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:
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:
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.
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:
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