Dispatches from the Frontier

A Dynamic Portfolio of Options

Ashton Udall over at the Product Global blog makes a couple of straightforward, but frequently ignored, observations:

• Companies have constrained capacities.  That is, they cannot do everything at once.  Furthermore, commitment to a strategy - by definition - consumes a great deal of capacity.  Often, little capacity is reserved for the cultivation of additional strategic and growth options.


• A portfolio of prospective innovations need not be created in one shot; they can be created dynamically over time.

As Ashton points out, it is extraordinary unlikely that a company will get it right with its first shot - even if they use a shotgun.  It sure helps to be aimed in the correct direction, but rapid, iterative learning is still the norm.

A Buyer's Guide to the Innovation Bazaar

In the June 2007 issue of Harvard Business Review, Satish Nambisan and Mohan Sawhney present a framework for understanding the differing roles of Invention Capital, Innovation Capital, and Venture Capital firms in the context of Open Innovation.  In their article, A Buyer's Guide to the Innovation Bazaar, they observe, "Companies can shop for innovation in various stages of development - from raw ideas to market-ready products - with the help of intermediaries."  Along this continuum, there are some key trade-offs:

• Risk and Reach - Licensing agents, patent brokers, electronic R&D marketplaces, idea scouts, and Invention Capitalists can help companies access a broad range of potential innovations, but the uncertainty related to such raw ideas is high.  At the other end of the spectrum, business incubators and Venture Capital firms can provide access to market-ready products in which there is higher confidence regarding market potential.  However, there are fewer such offerings to choose from.
  
• Speed and Cost - Raw ideas are inexpensive, but can take a relatively long time before they are ready for the market.  Market-ready products, as the name suggests, are ready to go (or are already in the market on a limited basis), but are expensive to acquire.  (Click here for the SpinBrush example.)

Per Satish and Mohan, the middle ground is the domain of Innovation Capitalists such as my firm, Evergreen IP.  As I interpret the authors' hypothesis, the unique characteristics of the different intermediaries along the spectrum from raw ideas to market-ready products include the following:

• Invention Capitalists, licensing agents, idea scouts, and electronic marketplaces offer access to the Long Tail of the distribution of prospective innovations.  They create options in an uncertain world.
  
• Venture Capitalists and incubators, on the other hand, are focused on the inflection point between the Long Tail and the Short Head of the innovation spectrum.  The ability to commit increasing amounts of capital in order to progressively resolve uncertainty distinguishes the Venture Capitalists from other innovation intermediaries.
  
• Innovation Capitalists sit at the precarious intersection between the creation and execution of innovation options.

I say precarious, because I suspect that Michael Raynor is probably on to something with his theory of Requisite Uncertainty, in which Raynor concludes that the management of uncertainty (the creation of options) should be separated from the making of commitments (the execution of options).  We at EIP constantly live with the tension between searching, screening, and refining ideas (creating options) and testing the marketability of such ideas by making increasing commitments of time, money, and relationships (preliminary execution of options).  Nevertheless, despite the challenge, we believe that there is value to be generated and earned in the management of a portfolio of real options, including facilitating the selection of options for execution.

Furthermore, Satish and Mohan observe that the relationship between acquiring companies and Invention and Venture Capitalists is fundamentally transactional.  On the other hand, they posit that the relationship between Innovation Capitalists and companies must be deeper:

Companies seeking innovation at the two ends of the continuum focus primarily on the type of innovation they want to buy, whereas in the middle they need to focus on the intermediary.  That is, because of the nature of the innovation capitalist's offering, large client companies need to build and nurture long-term and trusting relationships with selected IC firms.

Satish and Mohan's work is suggestive in a number of ways:

• As an "intermediate intermediary" Innovation Capitalists such as EIP may stand to benefit from cultivating relationships with its counterparts on either side of the development continuum.  We've certainly been doing just that in regard to upstream collaborators.  And, we're in the process of exploring co-development relationships and other downstream collaborations in order to run rapid go-to-market experiments.
  
• An auction may be consistent with the transactional nature of the sale of raw ideas and market-ready products to an innovation buyer.  On the other hand, full-on auctions may be counterproductive to the development of the kind of trusting relationships that Satish and Mohan believe are required for Innovation Capitalists.  Again, we at EIP find ourselves walking a tightrope.

Who said it was easy?  After all, Satish and Mohan call it the "innovation bazaar" for good reason:

Like a traditional bazaar, it can be chaotic and bewildering...Just contemplating a plunge into the hurly-burly of this space can be daunting.

Indeed.

Uncertainty, Consumer Demand, and the 80/20 Rule

Ask the chairman of P&G - the $70 billion consumer goods giant - who is more important to his company's success: Wal-Mart or housewives.  Sure, it's a tough choice, but I suspect that he'd answer "housewives."  In other words, although the Long Tail distribution of market outcomes in the highly competitive world of consumer products is undoubtedly the result of the interaction of supply and demand, it seems likely to me that the dynamics of demand provide the foundation for the emergence of the winner-takes-most characteristic of consumer markets.  Furthermore, the fundamental uncertainty of such dynamics are critically important for an individual inventor (and others in the innovation chain) to understand and appreciate when making investment decisions.

Skewed Demand

Robert Cialdini wrote Influence: The Psychology of Persuasion, one of the best selling books of its kind over the last decade or so.  In it, he notes the following:

In general, when we are unsure of ourselves, when the situation is unclear or ambiguous, when uncertainty reigns, we are most likely to look to and accept the actions of others as correct.

In the context of buying decisions, we tend to look to others to the extent that we're uncertain about what movie to watch, book to buy, or music to listen to.  It's a reasonably rational strategy in an uncertain world.  More generally, our buying behaviors are more likely to be socially contingent to the extent that the promised value is qualitative, experiential, and emotional.  That's important, because the dynamics of "social contagion" or "information cascades" are characterized by threshold rules or tipping points that are the signatures of "power law", "scale free", or "Long Tail" distributions.

As Chris Anderson has explored in a book, his weblog, and a downloadable manifesto, many consumer markets can be described in terms of a "short head" composed of a handful of hits and a "long tail" composed of everybody else.  This is popularly known as the 80/20 rule, in which 80% of the revenue is generated by 20% of the products.  Although directionally correct, the relative proportions aren't fixed.  For example, data from the book business shows that something like 87% of book sales are attributable to just under 8% of the 1.2 million books published in a recent year.  In other words, the book publishing industry reflects something like a 87/8 rule, which might look something like this:

(Distribution generated by demonstration tool developed by Fiona Maclachlan.)

Movies, similarly, seem to be distributed according to something like an 80/6 "rule".  Clearly, books and movies fit the criteria of qualitative, experiential, and emotional.  But, what about more tangible and objectively functional consumer products?  Well, even sporting goods, for instance, are well described by something along the lines of a 60/10 rule:

In any case, the improbable (i.e. hits) dominate the distribution, a point that Nassim Nicholas Taleb makes more generally in Fooled by Randomness and The Black Swan.  The implication for inventors of consumer products is sobering: Given a market composed of 100 distinct offerings, a 10% market share implies a #2 market ranking.  If your product's sales rank falls outside of the top 10%, your market share is likely to fall below 1%.  That is why, in my previous post, that I suggest that even in a success case, the range of revenue for a new, compelling product in a $400 million annual market might range between $4 million and $40 million and his most likely to be at the low end of the range.

Many times when we use words such as likely or expected, we are referring to the average or the mean of a distribution.  That makes a lot of sense if the distribution is the familiar bell-shaped curve, or normal distribution.  But, the average has no meaning (i.e. there is no representative scale) in the case of highly skewed Long Tail distributions.  In such cases (which, ironically, may be the more normal when it comes to the demand for consumer products), the median or mode of the distribution are better indicators of "likely" outcomes.

Democratizing Supply Effects

Although I think it is appropriate to focus on demand dynamics, Chris Anderson has some interesting hypotheses regarding changes on the supply side.  More specifically, he sees three key trends:

• The tools of production are becoming less expensive and more widely available.
  
• The cost of inventory and distribution is falling.
  
• The cost of search - the matching of supply and demand - is falling.

While most pronounced in the digital world of entertainment products such as movies and music, these trends extend to the physical world, as well.  P&G has explicitly acknowledged the democratization of invention - the fuzzy front end of production - in its embrace of Open Innovation.  As I wrote about here, the emergence of readily accessible and relatively inexpensive CAD software and expertise, rapid prototyping, rapid manufacturing, just-in-time inventory management, and various direct marketing techniques may mean that the distinction between digital products and physical products is more blurry than we commonly assume.

Anderson believes that these trends will shift the relative proportion of demand away from the short head toward the long tail.  But, Anderson acknowledges the continuing importance of hits, while offering hope for the masses:

I've described the Long Tail as the death of the 80/20 Rule, even though it's actually nothing of the sort.  The real 80/20 Rule is just the acknowledgment that a Pareto distribution is at work, and some things will sell a lot better than others...What the Long Tail offers, however, is the encouragement to not be dominated by the Rule.  Even if 20 percent of the products account for 80 percent of the revenue, that's no reason not to carry the other 80 percent of the products.  In Long Tail markets, where the carrying costs of inventory are low, the incentive is there to carry everything, regardless of the volume of its sales.  Who knows - with good search and recommendations, a bottom 80 percent product could turn into a top 20 percent product.

Much of Anderson's writing describes the emergence of Long Tail aggregators such as Rhapsody, iTunes, and NetFlix.  More broadly, Google, eBay, and Amazon.com are aggregators in that they provide a platform for reducing the cost of distribution and search across a broad range of products - digital and tangible, alike.  Guthy-Renker, HSN, and EIP are variants on what might be called Long Tail prospectors - firms that search the "Long Tail of things" in order to connect the next hit with the capacities that can take advantage of economies of scale and scope, which remain important in the tangible world.  (In a very real sense, EIP represents a search innovation.)

Implications for Inventors

• Having a great product helps, but there is no linear, causal relationship between the quality of your invention and market success.  (See the suggested reading list below for more.) 
  
• Look at the potential market from the top-down and the bottom-up.  Try to be realistic.  Express your conclusions in terms of a range of revenue.  Divide the result by 10 to give you an idea of the "home run" potential of your product.  Divide that number by 10 to give you a "likely success case" revenue estimate.  Think in terms of probabilities; avoid point forecasts.
  
• Look for ways to run an in-market experiment as quickly and inexpensively as possible.  In highly information-based markets, Anderson notes, "It's more expensive to evaluate than to release.  Just do it!."  (As I noted here, some venture capitalists are beginning to favor market experimentation over analysis, as well.)
  
• Invest assuming the likelihood of modest returns, but recognize that there is at least a small chance that your product will trigger a global cascade of demand.  That is, it could really be a hit.  Consequently, give early thought about how you might sell or license your product to a company that has the operational capacity to take advantage of the hit when it happens, because the window of opportunity is likely to slam shut very quickly.
  
• Respect the unavoidable uncertainty that surrounds the innovation process.  Acknowledge the risk that others - including licensees and customers - are taking in adopting your product as theirs.  On the other hand, don't fear uncertainty - it is the source of disproportionate opportunity.

More Reading

Feedback-driven, complex, non-linear systems are hard to understand and, quite often, counter-intuitive.  In addition to the resources mentioned above, you may find the following useful in your exploration of the Long Tail:

• Critical Mass by Philip Ball - This book goes deeper than The Tipping Point and brings together some of the ideas presented in books such as Emergence, Ubiquity, Nexus, and Linked.
  
• Six Degrees by Duncan Watts - Includes a nice description of the dynamics of information cascades as well as to the limits of our ability to engineer social epidemics.
  
• Hollywood Economics by Arthur De Vany - This is for more advanced readers, but is a terrific resource.

The Long Tail: A Practical Guide for Inventors

The likely sales of a compelling product in a large consumer market is smaller than you think.  On the other hand, there is small - but meaningful - chance that your product could be a runaway hit.  Many, maybe most, individual inventors tend to fixate on the latter and ignore the former.  The results can be disasterous.

The trap is easy to fall into.  Just the other day, an inventor sent me some research that suggests that the total U.S. retail market for products like his may be as large as $400 million per year.  To be honest, my initial reaction was, "That's pretty big.  If this product achieved a mere 10% market share, it could generate $40 million of retail revenue per year."

Maybe, but highly unlikely.

A better range for planning purposes would be to assume that in a success case the revenue for this product may be between $4 million and $40 million.  Furthermore, the most likely outcome will be $4 million or less.  In contrast, a typical inventor might assume that $40 million represents a success case, while, say, half of that - $20 million in revenue - might represent a conservative case.  The difference in expectations is very likely to drive quite different investing behavior, for starters.  In other words, an inventor who is convinced that his product can generate retail revenues of from $20 million to $40 million is likely to behave differently than an inventor that believes that his product could generate revenues as high as $40 million, but is most likely to generate revenues of $4 million or less.  The distinction could be the difference between a strained marriage and divorce; a smaller savings account and personal bankruptcy.

Consequently, I strongly recommend that inventors devote some time toward understanding the implications of the Long Tail distribution.  To that end, I'm going to summarize my understanding as succinctly as possible in my next post.  I hope it helps.

Entrepreneurship in Montana

John Cook, a venture capital reporter in Seattle, quotes a recent study that names Montana as the most entrepreneurial state in the U.S.  Heck, nobody is going to hire us, so we have to create our own work.

The Cost of Failure Falling...Success Remains Elusive

William Goldman, the playwright and author, once said of Hollywood, "Nobody knows nothing."  A little farther up the California coast, some Silicon Valley veterans are publicly admitting as much about the hit-and-miss nature of Web 2.0 startups.  In a recent profile in The Wall Street Journal [1] technology evangelist Guy Kawasaki notes:

If you raise $2 million from VCs, you have to pretend like you "know" all this stuff.  The truth is whether it's $12,000 or $2 million, you really don't know.  The only difference is what you think you can admit.

Quoted in Business 2.0 [2], Blogger founder Evan Williams chimes in:

More and more of us are becoming aware that you don't necessarily know what is going to be successful.

Why the sudden outbreak of candor?  For starters, there seems to be a growing realization that the returns to a Web 2.0 company are wildly uncertain. Investor and entrepreneur Naval Ravikant asserts:

The Web is the most hit-driven business the world has ever seen.

Possibly, but the hit-and-miss nature of Web 2.0 companies is not unique.  The market outcomes of a host of other businesses, including movies, music, and books are subject to long-tail economics, where a small number of offerings account for the bulk of revenues:

In fact, research shows that a remarkably broad range of consumer products, from food to sporting goods, can be similarly described [3].

Secondly, the cost of failure is falling.  As Kawasaki puts it,

During the dot-com bubble, you needed $5 million to do stupid ideas.  Now you can do stupid ideas for 12 grand.

The implication for these entrepreneurs is to predict less and experiment more.  To do that, Ravikant has launched Hit Forge:

This is like a movie studio.  It's about milestone-based development, piloting concepts, access to distribution...The engineers have the freedom to experiment, but they have 90 days to ship a product.  The product has to grow orginically without any marketing.

Those that survive get more funding and access to distribution.

We are going to build as many as 20 companies a year.  We need to find one hit to succeed.  We can do that.

Possibly, but the challenges are considerable:

• It's tough to manage 20 experiments in parallel.  That becomes particularly true when one or more of the experiments begin to exhibit some market traction and one must face the various challenges of scalability.
  
• Given confirmation and escalation bias, it is tempting to throw most of one's eggs into one or two promising baskets, which is very risky.
  
• On the other hand, absent substantial commitment to a product or project, it's very difficult to defend an early market lead.

Though it may be difficult to effectively manage a dynamic portfolio of real options, it beats the fool's game of making big, irreversible predictions in the face of unanalyzable uncertainty.  Jim Armstrong of Clearstone Venture Partners may be right when he asserts, "The old way of building companies is broken, and [Ravikant's] way could be the future."

Nevertheless, I can't help but think of a recent interview of Ingmar Stenmark, the most successful ski racer in World Cup history.  When asked about the impact of modern equipment on ski racing, he said that while skiing has gotten easier, winning is as hard as ever.  Similarly, although it may be easier and cheaper than ever to play in the startup and new product games, it is not likely to become any easier to win.  I'm confident that we can proactively tilt the odds in our favor, but a little (or lot) of luck is welcome.

[1] Gomes, Lee; In New Net Economy, Everyone Gets to Be Stupid for 15 Minutes; The Wall Street Journal; May 16, 2007.
[2] Copeland, Michael V.; Return of the Startup Factory; Business 2.0; May 7, 2007.
[3] Kohli, Rajeev and Sah, Raaj; Market Shares: Some Power Law Results and Observations; Revised November 21, 2003.

Spin Pop: A Black Swan

I made a discovery this weekend...I found a Spin Pop in my kitchen drawer:

The transformation of the Spin Pop(TM) into the Crest SpinBrush(TM) has been touted by many (including me) as an exemplar of Open Innovation.  I'm less sure about that today, but the SpinBrush story is, nevertheless, an entertaining one:

• The success of the SpinBrush - at least for John Osher and his collaborators - was a Black Swan.  Who, in their wildest dreams, imagined that an investment of a bit over $1 million in a novelty candy item was going to yield a total payoff of nearly $500 million (!) within four years?
• Linear extrapolation is dangerous, but it apparently worked out nicely for Osher et al.  I infer from various magazine articles that P&G had agreed to a final payout based on some kind of multiple of trailing revenues.  In the context of a fairly mature, diversified consumer product company, this kind of backward-looking, multiple-based valuation model might be considered appropriate - maybe even conservative.  But, in the context of a single product, it's far from conservative.  Individual products can, and do, reflect exponential growth in the short-term.  It appears that P&G got caught by a valuation model that multiplied the effect of unsustainable (and, ultimately, unsustained) revenue growth.
• When something this unexpected happens, most of us can't help but develop narratives to explain how the unexpected was inevitable.  A Harvard Business School publication provided a nice example of such retrospective prediction when it called the SpinBrush a "clear winner" - after the fact.

If you aren't familiar with the SpinBrush story, here's my understanding of the general timeline:

1998: John Osher and his colleagues at Dr. John's invest $1.5 million towards the adaptation of the Spin Pop technology (which they had previously licensed to Hasbro) to the disposable toothbrush market.  By all accounts, Dr. John's deliberately took aim at selling or licensing their innovation to P&G.

1999: Dr. John's runs limited market tests via selected retail outlets.

2000: Dr. John's sells 10 million units.

2001: Dr. John's is sold to P&G for an upfront payment of $165 million plus a payment in three years to be determined by a formula based on actual financial performance.  Presumably, this is some kind of fixed multiple of trailing revenues.

2002: Under the Crest brand, P&G generates sales of $200 million.  SpinBrush is the best-selling toothbrush in America.  P&G negotiates a final settlement with Dr. John's, which results in a payment of $310 million nearly two years ahead of schedule.

2005: SpinBrush revenues have declined to $100 million.  P&G forced to divest SpinBrush as a consequence of its acquisition of Gillette.  Church & Dwight buys SpinBrush for $75 million.

That must have been one wild ride.  I'm just thrilled to have a souvenir.

Where is the Venture Capital for Consumer Products?

The use of tangible consumer products constitutes a large portion of the economy.  Some of the largest companies in the world - from P&G to Wal-Mart - are engaged in the manufacture and sale of physical, consumer-oriented products.  Clearly, there is money to be made in consumer products - even in the information age.  So, why isn't there any venture capital that specifically targets consumer product ventures?

Sure, there are later-stage private equity firms that acquire and consolidate established consumer product and service companies.  I'm talking about institutional capital that will help guide and fuel the growth of young companies.

The standard answer to my question relates to the scalability of consumer product companies.  It's just harder (and possibly more expensive) to grow a consumer products company fast.  That's important to a VC for a number of reasons, including the following:

• VC's are motivated to maximize the internal rate of return on their investments, which places a premium on reducing the time to exit.
  
• The clockspeed of the consumer product industry is becoming faster, which means that the average lifecycle of a product is becoming shorter.
  
• Consumer products are marked by winner-takes-most dynamics and, consequently, wild uncertainty.

So, how fast must a company be able to grow in order to warrant a venture capital investment?  Given the unabated demand for innovative products, what are the alternatives to venture capital?

Answers are of more than academic interest to my colleagues and me at EIP.  To help myself think through some of the possibilities, I engaged in a thought experiment this weekend that resulted in my constructing  a dialog on scalability (Flash) among a fictional VC, the chief marketing officer of "NewCo," and the company's chief operating officer.  I found it worthwhile, and I hope you might, too.

Although outsourcing and other business network techniques can be used to enhance the scalability of consumer product companies, I suspect that we'll see the emergence of an adapted form of venture capital in this sector.  Furthermore, I suspect that the adaptation will look less like the information technology-driven variant found in Silicon Valley and will look more like the symbiotic relationship among biotech firms and big pharma.  In other words, new consumer products will be identified, developed, and market tested by very small firms with the specific intent of licensing or selling the underlying intellectual property (IP) to established players that already have built capacity.  Very small firms are better suited for exploring highly ambiguous territory, and larger companies are well-suited for scaling an individual product by leveraging existing manufacturing and marketing capacities.

Furthermore, I wouldn't be surprised if the relationships among the players in this innovation ecosystem are relatively close-knit.  On average, I suspect that the effective IP protection afforded a consumer product is somewhat less than the IP barriers that can be erected by a biotech company, for instance.  Although we tend to think of technology industries as being fast moving, the real speed champions are found in the consumer sector: the expected life of a novel or movie is measured in weeks.  Although those are extreme examples, the lifecycle of a tangible consumer product is rarely more than a few years.  Consequently, I expect to see more co-development agreements between Bigcos and NewCos in which the former provides money and technical expertise in exchange for some kind of option, and the latter provides domain expertise, focus, and risk mitigation.

Already, the consumer product world tends to be split between the very large and the very small.  Uncertainty makes the landscape dangerous for the very large (e.g. watch GM disappear before your very eyes), and physical realities and accelerating clockspeed conspire to make it very difficult for small companies to grow into big companies without becoming casualties of their own success.  It would seem that the very big and the very small need each other to survive and thrive.

Lumpy Payoffs

I've highlighted numerous passages in Nassim Nicholas Taleb's latest book, The Black Swan.  Here is one of them:

Many people labor in life under the impression that they are doing something right, yet they may not show solid results for a long time.  They need a capacity for continuously adjourned gratification to survive a steady diet of peer cruelty without becoming demoralized.  They look like idiots to their cousins, they look like idiots to their peers, they need courage to continue...The problem with lumpy payoffs is not so much the lack of income they entail, but the pecking order, the loss of dignity, the subtle humilitations near the watercooler.

Taleb's advice?  Avoid watercoolers.

Fortunately, there are few watercoolers to be found in Bozeman, Montana.