocery store (not your phone but your finger), and was secure (used a PIN). Obviously the pitch was compelling enough to create an avalanche of funding, but not enough to get consumers to sign on. They, in fact, gave Pay By Touch the finger (but not the one that they were supposed to pay with) and the investors lost it all.
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  • The daily deals/group buying market frenzy, fueled primarily by Groupon’s entry into the business in 2008, also drove a massive amount of investment in “offers”-based companies by venture firms and initiatives funded by just about every payments player in the land. It also ended up driving huge consolidation as about 170 of 530 offers and deal sites that existed in 2012 (down considerably from 2011) were either shut down or sold at fire sale prices. Groupon itself has lost more than 80 percent of its value since it went public in November of 2011, and Amazon’s book value of its $175 million stake in Living Social’s stood at $52 million at the end of 2012; after Living Social posted a $905 million operating loss that same year. Investors failed to recognize that the “80% off” deals was a race to the bottom of the market that few merchants wanted to run consistently and that deal customers didn’t have much of an interest in becoming full price customers at those same merchants.
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  • Then there’s NFC. It’s hard to know just how much venture firms — plus those in the payments and mobile ecosystems — have invested to help ignite this technology, but it’s likely we’re in the billions. We do have a few concrete data points though. At least $100 million was invested by AT&T, Verizon Wireless and T-Mobile in ISIS — the mobile NFC payments network that has delayed its launches many times and is barely in the market today. Vivotech – the NFC pioneer that came onto the scene in 2001, raised about that same amount over the decade that it was hawking NFC as well — investments fueled by analyst hype and payment network belief that that NFC was the future of mobile payments. In spite of payment network evangelism, a challenging value proposition, business model and steep ignition curve resulted in Vivotech selling its patent portfolio to a venture-backed start up in 2011 for pennies on the dollar.
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 So, where are we now? And just what is the architecture of innovation in payments going forward? Well, sort of where Lerner thinks it just might have its best prospects to succeed. 

The largest players in the space are today funding dozens of “innovation experiments” focused on driving payments into the mobile realm, and more broadly expanding the reach of electronic payments. At the same time, access to new technologies and the availability of IP-enabled devices such as the smart phone and tablet reduced the barriers to entry for many an emerging venture to make a play for something new, innovative and game-changing. Hundreds of millions of dollars of venture money poured (and are pouring) into the sector to foster the “next” new thing in payments. In 2012 alone, more than $1 billion was invested in emerging payments firms by VCs.

But as good (and well funded) as their great ideas might be, most of these ventures will need distribution and scale to ignite and access to the “incumbents” to make that happen in any sort of meaningful way. They’ll also need access to the people inside the organization who can “school” them on what it means to be in the payments business. Many of them have no clear idea of its complicated inner-workings.

Those two forces, Lerner believes, sets up exactly the right environment for the right model for innovation in large organizations – corporate venturing – something that takes the best of both worlds and devises a structure, a framework and a set of incentives for advancing strategic goals and generating good returns on those investments.

Simply stated, it involves having corporations invest in promising start ups, usually through a separate entity, and then creating an operating model that is helpful enough to the venture without drowning it in the corporate bureaucracy that would only slow things down – or worse.

Lerner is the first to point out that corporate venturing isn’t always the match made in heaven. As he recounts in his book, venture capitalists view corporates as “the dinosaurs that they’re trying to kill, the market opportunity they’re trying to capture,” so it isn’t a given that they’ll be met with open arms when they arrive on the scene with their corporate checkbooks. But, he also suggests that it has produced positive results. Lerner says the returns from corporate venturing are at least as good as venture firms produce – and has become a mechanism for both stimulating demand for a company’s product as well as seeding companies to develop innovation that complements its own. And it just has to in payments — because hardly anyone can do everything without playing with the big guys.

It certainly seems to have caught on in payments:

  • American Express launched a $100 million fund, American Express Ventures, to invest in ventures in 2011.
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  • Starbucks invested $25 million in Square in August 2012 and will be deploying its mobile payments app to its Starbucks customers. It now also sells Square dongles in its store.
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  • Citi Ventures, a unit of Citigroup, has invested in a number of companies, including Square, Jumio — an online credit card scanner, and most recently, Plastic Jungle — an online exchange for gift cards.
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  • Visa invested an undisclosed amount in Square in 2011.
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  • First Data has invested an undisclosed amount in Cardspring, a platform that has fuels its open redemption platform called OfferWise.
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  • Google Ventures invested in Square contender, Corduro, in 2011.
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  • MasterCard invested in a number of ventures in 2012, including Truaxis, a card-linked offers platform, and iZettle, the Swedish version of Square.
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  • Ingenico invested in ROAM, a mobile commerce entity.
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 Of course, this list is just a small sample of the activity that is mashing up the deep pockets of corporates and the new ideas of innovators to architect innovation for the benefit of both. For every strategic investment, there are many more partnerships struck that combine the assets and energy of these two very different types of organizations – in fact there is probably a press release a day announcing these sorts of alliances. 

Payments Innovation in Action

So, is this the right way to architect innovation in a sector as dynamic and complex as payments?

We’ll find out by probing five of payments most courageous and experienced innovators who will debate with each other, Innovation Project delegates and Lerner over 90 minutes in a place that has given birth to many an innovative idea – Harvard’s Science Center.

  • Chris Gardner, co-Founder and CEO of Paydiant, is a successful serial payments entrepreneur. It’s rare to get one hit in this complicated space, but Gardner and team seem poised to go three for three. Gardner, though, has a healthy respect for the complexity of the business and concedes, “Changes in the payments industry take a while.” Founded in 2010, Paydiant is a cloud-based solution that enables banks and merchants to accept payments via the mobile phone – primarily via a QR codes today. It has garnered some pretty high-powered incumbent partners and customers in its short life, including FIS, Vantiv and Bank of America, in order to do what all ventures want to do, “get our ecosystem and our acceptance method broadly deployed.”  Yet, working with incumbents, much less large incumbents, is not without its challenges. Scale can be a double edge – the same thing that makes incumbents attractive to work with – their largesse – may make it harder for them to move at the speed of emerging innovators as they wrestle with competing priorities and agendas. Gardner will share his thoughts on how he and Paydiant have aligned incentives for innovation with partners not known for moving quickly.
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  • Mike Kennedy, Chairman of ClearXchange, is pretty emphatic about its goal for innovating the role of banks in mobile payments: “We don’t want to end up in the background as another utility.” ClearXchange is a mobile payments network that connects Bank of America, JPMorgan Chase and Wells Fargo — those mega banks that together account for one of every three bank accounts in the U.S. — enabling the transfer of funds from one person to another across that network using only a mobile phone number. Kennedy, who also serves as EVP for innovation at Wells Fargo, is convinced that while a “game-changer” for mobile payments, ClearXchange is also poised for success because it is complementary to the current payments products issued by those same banks and used by those customers. Kennedy will dispel the myth that big banks, innovation and speed to market aren’t mutually exclusive. He will also lead The Innovation Project delegates through ClearXchange’s blueprint for getting the three biggest banks to the table around a new idea, and how that framework may have to change in order to take ClearXchange to the next level of innovation in mobile payments.
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  • Mike Pasilla, CEO of Elavon, seems attracted to payments innovation like a moth to a flame. “I’ve always chosen the option that presents the greatest challenge and provides the greatest return,” he says. “I don’t go for the sure thing.” Well, he sure seems to have picked the right industry at the right time. Elavon is the fourth largest merchant acquirer and card processor in the U.S. and is owned by U.S. Bank. It also operates in a sector that is being challenged by new and old players alike, who see acquiring as a logical place to disintermediate existing players. Tired of being labeled a “fast follower,” Passilla is creating an innovation agenda around new ideas that instead lead the market by giving customers and partners a bigger voice in how that agenda should look. And, initiating partnerships that accelerate the pace of innovation for its customers – and establishing a platform for emerging innovators to plug into. Passilla will describe how innovation works at Elavon, give us peek into his innovation roadmap, and explain how he attracts and retains key partnerships while balancing the requirements of his bank parent company, and a regulatory environment that layers added challenges to an already tricky process.
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  • Chitra Narasimhan, Managing Director at CitiVentures, is a payments innovation pioneer. She was tapped by Ken Chennault at American Express in the early to mid 2000s to develop both its Corporate Development and its Enterprise Growth initiatives – two groups that are at the heart of the innovation we see coming out of that 163-year-old company today. Now, as a driving force for CitiVenture’s incubation initiatives, she seeks out the next generation of innovators for Citibank. Narasimhan has, therefore, walked the high wire between corporate priorities and innovation imperatives many a time. Her advice for both innovators and investors is consistent: “Believe in the idea and don’t forget the big picture,” a nod to the slippery slope that consistently focuses on what’s wrong and not what’s right about what an idea can bring to both. Narasimhan will offer her insights about how to structure innovation inside huge financial institutions and then make investments that fulfill corporate commitments but don’t stifle emerging innovators.
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 These insights will be brought front and center to The Innovation Project 2013 delegates by Lerner and Diane Offereins, President of the Discover Network. Offereins was handed the reins in 2008 and given responsibility for Discover Network, PULSE and Diners Club International. But it was she who first thought about licensing the Discover network to other innovators to propel their innovation agenda four years ago. “We are kind of like a startup business,” Offereins says. “We have fierce competition with two established players in the market. We cannot use a me-too strategy. We need to be different. We need to be way more creative.” And way more creative she has been. Announcing the PayPal partnership in August 2012 was the result of that four-year journey that laid the groundwork for an entirely new innovation architecture at Discover; one that, frankly, rocked the industry when it was made public. The strategy that Offereins used to move that ball down the field, the incentives that were needed in order to get organization on board and aligned a new vision for its future, and what’s next for the sector will be the topics that she’ll use to challenge this panel and IP 2013 delegates to think differently about designing innovation. 

Key questions that she and Lerner will pose to this roundtable include:

  • Does payments pose any unique problems for innovation in large organization or is it just like innovating anything else?
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  • Discover is an innovation introduced by a very large company — Sears. How did Sears pull off creating a viable fourth payments network that’s worth billions and what does this teach other companies that are interested in doing something big?
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  • Are there other Discover/Sears plays in payments? If so, where do you see them happening and when?
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  • Groupon was a small firm innovation that Google was about ready to plunk $6 billion down to buy. How can large companies avoid getting caught up in the enthusiasm for the next big thing and avoid overpaying for ventures that may be promising but completely overvalued?
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  • Can strategic partnerships with new ventures help an organization stay innovative? Why not just structure those and avoid making financial investments?
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  • The rapid rise of smart mobile devices caught a lot of companies off guard, including a lot of savvy and hip high tech firms. Two questions: Can corporate innovators do a better job of predicting disruptive innovation and its implications for their own innovation? And are there any lessons for how companies should rejigger their innovation agenda when there’s a sudden change resulting from drastic innovation?
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  • What the biggest failure in innovation that you’ve seen from a large company in payments and how could it have been avoided?
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  • How do you avoid overpowering the innovative ideas that are brought to you by emerging ventures? How do you decide which to pursue and why? How do you motivate that individual or that group to continue to bring you new ideas?
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  • How do you know when an innovative idea has run its course and when to shut it down? Is the metric for that different in payments?
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  • How do you convince innovators that you really aren’t the dinosaurs that they think you are — and make them love you long after the check has been cashed?
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  • What internal and external forces have made innovation more difficult in the last three years? What needs to change going forward? And do you think it will?
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