"If Hewlett Packard knew, what Hewlett Packard knows--we'd be three-times more productive." - Lew Platt, former CEO of HP
The two main types of innovation
Many companies including large corporations have “Innovation” at the core of their values and - given the bell curve of a normal product life cycle - it goes without saying that companies cannot survive in the long run without a healthy product pipeline fueled by innovation. However, while startup and emerging companies are defined by innovation, larger companies often struggle with the concept. They come up with a lot of ideas that have the goal to foster innovation and to capture the creative potential of their vast workforce. Often, they create "innovation task forces" that are chartered to drive innovation. Ideas that these task forces come up with include establishing innovation days, conference-type meetings/exhibitions, online idea repositories, and so on. While these efforts are commendable, in reality, the outcome tends to be rather moderate - especially when considering the many creative minds these companies have access to. The following opinion article is investigating the reasons for this.
For the present discussion, it is important to distinguish between Endogenous Innovation (In-house Innovation) and Acquired Innovation (often referred to as Open Innovation). Endogenous Innovation is the process of harvesting the creative minds of a company’s workforce with the goal of filling the innovation pipeline. In contrast, Acquired Innovation happens when a company gains access to innovative ideas of other companies through a variety of processes including exclusive and non-exclusive licensing deals, OEM and VAR partnerships, joint ventures, as well as M&A activities. Endogenous Innovation has several important advantages over Acquired Innovation considering that it is much more cost-effective and builds in-house expertise that is invaluable for both effective product support as well as the development of meaningful and commercially successful product extensions. Looking more closely at large life science corporations, it is apparent that they are very successful at filling their product pipelines through Acquired Innovation especially through the acquisition of emerging and startup companies with breakthrough products. However, these companies often struggle with Endogenous Innovation. As a consequence, they tend to spend much more money on innovation than would be necessary. In the following we will examine the reasons for an unsuccessful Endogenous Innovation process and ways to innovate more cost-effectively.
Why Endogenous Innovation fails in large life science companies
There are two main reasons hindering Endogenous Innovation in large life science corporations: The companies are risk-adverse and the company’s decision makers are often not domain experts and don’t understand the trends of their target markets or customer needs.
Many novel technologies only see the light of day because they have a technology champion that understands the unmet needs of a market segment, who has the creativity and technical knowledge to invent a viable solution and is able to convince investors to risk their money by funding the development. In the startup environment, it is a known fact that somewhere between 75% and 90% of all startups will fail – depending on the definition of success. Investors that are risking their money know this and select their opportunities accordingly so that that even with the low success rate they are able to multiply their investment. Risk and failure are part of the equation and are seen as necessary in order to find the gold nuggets among the rubble. It is true that successful serial entrepreneurs will have an easier time finding investment money, but entrepreneurs are still likely to get money for a second or third project after failing, if they conducted an intelligent post-mortem and are able to point out why their new idea will succeed, when the old one failed.
In large, publicly traded companies, failure is almost never part of the equation. Employees are being punished for taking risks and people are not given a second chance. When projects fail, these companies are simply moving on to the next project without looking back, as the past failure is more seen as an embarrassment rather than a learning opportunity. Often, moving on means acquiring a company with a technology similar to the one they failed to develop in-house, thus adding the cost of the acquisition to the cost of the lost R&D dollars. In such a risk adverse environment, most Endogenous Innovation projects that do succeed are not exciting breakthrough innovations but instead incremental improvements to existing products - something safe and familiar both to the developers as well as to the executive management.
When investors or the board of directors realize that a company's innovation process is too expensive they put pressure on the executive management to improve these numbers. In response, the management team creates the above-mentioned innovation task forces that are asked to boost in-house innovation. It is not uncommon that such task forces that have the mandate of creating ideas for breakthrough innovation are, in fact, able to come up with a list of promising breakthrough products. This is because people on the task force tend to be technical and market experts. One of the reasons that more often than not none of these products ever make it to the market is that funding for internal product development is typically orders of magnitudes smaller than the funding for external acquisitions. Another reason is that the decision makers (executive management and the level below) are not equipped to decide which project has the highest market potential, which brings us to the second topic: executive leaders are often not domain experts and don’t understand market trends and customer needs sufficiently.
Executive positions in large life science companies are both scarce as well as attractive in terms of salaries and benefits. During the process of electing the next leaders of a company, the ability to understand the company’s financial statements as well as the ability of self-promotion are probably the most important qualities in a future leader to win over competitors. Understanding market an
d customer needs, technical trends, alternate and competitive technologies, or even basic scientific knowledge are very low on that list even for chief technical officers. It is, therefore, not difficult to understand why it is a challenge for the leadership team to select internal projects that have the highest potential for success in the marketplace. In fact, it is a common occurrence that valid market data are completely misinterpreted, put out of context, or simply misused to gain more personal influence. Internal innovation projects are selected and dropped almost at random with no long-term vision or an insight into future customer needs. It is also one of the main reasons why internal early stage innovation projects (Endogenous Innovations) only receive a fraction of the funding that the same projects get when they are acquired from other companies (Acquired Innovations). It’s simply based on the non-admitted uncertainty that stems from not knowing which innovation the market is looking for. Once the same technology has been validated through investors and initial sales, the uncertainty level shrinks and the amount of money that is made available for the acquisition is orders of magnitude higher than the internal development would have cost.
The best way to reduce the amount of money spent on innovation is to recognize the difference between Endogenous and Acquired Innovation, deciding on one main innovation strategy and then executing innovation accordingly.
Making Acquired Innovation work
As pointed out earlier, a lot of money is wasted if a company tries to execute the more cost-effective Endogenous Innovation, fails, and then has to shift back to the more expensive Acquired Innovation. Acquired Innovation is a viable strategy that many companies do anyhow. But deciding that this is the main mode of innovation would allow to reduce their R&D budget significantly. Most scientific technology companies spend between 3 and 10% of their revenues on R&D efforts. For the larger ones this amounts to several hundred million dollars. In many cases, these R&D dollars are split between early stage development projects and incremental product extension projects. Companies that focus on Acquired Innovation should probably not spend more than 2-4% of their revenues on these R&D projects, focus on product extension projects, and instead beef up their M&A teams. Following this strategy, the companies would save money, while becoming more effective at filling their product pipeline with innovative products through effective M&A activities. This way, technology companies can focus on their core competencies such as engineering, production, marketing, sales, and support. Innovation can remain a core company value as long as everybody understands that the overall strategy is focused on Acquired Innovation.
Making Endogenous Innovation work
Endogenous Innovation is the most cost-effective form of innovation. Let’s consider the development cost of a novel moderately complex scientific instrument from scratch. There is obviously a very wide range depending on how many years it takes to make a groundbreaking discovery. But typical instrument development costs are between $10 million and $50 million. This would mean that –theoretically - with an R&D budget of $100 million, a company could develop between 2 and 10 new instruments from scratch each year (of course in reality those numbers are much lower for obvious reasons). The acquisition of the same 2-10 instruments from third parties will cost by definition a multiple – as investors/companies aim at receiving a multiple of their investments. It will still be more cost-effective even if some projects fail. The advantages are clear but in order to switch from an Acquired Innovation model to an Endogenous Innovation model, companies have to make significant changes from the way they operate today. In many ways they have to create a microenvironment that works in very much the same way as the external startup/investor environment works. In particular that means:
Create a compelling company vision. It pays to invest into hiring a visionary who is a domain expert and understands the market as well as the customers. With the right vision and strategy in place, it is much easier to eliminate product proposals that don’t fall into the right space and focus on those that utilize a company’s core competencies.
Create a prioritized list of new product ideas. It would still be useful to use the tools of the innovation task forces such as the innovation days, idea repositories, etc. and come up with a list of breakthrough innovation ideas. But the teams would then need to be given the freedom to do more in-depth market research and create a well thought-through business proposal for each that are of the same quality as those required for external investors. The visionary/domain expert would act as the overall decision maker choosing the ones that make it into the product pipeline. The result would be a prioritized list of new products to be developed endogenously.
Fund the in-house product development appropriately. The next crucial step is to make sure the in-house projects are funded as merited. Endogenous Innovation can only become a company’s main strategy, if the majority of the R&D dollars (and a good portion of the dollars that have been traditionally reserved for M&A activities) is spent here. Having a visionary/domain expert in charge of innovation will also significantly reduce M&A spending, because promising technologies can be acquired years earlier and orders of magnitude cheaper – before those technologies have been externally validated through investor spending and initial sales.
Remove company silos. Almost all life science companies work in silos (matrix). While it is useful from a management and resource sharing perspective, it creates major hurdles for identifying the most promising breakthrough innovation. The reason for this is that each division (or department, group, section, etc.) is responsible for their own financial health. As a consequence, divisions are competing for R&D dollars as novel products are seen as the easiest way to ensure a department’s growth. As a consequence, the department with the most compelling (or loudest) advocate will get most of the R&D funding while more promising projects (with a quieter advocate) may not get the funding they warrant. This means that it is not uncommon that the most promising technologies with the largest potential for the company overall don’t win the bid. Instead internal politics, department interests, and huge (if largely exaggerated – often by orders of magnitude) sales projections in new business proposals will determine the split of the R&D dollars. In this situation, a visionary/domain expert who is responsible to the company overall but not to a specific department could ensure that the most promising project will get funded.
In order for a company to have a healthy and commercially successful innovation pipeline, many more pieces need to fall in place. Every part from prototyping, beta testing, the launch/commercialization process and post-launch activities all play an important role. This article was taking a look only at the two main strategies of creating an innovative product pipeline: Endogenous- and Acquired Innovation.