4: Have a Connection to the Money

How do you measure the results of an innovation programme? Do you count the number of new ideas you generate? How about the number of things your innovation team has worked on, or the number of new product introductions they’ve made?

These are useful measures, but don’t justify the existence of an innovation programme by themselves. There is only one thing that will do that: a connection to finan­cial results.

This is true whether you are running an innovation effort in the private sector (in which case you will be about creating new revenue), or the public sector (with a financial measure around cost sav­ings).

For most innovators, the financial hurdle they need to reach is quite simple: the portfolio of projects selected must recoup the operating costs of the innovation team, and return a premium above attractive enough to divert investment from the (perceived) safety of business-as-usual.

Consider a scenario where an organisation can choose to invest in, say, a Lean initiative on one hand, or an innovation programme on the other. Let us imagine the Lean initiative will result in a 20% return on invest­ment as bloated processes are thinned down and operational efficiencies are found.

Excluding their operating costs, innovators must find ways of making at least a 20% return on their efforts to be attractive for investment. This, however, is more challenging than it first appears for several reasons.

Firstly, it is probable that 8 of ten things innovators try will fail. This is a quite good success rate, actually, but has implications for financial returns – the two successful innovations must return enough to cover the costs of these failures. In other words, the two successes will have to go a lot further than their 10% contribution each if the innovation team is to be considered a better investment than Lean.

Secondly, the innovation team will have a challenge of timing.

The Lean investment starts making financial returns immediately. Innovations, however, rarely deliver so quickly. Genuinely new things take a while to catch on. It is an unusual innovation which can cover its costs in the same year as investment is made.

The two successful innovations, then, will only be favourably compared to Lean if they ramp up to big returns quickly.

All this makes it look as if a Lean programme will be more certain than an innovation investment.  As you can see, justifying innovation in terms of returns can be challenging.

So difficult can it be to get a reasonable comparison in situations such as these, innovation teams often retreat to “mushy” metrics such as number of ideas captured, speed of idea development, or any number of other non-financial measures.

They get away with doing so for a limited period of time, but sooner or later, they’ll be called to account. Previously excited stakeholders will start to ask what they’re getting for the money they’re committing. They’ll begin to wonder whether they might have gotten better outcomes by investing in, as we saw, something like a Lean initiative.

This will likely happen inside the first year and a half, and innovators will be asked to justify their budgets. Though every­one will agree the team has done “valuable work”, the only justification anyone will really con­sider valid is the finan­cial one.

In any event, if all other available investment opportunities can justify themselves financially, and it is only innovations that can’t, it is obvious where a rational business manager will direct future funding. This is especially true during a downturn, or any other time an organisation is under stress.

So innovators need to pay their own way if their programmes are to exist in the long term.

Some innovations, of course, do not have financial returns at all. For example, productivity improve­ments, particularly those based on information technology, often don’t have real money returns. Obviously, there may be a lot of value in doing such things, and a sophisticated innovation programme will certainly pursue them, re­gardless of the likelihood of getting them to pay.

How, then, does an innovation programme with an overall imperative to make excellent returns find a way to work on things which don’t make any money at all?

The answer is it must have a portfolio of innovations, most which pay, and some which don’t. There will need to be more of the former, of course, and the ob­vious implication is the innovation team would certainly de-prioritise those innovations without decent financial returns un­til it has paid the bills.

The observation that you need to make reasonable returns on any money invested in an innovation effort leads to a further question: how much up-front investment does a young innovation programme need to get started?

The natural temptation is to ask for as much money as possible. In other parts of most organisations, having more money means you have more control, more chance of doing big things.

But control of a big budget is a mistake for new innovation teams because it makes it certain they will miss expectations sub­stantially. Here is the reason.

When you start innovation projects, especially if they are more radical than incremental, the delay between investment and revenue can be protracted.

Let us take another hypothetical example. Let’s imagine the best invest­ment available to an organisation has returns of 49% in year one. That’s unrealistic, I realise, but I use the number to illustrate the point.

Let’s further imagine the innovation programme is spending a million a year in cash. In order to beat the best available alter­na­tive, they need to return 50% on their investments in year one. If the innovation team has made ten 100k investments in that year, and their (relatively standard) failure rate is 80%, the team needs to deliver two projects with returns of 750k each in the first year.

This is not really a very big ask: often you can do such a thing with a few properly screened innovations that touch high vol­ume transactional processes in incremental ways.

Now let us imagine a much bigger programme, say one with 10 million or so to spend.

To get to 15 million in returns (assuming the same success rate as before), you’d need to make a hundred 100k investments. The twenty investments that succeeded would each need to return at least 750k.

However, a starting-out innovation team is simply not going to have the bandwidth to run a hundred small projects at once. They have no choice but to reduce the number of investments, and concentrate on much bigger projects.

Given that, then, let us say the innovators make ten invest­ments of a million each. Now, in order to be better than the best available alternative investment, 2 of those ten investments have to return 7.5 million in the first year.

Now, you’ll recall earlier I pointed out that most genuinely new things take a while to ramp up to decent returns. Potential adopters of innovations take time to make their decisions about whether to proceed or not, and usually they’ll want to hear positive messages from people they trust before they do so. This doesn’t happen quickly, at least at the start.

In fact, the only innovations which ramp up to massive returns quickly are those very, very few products which are hits. iPad and iPhone were hits. The movie Avatar was a hit. The drug Viagra was a hit. But by far the majority of new introductions come nowhere close to the take up of these examples. The ordinary course to profitability is much more protracted.

What is the chance of having two hit products from ten investments? Very slim indeed.

In almost every case, it is better to ask for less money and grow slowly to the point where it is possible to do a hundred projects at once.

The challenges faced by a large-budget innovation programme do not stop there, however.

Because such a programme must do things at scale immediately, it will come to the immediate notice of those who run the primary operations of the firm. Moreover, the innovation team is likely to conclude (given their inability to guarantee the hits they need to make their numbers), they should invest in projects which touch core operations in fundamental ways.

There will be an immediate backlash from the core when this occurs. As I’ve mentioned previously, rational managers accountable for these operations are highly motivated to ensure nothing is done to change the status quo. In their fight back against the innovators, they have powerful weapons available to them. If nothing else, they are able to point to the high failure rate on innovation projects as evidence they should be closed down. Their arguments will be particularly cogent, given the fact any competent firm will execute its core operations perfectly most of the time.

Considering all this, it is much simpler to start an innovation programme with smaller budgets, because the possibility of making decent returns is much greater.

Is it reasonable that innovation be compared to mainline business operations already established? Of course it is: a rational business leader will always prioritise investments that support current revenues and opportunities, and will do so be­cause this leads to the lowest risk level for the organisation.

Innovation, on the other hand, is uncertain and (at least per­ceived to be) risky. Whether the innovation team likes it or not, this fact makes it significantly less likely that money will be available. This will be even truer if something happens to the executive sponsor who started the inno­va­tion effort in the first place.

Such sponsorship is one of the prerequisites for long term success, by the way. Given the great difficulty in justifying a large innovation budget in purely financial terms, the protection of a powerful sponsor is needed to ensure toleration for investments that look – on paper – to be less attractive than available alternatives.

Unfortunately, big people in big jobs do, generally, change responsibilities and roles ever 18 months or so. When that happens, the full force of business prioritisation hits almost immediately. The next guy wants to make his or her mark, and killing “risky” stuff that was a holdover from the previous incumbent is easy.

What all this discussion really boils down to, in the end, is the number one priority for innovators once they’ve started inno­vating, is to prove that though their activity has uncertain outcomes in comparison to core business, the returns they generate are eminently predictable and worthy of investment.

Running a portfolio of innovations is the best way to do this. Portfolios of in­novations, just as portfolios of stocks and shares, are much more predictable than the individual components that comprise them.

But getting to predictability leads innovators to another key question: if you have a dollar to invest, do you take a gamble with a single radical innovation that might pay off hugely? Or is it better to take a more cautious approach that leads to returns way more modest, but practically certain?

If one looks only at managing the concentration of risk, you’re better off doing many small innovations. Since innovation is a risky activity, it is certain a large percentage of what’s started will fail. For most firms the failure rate is between 80% and 90%, though it can be considerably higher in some industries.

The key to managing this appropriately is ensuring all these failures are good failures: failures that don’t cost very much and teach innovators a lesson they can use in the next innovation.

But failure is still failure, and it still costs money. By doing many small things in parallel, the innovation team is able to pay for their failure majority with those small numbers of things which are big successes.

The difficulty with this approach, unfortunately, is that it all takes time. Firstly, there’s the need to build up the systems and processes which allow the innovation team to do all those things at once. And secondly, unless the innovators can be cer­tain of their sponsorship (and therefore political protection), they have only 18 months to generate returns which will meet the long term success hurdle we’ve been discussing in this section.

These factors mean that in practicality, innovators who are starting up have to take some bigger risks than they might like to. If one had all the time in the world, the rational course would be a concentration on incremental inno­vations at scale, with the prospect of growing organi­cally into more radical projects when the bills are all paid.

The new innovation team is in a race against time, however. It will, there­fore, need to pick a few more radical projects to en­gage in if it is to ensure it scales up to the returns it needs.

It is impossible to give very many guidelines on which radical innovations should be pursued, of course, but there are two things which are absolutely certain.

The first is doing radical innovation is both more risky and more expensive than incre­mental. New innovators, therefore, should exercise caution and choose the least ambitious of their potential projects which have a reasonable chance of success.

The second, obviously, is en­suring not all the eggs are in one basket. Multiple radical in­novations should be added to the portfolio, since running only one will almost certainly result in failure. In other words, innovators should choose the least expensive of their radical options, to ensure they have the headroom to do as many as possible.

So far, we’ve considered the situation of innovators with too much money, and innovators who fail to get reasonable financial returns. There is one last scenario which is important, and that’s the one where the innovation team has no budget at all.

This is surprisingly common. Management, especially those who are pro­ponents of innovation culture, feel all it takes to get more innovation is the assignment of a couple of people to the task. In many organisations, in fact, finding people is much eas­ier than finding money, so this seems like an easy way to get an innovation effort started.

The problem, of course, is making innovation happen is not just about people and ideas. Execution, which is the differ­ence between having an idea that just sits around, and having an idea which can actually be converted into something useful costs money.

How much money is really dependent on the funding approach that’s applied to the innovation team, and there seems to be two major models around that are effective.

In the first, the innovation team is assigned a small “seed” budget, an amount of money they can use to try out a few things. If their experiments look promising, they are then expected to win the money to take things further from big budget hold­ers, who have to be convinced of the value of their work before they invest. By far, this is the most common model.

The second model is one where innovators have all the money they need in their own right. They can choose to invest, or not, as they see fit. Such a model, of course, implies much larger budgets, with all the dangers we’ve examined already.

However, the situation where the innovators have no budget at all results in certain failure, and here’s the reason.

Before anyone can make an investment decision in something new, there are three key questions to be answered.

The first is “Can we do this?”, and is really technical: are the technologies, production capabilities, management systems, and other artefacts needed to create the innovation available? If not, can they be created at a reasonable price?

To answer this question, innovation teams will likely have to pay for research, for prototypes, and for the time of analysts. It is a rare innovation group that has every skill it needs in-house.

The second key question is “Should we do this?” which really boils down to economics. Before an investment deci­sion can be made, sponsors have to know what the likely costs of the innovation are going to be, how much revenue it will generate (or new efficiency savings, for public sector organi­sa­tions), and over what time frame they will occur. Unless finan­cial analysts are part of the innovation team, they will either have to be borrowed from someone else, or their services paid for.

The final key question is “When?”. This question is, perhaps, the most difficult of all to answer, because it seeks to understand the probable reaction of those affected by the innovation. For start­ers, innovators need to know whether people are ready to adopt whatever-it-is, because throwing an innovation at an audience who really have little interest is an expensive way to fail.

They also have to predict the likely reaction of competitors: clearly if the business case for an innovation is predicated on the premise that no other organisations will be able to duplicate the functionality for some period of time, it is a rather unfortu­nate situation if competitors respond unexpectedly quickly.

To answer questions such as these, there will likely be input needed by marketers, by competitive analysts, and even firms that specialise in knowing what competitors are doing. Once again, this all costs money.

For innovators with no money at all, there are few alter­na­tives but to try to answer the key questions themselves.

Unsurprisingly, this results in poor business cases which are unattractive to big budget holders on account of their paucity of detail. The in­novators wind up tossing poorly formed proposi­tions over the fence for funding, with little or no chance of being taken seri­ously.

Reflecting back on the discussion in this section, it is possible to boil down the financial arrangements of an innovation effort to three big things that must be sorted out early.

Firstly, innovators need to make sure they’re able to justify the investment money they get by making sure they are the best available in­vestment around. Secondly, they have to be sure they don’t get too much money at the start, because new innovation teams simply can’t handle the volume needed to develop decent re­turns at scale without taking unacceptable risks. And finally, they need to consider the funding model their firms adopt for innovation, and if it’s one where there’s no funding at all, the best course is to call off innovation altogether.

Case Study

If you wanted an example of the challenges involved in scaling an innovation programme to make decent financial returns, they do not come much better than Proctor and Gamble, the global con­sumer products giant.

Proctor and Gamble are an example of a company with a Play-2-Win innovation strategy. They know most of their future successes will be driven by innovation activities, as they have been throughout the long history of the company.

Proctor and Gamble competes in fast moving consumer goods across five major categories, and invests most of its effort finding unique, innovative proposi­tions that will build huge global brands.

Most large organisations, if they wish to satisfy demanding shareholders, need to generate growth of between 4 and 6 percent. For Proctor and Gamble, that is equivalent to innovation worth almost $4 billion a year.

By the year 2000, Proctor and Gamble were realising traditional innovation processes, comprising very capital-intensive internal research and develop­ment, were never going to be able to keep up with growth demands of this magnitude.

Analysis of the company’s historical innovation performance showed the capital needed to create growth was increasing at a faster rate than the returns its investments were gen­erating. It was fast approaching an inflection point beyond which further investments would have negligible impact on the fortunes of the company. Not an especially enviable situation for senior leadership, who realised they had to do something significant.

The fundamental issue was Proctor and Gamble had 7500 researchers driving their innovation efforts, but each additional one they hired was delivering incrementally less. The declining return on innovation was the reason capital spending was outstripping returns.

As we’ve seen already, when an innovation team is responsible for everything, you tend to get scale issues. You have to put more resources into a programme to get more results, but in the case of Proctor and Gamble even continual, sustained investment could not outpace the market’s demand for growth.

Their response was itself, innovative. They decided to involve not only their researchers, but every­one else they had any relationship with in their innovation effort.

In doing so, Proctor and Gamble were pioneers of a very radical concept, now known as Open Innovation.

Open Innovation is the strategy adopted when you recognise you have a great deal of intellectual property which is valuable, but presently unused. Similarly, competitors and partners may have assets they aren’t using either, but which may be useful to you. The open exchange of these for fair value is the core proposition of Open Innovation, and often results in significant value for both sides.

By the end of 2000, Proctor and Gamble had made a decision they’d aim to have 50% of their innovations sourced from out­side the company. It made complete sense, since their internal estimates suggested there were at least 200 researchers available outside the company for every scientist within it.

The idea was not to replace the 7500 researchers owned directly by Proctor and Gamble, but to multiply their efforts by leveraging the work of the 1.5 million scientists outside the company.

There have been dramatic results. The company’s innovation success rate has doubled. Overall investment in innovation activities has decreased from 4.8% to 3.4% of sales. But research productivity has increased 60%, and the company has a port­folio of 22 billion-dollar brands.

The result – a financial one – is Proctor and Gamble has seen its stock price double in the years since it made its decision to open its innovation efforts to the public.