I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Tuesday, October 31, 2017

The Would-Be Innovator's Dilemma

It is appealing to think of your trading partners and competitors seeing your company as an industry leading innovator. More soberly, you know it's only a matter of time before the fundamental economics of your business shift not only out of your favor, but out of what you've always known them to be.

Unfortunately, as we saw last month, innovation is an increasingly expensive game. You aren't the pied piper who will lead industry change, nor can you afford an escalating arms race developing weaponized technology. How do you play the innovation game to win if you don't have infinitely deep pockets to finance voyages of discovery and if you don't have the clout or the charm to convince others to finance your vision?

Do You have the Financial Profile of an Innovator?

It is unrealistic to ask a debt-laden utility to suddenly find its creative mojo. Because it must extract maximum cash flows to service its capital structure, it is organized for maximum operating efficiency. Given that efficient utilities are intolerant to irregular operations, it goes without saying that they are similarly allergic to excessive bouts of creative thinking.

Companies that loaded up on debt in recent years have taken themselves out of the innovation game. Innovation is risk, and equity - not debt - is risk capital. A company that is serious about innovating cannot be beholden to investors demanding predictability. It must have sufficient high-risk capital to engage in high-risk investing.

Changing capital structure doesn't imply foregoing operational discipline. Ambitious innovation - that is, not the incremental kind - is expensive. The bigger your war chest, the longer you can stay in the game. Not to mention that having positive cash flows from operations means not having to beg investors for cash infusions just to keep the dream alive. Retained earnings are investment capital with the lowest cost of capital a firm can get. The operative word is "retained": operational efficiency doesn't fuel innovation if cash is pledged to investors. In exchange for foregoing distributions, you have to convince investors that they are wagering on value through innovation.

Before you go hunting for innovation, you must first thoroughly understand the financial incongruities in your business model that benefit you so that you can be prepared for them to disappear and, more importantly, set the terms for you and your industry peers for sacrificing them. Technology drives out inefficiency. For example, software firms have had to move away from a lucrative license revenue model (pay up front) to a metered cloud-based subscription service (pay as you go). When you go looking for innovation, expect that you will open Pandora’s box and unleash the commercial forces that conspire to contract those incongruities. More importantly, prepare your own company for the evaporation of easy money and prepare it to compete on different commercial terms - before someone else forces them on you.

Know Your Business, Know Your Commercial Ecosystems

It is alarming how much business knowledge erosion has already occurred. Some because of attrition, some because of acquisition, and some because expensive knowledge workers were swapped out for cheaper labor paid to simply turn the crank. Whatever the reason, you can't have much hope of ambitiously innovating if you don’t have people who know why your customers derive value from you for the things that you do.

That knowledge only covers the current lay of the landscape. You have to have people who understand customer and supplier needs as well as the needs of those who could be but are not doing business with you. You may have deep insights and lots of data about a universe of companies you work with today, but that does you no good if you’re not winning the business of people who will do business with you tomorrow. You can find that out through experimentation, but experimentation without context is just guessing. Context is tribal knowledge. It's hard to win the business of a new generation of buyer if none are members of your tribe (i.e., you don't employ anyone of that generation).

If the definition of value and the foundational economics are are being blurred in your industry, you probably can’t project your idea of the future all alone. That means selling your ideas on partners and convincing them to move in concert. That requires a thorough understanding of your trading partner’s businesses so you can explain why the innovation that is good for your business is also good for theirs.

Build Versus Buy Versus Co-Opt

We tend to think about innovation as something we have to go out and make. Big pharma showed that M&A can be an effective substitute for R&D. One is not a shortcut to the other as each is defined by a complex set of competencies and capabilities. Making requires competency in experience empathy, product management, design, analysis, engineering, analytics and many other skills. Acquiring requires competency in valuation, negotiation, financial engineering, integration (which itself extends to things like corporate culture) and rationalization. Do not go in pursuit of either making or buying in a big way until you build confidence that you have capability to execute competently in a small way.

Of course, the business landscape is littered with expensive technology boondoggles gone awry, and M&A is more likely to be value destructive than value generative. Sometimes the best use of capital is co-opting an emerging threat to the prevailing economics. Whether banks were ever quaking in their boots at unregulated peer-to-peer lenders stealing their most lucrative borrowers, the banks certainly did a good job fueling P2P lending growth to a point of dependency. The tightening of the credit cycle caused banks to pull back their buying, creating a crisis with peer-to-peer lenders that resulted in those would-be disruptors filing for banking licenses themselves - becoming the very thing they set out to disrupt in the first place. Instead of competing by creating a competitive marketplace or buying an emerging competitor, the established banks effectively greenmailed the threat.

Restructure to Innovate, then Innovate or Die

If the easy money of the idea economy has long past, and if “big ideas” are the only ones that will move the needle, then innovation is not incremental but wholesale in scope. This makes it a serious investing activity that encompasses the enterprise, not a lab in the business or a side R&D function. That requires the appropriate capital structure and investors (innovation is risk), the right knowledge (invest in what you know), and the acumen to choose when to act through making, acquiring or co-opting. Leading innovation doesn’t have to mean creating “the next big thing”, but it always means being prepared to exploit it.